REA Group delivered another very impressive half year of growth with revenue up 30%, EBITDA up 38% and both NPAT and EPS rose 37%. Keep in mind those impressive numbers aren’t being produced by a tiny microcap company either.
The result was driven by extremely good performance in Australia. REA’s Australian business now accounts for 78% of all minutes spent online on Australian property portal sites, absolutely dominating the market. Its position in the market has allowed it to push through price increases, even as it grows share, and a resurgent property market has certainly provided tailwinds.
The international business, however, was less rosy. Italy, Luxembourg and HK delivered ordinary results, and continue to remain very small parts of the overall business.
While the company has completely blown away all claims that it is a mature business, one does need to answer two questions:
- How much room is there for further growth in Australia?
- Can they replicate the Australian success in international markets?
Investing in REA at the current market price demands a positive answer to at least one of these. We start with Australia.
Growth in Australia
Given its dominance in its space, the opportunity for REA to grow share/volume in Australia now seems limited. Incremental growth from here requires increasing prices and/or extension of its business into other parts of the “property transaction market”.
The scope for ongoing price increases is difficult to gauge but given its monopoly position, one must believe that it can continue to push price increases through and surprise even the most optimistic analysts. Moreover, REA argues that the value it delivers is well in excess of what it charges, which indicates considerable scope. One initiative being progressed is to charge on the basis of transaction value, rather than a fixed fee. In the same way that a real estate agent charges a percentage of property value, REA feels it should also be able to charge a percentage of property value.
While I see the wonderful economics of this revenue model, I am not aware of any precedent for an advertiser being able to charge this way. While it is easy to be sceptical about how readily acceptable such a move would be by its real estate agent customers, you would also have to argue that there aren’t many reliable alternative options available.
Over the longer run, however, if REA were to charge a property value-based price for (essentially) the same advertising, it would open an opportunity for cherry picking by new entrants targeting the high end of the market. I could easily see the emergence of some disaggregation in the space as niche competitors emerge. Accordingly, the extent of this opportunity should probably be considered uncertain.
Extension of REA’s business into other parts of the property transaction market seems logical. For example, generating leads for mortgage providers, movers etc., and facilitating connection of (e.g.) Foxtel etc.
REA believes that the total scale of the property transaction market is very large, and expects to be able to capture a percentage of it. Again, however, this opportunity is difficult to quantify with any precision.
Source: Yahoo Finance
International growth
REA has the number one position in the Italian market, with an average monthly unique audience that is 1.4 times that of the nearest competitor. While not the sort of dominance it enjoys in Australia, it may become so over time. The low risk chance of this occurring, however, involves the Australian team and management replicating what they have done in Oz.
The Italian market is large. With a population of 70 million, the potential is greater than Australia, however, the market is some years behind in terms of internet adoption and penetration. In addition, care needs to be taken in extrapolating the Australian experience due to critical structural differences. In particular, the Australian market is unusual in that vendors pay for advertising. In international markets (including Italy), it is common for the agent to pay for advertising and include this cost in the fees charged to their clients. This results in a more concentrated customer base with considerably more bargaining power.
Notwithstanding this, over time it seems likely that the opportunity in Italy will be large. The structural differences may mean slow progress, and there is the risk of losing market dominance to an innovative competitor, however, on balance, the opportunity appears to represent a meaningful possible upside.
Luxembourg and Hong Kong
The opportunities in Luxembourg and Hong Kong add to the attractions of REA Group. As with Italy, these businesses make minimal contribution currently, but hold the number one position in their markets. There is meaningful potential upside and little downside.
In the case of the Hong Kong market, it should be noted that residential property values currently are extreme, and Hong Kong has a policy objective of reducing prices by 30%, which will take some momentum out of this market.
Risks
Leaving the discussion at this point, you’d be tempted to rush out and buy REA even at today’s rather lofty levels. Let’s consider however the identifiable risks:
- The Australian residential property market is expensive. A downturn – something I am in no position to accurately forecast – would have significant impact to REA.
- The market is evolving, and the possibility of losing dominance exists. It is worth noting that Move.com in the US lost its leadership position to Zillow and Trulia by not recognising and responding to changing trends in the US market.
- Importantly, the company could be very loosely described as being without a CFO or CEO. CEO Greg Ellis is departing and a replacement is yet to be named. Given the evolving nature of the market, good strategic leadership would, I think, be important to the continued success of the business.
- The final risk relates to valuation, and with the share price at 40 times FY14 estimated earnings, there is no doubt the company is being priced as though nothing could ever go wrong. Generally speaking, you want to be excited when others are fearful and fearful when others are excited.
If we assume continued return on equity of 40%, a cost of equity of 8.5% and a reinvested capital rate of 21%, we end up with a valuation of just $26.50.
The company has thus far been able to reinvest about 50% of its profits and while it’s tempting to adopt the assumption that this will continue indefinitely (producing an estimated value of $40), the reality is that as the company retains more and more cash, there will be a larger proportion of the asset base earning just 3%, and the residual operating assets will have to dramatically increase their profitability even above already extraordinary rates.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
Also in the Switzer Super Report:
- Charlie Aitken: Bank on it! [1]
- Fundie’s favourite: Macquarie (MQG) – well placed to benefit [2]
- Staff Reporter: Buy, Sell, Hold – what the brokers say [3]
- Penny Pryor: Short ‘n’ Sweet [4]
- Tony Negline: A new product that focuses on income [5]
- Questions of the Week: Bank fear and when to buy ETFs [6]