How safe is your money in REA Group Limited in 2018?

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REA Group Limited (ASX: REA) was the blue chip darling of many investors’ portfolios in 2017.

And it’s pretty easy to see why.

Looking at a chart of its share price over the last 12 months should provide shareholders with an almost parental sense of pride and satisfaction: a steady climb without too many bumps along the way, plus a dividend yield of 1.19%.

If we had to raise any minor quibbles maybe it’s that the yield is a little on the low side, but that tends to happen when the share price has made strong gains of around 37% for the year. 

REA Group is a pure play online company. In Australia, it operates the leading property websites realestate.com.au, realcommercial.com.au and flatmates.com.au.

However, it is also a geographically diversified business and operates (or has significant interests in) similar digital advertising platforms in locations across Asia and the US. 

REA’s global footprint sets it apart from rival Domain Holdings Australia Ltd (ASX: DHG). Domain is a pretty new addition to the ASX, having been spun off from Fairfax Media Limited (ASX: FXJ) in November. So far Domain has failed to spark much interest from the market, slipping downwards about 8% from its listing price of $3.80 to be now valued at a little under $3.50. 

The tepid response to Domain’s listing might be due to recent indications of contracting national housing prices.  According to property data group Corelogic, the national median house price index fell 0.3% in December.

The index was dragged down by Sydney property prices in particular, which were 0.9% lower for the month.  Melbourne property prices were also down by 0.2% for the month, the first such instance of a monthly decline since February 2016. 

Annual property prices are still up across the main markets, but these short-term declines could foretell a softer property market in 2018. And a lack of activity in the property market hurts both Domain and REA Group. 

And while REA Group’s international presence offers it more growth opportunities (particularly in the emerging Indian market), it also opens it up to increased risk.

In its FY17 results, REA Group recognised a $182 million impairment to goodwill for its Asian business segment – a segment that only generated revenues of $38 million for the year.

REA Group blamed the write-off on cyclical declines in many key Asian markets like Malaysia and Hong Kong.  This disclosure didn’t do much to dampen REA Group’s share price at the time, but if there are continued failures in its international operations it could end up being a pretty expensive embarrassment. 

The real driver for REA Group’s gains was the success of its Australian operations, where revenues grew by 14% for the year to $634 million.

And in terms of market penetration, REA Group continues to dominate even its closest competitors: realestate.com.au received 2.5 times more average monthly visitors than domain.com.au for FY17. And the 1Q18 results released in November were also promising, with total group revenues up 21% versus 1Q17, and outstripping growth in operating expenses.   

This result included first quarter revenues generated through realestate.com.au’s new online home loans products, which it offers in partnership with National Australia Bank Ltd (ASX: NAB).

REA Group believes this new financial services business will deliver an extra $26 million – $30 million of revenues for the year. Broker services are a natural extension of its current business model and could provide a useful source of income to offset declines in online listings brought about by a softer property market. 

The key question investors have to consider for 2018 is whether REA Group’s growth prospects support its current valuation. Its price-to-earnings ratio is 49, which is high even compared to other pure play online companies like Carsales.Com Ltd (ASX: CAR) which trades at a P/E of 32. 

Macquarie Group Ltd (ASX: MQG) analysts decided that REA Group was due for a pullback and downgraded its guidance on the stock at the beginning of December – even before Corelogic released its median property price report. Since then the share price has dropped about 5%. 

These are all signals that even after its stellar run in 2017 REA Group may still be mortal after all. 

Foolish takeaway

I’m not willing to give up my shares in REA Group just yet, even if I do view them as verging on being overvalued at current prices.

Despite indications that the Australian property market will soften in 2018, REA Group’s dominance over its local competitors should still see it deliver strong financial results, particularly with the extra revenues brought in through its new financial services segment. I still rate it as a better investment than Domain if you’re after some indirect exposure to the property market for your portfolio. 

Plus there’s even a slim chance it could surprise analysts with some good news out of its US and Asian businesses. 

But investors should recognise that some of the sheen has come off REA Group, and the blue chip growth story for 2018 will probably have to come from somewhere else. 

 

 

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