Compass 1Q2022: A Brief Note

I haven’t really written about Compass much, since my 1Q2021 analysis. Part of the reason is a lack of time, but a big part of the reason is a lack of interest. I have long held the view that Compass is a traditional brokerage pushing a tech-forward narrative, but with pretty dire margin problems. And nothing happened since writing my 1Q21 analysis to make me want to change my mind on that. Here’s what I concluded about Compass a year ago:

But at the end of it all, if Compass is indeed successful on all of its strategies, what exactly do we have?

A brokerage with high average sales price, concentrated in high-end markets like New York City, San Francisco, and other major urban metros, with tens of thousands of agents — many of whom will be top-notch team leaders — doing enormous volume, with a strong title, escrow and mortgage business to generate the path to profitability.

That sounds just like Realogy, whose market cap is less than half that of Compass, but already has everything that Compass wants to build other than the single sign-on platform with technology from 2014. Realogy dominates Compass on agent count, on number of markets, on national market share, on transactions, on sales volume, on revenue, on cash flow, on experience, in title, escrow, mortgage, on relationships within the industry… on everything other than splits/incentives and “technology platform.”

It’s not a terrible strategy, since Realogy at one time dominated residential real estate, and still is a power to be reckoned with. But unless something changes in the near future, let’s be clear about what Compass is building: a newer, better, shinier, Realogy.

Apart from Compass overtaking Realogy as the largest brokerage in the U.S. by Sales Volume, which is an impressive feat, there wasn’t much else to analyze or discuss.

So why write about Compass now?

Because I found something interesting about Compass, that’s why. And I like to share interesting thoughts with you all.

For the TL;DR crowd, as I need to take some time to put the pieces together, here’s the takeaway: the training costs for Compass vs. increased productivity required to generate an ROI is an interesting story.

The Compass Narrative of 1Q22

I’m sure you’ve seen the numbers and such by now. The big news is that Compass lost $188M in 1Q22 on revenues of $1.4B, both improvements YOY. And yet, Compass is losing its CFO, Kristen Ankerbrandt, did not name a new CFO, and made some strong statements about preserving cash. So the story from Compass is that it’s doing great, taking market share, continuing to grow, and “We’re #1!” But it’s also being cautious and conservative given the macro environment for housing, and now that Compass is #1, it can afford to take the foot off the accelerator a bit and really emphasize cash flow.

It’s actually a pretty solid narrative.

Compass is recruiting agents at better splits with fewer incentives. From the earnings call: “In Q1 2022, 63% of the agents who came to Compass told us, they did so for a less favorable split than at their previous profits. Why would an agent take less to join Compass? Quite simply, they believe they can grow their business better at Compass.”

Compass is retaining its all-important “principal agents” at 90%.

And Compass is driving technology adoption, since “our technology is a key driver of agent productivity and margin in the future.”

Reffkin then went on to really tout their big training initiatives:

Our technology is a key driver of agent productivity and margin in the future. We launched two new professional coaching programs in the first quarter of 2022. One third of our agents opted into the programs and for 10 weeks they spent three hours a week being trained on ways to grow their business using the Compass platform. [Emphasis added]

Later on, he expanded on the training:

Absolutely. Absolutely. Yes. This has been our biggest new initiative of the year, it’s coaching for agents. The way I would describe it, I think, the historical strategy was training agents on how to use tools.

…

And so that’s just like a high level shift in strategy and how we think about it. We created a team called a Customer Success Team, which is led by some of our best real estate sales managers and coaches that we already had in the company. And they’re scaling the training across all of our different markets and all of our agents and there’s both national and regional training. We called it the Compass 10/10 where there have been 10 weeks over three different types of trainings of an hour for each training. There’s one training that is about learning the actual tools, one training that is about how to grow your repeating business and better relationships with your clients. Yes, and then there’s one regional training, but the current training is called Compass Core that we have expanded from 10/10. And one-third of our agents are currently doing it one hour a week. It’s a 10-week program. But this is one of the things that we’re most excited about and we can see in the data that agents that go through the program are using the tools more and we also have the historical relationship that agents that use our tool. The tool is more to grow their business more.

And so we’re really excited to see the results of this new focus. [Emphasis added]

We’ll return to this shortly.

