[VIP] 3Q22, Compass: Unique Value Proposition?

This will be, I think, relatively brief. Compass reported its Q3/2022 numbers and… well, it’s not good. That was expected since every real estate company had a bad quarter thanks to macro conditions. But it’s the future course of Compass that should concern us.

To make a long story short, it seems to me that Compass is jettisoning everything that gave Compass a unique value proposition among brokerages. It may be that Compass was one of those boats that rose on a rising tide of cheap money. Now that the tide is going out, Compass might be the poster child for a real estate company that was swimming naked.

To be sure, it has strengths and all that might happen is Compass coming back leaner, meaner and stronger. But that path seems extraordinarily narrow and beset with danger.

Let’s get into it.

The Numbers

As usual, we’re not going to spend a lot of time on the numbers; you already know those. But from the press release:

  • Revenues of $1.49 billion, down 14% YOY
  • Operating Income/(Loss) of ($152) million, down 51% YOY
  • Net Income/(Loss) of ($154) million, down 55% YOY
  • Adjusted EBITDA of ($42) million, down 450% YOY
  • Cash and cash equivalents totaled $355 million at September 30, 2022.

None of that is good, but the Adjusted EBITDA number is kind of shocking. The company explained that the cause was “lower market activity” but that’s sort of cold comfort, because everybody had to deal with lower market activity… and companies like Realogy did not post a 450% drop in EBITDA.

Transactions were down 12% YOY to 54,606 as well, which Compass points out is better than the industry average of 21%. But that’s again, cold comfort.

On a positive note, Compass increased the number of Principal Agents to 13,314 — up 15% YOY. They also retained 90% of those agents, which is strong. More on that below.

Cash Flow Uber Alles

Predictably, the earnings call was all about what Compass is doing and going to do in order to dig itself out of this hole. The short answer: cut costs, stop spending, and then cut costs some more. From the prepared remarks:

However, we are not done. We are managing the business to reduce the cost base with a very specific goal to become free cash flow positive for 2023, starting with being free cash flow positive in the second quarter of 2023. Market conditions are continuing to deteriorate. And as a result, we will be implementing additional cost reduction initiatives to get ahead of any future market declines.

Then the COO, Greg Hart, mentioned this:

As we strive to be free cash flow positive in 2023, we have to balance the desire for top line growth with the cost associated with achieving that growth. In the near term, that means reducing costs. On the Adjacent Services side of the business, we paused all M&A in order to conserve cash and instead internally on growing the businesses we own and are operating today.

There wasn’t much interesting in the Q&A section either; analysts basically wanted to know how Compass was going to get profitable and start generating cash, and the Compass team basically repeated that they’re going to cut costs and get profitable.

Unique Value Proposition

So the issue for Compass is a simple one: what is the unique value proposition of Compass for agents?

It used to be a pretty simple one: more money. The incentives that Compass would offer agents were magnanimous. A couple of years ago, a reader sent me a copy of Compass’s independent contractor agreement that spelled out what Compass was offering. From that post:

Some of the more relevant Incentives are:

  • 90/10 splits, going up to 95/5 splits
  • A huge marketing budget split over multiple years, six figures in each year, that can be used for everything from yard signs to business cards, photo shoots and any other marketing-related expenses.
  • Six figure signing bonus
  • Six figure “Assistant Contribution” so that the agent can pay for administrative staff
  • Equity stock option grants
  • Production bonuses that can be paid out in cash or in additional stock options

By offering such riches, Compass terrorized the real estate brokerage industry for years. Since Q2, all of those incentives were shut down. Instead, Compass is focusing on “value of platform”, “strong company culture” and “network of top agents.” I am not exaggerating when I say that every single brokerage in North America of any size claims the exact same thing.

Speaking of the platform… Compass spent hundreds of millions in building out its tech platform, including significant M&A to acquire technology and technology teams. In 2018, Compass made a splash by hiring Joseph Sirosh away from Microsoft and setup a “technology hub” in Seattle.

