Across client portfolios that have elected the ‘Blend’ AEQ option, we have been implementing the following changes over the past 2 days:

• Selling AMP and Seek.  The sale of Seek is ongoing because current trading volumes have prevented us from selling the total shares needed without negatively impacting the price; and
• Buying IAG

Once the sale of Seek has been completed we will start buying Perpetual only for client portfolios that have nil holding in the company.  Due to current trading volumes we expect that these purchases will need to be done over a number of days.

IAG purchase

IAG is a general insurer with controlled operations in Australia, New Zealand, Thailand and Vietnam.  The Group also has joint ventures in Malaysia, India and China.  In Australia and New Zealand (“A&NZ”) it is one of the two largest domestic general insurers with well-known brands and high market share. Gross written premium (“GWP”) across the various businesses is approaching $10 billion. The Group has recently finally exited its struggling U.K. business to focus on its core business in A&NZ and its Asian strategy.  The UK business represented c. 6% of GWP but its profit contribution was immaterial.

We like IAG for the following reasons:

• The strong GWP growth which the Group has enjoyed over the past 18 months has continued into the 2^nd half of this year with further positive momentum expected going into 2014 as premiums are raised again. Management has guided to top-line revenue growth of 5-7% which will support margin expansion;
• Earnings certainty has been increased due to the purchase of A$100m peril reinsurance cover in excess of the already conservative natural perils allowance of 7% of net earned premium (i.e. A$640m).  A period of low catastrophe costs could result in higher dividends;
• The NSW compulsory third party (“CTP”) reforms (which had been expected to negatively impact Group GWP by -4 to -5%) have been removed given the government’s inability to pass the legislation;
• Trends in the Asian business are very positive with the franchises making a reasonable profit contribution in FY13 following very strong growth.  While still only a small contributor to overall profitability, these businesses will increasingly be factored into valuations of the Group as they continue to expand; and
• The domestic industry duopoly continues to act rationally and remain disciplined on pricing as they balance margins vs. volume.  This is illustrated by the fact that IAG has put the Queensland CTP book of business in run-off as it was uneconomical.

General insurance is of course an inherently risky business with adverse weather or catastrophe events which could cause significant claims losses beyond the control of management.  In our view IAG has however largely mitigated this risk via its existing reinsurance and peril allowance provisions.

PPT purchase

Perpetual is an independent and diversified financial services group providing specialised investment management, wealth advice and corporate fiduciary services to individuals, families, financial advisers and institutions.  The company has a strong reputation amongst financial planners and the investing public following the consistently strong performance of its products over the long term.

We like Perpetual for the following reasons:

• Lower fixed costs from the Transformation 2015 project will lead to better operational leverage in an improving environment where revenue grows;
• PPT has improved its sales and distribution capability, increasing its position on platforms, approved product lists (“APLs”) and model portfolio APL’s, as well as receiving several fund rating upgrades. This will help to drive an improvement in net inflows which could increase faster than system inflows;
• Margins in Perpetual Investments stand to benefit from changes in the mix of assets managed as investors switch from cash (lower margin) to equities (higher margin).  Any gain could be partially offset by the need to sacrifice some margin to access platforms and APL’s;
• Strong balance sheet and cash generation enables accretive acquisitions.  Corporate Trust earnings would benefit from the acquisition of the Trust Company if Perpetual is permitted to do it. This would bring significant scale, strength in fund services and geographic diversity; and
• The compulsory superannuation system provides regulated growth in the medium to long-term.  Perpetual Investments should benefit from this as they enjoy strong brand recognition while continued strong asset management performance saw a number of investment strategies receive initial or upgraded ratings from asset consultants in FY13.

The largest drivers of Group revenue are the level of FUM within Perpetual Investments and FUA within Perpetual Private, both of which are heavily influenced by the level of the Australian equity market. Any stall in the market recovery will pressure net FUM outflows and revenues i.e. Australian equity markets are a key risk, but also the key source of earnings leverage.  Given the leverage to equity markets, earnings can be volatile.

AMP sale

AMP has significant operations in funds administration, funds management, financial advice and life insurance. AMP’s flagship wealth management operations are the largest in Australia and New Zealand with a network that includes around 4,200 aligned and employed financial advisers and planners.  It is the largest domestic life insurer in Australia and the Group’s funds management business, AMP Capital Investors, currently has FUM of circa A$130bn.

While AMP is well placed to take advantage of the growing pool of superannuation assets, enjoys strong brand recognition and has an excellent distribution network, we decided to sell AMP due to the following:

• Wealth Protection is experiencing negative margin pressures due to higher than expected claims and policy lapses in the life book. Uncertainty remains around the success of management initiatives to address these, with the risk of further lapses in excess of current allowances skewed to the 2^nd half of the year due to annual age and CPI rate increases;
• The Group continues to lose market share with the latest insurance industry data showing that AMP had the lowest in-force premium growth amongst the ten largest players, with growth in the June 2013 quarter on the prior comparable period less than half the market average;
• Leverage to higher FUM in Wealth Management in the first half of 2013 was slightly disappointing due to higher rebates paid to fund managers and product/fee mix changes as new inflows move onto lower fee platforms;
• AMP Capital fund flows continue to disappoint, with the mature book driving outflows; and
• The announced $320m (pre-tax) investment over the next 3 ½ years to achieve business efficiencies and strengthen its competitive advantage will be excluded from underlying earnings.  When this cost is added to the $550m (pre-tax) related to the AXA integration and compliance costs which AMP has also charged ‘below-the-line” (i.e. excluded from underlying earnings), it raises questions around the adequacy of AMP’s recurring project/investment spend.

While AMP will also benefit from continued improvement in equity markets, has a very strong balance sheet able to withstand further one-off costs and the possibility exists that the margin pressures on the life book have peaked, in the near term we prefer exposure to the general insurers (i.e. IAG) which enjoy better pricing power and/or a purer play asset manager (i.e. Perpetual) offering greater operating leverage to increased FUM levels given our still positive view on equity markets.

SEK sale

Seek is Australia’s leading employment website and also has two non-employment businesses domestically,  SEEK Commercial which allows users to browse for business and franchises for sale and SEEK Learning which assists jobseekers with career development by providing vocational education through partnerships with leading training providers.  Seek has also bought minority stakes in dominant online employment sites within developing markets with large populations and low Internet penetration which represent longer-term opportunities for expansion.

Despite its dominant domestic position, robust cash generation and the attractive growth options offered by the international investments, we decided to sell Seek due to the following:

• The core Australian classified job ads business has reached maturity and offers limited growth potential.  Despite the increasing contribution from the international businesses, the domestic employment business remains the largest contributor to Group profit;
• The volume of domestic online job advertisements remain under pressure with the latest ANZ Job advertisement series having declined for six consecutive months, with jobs ads now only 5% above the lowest level reached during the GFC;
• The weaker online advertising market is inhibiting Seek’s ability to pass on price increases – prices across its Australian employment products have been increased by an average 5.5% for FY14 versus average increases of 8-10% during 2010/11 and increases in excess of 10% pre-GFC; and
• International experience suggests that competition from new entrants such as LinkedIn are limiting the pricing power of incumbents even once the job market starts recovering.

While the risk obviously exists that we are overly pessimistic on the outlook for the domestic employment business and are underestimating the potential growth from the international businesses, with consensus FY14 EPS growth of 14.4% and the shares trading at 24.7x forecast earnings we see significant downside risk should earnings disappoint.

Disclaimer

EP Financial Services Ltd

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