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Morningstar | Accelerating Structural Headwinds Means AMP’s Long-term Prospects too Uncertain to Invest In

We have reduced narrow-moat AMP Limited’s fair value estimate to AUD 2.05 per share from AUD 2.40 due to accelerating structural headwinds in its core Australian wealth management, or AWM, division. Strong first-half 2019 asset market performance is likely to hide increased cash outflows from AWM since the final report of the Financial Services Royal Commission was published in February 2019. In the first quarter of 2019, AWM suffered its highest ever cash outflows of AUD 1.8 billion, an acceleration from the already elevated levels of the fourth quarter of 2018. However, higher markets led to investment returns (AUD 7.9 billion) more than offsetting the cash outflows from members and clients. The net result is AWM funds under management, or FUM, increased to AUD 129.3 billion at the end March 2019, from AUD 123.2 billion at the end of December 2018. Despite the recent share price decline, the uncertainty around structural changes mean we think long-term prospects are too uncertain to recommend buying AMP at current prices.

We now forecast AWM’s FUM at the end of December 2019 to be AUD 130.5 billion, an upgrade from our previous forecast of AUD 127.7 billion. Markets have continued to rise since the end of March 2019 on the back of a lower interest rate outlook. Notwithstanding, anecdotal evidence, including a recent update from Challenger Financial Group, indicate disruption of major financial advice hubs is increasing. Consequently, we expect continuing elevated net cash outflows in 2019 due to the ongoing reputational damage caused by the Royal Commission and lower financial advisor productivity due to continuing disruptions, but this is likely to be offset by higher market returns.

Higher markets drive a forecast increase in AWM’s 2019 underlying NPAT to AUD 199 million from the previous AUD 187 million. However, due to the structural issues facing AWM, including continuing margin compression, we forecast underlying NPAT to fall by a CAGR of 5% in the next four years from 2019. This also represents a 15.5% five-year CAGR fall from AWM’s 2018 underlying NPAT. AMP is increasingly reliant on investment returns and stronger asset markets. We think Australian asset markets have been more recently supported by the reduction by the Reserve Bank of Australia's, or RBA’s, estimate of Australia’s non-accelerating inflation rate of unemployment to 4.5% and possibly lower, from the RBA’s previous estimate of 5%. This is positive for asset values as it gives more scope for the RBA to reduce interest rates without the fear of inflation accelerating past its target band. With the Australian unemployment rate currently at 5.2%, and the prospect of lower growth, this appears to have increased expectations of further future RBA rate cuts.

Nevertheless, we haven’t made material changes in our forecast for future investment returns. Australia’s All Ordinaries Index is currently trading on relatively high multiples and, as noted, the lower interest rates are also likely to be a response to lower expected future growth. On the other hand, the higher-than-expected levels of cash outflows in both the December 2018 and March 2019 quarters prompts an increase in our forecast net cash outflows. Accordingly, we now expect average AWM FUM will increase by a CAGR of 3.3% over the next five years from 2018, compared with the previous forecast of 3.8% and compared with a CAGR of 6.4% in the last five years.

We have also increased the firm’s weighted average cost of capital, or WACC, to 9.8% from 8.8% in our discount cash flow model to reflect the accelerating structural headwinds the group is facing and the group’s increasing sensitivity to asset markets. We are still at the start of the structural changes that are ongoing in Australia’s wealth management industry. Therefore, there is significant uncertainty on the likely features of the future state of Australian wealth management. However, we think what’s increasingly becoming clearer is the broad framework will include the interests of wealth manager shareholders taking much more of a backseat than in the past to the interests of superannuation members and financial advisor clients. This will affect all levels of AMP’s vertically integrated business model. The SIS Act and future of financial advice legislation already required the best interest of members of complying superannuation funds and clients of financial advisors respectively, to be paramount. However, several ASIC investigations and the 2018 Royal Commission revealed financial advisors and superannuation trustee boards were not adequately adhering to these obligations.

In the future, we think financial advisors and superannuation trustee boards will put the interest of clients and members squarely ahead of shareholders when making decisions. This is likely to be the consequence of more aware and demanding superannuation members and financial advisor clients as well as more aggressive regulators and increasing levels of scrutiny by the media. In the past, we believe margins and earnings were unsustainably inflated at AMP by their financial advisors and related party superfund trustees arguably systematically subordinating the interest of financial advisor clients and superannuation members to the short-term interest of AMP shareholders. We believe AMP’s recent material price reductions, including the cut in the administration fee on its cash management trust to about 0.5% to 0.7% per year from as high as 1.72% to 2.7% and the halving of AMP’s generic MySuper product administration fee to about 0.29% per year as well as the ongoing transition to the cheaper more contemporary North platform from higher-fee legacy platforms illustrates the unsustainability of previous margins. We also think the extent of the material reputational damage done to AMP by the Royal Commission is reflected by the fact that despite these substantial price reductions, net outflows in its AWM business were at historic high levels in the March 2019 quarter.

The 2018 Royal Commission also showed ASIC and APRA were not proactive or aggressive enough enforcing financial advisor and trustee board’s best interest duties and other obligations. However, since the handing down of the Royal Commission’s final report, the statements and actions by both ASIC and APRA make it increasingly clear things have changed. APRA seems to be more proactively reviewing risk management and governance structures at vertically integrated wealth managers, evidenced by the recently announced licence condition changes at both AMP and IOOF. Likewise, the management and board of AMP has recognised things have changed and have prioritised remediating aggrieved financial clients and superannuation members and improving corporate governance and risk management over writing new business.

While the company is already instituting a major change to its business model by exiting its life business, we think there is a strong likelihood the structural changes occurring in the Australian wealth management will result in the AMP board and management instigating further changes. Each level of the company’s vertically integrated business model will need to be considered against the structural shifts occurring in Australia’s wealth management. We think the regulatory risks have increased for all parts of AMP’s vertically integrated business model, including its aligned dealer group or ADG, financial advisor networks, its platforms and its superannuation products. However, we expect the regulatory risks and compliance costs is most acute for its ADG and financial advisors.

Notwithstanding, its ADGs and financial advisors are also the most unprofitable part of its vertically integrated model, being subsidised by, and acting as the distribution arm for its more profitable platforms and products. A more proactive regulation of the best interest obligation by regulators and stronger adherence to it by trustee boards is likely to mean AMP’s financial advisors will play less of a role in the future than they have in the past as the distribution arm for AMP’s platform and products. Accordingly, AMP will need to consider the future design of this business given our expectations of lower future returns generated by it but higher regulatory risks. Given this negative risk/return dynamic, we expect changes will be required to make AMP’s ADG and financial advisors more profitable as stand-alone businesses.

AMP’s platforms are also the subject of increasing competition from specialty platform providers like Netwealth and Hub24, which we think is increasing competition and making platforms a more commoditised product. We expect this will result in platforms likely suffering future pricing pressures. The fees and performance of AMP’s superannuation products are also likely to come under increasing scrutiny given the recent Productivity Commission report on Superannuation. Management has not yet indicated how these types of issues are proposed to be addressed or the costs and investments needed to address them. Consequently, due to the structural headwinds AMP is facing and uncertainty around how it will address them, including the cost of addressing them, we think long-term prospects are too uncertain to recommend buying AMP at current prices.