Realogy Faces Its First Test

Cendant's spinoff arrives at a troubled time for housing, but fundamentals are strong.
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Cendant's (CD) spinoff of its real estate brokerage business could surely have come at a better time, given that the U.S. housing market is slowing at a rapid pace.

Proponents, however, say that the new company is underleveraged and generates stable free cash flow, which will allow it to pick up attractive acquisitions and ride out the expected downturn in home sales over the next year and a half.

Shares of the brokerage company


(H) - Get Report

began trading Tuesday and recently changed hands at $25.18. Cendant shareholders received one share of Realogy for every four Cendant shares they owned. (Shares of Cendant's hotel spinoff,

Wyndham Worldwide


also begin trading Tuesday. Cendant shareholders receive one Wyndham share for every five Cendant shares they own.)

Realogy generates about two-thirds of its earnings from its franchise business through its five well-known brokerage brands: Century 21, Coldwell Banker, ERA, Sotheby's International Realty and Coldwell Banker Commercial.

The remaining profits come from the company's lower-margin brokerage house business, which includes the Corcoran Group -- one of New York City's biggest residential brokers -- along with relocation and settlement services.

Because of the slumping housing market, Realogy recently lowered its forecast for 2006 earnings before interest, taxes, depreciation and amortization. The company expects EBITDA of $925 million to $1.05 billion in 2006, down from $1.1 billion in 2005. The company had previously forecast a flat year. Growth will resume in 2007, the company says, though it hasn't provided specific guidance.

Realogy projects 2006 net income of $380 million to $465 million, down from $497 million last year. At $25, the stock trades at 15 times the midpoint earnings-per-share guidance of $1.69.

"Investors at this point are perhaps looking at the downside of the real estate cycle and not assigning a high value to Realogy," says Gautam Dhingra, portfolio manager with High Pointe Capital, which owned shares of Cendant and now Realogy. "But that's exactly what gives it the opportunity."

Dhingra says that even if you build in a 10% decline in home sales this year and another "couple percent" decline in 2007 and project lowered EBIDTA numbers for Realogy, the stock looks like an attractive investment.

Dhingra acknowledges, though, that if the housing market declines more than he models, the current price for Realogy may look like a bad entry point in hindsight.

Currently, Fannie Mae predicts that housing sales will fall 10% this year and 3% in 2007. In recent earnings calls, homebuilder management teams continue to say it is impossible to say how long the housing downturn will last or how severe the correction will be.

Realogy, in its recent investor presentations, says that there is no national housing bubble and that the underlying fundamentals of the housing market look favorable for the long term.

Richard Smith, the company's president, says Realogy can achieve growth in 2007, even in a down housing market, by selling more franchises and gaining market share through acquisitions. About 75% of the country's real estate brokerages are unaffiliated with a national brand; this provides ample growth opportunity for the company, he says.

Smith expects the spinoff to be well-received because it offers a pure play on the residential brokerage business -- something investors haven't had before, with the exception of



, an online real estate agent that has been a big disappointment.

"The country is just in love with real estate and has been for a number of years. The individual and also the institutional buyers have also had a lack of a tool to invest in residential real estate," Smith says.

Dhingra, the portfolio manager, says Realogy's attractiveness instead lies in its stable free cash flow.

Most of Realogy's income comes from the franchise fees it collects from brokerages. In a typical structure, Realogy collects 6% of gross revenue from franchise brokers. Since this is not a capital-intensive business, it allows for a steady stream of free cash flow (projected by management to be about $500 million this year).

Much of these proceeds will be used for acquisitions, Smith says.

The company captured a 25% share of residential real estate broker commissions in 2005. Smith expects to buy new brokerages nationally with a value of about $200 million to $300 million of gross commission income. As the real estate market continues to slow, this could provide Realogy with attractive buying opportunities, says Dhingra.

Realogy is also very underleveraged, Dhingra says, and this will help its acquisition strategy. The company's debt-to-EBITDA level is currently less than 1.0 times, but Dhingra says the company could support a 3.0 times level.

One looming question is whether the stock will trade in line with homebuilders, such as

Toll Brothers

(TOL) - Get Report


D.R. Horton

(DHI) - Get Report

, which have seen their stock prices cut in half since last summer.

"I don't the think the association with homebuilders is terribly strong, and I think the market will see through it," says Dhingra. "Most of the income Cendant generates is through the franchising model, and that model is a lot less capital intensive, and it doesn't have the same level of operational risk with homebuilders."

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