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Morningstar | AMP’s 2018 Results and Royal Commission Report Suggest Several Difficult Years Ahead; Reducing FVE

Narrow-moat AMP's 2018 results show that it continued to suffer elevated fund outflows from its core Australian wealth management business in the fourth quarter. We also expect that AMP Bank’s stellar run of earnings growth will end in 2019 because of disruptions to its key mortgage broker distributional channel and management’s new guidance of higher compliance costs in the business. Moreover, the Royal Commission’s final report also identified a number of instances where AMP and its leaders may have broken civil and criminal laws, and we believe there is a high likelihood that further court actions will be taken against it. We also think there is the prospect of additional license requirements. Together, these issues have prompted us to further reduce our fair value estimate to AUD 2.40 per share from AUD 2.60. We expect the issues the company is facing will take several years to address, and we don’t believe there is enough margin of safety at current prices to invest in the company.

While AWM’s underlying net profit after taxes fell only 7.2% in 2018 to AUD 363 million, this hides the true impact of the Royal Commission, and we forecast a more precipitous fall to AUD 175 million in 2019. The 2018 results only partly account for the lower repricing of its MySuper products and other price reductions that occurred during 2018. It also does not account for the AUD 85 million loss due to distribution fees and products that are being transferred as part of the sale to Resolution Life or extra compliance costs of AUD 15 million. AMP indicate that if these items were included, the underlying NPAT would have fallen to AUD 203 million. We believe this figure is itself overstated because it does not capture the full extent of fund outflows from AWM that accelerated in the second half of 2018.

We think AWM’s results provide evidence of what appears to be a trend of investors moving from retail super funds into industry funds, and we don’t believe AMP will be able to stem the outflows in the near term. We forecast outflows from its retail super platforms to continue at 1.7% of funds under management in 2019 compared with 1.9% in 2018, before stabilising to 1% growth by 2022. To stem the outflows, AMP will need to recover from the reputational damage caused by the Royal Commission, improve its product offering, and intensify its sales efforts. We don’t believe this is realistic in the next few years. Furthermore, the company has not prioritised increasing its sales effort. New CEO Francesco De Ferrari has said his three priorities are separating out the Australian and New Zealand wealth protection and mature businesses for the sale to Resolution Life, delivering advice remediation, and strengthening risk management internal controls and governance.

Fund outflows from AWM became more evident in the second half of 2018. AWM reported net cash outflows of AUD 1.715 billion from its core retail super platforms in 2018, with fund outflows accelerating from already elevated levels in the fourth quarter. We estimate fourth-quarter 2018 outflows were AUD 986 million compared with third-quarter outflows of AUD 708 million. This compares to fund inflows of AUD 164 million in the first quarter (just before AMP’s first disastrous appearance before the Royal Commission) and compares to yearly fund inflows between AUD 1.5 billion and AUD 3.4 billion in 2013-17. Corporate super outflows for 2018 totalled AUD 806 million. However, the fourth-quarter outflows decelerated to a still elevated AUD 259 million from AUD 380 million in the third quarter. As expected, these investor outflows were exacerbated by the market falls in the fourth quarter of 2018, leading to a reduction in the total FUM from retail and corporate superannuation platforms to about AUD 115.6 billion as of Dec. 31, 2018, compared with about AUD 121 billion from a year ago. Including external platforms, total FUM fell to AUD 123.2 billion from AUD 130.4 billion a year ago.

We also now don’t believe AMP Bank will be able to continue its recent impressive earnings growth momentum. AMP Bank’s underlying NPAT increased by 5.7% in 2018 to AUD 148 million, but we forecast earnings to fall to AUD 134 million in 2019. We expect more competition in the near term as major Australian banks rebase their businesses to focus more on their core banking products and services. AMP’s net interest margin averaged 1.7% in 2018, but at the end of the year it was tracking at 1.67%, and we expect it to average 1.65% in 2019. AMP Bank will also be affected by the Royal Commission. AMP Bank relies on the mortgage broker channel along with its financial advisors to originate its banking products. Both these distributional channels will be disrupted in the near term by the Royal Commission. Furthermore, management now indicates that compliance-related costs will increase by AUD 10 million by 2019.

