Shares in Pexa (PXA.ASX) have fallen sharply following a proposal by the Independent Pricing and Regulatory Tribunal of New South Wales, or Ipart, to regulate pricing for the property exchange based on a building block model.

Why it matters: A building-block model requires assessing an initial asset base on which the property exchange may earn a return. Unlike traditional infrastructure, the asset base here comprises intangible assets, which is unusual and introduces uncertainty about how it will be assessed.

  • A low initial asset base would lower the deemed appropriate return and therefore introduce the possibility that prices could be lowered.
  • However, we don’t believe the Australian exchange business is generating excess returns, given limited profits today and transaction fees that are small relative to other geographies and the value delivered. We therefore leave our base case forecasts unchanged.

The bottom line: But we assume a 25% probability that prices will be reduced nationally to allow for a 6% return on a capital base of $750 million, which is the midpoint of the examples provided by Ipart. This lowers our fair value estimate for wide-moat Pexa by 8% to $18.50 per share.

  • Our 25% probability estimate is based on our own calculation of the initial asset base, including both expensed and capitalized product development costs, as discussed by Ipart, both from the period during which the company was publicly listed and before that.
  • We believe that Pexa will argue for similar inclusions and that customer acquisition and onboarding costs should be included in the initial asset base calculation, which we believe is appropriate and would significantly increase the asset base.

Ipart increases uncertainty for Pexa

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 UK 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 in 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. We see Pexa’s wide economic moat as well protected by network effects and switching costs. We therefore expect Pexa to gradually increase its market share to close to 100% of transactions.

Bulls say

  • Pexa is a natural monopoly in Australia and well protected by a wide economic moat.
  • Despite heavy investment today, Pexa’s Australian exchange business, like other exchange and financial infrastructure businesses, has the potential for high margins.
  • Successful overseas expansion has the potential to materially increase Pexa’s addressable market and provide additional operating leverage on product development expenditures.

Bears say

  • Regulation changes may result in lower prices or limit price increases for Pexa’s Australian exchange business.
  • Pexa’s UK expansion may be unsuccessful.
  • Pexa’s expansion into adjacent products and services, including through acquisitions, has not delivered notable benefits and has been discontinued.

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company’s future cash flows, resulting from our analysts’ independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.