The market’s love affair with ‘new media’ technology stocks appears to be on the wane. Once super-sexy, high growth companies like REA Group (ASX: REA), owner of Realestate.com, aren't looking as attractive as they once did. In the past month or so, the company’s shares have dropped around 13% from record high levels, prompting many to ask whether further falls are to come.
But do those investors abandoning REA Group in search of the next torrid affair risk foregoing a meaningful and prosperous long term relationship? What, if anything, has changed with REA Group?
A Troubled Youth
A child of the tech boom, REA Group was something of a late bloomer. After listing in 1999, its first five years as a listed company saw the company fail to generate a profit -- the share price sank from a starting price of $1.15 to just 5c in the first two years.
Nevertheless, a viable business model, growing market share and increasing revenues set it apart from many of its vacuous and over-hyped IT peers. After posting a maiden profit in 2004, it has gone from strength to strength, with earnings since growing at over 47% per annum on average.
Today, the company is worth over $5.8 billion, employs 500 people and its various websites attract over 11 million unique visitors per month. Shareholders who invested in REA Group in 1999, would have turned $25,000 into more than $1 million today.
A Maturing Business
When you look at such rapid and sustained growth, the lofty valuations REA Group has historically attracted seem, if anything, too low! Price to earnings multiples of 25 or more may seem ridiculous when looking at a mature business with more temperate growth prospects, but for a youthful and ambitious new entrant, such conventions do not always apply.
But herein lies the problem. No company, no matter how expertly run, no matter how favourable the economics, can sustain such growth indefinitely. With the company dominating the domestic online real estate market it needs to find new growth prospects if it is to stave off the inevitable moderation of middle age.
Prolonging Youth
The first option is to branch out into new categories, and indeed the business has been doing exactly that with websites that cater to distinct, yet related areas such as commercial property and holiday homes. The scope here isn't as large as it is for residential classifieds, but it is a viable option for a business that can leverage off its existing technology and has the balance sheet to easily fund the establishment costs.
The second option is to move into new geographic markets, and here too the company has been busy. It presently owns real estate websites in Italy, Luxembourg and Hong Kong, though at present these contribute only a small proportion of total revenue (roughly 10% in total).
Both options certainly carry risk. The business today faces much more established and well-funded competition, and the structural move to online has now largely run its course. While the company’s strategy for growth is clear, the odds of success are less so.
At What Price?
In many ways, REA Group is in the prime of its life; it has no debt, a massive stockpile of cash, dominant market position and incredible pricing power. The most recent half year results revealed a 30% lift in revenue and a 37% rise in net profits. Shareholders were rewarded with a 38% increase to the interim dividend.
Shares may have dropped 13% odd since hitting a record high in early March, but the fact remains that the business is still trading at an eye watering price earnings multiple of over 45 times. If REA Group can sustain its historically high rates of growth, today’s valuation is in fact not that unreasonable. But that is a big ‘if’.
Charlie Munger, vice-president of Berkshire Hathaway, and famous for his wit and wisdom, once said:
“No matter how wonderful [a business] is, it’s not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life.”
Foolish takeaway
REA Group is indeed a wonderful business, and one whose future remains bright. However, if growth does slow, even to levels that many other businesses could only dream of, the market’s preparedness to continue paying such high premiums may well be tested.
Though the share price of REA Group has dropped of late, the argument for value is not straightforward. Though impressive, this might be a business for which the downside risk doesn't justify the potential gain -- at least unless the price falls further.
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Andrew Page is a Motley Fool analyst. You can follow The Motley Fool on Twitter @TheMotleyFoolAu. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
