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Morningstar | Trade Me’s Fiscal 2018 Result Exceeds Expectations; FVE Increased to NZD 5.00

We have increased our fair value estimate for narrow-moat-rated Trade Me by 9% to NZD 5.00 per share following a slightly stronger fiscal 2018 financial result than we expected, which prompted us to increase our EBIT forecasts. Group revenue growth of 7.8% exceeded our 6.1% forecast, mainly due to stronger-than-expected second-half performances from the general items and other division, which includes advertising, insurance, and payments, which reversed weak first-half performances. The EBIT margin of 55.2% also exceeded our 54.0% forecast, as relatively strong second-half revenue growth helped stabilise EBIT margins after years of steady margin compression. We have maintained our forecast revenue but increased our profit margins, with EBIT margins increased to an average of 56.0% over the next five years from 54.5% previously. This has increased our EBIT forecasts by an average of 3% over the next five years. However, we have also effectively increased our long-term earnings growth assumptions, which accounts for the balance of the fair value increase.

At the current market price of NZD 5.00, shares are fairly valued. The market price implies a fiscal 2019 price/earnings ratio of 19 and dividend yield of 4.2%, which we consider to be sustainable. Over the past five years, Trade Me has generated average annual underlying EPS growth of 4%, and we forecast an average of 8% over the next five years. Trade Me also declared a special dividend worth NZD 0.22, or 4.4% of the share price, which is fully imputed for New Zealand taxpayers. Management provided guidance that group revenue would grow by between 5% and 8% in fiscal 2019, versus our forecast of 8%, and that operating profit after tax would grow at a similar rate in percentage terms, versus our EBIT growth forecast of 9%.

The result was the last to be presented by CEO John McDonald, who’s been CEO for the past 10 years and with the company for 15 years, and who will retire in December. We’re not concerned that McDonald’s departure could herald an imminent downturn for the company, as we still believe Trade Me is in good shape and the resignation has had a long lead time.

Trade Me’s classifieds division, now the largest in the group and comprising 56% of group revenue, remains the growth engine, and we expect this to remain the case for the foreseeable future. The classifieds division includes motors, which increased revenue by 13% in fiscal 2018 and now comprises 29% of group revenue; property, which grew by 10% and comprises 15% of group revenue; and jobs, which grew by 14% and comprises 13% of group revenue. Like the leading online classifieds providers in Australia, such as REA Group, Seek, and Carsales.com, Trade Me’s classifieds growth is largely being driven by price or "depth" growth, rather than volume increases. This is evident in jobs listings, which rose by just 1.3%; real estate listings, which fell by 0.4%; and motor listings, which rose by just 1.9%. However, we expect Trade Me to continue increasing prices, enabled by its economic moat, and we forecast a revenue CAGR of 8% for the classifieds division over the next decade, as the company benefits from network effects both within the individual asset segments and among the wider group, which creates pricing power.

Offsetting the strong performance of the classifieds division is the general items division, which increased revenue by just 1.3% in fiscal 2018 and has grown at an average rate of just 1.8% per year over the past five years, reflecting the maturity of the business. Admittedly, revenue growth improved to 1.9% from 0.7% between the first and second halves, and management highlighted some positive KPI trends for the business. However, we’re not convinced that the division is likely to materially improve anytime soon, and we still forecast average annual revenue growth of just 2% per year for the foreseeable future. This division is the most vulnerable to competition from Facebook and Amazon, which we expect to limit revenue growth and create upward pressure on costs. Fortunately, the relative importance of the general items division to the group is falling as the classifieds division continues to grow.

The capital-light nature of the Trade Me business model means that cash conversion and cash flow is usually strong, and this was also the case in fiscal 2018, with free cash flow (operating less investing) exceeding NPAT by 10%. Strong cash flows enable the company to continue reducing net debt, which fell a further 23% to NZD 64 million as at June 30, 2018. We consider financial leverage to be extremely comfortable, as gearing (net debt/net debt plus equity) was only 8% as at June 30, 2018, net debt/EBITDA just 0.4, and EBIT/interest cover a massive 38. Trade Me’s challenge remains the deployment of its surplus capital, and we’re not particularly surprised by the NZD 0.22 special dividend, which will cost the company around NZD 87 million. However, this won’t materially weaken the balance sheet, and further special dividends are possible in the future, although we don't include any in our forecasts.