Taking the wraps off IOOF

After reading John Addis’s revelations about the financial services industry last week (see The financial planning quagmire from 16 Jun 14 and Six questions for your financial planner from 18 Jun 14), you’d be forgiven for wanting nothing to do with it.

But there is another way. If you’ve ever thought, between snarls, that this must be a good business to be in, then you’d be right. So here’s the ultimate hedge against those that would take a piece of your portfolio – you own a piece of them.

There’s no better way to gain exposure to the broad sweep of the wealth management industry than IOOF Holdings, which clips the ticket on savings as they pass through the hands of financial planners, wrap accounts, fund managers and trust administrators.

Our history with IOOF goes back to Australian Wealth Management (AWM), which was on our Buy list before the two companies got together in 2009 (see this chart for further details of IOOF’s complex genesis). Following the merger we moved our positive recommendation over to IOOF in Australian Wealth merger with IOOF on 30 Apr 09 (Long Term Buy – $3.76), but suggested members take some money off the table on 24 Feb 11 (Take Part Profits – $7.95).

The price promptly fell to around $5 before recovering to $8–9 in late 2012 and holding those levels ever since. The difference now is that the stock’s underlying value looks much higher, with 2014 earnings per share likely to be about 25% greater than in 2012 and the outlook continuing to brighten, particularly with the planned takeover of SFG Australia.

The company splits itself into four divisions – Financial Advice and Distribution, Platform Administration, Investment Management and Trustee and Estate Services – and, while the funds under advice, administration, management or supervision (FUMAS) are split fairly evenly between them, with about $30bn in each, just over half of 2013 net profit came from Platforms.

It's a wrap

The Platform division runs the various ‘wrap accounts’ that house customers’ investments. Wraps work by collecting money from lots of people, to whom they offer extensive investment options – different managed funds investing in the whole range of assets, both locally and overseas, as well as direct shares. By bundling people together, wraps can wield greater power with fund managers, thereby pushing costs lower. They also take some of the administrative burden away from planners, enabling the good ones to focus on giving good advice and the bad ones to do what they do.

Naturally in return for all this the wrap takes a fee, which is now quite a lot bigger than those charged by the planners and fund managers. After deducting commissions and other direct costs, IOOF’s Platforms division made a net revenue (known as ‘gross margin’) of 0.70% of FUMAS in 2013, compared to just 0.24% for the planners and 0.26% for the fund managers.

That gross margin has been trending lower over the past few years, from 0.75% in 2011. That’s partly due to pressure on fees and partly due to the economies from increased scale, with Platforms’ FUMAS increasing 12% to $27.2bn since 2011 (thanks to acquisitions, organic growth and increased asset prices).

In a sense these are two sides of the same coin – fees are under pressure precisely because there are scale benefits from administering more money, and the competitive environment is doing its job in delivering a chunk of these back to customers. With its track record at acquiring and consolidating platforms, IOOF is leading the way.

It’s not doing it out of the kindness of its heart, though, because, while the gross margin percentage has been coming down, the profit margin (profit before tax as a percentage of the gross margin) has been going up, from 41% in 2011 to 47% in 2013. As a result IOOF’s overall profit on the platforms it administers has remained pretty stable, edging up from 0.30% in 2011 to 0.33% in 2013, maintaining its share of the increased pie – and giving it the incentive to keep doing what it’s doing.

Investment management in reverse

Investment Management is also a scale business, although here it’s been happening in reverse, with FUMAS falling from an average of $32.0bn in 2011 to $29.2bn in 2013. While the gross margin on this money has remained stable (edging up from 0.25% to 0.26%), the profit made on that gross margin has fallen from 69% to 51%, leaving IOOF with a profit before tax of 0.13% of the FUMAS in 2013 compared to 0.17% in 2011.

As with Platforms, Investment Management FUMAS is intricately linked to markets, although here it is overlaid by the flow of investment funds – people are much quicker to switch investment funds than they are to switch platforms.

Fund flows have been disappointing for IOOF’s main manager, Perennial Investment Partners, and this division’s FUMAS fell 6% in the three years to March 2014 despite the improvement in markets. We’ll be watching the performance of this division closely, but with it contributing only about a quarter of net profit, it is not the main game.

The Advice business doesn’t scale as well as Platforms and Investment Management, since each financial planner can only deal with so many clients. These planners provide IOOF with a gross margin of 0.11% of the FUMAS they advise on, about half of which is paid out in costs, to leave the company with a profit of about 0.05% of FUMAS.

The importance of this division goes beyond the money it makes, however, because the planners provide the funds for the platforms. No doubt this is why IOOF has been investing in this area, with the acquisitions of DKN Group and Plan B driving relatively consistent annual growth of 21% in FUMAS and 29% in net profit over the past three years.

Sitting slightly outside of all this is the Trustee division, which advises on and administers trusts and estates. A respectable 33% profit margin makes this a decent business, but the 0.07% of FUMAS that it earns in gross margin makes it a small one. In all it made a net profit of 0.02% of its FUMAS in 2013, which amounted to just 7% of the group total.

