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Morningstar | Domain FVE Cut to AUD 2.80 on Lower Real Estate Turnover but Long-Term Thesis Unchanged

We have lowered our fair value estimate for narrow-moat-rated Domain Group by 10% to AUD 2.80 per share following the surprisingly weak trading update for the first four months of fiscal 2019. At the current market price of AUD 2.77, we continue to believe the shares are fairly valued. We expect the weak financial performance to continue until mid-2019 and that EPS will fall by 39% in fiscal 2019, which is much worse than our previous forecast for 12% growth.

However, despite the near-term real estate downturn, our long-term investment thesis is largely unchanged. Advertising on domain.com.au and realestate.com.au comprises a relatively small share of total real estate marketing spending despite adding much of the value to the sales process. Domain is increasing its share via growing sales of relatively expensive premium listings and we expect this trend to continue. We also expect the cyclical short-term problem of new listings weakness to improve from fiscal 2020. CoreLogic data indicates monthly real estate sales in Australia’s capital cities are tracking at around 23,000 per week currently, their lowest level in 20 years despite a 34% increase in population over the period. We estimate midcycle sales are around 27,000 per week and will increase with population over the long term.

Our revised fair value estimate implies a relatively high fiscal 2019 P/E ratio of 50 which reflects our expectation of a sharp rebound in revenue and profit margins in fiscal 2020, driven by a rebound in listings. We expect Domain’s relatively high exposure to the Sydney and Melbourne markets will drive a sharper earnings downturn and rebound than for REA Group.

The key issue facing Domain is the weak Australian real estate market but more so the sharp slowing of real estate turnover and associated drop in new listings. The deterioration in trading conditions has been rapid considering Domain reported revenue growth of 13% in the second half of fiscal 2018 versus the previous corresponding period, and its group EBIT margin expanded to 27%. REA Group was similarly strong with second-half group EBIT rising 25% and its EBIT margin expanding to 50%. However, the relatively fixed cost nature of Domain’s business means our new forecast for a 1% fall in revenue in fiscal 2019, from 12% growth previously, is amplified to a 34% fall in EBIT versus the prior year and a collapse in EBIT margin to 17%, from 25% in the prior year.

The other surprisingly weak aspect of Domain’s fiscal 2019 financial performance to date is the rate of contraction of its print business, which likely reflects the more pronounced downturn of relatively expensive properties. We previously assumed print revenue would fall by 15% in fiscal 2019, an acceleration of the 13% fall in the prior year, but we now forecast a much weaker 25% decline. Unlike the online listing business, this trend is mainly structural and will continue to drag on group revenue growth for the next few years. However, we expect print to comprise just 12% of group revenue in fiscal 2020 and further weakness only reduces the materiality of the revenue drag in future years.

We attribute house price weakness to a number of factors including the relatively high house price to income ratio, boosted by interest rates at multi decade lows, and credit tightening following the Royal Commission into the financial services sector. However, Domain is primarily exposed to real estate listings which are more correlated with the rate of change of prices than the absolute level and we expect price falls to slow in fiscal 2020.

Domain’s relatively high exposure to Sydney and Melbourne poses a challenge for the company currently. CoreLogic data indicates capital city real estate sales are down 10% nationally over the past year but Sydney and Melbourne are down 19% and 16% respectively with relatively expensive properties even harder hit. Total listings in Sydney and Melbourne are up 22% and 17%, respectively, which reflects an increasing backlog of unsold properties with new listings down 6% and 3%, respectively. We expect Domain’s relatively concentrated exposure to Sydney and Melbourne, compared with REA Group, to drive a relatively strong rebound when the market recovers.

From a debt perspective, Domain is in good shape to weather the downturn due to a combination of relatively low net debt and the cash generative nature of the business. The company had AUD 126 million in net debt as at June 30, 2018, implying a comfortable net debt/EBITDA ratio of 1.1 and EBIT/interest cover of 12, ratios which we expect to improve over the next few years. The company also has the support of Fairfax, which owns 60% of the company and is in the process of being acquired by Nine. We incorporated any benefit into our financial model from potential revenue or cost synergies, however, the enlarged Nine should be a reasonably reliable source of equity capital for Domain should it be needed which reduces balance sheet risk to some degree.