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REA – Housing Houdini

Chicken Little is scuttling about proclaiming the Australian housing market party is finally over and the roof is about to cave in. To the contrary, REA Group, whose business seemingly depends entirely on the health of the residential property market, is thriving.

National listings data show weakness across all the major markets which could be exacerbated by the approaching State and Federal elections. Victoria and NSW are due to go to the polls within six months and the Federal election won’t be far behind. These types of events typically subdue activity in housing markets as people tend to sit and wait for the outcome simply for the uncertainty it creates.  

The Royal Commission into financial services and the prospect of some big policy changes under a Labor government (negative gearing, capital gains, bank levy) are putting more pressure on homeowners and the decision on whether to sell or not.

The Reserve Bank is unlikely to lift official interest rates any time soon, but rising wholesale rates have squeezed some banks into nudging up their mortgage rates.

Property owners are understandably like possums in the headlights.

Amidst all the doom and gloom then, how did REA Group report 22% operating earnings growth in FY18, extending its unbroken growth over the last 10 years to 26% per annum on revenue growth of 20% pa?

The simple answer is the increasing number of premium listings and sustainable price increases. While volumes may be under temporary pressure, the revenue equation has been driven by higher value advertising. 

There is ample scope for this to continue as the sophistication of the product offering expands and the on-going competition with Domain Group lifts the innovation and intensity of the sector.

The Australian business will remain the dominant feature of REA’s results for some time yet, but it has fledgling businesses in Asia and the USA to provide longer term growth. Each of these requires plenty of time and persistence to achieve goals, but REA is unafraid to cut a business loose if this doesn’t happen. It sold its European business in 2016 essentially for this reason. 

As with other successful online businesses, REA demonstrates some quite amazing financial metrics that are unfamiliar to older investors. Operating profit margin sits comfortably above 60% creating large amounts of operating cash flow. Capital expenditure requirements are relatively miniscule leaving large dollops of capacity to either reinvest or acquire new businesses such as the Smartline mortgage broking acquisition this year. A dividend payout ratio above 50% still leaves the balance sheet with wads of cash and debt covenant numbers that would frustrate any lender for the sheer conservatism.

REA is bracing for a weaker listing environment in the current financial year, but this shouldn’t prevent the company from achieving more growth, albeit perhaps below its long term levels.

With an enterprise value close to $11.4 billion, REA Group is substantially larger than its closest challenger, Domain Group at $2.1 billion.

The Australian Bureau of Statistics noted Sydney house prices dropped 1.2% in the June quarter, but this was in the context of a 56% rise over the last five years. This view has been echoed by the Reserve Bank which remains watchful but not concerned by the shift. From a political perspective, falling house prices obviously helps first home buyers as affordability improves.

REA is not immune to a slowing housing market but has such a commanding position in property advertising that it is likely to withstand the current pressures.

Chicken Little might just have to find something else to crow about.

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