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One of my preferred strategies over many years has been buying online marketplace stocks – REA Group, Seek and Carsales.com – during bouts of price weakness. Each is an exceptional company and well off their 52-week highs.
Online property classified star REA Group is 20% off its 2018 peak. Jobs platform Seek is down 24%; and Carsales.com is off 26.
These are unusual falls for these stocks. Previously, investors snapped up the leading online marketplace stocks during short-lived corrections. Not this time. The stocks have fallen since mid-2018 and modest rallies this year, to varying degrees, have lacked conviction.
I confess it’s harder this time to buy these stocks. The auto industry is stalling as consumers, struggling with stagnant wages growth and high household debt, defer buying new cars. The slowing housing market is a headwind for listing volumes of property ads.
Pressured consumers will probably have fewer or shorter holidays this year and next, hurting travel agents that are already under immense pressure from giant international bookings sites. Jobs growth, at least, remains strong, but Seek is not the market darling it once was.
The sell off in global technology stocks and pullback in Australian equities in the fourth quarter of 2018 hurt sentiment towards the online marketplace stocks. They were easy stocks to take profits on, given the magnitude of gains in previous years, and buy back into at lower prices.
So has the market got it wrong with these stocks? Yes and no. REA Group and Carsales.com look undervalued at current prices as the market obsesses about falling property and car sales.
Five points support REA and Carsales.com. First, it’s too simplistic to extrapolate slowing property and car markets directly to their earnings and valuations. A manageable downturn in property is not all bad for REA because it forces vendors to advertise for longer.
A weakening car market is bad for Carsales.com, except that it encourages auto dealers to work harder for leads and car stock to be advertised for longer. Also, more people might sell their car through Carsales.com rather than as a trade-in at a dealership, to get a better price.
Second, the market underestimates the value of REA and Carsales.com’s network effect, which is the source of their competitive sustainable advantage and pricing power. Facebook, Gumtree and other sites have challenged Carsales.com, yet it remains the dominant platform. More site users attracts more car dealers, which attracts more car advertisements and thus users.
This network effect builds significant pricing power: REA, for example can and has lifted prices when conditions weakened in previous downturns. Vendors and real estate agents might grumble about it, but what choice do they have when so many home buyers use its realestate.com.au site?
Third, the migration from print to online classified advertising still has years to run. Advertising volumes overall might be down in property and auto categories, but REA and Carsales.com can continue to grow by taking market share from traditional media and smaller rivals.
Fourth, REA and, to a lesser extent, Carsales.com have traits of exceptional companies: a dominant product, higher barriers to entry, fat profit margins and low fixed costs. The result: excellent cash flow and Return on Equity (ROE). International expansion opportunities are another attraction, although not significantly priced into current valuations.
The fifth factor is valuation. At $75.97, REA trades on a forecast Price Earnings (PE) multiple of about 25 times FY20 earnings, using consensus analyst estimates. REA has traded on an average annual PE of about 30 over the past five years given its growth prospects.
Carsales.com is on a forecast PE of 19 times FY20, according to consensus forecasts. It has averaged around 25 over the past five years. Like REA, Carsales.com is trading at a sharply lower PE by its standards as the market prices in a period of slower growth and lower ROE.
Both stocks are worthy of portfolio inclusion at the current price, provided long-term investors can tolerate challenging trading conditions in the next 18 months. If market expectations for an interest-rate cut late this year are correct, property and car sales might get some much-needed relief in the second half of 2020.
Of the two, I favour REA. It delivered 19% growth in underlying earnings (EBITDA) for the first half of FY19, yet again defying the property downturn and slightly beating market forecasts. But the stock fell 5% of the result, possibly because of management’s subdued guidance.
REA has many challenges. An acceleration in the housing downturn has led to several economists revising their forecasts for larger peak-to-trough price falls in Sydney and Melbourne. And the Reserve Bank has signalled a higher possibility of a rate cut.
REA said listing volumes in January were weak but cautioned against extrapolating trends from what is a seasonally weak month to the rest of FY19. However, listing volumes in Sydney in the first half of FY19 were down 10%, so the property slowdown is hurting.
The upcoming Federal election is another party stopper. The election, expected in May, could be brought forward after the Government this week suffered its first defeat on legislation for 80 years, as the refugee Bill passed. The Coalition will surely be tempted to have the election earlier and pitch it on border control.
Either way, fewer people will sell their home during a Federal election campaign, in an already weak property market. Add to that Easter, Anzac Day and school holidays just before the election and the weak listing volumes in January could extend further into FY19.
A re-energised Domain Holdings Australia, now part of Nine Entertainment Co. Holdings after its Fairfax Media takeover, is another threat. The Nine tie-up gives Domain huge cross-promotion opportunities in free-to-air television and print newspapers, and greater scope to address a weakness in its property platform: lower reach outside Sydney and Melbourne.
The fallout from the Financial Services Royal Commission compounds the challenges for REA and other property-related companies. Tighter lending conditions threaten a credit crunch of sorts and uncertainty over the mortgage-broking industry and commissions could hurt demand for bank credit for home purchases and thus property advertising volumes.
These are significant threats. But the market seems too focused on “macro” issues confronting REA and not enough on the “micro”, at the current valuation. REA grew interim revenue by 15% in the latest result, despite a 3% decline in national listing volumes. That suggests a business that has many levers to maintain earnings growth when market conditions turn against it.
They include longer listing times for properties to sell; re-listing fees as properties that fail to sell change agents and are advertised again; new products around home lending and other initiatives; and price rises, albeit slower than in recent years as the property market slows.
How many other property-related companies grow revenue by double-digits in the middle of a sharp downturn? And if REA can deliver such growth in a tough market, what will it do when housing starts to recover slowly in a year or two?
Longer term, I suspect the market underestimates the value of REA’s “content”. What started as a property classified site has morphed into something more; a place where some property voyeurs I know spend hours each week daydreaming about trophy homes. That means extra eyeballs looking at property ads for longer and opportunity for add-on services.
An average share-price target of $88.65, based on the consensus of 10 broking firms, suggests REA is undervalued at the current price. Macquarie’s 12-month target is $90.
I’m not quite as bullish. My hunch is that REA will trade sideways or lower in the first half of calendar-year 2019 as property slowdown and election concern intensify, and as investors seek confirmation that REA’s listing volumes are holding up.
That will be the time to buy REA. By the second half of 2019, the market will look to a rate cut and expect the worst is over in the property correction. REA will look a lot more interesting as its aforementioned headwinds abate, but if you wait until they clear, it will be too late.
If I’m wrong, REA has consistently shown it can grow in good and bad markets. That’s why investors have paid huge PE multiples for it in the past and have it wrong now. A contraction of 13 PE points (from 36 in FY18 to a forecast 25 in FY20) looks overdone.