PART-II (for Part I, see Newsfeed 2-August)

Why this is an undervalued long-term winner

As we discussed in Part-I of this series, REA Group holds the most privileged position of any company in Australian real-estate.

While officially it is solely focused on helping real-estate agents do their job better, rather than replacing them in the value chain, one cannot help but be somewhat skeptical of the official narrative.

Given the natural progression of a genuine two-sided marketplace like REA Group, it is likely to continue reducing friction costs of buying, selling, and renting properties for customers and it is likely to capture a larger share of transaction economics over time. Similar to other internet enabled marketplaces that have served perform functions (e.g. Amazon, eBay, Uber, etc). 

To put some numbers around the potential opportunity for REA Group, broker commissions in Australia are currently 1.0-2.5% of the sale price of a property, while advertising costs are only 0.2-0.4%. To the extent REA Group continues to migrate towards a clearinghouse function, providing increasing value to customers, we would expect this gap to close and deliver an order of magnitude increase in the earnings potential for the business.

Additionally, COVID-19 has accelerated and reinforced the central role REA Group plays in the Australian property market and the online future of the industry by accelerating the introduction of products and services that are years ahead of their time (virtual tours, online auctions, payment on sale, etc).

Furthermore, there are 1.8 million active users logged-in to REA Group's portal which is growing rapidly, translating into significant data advantages and increasingly attachable insights on buyers, sellers, and renters.

This drives a more enjoyable and seamless property experience for customers through a virtuous loop (aka flywheel) in which REA connects consumers of property with providers of property, aggregating both supply and demand, reducing frictions, increasing choice and delivering superior value, with benefits compounding as both supply and demand scales (network effects).

REA Group's Property Flywheel

Source: REA Group

In terms of its structure, REA Group's business is segmented Residential and Commercial real-estate make up ~67% and ~15% of total revenues respectively (~82% combined), with each segment consisting of agent subscriptions (~7% of segment) and property listing fees on the platform (~93% of segment).

Additionally, with 115 million average monthly visits to its website, REA Group has a significant advertising platform along with a unique set of data insights on the property market, which it sells, these businesses are largely contained within the Media and Data segment (~10% of total revenue).

Given its unique view into the Australian property market, REA Group has started to deepen its role in transactions. To date this has largely been through the provision of Financial Services and taken the form of mortgage broking.

In fact, this focus is set to increase with the recent acquisition of leading Australian mortgage broker, Mortgage Choice for A$244mm (March 2021), this segment currently contributes ~3% of total revenues however will likely become more significant over time.

REA Group Revenues (LTM December 2020): A$810 million

Source: MGI

Finally, REA Group has several strategic interests ("real options") in some of the largest and fastest growing property markets in the world, particularly in Asia.

While the businesses within this portfolio are at an early stage, they address large populations and have significant runway, including the leading property portal in Malaysia, prominent portals in India, China, Indonesia, Hong Kong, Thailand and Singapore.

In addition to the Asian investments, REA Group owns a 20% interest in Move (realtor.com), one of the leading property portals in the United States, which rounds out a global footprint spanning three continents.

Global Footprint Spanning Three Continents

Source: REA Group

At Montaka Global we believe in owning the long-term winners in attractive markets, while they remain undervalued, we firmly believe REA Group comfortably fits within these criteria.

Montaka owns shares in REA group.

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For Formula E motorsport, the 2020-21 racing season was transformational. Seven years after electric single-seaters first raced, Formula E gained the elevated 'championship' status enjoyed by Formula 1, World Endurance, World Rally and World Rallycross.

Then came the embarrassment, the "absolute catastrophe", at the Valencia E-Prix in April. The Grande Finale turned shambolic when five appearances by the safety car forced an extra lap and the racers lacked the battery charge to compete at speed. Only nine of 24 qualifiers finished legitimately and three of these drivers crawled to the finish. Three other cars spluttered to a halt mid-last lap when they ran out of charge while five others were disqualified for exceeding energy limits to finish.

Don't be put off electric cars because an event to showcase the emissions-free driving option highlighted some of the challenges holding back the switch to green cars. In coming decades, electric vehicles are poised to become so reliable they will outsell autos propelled by fossil fuels. The race is on to switch to cars whereby an electric motor, battery and single-gear gearbox replace an internal combustion engine, radiator, fuel tank and multi-geared transmission and clutch because fossil-fuel vehicles account for about 10% of the global greenhouse-gas emissions driving climate change.

Governments worldwide are promoting or mandating the switch. Automakers have pledged at least US$300 billion to go electric and compete with Tesla Motors, the leader of companies created to build electric.

But there are issues that need solving to hasten the switch to electric. One is that batteries have power, thus distance, limits. But the improvements to batteries are expected to overcome this handicap before too long. Another is that the infrastructure to ensure country-wide charging needs to be built - it will be. Another hurdle to overcome is that while electric vehicles are simpler to make because they have fewer parts, a battery that is the size of the back seat makes the cars more expensive to produce. The 60% higher price tag on average is slowing sales even though electric car owners save money on energy costs (up to 70%) and maintenance (electric cars have only 20 moving parts compared with about 2,000 in fossil-fuel vehicles).

Another challenge is that while green cars emit no local pollution their environmental benefits come with caveats. The first is that generating the electricity they need to recharge produces emissions. But the emissions from generating electricity will fall over time as grids become more renewables based. A second qualification is that batteries make electric vehicles more emissions-intensive to manufacture. Part of the explanation for that is that the raw materials needed for battery cells, especially cobalt, lithium and rare earth elements, give off emissions during the smelting needed to extract them from ore. (Another might be that batteries are a challenge to recycle.)

