EUR 850.00 For Business Accounts Only

Morningstar | Netwealth Still Overvalued as Fee Pressure Impacts 1H Result

We were surprised Netwealth's share price rose by 7% following its first-half result considering it lacked any big surprises and contained more evidence of fee pressure. As fund flows were announced last month, the market was mainly focused on revenue and profit growth, both of which were broadly in line with our expectations. We have maintained our earnings forecasts but increased our fair value estimate by 4% to AUD 5.50 due to the time value of money impact on our financial model. However, at the current market price of AUD 7.49, we continue to believe the shares are overvalued.

We maintain our full-year dividend forecast of AUD 11 cents, 100% franked, following the interim dividend of AUD 5.5 cents. This leads to a fiscal 2020 dividend yield of 1.9%, or 2.7% including franking credits. We consider these dividends sustainable, representing a payout ratio of around 70% of underlying earnings.

We expect the market was more focused on strong profit growth and that Netwealth remains the most popular of the independent platforms. The company should also benefit from the likely abolishment of "grandfathered" trail commissions, which will reduce switching costs and benefit independent platforms. However, we expect the market is underestimating the long-term impact of price-based competition on earnings growth, particularly as Netwealth lacks an economic moat. We expect platform providers to quickly copy competitor's innovations and the reduction in industry switching costs is likely to impact all providers in the very long term. Notably, management also expects price-based competition to continue.

Although funds under management and administration, or FUMA, grew by 24%, this was well down on the 63% achieved in the previous corresponding period, or pcp. Revenue growth of 19% was worse than FUMA growth and sharply down on the 40% achieved in the pcp. To some degree, this reflected first-half equity market weakness, but we believe the more significant trend is price-based competition-driven fee compression which we expect to continue. Netwealth's revenue margin is falling year on year, illustrating these persisting competitive pressures. The firm's platform revenue/average funds under administration over the half is 49.3 basis points, down on 56.5 on the pcp, and in line with our fiscal 2019 forecast of 49.6 basis points.

We forecast 25% revenue growth in fiscal 2019, implying a normalisation of markets in the second half and a 13% revenue CAGR over the next decade, implying slowing revenue growth as the business matures. This in itself isn't necessarily a concern but Netwealth's price/earnings ratio of 46, implies Netwealth is a high-growth stock, and we don't believe the multiple is supported by our earnings growth forecast.

Although management's underlying EBITDA figure grew by 21% and its EBITDA margin expanded to 51.5% from 50.5%, this was only achieved without the inclusion of certain costs. Although the exclusion of off-off costs is reasonable, the subjective nature of doing so can create earnings uncertainty. Management maintained guidance of flat EBITDA over fiscal 2019 compared with fiscal 2018. Fiscal 2018 EBITDA margins were 50.8%, and we continue to expect fiscal 2019 EBITDA margins of 50.9%, implying a softer second half--notably from rising costs and increased investment. In a scalable business such as Netwealth, margins should be expanding. We continue to expect EBITDA margins can grow to over 60% by fiscal 2023.

From a balance sheet perspective, Netwealth remains in great shape, in part due to the capital-light nature of the business model which enables storing cash flows. The company conservatively expenses software development costs which means cash conversion ratio to EBITDA is strong, with 101% achieved in the first half. The company has no debt and cash balances increased to AUD 45 million by the end of the half.