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Morningstar | AMP’s FVE Reduced After First Earnings Guidance Following Shocking Royal Commission Revelations. See Updated Analyst Note from 29 Jul 2018

Our fair value estimate for narrow-moat AMP reduces to AUD 3.60 per share from AUD 3.90 after its first earnings update following the shocking Royal Commission revelations. Notably, AMP expects to make a AUD 290 million aftertax provision for remediating customers with respect to ASIC's required look-back into financial advice provided over the last circa 10 years. Additionally, AMP estimates a AUD 50 million aftertax cost per year in the next three years for conducting this investigation and an aftertax cost of AUD 35 million per year over the next two years to improve its risk management systems. These costs will not be included in AMP's underlying net profit after tax, or NPAT, guided to be in the range of AUD 490-500 million in first-half 2018.

Our forecast 2018 underlying NPAT reduces to AUD 939 million, from AUD 949.5 million, with higher NPAT growth from the bank and AMP Capital partly offset by an unexpected negative experience and capitalised losses in the chronically underperforming wealth protection division. Our forecast also did not account for a new initiative to reduce fees for about 700,000 of AMP's MySuper clients, which results in an expected AUD 12 million reduction in wealth management fee revenue in second-half 2018 and AUD 50 million reduction per year from 2019 onwards. We had forecast fee margin pressure to average 3.4% per year over the next five years, and the company provided new guidance that, not including the MySuper fee reductions, over the long term it expects margin compression between 3% and 4% with some volatility. Inclusive of the MySuper repricing, our forecast margin compression now averages 4.1% per year.

Our forecast for the full-year 2018 dividend also reduces to AUD 23 cents per share from AUD 24.5 cents. As expected, the company guided to a dividend payout ratio at the lower end of its 70% to 90% of underlying NPAT range but indicated the interim 2018 dividend may be below this range.

AMP remains well-capitalised, with AUD 1.8 billion surplus above minimum regulatory requirements, or MRR, at June 30, 2018, but the surplus has deteriorated from the AUD 2.3 billion surplus as at Dec. 31, 2017. We expect this is primarily due to lower statutory earnings and the dividend. We believe AMP will maintain a strong MRR surplus given the Royal Commission fallout and will continue with a lower payout ratio until the full ramifications of the Royal Commission become clearer.

We also reiterate our high uncertainty rating for the stock, with management seemingly still not in a position to provide clarity on a number of key earnings and balance sheet drivers. This may in part be because the Board is still looking to appoint a new long-term CEO, who over time will drive the company's long-term strategy. We also believe it is still too early to gauge the full fallout of the Royal Commission and other regulatory initiatives. Nevertheless, in the next five years, we forecast the compound average growth rate, or CAGR, of average assets under management in the core wealth management division to grow by only a little over half the growth rate of the past five years. While this is our best estimate, it will take some time to determine the full extent to which the negative impact of the Royal Commission has on potential clients using AMP advisors and acquiring its products as well as the extent to which it is losing financial advisors, and the impact that also has on fund flows. The combination of the expected phasing-out of grandfathered commissions, new educational requirements for advisors and the damage to AMP's reputation are all factors which underpin our view that more advisors are likely to continue to leave, leading to our lower fund flow forecast. Reputational damage caused by the Royal Commission is also likely to result in fewer potential clients using AMP advisors and acquiring AMP products. However, at this still early stage, there remains significant uncertainty in accurately quantifying the impact on fund flows. Another uncertainty is the damages or more likely settlement payment AMP may have to pay for the multiple class actions it is facing. We note the recent QBE class action was settled for approximately AUD 132.5 million and using this as reference point, we have forecast a settlement for these class actions in 2020 for AUD 150 million. However, we are still at the very early stages of proceedings and, therefore, there is considerable lack of clarity on the quantum on any damages or settlement payment and when proceedings will be finalised.

Other factors that lead to the high uncertainty rating include the potential impact from the government's response to the recent Productivity Commission recommendations into superannuation, the extent to which advisors will trigger buyer-of-last resort agreements and the potential contingent liability with respect to such action as well as the capping on fees on low superannuation accounts. However, we believe the impact of the fifth round of hearings at the Royal Commission commencing of Aug. 6, 2018 is the most immediate risk. This round of hearings focuses on superannuation, and AMP has been identified as one of the organisations required to potentially give evidence. Given the previous round of hearings, we expect the next round could focus on charging members fees for no service, and matters uncovered from the recent Productivity Commission report like the underperformance of some superfunds. AMP's recent initiative to reduce MySuper fees may in fact be a proactive decision in response to the upcoming hearings, although its announcement was couched in terms of a reset and a first step in regaining client trust.

Another key risk is that AMP will be required to break-up its vertically integrated model by separating its advice business from its product manufacturing and platform business, although we still do not believe this is the most likely outcome. Although there have been increasing calls for the break-up of vertically integrated business models since the Royal Commission, we note that submissions to the Royal Commission by both the Australian Securities and Investments Commission, or ASIC, and the Australian Federal Government Treasury, or Treasury, do not call for the structural separation of vertically integrated models. ASIC suggest that vertically integrated businesses should be able to manage their conflicts of interest and points to benefits of this model such as economies of scale advantages which could be passed on to clients in the form of cheaper advice, the convenience some clients value in dealing with a single organisation and the stronger capacity of large vertically integrated businesses to compensate customers when poor advice is given. Treasury also points to the practical complexity and disruptiveness of a required separation as well as the risks of unintended consequences. Nevertheless, the risk of a potential separation of vertically integrated business remains a genuine risk which the Royal Commission may shed more light on in its Interim Report scheduled for Sept. 30, 2018 or Final Report scheduled no later than February 2019.