That tech hub, all those engineers, and Sirosh himself were all victims of the cost-cutting measures in August.

Yes, Reffkin made a point of stressing how they “successfully rolled out [their] enhanced national end-to-end workflow platform.” It may be that Compass’s platform is in fact the best in the industry; I strongly suspect that “best” is extremely subjective since different agents have different workflows and different preferences. There is a reason why the industry is filled with CRM vendors, with transaction management vendors, with all manner of competitors who stress one area or another.

Furthermore, every large real estate company in North America also claims to have awesome end-to-end workflow platforms. Look at any earnings call from Realogy/Anywhere, from RE/MAX, from Fathom, from eXp. Look at the marketing for large private companies like Keller Williams, HomeSmart, Realty One, or United Real Estate. Every brokerage and franchise claims awesome productivity-enhancing tech platforms.

It is not at all clear that technology platforms make that much of a difference in real estate.

Objectively speaking, Compass has two truly unique propositions: beautiful branding (that is a bit… urban hipster for huge swaths of the country… but still beautiful), and lovely physical offices. The latter is actually a disadvantage in the housing market of 2022 and 2023. In this, Compass is the anti-eXp, which eschews physical office space entirely (unless required by state law) for the cost advantage that gives them.

On the other hand…

Having said that… Compass did retain 90% of its agents and recruited additional principal agents in Q3 so maybe getting rid of all the incentives and eliminating all those engineers really didn’t mean much.

From the earnings call:

The benefit of these combined steps means that we reduced our personnel costs for our growth team while simultaneously moving to a much better economic approach to recruiting agents as we no longer use equity or cash incentives to attract agents to Compass. Our ability to do this is a reflection of the value our platform provides, our strong company culture and our industry-leading network of top agents and the recognition of the value those assets provide across the agent community, both inside and outside Compass. In Q3, we added 335 principal agents, down from 405 principal agents added in Q2 but we’re not concerned. In October, the first month of recruiting was zero incentives after our September reduction in force, our growth came through the more expected profit per recruited principal agent than we’ve ever had.

It may be that Compass built enough momentum, enough of a network of top agents, and built enough of a great local culture with great local managing brokers that they’ll be fine without all the cash and prizes.

Cash vs. Liabilities

One interesting tidbit from the balance sheet are these three lines:

  • Cash and cash equivalents: $354.9 million
  • Total current liabilities: $443.9 million
  • Non-current lease liabilities: $494.3 million

It is normal for liabilities to be greater than cash on hand; companies make revenue, and paying obligations is what they do with the money they make. Current liabilities means within the next 12 months, so a company is doing over $1.4 billion in quarterly revenue shouldn’t fret $440 million or so.

Except that as Compass itself admits, Compass had $(69.1) million of free cash flow — that is, negative cash flow — in Q3. For the first nine months of 2022, that number is negative $(230.8) million. For comparison, Realogy/Anywhere had a tough Q3 like everybody else in real estate and they generated $107 million in free cash flow.

At $(70) million or so in negative cash flow quarterly, that gives Compass five quarters of life. Add in the Revolving Credit Facility of about $318 million left in it, and we’re at say ten quarters of life.

Those current liabilities are a big deal in that case. The non-current lease liabilities add another $500 million.

No wonder Compass is laser-focused on cash flow.

How Compass Survives: Rock, Meet Hard Place

All of that is pretty bad. But let’s steel-man the Compass story. How do they overcome and survive and position themselves to take advantage of the inevitable upswing in the market?

First, nobody knows when the Fed crushing the economy will end. But Compass has to operate as if it won’t end, and Reffkin did say that they’re planning (thought not expecting) for a negative 23% in transactions for 2023. And they’re expecting revenues of $1.15 billion on the low end for Q4. So they’re working towards non-commission expenses of about $1 billion for 2023.

In Q3, that amount — non-commission operating expenses — was $427.5 million, which translates to about $1.7 billion annually. So Compass needs to cut 40% or so in costs.

