Introduction
Realogy reported its Q1/2013 results last week. This report will be shorter than my full year 2012 Report, as there were not as many eye-opening revelations from either the numbers or the management commentary on results.
Nonetheless, I look at not just the publicly reported numbers, but the core operating numbers, listen in on the earnings call to find out what Wall Street and management are focusing on, and consider what they mean to the real estate brokerage industry as a whole. Until another major brokerage goes public, the only real data we have comes to us courtesy of Realogy.
If you purchased the 2012 Realogy Report, this Commentary is free to you. And if you were one of my first customers on the Trulia, Zillow, Move Report… well, then you get everything the Realogy buyers get so… this is free to you as well.
This report is provided for informational use only, intended to assist professional investors and industry professionals. The information contained herein does not constitute investment advice and may be subject to correction, completion and amendment without notice. 7DS Associates and Robert Hahn assume no duty to make any such corrections or updates. While the information contained herein contains opinions and projections, it is not our intention to state, indicate or imply in any manner that current or past results are indicative of potential future results. As with all investments, there are associated risks and you could lose money investing. Prior to making any investment, a prospective investor should consult with his own investment, accounting, legal and tax advisers to evaluate independently the risks, consequences and suitability of that investment. 7DS Associates and Robert Hahn disclaim any and all liability relating to any investor reliance on the accuracy of the information contained herein or relating to any omissions or errors and as such disclaims any and all losses that may result in an investment in any company mentioned in the report.
Executive Summary
Realogy turned in a very strong Q1. Core revenues of $916 million represent a 10% increase Y/Y from Q1 of 2012. The core operating income for Realogy went from a loss of $16 million in Q1/2012 to a profit of $18 million: a 212% swing. At the same time, the interest expense was cut from $170 million a year ago (and $187 million in Q3 of 2012) to $89 million.
Franchisees closed more transaction sides at higher average sale prices in terms of percentage increase year over year: 6.2% and 8.7% respectively. The NRT, in comparison, increased 5.0% in transaction sides and 6.1% in price. Yet the gain in actual revenues in percentage terms was 11.6% for the NRT Y/Y vs. a respectable but pedestrian 5.6% for the RFG.
That difference in performance goes hand in hand with another slight negative: commission splits increased 0.83% year over year. Both of these indicate that as the real estate market recovers, the strongest franchises and the top agents are doing the most business. He That Hath, Gets.
That factor points to a possible long-term dark cloud over Realogy, even as it keeps piling up excellent performance on top of excellent performance. Because of seasonality, and because the analysts on the earnings call did not delve into the issues, it is difficult to ascertain what the trends are for Realogy and its franchisees on the critical issues of agent teams, lead generation and lead distribution, and commission splits.
We will await results from Q2 and Q3 to see if we can make better sense of where things are.
THE NUMBERS
As the readers of the 2012 Report know, I focus on the core operations number, excluding items like Other revenues and interest expense.
Below are my calculations of Realogy’s core operations from Q1/2012 to Q1/2013:
Overall, Realogy turned in a strong Q1. Core revenues of $916 million represent a 10% increase Y/Y from Q1 of 2012. (Because of seasonality in real estate, the first quarter will always be the weakest, so a year-over-year comparison is more useful here than a quarter-over-quarter). The core operating income for Realogy went from a loss of $16 million in Q1/2012 to a profit of $18 million: a 212% swing. By any measure, that’s sweet.
What’s really sweet is the interest expense line.
Between the IPO and paying down some other high-interest loans, Realogy drove interest expenses from $170 million a year ago to $89 million in Q1. Now, $89 million in interest is still a large number, but so is the some $80 million or so that doesn’t have to be paid going forward.
Realogy continues to kick butt. All of my reservations tend to be long-term or macroeconomic in nature, but as far as I can tell, in terms of actual operations, the day-to-day work of the people at Realogy, it’s kudos all around.
The key drivers were as follows:
Let me discuss a couple of things that struck me about these numbers.
NRT vs. Franchises
GCI from the NRT division led the way with $70 million more in 2013 than in 2012 – likely a sign of the improving market conditions in real estate. But there is something a little odd here.
