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Does domain deserve a home in your portfolio?

The online property-services group has potential for larger industry disruption, according to Tony Featherstone.

 

The separation of Domain from Fairfax Media will add to Corporate Australia’s mostly good record on demergers. The online property-services group has more upside than nearest rival REA Group and higher risk. There’s a case to include Domain and REA in portfolios.

Switzer Super Report readers know of my interest in demergers done for the right reasons. I wrote about the merits of “spin-offs” for this report in February 2016, nominating Sydney Airport, DuluxGroup and Asia Pacific Data Group as three to own.

To recap, I noted demergers are usually a better bet than Initial Public Offerings (IPOs). More is known about the demerged entity compared to an IPO, where the vendor has a significant information advantage over buyers.

Also, full or partial demergers have better alignment of incentives between the parent company and new shareholders. With Domain Australia Holdings, Fairfax has strong incentive for the spin-off to perform: it will own 60 % of Domain upon listing and Fairfax shareholders receive a Domain share for every 10 Fairfax shares held. Compare that with IPOs where private equity firms try to make a quick dollar from a quick exit.

Moreover, the best demergers have a habit of finding new energy as standalone companies. Management is freed from the constraints of the parent company, the new organisation is no longer competing for capital internally or weighed down by underperforming divisions.

Some demergers are done for the wrong reasons, usually because the parent’s management sees them as a fast way to unlock value. These demergers destroy value because there was a clear reason to keep them within the parent company.

Domain’s demerger from Fairfax ticks the right boxes on strategic rationale – one of the first things I consider when assessing demergers. Domain’s valuation was weighed down by the market’s view on Fairfax’s legacy newspaper assets. Domain is worth more on its own.

Moreover, a technology-based property-services group is an uneasy fit with Fairfax.

Although Domain operates in one of Fairfax’s great advertising portals – property – the online business has a different culture to a newspaper. Could you imagine Seek doing as well within Fairfax?

Mostly, Domain needs agility to disrupt the property-services industry. Do not think of Domain as only an online property-advertising portal: the end game is providing a range of services through the property lifecycle, and capturing data and using it to predict behaviour. Domain is better able to experiment, take risks and do deals as a standalone business.

The best argument for Domain’s demerger is REA Group. The owner of realestate.com.au has been a cracking performer: the annualised 10-year total return is 27%. REA Group gives the market a clear valuation benchmark for Domain and a reason to buy it. Investors will hope Domain, earlier in its lifecycle than REA, also delivers tenfold returns.

The separation of Domain from Fairfax Media will add to Corporate Australia’s mostly good record on demergers. The online property-services group has more upside than nearest rival REA Group and higher risk. There’s a case to include Domain and REA in portfolios.

Switzer Super Report readers know of my interest in demergers done for the right reasons. I wrote about the merits of “spin-offs” for this report in February 2016, nominating Sydney Airport, DuluxGroup and Asia Pacific Data Group as three to own.

To recap, I noted demergers are usually a better bet than Initial Public Offerings (IPOs). More is known about the demerged entity compared to an IPO, where the vendor has a significant information advantage over buyers.

Also, full or partial demergers have better alignment of incentives between the parent company and new shareholders. With Domain Australia Holdings, Fairfax has strong incentive for the spin-off to perform: it will own 60 % of Domain upon listing and Fairfax shareholders receive a Domain share for every 10 Fairfax shares held. Compare that with IPOs where private equity firms try to make a quick dollar from a quick exit.

Moreover, the best demergers have a habit of finding new energy as standalone companies. Management is freed from the constraints of the parent company, the new organisation is no longer competing for capital internally or weighed down by underperforming divisions.

Some demergers are done for the wrong reasons, usually because the parent’s management sees them as a fast way to unlock value. These demergers destroy value because there was a clear reason to keep them within the parent company.

Domain’s demerger from Fairfax ticks the right boxes on strategic rationale – one of the first things I consider when assessing demergers. Domain’s valuation was weighed down by the market’s view on Fairfax’s legacy newspaper assets. Domain is worth more on its own.

Moreover, a technology-based property-services group is an uneasy fit with Fairfax.

Although Domain operates in one of Fairfax’s great advertising portals – property – the online business has a different culture to a newspaper. Could you imagine Seek doing as well within Fairfax?

