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Morningstar | REA Group Continues to Perform Well Despite Real Estate Downturn

Narrow-moat-rated REA Group’s third-quarter result was slightly worse than we expected, and we have cut our fiscal 2019 revenue and EBITDA forecast by 5% to AUD 893 million and AUD 532 million, respectively. However, our revised forecasts still imply strong fiscal 2019 revenue and EBITDA growth of 11% and 13%, respectively, and an underlying EBIT margin of 53%. In comparison, we expect Domain’s revenue and EBITDA to fall 3% and 18%, respectively, in fiscal 2019 and we expect an EBIT margin of 19%, reflecting Domain’s greater exposure to the Sydney and Melbourne markets--the two markets most affected by the current housing downturn.

The impact of the cuts to REA Group’s fiscal 2019 earnings forecasts has been offset by an increase to later-year forecasts on the expectation of a stronger property market recovery. We maintain our fair value estimate at AUD 62 per share, but at the current market price of AUD 81.14, we continue to believe the shares are overvalued. Our forecasts imply an EPS compound annual growth rate of 11% over the next decade, versus 21% over the past five years, and our fair value estimate implies a fiscal 2020 price/earnings ratio of 22 versus 29 at the current market price. The market price implies a fiscal 2020 dividend yield of 1.9%, or 2.4% including franking credits.

REA Group’s third-quarter revenue growth of 7.0% was a notable slowdown from 14.0% in the second quarter and benefitted from the acquisition of Hometrack last June. We estimate third-quarter underlying revenue growth would have been about 5% without Hometrack. Management expects market weakness to continue for at least the next two quarters, in part due to the consecutive long weekends last month and the upcoming federal election. These effects caused an unusually weak 22% fall in national listings in April versus the prior year, with Sydney and Melbourne down 39% and 35%, respectively. However, we continue to expect the market to normalise in fiscal 2020.

REA Group is not directly affected by falling house prices, but it is indirectly, because price weakness usually affects real estate turnover, including sales and new listings. Over the past year, residential real estate prices have fallen 7.2% nationally, and capital city prices are down 8.4%. However, the situation is even worse in the important Sydney and Melbourne markets where prices are down 10.9% and 10.0%, respectively, and 13.9% and 10.9%, respectively, since their peak.

Over the past year, new listings have fallen 29% nationally and 34% in Sydney and Melbourne, according to CoreLogic. Monthly residential real estate sales are currently around 30,000 properties versus the 10-year average of around 40,000. However, the impact on REA Group is being offset by a combination of advertisement price increases and an increase in relatively expensive Premiere advertisements. In the long term, we expect real estate listings to rebound and to grow at a similar rate to population growth and hence housing stock, which should support earnings growth for REA Group and Domain.

Aside from short-term and cyclical listings weakness, REA Group appears to be performing well. Management remained upbeat about the Asian business, which constitutes around 2% of group EBITDA, which continues to increase revenue quickly. The company is also continuing to deepen its product offerings and leverage its scale and expertise to develop relatively small but strategically important assets, such as its property-sharing platform, Flatmates.com. Unsurprisingly, the finance business, which constitutes around 2% of group EBITDA, remains weak due to credit tightening, following the Royal Commission into the financial services sector, in addition to weaker residential real estate turnover. However, we still consider the business to be strategically important and likely to generate revenue synergies in the long term.