Marcus & Millichap, Inc. Q1 FY2023 Earnings Call

Greetings and welcome to the Marcus & Millichap’s First Quarter 2023 Earnings Conference Call. As a reminder, this call is being recorded. And it is now my pleasure to turn the conference over to your host, Jacques Cornet. Thank you, sir. You may begin.

Thank you. Good morning and welcome to Marcus & Millichap’s first quarter 2023 earnings conference call. With us today are President and Chief Executive Officer, Hessam Nadji; and Chief Financial Officer, Steve DeGennaro. Before I turn the call over to management, please remember that our prepared remarks and the responses to questions may contain forward-looking statements. Words such as may, will, expect, believe, estimate, anticipate, goal and variations of these words and similar expressions are intended to identify forward-looking statements. Actual results can differ materially from those implied by such forward-looking statements due to a variety of factors including, but not limited to, general economic conditions and commercial real estate market conditions; the company’s ability to retain and attract transaction professionals; the company’s ability to retain its business philosophy and partnership culture amid competitive pressures; the company’s ability to integrate new agents and sustain its growth and other factors discussed in the company’s public filings, including its annual report on Form 10-K filed with the Securities and Exchange Commission on February 28, 2023. Although the company believes the expectations reflected in such forward-looking statements are based upon reasonable assumptions, it can make no assurance that its expectations will be attained. The company undertakes no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise. In addition, certain financial information presented on this call represents non-GAAP financial measures. The company’s earnings release, which was issued this morning and is available on the company’s website, represents a reconciliation of the appropriate GAAP measures and explains why the company believes such non-GAAP measures are useful to investors. This conference is being webcast. The webcast link is available on the Investor Relations section of our website at www.marcusmillichap.com, along with the slide presentation you may reference during the prepared remarks. With that, it’s my pleasure to turn the call over to CEO, Hessam Nadji.