Look at the Key Drivers chart, and compare Q1 of 2013 to Q1 of 2012.
Franchisees closed more transaction sides at higher average sale prices in terms of percentage increase year over year: 6.2% and 8.7% respectively. The NRT, in comparison, increased 5.0% in transaction sides and 6.1% in price. Yet the gain in actual revenues in percentage terms was 11.6% for the NRT Y/Y vs. a respectable but pedestrian 5.6% for the RFG.
What’s up?
The earnings call transcript suggests that what Realogy is dealing with is the He That Hath, Gets trend in real estate.
Tony Hull, CFO:
Also, the Realogy Franchise Group’s net effective royalty rate declined 18 basis points to 4.57% as its larger affiliates continued to achieve incentives for higher volume levels. RFG’s top 250 companies represented 58% of total franchisee revenue in Q1 2013 versus 55% in 2012.
The larger better-run franchisees did more business in 2013 than in 2012. They’re also the ones with the best deals and best performance incentives with Realogy. (Emphasis mine)
And at least on the franchise side, Richard Smith, Chairman & CEO, made it clear that he didn’t think this state of affairs would change anytime soon:
So we would not expect — it is going to take a few years. It is not so much a quarterly thing, it is going to take a few years for smaller franchisees to play catch-up. So, at some point the larger franchisees will have grown so much that sort of naturally limited to the market growth at that point, the NAR growth at that point. And the other ones, that is when they will play catch-up and a few years out you’ll start — I think it will take a few years to see some improvement in the effective royalty rate.
One of the more interesting things to think about here is why the Top 250 outperformed everyone else so much. Was it geography? For example, one of the largest Coldwell Banker franchisees is located in Houston (Coldwell Banker United). Another is in the Seattle area (Coldwell Banker Bain). Do those markets outperform the smaller markets by that much?
Was it perhaps a function of technology investment that the larger franchisees could make easier than the smaller ones? Was it that they could strike better deals with portals like Zillow and Trulia? Was it that as the market turned, consumers did in fact find comfort in bigger brand recognition of the larger franchisees?
We don’t know, of course. But these are all questions worth asking and researching in local markets.
Commission Splits
Just as the larger franchisees outperformed everyone else, one key number suggests that the same thing is happening at the NRT: agent splits.
Tony Hull said during the earnings call:
Commission splits increased 83 basis points to 67% in Q1 year over year. NRT has been trending toward adjusting agent splits on anniversary dates rather than all at the beginning of the year for competitive reasons. So you’ll see less variability during the year.
In the last Realogy Report, for the full year 2012, I spent an enormous amount of time and text trying to puzzle out what Realogy meant by taking “proactive steps” to reduce the cost of agent commissions (i.e., improve broker-agent splits in favor of the NRT). In this quarter, we get at least a partial answer: changes to when splits are adjusted.
Nonetheless, on a year-over-year basis, agent splits are up 0.83% overall.
One of the analysts tried to delve a little deeper:
First I was, Tony, you mentioned the 67% commissions as a percentage of the expenses was supposed to moderate a little bit and you — I didn’t quite understand the explanation about the anniversarying of things. And last quarter I think when we talked, you alluded to that was somewhat of an issue you were working on because last quarter was around 69%. So could you just talk about what transpired to lead to the sequential change?
The answer:
Sure. The — we were just — I think the increase looks much larger if you compare the first quarter of last year to the first quarter of this year, and one of the reasons for that is there was a lot of volatility last year. We went up pretty significantly as the year progressed.
And one change we made last year is in a lot of the markets, a lot of the agents reset on January 1 every year. That became a (technical difficulty) issue because all of our competitors knew that the agents were vulnerable on the first day of the year. So we moved a lot of those markets to anniversary of the agents’ employment or excuse me, not employment, but the agent working with one of our brokers, and so that is going to spread. The resets instead of happening all on January 1, they are going to be spread during the year. So you’ll see a much more stable split rate as the year progresses. As opposed to going from 64% in the first quarter up to 69% in the fourth quarter, should stay more equal during the year as a result of that change.
