Realogy Holdings IPO Strikes Gold
You can mark October 11 in your notebook as the day four companies went public with each of them delivering at least 20% first-day returns. The largest of the four IPOs, Realogy Holdings (NYSE:RLGY), gained 26.7% to close at $34.20. Now that it's gotten off to a good start, I'll consider the pros and cons of owning its stock, whether you're an IPO investor or looking to get in after its impressive debut.
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Realogy is the biggest residential real-estate services company in the United States, with approximately 26% market share from its Century 21, Coldwell Banker, Sotheby's International Realty, and Better Homes & Gardens Real Estate brands. Its goal is to handle every service revolving around buying or selling homes. It aims to achieve this goal by operating in four segments that each generate fees for services rendered: Real Estate Franchise Services, Company-Owned Real Estate Brokerage Services, Relocation Services and Title and Settlement Services. By far the biggest revenue generator is NRT LLC, Realogy's company-owned real estate brokerage, which operates 720 offices in 35 major markets across the U.S. In 2011, its revenues were $2.97 billion or 69% of Realogy's overall sales, with the remaining three segments responsible for the rest. While the company-owned business is the big revenue generator, the money maker's are Realogy Franchise Group, the franchising business of the holding company, and Cartus, its relocation services business. The former accounts for 61% of its 2011 EBITDA with the latter generating another 22% of EBITDA, for a combined 83% of the $520 million in segment EBITDA.
The argument for investing in Realogy comes down to one's belief in the housing market's future gains. Realogy chose to wait to go public until it could see a recovery. Although things were looking better by the end of 2011, it needed an increase in housing prices to be sure; this happened in the second quarter, with prices rising 5.4%. While things are definitely on the mend as witnessed by the rise in homebuilder stocks in 2012, I'd hesitate to suggest real estate is fully back from the dead. Nonetheless, it's more optimistic today than at any time in the past five years.
The first thing I look for in an IPO is a track record of profitability and revenue growth. Realogy exhibits neither. Its prospectus suggests it will capitalize on a real estate recovery, but that is a dubious claim. Apollo Global Management (NYSE:APO) acquired Realogy in April 2007 for $9 billion including $2.4 billion in debt. To pay for the deal, which was done at the height of the markets, Apollo chipped in $2 billion in equity while financing the remaining $4.6 billion with new debt. In a nutshell, it entered its ownership of Realogy with $7 billion in debt. Prior to its acquisition by Apollo, it was a public company as a result of its spin-off from Cendant Corporation on July 21, 2006. In its final fiscal year as a public company in 2006, its revenues were $6.5 billion on EBITDA earnings of $775 million, substantially less than the two previous fiscal years. Business was deteriorating but still profitable.
Apollo made the acquisition right as the real estate market was turning and the meltdown began. Over the next five years it proceeded to lose $4.1 billion while revenues declined from $6.5 billion in 2005 to $4.1 billion in 2011. On page 16 of its prospectus, Realogy points out that its adjusted EBITDA has been positive the entire five years and it could argue that its adjusted EBITDA margins are actually stronger today than they were prior to Apollo purchasing it. I wouldn't. Adjusted EBITDA takes big liberties with the numbers. On an EBITDA basis they've basically remained flat.
The question you have to ask yourself is whether the business is better off having been owned by private equity the past half-decade. On that score I'd say no. While its revenues are lower, due in large part to the real estate crash, its earnings have been brutally affected by the debt heaped on it by Apollo. Its interest expense in 2006 was $57 million compared to $672 million in 2011. The IPO will reduce debt by $2.9 billion and its annual interest expense by $333 million. But there's a catch - $2.1 billion of the reduction is the 11% convertible notes held by Apollo, Paulson & Co. and others. Those notes will be converted to 82.13 million shares subject to a 180-day lock-up agreement. Come April there will be a flood of selling going on as we recently experienced with Facebook (Nasdaq:FB), but that's not the worst part.
Apollo, Paulson and others have received approximately $1 billion in interest since acquiring Realogy in April 2007. They will come out of the 180-day lock-up with 90.15 million shares valued at $3.1 billion, assuming the first-day gains hold. With the interest added in, they'll be at a break-even position. Apollo has taken a profitable company, turned into a money loser, and increased its debt by almost 90%. Private equity strikes again.
The Bottom Line
Both Apollo and Realogy management are guilty of hubris. This is a deal that never should have taken place and now they are asking investors to dig them out of a hole. If you believe there is a real estate recovery underway, this is the last way you should play it.
At the time of writing, Will Ashworth did not own any shares in any company mentioned in this article.