Thank you, Jacques. On behalf of the entire Marcus & Millichap team, good morning, everyone, and welcome to our first quarter 2023 earnings call. As anticipated, Marcus & Millichap faced a challenging first quarter due to the market disruption caused by the Fed’s interest rate shock. The repricing of real estate and ensuing bid-ask spread was exacerbated by bank failures which elevated lender caution and further reduced liquidity during the quarter. Revenue came in at $155 million, resulting in an adjusted EBITDA loss of $7.4 million and a net loss of $5.8 million. The capital invested in various growth initiatives over the past several years, particularly talent acquisition and business development, pressured earnings significantly. Revenue production was hampered by a general lack of investor motivation to sell at reduced prices and elevated uncertainty, keeping many buyers on the sidelines. Reduced loan-to-values and frequent repricing of debt by many lenders challenged our key metrics, including an increase in our deal ratio and extended marketing and closing timelines. These forces impacted all business segments and price points but were pronounced in larger transactions as many institutions remained on the sidelines and many private investor deals priced above $10 million simply did not pencil out. First quarter sales transactions in the broader market fell by an estimated 46%, with a volume decline of 55% to 60% based on preliminary data from Real Capital Analytics and CoStar. This marks the second consecutive quarter of severe decline in trading activity, which reflects the broad nature of the current market dislocation. Marcus & Millichap’s brokerage transactions declined 40% for the quarter and reflect execution of nearly 1,300 brokerage transactions, which is a testament to our team’s creativity and commitment to help clients execute even in a tough market. Our results were particularly impacted by larger sales, which had posted outsized growth over the past few years and therefore had a very tough comparison. Private Client revenue fell 44%, while revenue from middle market and larger sales declined 63% and 70%, respectively. For perspective, revenue from these two segments priced at $10 million and above combined had grown by 134% in the first quarter of 2022. The firm’s IPA division, which primarily serves institutional investors, is fully engaged in providing opinions of value and advisory work to help these clients navigate challenging market dynamics. We believe the integration of IPA with our core private client business to be a major differentiator and a clear advantage when capital flows resume. Our team will be well-positioned to gain new relationships and market share in their recovery. On the Private Client side, our brokers are highly focused on creative solutions to get deals done for sellers with motivation and realistic price expectations. These include seller financing, equity expansion, and executing 1031 exchanges. The company’s financing revenue declined 40% as sources of financing became more restricted due to contagion fears. Decisive actions and messaging by the Fed and the Treasury alleviated these fears to some degree; however, virtually all lenders have taken a more cautious stance. Our financing team still closed 279 transactions with 142 separate lenders in the quarter, reflecting the skill, tenacity, and access our team brings to investors even amid the Fed-induced liquidity tightening. We believe that the eventual passing of the perfect storm currently impeding sales and financing will lead to higher volumes as the market works through repricing and normalization of credit conditions. We are positioning Marcus & Millichap to reach new milestones in that recovery through the actions and strategies we’re currently implementing. These include a continued focus on training, internal communication, and best practices sharing, all of which are there to support our sales force while leveraging our real-time research to help investors with strategy and execution. Our commitment to being a trusted adviser may not lead to transactions in the near term as many of our clients elect to postpone trade; however, partnering with them during these times will lead to a stronger bond and more business as the market recovers. This is not a new approach for Marcus & Millichap; rather, it is a page out of our own playbook from every significant market downturn, which resulted in above-average growth and new milestones in recovery cycles. To this end, we’re tightly balancing cost controls with critical investments that keep Marcus & Millichap on offense. The reduction of force executed in December lowered our expenses going into this year, and we continue to strategically prioritize costs. These include investments in proprietary technology enhancements that directly drive leads and revenue, expanding our auction platform, which has been off to a great start, heavily promoting our loan sales division to lenders and potential investors in loan pools, and sustaining the company’s presence at key industry conferences and signature client events. We believe all of these are very critical. Additional expense cuts in select areas are being executed. However, we believe sustaining current support levels is critical to helping our sales force remain in front of clients and respond to their elevated information needs. Taking a long-term view will weigh on our financial performance in the near term but will pay great dividends in the recovery. To accelerate external growth, management is aggressively pursuing talent acquisition to build on some key hires made in the first quarter. Our ongoing success in attracting experienced individuals and teams in both financing and brokerage continues to offset the elevated dropout of newer professionals due to market conditions. The first quarter’s more challenging environment added to the difficulty new brokers and originators are experiencing in generating revenue. The inflow of new candidates, particularly from other sales professions, also faces market headwinds. None of these obstacles are deterring our commitment and actions to reach a wider candidate pool and grow the sales force. Our multi-pronged strategy of traditional organic growth, experienced professionals and team additions, and strategic acquisitions remains intact. In fact, the pipeline of experienced prospects continues to grow, and we’re encouraged by active discussions with some quality M&A targets. Now looking forward, the timeline for the market recovery has pushed out, largely due to the bank failures and further tightening of capital availability. We remain cautiously optimistic that continued moderation of inflation rates and the likely end of the Fed tightening cycle will bring clarity to the market. As we shared on our last call, we believe investors will also regain confidence with visibility on the depth of the labor market slowdown. As the effects of higher interest rates work through the economy, we should continue to see a deceleration of job growth as opposed to severe net job losses. This is critical for real estate demand. It may take a few more months for this to emerge, which should coincide with more price adjustments, setting the stage for improving trading activity. The volume of maturing real estate loans and pressure on the banking system are understandably concerning many investors. Maturing loans face a major price correction in some categories, but it is critical to remember that most property types, with the exception of office, have experienced robust rent growth and strong fundamentals over the past 5 to 7 years. When this year’s maturing loans come to market, many properties will undoubtedly require fresh equity and restructuring to varying degrees. Lenders in the Fed appear to be focused on working with borrowers as opposed to offloading these loans at a discount. The banking system as a whole has substantially more liquidity going into the pandemic. This liquidity level has further increased in the last 2 years. This is a stark difference to the 2008-2009 period when bank liquidity prior to the recession was at a fraction of current levels. We have the balance sheet to be prudently offensive as a company during this market dislocation, while at the same time, continuing our strategy to return capital to shareholders. This is being executed through our semiannual dividend and extended stock repurchase program announced yesterday. The entire Marcus & Millichap team is committed to leveraging this difficult time to build client relationships and harvest the pent-up demand that will undoubtedly fuel growth in the recovery.

