Global returns and interest rates are so low that in Denmark borrowers are finding their mortgage balances are declining, even without making payments, because interest rates are negative. Elsewhere, high-quality companies are trading at eye-watering multiples. In private equity, too much money is chasing too few opportunities, and meanwhile investors are happy to buy property that is yielding barely more than bank interest despite the higher risk profile.
In such an environment, it is next to impossible to find high quality businesses that are still cheap compared with our estimate of their value.
However, one of those companies is REA Group (ASX: REA), which has just reported a 20 per cent increase in revenue in the third quarter. In fact 3Q16 revenues were reported by the company at $147m, which was up 20 per cent year on year.
Investors could be forgiven for feeling slightly anxious on the back of the news coming out of Australia’s real estate market. In the space of a few days we have had: The revelations of dubious real estate financing, as mortgage brokers reportedly put foreign buyers with poor documentation through to the major banks; Reports of large falls in apartment prices in Melbourne, and; Reports from McGrath Limited (ASX: MEA) of listing volumes declining by about 25 per cent in some areas of Sydney.
REA’s revenues are primarily driven by the sales of premier/highlight listings on the realestate.com.au website, and data that records listing volumes can be used as a proxy for where said revenues are headed. While nationwide listings are down since the end of December as per the seasonal trend, on a year-on-year basis, considerable growth is observed. And in a market where listings volumes have been under pressure, REA’s revenues have grown more than 50 per cent on the back of price increases and changes in the volume of premier ads (i.e. ‘mix shift’). This resilience — a function of pricing power — is an attractive quality to owners of the business.
For the nine months to the end of March 2016, group revenues rose 20 per cent year on year to $461m. This result was partly boosted by the consolidation into the accounts of the acquisition of the iProperty Group announced November 4, 2015 at $4 a share. Operating expenditure of $69m had risen 21 per cent year on year, which was not a surprise to the market, and so EBITDA rose by 18 per cent year on year to $77m.
Of the $6bn spent on marketing properties in Australia each year, real estate agents collect about 86 per cent and REA Group’s realestate.com.au website collects just 5 per cent (with the rest of the pie being split between traditional media and competitors). My investment thesis is partly reliant on the idea that real estate agents do not deliver 86 per cent of the value in a real estate transaction and that real-estate.com.au delivers more than 5 per cent. The change in the equation — in favour of REA Group — will be initially effected by a change in the willingness of vendors to accept higher prices for advertising on realestate.com.au but not higher charges from real estate agents. The second phase of the change in the equation will be that realestate.com.au’s higher prices will eat into the total spend of the vendor such that vendors will insist on lower fees from the agents.
We were pleased that REA introduced a price rise from July in the range of 10 per cent to 15 per cent, which beat some analysts’ expectations and confirms the pricing power of the model as well as reinforcing our thesis of being able to ultimately take a larger share of the total real estate market pie.
Encouragingly, REA also confirmed that despite investing aggressively, further EBITDA (earnings before interest tax depreciation and amortisation) margin expansion in the fourth quarter should be expected because marketing costs will be lower then. The company also announced that the US business Move Inc is now EBITDA positive.
Our REA valuation is currently $65 (against about $54.70 now) this compares with analysts we know who have price target/ valuations between: $52.19 and $56.50. The implication is that if we are right, not only could we make more money for our investors but it could happen quickly if the rest of the analyst community rerates the company.
The downside risk is that even though we expect the company to make more money in a property market downturn — because more properties will be listed and for longer — sentiment towards REA Group’s share price could turn negative.