Weighing up the PEXA IPO

-- | 02/07/2021

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Emma Rapaport: Hi, and welcome to Morningstar. I'm Emma Rapaport. We're here today talking with Morningstar's Gareth James about PEXA's IPO, which launched on the ASX this week.

Gareth, thank you so much for joining us.

Gareth James: Thanks, Emma.

Rapaport: Gareth, I know you've been following this IPO for a long time. It's really been a long time coming for PEXA and for Link and the consortium that owns PEXA. Could you just give us a sense of how we got to this point?

James: Yeah, sure. So what we saw with the Link share price over the last couple of years is that it's been pretty weak. And that's put pressure on Link's management to try and get the share price up. Now, an obvious area of latent value within the Link business has been the investment in PEXA. So the theory there is that the market was undervaluing PEXA, because it didn't really have much visibility of the business. And so Link ran a process whereby, you know, they looked at selling the stake in PEXA. And they also considered IPOing the stake. So they have listed the company ultimately on the stock market. And that should mean that Link share price reflects the value of its investments, much more fairly.

Rapaport: In your pre-IPO report, which is available online now. You talked about the fact that PEXA has ended up with an effective monopoly in the digital conveyancing market. How did a company like this end up with such a monopolistic position in the market?

James: Yeah, sure. So historically, conveyancing, which is the transfer of ownership of real estate, has been done in a very labour intensive and paper-based way. And, you know, the industry has recognised for a long time that it makes much more sense for the process to be digitised. And so that process was begun a few years ago, and state governments and the big banks in Australia all got together, and they came together to create this platform, this digital conveyancing platform, which is what PEXA is. So basically PEXA is the industry at this stage. So it's got 80% of the market and the other 20% is conveyancing, which is still being done, in the old way, but that will disappear. So PEXA will grow to be 100% of the market eventually. However, competition is going to be introduced into the e-conveyancing market in the next couple of years and that may push PEXA's market share back a little bit. But we still think that in the long term, PEXA is going to have a market share of around 90%.

Rapaport: So let's move and talk about the IPO quickly. It's listed on the ASX at $17.13 you consider that to be overvalued in your fair value estimation. Can you explain why you think the market is so bullish on PEXA and you're less so?

James: Yeah, sure. So PEXA is interesting, because it does have a wide economic moat. It's basically got a monopoly. And it's really the kind of business that you can think of as an infrastructure type business. And obviously, at the moment, we've got a situation where interest rates or the risk-free rate is practically zero. And so the capitalization rate that investors are using on assets like these are incredibly low. Now, we think that that's not a sensible way to approach the valuation of these businesses, because we think that interest rates over the longer term are going to increase to something closer to where they have been in the past. And so capitalization rates will increase. So I think that's one issue. I think the other issue with the PEXA is that they are listing the company in a very strong market for real estate. So we've seen a deferral of real estate transactions in Australia from 2020, when we were in lockdown, and we're seeing those come through, that's very positive for PEXA's short term financial outlook, but we don't think that will be sustained. And also, PEXA has talked about growth opportunities overseas. So it's hoping to build a similar platform in the U.K. to what it's created in Australia. But at this stage, PEXA has no business at all really in the United Kingdom. So that's a real long shot with regards to whether or not they're going to succeed over there. So I think that the difference is that we're just taking a much more rational long-term approach and the market's getting a bit more excited about what's happening, at this moment, in financial markets.

Rapaport: The other thing it's being pitched as is I guess, a place that can eventually sell their data, collect their data and sell it on, do you have a take on the prospects on the data side of the business?

James: Yeah, sure. So I think that they do have an opportunity to sell data that they collect. They're already doing this on a pretty small scale, we think that that business is going to grow very quickly. But we still think it's going to be a pretty small business. Investors need to bear in mind that there's already a number of big players in that space. So we've already got CoreLogic, who are doing a very good job of providing real estate data, you know, REA Group, which owns Realestate.com.au, Domain as well, are also doing a lot in that segment. So look, we do think that PEXA will be able to grow their data business, but we don't think it's going to be a material proportion of group earnings anytime soon.

Rapaport: You've given in your special report, a 15% chance on overseas expansion. If there were to be some more concrete moves towards going overseas and some plans that have been announced? How would that change your evaluation?

James: Yeah, sure. So look, the international opportunity, like I said, is very early stage. So at the moment, PEXA have employed one person in the United Kingdom. So that's all they've got so far. If PEXA progressed their position in the U.K., and they could demonstrate that they are getting traction with regulators and the industry over there, then I think we'd see our probability of success gradually increase, and the value that we attribute to the U.K. would gradually increase, and that would increase our fair value for PEXA as well.

Rapaport: Okay, so something to watch within the business. You have issued, I guess, a pretty rare, wide moat for this company that makes it Morningstar's 14th wide moat stock of around 200 that you guys cover. But you've also noted that, this monopolistic position that they hold could carry some political risk. Can you explain what those risks are? And how significant you think they are?

James: Yeah, so you know, we've seen, you know, PEXA is quite a politicised business in some ways. And we have seen quite a few headlines in recent years, around politicians who have been targeting PEXA and saying, the company shouldn't have a monopoly, and these kinds of things. The company is vulnerable to being attacked by politicians, because it is what you'd describe as a natural monopoly, right. And natural monopolies should arguably be owned by the state, right. There isn't much logic in having two versions of PEXA. And it's an important national asset. So you could say that it should be owned by the state in some way. Now, the other thing about PEXA is that obviously, it's kind of exposed to the real estate market. And real estate is a very sensitive topic, obviously, you know, real estate is very expensive in Australia. And it's an important part of everybody's lives. For example, it's easy for a politician to say, you know, that PEXA is earning too much profit. And this is at the expense of people who are trying to get onto the housing ladder. Now, in reality, those two things are very much separate things. But that doesn't stop politicians at least trying to make those kinds of arguments, and that can make things tricky for PEXA.

Rapaport: Right. So for investors that do want to get access to the earnings within PEXA, but don't want to pick it up at the what you consider to be overvalued, you suggested that they can get access to PEXA via Link, which has still a 43% owning of PEXA. Can you explain quickly, just why you think Link is a more attractive option for investors?

James: Yeah, we think that link is, you know, for investors who want to get exposure to PEXA. We think that Link is a much better way to do that, because we think the implied value of PEXA within Link is lower than you have to pay if you buy PEXA shares directly.

Rapaport: Great. Well, thank you very much for joining us today. Gareth's pre-IPO report is now available on Morningstar, and we'll place a link to it at the end of this video. Gareth, thank you very much for joining us today.

James: Thanks, Emma.

This report appeared on www.morningstar.com.au 2022 Morningstar Australasia Pty Limited

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