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Morningstar | IOOF’s FVE Reduced on Royal Commission Fallout, Despite More Clarity on ANZ Acquisition

Potential issues arising out of the fifth round of Royal Commission hearings, combined with the possibility for major structural changes in Australia’s advice industry (hinted at in the Royal Commission’s Interim Report) and the prospect of more aggressive regulation of narrow-moat IOOF, prompt a reduction in our fair value estimate to AUD 9.30 per share from AUD 9.80. This overshadowed news of the substantial completion of the acquisition of ANZ Bank’s wealth business. IOOF has announced that it took legal ownership of ANZ Bank’s Aligned Dealer Group, or ADG, on Oct. 1, 2018, representing substantial economic completion of ANZ’s ADG and One Path Pensions and Investments, or P&I, acquisition. IOOF has now paid AUD 800 million of the AUD 975 million price tag. This will fund a debt note paying a coupon of 14.4% to IOOF until the acquisition of the remainder of the business is complete, expected at the end of March 2019.

The acquisition is the main driver of our forecast earnings growth. We project EPS growing at 3.3% in fiscal 2019 and accelerating to 13.2% in 2020. This is lower than IOOF’s reaffirmed forecast for "mid-single-digit" EPS accretion in fiscal 2019 and about 15% in 2020. The difference stems from our more negative view of the fallout from the Royal Commission, primarily in the form of lower fund inflows into its advice and platform businesses. There was concern this acquisition would not go ahead following the fifth round of Commission hearings. Specifically, the chair of trustees of the ANZ funds indicated that while the trustee had given "in-principle" approval, she was monitoring media reports and the Royal Commission testimony to ensure that the deal is in the best interest of its members. We understand from IOOF that the current delay in the successor fund transfer is not because of the trustee’s concerns but is instead due primarily to technological difficulties in separating the insurance part of ANZ’s business, which is being sold to Zurich.

While this news alleviates one major risk to IOOF, the Royal Commission still looms large. We anticipate more aggressive regulation of IOOF, including possible future court action against the company by regulators, after the fifth round of Royal Commission hearings. The Interim Report only covered the first four round of hearings, so it did not cover IOOF’s testimony before the Commission in the fifth round or focus on APRA’s regulation of trustees’ of RSEs. Nevertheless, it appears clear from the Interim Report that the Commission is critical that regulators such as APRA and the Australian Securities and Investments Commission, or ASIC, did not take more aggressive enforcement actions when they uncovered breaches. The Interim Report indicated that enforcement action did not generally reflect the gravity of the breaches identified and regulators did not make enough use of the court system. We understand that IOOF has committed to APRA that it will split up the roles of the trustee of the RSE and responsible entity of its managed funds following the completion of the ANZ acquisition, which was one of APRA’s major concerns. Nevertheless, given the Interim Report’s sharp criticism of regulators and IOOF’s testimony in the fifth round of hearings, we believe there is heightened risk that regulators may take more aggressive action against IOOF in the future.

Our view that grandfathered commission would be abolished was also reinforced by the Interim Report. The Royal Commission clearly did not agree with arguments that there may be constitutional obstacles to their removal, referring to these arguments as “allusions”. The report also suggests the onus is on organisations that want to maintain them to provide justification. IOOF has indicated that removing grandfathered commissions will have an immaterial impact on its earnings, which it estimates in the "single-digit" millions, compared with AUD 191.4 million of underlying net profit after tax earned in fiscal 2018. Nevertheless, removing these commissions will reduce the revenue earned by financial advisors, and along with the new higher educational standards, this may prompt more to leave IOOF and the industry. These grandfathered commissions are also linked to higher-fee-generating legacy products. Accordingly, abolishing them negatively affects IOOF primarily via the loss of advisors, although it has had a history of attracting new advisors against the trend of competitors like AMP losing advisors, and by increasing IOOF’s gross margin pressure. IOOF also has a good record of operating cost discipline and generating stable net operating margins despite falling gross margins. However, we expect this may be more difficult to achieve in the future, as we believe one of the consequences of the Royal Commission is likely to be increased investment in systems and processes.

While still too early to accurately identify and quantify the types of new systems changes that may be required, our reading of the Interim Report indicates that these could be significant. The report found that some of the root causes of poor conduct in Australia’s financial advice businesses often lie with the systems and processes. Although the exact form of system changes is unknowable until we see the Final Report and IOOF’s response, we believe the changes will generally require stronger monitoring of financial advisors and potentially expensive changes to platforms, software, and processes. IOOF confirmed that a recent audit of its advisor files uncovered only about AUD 50,000 worth of client remediation, which is insignificant compared with remediation required by other financial advice organisations. It was also not asked to appear at the Commission’s second round of hearings that covered financial advice, although we are unsure whether this is more to do with the Commission’s focus on the major banks and AMP.

