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REA at a Low

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REA at a Low

REA Group is succeeding despite current market conditions, not because of them. The strength of the Australian housing market and REA’s own robust financial performance suggest the owner of the realestate.com.au property portal is riding boom times. However, the company is currently navigating one of the most challenging periods of the last two decades. There is plenty of room for REA’s earnings and stock price to rise from these lows.

For the fiscal year ending 30 June 2016, REA’s revenues grew by 20% to a record $630 million. Earnings grew even faster and totalled $347 million for the year – also a record. On the surface it would seem that REA is benefitting from home prices that were up almost 10% in the past year, continuing a trend of near double digit annual gains for the past 3 years. Perversely, the strength in the housing market has actually been a burden for REA.

Historically as home prices have risen or fallen, so have the number of home sales. But over the past 3 years this has not been the case. The rapid rise in home prices has been associated with declining sales volumes. In fact, the number of homes sold is approaching a 20-year low. This has not been good for REA which makes its money on the number of homes listed, rather than the price of the homes. If less homes are being sold, then less homes are being listed on realestate.com.au, and REA has had to work harder for its money.

And it has. By charging more per ad listing and encouraging sellers to buy higher priced premium ads REA was able to grow its revenues by 20% in fiscal year 2016 compared to marketwide listings that remained flat.

Australian property prices and sales volumes

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At the same time the number of listings required to sell each property has dropped by about a third, from 2 listings per sale in 2011 to just 1.4 listings per sale in 2016. As the housing market has heated up over the past few years there has been less need to list a property on realestate.com.au. Real estate agents have been able to make sales quickly and at high prices by using their own network of ready buyers. And when homes are listed they don’t hang around very long, so sellers rarely find themselves relisting an unsold property. The average time on market has also fallen from 2 months in 2011 to just over a month in 2016.

Listings per sale and time on market

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REA has been hit by a cyclical double-whammy: low home transaction levels and low listings per home. When the industry sales and listing numbers turn up from their lows, REA will have a long way to rise.

Montgomery funds own shares in REA Group.

Christopher is a Portfolio Manager at Montgomery Global Investment Management. Christopher joined Montgomery in January 2015 after spending more than four years at LFG, the private investment group of the Lowy family, where he was most recently a senior member of the research team based in New York. Prior to this Christopher worked as a research analyst at One East Partners, a hedge fund based in New York, and as an investment banker at Goldman Sachs in Sydney.

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This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564) and may contain general financial advice that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking advice from a financial advisor if necessary.

8 Comments

  1. If the RM thesis on oversupply of apartments is correct, then this should bode well for REA if this leads to rapid turnover – thoughts?

    • Christopher Demasi
      :

      Indeed, any rebound in sales and listing activity will positively impact REA’s financial performance.

  2. Justin Carroll
    :

    REA is fully valued (in my view, it is overvalued) at $50 a share. It earned $1.521 per share last year. It earned about the same the year before.

    To justify buying REA today at $50 a share requires some heroic assumptions as to the rate at which it is going to grow per share earnings over the next 2 to 5 year period in an environment of rising interest rates.

  3. Justin Carroll
    :

    Thanks Christopher. DCF valuation is the default valuation method of most equity analysts.

    What do you see in REA’s current price that you think the market does not see and has not priced into REA’s stock price? Is it merely a rosier earnings outlook or the use of a lower discount rate?

    • Christopher Demasi
      :

      Justin – we would never allow our investment thesis to rest on using a lower discount rate than the next investor.

  4. Justin Carroll
    :

    Just out of curiosity: Montgomery seems to be an investment firm that seeks to buy growth at a reasonable price. How does it avoid overpaying for growth?

    REA is a wonderful company. But, except for a period after the GFC, it seems always to have traded at a price that fully reflects the company’s prospects.

    I wonder in that case what Montgomery sees in REA (even at its current price, let alone when it was trading at $64 a share) that it thinks that the market does not see and that Montgomery thinks is not priced into the valuation of the stock.

    And lastly, whatever it is, how do you make sure that you don’t overpay for that?

    • Christopher Demasi
      :

      Thanks Justin.

      We view the value of REA (and indeed any company) as the summation of the cash it is expected to generate in the future discounted back to today at an appropriate rate. In short we avoid overpaying for any business by requiring this assessment of value to be significantly higher than the share price.

      In our assessment over a sustained period of time home sales levels should rise to more cyclically normal levels, REA should continue driving pricing upwards, and vendors should continue to buy more prominent and therefore more expensive advertisements. We think both the magnitude and persistency of the impact of these earnings drivers are underappreciated by the market at the current share price.

      Of course, as you allude to, the bargain that REA offers is much more appealing at $50 than at $65. The corollary to this conclusion is that you should expect us to own more of the stock at low prices and less at high prices. See my series on position sizing and price/value here: http://rogermontgomery.com/how-to-size-the-positions-in-your-portfolio/
      http://rogermontgomery.com/sizing-your-positions-part-2/
      http://rogermontgomery.com/sizing-your-positions-part-3/

  5. Hi Christopher

    John McGrath Real Estate is also suffering as a result of a fall off in listings and whether this is a temporary issue remains to be seen. Investors are buying and holding onto property rather than turning them over due to the substantial costs of selling and then buying again. In recent years Investors have been a big influence on the market overall and have pushed owner occupiers out. Owner occupiers are also reluctant to sell and renovating is generally more cost effective than upgrading for the same cost reasons that buying and selling incurs. The threat of a change to negative gearing is still alive which is more of a reason for Investors to hold than to sell. I believe there will be changes to negative gearing – the timing is the only issue. It’s way too generous a tax break and the government can’t afford it and owner occupiers have been forced out because of it.

    REA is a great business but the results in first Quarter 2017 leads you to conclude it is struggling to keep up the performance of past years. The IProperty buyout remains a major risk. When the $480 Million loan is repaid in the next few years it becomes equity on the Balance Sheet. Will the Return on that extra Incremental Equity be 35 % like it currently is???
    If it fails to achieve that return then overall Return on Equity for the whole Group will be affected – If that was to happen Shareholder value would be destroyed and that;s a real possibility. It’s also possible that Goodwill attributed to IProperty will become impaired requiring a write down.

    So, the next few years are risky for a number of reasons . At around $40 or below I would consider it to be a buy, but at current prices I would stay well clear. In the 2016 year it had normalized earnings of $1.63 per share. If those earnings grow at 16% in 2017 it’s trading on a prospective PE of about 27 and a PEG ratio of about 1.7 – At current prices it’s still looking expensive. At $40 the prospective PE becomes 21 and the PEG ratio becomes 1.3 – still not cheap but acceptable. A DCF Valuation will give a different result but that is based on assumptions over many years which are very subjective and prone to error.

    Yesterday is history and tomorrow is a mystery – we can all speculate how REA will perform in the future but we can’t really be sure what it will do, so a “decent ” margin of safety is wise considering the head winds it is facing..

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