I’ve written previously about competitive advantages, moats, and investing in high quality businesses. That’s the ideal scenario. But sometimes, the valuation can be so attractive that the investment case is still strong.
I posit that Atkore International (ticker: ATKR) is now too cheap to ignore. Management seems focused on this as well, having repurchased a large portion of stock (26.5% of shares outstanding) from the former Sponsor owner, CD&R.
Atkore is a leading manufacturer of electrical raceway products and tubes that are used in a variety of construction applications. The Electrical Raceway segment (65% of sales) is a leader in products that isolate, deploy, and protect electric circuitry as it moves through a building. The products include armored cable & fittings, steel and PVC conduit, and flexible conduit and cable trays. The Mechanical Products & Solutions segment (the balance of sales) manufactures in-line galvanized tube, metal framing and fittings, and other mechanical products used in non-residential construction.
I think it helps to see what these products include, as shown below.
Atkore generates roughly 85% of its sales from markets where it is the No. 1 or No. 2 player. Products are distributed through national electrical distributors such as WESCO, Rexel, and Graybar, independent electrical distributors, industrial distributors including Grainger and Fastenal, and big box retail including Home Depot, Lowe’s, and Menards.
When you look at these products, its really hard for me to see how “secret sauce” is involved with manufacturing these products. However, you would probably be surprised to learn the company has 15% EBITDA margins and capex has averaged <1.5% of sales for the past 5 years. That brings me to one of the metrics I tend to follow and that is unlevered FCF conversion. And by that I mean, (EBITDA-Capex)/EBITDA as a percent. The reason why I like to look at this is to move beyond some business that might have lower EBITDA margins (like distributors with 3-7% margins), but convert a lot of that EBITDA into FCF. Typically FCF conversion greater than 80-85%+ is a really solid business. ATKR averages 90%.
Now you can see that 2015 was not as high as the past 2 years. That is because ATKR undertook a significant portfolio restructuring, as summarized in the company’s slide below. The company divested low margin product and focused on higher margin product where it had strong market share and areas where it could raise price. Raising price is important part of the story here, as that extra price drops straight to the bottom line. EBITDA margins were less than 6% in 2011, moved to 15% by 2017 and their long-term goal is to reach 20% EBITDA margins.
Now to valuation. ATKR trades at a significant discount to peers. Most building products companies right now are trading at 10-12x and a FCF yield of about 5%. As can be seen below, ATKR is trading well below that and will generate a significant amount of its market cap in FCF. This provides flexibility for the company to pay a dividend, acquire additional companies, buy back stock, or even down debt (which builds equity value).
One quick comment about the projections – the top line growth expected in 2018 is mainly due to an acquisition and the moderation in 2019 is due to a divestiture. I do not expect much growth in 2020 just as we get to a more mature place in the cycle. Either way, the stock is too cheap to ignore.
Even using a 7% FCF yield, which foots to less than 9x EV/EBITDA, the stock has significant upside.
Now, the risk here is really the non-residential cycle. It could quite possibly be near peak or slowing down, but I don’t think my assumptions are too aggressive.
Real estate brokerage is a competitive business. The business doesn’t have that much barriers to entry, so the reason why someone chooses to work for a company like Realogy is the brand. The brand attracts the first call from a buyer looking for guidance and the brand helps drive leads. But currently, agent retention is under pressure given how competitive the market place is which in turn is pressuring commission splits, that is, the % of commissions that are split with Realogy.
However, I hope to explain over this write-up why despite these pressures that RLGY is a strong buy at current levels.
The thesis comes down to the following points:
U.S. Housing is still recovering, despite being 10 yrs after the prior cycle. Continued homes sales will drive additional volumes for RLGY
Largest real estate brokerage in the US, but asset-lite given franchise model. This leads to solid FCF
Company is turning focus to organic initiatives and returning excess cash to investors, rather than its previous M&A strategy
In sum, my PT on RLGY stock is $45, which foots to a 7% FCF yield to equity .
