REA Group: Interim result 2014

What does a company have to do to justify a price-earnings ratio of 38. An awful lot is the answer, but announcing a 37% profit increase is a good start. REA Group did just that this week, and the market applauded by pushing its shares up another 5% – to a PER of 40.

The result’s major feature was again the revenue from ‘listing depth’ products, which enable agents to enhance their property listings. Revenue from these rose 67% in the six months to December to $100m – more than double its level for the whole of 2010, when the main realestate.com.au website got a major revamp.

Overall, REA’s revenues rose 30% to $188m, but costs rose just 21%, sending the operating margin up from 42% to 46% to give a 41% increase in earnings before interest and tax to $96m. A slight increase in the tax rate meant that net profit and earnings per share each rose 37%, to $71m and 54 cents respectively.

Interestingly, soon-to-depart chief executive Greg Ellis said in a meeting we attended following the result that the booming property market hadn’t yet had much impact. The real boom, he explained, had only been in the December quarter, and most of REA’s contracts with agents are for 6-9 months.

But let’s go back to the original question: what does REA have to do to justify its lofty price tag? The answer of course is that it needs to maintain its rapid growth – if the growth slows in the next few years, then the shares will prove to be expensive, if it slows around the 4-8 year mark then they’re probably fair value and if it keeps going for ten years or more, then they’re probably a bargain.

Eating agents' lunch

The growth essentially depends on REA continuing to eat real estate agents’ lunch. The idea, according to Ellis, is that improving technology will enable it to add more and more of the services currently associated with agents – supply/demand data and price comparisons for example. Ultimately, he thinks, property sellers will work out that they get more from REA than they do from the agents, and a large chunk of the 3-4% people currently spent on selling a property will be up for grabs. Ellis suggested that REA might ultimately be able to take 2-3%.

Property sales currently run at around 500,000 a year and the current capital-city median house price is about $550,000 according to RP Data (not all sales are capital city, of course, but the average will also be higher than the median). That gives a total property sale value of about $250-300bn.

Based on Australian residential revenues of $218m over the 12 months to December, REA is currently taking a bit less than $500 per sale, or a bit less than 0.1%. Ellis’s ‘stretch target’ (and that’s probably a kind description) of 2-3% would imply around $15,000 per sale, or a total $7bn of revenue for REA.

The UK’s Rightmove makes operating margins of about 70%, but Ellis suggested 60-65% was more likely the top whack (REA is ‘run on talent and talent doesn’t come cheap’). Still, that would give an operating profit of $4.2bn, a net profit of almost $3bn and earnings per share of about $22 – and that’s without including anything for the display advertising, commercial or international revenues that contributed $111m or about 40% of the total in 2013. (We also haven't allowed for the fact that house prices are likely to rise over the long term, since this will be dwarfed by the other factors and there are more than enough moving parts in these calculations already.)

'Google can't beat us'

Clearly Greg Ellis thinks REA still has a long way to run – but of course he would say that.  More conservatively, you might think that sellers will retain more of the 3-4% that’s currently on the table. For that to happen, there would need to be some competition (or regulation) but it’s not obvious where it would come from. EBay’s Gumtree is a possibility, or perhaps free listings by an industry group of real estate agents (although this seems increasingly unlikely as agents become more marginalised).

Google is probably the major threat, but even here Ellis was confident: ‘If Google couldn’t beat us in 2010, they can’t beat us now’, he suggested, referring to the major push by the US giant into the Australian property market, armed with its Google Maps technology.

Even so, 1% seems like a more reasonable long-term bullish target, and that would deliver revenue of about $2.5bn for the Australian residential business, net profit of about $1.1bn and earnings per share of around $8.

Even if they’re achievable, though, these bullish outcomes will take time – so we can think of a target of doubling the revenue per property sale every five years, until it reaches whatever level it’s going to get to and then reverts to economic growth. That would get us to $1,000 over five years (still a mere 0.2% of the property value) and would suggest residential revenue of $500m and earnings per share of about $1.60.

Adding in the commercial, display and international revenues, and allowing them growth of 20% a year (in line with the past couple of years), would get us up to about $2.20 – growth of about 20% a year from now.

Range of outcomes

Taking that five-year assumption as read, for a moment, the share price could react in different ways. If in five years’ time investors are eyeing up another five years of growth – say to $2,000 per sale – then they might be prepared to pay the same PER of 40, so that the 20% annual growth flows straight through to the share price. If, on the other hand, growth has slowed and the market deems a PER of 20 to be more appropriate, then the share price will barely budge. In between, you might end up with a PER of 30 and share price growth of 8% (to which you can add a dividend yield of currently 1%).

On the downside, of course, you could imagine (although it’s hard), REA somehow losing its market dominance and everything going to pot.

So whether you think there’s value in the current share price will depend on which of these many scenarios you see developing. If it’s the first, and the next five years are just the first step on REA’s march towards getting 2% of property sales, then the shares will turn out to be a screaming bargain even at twice the current price (or more).

Inexact science

If you think 0.5-1% per property sale is the most REA can achieve, and that it’ll take 10-15 years to get there, then you’ll probably see the stock as a Hold; and if you think that less than 0.5% is the limit or, worse, that the competition is coming, then you’d see it as a Sell.

The share price has now risen 18% since we bottled it and downgraded to Sell in REA Group: Result 2013 (Sell – $37.67) and, on reflection, we’re going to switch back to the Hold camp. But this is an inexact science and for this reason we’re going to dispense with our price guide. Given the vast range of possible outcomes it gives a false sense of accuracy, and it makes little sense for us to keep chasing the stock up every six months while everything goes smoothly, only to be stuck out on a limb if and when it all unravels.

Probably the more important thing, if you do decide to invest in this company, is to keep an eye on your portfolio limits and take profits on the way up – growth stocks like this can be left very exposed if and when the growth falters. HOLD.