Value Investor: Three market darlings to watch

These listed companies have delivered strong revenue and earnings growth, but there are questions about whether they are trading above their market value.

Seek Limited (ASX: SEK), REA Group (REA) and Carsales (CRZ) are three market favourites which continue to deliver strong revenue and earnings growth and rising dividends. Their recent full-year results were no exception: The reported after-tax profits of REA Group, Seek and Carsales grew 30 per cent, 27 per cent and 15 per cent, with total full year dividends 36 per cent, 37 per cent and 13 per cent higher respectively.

Why have they been so successful? Why are they so popular with investors? And most importantly, are they in value and worth buying right now?

Their success and popularity can be traced to several common factors.

First, they all hold market-leading positions in their own advertising industries. REA, for example, was one of the first companies in online real estate classifieds and over the years has consolidated a strong market-leading position. This drives traffic to its websites, particularly realestate.com.au, as users know this is where a large share of real estate advertisements will be.

REA also benefits from the ‘network effect’: the more people who use its websites, the more valuable their services become. More interested buyers visiting the websites will attract more advertising from property vendors, which in turn attracts more interested buyers.

This reinforcing effect is visible in the 25 per cent increase in the average number of monthly visits to REA’s websites in fiscal 2014. At 40,786, this is over three times the number of its nearest competitor.

Secondly, all three have international growth prospects. This is particularly attractive for investors, considering the current domestic economic climate of patchy business confidence and rising unemployment.

Carsales recently expanded into the emerging markets of south-east Asia and Brazil, while REA focused on south-east Asia and also holds the number one property advertising website in Italy and Luxembourg.

Seek’s international operations are particularly impressive, with expansion into south-east Asia including Singapore, Hong Kong and China, as well as Brazil and Mexico. These countries have growing labour markets. Additionally, with rising internet penetration and the influence of urbanisation, these trends see likely strong growth in online employment advertising in the short and long term.

The strategy in the international markets is similar to the successful Australian and New Zealand model: driving more user traffic and advertisements to a market-leading job placement website.

These factors saw Seek report earnings growth in its International operations of 25 per cent to $80.6 million for fiscal 2014. This comprises around a quarter of total earnings.

Thirdly, all three companies have capital-light business models. Online businesses require relatively small amounts of capital to expand organically. Along with a strong market position driving revenue and earnings growth, when this is combined with relatively small capital requirements, Seek, Carsales and REA Group are able to deliver high rates of profitability and distribute their considerable excess capital to shareholders.

At StocksInValue we measure profitability by calculating a firm’s return on equity -- the earnings it can deliver from every dollar of equity. Carsales has delivered consistently high ROE numbers in the last five years, generally over 80 per cent!

Figure 1. Carsales' Historical ROE

Graph for Value Investor: Three market darlings to watch

Source: StocksInValue

Carsales’ dividend payout ratio (distributions divided by ROE) in 2014 was very high at approximately 80 per cent (65.6 per cent / 82.4 per cent). However, our 80 per cent ROE forecast means intrinsic value growth is still double-digit.

Despite all of these positives, we as value investors are ultimately interested in whether the stock is trading below its valuation and if we should invest.

In our valuation, we take into account not only ROE and its split between dividends and earnings reinvested but also its business and financial risks as measured by required return. We adopt a low RR of 12 per cent (blue above), reflecting Carsales’ consistent operating performance and strong financial position (note for comparison purposes, the Big 4 banks have an RR of 11.5 per cent).

Figure 2. Carsales' Future Valuation

Graph for Value Investor: Three market darlings to watch

Source: StocksInValue

Our fiscal 2014 valuation is $9.66. Carsales is currently trading above value. Seek and REA Group are respectively 64 per cent and 44 per cent overvalued.

Despite the attractions of Carsales, Seek and REA Group, market expectations capitalised in their share prices are too high. Not enough weight is being given to business and execution risks: if these eventuate, we could see a considerable re-rating back to value. For example, Carsales did not meet market expectations for its full-year results, despite delivering a 15 per cent profit increase, and saw its share price fall 7 per cent on the day.

While these companies are investment-grade, they should only be monitored for the time being.

By Brian Soh, Associate Analyst with insights from Adrian Ezquerro and Alex Hughes of Clime Asset Management. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For a no obligation FREE trial, please visit StocksInValue.com.au or call 1300 136 225.