EUR 850.00 For Business Accounts Only

Morningstar | Better-than-Expected Fund Flows Prompt a FVE Increase but With a Very High Uncertainty Rating

Better-than-expected fund flows into narrow-moat IOOF Holdings’ portfolio and estate administration business prompt an increase in our fair value estimate to AUD 5.60 per share from AUD 5.00 but with a very high uncertainty rating. The troubled wealth manager’s first-half fiscal 2019 result highlights the importance of completing the ANZ Bank Pensions and Investments funds, or P&I acquisition to ensure near-term earnings growth. IOOF’s underlying net profit after tax, or NPAT, of AUD 100.1 million was 5.8% higher than first-half fiscal 2018 but this hides the true like-for-like performance as the half includes underlying NPAT of about AUD 15 million from the partly completed P&I acquisition. Excluding this contribution, like-for-like NPAT is about 9.9% lower. Specifically, IOOF’s earnings includes an underlying NPAT of about AUD 20 million from a coupon representing IOOF’s economic interest in ANZ Bank’s P&I funds and a loss of about AUD 5 million for ANZ Bank’s dealer group already transferred to IOOF. Approval from the P&I trustee and ANZ Bank is required for P&I funds to be transferred to IOOF. IOOF’s management are confident this approval will eventually be granted. Notwithstanding, we believe that it is more likely that the transfer won’t be approved, with reasons for our view set out below.

Our fair value estimate of AUD 5.60 and earnings forecasts are based on our base-case view that the P&I funds will not be transferred to IOOF. There continues to be very high uncertainty over IOOF’s future sustainable earnings not only because of the unpredictability on whether the P&I funds transfer will occur but also because management indicates it is too early to tell what its ongoing costs and margin pressures may be given the several ongoing reviews it is conducting in response to the Royal Commission. Subject to these caveats, we expect IOOF’s fair value estimate could approach AUD 8.00 per share if the P&I funds transfer is in fact approved.

If the funds transfer to IOOF is not approved, IOOF management indicate it will institute a capital management program including a share buyback. We believe this is the most likely outcome. In this circumstance, we expect IOOF to redeem its AUD 800 million debt note and use the proceeds to repay most of its circa AUD 416.7 million borrowings and use the remainder to institute an AUD 400 million share buyback later in fiscal 2019. However, the extent of any share buyback is also dependent on results of the many reviews it is undertaking, the negotiations with regulators, and the broader regulatory and economic environment.

Management is currently working through reviews of client files with reference to findings in the Royal Commission final report and reaffirmed expected remediation costs of about AUD 5-10 million. Management also estimate the cost to conduct its full advice review will be in the range of AUD 20-30 million, with the bulk of this one-off expenditure occurring in fiscal 2020. Management also noted less than 10% of its financial advisor revenue is sourced from grandfathered commissions and the total impact of the likely removal of these commissions is expected to cost it about AUD 7 million per year.

We also expect further court actions against IOOF. This is in addition to the unprecedented action already taken by APRA in December 2018 seeking, among other things, to disqualify five of IOOF’s leadership team from being responsible officers of a superannuation trustee. According to the Royal Commission final report, the Commissioner also referred IOOF to the regulators for additional potential breaches of the ASIC Act and SIS Act. We also expect the evidence uncovered in the final report to spike the interest of class action lawyers who are likely circling. Management have not provided an estimate of costs for these types of actions, which we think is reasonable given the high level of uncertainty in forecasting them. Nevertheless, for the purposes of our modelling, in addition to the costs guided to by management, we have included further costs of AUD 80 million to cover potential court actions and future remediation of customers.

On a positive note, the company indicated it is not seeing significant outflows from its retail superannuation funds into industry funds. Unlike competitor AMP Ltd which experienced an elevated level of fund outflows from its retail superannuation platforms in the December 2018 quarter, IOOF reported fund inflows of about AUD 273 million. However, IOOF did experience elevated levels of fund outflows from its advice business of AUD 471 million in the December 2018 quarter (not including the circa AUD 17 billion fund inflows from the ANZ Bank-aligned dealer group). This compares with inflows of AUD 525 million in the same quarter in 2017. We also expect further margin pressures prompted by lower pricing in response to the findings of the Royal Commission as well as competition from third party administrators.

The Royal Commission’s decision not to break up IOOF’s vertically integrated business model is a 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 our fair value estimate. Nevertheless, we believe the Royal Commission recommendations will reduce the competitive advantages of having a large network of financial advisors as its distribution arm. This includes APRA and ASIC taking more proactive measures to ensure conflicts of interest are better managed under these business models.

With respect to potential further court actions, we expect there is significant likelihood ASIC will institute proceedings claiming IOOF engaged in misleading and deceptive conduct under s12DA of the ASIC Act with respect to what the Royal Commissioner referred to as the “Questor over-distribution.” This incident relates to the now nonoperational IOOF subsidiary Questor which at the relevant time was a registrable superannuation entity, or RSE licensee and trustee of several IOOF superannuation funds. In addition, it was the responsible entity or RE, of several IOOF managed funds. Questor as RSE invested in IOOF managed funds in which it was also the RE. The Royal Commission was highly critical of this dual RSE and RE arrangement and the effect of one of its recommendations is that such dual arrangements will no longer be allowed. The concern is the inherent conflicts of interest between the same entity acting in the role as an RSE and RE, which the Commission indicates is evident in the Questor over-distribution.