Mostly, Domain needs agility to disrupt the property-services industry. Do not think of Domain as only an online property-advertising portal: the end game is providing a range of services through the property lifecycle, and capturing data and using it to predict behaviour. Domain is better able to experiment, take risks and do deals as a standalone business.

The best argument for Domain’s demerger is REA Group. The owner of realestate.com.au has been a cracking performer: the annualised 10-year total return is 27%. REA Group gives the market a clear valuation benchmark for Domain and a reason to buy it. Investors will hope Domain, earlier in its lifecycle than REA, also delivers tenfold returns.

Chart 1: REA Group

Source: nabtrade (as at October 2017)

Domain’s structure makes sense. The market is familiar with online property-platform demergers thanks to News Corp’s spin-off of REA Group. News Corp remains a 61% shareholder in REA, so the market is familiar with media groups as majority shareholders.

Fairfax’s majority ownership of Domain means it is incentivised to continue extensive cross-promotion in its newspaper and radio assets. I hate my Sunday paper being wrapped in a four-page ad for Domain, but the brand awareness is vital and a reason why Domain has substantially lifted its profile against Realestate.com.au in recent years.

Fairfax has been involved in successful demergers: New Zealand auction platform TradeMe   Group was demerged from Fairfax over 2011-12. (Fairfax has since sold its full stake). Trade Me’s five-year annualised total return (including dividends) is 7%. The return would be higher if not for Trade Me’s tumble from its 52-week high this year.

On balance, the reasons for the Domain demerger – and the structure of the deal – is sound. But that does not make Domain an automatic buy. There’s the trickier question of whether portfolios should hold Domain or REA Group, both or neither.

Domain has higher earnings growth potential…

In some ways, REA Group has a simpler business model than Domain. REA’s strategy is to do more of the same: attract extra property advertising on its platform and charge a higher rate over time as it flexes its pricing power (the result of the company’s huge competitive advantage). And sell more products, such as home loans, to a larger customer base.

REA’s offshore exposure is a point of difference to Domain. REA, principally through its acquisition of iProperty Group in 2016, has a valuable foothold in emerging Asian markets. A strategic investment in realtor.com in North America is another strength. But offshore operations accounted for less than 5% of REA’s revenue in FY17.

REA’s strategy makes sense: why change a business model that works so well? That said, the model may not generate the same type of earnings growth over the next decade that investors are used to if REA’s emerging-markets operations do not kick in with faster earnings growth.

Domain’s strategy seems more complex. In September, Domain announced it would sell home, car and landlord insurance to its website and apps users. It was a good example of how Domain is offering a broader range of services across the property lifecycle. Initiatives in utilities connections, home improvements and trade service also highlight Domain’s strategy to take a cut of more products and services across the home-ownership lifecycle.

Domain estimates the opportunity in home loans and insurance is worth $2 billion a year in each market (profits would be a fraction of that). Still, these are big markets for Domain to disrupt and significant growth drivers, if the strategy works.

A diagram on page 28 of Domain’s Separation Scheme Booklet is instructive. The company has charted the path home owners follow as they go from searching for listings to buying a property, and services needed along the way. Domain looks further advanced on its “property ecosystem” strategy than REA and its ability to use data analytics to predict how consumers will behave, and feed that data to property agents. The market might be underestimating how much Domain’s strategy differs from REA’s.

There is potential for faster disruption in property services, from Domain and REA. Online advertising, entrenched in this market for almost two decades, is only part of the story. The potential is giant online platforms offering a range of property-related products and services and nibbling at the market share of banks and insurers.

Domain has plenty of “radical adjacencies” to consider: it could partly become a fintech company as more financial products and services are brought online through its platform or on mobile devices. Or a data company providing insights on property-buyer behaviour: a combined audience of 7.6 million users is a valuable database to exploit.

In time, Domain might even compete with property agents rather than complement them through its advertising services and property leads, as more “middle men” in real estate are disintermediated and more properties are bought and sold online.

… And higher risk than REA

This strategy, although attractive, has higher risk. Selling home loans and insurance products seems like a no-brainer, until Domain takes its eye off the main game and its users become annoyed with excessive cross-promotion and a lack of independence. Or when much larger rivals, such as Australia’s big-four banks, become incensed at Domain’s disruption.

