EUR 850.00 For Business Accounts Only

Morningstar | REA Group Brushes Off Property Market Downturn but Remains Overvalued

We have increased our fair value estimate for narrow-moat-rated REA Group by 5% to AUD 59.00 per share. The fiscal 2018 result was broadly in line with our expectations, with the 20% increase in revenue to AUD 808 million matching our forecast and the 23% increase in underlying EBITDA (to AUD 471 million) 2% ahead of our forecast. We were slightly surprised by the strength of the Australian real estate business, which increased revenue by 14% and generated an EBITDA margin of 64.4% in fiscal 2018, up from 63.8% in the prior year, despite property market weakness.

We have increased our revenue growth forecasts for the Australian real estate division, which has increased our fair value estimate, but at the current market price of AUD 84.00, we still believe the shares are materially overvalued. As usual, management did not provide earnings guidance but expects margin expansion in 2019, which is consistent with our forecasts. Nevertheless, earnings growth is slowing. Our model assumes an EPS CAGR of 11% over the next decade versus a 21% CAGR over the past five years. The current market price implies a fiscal 2019 price/earnings ratio of 33 versus the fair-value-implied P/E ratio of 23. Over the past decade, the P/E ratio has ranged between 12 and 39, but it has increased in recent years as EPS growth slowed, which isn’t a trend that’s likely to be sustainable.

REA Group’s revenue growth is still effectively being driven by price increases rather than higher volumes, which is enabled by the company’s leading market position, its narrow economic moat, and the relatively small cost of advertising on its platform relative to the value of the asset being sold. The company is attempting to diversify into new businesses such as financial services and agent marketing, but we expect the group’s relatively high margins to attract increased competition, particularly from key competitor Domain Group, which generates a relatively low group EBITDA margin of around 32%. Domain’s majority shareholder, Fairfax, recently announced it intends to merge with Nine and that the larger group will increase investment in Domain, which we expect to increase pressure on REA Group’s marketing and product development budgets, and ultimately its EBITDA margins.

Although REA Group’s Australian real estate business is extremely strong, it still comprises well over 90% of group EBITDA, and the company has failed to materially diversify into new businesses. In this regard, the AUD 750 million acquisition of iProperty group in 2015 has already been impaired by AUD 180 million, delivering revenue growth of just 18% in fiscal 2018 and 16% in the second half of fiscal 2018. This isn’t particularly strong, considering the relatively early stage of the business and lack of returns to date. Despite this, the business is performing in line with our expectations, and we expect growth to continue with a revenue CAGR of 14% over the next decade. Similarly, Prop Tiger appears to have generated revenue growth of around 50% in fiscal 2018, but REA Group’s share of losses after tax increased by 70% to AUD 5.6 million in fiscal 2018, and poor disclosure prevents visibility regarding underlying progress. We expect these businesses combined to comprise less than 5% of group earnings for the next five years.

REA Group’s other main international investment, its 20% stake in Move, appears to be performing well from a revenue perspective, with revenue up 15% versus fiscal 2017, but the net loss after tax increased to AUD 65 million from AUD 6 million in the prior year. To a certain degree, this reflects the large depreciation and amortisation charge, and we suspect cash flow is much better than EBITDA. Management expect earnings improvement next year and we forecast earnings growth in our model but we also expect the division to remain an immaterial earnings contributor to the group for the foreseeable future.

REA Group's finance division is performing in line with our expectations; however, we still believe that this division lacks an economic moat and faces industry challenges such as the impact of the Royal Commission into the financial services sector. In the short term, the Royal Commission appears to have had a positive impact, as mortgage applications have been delayed and the life of existing mortgages and associated trail commissions to REA Group has increased. However, we don’t consider this to be a structural positive trend for the business, which we only expect to comprise around 2% of group EBITDA, excluding corporate costs, for the next five years.

From a balance sheet perspective, REA Group remains in great shape, and if anything, the company’s challenges will increasingly be in deploying the cash it generates, which raises the threat of value-destructive acquisitions. REA Group’s net debt has increased to AUD 317 million as at June 30, 2018, largely due to the AUD 313 million cost of acquisitions; however, we expect the company to generate AUD 483 million in operating cash flow in fiscal 2019 and for net debt to be eliminated by fiscal 2020. In the longer term, we expect the company to return cash to shareholders via a growing dividend and dividend payout ratio, which will also enable greater franking credits for Australian investors.

It’s important to bear in mind that network effects come in two types and that REA Group has the weaker of the two. For companies like Facebook and TripAdvisor, users of their services benefit directly as more people use the service, which leads to dominant providers with strong economic moats. In contrast, marketplace businesses have two-sided network effects whereby more buyers attract more sellers and vice versa. This also leads to dominant providers with economic moats, but users of the services don’t benefit directly from additional users of the service. Both REA Group and Domain effectively have all the Australian residential real estate sellers on their websites already, which prevents dominance by either company in this aspect of the market. However, both companies’ main value proposition is their ability to offer a market of real estate buyers to real estate vendors, and REA Group’s larger audience creates an advantage over Domain in this regard currently. However, REA Group remains vulnerable to an enlarged Nine/Fairfax which we expect to leverage their combined audience to support Domain and potentially increase their investment in Domain.