Realogy is a long. Realogy is a high quality business we have followed for a long time while we waited for the valuation to come into our targeted range. The stock has moved lower after missing Q1 estimates, which we think is due to a short-term cyclical drop in housing transactions that does not impair the value of the long-term franchise. We believe we are buying a great business with a shareholder-friendly management and significant tailwind as the residential housing market normalizes. In a normalized housing market we think Realogy could earn $3.70 in free cash flow per share which, with a 15x multiple and ~$5 in NOL value, would yield a $61 stock or 60% upside.

Company Overview

Realogy is the world’s largest franchisor of residential real estate brokerages and the largest owner of residential real estate brokerage offices in the US. The company’s brand names include Coldwell Banker, Century 21, ERA, Sotheby’s, Corcoran, and Citi Habitats. The real estate franchise system has 13,700 offices and 247,800 sales associates worldwide; the franchise segment accounts for 13% of revenue, but 55% of EBITDA. The company owned brokerages consist of 700 offices and 42,300 agents and primarily focuses on high value markets, as evidenced by an average transaction value that is 2x the nationwide median. The company owned segment represents 75% of revenue and 26% of EBITDA. Realogy also has smaller, complementary relocation and title insurance businesses which represent 13% and 6% of EBITDA respectively.

Realogy was taken private by Apollo in 2007 with over $7bn of debt and EBITDA of $840M. EBITDA plunged to $240M in 2008 (30x Debt to EBITDA) before rebounding to $400M in 2009 (17.5x). During this time transaction volumes plunged and the company was focused on cutting costs and deleveraging. The company IPO’d in October 2012.

Key Investment Points:

• High Quality Business: Realogy’s franchise business (55% of EBITDA) is a fantastic business. It earns a recurring, commission-based revenue stream for the use of its well-known brand names such as Century 21 and Coldwell Banker, has minimal capital requirements, and 80-90% incremental margins. Though more volatile, the company-owned brokerage segment (25% of EBITDA) is also a quality business due to its trusted brand names and the defensibility of the real estate brokerage commission model. We believe the commission business model will be sustainable from the threat of the internet and for-sale-by-owner due to the key characteristics of real estate: transactions are high dollar value, infrequent, complex, and opaque due to the price variability and the incomparability of homes. The power of the agent model is evidenced by the growth the share of brokerage assisted purchases from 79% in 2001 to 88% in 2013, a time when many other business models lost share to the internet. Furthermore, broker power is apparent in the changing internet business models: a new real estate transaction internet site we spoke with is focused on working with brokers under the existing commission model as the National Association of Realtors is “too strong” to disintermediate. Warren Buffett’s purchase of the Prudential real estate brokerage operations in 2012 also gives us confidence in the sustainability of the model.

• Housing Tailwind: Existing home sales are expected to be 4.8M in 2014, which equates to turnover of 3.9% on 123M US Households.  Normalized housing turnover is closer to the 4.4-4.8% range, which would lead to 5.5-6M existing home sales transactions, an increase of 14-24% above the expected 2014 level. At this level of home sales Realogy would generate $975M - $1.2bn of EBITDA, significantly above 2013’s $796M. Realogy’s business model also benefits from home price increases, which provides an inflation hedge and further revenue growth driver as home prices should appreciate over time.

• Shareholder Friendly Management: Prior to the LBO by Apollo, Realogy bought back $900M of shares in 2006 with the same management team. Management currently is in the process of deleveraging from ~5x Net Debt to EBITDA to a target of 3x, which we think they can hit at the end of 2015 or in 2016. After reaching its leverage target, Realogy will be shareholder-friendly, likely through share repurchases.

Valuation

We acknowledge that while Realogy is a good business, it is also a macro bet on a housing recovery that has both operational and financial leverage. Therefore, it is helpful to understand the effect of various housing scenarios on Realogy’s fundamentals. We think it makes sense to frame three different housing scenario cases to illustrate the impact on Realogy. First, in a base case, housing turnover moves towards the low-end of the historical average at 4.2% or 5.2M existing home sales (only 3% above 2013 levels), in an upside case turnover is towards the higher end of historical averages or 6M existing home sales, and in the downside case we use a trough housing turnover of 3.6% or 4.5M homes. Using a 15x multiple and adding back ~$5 per share in NOL value we get a valuation range of ~$28 to $61.

However, it is also constructive to understand Realogy’s ability to deleverage and grow free cash flow in a very muted recovery scenario. In this scenario, which we assume means that housing turnover stays at 4% or approximately 5M homes and 3% home price appreciation, Realogy should be able to grow free cash flow per share at a 19% CAGR through 2017, in part due to its ability to repay substantial amounts of high cost debt. In this scenario the company should meets its target leverage ratio in late 2016 or 2017 and then be able to return capital to shareholders. In this scenario, we think is conservative, the company could be worth $46-52 per share and we would have a free call option for a housing recovery.

Risks

Housing downturn / Interest Rates: Realogy is a macro bet on housing. We think housing turnover is still at low levels and that there is more likelihood that it overshoots to the upside as lending standards ease than moves back to levels following the financial crisis. However, housing is interest rate dependent so a spike in interest rates will have a detrimental impact on the housing market and Realogy.

Internet competition: Internet businesses have attempted to disrupt the real estate brokerage model, however nothing has been able to break the commission structure as brokers control the market, have an incentive to keep others out, and home buyers/sellers value the services a broker provides in what is an infrequent and highly valuable transaction in their lives.

Broker competition: Franchisees and new entrants may poach high performing brokers from Realogy, hurting revenues and potentially increasing the fee splits paid to brokers. Though this can happen on a small scale, there is no evidence that it is hurting the Realogy commission splits. Realogy 98% retention rate also mitigates this threat.

Leverage: Realogy has significant operational and financial leverage. At 5x net debt Realogy is well above its 3.0x leverage target, although we expect the company to deleverage rapidly in the next 2 years, getting to its leverage target at the end of 2015.

Appendix: Real Estate Commission Economics

Realogy’s two main segments, franchised real estate and company owned brokerages, are both commission driven business models based on transaction value. In both segments the total gross commission dollars is approximately 2.5% of the total transaction value, or the number of home sale sides x price of home (home sale sides is buy and sell side, so 1 home sale would have 2 sides). The difference between the two segments is the split of the gross commission.

• Realogy Franchise Services: The franchise segment receives approximately 4.5% of the commission paid to the primary broker. For example, on a home sale of $250,000 the gross commission is ~$6,350 (2.5%) and the franchise business receives 4.5% or about $280. The franchise segment also receives commission income on similar terms from the company owned brokerages as well as marketing fees and other miscellaneous fees.

• Company Owned Brokerages: The company-owned segment receives the full gross commission and then pays out approximately 68% of the commission to the broker. For example, on a home sale of $500,000 the gross commission is ~$12,500 (2.5%) and the company owned brokerage pays $560 (4.5%) to the franchise business and $8,500 (68%) to the broker, leaving approximately $3,400 in contribution margin to the company-owned segment. The company-owned segment also receives miscellaneous other commission income.