M, I don't usually post negative thesis because as you point out...

M,

I don't usually post negative thesis because as you point out they are quite unpopular due to biases that investors have. I am not a holder (and i'm not a shorter) but in the interests of debate in my mind the answer to your questions depends on what the outcomes of the royal commission are (will be known Feb 2019). In my mind there are quite realistic (likely) scenarios in which IFL profits would not be sustainable at current levels. Some of which is due to laws that already exist.

If you asked IFL management :

Question 1: What would be the effect (in hard dollar terms) if trustees were no longer able to allow advice fees to be taken from superannuation (because it has been found widespread charging of fees for no advice and this breaches the sole purpose test)?

Answer: I am guessing slightly but the answer would pretty dire for IFL. Financial advice contributes 41% of IFL's UNPAT. For the sake of the exercise if you ask your financial adviser or a number of financial advisers what would be the impact on their business if they could no longer charge their fees through superannuation and instead had to get the client to write a cheque how would this impact their profitability? I would say the answer is "our profit would decline substantially" (30% possibly higher). Revenues might drop by say 20%.

You can then debate the likelihood of this occurring. Even if there is no legislation (unlikely) trustees will now view this as their own obligation to enforce (as they are the ones breaching the sole purpose test when they take money from superannuation).

There are other permutations such as "What would be the hard dollar impact on IOOF if clients had to positively opt in to allow the fee?" (I would say this is bare minimum the trustees will allow). And even this may have a substantial impact on the financial advice side of the business (profit to decrease by say 10-20%). There are many other variations that play out but essentially I personally think the market is questioning the sustainability of the current profit levels.

Question 2: Looking at the second largest part of the business (platforms - 42% of UNPAT) where does IOOF see margins going in the future and how can IOOF keep its margins high when competitors (BT) are cutting margins in the industry and legislation (best interest duty) compel advisers to select products that are in the best interests of clients? If you look at margins in the US there is no margins for "platforms" - they are free.

Answer: The legislation (best interest duty) really mandates competition across the industry such that never existed before. I think the legislation as it exists today is designed to ensure that high margin products don't exist (from a policy standpoint this makes sense for Australia) and the obligation according to the legislation is on the advisers to ensure this doesn't happen. If you google ASIC 515, ASIC 562 report for example what you find is that this legislation isn't doing the job it is designed to do not because the legislation is wrong but just that it isn't being policed adequately. Ironically, because most of the policing should be done by the AFSL (which just happens to be owned by IOOF) so conflicts of interest are at play.

Putting aside any remediation or litigation that may come out of past activities (speculation) going forward I think there is a strong likelihood that margins across the industry will be permanently lowered as legislation is enforced (lower margins is what policy makers want). Whether IOOF re-price the entire book or they bring out a new "on-sale" lower margin pricing that they need to keep the distribution is probably the question. While I don't think profits in this division will be impacted as quickly as their biggest division I can't see margins staying where they currently are in a sustainable way over the next say 10 years.

Potentially the question is: If you had to compete for every dollar with BT for example what would the new margins of this part of the business look like? And if best interest duty was policed aggressively how long do you think you would retain the back-book at high margin (best interest duty puts an obligation on the adviser to review the product on review so if the IOOF product fee is a legacy fee (high margin) and the client can clearly save $5,000 by switching to the new product with a lower fee (BT) then the competitiveness in this system is different to say making an old insurance book a legacy book (because it doesn't actively get priced by consumers).

Valuation wise while it has come off it is still not being priced like a legacy book of business (ex growth). The market is still pricing in growth and sustainability of margins which in my mind is much less likely. If I had to value IFL today I would value it about the same as Australian banks at the moment. That is - priced ex-growth with risks that could / may play out that would adversely impact the sustainability of current profit levels but are hard to quantify.