A bumper year for ASX darling but shares significantly overvalued
The wide-moat share is trading at a 67% premium to our fair value.
Mentioned: REA Group Ltd (REA)
We raise our fair value estimate for wide-moat REA Group (ASX: REA) by 3% to $121 per share following the release of fiscal 2024 results. The company had a strong year, as expected, due to a bumper year in its Australian residential segment and decreasing losses in its India segment. At current prices, REA Group shares continue to screen as materially overvalued.
We see two impediments to the company’s current market valuation.
First, we don’t believe the company will be able to continue raising prices as much as the market seems to expect. Historically, REA Group has grown by raising prices for residential buy listings by double digits every year. This includes both direct price hikes, and indirect price hikes through the introduction of new, more premium pricing tiers, which redirect eyeballs from existing tiers into these new tiers, thereby forcing property sellers to upgrade for these new tiers. In fiscal 2024, residential buy yields even grew 19%, or 16%, when accounting for a positive geographical mix, as REA raised prices on existing tiers and pushed sellers into the more expensive Premier+ tier.
We caution against projecting this into the future. Our hesitation does not come from the belief that the company lacks the pricing power to do so. We would expect REA Group and its narrow-moat, smaller peer Domain to be able to continue raising prices in unison and property sellers continuing to list on both, reluctantly. However, raising prices at 4-5 times the rate of inflation is bound to eventually consume a larger share of the property transaction value, especially if prices were to come down.
Business strategy and outlook
We expect REA Group’s near-term challenges to center around navigating significant volatility in the Australian housing market. After the onset of the covid-19 pandemic, REA Group received a substantial boost to revenue and profit margins from the booming housing market. We estimate that residential transactions were around a third above trend levels during fiscal 2021 and 2022. With the normalization of interest rates, we expect continuing swings in listings but an eventual return to trend, which started in fiscal 2023.
In the long term, we expect a gradual decline in listings due to friction in the housing market caused by ongoing increases in transaction costs in the form of stamp duty. Total dwelling transactions in the Australian housing market declined for nearly two decades until the onset of the pandemic, despite the number of dwellings increasing around 1.7% per year over the period. We attribute this falling liquidity principally to rising stamp duty, which has increased around five-fold in the past two decades. We do not forecast a significant reduction in stamp duties, despite some State governments undertaking initiatives to replace the upfront stamp duty with an ongoing land tax. We do not believe any Australian state is in a sufficiently financially healthy position to be able to afford this transition, as evidenced by their deteriorating credit ratings and as evidenced by recent state governments' decisions to raise property taxes and remove previously introduced land taxes. We therefore forecast a continuing decline in housing stock liquidity.
We expect REA Group’s growth to be primarily driven by growth in yield, or listing fees, within its residential division, rather than from market share gains. REA Group’s market share versus Domain has remained largely unchanged in recent years and we consider the competitive environment to be stable. Instead, we expect REA Group and Domain to focus on increasing revenue per listing through price increases and through increased depth penetration.
Moat rating
We believe REA Group has a wide moat based on network effects and cost advantages in its online listings platform for Australian residential real estate. We expect REA Group’s competitive advantages to be durable for at least the next two decades.
Online listings platforms derive their network effects from a virtuous cycle of additional demand on the network attracting additional supply and vice versa, at little incremental expense to the platform operator. In the case of real estate listings platforms, the value of the network increases for prospective listers commensurate with the size of the audience, while for the audience the value of the network increases commensurate with the size of the pool of listings.
REA Group has managed to establish network effects in its Australian residential real estate listings platform through a first-mover advantage. Network effects can be incredibly costly to establish in listings platforms as they require a critical scale on both the supply and demand side of the network. Only after a certain audience size and listings pool size has been achieved does one side of the network start attracting the other and vice versa. REA Group, with the backing of majority-owner News Corp has achieved this scale by creating and popularizing the first online listings platform for real estate in Australia, thereby becoming the primary beneficiary from the secular shift of print advertising toward online.
REA Group today operates the largest residential real estate listings platform in Australia. REA Group’s core website, www.realestate.com.au has a comparable number of listings as competitor www.domain.com.au and their respective mobile apps also have a comparable number of downloads. However, due to the fact that REA Group has had a first-mover advantage in the space, www.realestate.com.au attracts around three times as much traffic as www.domain.com.au and charges around three times as much in revenue per listing.
Domain and REA Group essentially operate a pay-per-view model whereby eyeballs to the platform are monetized. They therefore have two main ways of increasing revenue from listings, namely increasing the volume of traffic to their websites and directing this traffic to the highest paying listings. We do not consider the latter to be truly value creative as it merely distributes existing value within the network to where it can be best monetized. We consider the true value of each network to be its total audience size.
We see REA Group and Domain as structurally advantaged in maintaining their audience sizes due to their cost advantages, which we consider a secondary moat source. REA Group and Domain essentially have two ways of increasing their audience size, namely through marketing and through product improvements. In marketing both REA Group and Domain are structurally advantaged versus aspiring market entrants as their respective corporate parents Nine and News Corp provide them with access to their media assets, which include some of Australia’s most popular newspapers, websites, and television channels. We believe this is a symbiotic relationship which significantly reduces REA Group’s and Domain’s audience acquisition costs. We also believe that these relationships offer traces of an intangible asset, a potential third moat source, although we do not award this as such. REA Group and Domain also compete through product improvements aimed at attracting and retaining their audiences. We believe REA Group and Domain have cost advantages versus aspiring market entrants because they can spread out fixed development costs for a particular feature over an established and sizable business. Similarly, we believe REA Group has an advantage over Domain in this space because it can spread out these costs over a significantly larger business.
We do not consider REA Group’s other businesses, which includes adjacent markets and services, as well as investments in Asian online listings platforms, to have an economic moat. However, these businesses are not material enough to detract from REA Group’s overall moat rating.
REA bulls say
- REA Group, together with Domain, effectively operates a duopoly in residential real estate listings in Australia and REA Group is the dominant platform out of the two.
- REA Group has demonstrated its ability to defend its competitive lead over Domain where it matters most, in audience size, revenue, and margins.
- REA Group’s deep relationship with corporate parent News Corp provides it with access to some of Australia’s most popular newspapers, websites, and television channels.
REA bears say
- REA Group’s earnings are affected by the housing market, which is highly cyclical.
- REA Group has incurred large losses from its international divisions, and many have been disbanded. REA Group’s India division is currently still highly unprofitable.
- REA Group is attracting increasing regulatory scrutiny.
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Terms used in this article
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Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.
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