I will also attempt to answer some questions that people have on the business, such as the value realtors provide and their long-term place in the market.
U.S. Housing Still in Recovery Mode
No matter how you cut it, it is clear that US single family housing starts are still well below long-term averages. In fact, the ~850k starts in 2017 was the low point in some prior housing cycles. Part of this slow recovery was obviously overbuilding in the last cycle, but also the tepid recovery in the economy. In addition, permitting processes have lengthened and finding skilled labor to buy homes has been tough now that employment has tightened.
However, since the financial crises, the population has not stopped growing. What did change, was household formations. As people decided to move in together to save on rent or as those darn millennials stayed with mom and dad longer, and put off getting married and starting a family, it also put off new household formations which is the #1 driver of starts.
If all 30 year olds lived with 1 other roommates, there would be 1 house per 2 people for a headship rate of 50%. Changes in these headship rates have had a negative impact on housing growth. According to Joint Center for Housing, “from 2010-2015, when population growth and change would have produced 1.39 million additional households a year, [but] declines in headship rates reduced that growth by nearly 200,000 households per year.”
If you look at recent formations data, the positive news is that home owner formations are growing now at the expense of rentals, a sign that this trend of buddying up is starting to reverse and that the american dream to own your own home was delayed, not abandoned.
What does this mean for RLGY? Well, the 2 drivers of RLGY’s business are sales of existing homes and prices. Why am I discussing new home construction? To point out the current market is under-supplied relative to the amount of pent-up demand there is in the system. And if you review homebuilders’ earnings calls, you will find that they simply can’t find labor or lots to build homes. This should keep a cap on incremental supply which will lead to increased sales of existing homes + buoy prices.
As can be seen below, housing inventory remains near all time lows. While this will limit RLGY on the volume side, the price side of its transactions should move up meaningfully.
Asset-lite Business Equates to Strong FCF
RLGY is a service business and therefore it has a low asset base. In addition, most (~65%) of its earnings are derived from the franchise fees of its brands. It is the franchisor of some of the most recognized brands in the industry including Coldwell Banker, Sotheby’s, Century 21, and Better Homes and Garden Real Estate.
It also has its own company owned real estate brokerage service, a title insurance business, and an employee relocation service (Cartus).
But the bottom line is this is a franchise business model which generates significant FCF (as the franchise business carries 65-67% EBITDA margins).
Based on my estimates, I see RLGY generating ~$400MM of FCF in 2019, which is slightly over 13% of the company’s $3.05BN market cap. In other words, they could buy back over 10% of their company’s stock each year and still accrue cash.
First and foremost, I need to answer the question of, “what value does a real estate agent / broker actually provide?”. Buying a house is a significant commitment and lots of people I know have anecdotally not had great experiences. But hey, real estate is an inefficient market and that is part of the appeal from an investing standpoint.
Do realtors earn their fee? Let me first quote Warren Buffett at his latest annual meeting: “The purchase of a home is the largest financial transaction for a significant percentage of the population. A lot of people need a lot of attention. A realtor can show a lot of houses before they sell one.” He then noted that while real estate agents make a decent living, asset managers make “far more money with less welfare to the client.” He then said he would continue to acquire brokers in the future.
At the end of the day, however, a seller of a home doesn’t need to use an agent in order to execute a deal. However, the National Association for Realtors recently reported that in 2017, “87% of buyers purchased their home through a real estate agent or broker—a share that has steadily increased from 69 percent in 2001… 90% of sellers used a real estate agent” Why has it increased? Well for one, the service is free to buyers. The seller pays the commission. Also, a realtor can provide some value-added advice. For example, the same statistics highlight the median realtor has 10 years experience. This means they likely know the neighborhoods that are of higher quality, and that ranks higher on peoples list of desires compared to overall home size. Another study by NAR found that sellers that use an agent on average sell their home for more than if they otherwise did not use one. Since the realtor is paid based on the transaction value, they are aligned to get the best price.
