LSL Property Services — Update 1 September 2016

Total estate agency revenue increased by 9% to £118.9m (H115: £109.1m; and H215: £127.5m), with another strong performance from lettings and financial services.

Divisional costs rose by 9%, a similar rate of increase to overall divisional revenues. The cost increase includes Group First from February 2016 (we estimate perhaps 3% of the cost growth), a full period impact from the Thomas Morris acquisition, as well as last year’s selected staff recruitment (in lettings and financial services), higher D&A from earlier IT upgrade investment and a media campaign to promote the Your Move brand. We expect lower costs in H2 as management adapts to market conditions.

The divisional normalised operating profit increased 8% to £6.9m with the operating margin unchanged at 5.8%. Our forecasts indicate higher revenues in H2 and lower costs, with an H216 operating margin of 13.0%, making 9.5% for the year as a whole (2015: 13.2%).

Revenue was up 4% year-on-year at £32.5m. This growth was driven by higher average revenue per job, up 8% versus H115 and broadly flat on H215. The number of surveys conducted by LSL was c 2% lower. The step up in average revenues in H215 reflected a favourable mix shift towards contract work and across lenders.

Costs increased by less than 1%, in part reflecting some optimisation of the surveyor headcount, with 355 qualified surveyors employed at the end of the period compared with 367 at the end of 2015. There is an ongoing focus on efficiency, capacity utilisation and the use of technology to drive customer enhancements and quality improvements.

Normalised operating profit increased by 6% to £8.1m and the operating margin increased to 24.9% from 24.4%. Our forecasts indicate slightly lower H216 revenues, but with the decline more than matched by cost reductions. For FY16 as a whole we look for the underlying operating margin to be only slightly below FY15, at 27.4% versus 28.3%.

In view of market conditions, LSL plans selective cost measures across both businesses, with an H2 group-wide cost-saving programme. In addition to the ongoing technological refresh planned for the Surveying division, LSL expects £2.0-3.0m in exceptional costs in H2. The cost-saving programme is targeted at optimising efficiency rather than any significant structural changes and expected to pay back within one year. Our estimates allow for a £2.8m exceptional charge, offset by a c £300k gain (our estimate) on the part sale of Zoopla shares. In July, LSL disposed of 1m Zoopla shares for a consideration of £3.0m. At 30 June, its 2.7% stake at the time was valued at £30.1m.

During H116, transaction volumes in the UK residential market increased strongly in Q1 (+16.5% year-on-year, as defined by the BoE house purchase approvals series) as purchasers accelerated their activity ahead of the increase in stamp duty that came into effect at the beginning of April. Q2 growth was inevitably more subdued (+1.5%) as a result of these accelerated purchases and this was reinforced by increasing market uncertainty ahead of the June EU referendum.

In the immediate aftermath of the unexpected Brexit vote there was a tendency for provisionally agreed transactions and transaction chains to break down. Looking beyond this, the future direction of the market, for the balance of this year and into next year, has become more uncertain. The fundamental demand drivers largely remain positive, with high levels of employment and a further reduction in mortgage costs, although consumer sentiment has clearly taken a knock. The traditional summer lull in housing market activity is making it more difficult to gauge the underlying market impact, and this is unlikely to become any clearer until September data is available and beyond.

Inevitably, much of the sector discussion revolves around house price inflation. Halifax reported that average prices increased by 8.4% in the three months to the end of July versus the same period last year. Compared with the preceding three months, prices were up 1.6% and up 1.1% compared with the three months to June. There is a sense of weakening momentum that is borne out by the 1.0% decline month-on-month between June and July. By contrast, the Nationwide index showed a 0.6% tick-up in August, taking the annual rate of increase to 5.6%. Monthly volatility, and differences between surveys, is however normal and is not conclusive in itself (the Halifax index shows monthly prices dropped 0.8% in April and 1.5% in February). Rightmove, a property listing website, said average asking prices dropped by 1.2% in August, but concentrated on Central London, which is more expensive, facing increased supply, and more dependent upon overseas sentiment and buyers. The emerging consensus among property professionals appears to be that average price rises are likely to be tempered, or even show a small decline, but with Central London showing a larger correction.

Transaction activity continues to be held back by limited numbers of selling instructions (The Royal Institute of Chartered Surveyors, RICS has reported a fourth monthly decline in June) and more recently a decline in buyer demand as evidenced by a slowdown in mortgage approvals. If there is a shift in pricing levels, it is likely to take several months for buyers and sellers to adjust to the new market conditions.

Affordability measures have continued to look stretched in terms of prices as a multiple of earnings (Exhibit 2), although mortgage payments as a percentage of income have remained broadly stable, and near the long run average, due to the low mortgage rate offerings (Exhibit 3). The most recent reduction in mortgage rates should improve this measure further.

As things stand, it seems less likely that the usual seasonal pattern of H2 transactions being higher than H1 will repeat in 2016. Since 2006, H2 transactions have on average been 19% above H1, driven by the time lag between viewings (typically Q2 and Q3) and completion. Unhelpfully for forecasts, in 2015 transactions were even more skewed towards H2 than this average (25% above H1), but not dramatically so.

It is worth noting that transaction activity remains well below the levels seen at the height of the market prior to the financial crisis, but affordability constraints for first-time buyers and fewer discretionary moves by existing owners, in part reflecting the cost of doing so including stamp duty, are important limiting factors that suggest any near-term step improvement is unlikely.