Eh, I guess. The reason why this is important is that splits often reset each year. An agent might start each year on a 50/50 split and work her way up to 85/15 or whatever the final split is, based on production. It guarantees brokers a certain level of income from any agent, no matter how great her production.
When the NRT was resetting on Jan 1, all their competitors tried to lure agents away before they had reached whatever production level to get to the better split. By changing to the work anniversary, NRT forces competitors to figure out what the anniversary is. It doesn’t strike me as any sort of a major anti-recruitment move (how hard is it to find out what the anniversary date is if you’re talking to an agent?) but it is an improvement.
Talking about such adjustments, however, obscures the real issue at hand. Obviously, the Wall Street analysts on the call have not read my original report. 🙂 If they had, they would have asked some different questions to get at the heart of the dilemma of brokerage and the challenge for Realogy.
Here are a few such questions, and why analysts should ask them.
1. Given that we are in a seller’s market, what was the breakdown in percentage terms between listing-side and buyer-side?
It is exceedingly rare for newbies and unproductive tier-3 and tier-4 agents to be getting lots of listings. Given that the entire real estate industry – but especially the NRT with its geographic concentration – is operating in a low-inventory environment (places like California, the Northeast, etc.), it stands to reason that gains would come disproportionately from top tier agents who are also the strongest listing agents.
Those agents would have high commission splits with the brokerage. That would partially explain the 83bp rise in agent commission costs.
2. How was LeadRouter performance in Q1 of 2013? Have you guys tweaked the business logic of LeadRouter for the NRT at all? If so, how?
I have explained the mechanics of how traditional brokerages leverage the leads generated from the listings of its listing agents by sending them to lower-tier buyer agents on higher splits, with brokerage overrides.
LeadRouter is the most important tool in Realogy’s arsenal for both franchisees and for the NRT. But neither the 10Q nor the earnings call mentions LeadRouter at all.
Yet, if the NRT tweaked the routing business logic a touch to send 5% more leads to lower-tier agents, that could have boosted company dollar by quite a bit. One could surmise that absent LeadRouter, the 83bp rise could have been dramatically higher. In the alternative, perhaps LeadRouter was working overtime, but more listing agents were choosing to accept those leads to send to a buyer agent on their agent teams – which would also depress company dollar.
But of course, we don’t know, because we don’t have that data. Some analyst mighta coulda shoulda asked about LeadRouter.
Speaking of which….
3. Can you provide some additional color on how the NRT handles agent teams and commission splits?
The franchise fees would not be impacted by how franchisees setup agent teams: the royalty fee comes off the top of each transaction. But the NRT is a brokerage, and so would be subject to the same dynamics as any other brokerage when a strong listing agent forms a team of buyers underneath her.
Depending on when the brokerage split happens, we’re talking about a decrease in company dollar that could be as high as 75%. We’re not talking chump change here.
Given that the NRT is responsible for some 73% of the total core operating revenues of Realogy, the trend towards agent teams and precisely how the NRT deals with agent team commission splits are, it seems to me, critical factors in analyzing future earnings and cash flow potential.
Obvious follow up question would be…
4. How many agent teams are in the NRT today? What’s the average size in terms of total agents (i.e., not counting support staff)? How many of your agents are either leading or working in agent-teams? What has been the trend in agent team formation over the past few quarters/years?
Let me suggest that if 10% of the agents in the NRT were in agent teams in 2011, 20% in 2012, and 25% are in one in 2013… it doesn’t look good for NRT or Realogy.
If, on the other hand, the NRT has managed to keep the number of agent teams small and growth is flat… then the future looks very bright indeed. Whatever the NRT has figured out in terms of services, products, support, systems, and so on is something that every broker in America should be studying carefully. Go headhunt some talent from local offices, or from One Campus Drive. You need to know what the NRT knows if you’re going to make it.
At the same time, the numbers that concern me, and should concern Wall Street, is the disparity between GCI growth and Commission and Related Expense growth: 11.6% vs. 12.9%. The reasons may be several, but it is plain that if those two rates do not get brought back in line, the margins cannot help but shrink over time. We’ll see what Q2 brings.