Profitability and Cash Flow Prioritized

The eyebrow-raising parts of the call, which I imagine captured the interest of investors and of the industry, are where Reffkin made it crystal clear that Compass in 2022 is all about profits and cash flow.

Start with prepared remarks:

We are managing the business to ensure we will not require additional capital. To further emphasize the point, we are managing the business to ensure we will not require additional capital.

We have been actively engaged in assessing our strategic road map and we will slow the rate of investment based on our priorities.

We will do more with less.

So Compass is not going to raise more money. It’s going to grow with the money that it makes, i.e., profits and free cash flows. Some more:

We are committed as an organization to do what it takes to ensure that we continue to drive towards being free cash flow positive in 2023, with adjusted EBITDA margin of 10% in 2025 and 8% to 9% free cash flow conversion.

Then later in the call, an analyst asks whether Compass sees the opportunity to “lean in” to a weaker real estate market and actually pick up more agents, and how Reffkin & Crew see balancing share gains with preserving cash. Reffkin answers:

Look, I think the cash has to be the priority, preserving cash.

And so, if there is a more significant downturn, we would pause expansion. And we still benefit from the market, in our existing markets. There’s a tremendous market share to gain in our existing markets and the same reasons why founding agents in new markets would be particularly attracted to join Compass in a prolonged downturn. Agents in existing markets would have the same — we would have the same impact on them. But, yes, cash would definitely be the priority, but we would be able to take advantage of acquiring agents more efficiently in our existing markets and more cost effectively.

As well, there’s a real advantage that the table is set with the competitive landscape right now, because capital isn’t going to be funding new competitors.

So the table is really set and the investment is also set within the competitive landscape.

So I think a prolonged downturn will just distance the degree to which our platform’s value proposition will exist in two years — one to two years from now relative to the competition. It will be more valuable, because we’re still investing in the platform while the competitive set really doesn’t even have one to start investing in.

Reading between the lines, it really does sound like retrenchment. Cash is the priority, preserving cash. Compass doesn’t want to raise more money. It’s going to learn to do more with less. Technology is the key to doing more with less, and making more profits and free cash flows.

Organic Growth via Productivity Gains

The most important message, perhaps, from this earnings call is that Compass will be backing away from what they’re best known for: aggressive growth via recruiting and acquisitions. The industry has known for years that the Compass formula is to offer extraordinarily high splits plus incentives ranging from marketing support to outright cash for top producers. A big part of the growth story of Compass has been M&A deals of smaller brokerages, and “acquisitions” of agent teams. The freespending ways have led to real results, like taking over the top spot from Realogy.

This isn’t just me speculating. Reffkin said so pointing out that they’re recruiting more agents successfully at lower cost (better splits and fewer incentives), and Ankerbrandt echoed that, talking about how Compass doesn’t necessarily need to expand into new markets, how they could just bring more agents in, penetrate further in existing markets, etc.

The key to all of this is Compass’s technology platform. That platform has to generate increased productivity for current Compass agents, which will drive recruiting at lower cost for future Compass agents. As Reffkin said, winners want to be with winners. Now, I happen to be less than fully convinced of that strategy, as I’ve laid out in some detail in my analysis of Compass’s S-1 filings from back when they went public. Go read that in full if you’re interested, but pay particular attention to the section on tech spending.

In addition, the technology platform is essential for the cash flow and profitability strategy:

For example, over time, we have already driven down the cost to serve our agents. Since 2018, we have reduced the average cost to serve an agent by 35%.

We are targeting a further 9% reduction in cost to serve per agent in 2022.

As we apply technology, we will lower our cost to serve even further.

We will drive cost down more aggressively on all aspects of our business in order to achieve our objectives.

To do all of this, of course, Reffkin and crew have to get the Compass agents to actually use the technology. If they’re not using the Compass technology platform, then there’s no further reduction in cost to serve the agent, and no productivity gains by the agent.

Hence, the emphasis on training and coaching.

What Does This Training Strategy Cost?

No one asked what Compass is spending on all this training. We don’t know where this cost is put in the Operating expenses. Is it in Commissions and other related expense, which ballooned by 22% YOY? Or perhaps in Sales & marketing, up 30%, or Operations and support, up 56% YOY?

Either way, we know from the earnings call excerpted above that a third of Compass’s lead agents took part in these new coaching programs. We know that the main program is called Compass 10×10.

