Conventional wisdom would suggest that in a softening property market, any company exposed to property would suffer operationally. While that might be true for developers and builders, it might not be true for REA Group (REA). Indeed our investment thesis for REA, since first buying its shares below $50, has been built around the idea that it will benefit if and when the property market boom matures and/or weakens.
Our investment philosophy won’t produce the top performing fund results every week, every month, or even every year, but in the long run it will do just fine. Our first fund, for example, which is approaching its seventh anniversary, has never produced a negative return in a year since inception. If we are going to try to continue that track record, we have to do two things; first we have to buy quality at reasonable prices and second, we have to be able to hold cash when a dearth of opportunities exists.
In terms of defining quality, we have a very specific definition. A company needs to be able to generate a high rate of return on equity or invested capital, and it has to be able to generate high returns on incremental capital too. In order to achieve such a feat sustainably the company must be able to demonstrate a competitive advantage. Competitive advantages come in many forms but the most valuable competitive advantage is the ability to raise prices even in the face of excess supply, and without a detrimental impact on unit sales volume. REA has been able to demonstrate this, and at the right price, it certainly ticks the necessary investment criteria.
BHP, which is a far more widely held company, cannot raise prices in the face of excess supply and it cannot do it without a detrimental impact on unit sales volume. If they raise their price for iron ore, sales volume goes to zero.
Despite an excess supply of websites in Australia offering to list a vendor’s home or investment property – many for free – REA has the ability to raise prices. Indeed, it has been regularly raising prices either directly or by creating and offering superior products and services for several years. The result has been a strong growth in revenues despite the fact that listing volumes have been declining nation-wide for some years.
Since 2011, listing volumes have declined 21% nationwide but in 2011, REA Group reported revenue of $238 million. Since 2011, REA has reported higher revenues every year and in 2016 they exceeded $629 million.
REA’s revenue is a function of the number of ads listed multiplied by the time they are listed. Typically, each ad has a life of 30-45 days. In a boom property market, properties don’t remain listed for long, if they are listed at all. Indeed, the current boom has been accentuated by real estate agent’s abilities to quickly turnover stock, leaving buyers with what appears to be a shortage of quality offerings.
In a mature market property however, auction clearance rates fall. There is an inverse relationship between time-on-market and auction clearance rates. As auction clearance rates decline, time-on-market increases. If time-on-market increases, there must necessarily be more properties advertised at any one point in time. REA will therefore benefit if the property market sees demand slow or supply increase. In other words, it’s not the direction of property prices that determines REA’s revenue trajectory.
If it becomes harder for vendors to sell – auction clearance rates decline and time-on-market increases – it follows that selling becomes more competitive, suggesting a higher propensity to ‘feature’ one’s property by paying up for a ‘highlight’ ad. This equals more revenue for REA not only from more ads overall but also a higher proportion of premiere ads. And thanks to properties taking longer to sell, there will be more choice, causing buyer wariness, and listings will remain on the site for longer.
So, growth will come from more listings, longer listed listings, a higher proportion of depth/premium ads and price rises. That sounds like growth on growth, on growth, on growth.
Up until recently, our valuation for REA Group was significantly higher than market consensus and many of the broker/sell-side analysts covering the company.
We have been encouraged therefore, recently when one of the large brokers, Citi, upgraded their valuation for REA Group. Citi analyst David Kaynes wrote: “contrary to popular belief, Australia’s rapidly rising house prices have been a significant headwind for the two portals that advertise properties for sale”, adding, “both sites charge per ad (30-45 day duration) and, over the last decade, the average time on market for a property was 50 days. In a balanced market (auction clearance rates 60%) roughly half of all properties will require more than one listing (ad) in order to achieve a sale”.
Citi now have a target price of $80 on REA, similar to our own upper valuation. CEO Tracey Fellows and CFO Owen Wilson reported REA Group’s Full Year 2017 result on the 11 August along with underlying profit of A$228.3m, up 12%. Consistent with our thesis, the result was driven mostly by growth in premium depth ads. The company did however report some weakness in developer spending on media display ads for a reduced number of new apartment project launches. This is likely to persist through 2018, but in coming years, where once there was one ad by a developer, there will be 50 or 150 individual owners listing many properties for sale.
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