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Forming a bearish view on well-run companies benefiting from powerful trends is never easy. And it’s even harder when those companies, which you previously liked, delivered big returns.
That is true of Netwealth Group and HUB24, the star providers of independent investment platforms. Netwealth, the larger of the two, soared from a $3.70 issue price in November 2017 to a 52-week high of $9.99. HUB24 raced from about $1 in late 2015 to a high of $15.40.
I liked both stocks. They were among the few winners from the Financial Services Royal Commission, with more financial planners expected to move away from the banks and towards independent models of financial advice, and products and services, via the platforms.
Long term, the fintechs are prime candidates to increase their market share in funds under advice through their platforms and are capable of getting to 5% in a large, growing market (Netwealth’s share at September 2018 was 2.2 %).
Some good judges I know last year estimated HUB24 and Netwealth were attracting 30% of all new net fund inflows via investment platforms, such was the strength of the franchises. On their growth, the market share target looked feasible and both companies were beneficiaries of Australia’s expanding superannuation pool.
Rapid growth in funds under advice would translate into sharp earnings growth and declining valuation multiples in future years. At one point, Hub was on a PE of around 70 and Netwealth was above 50 – valuations more akin to hot information tech stocks. The multiples reflected the quality of Netwealth and HUB24 and their earnings growth potential.
But every stock has its price. I became bearish on HUB24 and Netwealth for The Switzer Report in June 2018, nominating them for a special issue on stocks to sell.
I said at the time: “With both stocks more than doubling over a year, and with sentiment (in terms of HUB24 and Netwealth) from the Royal Commission peaking, early investors should lock in some profits. My hunch is they will be able to buy back into both stocks at lower prices later this year or next and get cheaper exposure to the trend towards independent financial advice and platforms.”
HUB24 has fallen from $13.55 at the time of that story to $11 early this year and has since recovered to $12.10. Netwealth slumped from $9.02 in June 2018 to $6.40 earlier this month and now trades at $7.87. Both stocks have lost their status as market darlings in the past year.
Not yet. HUB24 and especially Netwealth are getting closer to value territory and deserve a place on portfolio watchlists. Both are good companies with good prospects. But their recent earnings results suggest ongoing share-price weakness and it is hard to identify a re-rerating catalyst this year. A larger recovery will take time.
HUB24 reported underlying net profit of $3.1 million for the first half of FY19, up sharply on the previous corresponding period but well below market expectations. Underlying earnings (EBITDA) of $5.4 million also disappointed. The market needed higher growth to justify HUB24’s high valuation metrics.
Strategically, there was a lot to like about HUB24’s performance. It attracted $2.1 billion of net inflows in the first half of FY19 and funds under advice grew $1 billion to $11 billion.
But operating costs rose to support the growth in funds under advice and there is a fear that HUB24’s growth rate in funds under advice will return to more normal levels in FY20. Slowing growth in funds, combined with a step change in operating costs and capital expenditure, would make it harder for HUB24 to achieve the high earnings growth needed to justify its valuation.
An average share price target of $14.11, based on the consensus of six broking firms that cover HUB24, suggests the stock is materially undervalued after recent price falls. I am not as bullish and expect analysts to downgrade their earnings forecasts and price targets this year.
Macquarie’s 12-month price target of $9.90 looks more realistic. If Macquarie if right, HUB24’s total shareholder return over 12 months will be minus 18%.
Macquarie wrote this week: “The counter argument to our view is that the selloff has created an attractive entry point. However, the step change in cost growth, capitalisation and lack of visibility makes this difficult, as shareholders are now invested in a company resizing its operating costs post-Royal Commission.”
I have a broadly similar view. HUB24 is getting closer to value after falls in the past six months but there is further go to. Moreover, the expected increase in operating expenses and capital expenditure adds to the risk profile. For a stock already on an estimated FY19 multiple of 66, on Morningstar’s numbers, there is not even the slightest room for earnings disappointment.
Chart 1: HUB24
I was more comfortable with Netwealth’s recent half-year result and believe it offers the better value of the two, although not a sufficient margin of safety to buy just yet.
Netwealth reported 19% growth in total income to $48.2 million for the first half of FY19 and EBITDA almost tripled to $23.7 million on the same time a year earlier. Almost 33% growth in operating cash flow was another highlight.
There is much to like about Netwealth in the medium term. The company has a strong balance sheet and is debt free. Cash flow conversion is a highlight and cost control is good. Netwealth is well run and rapidly building its market position in funds under advice (it ranks ninth). It continues to gain share in an $806-billion market that is shifting towards specialist platforms.
In short, Netwealth delivered a solid result in challenging markets. Investors liked the result, driving Netwealth 7% higher, although it is still well down on peak prices in 2018.
The main problem is margin compression. Netwealth’s first-half FY19 revenue margin were below market expectations. The second half usually has lower margins than the first for Netwealth and the risk of margin contraction – and weaker earnings growth – is rising.
Like HUB24, Netwealth is reinvesting to support a larger business. It is short-term pain for long-term gain and a strategy that portfolio investors should welcome. But with it comes higher risks and less earnings certainty for a business trading on a high valuation.
An average share price target of $8.55, based on the consensus of eight broking firms, suggests Netwealth is modestly undervalued at the current $7.87. Morningstar values the stock at $5.50.
The consensus is probably right. Netwealth offers some value at the current price but with earnings risks slanted to the downside (relative to market expectation), I wouldn’t buy for now.
Price-based competition will become a bigger headwind for investment platforms and their earnings growth in the next two years. Netwealth’s margins may have further to contract.
That does not mean Netwealth shareholders should sell their stock. But I wouldn’t rush to buy more of it just yet, given short-term uncertainty for investment platforms and high valuations.
Chart 2: Netwealth Group