Douglas Elliman: When It Rains, It Pours (NYSE:DOUG)

Since my last update, Douglas Elliman (NYSE:DOUG) has continued to trade down as the existing home real estate market continues to struggle from high mortgage rates. However, with shares down another 26% since August, the company is only worth ~$150 million (Figure 1). Is it time to finally turn bullish on the company’s shares?

Brief Company Overview

Douglas Elliman is a leading real estate brokerage company focused on markets like New York (including the NY suburbs), Massachusetts, Florida, California, Texas, and Colorado. DOUG has approximately 6,900 affiliated agents across 120 U.S. offices servicing its clients (Figure 2).

DOUG’s agents primarily focus on the high-end luxury segment of the market, with its agents advising on $43 billion in transactions in 2022 or ~$6 million per agent. DOUG’s average transaction value was $1.6 million, significantly higher than its peers (Figure 3).

Q3/2023 Was Another Weak Quarter

To nobody’s surprise, Douglas Elliman recently reported another weak quarter, with the company recording $239 million in revenues from advising on $9.3 billion in real estate transactions in the third quarter (Figure 4). This was an 8% decline YoY compared to $260 million in the prior year’s third quarter when Gross Transaction Value (“GTV”) was $10.2 billion in Q3/22.

However, the company’s long-talked-about focus on costs seems to be finally flowing through to the bottom line, as DOUG reported an operating loss of $8.8 million, not much lower than the $5.2 million operating loss in Q3/22, despite the large decline in topline revenues.

Cost Cuts Finally Taking Hold

With respect to costs, real estate commissions obviously scaled down YoY from lower transactions. However, it was encouraging to see total non-commission expenses decrease by $7.7 million YoY or 9.6% (note, my calculation is different from management’s commentary which quotes $7.8 million and 10%).

According to management’s commentary on the Q3 earnings call, the decline was driven by a reduction in headcount by 60 employees worth ~$3.6 million in expenses, a $2.2 million reduction in advertising and sponsorships, $1 million reduction in general expenses, and $400,000 reduction in travel expenses.

One of DOUG’s largest expenses is occupancy, which amounts to $34 million / year in lease expenses plus ~$10 million in additional costs. Between now and 2025, DOUG plans to consolidate offices and let some leases expire where it doesn’t make sense to renew them. Management believes there is scope to save a few million dollars per year in expenses from this effort.

Resale Activity Continues To Plumb Depths

Unfortunately, so far, the resale market continues to be moribund with little signs of life, as existing home sales recently broke to new multi-year lows at a 3.79 million seasonally adjusted annual rate in October (Figure 5). This pace of resale activity is unprecedented and is even lower than resale activity during the early days of the COVID pandemic.

This has caused Larry Yun, the National Association of Realtor’s (“NAR”) Chief Economist, to lower his full-year forecast for resale activity to 4.15 million for 2023. If 2023 resale activity ends up at 4.15 million, this will be even slower than in 2009, during the depths of the Great Financial Crisis (Figure 6).

When It Rains, It Pours

To put further pain on realtors’ misery, the National Association of Realtors and several brokerages were recently ordered by a federal jury to pay $1.8 billion in damages to class action plaintiffs who argued that they were forced to pay excessive fees to real estate agents. The jury’s verdict also allows the court to issue treble damages, which could raise potential damages to over $5 billion.

While Douglas Elliman was not directly named in the Sitzer/Burnett class action lawsuit, the company has been named in two separate cases involving customary real estate business practices and the National Association of Realtors rules that were the subject of the class action lawsuit.

Furthermore, aside from the immediate monetary damages from the lawsuit, the real estate brokerage business is in complete disarray as the existing business model may have to undergo extreme changes in the coming years as a result of this verdict.

For example, under the existing model, real estate sellers pay up to 6% commissions, or $60,000 in commissions on a $1 million property, to both buyer’s and seller’s agents. However, under the court verdict, “the sellers would no longer be required to pay their buyers’ agents, and agents would be free to set their own commission rates”.

This could potentially lead to a price war where brokerage commissions are permanently lowered for all industry participants, including Douglas Elliman. For context, DOUG generated $1.1 billion in commissions in 2022 from advising $43 billion in transactions or a 2.56% commission rate. Any reduction in commission rates could have massive ramifications for real estate brokerages’ valuations and DOUG investors will need to closely monitor the legal developments in the coming quarters.

Real Estate Development Pipeline May Lead To Sizeable Payoff In Coming Years

One interesting aspect of the Douglas Elliman story that is not well covered is its exposure to the new construction market. Going through the company’s reports and conference calls, we find that Douglas Elliman has a nascent business segment called ‘Douglas Elliman Development Marketing’ (“DEDM”) that provides expertise in sales, leasing, and marketing for new development projects in key markets like Florida and Texas.

In 2022, this segment generated $71 million in revenues and is on pace to match or exceed that in 2023 (Figure 7).

On the Q3 conference call, management noted that they currently have $21.5 billion in the development pipeline that should flow through to the P&L in the coming years. Assuming new development commission rates are similar to resale commissions, this could be quite a lucrative complementary business segment for Douglas Elliman.

Unfortunately, so far, financial figures for this business segment are scant, so it is difficult for analysts to properly value this opportunity.

Updated Model Still Sees Losses

Figure 8 shows my updated financial model following the latest reduced resale forecast from NAR and DOUG’s cost cuts. Overall, financial performance is expected to be worse in 2023, primarily as revenues are now projected to decline 15.5% YoY to $974 million, consistent with a steep 17.5% decline in resale activity projected by NAR. My operating income estimate is lowered to -$53 million and I expect DOUG to report a $0.42 / share loss for the year.

Even with a projected 13.5% YoY rebound in resale activity in 2024 and lower non-commission expenses, I still expect DOUG to run an operating loss of $18 million and a $0.09 / share loss.

Warming Up To DOUG’s Valuation

However, with the company now trading at a valuation of only $156 million enterprise value, the stock is certainly starting to look interesting (Figure 9). DOUG’s current valuation is only implying EV / agent of $22,600.

As I noted in my prior article, Douglas Elliman may appeal to another brokerage firm that can use the Douglas Elliman brand to sell luxury real estate. As a private company, a potential acquirer may be able to cut costs further than what DOUG management has done to date and can return the company to profitability.

However, one impediment to an M&A transaction is the overhang from the class action lawsuit. Until the dust settles and industry participants get clarity on where commission rates will end up, I doubt anyone would be willing to take on the risk of making a bid on Douglas Elliman.

Conclusion

For now, I continue to be cautious about the shares of Douglas Elliman as the resale market continues to suffer from high mortgage rates. If industry estimates are correct, 2023 may prove to be the worst year in terms of existing home sales since the Great Financial Crisis.

Looking forward, there is also an overhang on DOUG’s shares from the potential fallout of the Sitzer/Burnett class action lawsuit. The federal jury’s verdict opens the door for agents and brokerages to opt out of the NAR and the potential for commission rates to fall significantly in the coming years.

Balancing the negatives is DOUG’s valuation, which is starting to look very cheap, at just $156 million enterprise value. A potential acquirer can buy DOUG and use the brand as its luxury real estate offering. However, I do not believe any deal will be consummated until there is more clarity on how commission rates will shake out in the coming years.

I maintain my hold rating.