2023-04-04 03:12:18 ET
Summary
- A recent tweet from eXp’s CEO reminded me of the book “Capital Returns”, which discusses the approach of analyzing investments with a supply side and capital cycle lens.
- From this supply side perspective, eXp looks more like a buy for those investors with a multi-year time horizon. I will go into more details in this article.
- However eXp must take advantage of this favorable supply side which, oddly enough, management may not be too keen to do.
- I also discuss the most recent quarterly results. The results are not surprising but there are some interesting details from the newly disclosed breakdown by segment.
I recently saw a tweet from Glenn Sanford, CEO of eXp World Holdings, Inc. ( EXPI ) that read: “There are those days where you’d love to share what comes across your screen as companies looking for an exit… Let’s just say one of the similar multi-country models is evaluating their options.”
This reminded me of the well-known book, “Capital Returns”. This book is a collection of essay written by money managers at Marathon Asset Management which discusses the approach of analyzing investments with a supply side and capital cycle lens. This differs from the approach of many investors and sell-side analysts that use demand driven analysis.
I’m included in that group. All of my past analysis on eXp has been from a demand perspective, like my last article . My views on the demand side haven’t changed. I think demand for eXp’s platform will continue to grow as it offers more value to agents than other brokerages. And my opinion on overall residential real estate demand hasn’t changed as I think mortgage rates will stay elevated for some time.
From this demand perspective, I mistakenly was bullish on eXp when demand for residential real estate was at its peak. In my last article, I was less bullish due to demand likely being depressed for some time. I’ve been extrapolating current demand trends to future years.
In this article, I’ll discuss eXp from a supply side perspective and why now is a better time to buy EXPI stock for those with long-term time horizons even though I remain cautious because of the demand outlook. There are also risks specific to the business which I will discuss but the supply side is setting eXp up to earn higher returns on invested capital in the future.
In addition to this supply driven analysis, I’ll also discuss the most recent earnings results.
Q4 and FY 2022 Financial Results
The most recent quarterly results reflected weakness in the residential real estate market as higher mortgage rates reduced demand for homes. This is especially negative for brokerages like eXp as they make money on transactions. When there are fewer real estate transactions, the business suffers.
Revenue grew for the year but operating income was down as expenses increased at a faster pace due to international expansion and higher corporate costs. This is also the first time that the results were broken down by segment which provides some more detail on what we already had an idea of, such as North American Realty financing the rest of the business.
eXp 2022 Results by Segment (eXp 2022 10-K)
Most of the increase in expenses likely came from growth spending. This is especially the case in the international segment as there are fixed costs to get started in a new country.
I am surprised at the loss attributed to Virbela. I did not think margins for the segment would be quite so negative but I’m assuming maintenance, support and cloud expenses rise quickly with the company’s growth aspiration. While the loss attributed to Virbela got smaller in 2022, I think there are levers here to pull to reduce costs. In the earnings call Glenn mentioned that he leans in favor of moving the realty business to FrameVR. This is a virtual office product that is under the Virbela umbrella but is web-based rather than cloud-based. A move to Frame could lead to cost savings because of how quickly cloud expenses add up.
But barring the -100% adjusted EBITDA margins for Virbela, these results are not surprising. Agent growth spending is surely the culprit for costs that grew faster than revenue. As a shareholder, of course I’d like to see more cost controlling measures but that’s not how the management team operates. Plus this spending sets the business up well to take advantage of a now favorable industry structure, which I’ll discuss below.
Supply Driven Analysis
The turn in the capital cycle often occurs during periods of maximum pessimism, as the weakest competitor throws in the towel at a point of extreme stress. When the pain of losses coincides with a depressed share price, investors can find wonderful opportunities, particularly if they are willing to take a multiyear view and put up with short-term volatility.
Glenn Sanford’s recent tweet about a competitor potentially looking to exit is a key indicator of where we are in the capital cycle for the real estate brokerage industry. It also reminded me of the quote above from “Capital Returns”.
The real estate brokerage industry is going through consolidation. With this, competitors such as Fathom Holdings Inc. (FTHM), are also raising prices in an attempt to reduce cash burn. Brokerages are clearly not doing well at the moment.
From a supply side perspective, the best time to buy a stock is when the industry it operates in is providing lower than average returns on invested capital. This is counterintuitive but is the case because when returns on invested capital are low, capital doesn’t flow into the industry. When capital doesn’t flow into the industry the weaker and unprofitable competitors struggle greatly while the stronger ones stay afloat. This leads to industry consolidation and less supply, which leads to pricing power and higher returns on invested capital. The inflection point where returns start to rise is the best time to buy these stocks.
This type of investing is easier said than done because the time to buy is when sentiment, demand, and stock prices are at their lowest.
I think eXp and the real estate brokerage industry are closer to that inflection point than not. For those that buy into this supply side approach, are fine with short-term volatility, and have a multiyear view, this would be a better time to buy shares than when real estate agent demand was at its highest.
However this type of consolidation doesn’t necessarily mean that eXp will have stellar returns going forward. Returns on capital go up only because the industry consolidation leads to less competition and pricing power. This means eXp needs to eventually raise prices to take advantage of this favorable industry structure. This is especially true when management estimated that the total number of registered real estate agents could drop by 25% in the next year or two.
Glenn Sanford seems to be quite against raising prices for now even though it is a natural part of providing value. The more value eXp provides to agents, the more they should be able to raise prices. There are plenty of businesses that operate by raising prices over time and the good ones are able to do so because they provide so much value to their members. If eXp truly provides the most value to its agents raising prices is not a bad thing.
For illustration, if in 2020, when GAAP EBITDA margin (using gross profit as revenue) for the full year was ~22% and the agent count was 40,000, if the membership fee per month was $5 higher (from $85 to $90) EBITDA margin would have been ~23.5%. If the monthly fee was $10 higher, EBITDA margin would have been 25%. These are just back of the envelope numbers but they reflect just what pricing power can do.
Applying hypothetical margins to a higher revenue base is generally folly but I think these margins are doable with price increases, operating leverage in the international realty segment, and a shift to FrameVR which would save costs in the Virbela segment.
Final Thoughts
eXp’s recent quarter was as expected, barring the very negative Virbela EBITDA margin. Growth slowed, profitability declined and management commentary was negative on the residential real estate market.
This isn’t a surprise because the brokerage industry is going through a difficult time. So much so that we are starting to see the beginnings of some industry consolidation.
What this means is that, through a capital cycle lens, now seems to be the start of an inflection point as capital has fled the industry because of low returns on invested capital. For the competitively advantaged companies such as eXp, this will allow for some measure of pricing power as there are fewer competitors. While it's still smart to be cautious as housing demand is quite low, this eventual pricing power could boost returns on invested capital for the business when demand rises again. This may take a few years, but the supply focused investor needs to have a multiyear time horizon.
For further details see:
eXp World Holdings: A Supply Side Perspective