EUR 850.00 For Business Accounts Only

Morningstar | Seek Looking Overvalued Despite Making a Strong Case for Reinvestment. See Updated Analyst Note from 15 Aug 2018

Narrow-moat-rated Seek already announced the key components of its fiscal 2018 financial result last week, meaning the official result came as little surprise. We maintain our fair value estimate at AUD 18.00 per share, and at the current market price of AUD 21.29, continue to believe the shares are overvalued. Management has been under pressure from investors recently due to its strategy of reinvesting earnings into the business to maintain strong revenue growth at the expense of short-term profit margins and cash flow. However, we believe this strategy makes sense as the type of markets in which Seek competes, such as the online employment advertising market, are generally "winner takes all" markets meaning it's important to prioritise market share dominance. The current market price and our earnings estimate imply a fiscal 2019 price/earnings ratio of 38, versus 33 at our fair value, and a dividend yield of 2.1% or 3.0% including franking credits.

As expected, Seek reported an 84% fall in statutory NPAT to AUD 53 million but this decline was largely due to the impact of AUD 144 million in one-off items, which primarily relate to the AUD 182 million noncash impairment of Seek's South American businesses, including Brazil Online and OCC in Mexico. Both businesses have been struggling with cyclical macroeconomic headwinds for some time, but we don’t believe either faces structural challenges, and we expect both to recover eventually. Combined, these businesses only contribute around 7% of group EBITDA, meaning they aren't key earnings drivers for the group and their book values have a high degree of subjectivity. The noncash nature of the impairment reduces the sting, but the loss still represents value destruction. On an underlying basis, NPAT fell just 1% despite a 24% increase in revenue and 16% increase in EBITDA, with higher reinvestment, depreciation and amortisation, net interest expense, and share based payments, the main factors.

Interestingly, Seek's share price has recovered from the initial 9% slump which followed the announcement last week and we expect management has been reminding investors of their strong investment track record. The lengthy result presentation was peppered with justifications of the strategy but there's no avoiding the fact that the market is likely to remain cautious on the strategy until profit growth and cash flows starts to accelerate. Management is not concerned about profit margins in percentage terms as much as revenue growth and profits in dollar terms, which is evident in the steady decline in the EBITDA margin from 47% in fiscal 2009 to 33% in fiscal 2018 and we forecast further weakness to 30% in fiscal 2019. However, we also expect margins to recover longer term and we forecast an average EBITDA margin of 35% over the next decade.

Admittedly, the complexity of the group's corporate structure and the high growth nature of the portfolio of businesses mean long-term margin comparisons aren't necessarily appropriate. However, investors are likely to question whether the margin compression will reverse and if the investment is really worth it. The increasingly convoluted financial reporting is understandable to some degree but doesn’t help build investor confidence. In fiscal 2019, management expects "reported NPAT to remain broadly similar to FY18," which appears to imply an underlying NPAT of around AUD 200 million, excluding "significant" items such as impairments but including AUD 35 to AUD 40 million in losses from early stage ventures. This guidance is broadly in line with our AUD 195 million forecast.

Despite the short-term lack of profit and EPS growth, Seek continues to deliver strong revenue growth, which seems to be the "new black" in investment markets these days. Management expects revenue growth of 15% to 20% in fiscal 2019, although reinvestment will drop EBITDA growth to 5% to 8%. This guidance is broadly in line with our forecasts which includes fiscal 2019 revenue growth of 22% for the Chinese business Zhaopin, which now comprises around 37% of group revenue. We expect Zhaopin to be a key revenue driver for the group over the next decade but fierce competition in its Chinese market is necessitating high levels of investment in the short term. At this stage, we expect Zhaopin's margins to recover but the competitive environment is rapidly evolving and the company's decision to increase free access via a "freemium" model reflects this.

From a balance sheet perspective, Seek remains in good shape despite a tripling in net debt to AUD 573 million in fiscal 2018 which was impacted by the privatisation of Zhaopin during the year. We remain comfortable with credit metrics, including the net debt/EBITDA ratio of 1.3 and EBITDA/net interest expense of 17 as at June 30, 2018, and expect all metrics to gradually improve over the next five years.