Let’s assume they’ll do that.

Second, Compass does have an awful lot of top producing agents. And they managed to recruit more in Q3 even without the rich incentive plans of the past. Plus, let us assume that Compass has an awesome company culture, great local managers who can recruit and retain, and a great tech platform. Compass was the largest brokerage by sales volume last year; let’s assume they keep that in 2022.

Looking at the revenues and commission expenses, Compass looks like an 80/20 split brokerage when it’s all said and done.

So… in order to survive, Compass must cut its services to the bone. Unless Compass has had just a ton of useless staff all over the place, I don’t see how you cut 40% in opex without impacting core services. We’re not gonna get there by just eliminating free lunch or some such. Compass has to cut drastically.

Then Compass has to fend off all of the competitors who will be trying their damnedest to recruit their agents away. Some, like eXp, will offer far far better splits than 80/20. The way that brokerages can keep high splits is by offering more in services — things like nice offices, admin support, and marketing support. Well, Compass is about to slash a lot of those services. If Compass can only offer services of a discount brokerage like an eXp or HomeSmart, then charging boutique brokerage prices to agents is gonna be tough.

Inertia is a big thing in real estate. It’s hard to get agents to move brokerages for a lot of reasons. It’s hard to get consumers to change their behavior, especially with something like real estate where differentiation is hard to come by. And quantity has a quality all its own. Compass has a lot of top agents, and does a lot of transactions.

So predicting that Compass will simply crash and burn is a step too far. But boy, that tradeoff between price and value, between robust services and cost cutting, is a tough one. The way out implies that somehow Compass can offer less to its top tier agents (all of whom are the most prized asset in real estate) while charging more and simply cut their way out of their problems. Not saying it can’t be done, but I am saying if Reffkin manages it, he should go down in history as one of the great turnaround managers of all time.

There is a part of me that thinks perhaps the way out for Compass to remain an independent ongoing enterprise is to become agent-owned. As of this writing, Compass’s market cap is down to $1.47 billion, but its stock is down 70% over the past year. Q4 results could be bloodier still. Compass has 13,000 Principal Agents — who typically are among the top producers in the industry. That’s only $113K per Principal Agent; many of those guys and gals are probably paying Compass that much in splits each year.

Why not own the whole damn thing?

It isn’t as if the Wall Street investors are going to look down their noses at getting bought out by the economic engine of the company, especially if the alternative is that the economic engine leaves and goes to another brokerage.

Yes, it’s likely crazy and most likely won’t ever happen. But fact is that Compass has built something over its ten year period. It doesn’t much matter if they built it using cheap-as-shit capital from investors, or how they built it. What matters now is that they have the number one brokerage by volume in the United States. If I’m a top agent in Compass, and I’m reasonably happy with the arrangement, why leave and take my chances elsewhere if I could just stay and own the company?

Having the actual revenue generating agents own the company means aligning interests overnight: the agents will cut what they don’t really need, keep what they do need, and try to maximize cash flow and profits for the company since the company is them.

Wrapping Up: The Crucible

Basically, Compass is forced to jettison everything that gave it a unique value proposition among real estate brokerages. It will need to navigate the treacherous market, while threading the needling on cost cutting vs. services vs. price. And it will need to figure out how to do that while their customer base is the top sought-after demographic in real estate: top producing agents.

This is the crucible. If Compass can make all the right decisions, cut enough for cash flow but not so much that agents start bitching about what they’re getting for what they’re paying, keep recruiting top producers while keeping most of the top producers they already have, and get the kind of fiscal discipline that it has never had to exercise during its entire history as a company… then it will emerge as a potent competitor on the other side of this. It will be leaner and meaner, with real fiscal discipline, a real company culture, solid financials, and impressive market share in some of the top markets in the country.

Removing cheap easy capital could be the death of Compass, or it could be the rebirth of Compass. We’ll see if they emerge from the crucible or get burned up in it.