EUR 850.00 For Business Accounts Only

Morningstar | Proposed Fairfax and Nine Merger Unlikely to Materially Benefit Domain

We don't believe the proposed merger of Fairfax and Nine Entertainment materially changes the earnings outlook for narrow-moat Domain. However, we have increased our fair value by 3% to AUD 3.10 to reflect the time value of money impact on our financial model since our last update. The current market price of AUD 3.32 implies a price/earnings, or P/E, ratio of 30 versus our fair value implied P/E ratio of 29 and we consider the shares to be slightly overvalued. As a comparison, REA Group trades on a P/E ratio of 37, based on its AUD 88.00 market price, whereas our AUD 56.00 fair value implies a P/E ratio of 24 for the relatively mature business.

Although called a merger, the proposed transaction is more appropriately described as an acquisition of Fairfax by Nine, with Fairfax shareholders set to own 49% of the combined entity. Although the transaction looks likely to proceed, and has been recommended by Fairfax directors, it still needs approval from Fairfax shareholders and the Australian Competition and Consumer Commission, or ACCC. The scheme booklet, containing an opinion of an independent expert, will be sent to Fairfax shareholders in the coming weeks. For further opinion on the transaction, see our Fairfax and Nine notes of July 26, 2018.

The Domain share price responded positively to the announcement, jumping 9%, presumably on the prospect Domain could gain access to a much larger audience, a key driver of real estate advertisements on its website. However, we are less convinced about the benefits of the transaction and we don't expect Domain to realise any of the AUD 50 million in cost synergies management expects from the merger. If Domain does benefit, it will be via revenue synergies, or cross selling, but considering Domain is a separate corporate entity, we expect the company will need to pay an "arm’s length" price to access the larger audience.

Fairfax and Nine intend to make targeted investments into their "high growth" investments, including Domain and Stan, but considering Domain operates a capital-light business model, we don't believe additional capital will provide a material boost to the company.

It is possible Fairfax and Nine's comments about investing in Domain are a red herring designed to ameliorate investor concerns about a stock overhang. However, even if the combined group does intend to sell the 60% shareholding in Domain, we expect management would be preoccupied by the merger for at least a year following the transaction. We also believe the combined group is also more likely to sell to institutional investment fund managers over an extended period rather than a single sale to a trade buyer. It is difficult to identify an obvious trade buyer with compelling synergies with Domain, other than REA Group which would almost certainly be blocked by the ACCC.

Although we continue to expect Domain to grow revenue by effectively increasing the price of its real estate listings, there’s no avoiding the fact REA Group-owned realestate.com.au is the leading real estate platform in Australia and benefits from a strong network effect. Real estate buyers and vendors effectively consider realestate.com.au to be the main real estate marketplace and this will be a big challenge for Domain to overcome. A combination of Fairfax and Nine may boost Domain's audience but we doubt REA Group will cede its leading position considering its constant website improvements, support from Newscorp, and portfolio of international businesses over which it can defray development costs.

The merger also doesn’t change the fact real estate transaction volumes, a key driver of Domain's revenue, remain weak. High real estate prices appear to have impacted turnover which is being exacerbated by tightening lending standards and higher mortgage rates. Over the past year, real estate prices have weakened but vendors appear to be reacting by sitting tight, further exacerbating the volume issue. In addition, Domain's new CEO, Jason Pellegrino, is yet to clarify his strategy for the business meaning there is are too much uncertainty to materially change our view on Domain at this stage.