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Morningstar | Domain Remains Overvalued as Fiscal 2018 Result Meets Expectations

Our investment thesis for both narrow-moat-rated Domain and REA Group--namely, that both companies comprise a significant component of the real estate marketing value chain but capture a relatively small component of real estate marketing spending--is largely unchanged following their results. We expect this situation to enable both to keep increasing listing prices and increasing revenue and margins without taking significant market share from each other.

Domain's fiscal 2018 result was broadly in line with our forecasts, and we have maintained our fair value estimate at AUD 3.10 per share. As with REA Group’s result last week, Domain hasn’t yet been significantly affected by the recent downturn in the Australian real estate market. However, we see little reason to justify the 4% jump in the Domain share price that followed the result, and at the current market price of AUD 3.31, we still believe the shares are overvalued. We forecast EPS to grow by 15% in fiscal 2019 and at a CAGR of 13% over the next decade, driven by a combination of revenue growth and margin expansion. At the current price, Domain trades on a fiscal 2019 price/earnings ratio of 31 versus 29 at our fair value estimate. Management remains unable to provide convincing examples of how Domain will materially benefit from the proposed merger of Nine and Fairfax, and we still assume no benefit to Domain from the deal.

Despite the results broadly meeting our expectations, we were somewhat underwhelmed by certain aspects of Domain’s results. For example, the media, developers, and commercial division, which comprises 15% of group revenue, reported underlying revenue growth of 11% but the annual growth rate fell to 3% in the second half from 20% in the first-half. This was attributed to strong competition in the media sector, in addition to weakness in the developer and commercial markets, which we consider to be cyclical. Similarly, agent services, which comprises 8% of group revenue, slipped from an annual growth rate of 11% to 8% between the first and second halves, but we don’t believe this reflects more than normal revenue volatility and the seasonal nature of the business. Print revenue, which comprises 22% of group revenue, fell 12.7% on the prior year, slightly quicker than our 12% forecast, reflecting structural decline in the business, but we haven’t changed our assumption of a 12% annual revenue decline for the foreseeable future.

The 17% increase in Domain’s group revenue to AUD 357 million was in line with our forecast and similar to the 16% revenue growth generated by REA Group’s Australian businesses, which generates around twice the revenue of Domain. The 12% increase in Domain’s group EBITDA, to AUD 116 million, was also in line with our forecast but was much higher than the statutory result of just AUD 34 million, owing to the large value of significant items and adjustments, mainly relating to the initial public offering last November. In comparison, REA Group generates four times the EBITDA generated by Domain from its Australian listings business with an EBITDA margin of 64%, versus 46% for Domain’s comparable business. Over the next decade, we expect Domain to reduce this margin gap but not to match REA Group’s margins. This is partly because we expect REA Group to spend more than Domain on marketing for the foreseeable future. In fiscal 2018, for example, Domain spent AUD 41 million on marketing versus AUD 74 million for REA Group. We also expect Domain’s group EBITDA margin to experience a drag from its relatively low-margin print business, which we expect to experience margin compression as its revenue falls.

From a balance sheet perspective, Domain remains in good shape. Like REA Group, the company operates a capital-light business model, which we expect to enable sustainable franked dividends and relatively low financial leverage for the foreseeable future. For example, Domain had just AUD 126 million in net debt as at June 30, 2018, which implies a comfortable net debt/EBITDA ratio of 1.1 and EBIT/interest coverage ratio of 12. We expect these metrics to steadily improve over the coming years, assuming no material acquisitions or share buybacks are undertaken.