REA Group earnings expectations unjustified

Earnings expectations for REA Group are too aggressive and out of sync with economic growth forecasts, according to a Morningstar report, which suggests the owner of Australia's No 1 property listings website is significantly overvalued.

REA Group (ASX: REA) is overvalued by more than 90 per cent says Morningstar analyst Gareth James in a report that suggests interest rates appear to be the chief cause of the expansion in its price-to-earnings ratio.

"Our analysis indicates REA Group's PE ratio expansion has primarily been driven by falling interest rates rather than an improvement in the company's earnings growth outlook," says James in a new report entitled REA Group Share Price Growth Is Built On Sand.

"Although interest rate falls justify a higher valuation for REA Group, we think the market is overestimating the benefit. We also think investors should be mindful that interest rate falls are an unsustainable source of share price returns."

James concedes an economic recovery and potentially higher inflation could put upward pressure on rates and consequently reverse REA's PE ratio of about 60, as at the 18 December report, and share price gains. 

But he argues that even if rates stay put, the market is ignoring the likely read through for inflation, real economic growth and the company's earnings growth. 

“REA Group's PE ratio of around 60 implies investors are assuming the company will generate an equivalent EPS CAGR of around 6 per cent for the next 60 years,” James says. 

“This seems at odds with the sub-1 per cent nominal GDP growth implied by the 10-year government bond yield.”

The PE ratio indicates if the market is overvaluing a stock based on how many people are willing to buy it and its value over time. 

In general, the lower the number the better because it suggests the company may be undervalued.

REA Group (REA), Domain Holdings (DHG) – 10k growth, 10YR

Source: Morningstar Premium; as at 7 January 2021

Not that the narrow-moat company hasn’t done well. Far from it. Over the past decade, James notes, it has generated a compound annual total return of 30 per cent excluding franking credits, versus 8 per cent for the S&P ASX/200 total return index. 

REA Group opened Thursday trading at $149, which is a 89 per cent premium to James's fair value estimate of $80. 

REA’s main rival Domain Holdings Australia (ASX: DHG), which also has a narrow moat rating, or ten-year competitive advantage, is only marginally better value. It is trading at $4.55 which is a 42 per cent premium to James's fair value estimate of $3.20. Its PE was about 60 at the time of the James report.

First-mover advantage

With a market cap of $2 billion, REA Group offers online advertising, website development services, and software licensing of estate agent back-office solutions and print publications to residential and commercial agents, franchise groups, developers, consumers, and non-real estate industry advertisers. It operates real estate and commercial property advertising sites in Australia, Asia, and North America.

REA's first-mover advantage means it is the premier site to find real estate online in Australia, although Domain is making gains in the rapidly growing mobile segment, James notes. 

However, weak property prices and a decline in economic conditions typically affect the volume of real estate sales, which could in turn affect REA. 

Although housing markets are gathering pace, four of the eight capitals are still recording dwelling values lower relative to their previous peaks, according to property data firm CoreLogic.

Melbourne home values are still 4.1 per cent below their March 2020 peak and Sydney dwelling values need to recover a further 3.9 per cent before surpassing the previous July 2017 peak. Perth and Darwin values remain 19.9 per cent and 25.7 per cent below their 2014 peaks.

According to James’s calculations, REA Group's earnings per share must grow at a CAGR of 16 per cent over the next decade to catch up with the market and compensate investors for the period during which REA's earnings are less than the market. 

“Considering REA Group's declining EPS growth rate in recent years and seemingly weak outlook for its international 'growth' investments, we think this implied EPS growth rate is overly optimistic, and we think this analysis supports our view the stock is materially overvalued.”

In terms of trailing returns, over the past 10 years REA has returned just under 30 per cent versus 7.19 per cent for the Morningstar Australia GR Index. In 2020, REA Group paid a fully franked dividend of $1.10. 

According to James, earnings growth fails to justify the growth in the share price. James has reduced his longer-term earnings forecasts for the company in recent years. 

He forecasts a 16 per cent underlying earnings per share compound annual growth rate over the next five years, which includes a rebound from the covid downturn. 

James says he is surprised by the fact that REA's PE ratio has expanded by so much considering earnings growth expectations appear to have fallen from four years ago. 

The key source of the company's revenue is the Australian residential real estate market. However, as James notes, housing turnover has fallen in recent decades. 

"Despite steady population growth, the number of houses being sold each year has gradually fallen, as has the number of real estate listings, and the number of new real estate listings."

James suspects that a large proportion of this change is structural and related to the increase in house prices and accompanying increases in stamp duty, and hence absolute transaction costs. 

As a result James says the fall in listings means the company's revenue and earnings growth has been driven by the increase in its revenue per listing; in other words, its prices. 

"REA has been able to achieve this due to its network effect based economic moat and associated pricing power. Our forecasts assume further price growth and a steady improvement in sales volumes. 

“We don't believe an improvement in the outlook for Australian listings is the reason for REA Group's PE ratio expansion in recent years, considering the deterioration in the market we've observed."

Nor does James attribute the PE expansion to an improvement in REA group's international businesses. Asian digital real estate marketing business, iProperty Group, which REA acquired in 2015, has failed to live up to expectations. And it's a similar story for Elara Technologies, which owns three real estate websites in India. 

"Like the Asian business, Elara is an immaterial component of REA Group, a situation we don't expect to change in the foreseeable future," James says. 

Add to that, REA's $200 million investment in US real estate business Move, which is 80 per cent owned by News Corp, also appears lacklustre. 

 See also Morningstar Guide to International Investing