It is difficult to swim against the tide when investing. Even successful investors can pick the wrong investments about 40 per cent of the time. However, being wrong as a contrarian manager packs an extra punch, because everyone ‘knew’ you were wrong from the beginning. But it is also incredibly rewarding, with often outsize gains for the 60 per cent of our investments that end up being right.
As we look around our investment universe today, there is no idea more contrarian than AMP Limited (AMP). The company is a household name for wealth management services, spanning the spectrum of advice, superannuation, investments, insurance and banking. The past year or so has exposed some serious missteps that have legitimately led investors to question the company’s moral compass and the competence of the board.
Previous management appears to have misled one of its regulators and presided over inadequate compliance procedures in its advice business that did not put its clients first. These actions have been publicly scrutinised by the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry.
AMP’s poor practices have already resulted in client remediation costs in excess of $500 million. In October 2018, in an effort to simplify the business, the board agreed to sell AMP’s Life businesses to Resolution Life for $3.3 billion, about $2 billion less than what investors, the market and their own actuaries had thought they were worth.
The recent past has been awful and AMP’s share price has fallen close to 60 per cent over the past year, a stark reminder of the impact unsustainable business practices and poor governance can have on investment returns. Although the past plays a key role in assessing a company’s future, it is only what happens in the future that is important in investing.
As current investors, we have to look forward and move on from the poor decisions by management and the board. AMP’s future is impossible to predict with certainty, but we believe investors have cause for optimism today.
AMP is priced at a much lower multiple of current earnings than the broader share market, but it faces a more uncertain future thanks to reputational damage and structural changes. We outline some of these headwinds below and show that a disastrous outcome for the business would make AMP a poor, but not necessarily disastrous, investment. However, if AMP addresses its elevated cost base then it could be significantly under-priced.
Today one pays very little for AMP’s most troubled division, wealth management, and even a mediocre outcome over time could provide for good investment returns.
A simpler AMP
First, an overview. AMP will have four remaining businesses following the sale of Life:
- Wealth management provides administration services for $130 billion of superannuation and pension assets on platforms that allow investors to transact and report holdings. It also supports 2,500 financial advisers who, while mostly not employed by AMP, operate under AMP financial services licences.
- AMP Capital is a fund manager with $190 billion of assets under management. Sixty per cent of these assets are sourced internally (e.g. from wealth management clients) and 40 per cent externally.
- AMP Bank is primarily a residential mortgage lender, with a loan book of $20 billion and no branches.
- AMP has also retained a wealth management business in New Zealand.
In addition to these operations, AMP will have about $1.4 billion of surplus capital and a further $1.4 billion of income-generating assets received as part proceeds from the sale of Life.
The new management team communicated a ‘rebased’ 2018 financial year underlying profit after tax of $461 million, accounting for the sale of Life, an expected rise in compliance costs and fall in platform fees. This implies ongoing earnings of $515 million if we annualise income on investments, and adjust for planned cost reductions and fee reductions.
AMP’s adjusted market capitalisation of $5.6 billion ($6.4 billion, less an expected $0.8 billion return of capital) implies a multiple of 11 times after-tax profit. This is somewhat lower than the market, but given the headwinds AMP faces it might not be the bargain it initially seems.
A street full of buses
It is the bus you don’t see that is most likely to hit you and, in the case of AMP, we are stepping out onto a busy street. Hazards we see include:
- Reputational damage and adviser departures are likely to elevate outflows from wealth management’s administration platforms and AMP Capital’s fund management business.
- AMP faces mounting obligations under its commitment to act as a Buyer of Last Resort (BoLR) for retiring advisers who want to sell their practice. BoLR prices are above common market rates at up to four times revenue. The banning of grandfathered commissions and new educational standards are likely to elevate the number of retirements.
- AMP Bank faces the prospect of a sharp slowdown in credit growth. The bank has also advanced $580 million of loans to financial planning practices whose outlook as a whole has deteriorated.
- AMP’s fund management and platform administration businesses have benefitted from rising asset prices over the last 10 years, as fees are linked to total assets, but cost bases are relatively fixed. Asset prices may not be as favourable in coming years.
- Platform administrators face fee pressures as they compete for scale, and active fund manager fees are being squeezed by the shift towards passive investing.
- AMP is likely to face more class actions with potentially material settlements being made, some of which may not be covered by their insurance policies in place.
How bad could things get?
One of the worst outcomes for the business would be unprecedented outflows from wealth management (rendering the platforms unprofitable) and a concurrent outflow of internally-sourced assets from AMP Capital (causing its profits to fall by 60 per cent). In this scenario, AMP may also lose some $500 million of surplus capital as it meets elevated BoLR commitments and write-offs on defaulting practice loans at AMP Bank. AMP is priced at about 20 times the resulting profit after tax of about $300 million.
However, the probability of this outcome would seem low and, with the market as a whole (ex-banks) trading at 17-18 times, AMP may not be a disastrous investment if this represents trough earnings and the remaining business is sustainable.
Given these hazards, why would one consider stepping out onto the street? Only if the prospect on the other side compensates for the risk of crossing.
AMP could be very attractive given its earnings potential
There appears to be significant scope to reduce costs within AMP. For example, AMP’s wealth management cost base is approximately 0.47 per cent of the $130 billion of assets under administration (AUA). As seen in chart one, this ratio is equivalent to significantly smaller platform administrators Praemium and HUB24. Yet it is almost double that of Netwealth, which administers one sixth of the assets of AMP, but has displayed the benefits of scale as it has grown.
AMP’s costs are elevated by the loss-making arrangements of supporting advisers that operate under its licences. The status quo is unsustainable, as evidenced by Westpac’s recent decision to withdraw from advice. AMP will have to oversee its licensees more effectively and/or recover the costs of these services.
Management have committed to removing $65 million of post-tax costs after 2020. Were AMP to halve the efficiency gap to Netwealth, post-tax cost savings of $100 million could be achieved. Such savings could increase AMP’s operating earnings by a quarter, with today’s share price implying a very attractive nine times after tax earnings.
Chart 1: Platform providers’ operating costs and assets under administration
Source: Allan Gray and latest company reports
We don’t pay much for any potential upside from Wealth Management
Given AMP’s $6.4 billion market capitalisation we don’t pay much for wealth management. Investment assets received from the sale of Life and other surplus capital are valued at $2.7 billion. If we assume AMP’s operating businesses, excluding wealth management, are worth 12 times profit after tax, they can be valued at $3.3 to $4 billion. Any future value for wealth management is largely upside at today’s market capitalisation. This is shown in chart two.
Chart 2: AMP: sum-of-its-parts valuation
Source: Allan Gray estimates based on AMP Limited company reports
To put this in perspective, Netwealth is valued at approximately $2 billion, despite administering less than 20 per cent of the assets of wealth management!
We believe the possibility of capturing the upside from a rejuvenated and more efficient wealth management business sufficiently compensates for the downside risk that wealth management turns out to be worthless. This is what makes us warily attempt to cross a street full of buses, with AMP now three per cent of the Allan Gray Equity Strategy.
Simon Mawhinney is managing director and chief investment officer of Allan Gray and Tim Hillier is an Allan Gray analyst.