Over the past 10 years, REA Group Limited (ASX: REA) has been a standout business and investment listed on the ASX. During this time, the group has grown revenue from $33 million to $550 million and $10,000 invested in 2005 would now be worth over $200,000 – an average annual return of 35%!
Since 2005, shares have surged from $2.50 and currently trade for around $45. After such a strong run, what should investors expect in the future – will this champion keep on winning or are its glory days over?
This article analyses the REA Group businesses and provides an in-depth assessment of their outlook for the future.
The business
Most readers will have used the services of the digital advertising business REA Group at least once in their life. Its key asset is the dominant Australian property website www.realestate.com.au. It has also entered foreign markets by investing in existing businesses or buying businesses outright.
Leading digital businesses enjoy a self-reinforcing competitive advantage commonly referred to as the "network effect". Put simply, the more people using a website attracts other users and customers who want exposure to the largest audience.
News Corp (ASX: NWS) owns approximately 60% of REA Group which places it under the control of the media empire (for better or worse, which we'll cover later).
Australia – www.realestate.com.au
Australia is the current engine of REA Group and produces more than 90% of its total revenue and earnings.
Management estimates that the Australian digital real estate classified market is worth around $700 million. Revenue for FY15 was $473 million which implies a market share of 65%. Domain Property Group, owned by Fairfax Media Limited (ASX: FXJ), is REA Group's main competitor in Australia. The Domain website generates around 10 million monthly views compared to 33 million for REA Group, putting it in a distant second place.
Although REA Group is dominant in the Australian market, it continually improves its websites and services while increasing the size of its addressable market by launching new products.
Australian revenue growth was 21% in FY15 despite a 4% reduction in listings. This was driven by the aggressive implementation of premier listing products and a move to market-based pricing where the advertisement cost will change depending on property prices in that suburb.
REA Group is smartly expanding into the utility connection market and home finance leads via partnerships with existing players such as mortgage financing company AFG. Expansion into these areas is logical as consumers often begin their journey, whether it be buying or renting a home, with REA Group and are therefore in a strong position to capture the market.
Cash machine
REA Group, similar to many digital businesses, requires minimal capital expenditure for expansion – averaging around 6% of total revenue. The flow-on effect is that cash flow from operations (CFO), shown below, provides a decent estimate of free cash flow. CFO for FY15 was around $200m that can be used to pay dividends, invest in other businesses or bank for future use.
REA Group has used some of this surplus cash for expansion into international markets with expectations they will power business growth into the future. These are important areas for investors to watch.
International businesses
1. Italy – Casa.it
Casa.it was the largest real estate website in Italy when REA Group purchased it in 2006 for $16 million. In 2012, it was overtaken by competitor www.immobiliare.it and is a living reminder for the group that it can lose the top dog position.
Google Trends data confirms website searches have declined at a similar rate to the active agencies in the chart above.
Although Casa.it isn't a huge financial contributor to the group with FY15 revenue around $30 million, it is important for REA Group investors to see if it can win back market share from the leading company. Second place is a tough operating environment for digital businesses due to the network effect, just ask Domain Property Group or Myspace (if you remember it).
REA Group is fantastic at highlighting its leading position in Australia against Domain Property Group but, unfortunately, doesn't provide this data for its other operating markets.
2. Luxembourg, France, Belgium & Germany – atHome websites
The atHome group of real estate websites was acquired by REA Group in 2007 for $7.5 million.
atHome is currently the market leader in Luxembourg and the group is focusing its energy on further expansion into France.
This part of REA Group's European business is performing well and looks set to increase both revenue and profit at a steady pace. The numerous other European countries could provide additional future growth opportunities.
Equity ownerships
REA Group announced two equity investments in 2014 which, if successfully executed, have the potential to multiply current group earnings.
3. Asia – iProperty Group
REA Group acquired around 20% of iProperty Group Ltd (ASX: IPP) in July 2014 for around $120 million.
iProperty Group is similar to REA Group and holds market-leading real estate websites in Malaysia, Hong Kong, Indonesia, Macau and Thailand. The real estate advertising market in these countries is estimated to be around 30% larger than Australia and only a fraction is currently spent in the digital market.
iProperty Group is on the verge of profitability and now has the experience and resources of REA Group behind it. Asia is one of the fastest growing real estate markets in the world and the potential for this business in the future is enormous.
4. United States – Move, Inc.
REA Group entered the massive US$14 billion US real estate advertising market after purchasing 20% of Move, Inc. for US$199 million in November 2014 (News Corp owns the remaining 80%).
