IOOF Holdings Analysis

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IOOF Holdings Analysis
ASX: IFL
IOOF Holdings makes money by administering wrap accounts. Wrap accounts are pushed by financial advisors and enable you to hold a number of different assets or asset classes under the one umbrella – IOOF tends to refer to these accounts as platforms.  Most people seem to like going through a financial advisor for their investments and they tend to recommend a product like this. IOOF is able to “clip the ticket” on their wraps. This accounts for the majority of IOOF’s earnings. So they are probably more of a software company than a traditional fund manager and part of the reason they are cheap is because some of their software is a little dated.

IOOF also makes money by running funds directly and taking a fee for the management of these funds. They also charge fees by providing financial planners that they operate, and trustee and estate charges. The resultant overlap allows some cross selling as well. Perhaps your financial planner is selling you a fund, a platform for your fund and the possibility to act as a trustee.  An SMSF for example could benefit from this structure and the resultant taxation and investment management.

Quality
In quality terms IOOF Holdings is an above average company.  The reasons IOOF’s quality exceeds the average company on the ASX are as follows:

1. IOOF has pursued a successful rollup strategy for a number of years now. The logic follows that as subsequent businesses are purchased their IT infrastructure can be incorporated into IOOF’s and eventually their platform can be changed to IOOF systems.  Obviously the IOOF is able to pull costs out of the business through such synergies resulting in higher EBIT margins.  Overlap in administrative, legal and accounting services may also improve margins.  Specifically, in regards to quality, IOOF has pursued this strategy carefully.  IOOF does not tend to overpay for acquisitions and their most recent and probably largest acquisition (ANZ Wealth Management) is a classic example.

2. A wealth management company like IOOF doesn’t take financial risk directly. Instead IOOF is charging for the use of their platform or investing customer funds directly and charging commission on the investment.  A significant fall in markets will greatly impact IOOF’s earnings, but assuming markets eventually bounce back the company shouldn’t face insolvency.  Compare this to say a bank, where bad debts can quickly reduce a bank’s equity to zero, because of its enormous leverage, requiring a huge government bailout and effectively reducing shareholder equity to almost zero.  This happened to a number of major international banks during the Global Financial Crisis.

3. Competitive pressures are increasing in this industry. Whilst this would normally be a concern, due to its scale and resultant cost efficiencies, IOOF is set to benefit from this trend by being able to undercut competitors and by making acquisitions cheaper.

Valuation
Approximate values below are my estimates for FY18 (excluding ANZ Wealth Management contribution):
EV/Market Cap = $3.5 billion
Underlying profit/ cash flow = 190 million*
PE = 18
Dividend = $0.55
Dividend yield = 5.5% (fully franked)

On first glance these are relatively uninspiring metrics.  Many better known fund managers are trading on similar or cheaper metrics.  The difference in IOOF’s case is both the added quality from their platform based approach and the impact on this valuation from the ANZ Wealth Management contribution.  Also, due to impairments the underlying earnings figure in IOOF’s interim 2017 report is much stronger

The wrap side of IOOF’s business, which consists of financial advice and platform management, is significant and accounts for 75 to 80% of their underlying profit.  Investment management (FUM fees) and trustee services round out the remainder.  Obviously there is a strong crossover in sales between these divisions and as a result this enhances IOOF’s business model.

The addition to FY19 earnings through the acquisition on ANZ Wealth Management should be significant.  ANZ decided to broadcast the sale of this division, along with their insurance division, before they had a buyer.  Originally ANZ had tried to sell both insurance and wealth management together.  Buyers appeared thin on the ground and as a result IOOF seems to have gotten a good price.  With almost $50 Billion client funds, ANZ Wealth Management was sold for under $1 Billion.  This seems fairly cheap when compared to similar businesses and their market capitalizations if listed.  Lastly, IOOF should be able to obtain synergies from the combined businesses, resulting in margin improvement and higher profits.  IOOF has a long history of successfully integrating acquisitions.

Competitors
Falling margins are apparent right across the wealth management industry.  Whether it be in FUM, advice or platforms and administration, margins are under pressure.  One only needs to look at Platinum Asset Management, perhaps one of the better know, better performing managers.  The business has been under enormous pressure of late and margins have been cut significantly.  However, due to consolidation the long term competitive landscape may be more benign than it initially appears.  Wealth management is undergoing an automation revolution, reducing costs and ultimately it is not just margin contraction, but also cost contraction that is driving savings for the consumers of these products.

IOOF is in a somewhat unique situation of having a large platform/advice business and not being under the auspices of a major bank**.  Apart from BT Financial Group, The Commonwealth bank has a significant Wealth Management division which may be a spinoff in the future.  The resulting business environment is somewhat fragmented with IOOF emerging as one of the market leaders and in a very strong competitive position.  Scale is essential in this business and a much smaller business would still need to have a significant IT spend to maintain their platforms.  This enables a larger business such as IOOF to have higher margins and a clear competitive advantage.  Arguably, scale is less important in the FUM and advice, but IOOF can still utilise network effects here by packaging these products in a wrap account.

Summary
IOOF is a good quality company that tends to be more insulated from financial markets than a typical fund manager.  Make no mistake, if financial markets fall IOOF earnings will be under pressure.  However, due to the secondary order of impact on the advice and platform parts of the business, the impact may not be as extreme.  This give the business a better earnings visibility than many other financial facing businesses and as a result IOOF should trade on a higher multiple.  When the acquisition and resultant earnings from ANZ Wealth Management are factored in the multiple is in fact lower than most other similar businesses.

Currently it appears as if the market doubts the ability of management to successfully integrate this acquisition and extract synergies.  Considering IOOF has done this multiple times in the past, it seems likely that they will be successful again.  Herein lies the opportunity, as even if the integration is moderately successful, the business will be cheap.

IOOF is trading at an attractive price for a patient investor.  Over the next three to four years earnings should increase by a material amount.  IOOF estimates integration costs of $130 million and an increase in earnings of more than 20% by FY2021.  IOOF will also form a strategic retail alliance with ANZ, gaining access to up to 5.6 million retail customers and 0.5 million business customers.

IOOF should grow its earnings significantly over the next three years and earnings could be in the order of 30-40% higher than they are today, making this an attractive investment at current valuations.

* Due to IOOF’s strong cash conversion, cash flow tends to closely follow underlying profit and indeed this makes the 30 million impairment figure in the 2017 interim report less of a concern – i.e. in this case it appears to be an accounting loss, rather than the cost of doing business.

**BT Financial Group was a Westpac Spinoff in 2007

Disclosure: IOOF is held in a portfolio managed by the author of this article.