Thank you, Hessam. Before delving into the details, I want to provide some historical context. If you recall, the first quarter of 2022 was a record first quarter, and the fourth best overall quarter in the company’s 52-year history where revenue increased 74% over the first quarter of 2021, creating a high watermark and an even tougher comparable for Q1 2023. The outsized results a year ago were driven by an urgency in the marketplace to transact in anticipation of rising interest rates. Today’s market conditions are much different and reflect 10 consecutive rate increases totaling 500 basis points as well as the failure of three regional banks in recent weeks that has tightened credit markets significantly. With that as a backdrop, let’s move to first quarter results. Revenue for the quarter was $155 million compared to $319 million in the prior year quarter. Breaking down revenue by segment, real estate brokerage commissions for the first quarter were $135 million and accounted for 87% of total revenues compared to $287 million last year, a decrease of 53% year-over-year. This represents total sales volume of $7.1 billion across 1,279 transactions, which is down 59% and 40%, respectively. To again add perspective, the $17 billion in sales volume in the first quarter of last year was far and away the largest first quarter in our history. Average transaction size was approximately $5.6 million, down from $8.1 million a year ago, reflective of the mix shift to fewer active institutional buyers given the current market environment. Within brokerage, our core private client business accounted for 67% of brokerage revenue or $91 million. This compares to 56% and $161 million last year. Our middle market and larger transaction segments, which have accounted for outsized growth over the past couple of years, together accounted for 29% of brokerage revenue or $40 million compared to 42% and $120 million last year. Many institutional buyers remained on the sidelines in Q1, waiting for clarity on interest rates and pricing before reentering the market. Revenue in our financing segment, including MMCC, was $16 million in the first quarter compared to $26 million last year. Fees from refinancing and recapitalization accounted for 46% of loan originations for the quarter compared to 52% last year, driven by the sharp rise in interest rates during the past year. In the quarter, we closed 279 financing transactions totaling $1.7 billion in volume compared to 520 transactions for $2.7 billion in volume in the prior year. Despite market conditions, the average transaction size in the financing segment increased 21% over the prior year, driven by the addition of top talent in our institutional capital markets group. Other revenue, comprised primarily of consulting and advisory fees, along with referral fees, was nearly $4 million compared to $6 million during the first quarter last year. Moving on to expenses for the first quarter. Total operating expenses were $171 million, 38% lower than a year ago, primarily as a result of lower variable expenses directly attributable to revenue. Cost of services was $95 million or 61.6% of total revenue, flat on a percentage of revenue basis with the first quarter of 2022 despite lower revenue. In challenging markets like this, a larger share of revenue was generated by more senior producers who have the skill and expertise to complete deals. SG&A during the quarter was $72 million, a decrease of 3% year-over-year, primarily due to lower employee compensation expense tied to company performance, largely offset by expensing of investments in talent acquisition and retention as well as new business development and client marketing support. The headcount and expense reduction actions taken in December benefited us in the quarter as they will throughout the year. The combination of lower revenue and proportionally higher operating costs resulted in a net loss of $5.8 million or $0.15 per share compared to net income of $32.8 million or $0.81 earnings per share in the first quarter of 2022. For the quarter, adjusted EBITDA was negative $7.4 million compared to a positive $51.9 million in the prior year. The effective tax rate in the quarter was unusually high compared to our historical range, primarily due to the amount of expenses that are non-deductible for tax purposes in relation to lower pre-tax income for the full year. Over the long term, we would expect our effective tax rate to return to the normal range in the mid to high 20s. However, for the remainder of the current year, we will likely experience rates similar to or even greater than what we saw in the first quarter. Moving to the balance sheet, we remain extremely well capitalized with no debt and cash, cash equivalents, and marketable securities totaling $431 million. The decrease in cash during the quarter was expected due to seasonal outlays for current and deferred agent commissions, performance-based management bonuses for 2022, investments made in talent acquisition and retention, and share repurchases. The deferred commission outlay was larger than usual given the record revenue performance over the past 2 years. During the quarter, we declared a semiannual dividend of $0.25 per share, representing a total of $10.3 million that was paid in the first week of April. In addition, we repurchased approximately 560,000 shares of common stock at an average price of $31.73 per share for a total of $17.8 million. Since initiating our stock repurchase program mid last year, we have repurchased approximately 1.8 million shares at an average price of $32.88 or $60 million in total. Yesterday, we announced that the Board has authorized an additional $70 million for future stock repurchases. Combined with our remaining open authorization, we have up to $80 million available to repurchase stock under the program, which provides valuable optionality to take advantage of near-term market dislocations. We remain committed to a balanced long-term capital allocation strategy, which includes a combination of investing in technology, recruiting and retaining the best-in-class producers, and strategic acquisitions while returning capital to shareholders through dividends and stock buybacks. As we look ahead, we expect current market headwinds to persist through the second quarter with improvements gradually emerging in the latter half of the year, albeit at a slower pace than what was anticipated when we last spoke in early February. The onset of the regional banking issues in recent weeks likely has pushed out the recovery timeline as markets need to adjust to even tighter lending requirements and reduced credit availability. However, the Fed commentary earlier this week seemed to signal that they are ready to pause further rate hikes, which begins to provide some clarity. Cost of services for the second quarter will follow the usual pattern and be sequentially higher than the first quarter. SG&A is expected to be largely in line with the first quarter on an absolute dollar basis, reflecting the benefit of cost actions taken previously. We remain focused on cultivating client trust, pursuing strategic growth opportunities, and driving operational excellence through best practices with our sales professionals and corporate support staff. The investments we have made and continue to make will position us to return to strong growth as market conditions improve.