Recognising the level of current uncertainty, we have based our revised forecasts on the assumption of no seasonal uplift in H216 transactions and a flat 2017 (1.2m transaction versus 1.25m previously for 2016 and 2017). This is effectively a near 20% year-on-year decline in H216 transactions. We have also assumed no increase in average fees per transaction, consistent with unchanged fee rates and flat house price inflation.

LSL had warned in its pre-interim results trading update on 22 July 2016 that it did not expect post-Brexit market conditions to improve sufficiently in the second half of FY16 for the group to be able to meet full year expectations at that time. It indicated that it was still expecting H216 to be stronger than H1, but that nevertheless underlying operating profit would likely be significantly lower than the market had been anticipating previously. Our revised estimates reflect this assessment of the new market situation, and also the detail provided with the interims. Our revised FY16 estimate for underlying operating profit is reduced from £45.9m to £33.4m, with H216e at £22.1m, well ahead of the £11.3m reported in H116, but down from £32.6m in H215. We have assumed no market recovery in FY17 and our estimates for that year similarly fall, but by a smaller amount.

As discussed above, the transaction revenue forecast is based on the assumption of flat transactions and fees.

For lettings revenue, we have assumed no further acquisitions of lettings books in H2, which is likely to prove conservative. 6.3% revenue growth for the FY16e year as a whole implies an H2 slowdown to 2% year-on-year growth in H2 versus 11% in H1 and represents little more than a full period contribution from lettings books acquired in H1. For FY17 we have assumed 5% growth in revenues.

For financial services, we expect further revenue growth in H216, but for the year-on-year growth to slow from 29.4% to c 22%. GFL, acquired in February, will contribute for the full six months and we expect organic growth in addition. For FY17 we have assumed c 9% revenue growth.

We note the countercyclical nature of mortgage repossessions contained within the asset management revenue stream but assume no recovery from the H1 level through FY17.

Overall we look for 3% growth in estate agency revenue in FY16 (4% in FY17), compared with 8% underlying cost growth (3% in FY17).

For the surveying division, we forecast flat revenues in FY16 versus FY15 (H2 down c 3% on H1) and 1% in FY17. Costs are forecast to increase 2% in FY16, with a decline in H2, and hold flat in FY17. We look for revenues per job to hold the levels seen in H215/H116 but for the number of jobs to decline slightly in H2 and recapture the H116 level by the end of FY17.

Generally on costs we expect these to decline in H216 versus H116 as management responds to changed market conditions. LSL plans selective cost reduction measures across both businesses, with an H2 group-wide cost saving programme. We have allowed for £2.8m exceptional costs in H2, partly offset by our estimate of a £300k gain on the sale of Zoopla shares in July.

In line with the forecast earnings reduction, we have assumed that dividend payments will continue to be held flat on the FY15 level. This implies a payout ratio somewhat above the c 40% long-term target indicated by management for the FY16 year but broadly in line for FY17.

The change in our FY16 and FY17 net debt estimates (bank debt plus deferred and contingent consideration less any cash) is fully explained by the lowered earnings forecasts. We have allowed for the H216 £5.6m repayment of 2% loan notes in respect of the M&P acquisition, the sale of £3.0m of Zoopla shares, and £5.1m of First Group deferred consideration in FY17. Our forecasts indicate £61.7m of bank debt/overdraft at the end of FY17, similar to the H216 level, and well within the recently renegotiated (on more favourable terms, until May 2020) £100m revolving debt facility.

The estate agency sector’s underperformance versus the wider market has accelerated since the June EU referendum vote and is now down by c 45% versus the FTSE All-Share Index over the past 12 months. LSL has performed better than the average, but is still down by 38% over the same period.

Our fair valuation for LSL takes into account a peer (relative) comparison and an (absolute) DCF valuation. A comparison with peers indicates that LSL remains undervalued relative to traditional estate agent peers and that a peer average valuation would be c 306p (previously 358p). Our DCF calculation implies a valuation of 301p (previously 380p) per share, which suggests that LSL is undervalued in an absolute sense and could be expected to trade higher as cash flows are delivered as forecast and on any improvement in investor sentiment towards the sector. The average of these two approaches is 304p per share.

Peer comparisons

LSL’s P/E ratio continues to be well below the estate agent peer group average, while the prospective yield is in line, attractive and well covered both in absolute terms and compared with peers (although we forecast a higher payout ratio in FY16 than management targets in the longer term). We believe that a peer average P/E rating for 2017 would be fair. This suggests a fair value of c 306p per share.

LSL’s business model is highly cash generative and operating cash flow after tax has represented more than 90% of underlying net profit over the past five years. Our forecasts for FY16 and FY17 suggest this ratio will decline (an average 76%) partly because we have assumed tax payments in line with the reported tax charge and partly because we assume that payment of the historic PI provisions will accelerate as the provided for claims are paid. We make an explicit one-off adjustment to operating cash flow from 2018 to allow for expectation that this drag on reported cash flow will be complete by the end of 2017. Our revised estimates for 2016 and 2017 have reduced the DCF value, only partly offset by assuming a deferred pick-up in long-term growth from 4% pa to 5% pa from 2018 to 2025. The adjusted 2018 cash flows, grown at 5% pa to 2025, are discounted at 10%, with a terminal value set at 10x the 2025 cash flow. The NPV of future cash flows is £388.3m or 379p per share (previously £451.8m or 441p per share) and after deducting FY16e net debt (including deferred and contingent consideration) of £79.7m, the DCF value is 301p (previously 380p) per share. The terminal value represents 176p per share. The main sensitivities are: