LSL Property Services — Update 24 March 2016

The UK property services market saw a sharp contrast between conditions in the first half of the year and those in the second half. H115 was burdened by strong a comparative period in the prior year, which saw a boost in activity ahead of the implementation of the Mortgage Market Review, and then by general election uncertainty in Q2. Bank of England data shows that house purchase approvals dropped by 3.3% in H115, but showed a modest recovery in H215 to be 4.7% ahead for the year as a whole. Mortgage approvals followed a not dissimilar H2/H1 trend but increased 8.4% for the year, with additional support from increased re-mortgage activity.

As can be seen in Exhibit 2, average house prices have continued to increase. LSL/Acadata estimates indicate that the average price of a house in England and Wales grew 6.6% to £292,000. Halifax data puts the annual increase at 9.5% to £209,000. Against the general trend, the main area of weakness was in the prime Central London, which has been affected by a number of factors including the 2014 Stamp Duty changes, weakening overseas demand and some concerns about increased supply of new built luxury apartments. In contrast to prime Central London (average values down 8.7%), LSL/Acadata indicate Greater London values similar to the national trend, up 5.6%.

Inevitably there are uncertainties, some positive and some negative, but our view for the 2016 outlook for the property services market as a whole is that it will remain steady. This is somewhat unexciting in relation to the market’s pre-financial crisis historical highs, suggesting no let-up in competitive pressures. However, LSL management is confident of its own prospects, based not on the market but primarily on internal initiatives, potentially supplemented by further add-on acquisitions.

It seems likely that the H215 recovery in transactions will have reflected some improvement in underlying sentiment and market conditions, but will largely have reflected the usual seasonal pattern. Since 2006, H2 transactions have on average been 19% above H1, driven by the time lag between viewings (typically Q2 and Q3) and completion. In 2015 transactions were more skewed towards H2 than this average (25% above H1), but not dramatically so.

We share management’s view that there is little sign of transaction activity breaking out of the range of 1.0-1.2m pa that has been seen in recent years, still well below the levels seen at the height of the market prior to the financial crisis. 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. We are forecasting on the basis of effectively flat transactions, at 1.25m, for both 2016 and 2017.

Management is planning for continued moderate house price inflation (we would consider 4-6% a reasonable expectation at the current time). Affordability measures are continuing to look stretched with house price inflation continuing to outstrip earnings growth. House prices as a multiple of earnings are at peak levels, although mortgage payments as a percentage of income have remained broadly stable, below the long run average, due to the low mortgage rate offerings. This measure of mortgage affordability could look a lot more challenging if we enter a rising interest rate environment.

There is some uncertainty in the market as to how the increase in stamp duty on buy-to-let properties and second homes (3% across all bands) will affect the market. Buy-to-let mortgage lending has been steadily increasing and represented 15.6% of the total in Q315. Anecdotal evidence suggests that it is already having an impact on activity as purchasers rush to complete transactions ahead of the April introduction, and some slowdown should be expected thereafter. In the longer term, we doubt that the additional stamp duty will have a material impact on buy-to-let demand when spread over any reasonable life of the investment. More difficult to call is the effect of buy-to-let tax changes effective from 2017, which will see individually-taxed landlords no longer able to claim for notional wear and tear on properties or deduct mortgage interest from their overall tax bill. There are ways that the impacts can be mitigated (for example, by incorporation) and for now we have assumed no material impact on the market in our forecasts.

Management has given a confident outlook for the current year, which reflects a continuation of the strategy for growth that was communicated in March 2015. For estate agency the strategy focuses on growing the share of recurring and counter-cyclical income streams while increasing profitability per branch. Further selective acquisitions, including letting books, should be expected, while the London-based agency, Marsh & Parsons, will continue its branch roll-out into a slightly wider “outer-prime” geographical London footprint. Surveying looks to further optimise contract performance to increase revenue generation from its business customers and seeks additional improvements in capacity utilisation and efficiency, with IT investments to that end. The graduate surveyor programme continues to build capacity, with management expecting an additional 20 graduate recruitments this year.

As previously indicated, management expects market transaction activity to be flat with some continuing benefit to fees from modest house price appreciation. A key challenge facing all players is a shortage of stock coming to market, although the accelerated speed of sale is offsetting the negative impact. The pipeline of current instructions is healthy and management reports that stock, when sold, is replenishing itself, which it ascribes to strong local positioning of its brands.

Lettings and Financial services are expected to continue to drive growth and profitability per branch.

Lettings should benefit from the accelerated pace of lettings book acquisitions of (Exhibits 8 and 9). Management indicates that the typical price paid remains 2-4x year one operating profit and that it continues to prioritise investment in this area.

As the growth in mortgage arrangements and market share indicates, growth in financial services has done more than simply track the increased transactions levels. We expect the current year growth to be enhanced by the GFL acquisition, which management indicates has been made within the 4-6x first-year EBITDA range that management targets for operational (as opposed to letting book) acquisitions. This implies a full year contribution well in excess of the last reported £700k PBT as a stand-alone entity.

Underlying operating profit per owned branch remains a key internal metric for managing the business and has been communicated as an external target. Bottom-up analysis of the branch portfolio has convinced management there is material room to improve non-Marsh & Parsons branch profitability from the current £42,500 average per branch towards £80,000-100,000 per branch, still well below the c £300,000 per branch achieved in London by Marsh & Parsons.

The 2015 underlying operating profit per branch level was actually lower than 2014, reflecting the investments made in increasing lettings and financial services headcount, but management expects the 2016 level to be higher and significantly ahead of the 2014 level. We believe this is reflected in our forecasts although it not entirely possible to track branch profitability, an audited internal measure, from the divisional disclosure. The metric used by management applies to owned branches only (excluding franchised branches) and excludes Marsh & Parsons. Also excluded are earnings streams that are not entirely within the control of the branch (asset management profits and financial services profits generated through the intermediary network). While there is public disclosure on Marsh & Parsons profitability, it is not possible to track the other excluded items from the published results. However, using the published data and some of our own assumptions, we believe our divisional forecasts do indeed imply the growth in owned branch profitability that management targets this year and next, with the implied average owned branch profit increasing to £49,000 this year and £50.800 in 2017. We are unlikely to be correct in terms of actual branch profits, but we believe we are directionally accurate.

The crucial assumption that we have needed to make is the “gap” between published divisional underlying profit and the profits implied by branch data for owned branches. In the past two years this has averaged 26% of the divisional total. We have assumed the gap will increase in 2016 compared with 2015 and increases again in 2017 (or that these excluded activities will in aggregate see higher profits) and the share of the total divisional profit will be on a slightly increasing trend. We believe this is consistent with 1) intermediary financial services profits growing, as are our overall financial services revenue forecasts; 2) franchise profits being a similar share of divisional profits; and 3) asset management profits being no higher than in 2015, which would be consistent with our asset management revenue estimates. The other assumption that we implicitly make is that Marsh & Parsons’ operating profits grow in line with its branch numbers.

Management indicates that Marsh & Parsons branch profitability is essentially stable at a high level. The target to further increase the branch footprint remains (from 24 now to 36 by 2019), particularly by opening in the “outer prime” areas of the capital. Recently opened branches (in Shoreditch and Queens Park) are said to be trading positively, while a branch has been opened in Tooting in the current year with another approved. We have assumed two additional branches pa in our analysis above.

The surveying division made significant progress in 2015, delivering the highest underlying operating profits and margin since 2011. Management expects further modest top-line growth in the current year, while at the same time investing to refresh the IT as a way to drive further customer enhancements and quality improvements, and continuing to focus on B2B contract performance and revenue generation.

The internet has already carved out a large position in the market through online marketing portals Rightmove and Zoopla, acting as an online shop window for their estate agent customers. These businesses have gained from increasing digital advertising spend by branch-based estate agents seeking to promote their properties and brands more widely.

It is the growth of the pure online estate agent model and the hybrid model, which combines online technology with a minimal face-to-face presence that is of more significance to the longer-term prospects for the sector and potentially LSL. The main attraction of the online model is price (fees are generally significantly lower than those charged by the branch-based agents) and the convenience of 24/7 online availability. Growth has been strong but from a low base and LSL management estimates the total online share of the market to be less than 4%, with the largest provider at c 2%. LSL management says that it is currently seeing no appreciable competitive impact from online competition, which it attributes to the strength of its brand, its expert knowledge of the local markets in which it operates, and the quality of its service offering. Combined with its ability to provide face-to-face advice throughout what for most people is a complex and financially material process, it expects these factors to enable LSL to defend both market share and fee levels.

