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Investors in McGrath IPO headed for disappointment

Credit: Alex Livet

McGrath Limited (ASX: MEA) or McGrath Def Set (ASX: MEA) as Google Finance refers to the company, saw its share price tumble below its $2.10 listing price, as investors abandon ship. In afternoon trading, shares in the real estate company were trading at $1.96, down 6.7%.

So why the fall?

Investors may have been put off by the falls in the share price of Spotless Group (ASX: SPO) and Dick Smith Holdings Ltd (ASX: DSH), which recently listed on the ASX and disappointed investors with profit downgrades.

A relatively long period of record-low interest rates means demand for housing has been strong historically. A low Australian dollar also means foreign buyers represent a big portion of buyers. That won’t always remain so.

These are some of the other headwinds McGrath’s business faces…

  1. Sydney home prices have soared well above the country and capital city averages, rising a cumulative 48%, compared to Melbourne of 32%, Brisbane at 15% and the capital city average of 31%. Since the last low price in May 2012, Sydney houses have soared 52% and units 38% to November 2015. As a result, McGrath has enjoyed strong tailwinds over the past three years.
  2. McGrath is concentrated in NSW, with a strong focus on Sydney. Sydney median home values are already starting to fall. In November, median prices in Sydney fell 1.4% and 3.5% in Melbourne, as we wrote a week ago. Investors are opting out of the market – thanks to the discouragement of the banks to limit investor loan growth. That means lower growth in home values and revenues for McGrath. In fact, 2015 could be the peak of the Sydney market for some time.
  3. The number of new properties listed for sale has dropped 9% in Sydney and 4.1% across the combined capitals since November 2014. NSW properties for sale have fallen 6.8% over the same period, according to CoreLogic RP Data.
  4. Auction clearance rates in Sydney have dropped from around 90% to sub-60% in a short period of time, according to Domain. Domain’s senior economist Andrew Wilson noted, “The market is looking very tired at the moment.
  5. The Commonwealth Bank of Australia (ASX: CBA) thinks that low auction clearance rates are a possible signal of a significant change in the economy, according to The Australian. “That’s a big fall and fast. Big falls, occurring quickly, send a pretty powerful signal to us from the market, ” the bank says.
  6. Other capital cities and states haven’t grown as fast as Sydney and aren’t likely to. McGrath’s strategy of expanding its points of presence in other states is likely to expose it to lower growth rates – bringing down the group’s overall revenue growth.
  7. There are reports that negative gearing, a highly popular strategy used by property investors, could be abolished or amended to save the federal government at least $3 billion over four years. The RBA has urged the government to consider it.

The company also faces a number of major risks…

An upgrade from its proprietary IT system to a SalesForce Saas System beginning in Feb 2016 and due for completion by June 2016. System implementations don’t always run perfectly or on time and budget, which could result in damage to the company’s reputation and clients using other agents to sell their homes. It will also take some time for staff to learn the new system and that could also impact on earnings.

Agents can easily leave McGrath and set up a competing agency, taking revenues with them. Hence the fragmented market. McGrath, as the third-largest residential real estate agency, has just 3.2% market share, with 70% of the market held by agents outside the top 10, most likely by many low or single agency businesses.

Foolish takeaway

The initial IPO price of $2.10 offered is what appears to be a cheap price, with a P/E ratio of 13.4x. But the real estate company faces the prospect of missing its prospectus forecasts if existing trends in the housing market continue. Earnings could also fall further in the 2017 financial year if property prices continue to sink in 2016. Investors might want to bypass the McGrath share auction for now.

Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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