The United States housing market took a massive hit following the Global Financial Crisis, which could help explain why the digital transition of its real estate industry is still in its infancy.
In FY14, the three top digital websites in the US (Move, Inc., Zillow and Trulia) reported revenue of US$244 million, US$325 million and US$252 million, respectively, totalling US$821 million. In contrast, REA Group recorded revenue of $400 million during the same year despite the US market being more than 10x the size of Australia.
Zillow acquired Trulia in February 2015, creating a much larger competitor and setting the stage for an epic battle between Zillow and Move, Inc.
How is Move, Inc. performing?
Until recently, Move, Inc. used to be the top online real estate company in the US, measured by revenue.
What happened? The chart below plots annual revenue against sales & marketing (S&M) expenditure for Move, Zillow and Trulia.
Since 2010, Zillow and Trulia have rapidly increased their S&M expenditure every year and each $1 spent resulted in around $2 of additional revenue. Using this aggressive strategy, revenue has surged at a compound annual growth rate (CAGR) above 80% during this time.
In contrast, Move Inc.'s S & M expenditure was stagnant from 2010 through to 2012 when it finally woke up. Is it too little, too late?
Rupert Murdoch, Executive Chairman of News Corp doesn't think so. Move, Inc. now has the advertising and marketing expertise of News Corp behind it which includes access to the popular US publications The Wall Street Journal, The New York Post and Barron's which reach millions of readers every day.
Move, Inc. owns the rights to operate the realtor.com® website – the official site for the National Association of Realtors®. REA Group has had issues in Australia with realtors opposing its dominance and pricing power and working with the realtors in the US could give it wider industry appeal and support.
It will be a difficult task catching up to Zillow, but the US market is huge and in the early stages of digital transition which gives Move, Inc. a good chance.
As a last resort, if REA Group wants to Move out of the US market completely, it has a put option to sell its 20% holding in Move, Inc. to News Corp for a period of two years from the date of acquisition. In simple terms, this allows REA Group to sell out of its 20% Move, Inc. investment at fair market value until 18 November 2016. Both parties will hope that doesn't occur!
Financials
REA Group reports four segments – Australia, Europe, Asia and the US. The chart below plots the profitability of each segment using the ratio of EBITDA/revenue (EBITDA = earnings before interest, tax, depreciation and amortisation).
Note that data for Asia and the US came from the iProperty Group and Move, Inc. financial reports.
The Australian segment has an impressive EBITDA/revenue margin of 55%. Due to the low capital intensity of the business, the depreciation & amortisation charge (the DA in EBITDA) is relatively small, and most of this EBITDA (minus 30% tax) will fall to net profit. These economics are the envy of the business world.
Europe is profitable and this margin should continue to grow as REA Group expands further across the region. If not, it could signify further issues with the Italian business or expansion difficulties, or both.
iProperty Group (Asia) expects to achieve profitability by the end of 2015. It owns the leading websites in most of its operating countries and now has REA Group's experience behind it. I would expect its EBITDA/revenue margin to follow a similar path to REA Group in its earlier days (at a minimum). This investment looks set to be a winner for REA Group.
Move, Inc. (US) has performed relatively poorly and barely turned a profit throughout its long history (the significant annual charges for stock-based compensation would paint a different picture). REA Group will aim to turn things around quickly, but it can be hard to change established corporations full of people set in their ways.
What is it worth?
Using a discounted free cash flow (DCF) valuation and conservative input parameters (assuming moderate success from iProperty Group and slow growth in the US and European markets), my valuation for REA Group is around $45.
With a more aggressive set of parameters and assuming faster growth in the US and European markets, my valuation for REA Group is around $55.
With high growth businesses such as REA Group, quantitative valuation methods including DCFs are extremely sensitive to the numerous inputs and must be combined with thorough qualitative research before making an investment decision.
Foolish takeaway
My analysis reveals that REA Group appears fairly priced for a conservative investor, however, for those more confident in its international businesses and investments, the stock appears relatively cheap.
Often the best companies tend to keep on winning. Given its history of performance, investors should have faith that REA Group can expand its business internationally while continuing to grow revenue at home. The business requires no debt, produces truckloads of cash and has delivered huge returns for long-term shareholders.
Warren Buffett has said "it is far better to buy a wonderful company at a fair price than a fair company at a wonderful price" and I think REA Group fits this description.
