COMP - The Housing Market May Be Tough But Compass Is Still On Top

2023-09-11 11:17:00 ET

Summary

• The demand for homes is cooling off due to high mortgage rates, affecting both buyers and sellers in the real estate industry.
• Compass, the leading U.S. broker, has used the housing downturn to become a more scalable and profitable business.
• Compass has a dominant market share in U.S. real estate transactions, is expanding into new markets, and has strong branding and a scalable platform.
• Recent efforts to cut opex have turned Compass FCF positive, staving off concerns about the company's liquidity position.

After what appeared to be a second iteration of 2008's housing bubble, the demand for homes finally seems to be cooling off: a symptom of ultrahigh 7% mortgage rates. And unfortunately for real estate brokers, high interest rates aren't just stopping the buy-side of the industry from seeking new homes, but it's also preventing would-be sellers from listing their homes for fear of giving up their low rates.

This has left undeniable scars on the real estate industry. But in the case of Compass ( COMP ), the leading U.S. broker, I think there is plenty of opportunity in the stock, which is already up ~50% year to date.

Though current market conditions are certainly frigid, we have to be able to take a long term outlook and ask: when the housing market bounces back as it inevitably will, which brokerages are poised to lead the rebound, and which have used the downturn to become more scalable, profitable businesses?

In the case of Compass, the company was quick to react to the housing downturn. The company executed three rounds of layoffs with the goal of eliminating $500 million in annual operating expenses. By the end of this year, it expects to hit a target annual opex excluding commissions of $900 million (which, for sizing's sake, is less than a quarter's worth of revenue). And in spite of broad contractions in housing transactions, Compass has actually managed to perform better than peers and gain market share.

For this reason, I believe Compass will exit the current downturn as a much sturdier business. For investors who are newer to this stock, here is a recap of my full long-term bull case on the company:

• Within a few years, Compass has become a dominant brokerage - Compass' market share of U.S. real estate transactions are growing rapidly to ~5%. Already deeply embedded into major coastal markets, Compass is more recently pushing into new office opportunities in the Midwest. There's still room for further expansion. Even after the new market activity this year, Compass is still penetrated into less than half of the U.S. population.
• Tertiary revenue opportunities - Recently, Compass has been opening the door to new monetization opportunities, including starting its own title company. This positioning helps Compass derive more wallet share from real estate transactions as a whole. Compass has commented that attach rates on these tertiary services are rising. Compass estimates its U.S. TAM is $240 billion, of which only $95 billion is transactional commissions and the rest is coming from adjacent services.
• Strong branding - Compass built a brand around being a full-service, high-quality real estate brokerage, very similar in style and profile to competitors like Berkshire Hathaway HomeServices or Sotheby's. This gives the company a very strong distinguisher against other tech-first rivals like Redfin.
• Scalable platform - Compass' primary costs lie in the R&D spending to deliver its technology platform for Compass agents, as well as the sales and marketing costs of advertising its brand to homebuyers/sellers and potential new agents. These costs are scalable: as Compass' scale grows, and as agent productivity grows (the average Compass agent generates 19% more sales in the second year), Compass will be able to improve its profitability margins, which we have already seen in the company's latest results.

All in all, I remain bullish on Compass and am happy to add to my position on the stock in the low $3s. The stock has been volatile over the past few quarters, so it's also a good candidate for short-term trades (a near-term ceiling seems to form around $4, but the stock usually finds support in the low $3s). Nevertheless, as a long-term hold the company stands out as well, as the company's relatively low ~$1.5 billion market cap is about equivalent to a quarter's worth of revenue (during the downturn). Stay long here and buy the dip.

Q2 download

Let's now go through Compass' latest quarterly results in greater detail. The Q2 earnings summary is shown below:

Compass' revenue declined -26% y/y to $1.49 billion, which was a more modest drop than in Q1 (-31% y/y to $957 million). We note that Compass' strength is in spite of the fact that the company is generally dominant in large, expensive markets (where renting is an easier alternative and high-priced homes are more sensitive to interest rate fluctuations).

The chart below shows some additional key metrics. Gross transaction value in the quarter fell -26% y/y to $56.8 billion, while the number of transactions fell -19% y/y to 54.2k, indicating a lower average transaction value.

Meanwhile, the company's count of principal agents remained roughly flat y/y. As a reminder, Compass employs a traditional brokerage model in which its real estate agents are bona fide agents of the company who receive commissions upon sales, which is different from one of its primary rivals Redfin ( RDFN ), which directly employs agents and does not employ a commission fee structure (and hence bears more of the burden when transactions decline). And speaking of Redfin, note that over the same time period Redfin saw a -28% y/y decline in revenue, two points worse than Compass.

Compass, in fact, gained 13bps of market share in Q2 (while Redfin lost 8bps of share), and this is the third straight consecutive quarter of market share gains for the brokerage (over which time period Compass gained 45bps of market share overall).

And during this downturn, Compass has poured resources and energy into one of its core distinguishing factors: its technology platform. Management notes that doing this has helped Compass retain more agents and distinguish its brand from scores of discount brokerages like Redfin. Per CEO and founder Robert Reffkin's remarks on the Q2 earnings call :

We have invested over $1.5 billion in our technology platform over a 10-year period and continue to invest approximately $100 million in R&D a year, which makes it very challenging for competitors to catch up in a meaningful way. In the peak of the pandemic real estate boom, many competitors were talking about investing significant dollars in R&D. But with the shift in the market, we are not seeing that come to fruition.

The current pressure on competitors is resulting in two positive trends for Compass: one, we're seeing competitors reduce the financial incentives, they were using to attempt to recruit Compass agents; two, a race to the bottom environment where many traditional brokerages that historically competed on value out of support and services, for example, support staff, training, coaching, in-person office culture, attempts to integrate third-party tech. We are now seeing them cut back on these areas, and in many cases, are adding themselves to the already crowded low-cost, low-value brokerage service landscape, a model that is defined by charging agents the lowest possible amounts and providing them the lowest possible amounts.

Quite simply, Compass is going the other direction. We are strengthening our in-person culture and investing heavily in tools and technology for agents, capitalizing on the downturn to widen our competitive advantages, as the high-value brokerage space is becoming much less crowded. It would not surprise me to see in the years to come, Compass as the only major national brokerage competing to serve agents with high-value products and services and universally known for creating more tangible value for agents than any other company."

And in spite of these technology investments, Compass continues to shine on profitability. Its adjusted EBITDA in Q2 rose to $30.1 million, or a 2% margin, versus approximately flat in the year-ago Q2.

Excluding commissions, depreciation, and restructuring costs, pro forma GAAP opex in Q2 was $238 million, or $956 million on an annualized basis. The company has a target of hitting $900 million in annual opex by the end of the year, a level that it intends to hold through FY24 and FY25.

Free cash flow in the quarter was also $50.7 million (versus a -$30 million loss in the prior year Q2), and the company expects to be FCF positive for the entirety of FY23.

It's worth noting as well that after the close of the second quarter, Compass completely paid off its $150 million credit facility, indicating its confidence in continuing to generate positive cash flow.

Key takeaways

Earlier this year, there was a lot of pessimism that Compass would extinguish its cash reserves as housing transactions plummeted. To the contrary, the company seems to have found a way to generate positive adjusted EBITDA and FCF even in the midst of double-digit revenue declines (which are better than industry declines, as evidenced by Compass' growth in market share) while essentially becoming debt-free.

Focus on the structural improvements that Compass is making to its business here: the company is slated to emerge from the downturn as a much more profitable enterprise. Stay long here and buy the dip.

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