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Morningstar | REA Group’s Economic Moat Provides Shelter from Australian Real Estate Storm. FVE Lifted to AUD 62

Narrow-moat-rated REA Group continues to defy the worst Australian real estate downturn in decades, with its 19% increase in first-half EBITDA slightly exceeding our expectations. We have increased our fair value estimate by 5% to AUD 62.00 per share, reflecting higher earnings forecasts and the time value of money impact on our financial model. At the market price of AUD 74.18, we continue to believe the stock is overvalued. The market price implies a dividend yield of 1.9%, or 2.3% including franking credits versus 2.3%, or 2.8% with franking, at our fair value. Our forecasts imply underlying EPS will grow at a CAGR of 11% over the next decade.

We were surprised that the stock fell 5% following the strong result, with revenue up 16% in Australia despite real estate listings falling 3% nationally and by 10% in Sydney. We expect share price weakness was caused by management’s guidance for weaker revenue growth in the second half due to the Federal and New South Wales elections. In addition, the noncore businesses didn’t perform particularly well, with the Asian division incurring a significant impairment. However, guidance is broadly in line with our expectations and negative short-term factors don’t materially impact our DCF-based fair value. REA Group remains in a strong competitive position and even increased its average monthly traffic lead over Domain in recent months from 2.8 to 3.0 times.

Our primary concern remains that the company is dependent upon its core Australian listings business, which comprises 95% of group EBITDA, and effectively increasing listing prices rather than listings. Domain is also likely to be a stronger competitor in future, following the appointment of its new CEO last year and the acquisition of Fairfax by Nine.

The AUD 173 million impairment of, and weaker outlook of, the Asian business was surprising but doesn’t materially impact our fair value as it’s non-cash and the division only generates 2% of group EBITDA. The Asian business was formed via the acquisition of iProperty Group in 2015 for AUD 750 million but was already impaired by AUD 182 million in 2017,around half of the total investment has now been written off. Although the latest impairment is noncash, it still reflects a destruction of shareholder value and raises questions about management’s ability to allocate capital and meaningfully diversify beyond its very strong core Australian listings business.

Management attributed the impairment to a combination of things, including a higher discount rate used in its financial model, a deferral of investment returns due to higher short-term reinvestment, a more competitive environment, and regulatory changes. However, we expect the main challenges are the regional differences between real estate markets and the tougher competitive environment. Management also said the first-half EBITDA would be a high-water mark in the short to medium term and we have downgraded our earnings forecasts for the Asian business accordingly.

REA Group’s financial division is also struggling due to the weak Australian property market and the consequences of the Royal Commission into the financial services sector. Although divisional revenue grew by 12%, like-for-like revenue growth excluding the Smartline acquisition was flat and is likely to remain so for the remainder of the year. We’ve long been concerned about REA Group’s diversification into financial services because we don’t believe the company has a strong competitive advantage in the sector. We expected competition to be challenging but didn’t envisage the Royal Commission’s recommendations.

Although trail commissions aren’t likely to be banned for mortgage brokers before 2020, if enacted, the ban could be devastating for mortgage brokers including REA Group and result in an impairment of the business. At this stage we have slightly reduced our earnings forecasts but await further regulatory clarification before making more material changes. However, these changes aren’t material considering the division comprises only around 2% of the group.

REA Group’s investment in Move is also performing worse than expected with revenue growth of 11% versus our full-year forecast of 17% despite the additional benefit of the Opcity acquisition. This isn’t a big issue from the perspective of our fair value as Move is a very small part of the group and has been loss making for some time. However, we expected stronger revenue growth at this stage of the business’ development and the performance raises questions around this and other investments which have been made.

The media and data businesses also delivered a rather disappointing first-half result despite its 19% revenue growth. We estimate the Hometrack acquisition boosted revenue by around AUD 7.5 million, without which revenue growth would have been around 3%. However, like the other poorly performing businesses, the media and data division is a relatively small contributor to the group.

From a cash flow and balance sheet perspective, REA Group remains in great shape. Free cash flow (operating less investing) far exceeded statutory NPAT due the large non-cash impairment of the Asian business, and free cash flow grew strongly versus the prior comparable period due to lower investments. The 20% fall in net debt during the half was not surprising due to the cash generative nature of the business and relatively low financial gearing. Credit metrics remain very strong with net debt/EBITDA of just 0.9 and EBIT/net interest of 49 as at Dec. 31, 2018.We expect the company to be debt-free by fiscal 2021. If anything, management may be wondering how to deploy expected cash flows and balance sheet capacity more effectively than was the case in its previous investments. However, we expect new CEO, and ex CFO, Owen Wilson to take a measured and considered approach based primarily on financial rather than strategic benefits.