COMP - Compass: Potential Upside Is Attractive But Needs A Lot Of Work

2023-06-28 03:24:45 ET

Summary

• I maintain a hold rating on Compass until the residential real estate market recovers, as the timing of the upturn remains uncertain.
• COMP's management is focusing on cost-cutting measures and achieving the OPEX target for FY23, which should yield long-term margin improvements post this upcycle.
• There is a bullish scenario where COMP could generate substantial revenue and EBITDA in a normalized market, supported by market recovery, OPEX restructuring, margin enhancement initiatives, and new service offerings.

Description

With Compass ( COMP ), residential real estate agents have access to a robust platform that helps them provide outstanding service to their seller and buyer clients. Further, the platform comes equipped with a suite of real estate-specific cloud-based software that handles marketing, client service, and customer relationship management, among other tasks.

Previously, I recommended a hold rating as the stock was fairly valued based on my model. I continue to recommend a hold rating until the economy recovers and COMP sees an acceleration in residential real estate market.

Macro uncertainty

Despite management's assurances that the residential real estate market is stable, I wonder how much longer we'll have to wait for the actual recovery that will speed up growth. On where the trough and recovery timeline are, management expect CY23 to see a total transaction volume declines of 15 to 23%. In their 1Q23 call, management mentioned that 85% of homeowners have secured mortgage rates at or below 5%. As such, I believe if interest rates were to return to last year's levels, we might see a similar uptick in listing and pricing activity. That said, until this happen, I think we are going to be stuck in the limbo.

On the other hand, I appreciate how management is making the most of the current downturn by concentrating on cost-cutting measures in order to reach the $850-$950 million OPEX target for FY23. The keywords here are: ...at a run rate lower than the $900 million middle of the range as of the end of FYU23. This means that COMP will only yield the full benefit of these initiatives in FY24, which helps with easy margin comparison. Additionally, COMP is making progress toward one of my primary targets I had for the business: generating positive free cash flow (refer to my previous post). As the market returns to normalcy over the coming years, management is still optimistic that free cash flow will be positive in 2Q23 and that they can keep OPEX under control.

AI to improve margin

In addition to implementing cost-cutting measures, I firmly believe that COMP has the opportunity to enhance operational efficiency and drive further margin expansion. One viable approach is the integration of generative AI capabilities into both the front and back ends of the business. Given the significance of managing customer relationships in the COMP industry, streamlining mundane paperwork through generative AI would elevate the overall value delivered to customers. Tasks such as writing listing descriptions, conducting marketing activities, and handling repetitive paperwork can be efficiently handled by AI, enabling agents to dedicate more time to client management.

Furthermore, deploying an AI chatbot within the general call center function can effectively handle a majority of inquiries before routing them to a limited pool of human customer service officers. While there are potential disadvantages associated with immediate AI deployment, such as resource divergence and short-term operational inefficiencies during the learning phase for employees and agents, pursuing this avenue is crucial for COMP's scalability and long-term margin improvement.

Although this deployment may temporarily impact margin expansion, I strongly advocate for COMP to embrace this option, as it has the potential to foster business growth and enhance the company's long-term margin profile.

Valuation

While I continue to recommend a neutral rating, it is worth noting the potential upside in COMP's bull case. In a normalizing market, management stated at the 18th Annual Needham Technology & Media Conference that the company could generate $7 billion in revenue in a normalized market, which translates to $500 million in EBITDA assuming a 20% gross margin and $900 million in OPEX. In my opinion, the path to $500 million EBITDA is now possible, and it would be primarily driven by market recovery, OPEX restructuring efforts, margin enhancement initiatives (generative AI), and the roll out of new services that COMP can upsell at little incremental cost.

My expectation is for COMP to achieve this in the next three years (model below uses management estimates in a normalized market), and COMP trades at the average of its peer's valuation, I see a bull case with a 157% upside. While this is appealing, I believe the stock will only move in this direction if COMP demonstrates what I mentioned above.

Risks

Competition

While agent commission rates and homebuyer/seller agent usage have been stable for decades, initiatives such as discount brokerage models (such as Redfin), iBuyer models (such as Opendoor), or other factors that put pressure on agent commissions or reduce the use of agents on either side of the transaction could have a negative impact on COMP long-term growth potential. Furthermore, if competitors invest in replicating COMP's technology solution, COMP's business may suffer.

Macro impact

Agent productivity is a key factor in COMP's ability to generate commission revenue, so a drop in existing home sales transactions as a whole is likely to hurt COMP's financials.

Summary

In summary, I maintain a hold rating on COMP until the residential real estate market experiences a notable recovery. Despite management's assurances of stability, the timing of the market's upturn remains uncertain, and it may continue to face challenges until interest rates normalize. However, I commend management's focus on cost-cutting measures and achieving the OPEX target for FY23, which is expected to yield positive free cash flow in the future. Regarding valuation, there is a bullish scenario where COMP could generate substantial revenue and EBITDA in a normalized market, supported by market recovery, OPEX restructuring, margin enhancement initiatives, and new service offerings. However, this depends on COMP's ability to demonstrate these factors over the next few years.

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