Thank you, sir. And the first question comes from Blaine Heck with Wells Fargo. Please proceed with your question.

Great. Thanks. Good morning out there. So you guys clearly have a great vantage point into the investment sales market and recent trends. So I wanted to ask for a little more color on what trends you might be seeing and which deals are most likely to trade in this environment from a real estate sector standpoint, a geographical region standpoint? And any other characteristics like in-place debt or others that might be important. I guess just where is the sweet spot in the market for getting a deal done today?

Good morning, Blaine. There is a lot of variation across the country and by property type. What’s unusual is the drop-off in multifamily trading activity because multifamily for so many years has been the darling of the industry and the most stable asset class during market disruptions. What’s happened there is the gap between the interest rate shock and the rapid increase in the cost of debt versus the lowest cap rates in the industry that were basically held by apartments and industrial properties. Those ironically had the biggest shock in valuation resets, with maturing loans facing the challenge of securing new debt in this environment. So that really affected the trading volumes in an unusual way. However, I will tell you that we are starting to see stabilization and creative financing solutions that are restarting transactions, at least coming back into the pipeline; it might be a while before they close. This comment refers to many of our deals that got postponed or canceled during the first quarter on the multifamily side. From an institutional perspective, multifamily has also been hit very hard because of the pencils down approach really starting in the fourth quarter, but showing up in the numbers significantly in the first quarter. Lots of institutions are completely recalibrating the buy-sell decision based on the same factors that I talked about, but at a larger scale. When looking at other property types, what’s interesting is that the interest in retail is as strong as ever. Our trading activity on retail was down significantly as well. However, because retail is far ahead of any other product type in the reinvention and reimagining that’s been going on for 10 years plus because of e-commerce, it’s in a whole different space now than it was even 3 or 5 years ago, both on the multi-tenant side and ongoing demand on the single-tenant side, where private investors are simply putting in more equity, leveraging less because of interest rates, keeping their options open to refinance later while still achieving their desired investments. Now, there is clearly a bid/ask spread across the board that isn’t unique to any property type. Other areas of strength include hospitality, very comparable to multi-tenant retail coming out of the pandemic and now showing sustainable recovery, especially on the consumer side, not so much on the business travel side just yet, and self-storage holding up very strongly relatively speaking. One universal comment I would make is that there is no shortage of capital. We are starting to see price adjustments in the 10% to 15% range, generating multiple tours, multiple offers, and the private capital side always finds a creative way to get a deal done when the price is right. The fact that financing is tight and rates are higher doesn’t stop an entrepreneurial private investor or group from pursuing the asset they really want if the price is right. That’s a big 'if' right now as the market continues to undergo this price discovery period. That said, it's encouraging to see so much interest and capital still in the marketplace, including new groups forming funds; however, we are not quite there yet regarding the bid-ask spread and the digestion of the interest rate shock. Geographically speaking, growth areas of the country such as Georgia, Florida, the Carolinas, Texas, Nevada, and Arizona continue to see in-migration and business formations. In contrast, more urban areas are still lagging, particularly with office space usage. We are seeing serious issues in San Francisco, Downtown Chicago, Downtown Seattle, and Manhattan from that perspective. Hopefully, that provides a bit more color on what’s happening out there.

Yes. Very helpful. Thanks for all that color Hessam. On the share repurchase front, where you guys have increased your allocation, can you just give us an update about how you are thinking about that relative to other opportunities for capital allocation? How do you think about relative pricing or yields with regard to where your stock is trading versus external acquisition opportunities, and maybe when it makes sense to shift from one to the other?

I will go first and ask Steve to weigh in as well. Those are, of course, very important considerations. We spent a lot of time thinking through them and discussing them with the Board. To us, there is almost as important, if not slightly more important, a bigger picture driver behind this. We have always aimed to develop a diverse and sustainable capital allocation strategy. We want the company to be able to maximize shareholder returns while being aggressive on acquisitions. We understand the importance of accelerating our external growth and scaling it as much as possible, while also being strong defensively to withstand market turbulence, including the one we are experiencing now. Simultaneously, we want to maintain the firepower to keep investing in our platform. The biggest returns come from investing in the platform, making our sales force more productive, and adding more talent to the team. We feel strongly that we can balance all these elements without sacrificing one for another. That's why it’s been critical for us to find that equilibrium and create value across each of those areas. So that’s my broader perspective on it. Steve, anything to add?

