REA Group bids for iProperty

News Corporation has seen the future, and it is digital real estate. News already owned a 62% stake in REA Group, the company that dominates online property advertising in Australia. Then, last year, it purchased 80% of US-based real estate portal realtor.com (via Move Inc.), with REA Group taking the remaining 20%.

Now REA Group has proposed the acquisition of iProperty Group, an ASX-listed company with property portals across Asia. We've been following iProperty's progress, hoping for a buying opportunity after spending some time on the company for our review Will REA Group dominate Domain? from 13 Jul 15 (No view – $2.39). But the price then ran away so an opportunity never presented itself.

The deal – which iProperty shareholders will vote on in early 2016 – looks likely to proceed (although a counter-bid isn't out of the question). The proposal has the support of Catcha Group, iProperty's second largest shareholder with a 17% holding. REA Group had been creeping up iProperty's share register after acquiring a 17% stake in July 2014 and yesterday launched its bid from a holding of 23%.

Unusual structure

The proposal is structured slightly unusually. While iProperty shareholders will be offered $4.00 in cash per share, REA Group will pay a maximum consideration of $500m (funded from a new $480m debt facility and $20m of cash reserves). As acquiring iProperty would cost REA Group $580m based on a $4.00 cash price, where will the remaining $80m come from?

It comes as a share alternative, but the shares aren't in REA Group itself. iProperty shareholders will have two options – either cash of $4.00 per share, or 'mixed consideration' of $1.20 a share and 0.7 of a share in a newly unlisted company that will own a stake in the iProperty business.

It's unclear why the deal has been structured this way. A straight-out cash bid would have been simpler. But it's possible Catcha Group, in return for its support, wanted to retain an economic exposure to iProperty's upside over the next few years. Once further details are released, iProperty shareholders will need to decide which option to accept (and may end up owning some shares in the unlisted entity even if they prefer cash).

Significant free cash flow

From REA Group's perspective, the company will take on debt of $480m to fund the acquisition. The company has a pristine balance sheet, generates significant free cash flow and has a market capitalisation of more than $6bn, so $480m of debt is perfectly acceptable.

iProperty Group has only recently turned cash flow positive so the acquisition will be mildly dilutive in the short term. In other words, the debt will cost REA Group more to service than the cash the iProperty business will produce. However, iProperty's revenues have been growing strongly – expected to be up by more than 50% this year – and REA Group might be able to accelerate growth with capital and expertise.

The iProperty acquisition will however increase REA Group's risk profile. Not only does iProperty operate in less mature markets but its business model is slightly different to REA's. Over time, we expect REA Group will shift iProperty's business model away from the property developer advertising on which it currently depends but a cyclical downturn in Asia will remain a significant risk.

REA Group's share price has been on a tear lately, taking it further away from our proposed upgrade price around the $36 mark. It's now up 21% since Will REA Group dominate Domain? from 13 Jul 15 (Hold – $40.52).

The acquisition will make REA Group look nominally more expensive. iProperty is barely profitable but will increase REA Group's debt by $480m, thereby lifting its enterprise value. Assuming the acquisition completes, REA Group will be trading on a 2016 forecast enterprise value to earnings before interest, tax, depreciation and amortisation (EBITDA) multiple of 20 times at the current share price.

Property market downturn

At that price, shareholders should be wary of a property market slowdown – whether in Australia or overseas. While the once-booming Sydney and Melbourne property markets are easing, listing volumes remain high, which should generate about a 20% increase in EBITDA in 2016 (to around $350m).

But lower listing volumes tend to follow booms, so we're cautious about 2017 and beyond. At this price REA Group looks somewhat expensive, although it remains an exceptional business that should prosper longer term. Our recommendation remains HOLD although keep your portfolio weighting in check.

What does this mean for News Corporation, on which we have a Buy recommendation?

You might think 'not a lot', and in one sense that's true. REA Group's purchase of iProperty isn't a big deal for News Corporation itself. What's certain though is that the company supports it. With last year's purchase of realtor.com, News sees digital real estate as an important growth avenue.

News stock has tracked REA Group's upwards although, as a more diversified company, not to the same extent. News' share price has now risen 12% since News Corp: Result 2015 from 13 Aug 15 (Buy – $19.59).

It's approaching our Hold price of $22.00 and so is becoming a little less attractive. However, there's a lot going on under the surface at News Corporation so look out for a more comprehensive review shortly. For now, the recommendation remains BUY.