A Gem from the Transcript
Finally, there was an absolute gem contained in the earnings call transcript that should be of interest to some sectors of the real estate industry.
Check out the following exchange:
Dan Oppenheim – Credit Suisse – Analyst
One quick question. In terms of the agents that you are seeing, given the improvement in the market are you seeing more — some new agents come into it which could essentially help your splits, your agents split over time in the NRT business?
Richard Smith – Realogy Holdings Corporation – Chairman, CEO and President
Yes, you are very intuitive. As the market improves people who have shied away from the business get back into the business. NRT in particular has a very concerted effort to recruit, continue recruiting top-producing agents and also entry level agents for the obvious reasons. The splits are far more attractive as they start producing that, that has the expected impact on our retained dollar. Not only are we doing that, but our franchisees start doing the exact same thing on their own, independent of us.
So they are recruiting aggressively now. Listen, it is what the market will bear. So they will recruit agents as long as the volume is there and the upside is there. So we see that developing, it will continue into the — deep into the second and third quarter. So we welcome that and that’s a very good question.
Tony Hull – Realogy Holdings Corporation – CFO
Yes and as we have talked about before, the footprint for NRT’s offices is about a 60% capacity utilization. So we can do a lot of recruiting and not have incremental fixed costs.
Dan Oppenheim – Credit Suisse – Analyst
Great. And —
Richard Smith – Realogy Holdings Corporation – Chairman, CEO and President
Our franchisees are pretty much in the same boat. They can accommodate the same kind of growth.
The key phrase, I think, is “a very concerted effort to recruit” entry-level agents, who provide a far more attractive split to the brokerage as they start producing. Because of the past few years, the offices of both the NRT and the Realogy franchisees are under capacity by a whole lot – 60% capacity.
That means a whole lot of new bodies can be added without adding costs.
It would be difficult to find a more succinct statement both of intent on the part of major brokerages, and of the brokenness of contemporary real estate brokerage.
I can think of no other industry that creates a similar incentive for companies to hire less experienced, less skilled people. More experience and more skill translate to more productivity and more margins for the employer in virtually every other commercial venture. Even in professional services, law firms usually regard first and second year lawyers as an investment since they rarely justify their salaries. Accounting firms do not, as a rule, go out and try to hire more inexperienced accounting school grads to improve their profit margins.
The so-called Raise the Bar Movement in real estate, which seeks to raise the level of professionalism, expertise, and skill amongst real estate professionals, frequently rage against “Big Box” brokerages that just churn and burn, bring on warm bodies, and so on. They agitate for higher state licensing requirements.
What they all ignore is the fundamental disconnect between broker incentives and agent incentives in the post-REMAX brokerage model. As agents gain expertise and skill, the broker loses money.
Connect that up with the rise of agent teams, where the lead agent controls the listings and therefore controls the entire value chain, and the disconnect is bound to get larger rather than smaller over the next few years.
So brokerages are going on a recruiting spree for Q2 and Q3 and beyond, as market conditions improve. What I wonder about is whether agent teams that generate and keep their own leads would somehow fail to recruit as well, whether from the ranks of the brokerage itself or from other brokerages. Since each buyer’s agent joining an agent team represents a loss of company dollar for the brokerage (or else, they risk losing the lead agent and the entire team to a competitor, such as Keller Williams or Realty One), the margin numbers from Q2 and Q3 will be of real interest.
Conclusion
Realogy produced another strong quarter of excellent performance. 10% core operating revenue growth is absolutely fantastic, and the 212% growth in core operating income is impressive as hell. Paying down debt with proceeds from the IPO and operating cash flows are showing real impact, by cutting interest payments by almost half. It will still take time to get out from under the debt load, but Realogy does appear to be on the right track.
The areas of concern – agent teams, commission splits, government regulation, macroeconomic factors – are all unknown at this time, and with seasonality of real estate, frankly unknowable yet. I have seen nothing from Q1 results that changes my mind on the threat to brokerages posed by agent teams, but then again, with the improving real estate market, we may see totally different results come Q2.
Until next time…
-rsh
