Most of us have watched in amazement as the residential real estate market in the U.S. has gone through the roof. Almost all of the homebuilding stocks have reflected the positive environment. Even though there have been some healthy corrections this year, homebuilder DR Horton
I have been reluctant to get involved in this area, both because I thought the boom was getting a little long in the tooth and because I have direct real estate investments that have done well and are totally under my control. I've viewed the residential builders as an industry play, and the group seems to perform in lockstep. Similarly, I believe the commercial real estate service providers are now in the sweet spot of the economy, and the major factors in the group should continue to do well for the next year or so.
I use a screening system to come up with ideas for further research. Three companies in this industry -- CB Richard Ellis
While I certainly wouldn't object to taking an industry approach and buying a basket of all three stocks mentioned above, some of us are on a stricter budget and can afford to buy only one stock in the industry. My favorite is CB Richard Ellis Group, which happens to be the largest player in the real estate services industry and is more than twice the size (in terms of revenues) of its nearest competitor. Although publicly traded since only June 2004, the company has a 99-year history and is No. 1 in commercial real estate brokerage, No. 1 in appraisal and valuation, No. 1 in property and facilities management, and No. 2 in commercial mortgage brokerage. The company has a very strong global presence, with more than 200 offices in the U.S., Europe, and Asia.
CB Richard Ellis' growth strategy seeks to capitalize on industry trends by concentrating marketing efforts on large clients. A global relationship manager is assigned to each client, and that individual is compensated on a performance basis, attempting to maximize revenue per client. The company has been very successful in generating repeat business, cross-selling corporate services, and leveraging each client relationship. The company's investment management business is also an important focus. Clients of this segment get to know the full capabilities of the organization and are good candidates for other services. Finally, the company continues to make acquisitions that are a good fit geographically or can broaden the company's service offerings.
CB Richard Ellis has demonstrated excellent growth characteristics for many years. Average annual organic revenue growth for the period from 1992 through 2004 was 9%. Earnings grew at a faster pace, but both sales and earnings have had periods of decline. Both 2001 and 2002 were affected by the weak economy in the U.S., as well as by the terrorist attacks on 9/11 and the imminent war in Iraq. Since that time, growth has accelerated again. Revenues in 2003 were up 39% and increased again in 2004 by 45%.
The company recently reported results for the first nine months of 2005, and results continue to be impressive. Revenues advanced by 25% (almost 30% in the third quarter alone), and net income was up 163% (94% in the third quarter). Growth this year has been driven by strong investment sales activity and related services such as mortgage brokerages. Clearly, this is a cyclical business that has some relationship to interest rates. However, if the economy remains strong next year and inflation remains contained, commercial real estate sales could remain very strong. After all, pundits have been predicting the end of the residential real estate boom for several years, but in the final analysis, it's going to be the economy and interest rates that determine when this boom ends.
And the leasing market, which represents about 50% of revenues, is just now beginning to show some life. This segment should be a solid contributor to growth for the next couple of years. In the third quarter, leasing revenues were up 15%, which was an acceleration from the 11% growth reported in the second quarter. Many major markets are positioned in the sweet spot of the cycle, where rents are just now beginning to show increases.
With only one quarter left to report for this year, CB Richard Ellis is expected to report earnings per share of around $2.75 for 2005. The implied P/E ratio of less than 20 approximates the company's projected earnings growth target for the next few years and seems very reasonable for a company with excellent prospects. Analyst estimates for next year are set at around $3.00, but if the economy remains strong, I believe earnings could be 10% or so above that level.
In terms of valuation, the company's stock seems very attractive. The property management industry sells at a P/E of 33, a price/sales ratio of 2.57, and a price/operating cash flow ratio of 23.6. These values are based on latest 12-month results and are substantially higher than CB Richard Ellis' P/E of 20.9, P/S of 1.42, and price/cash flow of 16.2. In addition, CB Richard Ellis has a long-term debt/equity ratio of 0.79, compared with the industry at 1.32, and a return on capital of 15%, compared with the industry's 3.8%. The company does sell at a premium compared with its primary competition. Valuation measures are somewhat lower for Jones Lang LaSalle and Trammell Crow. But CB Richard Ellis is the premier company in the industry with a much larger market capitalization, better return on capital, and a higher expected growth rate. I believe the company deserves the premium and will prove to be an excellent investment over the next year or so.
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Fool contributor Richard Moore owns shares in CB Richard Ellis.