IOOF: Interim Result 2019

It's been a wild ride for IOOF over the past few months, with proceedings launched by APRA, uncertainty over the ANZ Wealth acquisition and the final report of the Hayne Commission, but the company's interim result showed that underneath it all there's a strong business churning out cash.

Perhaps most importantly, it appears that customers are sticking with the company. Financial advice is a personal business that relies on trust between an adviser and a client rather than an organisation - and it appears that plenty of trust remains in IOOF's advice and platform businesses.

A net $688m flowed onto IOOF's platforms in the half, slightly more than the $617m that flowed in during the first half of the 2018 financial year - before any inkling of the current crisis. The financial advice business saw a net outflow of $176m (compared to an inflow of $1.2bn a year earlier), but that included about $1bn that shifted to direct BT platforms following its recent price cuts. IOOF has launched a new product replicating BT's pricing, and net transfers to BT platforms had slowed to $66m in December.

After all the flows and the market falls in the December quarter, IOOF's funds under management, advice, and administration (FUMA) was unchanged on a year earlier at about $120bn, excluding the funds that came with the purchase of ANZ's advice businesses. Including ANZ, FUMA rose 15% to $138bn.

The group net operating margin declined to 0.17% from 0.23%, but that includes $7.5m of losses (before tax) from the acquired ANZ advice businesses, which IOOF expects to improve over time. Excluding those, the margin fell to 0.21% owing to increased competition and customers transitioning to lower-margin products.

Continued margin pressure

IOOF has always faced pressure on margins but has kept them stable, at an operating level, by consolidating platforms, increasing efficiency and lowering costs. This may be getting harder. On top of the potential problems with the purchase of ANZ's wealth business, IOOF has announced an extra $20m-30m in compliance and regulatory costs, which will be incurred over the next few quarters.

Regulatory changes will also have an impact, with the removal of grandfathered commissions, for example, expected to reduce revenue by $7m. Meanwhile, competition within the industry continues.  

'Underlying' net profit - IOOF's preferred metric - rose 6% to $100m. In truth, though, there's nothing underlying about it, because it includes the $7.5m of pre-tax losses from the ANZ aligned dealer network, as well as a $28.9m coupon payment from ANZ designed to mimic the effect of buying the wealth business. The latter was intended to compensate IOOF for delays but will disappear if the transaction doesn't ultimately proceed. Excluding these things, the underlying earnings dropped 10% to $85m.

Overall, there's plenty to support the contrary view expressed by senior analyst James Greenhalgh when we downgraded IOOF to Sell back in December. The underlying business is still ticking along, albeit with a rattle here and there, and there have been one or two major positives, including an agreement with APRA over licence conditions and the absence of a ban on vertical integration in the Royal Commission's final report.

Risks remain

However, significant risks remain. APRA is still seeking to disqualify five of the company's senior management - three of whom remain in their positions. We have no idea how the proceedings will play out - and IOOF is still standing firmly behind its executives - but it must play on the minds of the ANZ wealth business trustees.

Even if the ANZ wealth acquisition is approved and even if chief executive Chris Kelaher is vindicated by the APRA proceedings, it's hard to see him and chief financial officer David Coulter overseeing the integration of that business - and it's unnerving to think of such a major integration being left to a less experienced management team.

If the ANZ platform purchase doesn't proceed it wouldn't be a disaster. IOOF would receive nearly $800m back from the bank which it could use to buy back shares - perhaps a third of shares outstanding at present levels. The point is that the impact of any fall in earnings might be reduced on a per share basis.

Longer term, though, the business looks like it will remain under pressure. The Advice division will have to absorb the losses from the ANZ dealer groups, and its business model may need to be adjusted to account for changes following the Royal Commission. The Platform division will continue to face margin pressures and tighter regulation can be expected across all divisions.

There's also the threat of class actions and the potential for greater customer remediation - although the company indicated at the interim result that it still hasn't found any more than the $5m-10m already disclosed.

The uncertainties are underlined by a range of broker estimates for underlying earnings per share of 43-75 cents for 2020. That gives a consensus - such as it is - somewhere in the low 60s, putting the stock on a price-earnings ratio of 10-11 for 2020 earnings.

Our downgrade to Sell in December looks badly timed given the stock's near 50% rise since then. However, the decision was based on our no longer having any confidence in our assessment of the stock - so that view, at least, has been comprehensively vindicated.

With the price so much higher and many of the uncertainties remaining, we continue to recommend that you AVOID the stock.