Further, Domain’s geographic exposure is more concentrated than REA’s. The latter has a broader national footprint and is comparatively less exposed to key markets, such as Sydney’s Eastern suburbs. A sharper property downturn in Sydney, not my base case, would affect listing volumes and might reduce Domain’s pricing power with agents.

Domain’s agent ownership model is another complication. The model attracted strong support from more than 1,600 agents who shared in value creation from Domain and its earnings. The structure has been effective, but messy. The main concern is whether Domain will have the same level of industry support in the next few years as a standalone entity.

Then there’s criticism that Fairfax is selling part of Domain at the top of the property cycle. The disastrous McGrath Holding Company float, a sign that the housing market was becoming overheated, shows the risks of investing in property-services companies at the top of the cycle. Domain’s revenue growth reported in the Separation Scheme Booklet was a touch less than the market expected and perhaps a sign of slowing market conditions.

But an orderly housing slowdown, which I expect, might help rather than hinder Domain and REA if listings volumes remain okay and it takes longer to sell properties. A sizzling property market can be a problem for Domain and REA if less advertising is required to sell houses.

Domain’s lack of history as a listed entity is the final risk. That is true of all demergers, but Domain is emerging from a challenged parent: Fairfax Media. Domain is also more reliant on its parent (through advertising cross-promotion) than most demergers.

Chart 2: Fairfax Media

Source: nabtrade (as at October 2017)

On balance, Domain stacks up

As always, valuation is the key issue. Brokers used a median valuation multiple of 18.2 times its FY17 earnings when valuing Domain as part of Fairfax, at the announcement of the proposed separation, according to the independent experts’ report in the Scheme booklet.

REA Group at the time traded on a forward EBITDA multiple of 18.9 times, so the market is so far valuing Domain at only a slight discount to REA. Key offshore property platforms comparable to Domain trade on EBITDA multiples of between 20 and 30 times. Some top broking firms value Domain shares around $3.50.

One should not read too much into simplistic valuation comparisons. But Domain’s implied valuation (while part of Fairfax) does not look excessive on national or international comparisons with its closest listed peers.

I suspect the market will value Domain (based on the forward earnings multiple) just below REA (as it has so far). But Domain should grow earnings faster than REA, partly because growth is off a lower base. The combination of a similar valuation multiple and faster earnings growth could see Domain outperform REA.

That’s the theory. The reality is REA might become cheaper if fund managers take some profits to buy Domain shares when they list.

My hunch is Domain might be a little quiet for the few first months, once the usual price machinations play out as the shares hit the boards and the market price is discovered.

Domain is due to list on November 16, so it’s hard to see much news flow over the Christmas/ New Year period. The best demergers have a habit of underperforming their parent company for the first six months as a standalone entity, before outperforming after that. That might be true of Domain as the market looks for signs that slower revenue growth is temporary.

Inevitably, commentators and analysts will focus on owning Domain or REA. There’s a case to own both. Leading online platforms, such as REA, Seek and Carsales.com, are fabulous businesses with years of growth ahead. They have lower capital-expenditure requirements, good margins, massive customer bases and significant barriers to entry.

To my thinking, the market is underestimating the potential of Domain and REA to disrupt a range of property-related services, beyond advertising. The property and financial-services industries, still with too many middle-men and layers of fees, are ripe for disruption.

The well-run, entrepreneurial Domain will be worth a lot more if it extends its reach across more property services. Still, I wouldn’t bet the farm on Domain or rush to buy it on listing. The stock might offer better value three to six months after listing if it follows the pattern of other quality demergers.

A final thought: keep an eye on Fairfax after Domain’s listing. Some brokers estimate Fairfax shares will be worth 74 cents post separation. The market has many concerns about Fairfax sans Domains, and some who bought Fairfax shares, to get a slice of Domain, might be eager sellers. That could create a value opportunity in Fairfax, which has plenty of life left in it   – and a 60% stake in Domain that will become more valuable.


About the Author
Tony Featherstone , Switzer Group

Tony is a former managing editor of BRW, Shares, Personal Investor, Asset and CFO magazines and currently an author at Switzer Report. He specialises in small listed companies, IPOs, entrepreneurship and innovation and writes a weekly blog for The Sydney Morning Herald/The Age on small companies and entrepreneurs.