Here’s Inman News from December of 2021, with a story headlined, “Compass will give agents $10K for training and coaching.” Key passage:

Company co-founder and CEO Robert Reffkin announced the “10×10 Business Growth Challenge” in an email to agents. The email, which Inman also received, explains that the program will take place over 10 weeks. During that time, agents can earn $1,000 for coaching and virtual assistant support if they participate in 10 external group coaching sessions. Compass has teamed up with a variety of coaches including Tom Ferry, Steve Shull and Brian Buffini for the program.

As of 1Q22, Compass reported that they had an average of 12,574 Principal Agents. One third of that number is 4,191 agents so one assumes that Compass hit that initial 2,500 and then added another 1,700 agents or so.

At $10K each, that represents $42 million in expenses so far. That’s a lot of spend for a company now obsessed with preserving cash. So what’s the ROI possibility here?

In 1Q22, Compass did $53.7B in Sales Volume on 47,367 transactions, which is 3.8 transactions per Principal Agent, generating $19,930 in gross profit per Agent, or $5,244 per transaction. I didn’t major in math, but even I can work a calculator enough to know that in order to breakeven on $42 million spent on coaching, those 4,191 agents who went through the program have to do an additional 8,000 transactions at the same home price. That’s just under two additional transactions per agent who went through the program. That’s a 50% increase in productivity from 1Q22… in a less-than-rosy macro environment.

Betting on a 50% productivity increase from training is… well… let’s call it optimistic. I’m not saying that can’t be done. Maybe it can. And maybe the Compass 10×10 has already shown that kind of productivity increase for those agents who went through the program. I guess we’ll see from 2Q numbers.

Then again, this $10K per agent is a one-time investment, so perhaps over the course of a couple of quarters, Compass will see a real lift in profitability and cash flows. Over a couple of years, this might end up being the best investment ever.

Thing is… if giving agents $10K for coaching leads to a 50% increase in productivity, there is no shortage of brokerages with technology platforms who can do the same thing. Training and coaching is not a competitive moat. Literally every brokerage in America offers coaching and training and handholding and support. Realogy can spend $10K per agent for a 50% increase in productivity too. So can RE/MAX and KW and HomeServices and eXp and, and, and.

So we have to return to the Compass technology platform. The logic has to be that it isn’t just the $10K in coaching, but the $10K in coaching combined with the unique and superfantastic Compass tech platform that will yield 50% increases in productivity. The platform is that good. It’s that amazing.

The Industrial Mindset

My trouble with embracing that is that it represents a particularly industrial mindset and outlook on real estate. It’s basically an expression of the Bill Belichick philosophy of football, which I wrote about in this post back in 2009:

It seemed clear to me that Bill Belichick, the coach of the Patriots, believes that it is his system that makes players great, not the other way around. It is his plays, his offensive and defensive schemes, his practice methodology, his way of playing football that makes the Patriots great, not the individual excellence of his players. Then when you add superstars to that system, superstars who understand how it works and understand how to sublimate their egos to the Belichick system, you get results like the recordbreaking 2007 Tom Brady – Randy Moss season. But without stars, Belichick’s team will find a way to win, even if that means using second and third string running backs, or putting WR’s in as cornerbacks. It’s the system that wins, not the players.

I think the Patriots 2020 and 2021 record after the departure of Tom Brady suggests that maybe the system isn’t what wins.

Back in 2009, I thought this approach, which I called “systemic brokerage” was the future:

The agent-centric model of today is lacking because while some individual agents can deliver high quality service, as a brokerage company, there is little if any consistency in service delivery.  A pure web-based lead-generation play (or ad-supported media play like Trulia) is lacking because it cannot provide end-to-end service quality, even if it can deliver consistently good user experience online.

Only a systemic brokerage approach — whether done by a Big Brand broker or by a small independent — can ensure end-to-end service quality as well as across-the-brand consistency.  Objective, definable, and trainable processes — backed up by technology and training — are the only ways to combine them both.

The specific implementation, the specific processes are all up to the individual or to the brokerage itself.  Some will be more successful than others.  And new innovation will drive new systems and new processes in time.

But they will all be systems of some sort, codifying processes that derive from best practices, with support from well-designed technology systems, and leveraging enforceable (and enforced) processes for business development and service delivery.