However, there is the potential for the Commission to recommend systems changes that may still affect IOOF. This is likely to be in the form of higher operating costs or capital investment in improving system infrastructure. We expect more investments may be needed for monitoring to ensure that the advisor is authorised to receive fees and is providing the services promised. Notably, the Interim Report expressed a concern that systems allowed platforms to automatically deduct advisor fees from client accounts, resulting in clients being unaware they were being charged a fee for no service, which meant they seldom complained. We also believe process changes will likely involve more regular random audits of advisor files and the facilitation of faster breach notifications and remediation of aggrieved customers, as well as stronger record-keeping processes to facilitate this.

We think part of the monitoring by licensees is likely to include ensuring that individual advisors do not have more clients on their books than they could monitor or advise annually, affecting funds under management per advisor. We also believe that ongoing advice agreements may need to be renegotiated annually instead of every two years. Additionally, we expect organisations will be required to provide more transparency on platform fee charges, potentially disclosing fees charged by competitor platforms. Nonetheless, given that IOOF operates an open architecture platform model, this may be less disruptive to its business than competitors such as AMP. Processes may also be required to allow clients to change platforms more easily, including providing in specie transfers.

We still believe the most likely outcome is that the government will not seek to completely abolish vertically integrated business models. However, given the Interim Report’s expressed concerns about this model, we are less confident in this view. The report noted that the "virtue" of vertical integration is the promise of efficiency that is then passed on to customers in the form of lower costs and greater access, as well as the convenience of dealing with just one institution. However, it also noted that the one-stop shop also has an incentive to promote the product manufacturer’s product over others, even when this may not be in the best interest of clients. It also suggested that the higher platform fees of organisations like AMP invited the question as to whether vertical integration may harm clients by protecting entities operating platforms from competition, resulting in them paying more for platform services than others.

The Report also indicated that one of the fundamental premises of the Future of Financial Advice, or FOFA, legislation was that conflicts of interest between advisors and clients should be permitted but "managed". To implement this premise, FOFA provisions required the licensee to have adequate arrangements to manage conflicts, a requirement to act in the client’s "best interest", and a ban on conflicted remuneration subject to the grandfather provisions. However, the Interim Report points to ASIC’s recent investigations into the vertically integrated business of the four major banks and AMP, suggesting the results on their face deny FOFA’s fundamental premise that conflicts can be managed. Notwithstanding, the Interim Report also makes it clear that it wants to avoid placing an extra layer of legal complexity on what it regards as an already complex regulatory regime. We believe requiring the structural separation of advice business on the one hand, and platform and investment management business on the other, will result in more complex layering of legislation, with the potential for unintended consequences.

Another potential structural change hinted at by the Interim Report that would negatively affect IOOF’s vertically integrated model is the prospect of advisors being individually licensed and directly supervised by ASIC. Currently, the regulation of advisors has been at the intermediary or firm level and not at the individual level. The licence entity is commonly the financial services company, and the individual advisor operates as the authorised representative or employee of the licenced entity, with the licence entity being responsible for ensuring that individual advisors comply with the law. While this question was posed by the Interim Report, we do not think ASIC has the capacity to individually supervise the circa 25,000 financial advisors in Australia, and there is the potential for unintended consequences, such as individual advisors not having the funding to compensate clients if misconduct occurs.

However, there is the potential for wealth management organisations to require more expansive and transparent approved product lists, or APLs. The Interim Report noted that advisors may satisfy their best interest duty by simply choosing the most appropriate product from its licensee’s APL. The report suggests this makes the best interest duty more akin to an obligation to do no harm rather than a requirement to do what is best for a client. This again may not be as disruptive to IOOF as competitors like AMP, given IOOF’s open architecture platform model.

Unfortunately, while the Interim Report poses a lot of questions, it provides few answers, but hints at the potential for material industry changes. The Royal Commission has the potential to substantially affect IOOF’s intrinsic value, particularly if it leads to the dismantling of IOOF’s vertically integrated business model. The impact of this worst-case result is difficult to model because of the level of integration of IOOF’s business, and especially without knowing the Royal Commission’s final recommendations and the government’s response to them. Subject to this major caveat, we believe IOOF’s intrinsic value could be significantly below its current share price if this worst-case scenario were to occur. Accordingly, while we reiterate our narrow-moat rating for the company, we see risk to IOOF’s competitive advantages if the Commission’s final recommendations include such a provision. We also expect it will be difficult to successfully lobby against the Commission’s final recommendations even if they cause major disruptions to the industry. The final Royal Commission report is scheduled for release by Feb. 1, 2019, and Australia’s next half-senate election must be held before May 18, 2019. This means there is significant probability that the Royal Commission’s final report will be released in the lead up to or during the next Federal election. Given the significant media attention and negative fallout from the Royal Commission, we believe it will be very difficult for either major party not to accept the Royal Commission’s recommendations, particularly in a heated election campaign.