On a more positive note, we expect AMP Capital to continue to be the earnings growth driver of its retained businesses. AMP Capital’s underlying NPAT grew by 7.5% in 2018, driven by continued strong fund inflows from sources external to AMP’s business. We expect underlying NPAT of AUD 179 million in 2019. Net cash inflows from external sources totalled about AUD 4.2 billion for 2018. Although this was lower than the AUD 5.5 billion inflows in 2017, FUM inflows accelerated in the second half of 2018 (AUD 2.6 billion) from the first half (AUD 1.6 billion). Fund outflows from internal sources into AMP Capital continued at elevated levels in the second half of 2018 (AUD 3.1 billion in first half 2018 and AUD 3.9 billion in the second half). However, the higher management fee margins earned on external-sourced funds, which are focussed on infrastructure and property asset management, resulted in management fees increasing by 16.2% in 2018 to AUD 309 million, compensating for more moderate growth in fees on internally sourced funds.

As previously announced, AMP’s 2018 full-year dividend will be AUD 0.14 per share, with the lower dividend reflecting the weaker performance in the second half of 2018 and uncertainties in its operating environment. The lower dividend also reflects a deteriorating capital position. AMP reported an AUD 1.65 billion surplus above its minimum regulatory capital requirements as of Dec. 31, 2018, falling from AUD 1.8 billion as of June 30, 2018. While AMP will become a more capital-light business after selling lower-growth businesses of Australian Wealth Protection, New Zealand Financial Services, and Australian Mature, there may be short-term impacts while the sale is pending. AMP remains responsible for the operations and capital management of these businesses until the sale is completed, which it reiterated is scheduled for the second half of 2019. AMP also reconfirmed that it proposes to return most of the net cash proceeds of the sale to Resolution Life back to investors, and although management did not provide details on how this would occur, we continue to forecast this to be in the form of share buybacks.

The Royal Commission’s decision not to break up AMP’s vertically integrated wealth management business model is a key risk that increasingly appears to have been avoided. Our base case assumed this would be the commission’s ultimate decision and so it does not affect AMP’s fair value estimate. Nevertheless, the final report raises several issues for AMP that are likely to keep its misconduct in the public eye, which we expect to continue to be an obstacle to attracting fund flows and financial advisors. Of particular note is the potential for criminal proceedings against it and some of its leaders. Additionally, the final report provides a smorgasbord of evidence for the class action lawyers circling it, as well as regulators for breaches of civil law. We have already assumed class action costs of about AUD 150 million in our modelling, and below we summarize some of the issues brought up by the Royal Commission’s final report, which is the basis of our view that further court actions and license conditions changes are highly likely.

The final report revealed that the Royal Commission invited ASIC to consider whether criminal proceedings for contraventions of s1014G of the Corporations Act should be instituted against several entities that gave evidence that they allegedly charged clients fees for no service. The commissioner did not name the entities he referred to ASIC, but AMP was one of the entities that was caught up in the scandal during the commission hearings, and we expect there is a high likelihood that it is one of the organisations referred to ASIC. While potential criminal proceedings against AMP and its leaders is likely to generate the most media attention, the final report also identified several other potential breaches by AMP of civil law.

For example, the report is highly critical of AMP superfund trustees’ outsourcing agreements with its related parties, primarily because the trustees made themselves “submissive” to AMP’s related parties. Two themes of the commissioner’s criticism is a deficiency in reporting to the trustee and the failure of the trustee to take steps to remedy deficiencies in information provided to them. The commissioner indicates that the way AMP arranged its outsourcing agreements may not allow the trustee to perform its duties in the “best interest” of beneficiaries (potentially breaching covenant s52 (2)(c) of the SIS Act), prioritise the interest of beneficiaries over its own and others (s52(2)(d)) and meant trustees potentially entered into arrangements that hinder the trustee from properly performing its functions (s52(2)(h)). The commission referred these potential breaches to the regulators for further investigation.

