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Morningstar | IOOF's FVE of AUD 10.30 Unchanged, but Royal Commission Poses High Risks

Our fair value estimate of AUD 10.30 for narrow-moat IOOF remains unchanged following strong growth in funds under management, administration and advice, or FUMA, in the fourth quarter of fiscal 2018. This continues the strong FUMA growth of the last two fiscal years. We expect continued organic FUMA growth in the next five years but at a slower pace than the previous five and with more margin compression. These results also exclude the impact of ANZ Wealth, with substantial completion of this acquisition brought forward one month to Oct.1, 2018, and earnings per share accretion guidance from the acquisition unchanged. We forecast the acquisition to materially add to its organic growth. IOOF also confirmed it intends to maintain its dividend per share for second-half 2018, despite a high payout ratio, and we continue to expect a fully-franked AUD 0.53 dividend per share for fiscal 2018.

However, we reiterate our high uncertainty rating on the stock. In early May 2018, we raised IOOF's rating from medium due to the regulatory risks posed by the 2018 Royal Commission, even though, at that stage, it had not been called to give evidence. Earlier this week, IOOF was identified as one of the organisations required to give evidence at fifth round of hearings starting Aug. 6, 2018. This now significantly increases the probability of negative fallout from the Commission, including the potential for reputational damage and more margin compression than we forecast in our base case.

As noted, we already forecast margin compression, with gross margin as an average of funds under advice expected to compress over the next five years from fiscal 2017 by a compound annual growth rate, or CAGR, of negative 2.9% in its advice business and by a CAGR of negative 3.3% in its platform business. While this remains our base case, recent actions by BT Financial Group to reduce their platform fees may place some pressure on IOOF to reduce its fees. Additionally, potential revelations from the Royal Commission may result in more margin compression than currently expected.

The next round of Royal Commission hearings will focus on superannuation, including structural and governance arrangements of funds, the relationship between trustees and financial advisors and selling practices. In light of the extraordinary revelations from the previous hearings on wealth management, it is very difficult to predict the impact of the upcoming hearings. However, given the previous hearing, the governance issues could include charging superannuation members fees for no service as well as issues brought up by the recent Productivity Commission report which highlighted the underperformance of some funds, without naming them, and issues like unreasonably delaying the transition of members into the low-fee default MySuper product.

Some of the negative impacts could include, for example, the potential for further margin compression if IOOF is required to transition more members from higher legacy products to cheaper MySuper products. The potential for reputational damage and the impact on things like funds flow are even more difficult to predict. Therefore, we again emphasise an investment in IOOF given the upcoming Royal Commission hearings remains high risk requiring a significant margin of safety.