I think I would reiterate that we look at those three prongs of a diverse capital allocation strategy, internal investment, M&A, and return of capital to shareholders, with the strongest pull for us being internal investments as they generally offer the greatest return. M&A is pursued at the right price, and we can speak a little to that as we have said on prior calls, there has been and continues to be a bid/ask spread on that front. I think it’s closing. That still leaves us ample opportunity for returning capital to shareholders. We have been active, and when we initiated the program back in August of last year, we indicated that we would be active participants where appropriate. I believe we’ve done a commendable job balancing those three areas, although there is nothing new to report on the M&A side.

Okay. Great. That’s very helpful. We noticed that you guys added a slide on commercial real estate debt maturities in your presentation this quarter and I appreciate your earlier commentary on the topic. But can you give us a little more color on what you are seeing and hearing in terms of lender and borrower discussions around potential workouts for looming maturities, or alternatively for sales or distress transactions? And also, what sectors other than office seem to be seeing the most stress and which sectors appear to be best positioned?

Sure, Blaine. We added that slide because we get so many questions about it, and there is so much concern about maturing loans that we wanted to go one layer deeper and show the breakdown of rent growth over the past 5 years by property type. Looking at that chart, you can see the fact that the story is so different by property type, where industrial rents have increased almost 50%, apartment rents are up 35% over the past five years. Even hospitality and retail posted 15% to 20% rent growth. The property values at the time of the issuance of these loans five or seven years ago were significantly lower than they are today, even with a price correction from our recent peak about a year ago. The concern in the marketplace appears to be a reaction that judges the entire market by the office segment due to headlines. When isolating the fact that office properties have had minimal rent growth in the last five years and are now declining, renewal leases are being signed with smaller footprints at lower rents or tenants are leaving low-quality buildings for higher-quality Class A spaces. Obviously, there will be major gaps in valuation and operations as this office volume rolls over this year, which is the largest segment concerning maturities for 2023, as depicted in the top part of the chart that we added. Rescue capital will be necessary, and price-reduced distressed sales will occur in office buildings. We are seeing some stress on the multifamily front, where debt fund short-term loans were aggressively underwritten over the last three years, are now coming due. Thankfully, we have the agencies very active. In fact, we have managed to engineer many bridge solutions and created numerous ways to help clients facing maturities in the multifamily side, thanks to our Eisendrath team and other originators within MMCC and our IPA Capital Markets, working closely with the agency solution more than we have ever been able to do in the past. Beyond this, it's case-by-case and varies by property type. We are not seeing as much distress in the shopping center sector; rather, it has repositioned itself better. While some issues do exist in retail, they are not as severe as one might perceive. Surprisingly enough, as many banks have exited the market or priced themselves out, our originators are finding new sources of funding for private capital deals. Local and regional banks you've never heard of are stepping up due to their solid balance sheets, as are credit unions. We closed almost 300 financing transactions in the quarter with 142 separate lenders, with 60% of those being banks. So, for every problem, there is a solution, and we are actively working to find creative ways to help our clients navigate what should be the worst of this market correction cycle. Hopefully, we are hitting the bottom and beginning to see a recovery form.

Okay. Great. Very helpful. Last one for me. We noticed a significant decrease in the marketable debt securities balance on your balance sheet this quarter from around $253 million at year-end to $133 million at March 31st. Can you just talk about that decrease, whether that was due to sales or maybe a reduction in the value of those assets?

Yes. Blaine, this is Steve. Not a reduction in value. Our investment portfolio, of course, is investment grade, very much managed in accordance with our stated charter, which is reviewed both internally and with our Board. From our perspective, I view our cash balance in totality, including both long and short-term marketable securities. Overall, that balance did come down during the quarter. The overwhelming majority of the change from December 31 was due to deferred payments related to outperformance over the last couple of years. We use a deferred commission program where a portion of commissions are paid currently, and another portion is deferred; this serves as a great long-term incentive tool for our team as well as accounts for the outperformance of last year and variable compensation paid to management. We consider the cash balance in totality; there’s nothing unusual there, no write-downs and no need for us to sell long-term assets to meet short-term needs.

Alright. Great. Thanks so much for your time.

Thanks Blaine.

Thanks Blaine.

At this time, there are no further questions. Now, I would like to turn the floor back over to the Marcus & Millichap management team for any closing comments.

Thank you, operator, and thank you for joining our call. We look forward to seeing you on the road and look forward to our next earnings call. The call is adjourned.

Thank you everyone. This does conclude today’s conference. You may disconnect your lines at this time. Thank you for your participation and have a great day.