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Morningstar | Netwealth Remains Overvalued as 2Q Fund Flows Disappoint the Market

We have maintained our earnings forecasts and AUD 5.30 fair value estimate for Netwealth following its second-quarter trading update which was in line with our expectations. Funds under management and administration, or FUMA, fell by 1% versus the prior quarter but were impacted by particularly weak equity markets, including a 9% fall in the S&P/ASX 200 index. Excluding market movements, FUMA grew by 4.8%, versus the prior quarter but we expect the 15% fall in net FUMA inflows was the main cause of the 10% fall in the Netwealth share price. As a growth stock, Netwealth shares are highly sensitive to trading updates and associated growth rates which can cause share price volatility. However, we maintain our fiscal 2019 FUMA growth forecast at 27%, following the first- and second-quarter growth rates of 43% and 24% versus the prior comparable period respectively.

At the current market price of around AUD 7.30, we continue to believe Netwealth shares are overvalued. Although growth slowed in the second quarter, it’s largely in line with our forecasts which assume FUMA growth will slow as the business matures. Over the next decade, we assume a FUMA CAGR of 20% as the company wins market share from incumbent providers and the value of clients’ portfolios grow. However, we also expect competition combined with the lack of an economic moat to result in lower FUMA margins and a corresponding revenue CAGR of 13% over the period. Netwealth shares typically trade on a relatively high price/earnings ratio due to the high earnings growth outlook but our fair value implies a fiscal 2019 P/E ratio of 35, versus a market P/E of around 47. Our fair value also implies a dividend yield of 2.2%, or 2.9% including franking credits, versus 1.5%, or 2.0% including franking, at the current share price.

Management claim Netwealth is still winning customers despite competitors cutting fees, and that the Royal Commission into the financial services sector will be a tailwind for the business. However, the quarterly update looked a little soft relative to key competitors Hub 24 and Praemium which both reported record inflows for the December quarter, albeit smaller in an absolute sense than Netwealth’s growth. Netwealth’s quarterly updates do not include fee or earnings info, meaning it’s impossible to know the movement in the margin earned on FUMA. Surprisingly, the proportion of fee-paying FUA increased to 62.3% from 60.9% in the prior quarter and reversed consistent quarterly declines from 69.3% in the June 2017 quarter. However, this doesn’t necessarily mean that the FUMA margin has also increased and we have maintained our forecasts pending further clarification at the interim financial result on Feb. 18, 2018.

The regulatory landscape remains extremely uncertain with the report from the Royal Commission into the financial services sector due to be released on Feb. 1, 2019. The productivity commission’s report into the Superannuation sector was also released this month and made a range of recommendations, which in turn has triggered much debate and yet further suggestions from a range of interested parties. The federal government’s proposed changes to superannuation, announced at the 2018/2019 Federal budget last May have been passed by the House of representatives but are yet to pass through the Senate and may not be before the next Federal election, to be held by May 18, 2019. However, the consistent theme running through most proposals is that customer service needs to improve, and fees reduced. Greater competition may benefit Netwealth via FUMA market share gains from incumbent providers, but we also expect fee compression to be a significant trend, both due to regulatory pressures and greater competition.