With the benefit of experience and evidence, I think I was too gripped by the industrial mindset.

There is something in real estate that resists systemization. It is too personal a transaction, involving people’s homes where they raise children, have triumphs and heartbreaks, and which is usually the largest investment of any family. The home is the center of our lives; it is, in a very real way, where life happens.

Productive agents are productive in large part because they have social skills, human skills, and an undefinable quality most often found with successful politicians: an ability to connect, to convince, and to comfort. Adding technology to that is beneficial, but it isn’t obvious to me that it is transformative. It’s a little bit like golf, or some other skill-based game. A great player with crappy gear will beat the hell out of a mediocre player with top of the line gear. A great agent with a crappy tech platform will beat the hell out of a mediocre agents with an amazing platform.

If the tech platform is so amazing that you can just plug in any random Joe off the street and have him perform at a high level, then you really don’t need these top producing agents and have to pay them incentives and offer high splits and whatnot. Going an industrial W-2 based model makes far more sense. That’s Redfin, in a nutshell, and it hasn’t quite worked out the way I imagined back in 2009. If Redfin couldn’t make that work, I’m not seeing how Compass will.

Don’t Write Off Compass

What’s funny is that I’m rather bullish on Compass, in a weird way. I have never bought and can’t buy the idea that Compass is some kind of new technology company that has figured out real estate service delivery. From the very start, I’ve thought that Compass was a traditional brokerage that was implementing some of what Reffkin learned about how investment banking works from his time at Goldman Sachs. Bring the time-tested methods of recruiting top investment bankers to your firm to real estate, and you can probably recruit top agents to your brokerage. That meant big signing bonuses, bigger cut of the revenue, fancy dinners and presentations, and plenty of ego-stroking. Compass got to the #1 spot using this methodology.

You can’t knock that, can you? Whether you like their methods or not, Compass got to the #1 spot in just a few years of being in business.

The whole technology platform narrative was nonsense from the start, but… once you get to the top, does it much matter?

Put differently, now that Compass is focusing on profitability and cash instead of growth and market share, what does that company actually look like?

It’s a company with some 12,500 top-tier agents (probably more than double that in actual agent count, since Compass only reports on Principal Agents), focused mostly in high-dollar areas of the country, who do roughly 4 transactions a quarter at a $1.13 million average sale price. The implied splits are 90/10 on average. Each agent is generating some $20K in gross profit to Compass. That’s about $180 million in quarterly gross profits, with virtually no debt. I for one am not recoiling in horror. That’s not horrible.

Of course, you have all these other expenses that have to be taken out of gross profits, so yeah, some austerity is headed to Compass, I’d imagine. Maybe start with that whole $42 million for training thing, and the expensive real estate leases for offices, and stuff like that. But even that stuff is relatively minor.

What really hurts Compass is that it doesn’t have ancillary revenues from title, escrow, mortgage, insurance, etc. but it is clear that Reffkin and crew are hard at work on trying to build those out. Maybe they make some smart acquisitions, or maybe some big established title, escrow, mortgage player decides to add brokerage as a top-of-funnel division.

Once they pivot away from the pretense that they are a real estate technology platform company and embrace the fact that they are a traditional split-based brokerage with top agents across numerous markets, Compass could take a much stronger step towards becoming the new Realogy. (In fact, that name may be available now that Realogy is becoming Anywhere.) Why is that bad?

If the industry divides into a bloody competition between say eXp, Compass, Anywhere, and HomeServices of America… I don’t know that that’s a bad thing for Compass.

Of course… the billion dollar question is whether Compass, with its culture and its current leadership, will pivot. Like everybody else in the past decade or so, Compass ran away from getting tagged with brokerage valuations. With what’s already happened to its stock price, and with what’s coming for growth tech stocks, maybe Compass would rather be valued as a top tier traditional brokerage.

The real emphasis that Reffkin put on cash preservation, on profitability, and on retrenchment might be a sign that the pivot is already underway. That’s not a bad thing for Compass, though it might be bad news for COMP investors. Over the short-term, I expect some pain for Compass, but over the medium and longer term, I think things are actually pretty positive.

-rsh

ZZ Top – I Gotsta Get Paid

Music video by ZZ Top performing I Gotsta Get Paid. (C) 2012 Universal Republic Records, a division of UMG Recordings, Inc.