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Morningstar | REA Group’s Earnings Forecasts Cut Following Domain Profit Downgrade but FVE Maintained

We have downgraded our fiscal 2019 earnings forecasts for narrow-moat-rated REA Group following Domain’s weak trading update for the first four months of fiscal 2018. However, the impact on REA Group is smaller than Domain and insufficient to justify changing our AUD 59.00 fair value estimate. At the current market price of AUD 75.50, we continue to believe REA Group is overvalued. Our fair value and revised earnings forecasts imply a relatively high fiscal 2019 P/E ratio of 25 which reflects our expectation of a rebound in listings in fiscal 2020, and strong long-term growth.

The key issue facing both REA Group and Domain is the weak Australian real estate market but more so the sharp slowing of real estate turnover and associated drop in new listings. Real estate sales in Australia’s capital cities are at their lowest for 20 years and a backlog of unsold properties is building. We have cut our fiscal 2019 revenue growth forecast for REA Group’s Australian online listings business to 6%, from 13%, but this is above the 4% growth we assume for Domain’s equivalent business. Our group revenue growth forecast for REA Group is 9%, down from 15% previously, but well above the 1% decline we assume for Domain. The net result is a fiscal 2019 EPS growth forecast of 12% for REA Group, down from 20% previously.

REA Group has differences to Domain which justify the different near-term earnings growth forecast. REA Group dominates the online real estate listings market in Australia and has the largest audience of real estate buyers which creates greater pricing power. The company is also more geographically diversified within Australia which reduces exposure to the particularly weak high-end real estate markets in Sydney and Melbourne. Its ownership of businesses in the United States and Asia, which are not exposed to the Australian market, also provides diversification and, unlike Domain, the company does not own a print business.

Despite the real estate downturn, our long-term investment thesis for both REA Group and Domain 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 and we expect both companies to increase their share of total marketing spend. 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 for 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.

We attribute house price weakness to a number of factors, including the relatively high house price to income ratio, following interest rate cuts to multi decade lows, and credit tightening following the Royal Commission into the financial services sector. However, REA Group 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.