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A stock picker’s guide to REA Group Limited in 2014

REA Group Limited (ASX: REA) has one of the most attractive business models on the ASX, and is well known to Australians, who spend a startling amount of time perusing the company’s flagship website, realestate.com.au. The Murdoch-controlled News Corp (ASX: NWS) is the majority shareholder of the $5.3 billion REA Group, having taken an initial stake in the wake of the tech crash more than a decade ago.

Murdoch’s control of REA Group could be a concern for shareholders, as he is not known for accommodating minority holders. On the other hand, News Corporation has provided advertising, assistance with acquisitions, and help entering new markets. I believe that the association adds extra breadth to REA Group’s business moat. The recent acquisition of online tenancy application service 1form.com demonstrates the company is continually looking to expand its offerings and dominate its industry.

REA Group is essentially an online real estate advertiser. Its most important assets are real estate websites in Australia and Italy. The key drivers of revenue for REA Group are transaction volume and property prices, both of which seem to be increasing in Australia, at present. However, REA Group is not without competition. Fairfax Media Limited (ASX: FXJ) owns the number two real estate website in Australia, domain.com.au, and upstart Onthehouse Holdings Ltd (ASX: OTH) is attempting to challenge for the number three spot. At present, REA Group’s lead seems unassailable.

Why to buy

Real estate advertising is a sweet spot because advertising costs make up such a small proportion of the value of the sale. Because REA Group is the number one website, it has pricing power: real estate agents have little choice but to advertise on the website. Due to high house prices (relative to cars, or hotel rooms, for example) REA Group’s customers can afford to pay higher rates, and the company is therefore in a position to continually increase prices. The chart below tracks the amount of revenue the group receives, per month, per agent.

 

Source: REA Group’s 2013 AGM Presentation

Why not to buy

REA Group may be one of the best businesses on the ASX, but it has a price tag to match. With stock costing over $40 per share, the market has priced the company to grow free cashflow at over 20% per year for a long time to come. This may be achievable, but it leaves very little upside for a buyer at this price. With the share price up almost 100% in the last 12 months, investors might do well to accept that they have missed the opportunity to buy shares at a great price, for now, and keep the company on their watchlist.

Foolish takeaway

At current prices, the company yields about 1.2%, fully franked. The company has a cash horde of $250 million and no debt. It’s in a strong position to grow over the next decade, and is an apt demonstration of the splendid returns long-term investors can achieve, if they buy and hold the right small-cap company.

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Motley Fool contributor Claude Walker (@claudedwalker) does not own shares in any of the companies mentioned in this article.

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