The switch to electric, it needs to be acknowledged, comes with social costs. The typical electric car requires six times the mineral inputs of fossil-fuel counterparts by weight, and securing triple the number of raw materials can be problematic. A notable social cost is that more than 60% of the world's cobalt supply comes from the Democratic Republic of Congo where children become ill and die mining for US$2 a day to attain the ore - though Western companies are seeking to improve conditions. Another possible side effect is that securing the supply of key battery ingredients that are located in far fewer countries than is oil might add to tensions between the West and China.

Electric cars right now are more a luxury purchase due to their higher price. But already 30% of global sales of mopeds, scooters and motorcycles are electric because the price differential over petrol equivalents is lower. Car sales will trend the same way if the price gap to fossil power is eliminated as expected this decade as batteries become cheaper and greener grids enshrine the climate benefits of electric. Of the three touted future trends in driving - namely, car sharing that makes ownership redundant, fully autonomous driving, and electric vehicles - a world of green cars is the most believable.

To be sure, more advancements in the fuel economy of fossil fuels would sap the case for electric vehicles. A halfway switch to hybrids might slow the switch to fully electric while unexpected leaps in hydrogen power could make electric cars passé. Governments might wind back green subsidies to repair their finances (especially as some will lose revenue from fuel excise). Any delay in battery improvements would slow the switch. Banning conventional cars might misfire if the masses can't afford electric. Sales of electric vehicles could disappoint if people adopt a mentality that green cars will be cheaper and better distance-wise in a few years.

While the pace of the switch is debatable, the world of electric cars is coming. Valencia E-Prix debacles aside, the breakthrough into mainstream should prove as seamless as the switch from manual to automatic.

We have written previously about the importance of exits (link to previous article) and the important role that Private Equity managers play in generating returns through identifying the optimal path to a company sale.

The other critical role that Private Equity managers play in generating return is the provision of capital and management expertise to meaningfully help a company improve its operating performance.  The common misconception about Private Equity is that managers simply find companies with good cash flows, apply leverage to the balance sheet, significantly cut costs then pay down debt using those cash flows hence increasing the value of the business.  In the mid-market growth/buyout segment that Vantage Asset Management invests in, this misconception could not be further from the truth. For small to mid-market sized private companies, significant value can be created by leveraging the expertise provided by private equity firms. Company efficiencies are improved, growth is accelerated through customer expansion, M&A activity, managing cash, reducing costs, attracting talent and improving IT systems.

Often these businesses see private equity as a valuable way of accessing industry experts who can assist with benchmarking, entering new markets and generally providing expertise that is not readily available otherwise.  A study conducted by Adams Street Partners of the US buyout market found that the source of value creation from revenue growth through Private Equity manager intervention created 38% of the total return and multiple arbitrage (which is often a by product of revenue growth) created 33% of the return.  Leverage ranked a distant third of the return drivers.  This highlights the ability of Private Equity managers to bring meaningful value to private investments through the enhancements they make to businesses and ultimately the returns they generate for investors.

CASE STUDY: SILK LASER CLINICS

SILK was co-founded by its current CEO Martin Perelman in 2009 in Adelaide and had an initial focus on laser hair removal treatments.  The Australian non-surgical aesthetics industry is projected to generate revenues of $5.8Bn in CY2021 however it is highly fragmented with five large specialist clinic chains estimated to account for approximately 31% of the total number of clinics (as at 9 September 2020).

Advent Partners, one of Australia's leading Private Equity managers with a 35 years track record of investing in mid-market companies, first invested in SILK in January 2018. At the time the business consisted of 12 clinics primarily based in Adelaide whose revenue was mainly derived from hair removal procedures, a treatment which was experiencing margin reduction due to the procedure becoming more accessible to consumers.  At the time SILK also offered cosmetic injections, skin treatments and tattoo removal.

Subsequent to the acquisition, Advent worked with management to put a number of key initiatives in place to grow SILK including:

• Accelerating the adoption of a refined franchise model to boost the speed of network expansion into new geographical markets
• Improve clinic productivity through a focus on cosmetic injectables which attract a higher profit margin
• Nurse training and recruitment to enhance the cosmetic injectables rollout
• Adoption of data analytics to improve in-clinic financial operating performance as well as personalization of the offering
• Acquisition of rival networks of clinics
• Launch of a high-margin proprietary skincare brand Aesthetics Rx
• Introduction of body sculpting, a new technology attractive to existing SILK clients as well as attracting new clients

These initiatives saw SILK grow from 12 clinics to 56 clinics by December 2020 achieving two year compound annual growth rate (CAGR) of 79% and 414% to FY2020 in Network Cash Sales and Underlying EBITDA respectively.

During December 2020, the Advent Partners 2 Fund completed the successful exit of SILK Laser Clinics Australia via an IPO. SILK Laser Clinics Australia (ASX: SLA) listed on 15 December 2020 at a share price of $3.45, implying an enterprise value of $162 million. Upon listing Advent Partners 2 realised 50% of their original investment holding in SILK, representing 2.0x of the Fund's original investment in SILK, with the Fund retaining 28% of SILK post IPO. Once fully completed the exit will deliver Advent Partners 2 investors, including VPEG3, with top tier performing returns across a 2.9-year investment period.  Pleasingly SILK has continued to perform since listing up 40c from its listing price with FY21 prospectus forecasts recently upgraded off the back of continued operating success thanks to the initiatives that Advent Partners have helped put into place.

If you would like to share in the growth and ultimate returns derived from similar small to mid-market company investments, Vantage Private Equity Growth Fund 4 ("VPEG4") remains open until 30 September 2021.

Funds operated by this manager: 

Premium Asia Fund, Premium Asia Income Fund, Premium China Fund