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Morningstar | The Precipitous Market Fall Drives a Reduction Perpetual’s Fair Value Estimate. See Updated Analyst Note from 21 Dec 2018

The precipitous fall in the Australian All Ordinaries Index since June 30, 2018, and the expectation of future tightening of credit drives a reduction in narrow-moat Perpetual Ltd.'s fair value estimate to AUD 36.30 per share from AUD 44.50. We now forecast underlying net profit after tax, or NPAT, for fiscal 2019 of AUD 120.7 million, down from our previous forecast of AUD 136 million and fiscal 2018 NPAT of AUD 139.0 million. At our fair value estimate the stock trades on a fiscal 2019 P/E multiple of 14.2 times and has a dividend yield of 6.7%.

Since June 30, 2018, the Australian All Ordinaries Index has fallen more than 10%, which has led to our forecast for market related funds under management, or FUM, in Perpetual’s core Australian equities division falling 10% in fiscal 2019, from the previous forecast of a 6% increase. While we expect a gradual recovery from these levels, we believe market-related FUM to grow by a lower compound annual growth rate, or CAGR, of 3.8% over the next five years, compared with the previous forecast of 6%. About 70% of its funds in its core Investments division are invested in Australian equities and about 65% of its revenue in its newer Private segment is also linked to the performance of the market. Consequently, the company is highly sensitive to Australia’s domestic equity market, even more so because its Investments division is facing the structural headwinds of a trend to passive investment styles, and industry superfunds in-housing asset management, exacerbated by poor short-term performance.

We also forecast continued fund outflows by investors, mainly institutional investors, from its core Investments divisions increasing to a CAGR of 5.8% over the next five years from the previous 4%. The recent increase in market volatility, along with the share price correction and increasing likelihood of interest rates remaining lower for longer may provide the environment for better performance for the company’s value investing style. However, we expect a prolonged period of improved performance will be required to stop the fund outflows from its predominantly domestic-equity funds. We also expect the strategy of industry superfunds in-housing asset management to continue, leading to continued institutional outflows.

Given the structural headwinds faced by its core Investments division, it has been relying on higher market values and strong earnings growth from its new financial advice business or Private, plus its debt markets services and managed funds businesses, or collectively Corporate Trust. However, we believe the lower markets will also impact its Private business. The lower markets will have a direct impact on the funds under advice as well as a likely indirect impact of less potential customers seeking out financial advice. This will also likely be exacerbated by the Financial Services Royal Commission.

Perpetual Private has not faced any direct fallout from the Royal Commission, but we expect the egregious level of misconduct by financial advisers revealed by the Royal Commission will have a negative impact on the reputation of financial advisers more generally. Combined with a reduction in market related revenue from the recent fall in markets, we expect underlying profit before tax, or PBT, in this division to fall to AUD 40.8 million in fiscal 2019, from AUD 46 million in fiscal 2018.

We expect more modest growth in its Corporate Trust segment in fiscal 2019, with the Royal Commission likely to negatively impact this division as well. We expect the Commission to foster a period of continuing tighter credit conditions that we believe will lead to lower residential mortgage-backed securities being issued, particularly from the banks. However, we expect this may be partly offset by non-bank lenders, which generally generate higher margins. Nevertheless, lower asset prices from the recent market correction in both the equity and property markets is likely to also impact its earnings from its managed funds services business. The Royal Commission should also foster a greater focus on compliance in its custody and responsible entity services in its managed funds business leading to higher operating costs. In combination, we forecast PBT growing by 4.6% in this division in fiscal 2019, much lower than its recent growth rates, including the 16.4% growth in fiscal 2018.

One major positive for the company is its strong balance sheet. The company’s gearing ratio (corporate debt divided by corporate debt and equity) in fiscal 2018 was a low 11.6%, much lower than its target gearing of 30%. Notably, new CEO Rob Adams joined Perpetual on Sept. 24 and has a mandate to examine fresh opportunities that are emerging as companies assess the impact of the Royal Commission. Some of the likely outcomes from the Royal Commission include organisations more directly impacted by the Commission selling off parts of their businesses. This may provide Perpetual with the opportunity to inorganically increase earnings via acquisition of businesses at depressed prices.