I have looked for the first time into IFL over the past couple...

I have looked for the first time into IFL over the past couple of days and here are my first impressions:

1) The vast majority (84% ca) of Revenue appears to be, essentially, derived as a fixed (fee-driven) percentage of Funds Under Management, Administration, Advice and Supervision (FUMAS).

2) The level of FUMAS is, at any given point in time, a “mark-to-market” value, based on the prevailing market price of the underlying securities; as such, it is subject to all the vagaries of “Mr Market”.

3) The overall composition of FUMAS is heavily skewed towards Equities (50% ca, as of June 2017, half of which non-Australian), the remainder consisting mostly of Fixed Income, Property/Infrastructure and Cash.

4) The Cost base is largely fixed, with employee-related expenses amounting to 23% ca of revenue (pre- ANZ WM acquisition).

Therefore, before factoring in the impact of new fund inflows and acquisitions, the equity of IOOF (i.e. the IFL stock) can be viewed as an in-the-money call option on the market value of FUMAS, which is essentially a broad, equity-heavy “market index”.

In order to get a sense of how in-the-money this option is (i.e. where it is struck), I looked at the breakdown of Revenue in the 2017 AR, which shows that 760m$ out of 908m$ Total Revenue is “Management and Service Fees” (charged, presumably, as an explicit percentage of FUMAS). The Gross Profit being 183m$, it follows that a move down in the mark-to-market of FUMAS by 183m$/760m$ = 24% would be enough (before fund inflows and acquisitions) to wipe it all out, i.e. to send the Gross Margin down to zero.

In the grand scheme of things, a -24% move in equities (especially international equities), bonds and property looks far from unrealistic, given the prevailing valuations across asset classes relative to historicals.

Therefore, while the current PE valuation of IFL may look cheap (once the impact of the ANZ WM acquisition is factored in), it should be kept in mind that this is only relative to the present, market-implied value of FUMAS. Shift that level down by (for argument’s sake) -12% and the implied PE is already doubled. So, there is a roughly 4-to-1 leverage to the level of FUMAS embedded in the stock, everything else being the same.

While I have assessed that I do not feel comfortable enough to own the stock at its current price, given the structural market risk described above (and despite the remarkable track record of the Company’s Management in delivering acquisition-driven growth), I do find the asymmetry of the risk/reward profile attractive.

So, having ascertained that there are listed options on IFL available on the ASX, and that they trade at an undemanding 20% implied volatility (certainly not an outrageous price to pay, given the underlying market volatility and the 4x leverage to FUMAS), I have so far decided to allocate a modest 0.25% of my total investable capital to the purchase of a 3-month, 2%-out-of-the-money call option on IFL.

A call on a call, so to speak, it doesn’t get more leveraged than that, but that’s also its beauty (a +13% move in the SP would be enough to quintuple the value of the option, purely in intrinsic value terms).
It is also a hedge on the market value of the Company while I do some more serious due diligence on it and determine whether I actually want to own some of the stock or not.

All IMHO, for discussion purposes only, etc.
All comments welcome, I’d be grateful if anyone could point out any important fundamental aspects I might have missed so far.
And perhaps someone will find some food for thought in this slightly alternative take on things.

Cheers