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Morningstar | Magellan Hits Fiscal 2018 Results for Six, Increases Payout Ratio. FVE Raised to AUD 28.

Narrow-moat-rated Magellan Financial Group reported a strong fiscal 2018 result driven by increased funds under management, or FUM, and a subsequent 8% increase in net profit after tax, or NPAT, to AUD 212 million. The strong result prompted management to increase the 2018 dividend by 57% to AUD 1.35 per share, which was well above market expectations and to raise the payout ratio. All this during what has been a busy, and not always smooth year for the fund manager. A year which included a successful initial public offering, or IPO, of the Magellan Global Trust, the acquisitions of Airlie Funds Management and Frontier and the marketing debacle with Cricket Australia. Encouraged by strong FUM growth and continued investment outperformance, we increase our fair value estimate to AUD 28 and at current prices, the stock is fairly valued.

A healthy combination of organic fund flows, investment performance and acquisitions were the backbone of this result, with average FUM up 29% during the year to AUD 59 billion and year-end FUM up 37% to AUD 69.5 billion. Excluding the growth from investment performance, AUD 4.4 billion of new money flowed into Magellan's funds, representing a 10% increase year on year. AUD 2.5 billion of this came from institutional clients and AUD 1.9 billion from higher-margin retail investors. Within these flows, AUD 1.6 billion is attributed to the IPO of Magellan Global Trust. The acquisition of Airlie in February added a further AUD 6.3 billion to total FUM. We expect total FUM to increase approximately 7.0% per year towards AUD 98 billion by end 2023, which supports Magellan's healthy earnings profile.

In addition to healthy flows, strong investment performance contributed AUD 8.5 billion to FUM. Magellan raked in AUD 40 million in performance fees, almost twice the prior year's takings, highlighting the manager's continued outperformance of its benchmarks. For example, the Magellan Global Fund returned 16.9% this year, well above the fund's 9% performance objective, supporting Magellan's reputation as a global equities manager.

The Magellan Infrastructure Fund underperformed, however, returning only 6.9% and failing to meet its performance objective of CPI + 5%. Infrastructure represents 15% of Magellan’s business with AUD 10.3 billion FUM. As a result, the proportion of FUM earning performance fees dipped this year to 34%, but we see it returning to the long-run average of 38% next year. Our average base management fee assumption trends downwards towards 60 basis points by 2023 relative to 65 basis points for fiscal 2018.

The strong growth in FUM supported earnings, with top line revenue growth outpacing operating expense growth. Not surprisingly, management fees were the main revenue driver, up 27% during the year to AUD 381 million, while operating expenses, excluding one-offs, were up 20%. In line with these movements, the cost to income ratio fell approximately 200 basis points during the year to 22.7%. Expenses were three times higher than in fiscal 2017 at AUD 130 million, owing mainly to the IPO of Magellan Global Trust as well as greater marketing expenses. Magellan incentivised investors with a bonus 0.0635 units for each unit purchased in the new fund, amounting to issuance of AUD 59 million in free shares. We treat this as well as AUD 29 million in issuance costs, as a one-off. As a result, we expect other expenses to decrease to AUD 50 million next year, and for staff expenses to increase about 10% per year, assuming high-single digit headcount growth going forward. This brings expenses in line with company guidance of AUD 105 million for fiscal 2019.

The standout feature in this result is the revised dividend policy with the payout ratio increasing 20% to a range of 90%-95% of the funds management business NPAT. This highlights the strength of Magellan’s balance sheet and signals a high degree of confidence in their ability to continue generating free cash flow. Given the capital light nature of this business, relying mainly on intellectual capital, we are very comfortable with the ability of management to both maintain this payout ratio and continue to pursue growth opportunities. We increase our expected payout ratio to 92.5% going forward, seeing total dividends per share increase to AUD 1.57 in fiscal 2019 and representing a forward dividend yield of 5.6%.

While this was an excellent result by Magellan we shouldn’t ignore the continued challenges that the industry faces. Competition remains fierce with management fees continuing to face inevitable downward pressure as lower cost options continue to surface and new players enter the market. Furthermore, periods of investment outperformance cannot go on forever, so we expect periods of underperformance going forward. Key person risk remains another concern, which for an organisation such as Magellan, is high, particularly with respect to Magellan co-founder Hamish Douglass, although this is mitigated by our view it remains highly unlikely he will depart.