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Morningstar | A Strong Rebound in Markets Sees Modest 2.5% Uplift to Perpetual’s Fair Value Estimate. See Updated Analyst Note from 21 Feb 2019

A major rebound in Australia’s equity market from its precipitous fall in the December 2018 quarter sees a moderate uplift in narrow-moat Perpetual’s fair value estimate to AUD 37.20 per share from AUD 36.30. Australia’s All Ordinary Index has staged a strong comeback since its precipitous circa 10% fall in the December 2018 quarter to be currently about 8% higher. Higher markets than we previously expected should see improved earnings in the second half of fiscal 2019 from the disappointing first half results recorded in both the Investments and Private divisions. Nonetheless, our longer-term forecasts have not materially changed. Our fair value estimate implies a fiscal 2019 P/E of 13.3 times and high dividend yield of 7.2%--despite our forecast of a 5.5% lower dividend in fiscal 2019. These undemanding metrics reflect the continuing headwinds in Perpetual’s Investments division and slowing expected growth rates in its Private and Corporate Trust. At current prices it screens as fairly valued.

We expect Profit before tax, or PBT, in Perpetual’s core Investments’ division to fall by about 14% in fiscal 2019. PBT in this segment fell 20% in the first half of fiscal 2019 compared with the first half of fiscal 2018. However, we think this sharp fall overstates the true decline in performance. Part of the fall is due to an accounting change (AASB 9) which requires fair value changes to now go through the profit-and-loss statement instead of below the line through comprehensive income. The significant fall in markets in the December 2018 quarter led to its financial assets, such as its seed investments, incurring an unrealised fair value loss of AUD 10.1 million. While this new accounting treatment will lead to more volatile reported earnings, if the recent improvement in markets extends to June 30, 2019, this should see much of this unrealised loss reversed in the second half of fiscal 2019. However, a more pressing concern is the continuing net fund outflows.

During the half the company’s core Australian equities division of its Investments’ segment suffered AUD 1.3 billion in net cash outflows mainly from institutional clients. We continue to believe Perpetual will be unable to address these fund outflows in the near term. We think these outflows are primarily due to the structural changes of major superannuation funds in-housing their Australian equities asset management and investors moving into more passive investment styles. More cyclical factors like investor preference for active growth strategies at the expense of Perpetual’s active value strategy and poor medium-term performance of some of Perpetual’s funds has exacerbated the fund outflows. New CEO Rob Adams is looking to address these issues by expanding beyond solely concentrating on its value investment style and embracing new asset classes and investment styles. He also plans to promote a “boutique” culture within its Investments division where portfolio managers will own their strategy without interference from Perpetual. The company will support these managers with their back-office administration capabilities, including a revamped distribution effort.

This new strategy should provide Perpetual a broader opportunity set to grow its underperforming Investments division, but we do not expect this will itself address the fund outflows in the near term. Investors typically require a period of prolonged performance in the order of circa 3-5 years prior to taking the step of investing in a fund. However, the swing factor is the potential for Perpetual to acquire growth inorganically, which management confirms is also part of its new strategy. Perpetual’s strong balance sheet, with gearing (corporate debt/corporate debt plus equity) of 11.6% as at Dec. 30, 2018, is well below its target of 30%. This gives it scope to acquire earnings growth and management is open to the potential for acquisition in all three of its segments.

We expect Perpetual Private’s impressive earnings-growth rate in fiscal 2017 and 2018 to stall in fiscal 2019 and forecast PBT to fall by about 1%. We believe the erosion of trust for financial advisers from the misconduct revealed by the Financial Services Royal Commission will continue to indirectly impact its Private business. Representatives of Private did not appear before the Royal Commission or provide it with witness statements and it did not suffer the brand damage of some other wealth managers. Nevertheless, management observed a reluctance in investors more generally to seek out financial advisers, which may have been exacerbated by recent market volatility. We also expect the fall in markets in the December 2018 quarter impacted market-related revenue. This resulted in PBT in the first half of fiscal 2019 falling by 2% compared with the first half of fiscal 2018. However, we expect the recent rise in Australian All Ordinaries Index to increase market-related revenue and offset some of these losses in the second half of fiscal 2019.

Unlike other wealth managers that cater to the mass-affluent and have a large network of aligned financial advisers such as AMP and IOOF, Private’s advisers are all salaried employees who focus solely on high-net-worth clients. This means Private should not suffer as much from the consequences of likely regulatory changes prompted by the Royal Commission, such as the abolishment of grandfather commissions. Management indicates that its aggregate exposure to trailing commissions among its circa 60 salaried employees is only about AUD 200,000. Furthermore, Perpetual has not, nor does it expect to include a provision for remediation or other costs because of the Royal Commission. The disruption caused to financial advisers by the Royal Commission may also provide it with opportunities to institute its stated strategy to acquire financial advice business or attract high quality financial advisers.

On a more positive note, we forecast Corporate Trust to continue its impressive earnings growth in fiscal 2019. We expect PBT to increase by about 7% in fiscal 2019, following an impressive 13% increase in the first half of fiscal 2019 relative to the first half of fiscal 2018. While we expect continued earnings growth in fiscal 2019, we don’t expect the first-half growth rate to repeat in the second half. Part of the reason for this is that capital flows into infrastructure and property funds stabilised from strong growth rates toward the end of the half. Furthermore, there is the potential for the Royal Commission’s recommendation to disrupt mortgage brokers, which may have an indirect effect on its debt services business. Mortgage brokers are the main distributional arm of non-bank lenders that use Corporate Trust’s securitisation administration services. The disruption to mortgage brokers has the potential to lead to less demand for Corporate Trust’s securitisation services from higher-margin non-bank lender clients. Additionally, we expect a general slowing in systemwide credit growth to also impact earnings in the second half of fiscal 2019.