REA Group – A look at the compounding machine
REA Group owns the business realestate.com.au and anyone in Australia who has anything to do with property knows it is the dominant market player.
What is the current state of the business?
Is REA Group a Legacy moat or still in Reinvestment Moat mode?
We define Legacy Moat as one that has its competitive market in tact but it cannot deploy earnings back into the business at the high rates of return it has in the past. These businesses are like toll bridges collecting revenue, but it cannot use the revenue to build another toll bridge.
Alternatively a Reinvestment moat business can still reinvest its capital in its existing business and still achieve high rates of return on this incremental capital. These are the compounding machines we all love to own.
Management can recognise that they have a Legacy moat business and they typically respond in two ways. First they understand that reinvesting in the business is not gaining incremental returns and they should just collect the rent from the moat and then past this on via dividends or opportunistic buybacks.
Secondly, and probably the most common, management attempts to invest additional capital in businesses outside its existing moat. They try and become a private equity player.
Historically studies on acquisitions have shown they are not a good way of allocating capital as the benefits tend to flow to the shareholders of the acquired company.
So where is REA Group now?
Measuring what has driven REA share return over the last decade
Michael Mauboussin has done a lot of work on what drives shareholder return. I agree with him that changes in a business intrinsic value is derived from what return it achieves on its capital, how much capital it can invest at this level of return and how sustainable this return can endure.
I have a rough measure of working out how a business is changing its intrinsic value. Connor Leonard from IMC has written about these concepts before so if you have the chance read up on his articles.
Intrinsic Value Compounding Rate = ROIC x Reinvestment Rate
The formula above shows a company changes its underlying intrinsic value by the level of incremental capital it can reinvest into the business multiplied by the rate it achieves on this investment. Now by no means is this a full proof method as there are a lot of drivers of value. But it gives us a rough guide to how well a company is doing with the most important business decision, allocating capital.
This formula tells how a company is improving or destroying future cash-flow. Ultimately cash-flow is what drives the value of a business.
These are all well-known concepts; a company that can reinvest a large portion of its earnings at a high rate of return and sustain this over a number of years is a business that we all should own.
So how has REA performed in the past 10 years on allocating its capital?
If we look back at REA Group we can safely say that this has been a superb compounding machine.
So let’s take a quick snapshot of how it has performed since FY2006. FY2006 was the last year that REA had negative retained earnings.
In FY2006 Net Profit was $8.22m and closed the year with invested Capital of $63m*
*I use the asset side to calculate invested capital and I have included goodwill and intangibles. At the end of FY2006 the invested capital was basically goodwill valued at $63.9m. I also exclude excess cash in the calculation of invested capital.
Note also under the common formula of ROIC we use NOPAT = EBITDA * (1- Tax Rate). For simplicity I have swapped NOPAT with NPAT. For REA, NOPAT is close to NPAT as there is limited Depreciation (in fact since FY2006 to FY2016 depreciation has amounted to $40m and net Interest $28m)
By the end of FY2015 reported NPAT had climbed to $210m and invested capital increased to $491m
For the nine years between FY2007 and FY2015, REA Group cumulatively earned NPAT of $650m, of this, $232m was distributed in dividends. Therefore a total of around $420m was retained and reinvested in the business giving a reinvestment rate of 67% ($420m/$650m).
Over FY2007 and FY2015 this additional $420m in invested capital increased NPAT by around $201m or a return of incremental capital of 46%. Very impressive result and was all done inside the Australian business.
REA was able to compound its intrinsic value by 31.1% over this 9 year period (66.9% x 46%). When you compare this with the share price on the 30 June 2005 at $3.80 to the FY2015 closing price of $39.21, this equates to a CAGR of 33.9%. Pretty close to what the underlying intrinsic value compounding of 31.1%.What about REA’s ability to compound into the future?
The above work shows us its ability to compound capital in the past. We don’t get to invest in the past.
In FY2016 REA Group increased its capital base dramatically. It acquired the remaining stake in iProperty group as well as acquiring a 14.7% stake in PropTiger.
At the end of FY2016 the capital base had climbed to $1,127m, an increase of $635m from FY2015.
REA has increased its capital base by 2.2x, so what kind of return on capital can we hope from this for the next 10 years? This is the challenge, we do not know for sure but we can set up scenarios to help us track their journey.
The following table shows actual FY2016 results plus some broker estimates for FY2017-FY2019.
We can see cumulative NPAT for 2016-2019 is estimated to be $1,260m. I have assumed invested capital will stay constant to FY2019 which gives an increase of $635m in invested capital from the beginning of FY2016. This may change as we do not know what capital allocation decisions the board will be.
This gives a reinvestment rate of around 50.4% (below the rate of 66.95% from FY2007-2015). If REA were to maintain their rate of investing capital for the future as in the past then they would need to add $210m in invested capital by FY2019.
The return on incremental capital will be 19%, a lot lower than the 46% achieved between FY2007 and FY2015.
The intrinsic value compounding rate will be around 9.6% (50.4% x 19%). Remember between FY2007 and FY2015 REA was compounding its intrinsic value at 31.1% pa.
If we take REA’s FY2015 closing share price of $39.21 and compound it 9.6% till 2019 we have an estimate of intrinsic value of $56.58. Note that the starting price of $39.21 tells us nothing about whether this represented value at the time, however it gives us an anchor to work off.
What compounding rate is the price of $64 indicating?
At the end of May, REAs share price was $64.
Working backwards this is a value compounding rate of 13%. Or putting it another way REA would need to add $50m in NPAT between now and FY2019 so the cumulative earnings will be $1,310m.
The following table shows changes in share prices (2nd row) with changes in cumulative NPAT in $m. For example if NPAT came in $100m lower than the current forecast of $1,260, then you would expect the shares intrinsic value to be around $42 based on the starting point at 30 June 2015.
Alternatively if the cumulative NPAT surprised on the upside by $100m then the intrinsic value moves to $71.61.
It is important to remember that these are estimates of value. As we saw from 2007-2015 the actual CAGR of the share price was 33.9%, more than the estimate of 31.1% given by the intrinsic model.
The movements of PE ratio and expectations can alter the actual price move.
The key thing is to understand that the driver of underlying value of share price is the return achieved on invested capital and the amount of capital that can be invested.
There is no doubt that REA has diluted ROIC with its Asian acquisition as the ROIC chart below shows. These capital allocation decisions have already been made the key metric is can REA lift earnings from these investments.
It is also worth pointing out on a segment basis over 88% of revenue is derived from the Australia operations and a similar percentage when comparing EBITDA. So REA would be posting extraordinary ROIC in excess of 100% on the Australian business if we exclude the iProperty and PropTiger purchases made in 2016.
It is worth remembering the natural decay of ROIC. This chart from the book Valuation by McKinsey shows the natural decay over an extended time.
So will REA Group be able to post 100% ROIC on this incremental capital invested in FY2016 in Iproperty and PropTiger into the future? I do not know but if we look at the base rates of what has happened in the past then sustaining ROIC of greater than 50% is historically abnormal.
History tells us that achieving a ROIC on these acquisitions greater than 30% for a sustained period is not the norm. At current price of $64, I believe the market is looking for ROIC to average around 27% (blended with the Australian operations) on this incremental capital uplift for the next 3 years.
RIOC of 30% is still an extraordinary business and shows the moat that surrounds REA Group. The question we need answered is should REA be a Legacy moat and return excess capital to shareholders or pursue allocating capital to other businesses outside its Australian moat?
Management has chosen to allocate capital to the Asian business, so we will be able to judge the success of this strategy in the coming years.