North America Equity Research 20 November 2012 Initiation Overweight Realogy Holdings Corp. RLGY, RLGY US Initiating Coverage with an Overweight Rating, $42 PT Price: $37.06 Price Target: $42.00 We are initiating coverage on Realogy Holdings Corp. with an Overweight Real Estate Services rating and $42 year-end 2013 target price. We think the U.S. housing Anthony Paolone, CFA AC market has turned the corner and RLGY is a leveraged way to invest in (1-212) 622-6682 this recovery. [email protected] J.P. Morgan Securities LLC RLGY is the largest residential brokerage platform... The company owns and franchises out the most recognizable brands in the residential Michael W. Mueller, CFA (1-212) 622-6689 brokerage business, including Century 21, Coldwell Banker, ERA, [email protected] Better Homes and Gardens Real Estate, Sotheby’s International Realty, J.P. Morgan Securities LLC and The Corcoran Group. This network has over 238,000 brokers in 13,500 offices, and we estimate that in 2012 it will have been a part of Joseph Dazio, CFA (1-212) 622-6416 one-in-five existing home sales in the U.S. [email protected] …with significant leverage to a U.S. housing recovery. We calculate J.P. Morgan Securities LLC that RLGY's EBITDA should increase by about $10 million for every Molly McCartin percentage point growth in either existing home sales or average home (1-212) 622-6615 [email protected] prices. Furthermore, given the company's NOLs and above-average financial leverage, incremental EBITDA should drop to bottom-line cash J.P. Morgan Securities LLC flow. We think this set of dynamics makes RLGY among the most direct Alpita Maheshwari (91 22) 6157-3273 equity trades on the broad U.S. housing market. [email protected] We see 20% growth in home prices and 20% growth in sales over J.P. Morgan India Private Limited the next five years. To estimate RLGY's earnings, we make forecasts Price Performance for U.S. home price appreciation and the number of existing home sales. 40 In summary, we think each of these measures should increase by a total 36 of 20% over the next five years, which would land the U.S. housing $ 32 market in 2017 with prices still 10% below peak levels and volumes 28 only back to pre-boom (i.e., 2002) levels. For RLGY, this backdrop 24 should afford it a five-year EBITDA CAGR of 12%. Nov-11 Feb-12 May-12 Aug-12 Nov-12 RLGY share price ($) RTY (rebased) We are introducing a year-end 2013 target price of $42/share. We YTD 1m 3m 12m Abs 37.3% 0.4% 37.3% 37.3% use a discounted cash flow model to arrive at our target price. We Rel 30.3% 3.8% 40.6% 24.3% assume a discount rate of 10% and long-term growth rate of 4% after above-trend growth over the next five years. Realogy Holdings Corp. (RLGY;RLGY US) FYE Dec 2012E 2013E 2014E Company Data EPS Reported ($) Price ($) 37.06 Q1 (Mar) - (0.65) (0.25) Date Of Price 19 Nov 12 Q2 (Jun) - 0.92 0.76 52-week Range ($) 39.77 - 27.00 Q3 (Sep) - 0.58 0.74 Mkt Cap ($ mn) 5,365.94 Q4 (Dec) (3.30) 0.16 0.28 Fiscal Year End Dec FY (9.82) 1.02 1.53 Shares O/S (mn) 145 Cash EPS FY ($) (9.82) 1.38 2.28 Price Target ($) 42.00 Source: Company data, Bloomberg, J.P. Morgan estimates. Price Target End Date 31 Dec 13 See page 62 for analyst certification and important disclosures, including non-US analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. www.morganmarkets.com Anthony Paolone, CFA North America Equity Research (1-212) 622-6682 20 November 2012 [email protected] Table of Contents Investment Thesis ....................................................................3 Risks to Rating and Price Target ............................................5 Company Description ..............................................................6 Financial Outlook .....................................................................7 A Brief Look at Realogy's History...........................................8 Formation of the Company and Separation from Cendant.........................................8 Apollo Acquisition and Subsequent Housing Downturn...........................................8 Balance Sheet Restructuring and Cost Cuts..............................................................9 A Brief Look at the Company Today.....................................10 Realogy Franchise Group (RFG) ...........................................................................10 NRT LLC .............................................................................................................11 Cartus Corporation................................................................................................11 Title Resource Group ............................................................................................11 Realogy Franchise Group (RFG)...........................................13 NRT LLC..................................................................................21 Cartus Relocation Services ...................................................27 Title Resource Group (TRG) ..................................................30 The Number of Existing Home Sales Is Recovering...............................................34 The Value Proposition: Affordability Is High and Rates Remain Low ....................37 Distressed Situations Beginning to Resolve ...........................................................40 Balance Sheet: Business Improvement and Free Cash Flow (Especially Given the NOLs) Should Drive Leverage Down, but It Will Be a Long Process ................................................44 The Good News: NOLs, Free Cash Flow and Little Near-Term Maturities .............45 The Bad News: RLGY Faces a Long Road and Has High-Cost Debt It Can’t Pre-pay Without Penalties..................................................................................................46 Valuation .................................................................................48 Our DCF and $42 YE 2013 Price Target................................................................48 Sum-of-the-Parts Valuation ...................................................................................49 Comps Valuation – Not a Great Approach, in Our View ........................................51 Free Cash Flow Multiples......................................................................................53 Management and Board of Directors....................................55 Board of Directors.................................................................................................56 2 Anthony Paolone, CFA North America Equity Research (1-212) 622-6682 20 November 2012 [email protected] Realogy Holdings Investment Thesis Corp (RLGY) Realogy is a leveraged way to invest in the U.S. housing market Rating (Overweight) RLGY is the largest owner and franchisor of residential brokerage operations in the U.S. and around the world (through master franchise agreements). It owns and franchises out some of the most recognizable brands in the business, including Century 21, Coldwell Banker, ERA, Better Homes and Gardens Real Estate, Sotheby’s International Realty, and The Corcoran Group. These brokerage networks have over 238,000 agents in 13,500 offices, and by our estimates will represent the buyer or seller in about one-in-five U.S. existing home sales in 2012. About 80% of RLGY’s EBITDA comes from its owned and franchised residential brokerage operations, with the balance coming from its corporate relocation business (Cartus) and its title insurance and closing services business (TRG). With residential brokerage profitability driven almost entirely by the volume and price of existing home sales, RLGY is squarely tied to the health of the U.S. housing market. We think the U.S. housing market has turned the corner… 2012 represents a turning point in the U.S. housing market, in our view. After a roughly six-year downturn where home prices declined over 30% peak-to-trough and sales volumes were cut almost in half, all major indicators suggest both stabilization and improvement. There have been consistent positive home price changes in series published by S&P/Case-Schiller, CoreLogic, NAR, FHFA, Fannie, and Freddie. Home affordability is at a 25-year high, as measured against the cost of renting. The drop in the home ownership rate is slowing as the foreclosure backlog is worked through. Household formation is picking up compared to the depressed levels of the last couple of years, and surveys such as NAHB’s show markedly better sentiment. All of these items demonstrate an inflection point for the U.S. housing market. …And we forecast 20% growth in prices and volumes over the next five years There are many forecasts for housing-related data. For purposes of estimating RLGY’s earnings, we estimate home price appreciation and existing home sales over the next five years. Specifically, we forecast home prices to rise about 20% between 2012 and 2017, bringing values to levels last seen in 2004/2005 and still about 10% off peak levels. As for existing home sales, we forecast a 20% rise, putting volumes at about 5.4 million in 2017 – back to roughly 2002 levels. To put our forecast into the context of other forecasts, our price appreciation estimates are