REA profits go through the roof

You can’t win ’em all. The one thing we can safely say about REA Group is that we haven’t won with it. Since we first passed it up in Realestate.com.au lays firm foundations on 2 Feb 07 (Avoid – $5.60), the stock has risen fivefold.

That review offered a glowing write-up but faltered at the stock’s price-earnings ratio of 86. ‘Forecasting the future profitability of these international operations is impossible,’ we wrote in 2007. ‘But even using some generous “best case” scenarios, we struggle to make a case for profits quintupling over the next few years (in order to bring the PER back to more palatable levels).’

And we were right. Profits haven't quintupled in the seven years since then (including the current year) – they've duodecupled (that’s 12 times according to Wikipedia). So the PER is down to a somewhat more palatable 36 times, despite the fivefold increase in the share price.

We needn’t have concerned ourselves with the international operations as the growth has been almost entirely domestic. Although we noted the beneficial effect of rising average revenues per agent (ARPA) in that previous review, our mistake was to think that this process had almost run its course.

Agents paying more

It hadn’t. ARPA in the Australian business has almost tripled since and is the main factor behind a fivefold revenue increase, despite a lower rate of increase in the number of agents subscribing. REA’s operational gearing (see Shoptalk) has done the rest.

The increase in ARPA reflects the value of in REA’s product. In the 2012 financial year, realestate.com.au accounted for 61% of the time Australians spent on residential property portals. Sellers and agents have to use it.

Amongst a sea of properties, they have to work hard to make their properties stand out, which is why they pay REA to access its premium products. Recent examples include the ‘Highlight’ mid-range listing product and a ‘Diamond platform’ for residential agents.

Maiden profit in Italy

Going back to those international businesses, while they aren’t troubling the scorers too much at this stage, they are laying some foundations for future growth.  The largest of them, casa.it in Italy, which claims 1.6 times the online audience of its nearest competitor, delivered a maiden profit in 2012 thanks to a 44% increase in revenue to 17.3m euros ($22.4m, or 8% of the group total).

Continued steady growth for REA Group looks assured, thanks to further increases in ARPA and the international operations. But it must surely be at a slower rate than in the past. And that leaves us still baulking at the price.

The stock’s multiple of 35 times this year’s forecast earnings is off-putting but, with more than 80% of net profit coming through as free cash flow, the free cash flow yield of 2.3% is somewhat less so. There’s also the possibility of a bid or perhaps a demerger from News Corp, which owns 61.6% of REA, as it reorganises its Australian operations – but it's generally unwise to pay a premium in the hope of such events.

If you followed our advice and missed the boat on REA Group then we wouldn't recommend trying to correct that mistake by buying in now. But if you’re in the happy position of owning these shares, there’s still reason to hold on, although we're nearing the Sell price of $30 in our recommendation guide. HOLD.