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Morningstar | IOOF’s FVE Reduced on Ord Minnett Sale

Narrow-moat IOOF Holdings’ fair value estimate is cut to AUD 5.30 per share from AUD 5.60 primarily because of the sale of its 70% interest in Ord Minnett. We expect the sale to reduce IOOF group’s underlying net profit after tax, or NPAT, by about AUD 12 million per year, representing about 6% of forecast fiscal 2019 underlying NPAT. Notwithstanding the near-term earnings impact, which drives our valuation downgrade, we support the Ord Minnett sale because it should allow IOOF to focus on its advice-led strategy and solidify its balance sheet. Brokerage and other transactional services are the primary sources of earnings from Ord Minnett, which are noncore functions in IOOF’s advice-led strategy. While the sale will also reduce IOOF’s funds under advice, or FUA, by about AUD 10 billion in fiscal 2020, this part of Ord Minnett’s business is not profitable. Shares currently screen as fairly valued.

The sale is scheduled to be completed on Sept. 24, 2019 and should result in sale proceeds of AUD 115 million and an AUD 83 million after-tax profit for IOOF. We think the company would normally allocate these funds to a share buyback, but seems unlikely, given the headwinds it's facing and because we continue to expect IOOF’s proposed acquisition of ANZ Bank’s pensions and investment funds, or P&I, will ultimately prove unsuccessful. We already forecast IOOF to redeem its AUD 800 million debt note, representing the economic interest in ANZ P&I, and use proceeds to repay outstanding debt and institute an AUD 400 million share buyback. As such, we expect Ord Minnett proceeds will be retained, to provide a capital buffer against material headwinds, such as defending class-action lawsuits, instituting APRA licence and governance changes, and possible future financial adviser client remediation.

At our fair value estimate IOOF has a fiscal 2019 P/E of 9.1 times and a fully franked dividend yield of 8.9%. We forecast lower underlying NPAT in fiscal 2020, with earnings per share partly supported by the forecast AUD 400 million share buyback. This leads to a fiscal 2020 P/E of 10.9 times and fully franked dividend yield of 7.5% at our fair value estimate. In comparison, IOOF’s interest in Ord Minnett is being sold at fiscal 2019 P/E of about 9.6 times.

More so than usual, the company’s fiscal 2019 earnings result in August 2019 is likely to be a major catalyst. At or before this announcement, we expect to hear an update about its ongoing comprehensive review of the quality of advice provided by its aligned and salaried financial advisors. This review is scheduled to be completed in September 2019. So far, management have indicated they have not uncovered any systematic issues with respect to their financial advisors and their best estimate of potential client remediating costs is only AUD 5 million to AUD 10 million. We remain sceptical of this guidance in regarding to the sizable remediation provisions already announced by AMP and the major banks. Consequently, we have assumed IOOF will incur remediation costs of AUD 50 million, which we have modeled to be paid over the next four years.

We also expect the company to provide an update on the ANZ P&I acquisition at or before the announcement of its August 2019 results. The completion date for this acquisition has been recently postponed until Oct. 17, 2019. We expect that this acquisition is unlikely to be completed. We are also surprised that IOOF has not already redeemed the AUD 800 million debt note representing the economic interest in ANZ’s P&I business, given the interest rate it's earning on this debt note had dropped to 2%, from 14.4% per year on 11 May 2019. We had previously forecast this note to be redeemed, the P&I acquisition abandoned and the AUD 400 million share buyback to occur in fiscal 2019, and now forecast them to occur in fiscal 2020.