McGrath’s Problems with its Partners

McGrath’s Problems with its Partners

McGrath Estate Agents (ASX: MEA) share price fell over 30 per cent on the back of an announcement that its profits will fall short of the prospectus forecasts in FY16.

The company blamed an “unforeseen low volume of listings and sales” that started to emerge in the latter part of March. Prior to this, the company was performing slightly ahead of the prospectus forecasts.

In the 9 months to March 2016:

• Revenue was 6 per cent above budget,
• Revenue from pre-existing company owned offices was 9 per cent above budget, and revenue from company owned offices acquired from Smollen Group was 10 per cent below budget, and
• EBITDA was 1 per cent above budget.

The fall in listings and sales in the first half of April was mainly caused by weakness in volumes in the Northern and North Western suburbs of Sydney. These are the areas covered by the Smollen Group offices that were acquired by MEA in early December last year. Smollen Group June quarter volumes are now expected to be 25-30 per cent lower than was forecast in the prospectus. Smollen Group was MEA’s largest franchisee prior to its acquisition.

Despite the localised weakness in volumes, MEA believes that its performance is in line with the broader industry in that region.

The company has revised its revenue forecast for FY16 down by 0.8-3.5 per cent to A$136-140m and its EBITDA forecast by 13-16 per cent to A$26-27m.

The first question these revisions raises is that given the revenue forecast has been reduced A$1-5m and the EBITDA forecast has fallen A$4-5m, the cause of the revision is more than just a revenue shortfall. Operating costs are also higher than expected. This is certainly not explained in the release.

We believe that this is due to continued growth in vendor marketing spend (ie advertising). MEA bills its customers for the cost of any advertising plus a small mark up. This is included in the revenue line, with the cost of the advertising as an offset in expenses. Customer spend on advertising has increased despite the lower amount of listing and sales volumes. This shifts the mix of revenue for MEA from very high margin commissions (which are now expected to fall significantly in 4Q16) toward very low margin advertising. Higher advertising revenue results in higher operating costs, but the dramatic fall in sales commissions has little offset on the cost line. The net impact is a relatively neutral outcome at the revenue line and higher operating costs from increased advertising purchases, leading to lower EBITDA.

This obviously has read-through implications for both REA and Domain, suggesting that for the time being at least, demand for property advertising remains strong.

The second issue harks back to a post we did on 22 June last year following the Woolworths profit warning. The issue with any profit warning late in the financial year is that you need to isolate the change in earnings outlook for the remainder of the period from what has already been reported. This will provide a better indication of the current earnings run rate as the company enters the new financial year.

In the case of MEA, while the revised guidance implies flat EBITDA in the full year, 2H16 EBITDA will be down A$2-3m or 13-21 per cent on the prior year, after rising 13 per cent in the 6 months to 31 December 2015. This shows the dramatic turnaround in the momentum of the business. The problem for market expectations is that the company is likely to be carrying the 2H16 earnings momentum into FY17, not the flat EBITDA indicated by the full year 2016 performance.

This would suggest that the market should be expecting a fall in FY17 EBITDA relative to FY16, unless the run rate earnings performance is likely to rebound dramatically from current levels. However, the weak business momentum in 2H16 might take some time to be fully factored into broking analyst expectations. At this early stage, the limited number of sell side earnings forecasts suggest an expectation that EBITDA will be at worst flat in FY17. This appears to be optimistic.

One of the issues we have with MEA is its acquisition of franchisees prior to the IPO. The performance of a real estate agent office is heavily dependent on the efforts and relationships of the individual agents in the office. There is a lot of human capital in the business that walks out the door each night. The relationships and the franchise of the individual agent is largely portable, and the cost of establishing your own office is relatively low (low fixed costs and capital requirements).

Consequently, high levels of incentivisation payments are required to retain key staff. The value of a franchise system is the incentivisation provided to the local staff by ownership and equity in the business. By acquiring the Smollen Group, MEA has taken away this incentivisation for a significant part of the MEA network. While the A$14.9m of deferred payments should provide some incentives for the 5 ‘Smollen Sellers’, it would not be surprising if their engagement in the business had dropped slightly post the IPO.

The prospectus acknowledged this issue as a risk for the company:

“Following completion of the Acquisition, the Smollen Group’s future performance and integration with McGrath will depend on, to a large extent, the efforts and abilities of its senior management team to effect a successful transition. Shane Smollen will assist in leading that transition and has entered into a one year consultancy agreement with McGrath. However, the loss of Shane Smollen, particularly during the transition period, may have a material adverse impact on the Smollen Group’s transition and, consequently, McGrath’s operating and financial performance.

McGrath’s Agents are key to the success of its business. The majority of Agents are independent contractors and are able to leave McGrath at short notice and potentially join other agency networks or offices. The market for quality agents is also considered highly competitive. The loss of key Agents could undermine McGrath’s ability to operate its business to the current standard and scale.

These occurrences may have a material adverse impact on McGrath’s revenue and profitability. The departure of a number of key Agents simultaneously or over a short period of time could have a particularly material adverse effect on McGrath’s financial position and performance.”

The results for the 6 months to 31 December 2015 include some detail on the acquisition of Smollen Group. These note that the balance sheet includes A$14.9m of deferred consideration for Smollen, which would be satisfied by non-market conditions (revenue and other performance indicators) and payable after the end of FY16 and FY17. This represents 23 per cent of the A$65.4m adjusted consideration MEA paid for Smollen. Of the A$65.4m consideration, A$65.7m (over 100 per cent) was intangibles. Essentially what MEA acquired was relationships and the staff in the Smollen Group.

We note that the bulk of the profit warning appears to stem from this part of the business. While the company stated that the performance of these offices was in line with the regional market performance more broadly, it is fair to be concerned about the impact ownership these offices are having on the incentivisation of key staff.

Stuart Jackson is a Senior Analyst with Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.