Pexa (ASX: PXA) shares dropped close to 12% on December 20th after providing a negative update on U.K acquisition Smoove.

Despite the drop we maintain our $15 per share fair value estimate for wide moat Pexa, following the completion of the acquisition of Smoove. Pexa shares have been volatile surrounding updates around the acquisition and currently screen as materially undervalued.

We believe Pexa’s core exchange business in Australia is worth $14 per share on a stand-alone basis or $12.50 per share when including net debt. With shares trading at $10.92, we believe the market attributes negative value to Pexa’s expansion in the U.K. market.

Pexa believes that the Smoove acquisition will improve its ability to enter the U.K market. Smoove is an online conveyancing panel manager for sales and purchase agreements, which complements Pexa’s existing business in the U.K. for remortgaging. So far, Pexa has been unable to make meaningful inroads into the remortgage market.

Feedback from banks has been that a mere remortgaging offering wasn’t as attractive as a more comprehensive offering which also includes sale and purchase agreements. Although we can see the logic with this reasoning, we believe the acquisition does not signal strength and that a comprehensive offering also comes with more implementation costs, which may provide a barrier to adoption. We maintain our assessment of a 25% likelihood of successful market entry.

Our thesis has been that Pexa’s entry into the U.K. would prove to be more difficult than its adoption in Australia. In Australia, the country’s largest banks co-owned Pexa at the time of its product adoption, and Pexa also enjoyed a supportive regulatory environment at the time, as state governments pushed e-conveyancing. Without a similarly supportive environment in the U.K., Pexa is facing the so-called cold start problem, meaning Pexa is struggling to get its network effects started.

Business strategy

We expect Pexa’s strategic focus for the foreseeable future to be on its overseas expansion into the United Kingdom. Pexa’s exchange business is mostly saturated in Australia, leaving overseas expansion as the primary driver of growth.

However, Pexa does not enjoy an equally supportive environment in the U.K. as it did in Australia. In Australia, the country's largest banks co-owned it and with a legal mandate from state governments to move to e-conveyancing, this helped drive adoption. Pexa will therefore have to invest heavily into product development, and especially sales and marketing to drive adoption of its platform by sufficient market participants for network effects to kick in.

We don’t expect Pexa’s Australian business to require much ongoing strategic focus. Pexa’s Australian exchange business is used for the settlement and lodgment of around 90% of property transactions in Australia, with the balance consisting nearly exclusively of transactions that are still paper-based in some of Australia’s smaller jurisdictions and functional niches.

We don’t see competitive threats to this business, including from interoperability, which would allow competitors to operate on Pexa’s exchange network. We see Pexa’s wide economic moat well-protected by network effects and switching costs. We therefore expect Pexa to gradually increase its market share to close to 100% of transactions.

Pexa's economic moat

We award Pexa a wide moat based on switching costs and network effects in its Australian digital settlement business. An economic moat allows Pexa to resist the negative impacts of competition and earn returns that exceed the cost of capital over the next 20 years.

Pexa’s economic moat is primarily supported by network effects. A network effect refers to the value of a business increasing as adoption of a good or service increases. In Australia, property transactions require the involvement of numerous stakeholders, such as buyers and sellers, conveyancing firms, banks, land title offices, state revenue offices, and the Reserve Bank of Australia.

In the traditional paper-based model, this entailed error-prone manual processes, inefficient duplicate paperwork and slow, in-person final settlement. When all stakeholders involved in a transaction can collaborate on a common digital platform, however, transactions can be conducted more securely, more efficiently, and more quickly.

Pexa operates a virtual monopoly on digital settlement and lodgment in Australia, at around 99% market share of digital transactions and close to 90% market share of total transactions. Pexa’s only digital competitor, Sympli, a collaboration between the ASX and InfoTrack, is responsible for less than 1% of total transactions.

Crucially, Pexa remains the only platform capable of multiparty transactions, leaving only a small part of the market addressable for Sympli, such as mortgage discharges after a final mortgage payment. The remaining market share consists of paper-based conveyancing in some of Australia’s smaller jurisdictions and functional niches. Given the widespread adoption of Pexa’s platform by stakeholders, we expect this remaining market share to eventually move to Pexa’s digital platform as well. Network effects from nationally operating banks and conveyancing firms that prefer operating their businesses on a single platform, will further support this adoption.

Pexa’s network effect can potentially weaken in the future through the introduction of interoperability, which would allow third parties like Sympli to ride on the digital rails laid by Pexa. However, the introduction of interoperability is complicated because it requires the integration of Pexa’s platform with that of competitors, while ensuring property transactions can continue to be conducted securely and without negatively affecting the user experience. Unsurprisingly, the introduction of interoperability has experienced long delays, while Pexa has continued to grow its market share as the industry digitized.

At this stage, we believe digital competitors to Pexa will also be faced with prohibitively high switching costs. As with most software products, switching away from Pexa will require the integration of technologies and retraining of people, which incurs direct financial costs, opportunity costs, and business risk involved with the switching process. Given the high value of real estate transactions, we believe there is a strong disincentive to switch away from Pexa’s proven and reliable platform.