Perpetual: Crisis averted?

In the 2003 annual report, then Perpetual chairman Charles Curran said, ‘The new managing director will be expected to lead the Perpetual team into a stage of further expansion, capitalising upon our strong position as a leading fund manager and corporate trustee’.

Curran’s new managing director turned out to be David Deverall, and we now know how that ‘further expansion’ worked out. Which is to say, not well.

In 2011, Chris Ryan was appointed to fix Deverall’s mess but his softly, softly approach was a bit too soft, at least for the board. Geoff Lloyd took his place and launched a new strategy last month, titled ‘Transformation 2015’, which includes selling Perpetual’s mortgage processing business and cutting another $50m (or 18%) from the cost base.

Does this presage a buying opportunity? The cost cuts are larger than we expected but still possibly conservative, and perhaps damaging. How can one cut 18% from the cost base of a people business without damaging morale?

Cost-led turnaround?

Nor can one turn around a business like this with drastic cost cuts alone. Perpetual needs to arrest the decline in funds under management (FUM). In 2012, another $4.1bn leaked from the company’s bucket, with FUM finishing the year at $22.6bn, down from $39.0bn in 2007.

That won’t be easy. Retail investors are still loath to invest in equities. Too little money has been coming in to Perpetual’s funds, and too much leaking out. Neither is likely to change in the near term. The advancing age of unitholders in its flagship Industrial Share Fund also means this important fund is seeing more money leave than enter.

Then there are the legacy issues. Perpetual is gradually winding down its mortgage funds and, while these are lower margin products than equities funds, another $750m will leak from FUM over coming years. And who knows how much money might migrate to John Sevior’s boutique funds management venture when he throws open the doors.

So, cost reductions are necessary. But they’re not enough to overcome the revenue erosion Perpetual faces.

You can see this in the accompanying spreadsheet. Without a market surge, average FUM—and therefore revenue—is likely to fall in 2013. Cost reductions should start taking effect beyond that, but a sustainable upturn in profit depends on outflows stabilising and, eventually, a market recovery.

Depending on whether you’re more bullish or bearish, you can enter your own flow estimates and market movements into the yellow cells of the spreadsheet. Chart 1 however, shows that, in recent years, it has paid to be bearish on outflows.

Not cheap enough

The stock is not sufficiently cheap to buy yet, although we’ve lifted the prices in the recommendation guide to reflect the positive effect of the cost reductions. Eventually, we suspect a bank or financial services giant will acquire Perpetual. The tailwinds of Australia’s compulsory superannuation system are still blowing, but the company needs the distribution muscle of a much larger outfit.

While cost reductions are a step in the right direction, the risk of significant outflows remain. With the share price up slightly since 25 Jun 12 (Hold – $23.70), there’s just enough reason to remain a shareholder, assuming you understand the risks of the situation deteriorating further. HOLD.

Download the accompanying spreadsheet here.