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Morningstar | Pendal’s Disappointing 1H19 Prompts FVE Reduction; Magellan and Platinum Under Review

The transition of coverage to a new analyst and a precipitous fall in earnings prompts a reduction in narrow-moat Pendal Group’s fair value estimate to AUD 8.30 from AUD 10.30 per share.

We also place Magellan Financial Group Limited and Platinum Asset Management Limited Under Review while we transition coverage to a new analyst.

First-half fiscal 2019 underlying net profit after tax, or NPAT, was 26.6% lower than the previous corresponding period, or pcp. The compounding impact of lower average funds under management, or FUM, and margin contraction exacerbated by historically low performance fees from subsidiary JO Hambro Capital Management, or JOHCM, generated the sharp fall in earnings. JOHCM’s performance fees were a major disappointment. At only 2.5 basis points of FUM, they were well below the 16 basis points weighted average achieved over the last five years and management’s previous expectation of averaging 20 to 25 basis points. The prolonged delay in finding key management personnel for JOHCM, along with poor fund performance and its exposure to U.K. and European equity markets means we don’t expect a major rebound in performance fees in the near term. At our fair value estimate, the company trades on a fiscal 2019 P/E of 15.6 and dividend yield of 5.5%.

The disappointing average FUM decline, lower base management and performance fees, declining margins along with changes in our methodology to include employee share rights in our calculation of Pendal’s diluted share count leads to a reduction in our forecast fiscal 2019 underlying earnings per share, or EPS, to AUD 0.53, from AUD 0.61. The major fall in global equity markets in the first quarter of fiscal 2019 prompted investors to exit risky assets, leading to net outflows especially in its European equity strategies. Although global markets have since rebounded and the company is seeing early signs of some fund inflows into risky assets, we expect fund flows from the U.K. and Europe to be subdued due to continued risk-aversion from Brexit and growth concerns. We also expect fund inflows into its Australian strategies will continue to suffer from the ongoing structural change in Australia’s financial advice industry following the 2018 Royal Commission.

The reputational damage done to Australian financial advisors generally and major Australian advisor dealer groups focusing on retaining and remediating customers as opposed to writing new business is likely to reduce the fund flows from this channel. Pendal’s diversification strategy helped alleviate the fund outflows from its equity strategies especially in Europe, emerging markets and Asia, with the chase for defensive assets resulting in net inflows into its cash and fixed income strategies. However, these are lower fee strategies and the change of FUM mix led to fee margin compression of 2 basis points. Although Pendal has proven relatively successful over recent years in maintaining its margins, we think its first-half 2019 margin contraction is precursor for future margin pressures.

We believe future lower margins will result from the trend of investors demanding lower-fee passive investment strategies, including index funds and ETFs, institutional investors in-housing some asset management and near-term poor performance of its funds, with only 36% of its funds achieving first or second quartile performance rankings over one year and only 47% over three years. Poor near-term fund performance is also likely to prove a headwind for future FUM growth, with investors typically requiring evidence of strong fund performance prior to taking the step of investing in a fund.

Corresponding to weaker top line growth, operating expenses fell by 13% from the pcp to AUD 140 million. This was largely led by reduction in variable staff costs of AUD 24 million. On the other hand, fixed costs (which represent over 50% of total costs over the half) were up by 10% to AUD 70.7 million, which management guided towards an increase of 5%-7% for fiscal 2019. We think that it will be challenging for the asset manager to aggressively trim down costs in the face of managing Brexit risks and its pursuit of growth. Accordingly, we believe costs will continue to trend up over the long term, with our operating margin assumptions reflective of this. It will be critical for Pendal to increase FUM and improve performance, as the downside alternative will see costs progressively eat into the bottom line.

Pendal Group’s balance sheet remains in a pristine condition, supported by strong cash flow generation. A historically upwards trending net cash position has allowed management to deploy cash into its seed capital investments, which sits at AUD 238.9 million, up from AUD 68.7 million in March 2015. With zero leverage on the balance sheet, net tangible assets have also increased to AUD 324.7 million from AUD 105 million at March 2015. Despite the drop in interim 2019 dividends to AUD 20 cents, we believe that the target payout ratio of 80% to 90% of cash EPS remains sustainable over the long term.