IOOF takes its lumps

When we saw IOOF management on Friday last week, they were clearly surprised by the reaction to last week's interim profit announcement – although chief executive Chris Kelaher did suggest he was getting used to it.

As we explained in our update following the result, the stock fell almost 10% after the company reported a fall in its gross margin to 0.58%, from 0.62% in the preceding half, and a fall in the net operating margin to 0.30%, from 0.32% in the preceding half.

In that review, we said that the gross margin fall ‘would be fine if customers were simply migrating to cheaper, more efficient platforms, because it should push operating costs down' but then noted that costs were flat.

In fact, management has been at pains to point out that this is exactly what has happened – it's just that the gross margin impact of customers switching is immediate, whereas the cost impact has been delayed. In this case customers of Bridges (one of IOOF's advice businesses) have been moved from The Portfolio Service to the flagship Pursuit platform.

That has enabled them to reduce their fees – driving down the gross margin – but it will also enable IOOF to reduce costs by about $5m–6m a year, although little of that was seen in the December half. It should all be flowing now, though, with the result that all things being equal the net operating margin should tick back up by around 0.01% in the second half.

Chris Kelaher is of the view that the net operating margin is only one of the numbers to look at when judging IOOF's performance and the transfer of Bridges clients supports this point. Not only is there a timing difference between gross margin and costs savings, but he also expects it to drive future fund flows and ultimately support profits. ‘Pursuit is a far more contemporary, far more flexible platform for those [Bridges] clients,' said Kelaher, ‘and we expect funds to grow significantly in response to that'.

Impressive flows

Fund flows were certainly a highlight of the result, with $401m of net platform flows (compared to $383m and $147m in the preceding two halves). That contrast with experience elsewhere in the sector, with AMP reporting disappointing flows in its latest result and Morningstar suggesting that, industry-wide, platform flows fell 40% in the year to September 2016.

Flows into the advice business were also impressive, with a net $865m flowing in, compared to $542m and $741m in the preceding two halves. Management put that down to ‘high adviser retention and attraction', noting ‘record levels of interest in IOOF advice groups', including ‘30 applications from new advisers from other institutional licensees'.

And this comes after AMP revealed it had lost 570 (or 16%) of its advisers in the December half. It's fair to say that Chris Kelaher was unconvinced by the excuses given by AMP (of the reclassification of some advisers and the retirement of others).

Advisers, he said, were ‘leaving the big guys above us', attracted by the flexibility offered by IOOF's open architecture (whereby advisers can offer other non-IOOF platforms) and its less bureaucratic nature. This obviously bodes well for future fund flows, but we'll have to see if it translates into a higher net operating margin.

There were other factors depressing this result. For one thing, this was the first period that took the full impact of the lower pricing on MySuper. Non-core disposals also reduced underlying net profit by $3.3m compared to the prior comparable period.

Champing at the bit

So IOOF continues to drive efficiency from within, albeit with lumpy results and no obvious increase in earning power, but management is obviously very keen to make another large acquisition. There have ‘never been more [merger and acquisition] opportunities' for IOOF, enthused Kelaher, before singling out ANZ's wealth business as a particularly juicy target. Full details of the sale process for this business are due by the end of February and Kelaher is clearly champing at the bit.

In regard to funding, he noted IOOF's current net debt of just $15m. That represents about 7% of underlying earnings before interest, tax, depreciation and amortisation, but the company would be comfortable with that ratio up as far as 150% (suggesting net debt of around $300m).

Kelaher explicitly stated, though, that for a deal the size of ANZ Wealth, the company would need to use a mix of debt and equity. We'd be fine with that – for the right deal at the right price, and Kelaher has a first-class record of making and integrating acquisitions – but it certainly adds some risk.

When we first upgraded IOOF on 23 June 2014 (Buy – $8.28) – with a Buy price of $9 (the same as before the latest announcement) – we felt the company offered 'mid to high single-digit annual growth prospects'. So far, over three years, based on the new consensus forecast of 54 cents for the current year, we'll have got earnings growth of about 1% a year.

That's not a disaster for a stock churning out a fully franked dividend yield of around 6%, but it's also not what we'd hoped for. We agree that this result wasn't as bad as the market seemed to think, but we're nevertheless happy with our lowered price guide and will stick with that. HOLD.

Note: The Intelligent Investor Growth and Equity Income portfolios own shares in IOOF Holdings. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.