In underlying terms, the 2015 performance was very close to our estimates for both revenues and profits. Underlying operating profit was up 2% and was 1% ahead of our forecast. The 2015 DPS increased 2.4% from 12.3p to 12.6p and was in line with management’s stated policy of paying out between 30% and 40% of normalised earnings. In retrospect, our 13.25p forecast was a little demanding and we have reduced our FY16 forecast by a similar amount.

Other than the dividend adjustment we have made no material changes to our 2016 estimates. We forecast flat transactions for both LSL and the market, in line with management’s best guess at this stage of the year, and c 3% average fee growth (just slightly below the 4% FY15 like-for-like growth and reflecting continued steady house price growth). Our forecast 10% lettings revenue growth reflects little more than a full year contribution from recent acquisitions and may prove conservative. For financial services, we expect revenue growth in FY16 to accelerate to 13%, reflecting low single-digit organic growth and a first contribution from GFL. We assume no pick up in mortgage repossessions or in asset management performance. Overall we look for 6% growth in estate agency revenue in FY16, and 5% cost growth. For the surveying division we forecast modest 2% revenue growth in FY16, driven by modest further improvement in revenue per job. Reflecting the signalled investment, costs are forecast to grow 5%.

We have introduced FY17 forecasts for the first time, reflecting similar drivers to 2016.

Another notable feature of the 2015 result was the strong cash flow generation. Net debt (including deferred and contingent consideration payments) ended 2015 at £62.7m, £13.3m lower than our forecast. Net banking debt was £39.9m. The difference from our forecast was driven by stronger cash flow than we had forecast with a positive outcome versus our estimates in respect of the changes in trade debtors, creditors and the movement in provisions. This better than forecast net debt position continues through our 2016 and 2017 forecasts where we allow only for the £9.1m acquisition payments in respect of GFL (half in the current year and half deferred), although other acquisitions are likely, particularly of additional lettings books.

The estate agency sector has underperformed the broader market by c 10% over the past year, with the decline occurring over the past six months. The market appears to have taken positively LSL’s ability to deliver on its full year earnings guidance set at the interim stage and it has outperformed the sector by c 15% over the past year.

We have updated our valuation to focus on a peer (relative) comparison and an (absolute) DCF valuation. A comparison with peers indicates that LSL is undervalued relative to traditional estate agent peers and that a peer average valuation would be c 358p. Our DCF calculation implies a valuation of 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 traditional branch-based agents. The average of our relative and absolute valuation approaches is 369p.

Peer comparisons

LSL’s P/E ratio is noticeably below the estate agent peer group average and while the prospective yield is slightly lower than the peer average, it is both attractive and well covered. We believe that a peer average P/E rating for 2017 would be fair. This suggests a fair value of c 358p per share, and although this would imply a dividend yield well below the peer average, there appears ample room for the pay-out ratio to increase should the board decide this to be appropriate.

LSL’s business model is highly cash generative. In 2015, operating cash flow after tax represented 90% of underlying net profit, and this ratio has averaged 85% over the past five years. Our forecasts for 2016 and 2017 suggest this ratio will decline (an average 80%) partly because we have assumed tax payments in line with the reported tax charge and more importantly we assume a faster payment of PI provisions (£15.0m pa in both of 2016 and 2017 versus £11.2m in 2015). We expect the unusually high settlement of previously recognised provisions to be largely complete by the end of 2017 and so we make an explicit one-off adjustment to operating cash flow from 2018 to account for this. The adjusted cash flow is assumed to grow at a rate of 4% pa for an additional eight years to 2025. We discount the cash flows at 10% and calculate a terminal value by applying a 10x multiple to the 2025 cash flow. The NPV of future cash flows is £451.8m (441p per share) and after deducting 2015 year end net debt (including deferred and contingent consideration) of £62.7m (61p per share) the DCF value is 380p per share. The terminal value represents 196p.