Master of consolidation

All the divisions require little capital, which results in excellent cash flow. Before acquisitions, free cash flow has averaged around 90% of underlying net profit over the past 3 years. After acquisitions, that figure falls below 50% (it was only 6% and 35% in 2012 and 2013 due to the purchases of DKN and Plan B), but the company has maintained a 90% payout ratio by taking on more debt.

Normally we’re wary of acquisitions, but there are exceptions to every rule. Platform administration is a scale business, so it makes sense to pull lots of them together and consolidate people onto larger platforms. This isn’t as easy as it sounds, but chief executive Chris Kelaher has done it successfully time and again, first with Select Managed Funds, then with AWM and now with IOOF.

What’s more, he’s done it, by and large, without issuing more shares – save for the big mergers between Select and AWM, and then AWM and IOOF. He’ll soon be issuing more shares, though, to buy SFG Australia, with a scheme of arrangement expected to complete in August.

Again this deal makes sense, with SFG adding 32% to Platform FUMAS and 42% to Advice FUMAS. The combined company will be the third-largest advice group in Australia, behind AMP and Commonwealth Bank, with $45.6bn of FUMAS (IOOF is currently placed fifth and SFG eighth).

SFG’s advice business focuses on higher net worth clients and boasts average FUMAS per adviser of $75m – more than twice IOOF’s current figure of $34m. As a result, margins are higher, with the group making profit before tax of 0.19% of its FUMA in 2013, compared to 0.12% for IOOF (excluding the trustee business, which is less comparable).

The downside is that IOOF is having to pay a multiple of 20 times SFG’s 2013 underlying earnings, so that IOOF shareholders will be diluted by the issue of 22% more shares. But an anticipated $20m of additional profits from the merger (from lower costs and greater cross-selling opportunities) should ensure that two plus two equals five.

Risks from regulation and technology

Sharemarket volatility is the greatest threat to profits in the short term, as a major fall would reduce both FUMAS and margins, leading to a double whammy on profits. But over the long term savings are certain to grow, both due to economic and market growth and an increased requirement for saving – manifested in the increase in compulsory superannuation up to 12% of earnings by 2022.

So, over the long term, the greatest threat to IOOF is that it doesn’t get its share of this, or that the value it is able to provide – and the margins it’s able to earn – are substantially reduced. The most obvious danger here is from regulation, which was in the news again on Friday, when Acting Assistant Treasurer Mathias Cormann confirmed the Coalition’s planned changes to the Future of Financial Advice (FOFA) reforms.

It’s hard to figure exactly how all this will play out, and it’s probably not worth trying too hard – because the one certainty is that the rules will be tinkered with again and again. The longer-term picture is that regulation will need to balance two somewhat conflicting imperatives: to encourage us to save enough to fund our retirements; and to enable us to do it fairly and efficiently.

With encouragement in the bag thanks to compulsory super, both major parties appear ready to address the second imperative. With the FOFA reforms, the former Labor Government seemed to be prioritising fairness, but the Coalition seems to want to move the dial back towards efficiency.

Whichever way it goes, we doubt that either side would want to make life too difficult for IOOF, as the main alternative to AMP and the banks. Platforms also seem likely to continue to form part of the solution (although more on this in a moment), helping to create efficiency and freedom of choice. There are issues over conflicts of interest between advisers and wraps, but because there are no performance issues, they’re of a different intensity to the conflicts between advisers and specific product providers.

The other major long-term risk is obsolescence. Try though we might, it’s hard to see a world without financial advisers and fund managers, but it’s not certain that wraps will remain a popular way to organise it all. If technology enabled more efficient ways for customers and planners to access fund managers, then no doubt they’d take them.

Whatever that technology is, however, there seems a fair chance that IOOF will be leading the way in developing it, and earning a margin for its efforts. Indeed this is a key plank in IOOF’s strategy – to cover plenty of bases, so that however the savings industry is structured in future, it will be in a good position to help drive the changes and turn a profit in the process.

Attractive price

There are undoubtedly risks to IOOF’s business, which is why we’re giving it a maximum portfolio weighting of 5%, but we think they’re bearable and the current attractive price is ample compensation.

So what about that price? Well, if the company makes the consensus forecast for 2014 of 52 cents of earnings per share, then the stock would currently sit on a multiple of 16, which is not at all bad for what we’d estimate as mid- to high single-digit growth prospects.

It looks better still in terms of cash and dividends. If we assume that 90% of earnings come through as free cash (before acquisitions), then the free cash flow yield is over 5%. The fully franked dividend yield is likely to match that given the company’s payout ratio of 90% (which is why we're adding a holding to our model Income Portfolio – see details below). These numbers could fall a little if the company spends heavily on acquisitions, but of course acquisitions would likely increase the growth prospects.

With IOOF’s improved prospects, particularly in light of the anticipated merger with SFG, we’re upgrading our Buy price from $6 to $9 (a forecast 2014 multiple of 17) and our Sell price from $9 to $14 (a forecast 2014 multiple of 25). That brings the current share price well into the Buy range. Remember, however, that profits can be bouncy in this business and so, therefore, can share prices. It would probably make sense to start some way below our recommended portfolio limit of 5% to leave room for a top-up in case of further weakness. BUY.

Note: We're adding 800 shares in IOOF at $8.28 each to our model Income Portfolio.