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Morningstar | Market Ignores the Positives from Link’s Trading Update. FVE Maintained at AUD 8.90.

We’re not surprised the share price of narrow-moat-rated Link Administration plunged by 23% following its trading update but we don’t think the announcement justified the reaction by any means. It is not unusual for the market to panic at the sight of an ominous "trading update" and ask questions later, and we think this reaction was irrational.

Management hadn’t previously provided earnings guidance but said fiscal 2019 underlying NPAT, excluding amortisation of acquired intangible assets, would be between AUD 195 and AUD 205 million. Although guidance is in line with our maintained AUD 203 million forecast, it was around 9% below consensus estimates and will likely cause analysts to downgrade earnings forecasts and valuations. However, from our perspective, little has changed, and we maintain our earnings forecasts and AUD 8.90 fair value estimate. Fundamentally, we view current issues as relatively minor and short-term in nature and we maintain our positive long-term outlook on the stock.

At the current market price of AUD 5.96, we think the shares are materially undervalued. Our fair value implies a fiscal 2019 P/E ratio of 23 and a dividend yield of 2.6%, or 3.7% including franking credits. However, 17% of our fair value estimate comprises Link’s AUD 706 million investment in PEXA which is equity accounted and contributes nothing yet to reported earnings, thereby elevating the P/E ratio. The market price implies a P/E ratio of 17 and dividend yield of 3.6% or 5.2% including franking.

Management attributed the ‘downgrade’ to a range of factors including weakness within the Australian fund administration division, the corporate Markets business, and Link Asset Services in the U.K. Although the extent of weakness within each division was not quantified, we expect the Australian fund administration is the main culprit.

As explained in our April 2019 special report "Link a Likely Winner from Superannuation Reform," Link will be impacted by new legislation which requires inactive superannuation accounts be transferred to the Australian Taxation Office, or ATO, in late October 2019. This process appears to be progressing largely as expected, however, the new legislation passed through parliament sooner than Link’s management expected and its superannuation clients have already begun informing their members of the changes.

As the superannuation fund’s administrator, Link is responsible for contacting members and responding to inquiries. The acceleration of the process means some costs which were expected to be incurred in fiscal 2020 will now be incurred in fiscal 2019. Interestingly, members who were previously considered to be "inactive" have been contacting Link’s call centres at a much higher rate than expected. In the short term, this means unusually high call centre costs for Link, but also raises the prospect that more accounts than expected will be reactivated by members which could provide an unexpected revenue benefit for Link.

At this stage, Link’s management is reluctant to be drawn on the potential upside from member account retention, instead preferring to focus on the cost increase. We’re also reluctant to second guess the member retention at this stage but we expect Link to provide further information as we approach Oct. 21, 2019, when accounts will be transferred to the ATO.

Although Link is being impacted by the transition of superannuation accounts in the short-term, we continue to expect Link’s relatively high cost competitors, such as AMP and the big four banks, to be impacted more which will improve Link’s competitive position. In addition, Link’s largest superannuation fund clients continue to win market share, with annual member growth of around 3% to 5% implying market share growth, largely thanks to the Royal Commission into the financial services sector.

We’re not particularly surprised or concerned about weaknesses within the corporate markets division considering the business already operates in a competitive industry and is somewhat cyclical anyway. The U.K. business, which comprises around 43% of group revenue and 37% of group EBITDA, also appears to be suffering from uncertainty related to Brexit which is impacting client activity, but we also consider these issue to be resolved eventually.

Link has already agreed to sell one of its four U.K. divisions, at an 8% gain on its acquisition cost in late 2017, which will reduce its exposure to the U.K. to around 38% of revenue and 31% of EBITDA by fiscal 2021. We also expect the U.K. issues to eventually pass once Brexit is resolved. Importantly, the weakness in the U.K. and corporate markets businesses don’t appear particularly material based on fiscal 2019 guidance and were encouraged by the maintenance of companywide cost out targets.