This business bought its biggest rival and is primed for growth

That fundamentally changes our original investment case. Shareholders in Belvoir could use this opportunity to exit and reinvest elsewhere, but we see value in keeping their new shares, or even doubling down. In TPFG's case, bigger really looks to be better.

To start, following the Belvoir takeover, TPFG has no rival of scale. Foxtons (FOXT) and Savills (SVS) are listed estate agencies, but not franchises. Fellow franchise group LSL Property Services (LSL) is a quasi-competitor but focuses much more on property services. Rather than compete, TPFG counts Mortgage Advice Bureau (MAB1) as its biggest partner, to both diversify and provide a third of sales. TPFG's only direct competitor is Winkworth (WINK), but its relative size poses little threat. In short, investors keen to invest in estate agency and property services franchising have one serious UK option.

A new entrant to the market would struggle to catch up. TPFG has spent over a decade building up the UK's largest network of estate agency and property services franchises, across nine brands. It also owns several estate agency businesses outright. Those intangible assets cannot be created overnight, even with cash to burn. Finally, while margins are healthy, they probably aren’t high enough for an upstart to easily undercut TPFG. This gives the group what Morningstar would call a 'wide economic moat'. 

Then there is the timing of the Belvoir merger. Market expectation that interest rates have peaked and may even come down this year has helped the housing market to recover somewhat. That should translate into higher housing transaction activity for TPFG’s franchise partners. TPFG will no doubt welcome any improvement in the house sale revenue stream, which TPFG said was "subdued" in the six months to 30 June, the most recent reporting period. With full-year results due at the end of April, investors will not have to wait long to find out whether momentum here is starting to return.

Even if the housing market does not roar back to life, TPFG is well diversified because of its push into lettings, a revenue stream that has grown throughout the downturn because of the rental boom (and which Belvoir also developed as a standalone firm). As TPFG puts it, "the 12 per cent increase in lettings management service fees more than offset the expected weakening in sales management service fees" in the first half of 2023, and explained how the business managed to grow revenue, pre-tax profit and earnings per share basis year on year, despite the housing market downturn. It boosted the dividend by 10 per cent, which remains covered by earnings.

And although the past is no guarantee of future performance, the growth in TPFG’s revenue, earnings and dividend over the past decade has been quite consistent – despite the sentiment-dependant nature of the housing market. One reason for TPFG's success here is its ability to sign up franchisees, whatever the market is doing. When booming, TPFG offers them a chance to take advantage of the boom. When slumping, TPFG provides the security to survive the slump.

Meanwhile, franchisees work hard because they are independent business owners, not salarymen. If the market is strong, they strive to beat their rivals. If the market is weak, they need to earn a living. That, as TPFG tells it, is key to its investment case. Its business growth suggests this balance works well.

The two analysts that cover TPFG expect this growth to continue. As Singer and Canaccord Genuity are both corporate clients of TPFG, investors should take their analysis with a pinch of salt, but their general thesis seems solid. TPFG operates 930 property franchise locations. At last count, the Office for National Statistics calculated there were more than 20,000 estate agency businesses in the UK, and many will have multiple locations. In short, the market is deep, meaning TPFG has a lot of capacity for future growth.

In asset terms, that growth has largely centred on intangibles created from the development of its franchise relationships, and which accounted for 82 per cent of total assets as of June. On the plus-side, TPFG’s franchising model is both asset- and liability-light, and the group entered 2024 in a net cash position. Should the business want or need to commit cash to invest, it is starting from a sound position.

Other franchise businesses' balance sheets are not so robust. Like the world’s most famous franchising group, McDonald’s (US:MCD), the UK-listed Domino’s Pizza (DOM) has negative shareholder funds. The reason for this is a different model – not just in the obvious sense that TPFG's franchisees sell homes and Domino's franchisees sell pizza – but that Domino's has fewer intangible assets and greater exposure to lease debt than TPFG. But lower net debt and net assets should normally be seen as a plus, whether it all relates to pepperoni or property.

Still, none of this means TPFG would be immune to a market downturn. Revenue did drop during the pandemic, suggesting there are some market conditions that even an army of entrepreneurial estate agencies cannot turn to their advantage. Many argue the housing market is improving, but it could get worse instead of better if mortgage arrears keep rising and forced sales flood the market. The Bank of England  (BoE) has warned about this possibility, predicting that average mortgage affordability will get close to 2008-09 levels over the coming years as homeowners on pre-2022 fixed rates look to remortgage.

As for the rental market, Savills predicts that the boom will normalise over the coming years due to unaffordability. In theory, TPFG and its agencies will still have business from those looking to rent somewhere cheaper or who turn to buying instead of renting. Still, considering the bearishness from both Savills and the BoE, investors should not assume growth is inevitable.

The other potential issue is more general: with any profit-seeking franchise model, there remains the possibility of conflicts of interest. While shareholders want rising dividends and free cash flow, and franchise partners want investment. TPFG's past and current performance shows it can navigate this, but investors should be aware. There is also the concern that the owned part of its business dilutes the franchise element.

Perhaps the biggest worry is that future growth may be more gradual. Although the theoretical market is massive, TPFG’s absorption of its closest rival means deal-making will need to drop down in size. As such, TPFG's future is likely to lie in the continual grind of acquiring brands and franchises piecemeal, although given the company’s relatively small size, this needn’t necessarily concern the long-term investor.

We believe the market has factored this in. The price-to-future-earnings ratio reflects confidence in growth while showing an understanding that it will not be rapid. However, in the long term, we believe today's price represents good value. Investors should not expect a massive return in a flash, but this estate agency company looks as though it is moving places.

Last IC view: Hold, 220p, 27 Apr 2021