The Questor over-distribution relates to Questor as RE of IOOF managed funds making overpayments to unitholders, including members of IOOF’s superannuation funds in which it was also the RSE. To rectify this overpayment, Questor reduced the payments from its managed funds to unit holders. This action prejudiced new members who did not receive the initial overpayment and members who increased their investment in the managed fund. Subsequently, it used funds received from a settlement against its former third-party custodian involved in the overpayment to wholly compensate aggrieved unit holders other than those members of its superannuation funds. Instead, it compensated aggrieved super fund members by using a general reserve of the super fund. Furthermore, it refused to replenish the reserve from IOOF’s own funds despite several requests from APRA to do so (although it eventually did so in October 2018, following its appearance at the Royal Commission).

While the Commissioner did not make any comments on the alleged contraventions identified in the APRA action with respect to the Questor over-distribution, it did find a potential breach of the ASIC Act’s misleading and deceptive provisions with respect to a letter sent about it to members in 2016. The letter stated that a “periodic review…identified a historical distribution error…that resulted in income distributions being credited to your CMA at a lower rate than it should have been.” The Commissioner believed this statement to be untrue because, amongst other things, there was no “periodic review” and there was no “historical distribution error”, as the lower distributions was not due to an error but caused by a deliberate decision. The letter also did not explain why the over-distribution was made or where the compensation money came from, that is, from a fund asset. The commissioner formed a view that taken as a whole, this communication may have been misleading and deceptive and referred the matter to ASIC.

We also think there is significant likelihood APRA could take further court action against IOOF Investment Management Ltd, or IIML. IIML is trustee of IOOF super funds and the Final Report indicates it may have contravention of s52 (2)(c) of the SIS Act by failing to act in the best interest of members. This relates to IIML’s decision to reduce the fees on its superannuation funds for which it was RSE in 2018. The repricing was based on the IIML management’s assumption that many existing members would not move to the lower price. These members included those who were advised by financial advisors that benefited from grandfathered commissions and those who were not advised by financial advisors. The trustee decided that only new members would be automatically moved to the new lower pricing and that existing members would receive, among other things, a letter in the mail about the new pricing and financial advisors of members would receive a notice of the new pricing.

The Commissioner was critical of the implementation of the repricing because the trustee board could not make an informed decision due to IIML management not providing it with key information such as how many existing members’ advisors were being paid grandfathered commissions. The Commissioner was also concerned about IOOF’s analysis that financial advisors who received grandfathered commissions would not act in the best interest of members and that IIML management may not have given priority to members’ best interest, relying on the assumption that some existing members would not move to the new lower pricing. Consequently, the Commissioner concluded that IIML may have contravened the SIS Act and referred the matter to APRA.

With respect to the transfer of the relevant P&I funds to IOOF, the P&I trustee informed the Royal Commission that it is not only interested in the technical transaction but is concerned about IOOF’s view about the business’s future and is receiving media and legal reports about IOOF. The P&I trustee made it clear that if it is not satisfied that joining the IOOF group is in the best interest of members, it will not approve the fund transfer to IOOF. The P&I trustee has since stated that following the significance of APRA’s actions against IOOF and its leadership team in December 2018, they will assess various options and seek urgent information from both IOOF and APRA. IOOF’s management indicate they are working with the trustee and are still confident the transfer will be approved. Notwithstanding, given the unprecedented APRA action and allegations made at the Royal Commission, including that senior leadership at IOOF were not aware of their obligations as a trustee of a super fund, we believe on the balance-of-probabilities the trustee and/or ANZ Bank is unlikely to approve the transfer to IOOF. We also believe that the potential additional court actions that may be taken against IOOF by either/both APRA and ASIC, further reduces the likelihood of the transfer being approved.

An important lesson from the Royal Commission is the critical importance of strong corporate governance and risk management culture in a wealth manager like IOOF. This includes maintaining a good relationship with regulators by being responsive to their requests. One aspect of the Royal Commission revelations we find particularly hard to comprehend is that IOOF’s board apparently thought it was acceptable not to adhere to APRA’s requests over what were relatively insignificant amounts. For example, the Questor over-distribution amount totaled only AUD 6.2 million. Furthermore, IOOF’s former CEO Christopher Kelaher gave evidence before the Royal Commission that he was indifferent to IOOF’s dual regulatory arrangements, which begs the question why didn’t IOOF’s leadership team remove this structure when first asked to do so by APRA. It’s difficult to gauge a company’s risk management and corporate governance from the outside, but what these types of incidents indicate to us is that the corporate governance and risk management in IOOF is inadequate, underscoring our poor stewardship rating. Consequently, we are supportive new CEO’s Renato Mota’s stated “first priority” of resetting relationship with APRA and restoring trust by setting higher standards in governance.