Do I think Zillow and other services like Redfin will pressure the industry? I think these services will probably make the market more efficient from the perspective of what home values are, but again, that’s just one factor. Realtors also have a network in the industry that may help expedite a transaction that zillow will not.
MLS is another barrier to entry. MLS is essentially a listing of every home for sale or rent that is represented by an agent. In order to get into MLS, you have to have an agent. Zillow and Trulia, to my knowledge, do not. Only agents can search this database of homes that is right for their clients. While this may not last forever, it is something that provides some competitive moat.
Realtors do provide value
I need to answer the question of, “what value does a real estate agent / broker actually provide?” to continue this pitch. Buying a house is a significant commitment and lots of people I know have anecdotally not had great experiences. But hey, real estate is an inefficient market and that is part of the appeal from an investing standpoint.
Do realtors earn their fee? Let me first quote Warren Buffett at his latest annual meeting: “The purchase of a home is the largest financial transaction for a significant percentage of the population. A lot of people need a lot of attention. A realtor can show a lot of houses before they sell one.” He then noted that while real estate agents make a decent living, asset managers make “far more money with less welfare to the client.” He then said he would continue to acquire brokers in the future.
At the end of the day, however, a seller of a home doesn’t need to use an agent in order to execute a deal. However, the National Association for Realtors recently reported that in 2017, “87% of buyers purchased their home through a real estate agent or broker—a share that has steadily increased from 69 percent in 2001… 90% of sellers used a real estate agent” Why has it increased? Well for one, the service is free to buyers. The seller pays the commission. Also, a realtor can provide some value-added advice. For example, the same statistics highlight the median realtor has 10 years experience. This means they likely know the neighborhoods that are of higher quality, and that ranks higher on peoples list of desires compared to overall home size. Another study by NAR found that sellers that use an agent on average sell their home for more than if they otherwise did not use one. Since the realtor is paid based on the transaction value, they are aligned to get the best price.
Do I think Zillow and other services like Redfin will pressure the industry? I think these services will probably make the market more efficient from the perspective of what home values are, but again, that’s just one factor. Realtors also have a network in the industry that may help expedite a transaction that zillow will not.
MLS is another barrier to entry. MLS is essentially a listing of every home for sale or rent that is represented by an agent. In order to get into MLS, you have to have an agent. Zillow and Trulia, to my knowledge, do not. Only agents can search this database of homes that is right for their clients. While this may not last forever, it is something that provides some competitive moat.
Self-help Story
The company wouldn’t trade where it does if it was a straightforward story. That’s partly what makes investing challenging, yet fun. Realogy is sensitive to what is “split” with the agents. While commission rates have been relatively stable over the past 10 years, splits have moved from 65% of sales to nearly 71%.
To put it in context of RLGY, lets say they represebted 350k home sales (volume) at an average price of $515k. Collecting a commission of 2.4% would bring in $4.3BN of gross revenue (note, this is very similar to what RLGY’s NRT segment did in 2017). If splits were at 65%, then earnings before other costs (such as marketing or corporate costs) would be $1.52BN. However, at 71%, it is $1.36BN, or 17% lower.
This has been less-than-ideal for RLGY and although mgmt has said they expect commission split pressure to moderate, I still model it increasing over time moving from 69.6% at the end of 2017 to 70.8% by YE2019 (as a % of company-owned brokerages). However, there is a new CEO in place that is focused less on M&A and more on reinvesting in the core business. This includes investing in technology and hopefully curbing the split pressure the business has faced. This is a risk to the thesis, but with a stock this cheap, there seems to be plenty of room for error given little success is actually priced in.
Bottom Line: I model ~$400MM of FCF on $870MM of EBITDA for RLGY in 2019, which foots to a 13% FCF yield. This is well in excess of the 5% FCF or less that the average S&P 500 company trades for. Targeting a 7% FCF yield, acknowledging there are some pressures on the business, my PT on RLGY is $45, which represents ~85% upside from the closing price of $24. Again, I think positive fundamentals plus strong FCF will at least provide a floor in the near term and give upside to the stock as the company uses the cash to repurchase shares.