The final report also indicates a potential contravention of s52 (6) of the SIS Act and Prudential Standard SPS 530. Section 52(6) of the SIS Act, among other things, requires superannuation trustees to regularly review investment strategies for each investment option offered by the trustee having regard to the likely return from the investments. SPS 530 requires, among other things, trustee boards to monitor and assess whether investment objectives are being met. The potential breaches relate to Superannuation Limited, or ASL, and NM Superannuation Limited, or NM, which are wholly owned subsidiaries of AMP Life Limited and are trustees of a series of AMP superfunds, which have in aggregate circa AUD 115 billion in FUM. Both trustee’s delegated day-to-day operations and administration of their respective funds to related parties in the AMP Group, including to AMP life and AMP Capital.

Evidence showed that some of the members of the AMP funds who were invested in a cash management trusts option received negative returns or exceptionally low returns over an extended period of longer than about three years after fees were deducted. The primary way the trustees monitored the outsourcing arrangements was via a business monitoring model, or BMM. The final report indicates that the trustees may have breached their obligations because, among other things, the BMM framework did not provide the trustee with an adequate level of information to effectively monitor performance because net-of-fee information was not provided.

AMP has since reduced administration fees on these cash management options to about 0.5%-0.7% per year from as high as 1.72%-2.7% on FUM. The final report also indicates that the AMP trustees may have breached s29VN of the SIS Act by, among other things, not promoting the financial interest of beneficiaries of AMP’s MySuper products. The Royal Commission suggests that the reduction in AMP fees was not solely due to negative returns but was also due to APRA identifying the relative high cost per member of AMP’s MySuper products offered by ASL and NM. In July 2018, AMP halved the administration fee on its generic MySuper products to 0.29% per year. Notably, these changes were subject to a previous AMP announcement, and we have already accounted for them in our modelling. Along with the ongoing transition of funds to its North Platform, they are part of the reasons why we expect AMP to continue to face margin pressures. The final report also noted that AMP’s description of the cash management trust as “cash and cash equivalents” has the potential of being misleading and deceptive given there was an allocation to securities with low investment-grade credit ratings of BBB+ and BBB-. However, the final report did not provide a view on whether AMP has engaged in misleading or deceptive conduct on this matter but intimated that ASIC should take a closer look at the description.

There was also criticism that pricing of AMP superfunds was determined by parts of AMP group other than the trustees. Although the trustee board had to approve the fees, the commissioner was particularly critical that trustees did not inquire enough on the impact of the fees on investment returns or whether the fees were competitive. The commissioner suggests this is evident because the 2013 MySuper fees were reduced significantly in 2018. The final report also indicated that AMP trustees may not have exercised the same degree of care, skill, and diligence of a prudent superfund trustee in the process of transitioning of members’ default amounts into its MySuper products.

AMP trustees may also have breached s102 of the SIS Act by, among other things, not having in place an agreement with its investment managers to enable the trustee to require information from them. This relates to the lack of visibility the trustees had over the indirect fees charged to members, including expense recoveries by AMP Capital. The commissioner also expressed concern that the BMM framework does not provide AMP trustees with enough visibility on the financial advisors who direct members to invest in AMP’s superannuation products or whether the strategies for these members are appropriate.

In addition to being critical of AMP’s outsourcing arrangements, the commissioner was also critical of APRA’s regulation of these arrangements. The final report noted somewhat deridingly that APRA conducted a review of AMP’s BMM arrangements in 2017 and found them to be “robust.” The final report suggests APRA needs to do more in its evaluation on how trustees of vertically integrated models comply with their fundamental duties to their beneficiaries. This potentially includes having certain types of decisions made by the trustee reviewed and certified by an external expert. The commissioner also suggests that additional license requirements may be warranted for organisations operating vertically integrated models with the purpose of improving evaluation of conflicts of interest.

The final report also found potential breaches with respect to AMP’s recently sold insurance businesses. This includes charging life insurance premiums even after the member has died. Evidence showed that some premiums were charged from the date of death to the finalisation of the claim and then refunded. The commissioner indicated that this was a potential breach of s912A of the Corporations Act to provide financial services efficiently, honestly, and fairly as well as a potential breach of the SIS Act covenant s29VC. The commissioner also suggests there may be potential breaches of the SIS Act when AMP defaulted members from being previously part of an employer super plan (after ceasing employment) into a standard insurance premium rate plan, instead of the cheaper nonsmoker rate plan.