Treasure Chest: New REA Model Offers Enhanced Upside

This story features REA GROUP LIMITED. For more info SHARE ANALYSIS: REA

– REA dominant in real estate
– Superior growth to peers
– Business model change in the offing
– UBS upgrades earnings forecasts

By Greg Peel

Late in May, BA-Merrill Lynch downgraded REA Group ((REA)) to Neutral from Buy. Merrills problem was that REA’s FY14 PE multiple had reached 30x and its share price had reached a level representing a 30% premium to REA’s online classified peers. A premium is certainly deserved given REA’s superior earnings growth profile, suggested Merrills, but at close to $30 the shares had reached fair value in the analysts’ view.

REA Group, formerly Realestate.com, has had a stellar run, outperforming the market by 73% over the past twelve months. The stock price has more than doubled in that time. REA has established itself in a relatively short space of time to be Australia’s dominant online real estate classified advertiser, and one of a group of three who have managed to divert the “rivers of gold” once enjoyed by the likes of Fairfax Media and rival newspaper publishers, which, like many old world businesses, failed to pay heed to the online revolution occurring right in front of their eyes. REA has piped off real estate, Carsales.com auto, and Seek employment.

REA’s share of total of all real estate classified advertising came from nowhere to reach 26% in FY12. Merrills noted in May the company’s domestic price structure encourages advertisers to shift up to higher value listings which is likely to see growth sustained even without substantial price increases. The broker community simply does not have a bad word to say about REA, its revenue and earnings momentum, and its market share growth. Broker ratings simply reflect the perceived capture of value, and with Merrills downgrading in May, Macquarie earlier in May, and Credit Suisse back in February, REA now shows a full set of seven Hold (or equivalent) ratings from seven covering brokers in the FNArena database.

One of those is UBS (Neutral), but in a report today the UBS analysts have announced an adjustment to their valuation model to accommodate a change in business model REA Group is looking to implement. This sees UBS’ target price on REA jump to $29.30 from $19.75, although this brings the target to in line with the current trading price, hence no rating upgrade. Importantly, nevertheless, UBS has upgraded its earnings forecast substantially on the back of the new business model, which sees the analysts’ numbers rise to 7% above consensus for FY14 and 16% for FY15.

REA’s new plan is to lower real estate agent subscription fees as a sacrifice to drive a price per listing model with greater depth penetration across the residential and commercial segments, UBS explains. The analysts also expect REA will look to cross-sell real estate leads to “adjacent verticals”, such as telcos, pay-tv, banks, insurance companies and utilities. If the change is successful, UBS expects REA’s revenues and earnings will accelerate over the next three years.

Which is no small feat. UBS suggests REA’s lofty PE can be supported by a compound average growth rate in earnings per share of 21% per annum in FY14-17. The analysts’ rebuilt valuation model focuses on the company’s potential to leverage its dominant position, increasing its online real estate market share from 26% in FY12 to 65% in FY22. In that period, UBS expects online advertising as a share of all real estate advertising to grow from 40% to 90%. The 21% earnings growth rate will be supported by a 15% growth rate in revenues and an increase in margins from 53% now to 62% in FY17.

The result is forecast earnings increases of 7%, 18% and 27% from UBS for the period FY13-15, which feed the rise in target price. Notwithstanding such forecasts, the analysts note that further upside exists if REA can execute in Italy on its leads-based model.

The company is also sitting on $210m in cash, leaving room for M&A, which might be interesting when one considers that while REA controls 26% of the online real estate market at this point in time, that only represents around 3% of all online classified advertising spend.

 

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