Pressure on revenue margins could cap Netwealth's profitability despite strong flows.

-Funds under management up 12.6% for the quarter and 50% on the year-
-First half net inflows up 125% from a year earlier
-Brokers see falling revenue margins with downward pricing pressures

The outlook is mixed for Netwealth ((NWL)), with strong flows boosting the company's investment platform business despite very competitive pricing pressures and low interest rates putting downward pressure on revenue margins, according to brokers.

Some stockbrokers say falling margins will cap profitability, while others expect the strong flows to continue to the independent Netwealth as the vertically integrated companies exit the wealth management business, benefitting the more nimble and independent players.

Netwealth recently announced strong growth in funds under administration (FUA) to $28.5bn in the second quarter of financial year 2020, up 12.6% for the quarter and a jump of 50.2% on the previous calendar period.  Netwealth reported net inflows of $2.9bn during the quarter.  For the first half, FUA net inflows totalled $4.4bn. Highlighting strong growth since its IPO in 2017, that represented an increase of $2.4bn or 125% compared to the first half of FY19.

Funds under management (FUM) jumped too, climbing to $5.7bn, up $1.3bn or +9.4% over the previous quarter. Managed Account assets were $4.4bn at the end of the second quarter, an increase of $1.3bn or 40.6% since the end of the first quarter. The company recorded Managed Account net inflows of $1.2bn during the quarter.

Given stronger than expected flows and rising share markets, Netwealth increased its FUA outlook for FY20 to $32bn, up from $30bn previously. The shares initially rallied on the result, buoyed by the strong flows, closing at $8.20 before settling to around $8. Bell Potter has a price target of $10.50.

Citi is one of the most upbeat brokers on Netwealth. The platform provider is attracting the highest flows in the industry, which it sees as a reflection of the strength of its platform offering from a technology, functionality and service perspective. Citi sees further upside to Netwealth's earnings and forecasts $34bn for FY20. "We see guidance as conservative and see upside risk to near term earnings from better than expected flows and forecast 3-year EPS growth of 24%." Citi has upgraded it FY20-22 profit estimates by 3%-4% to reflect stronger than expected flows, and set a new target price of $9.65.  

Bell Potter is also very upbeat, suggesting Netwealth is benefiting from the unwinding of the large vertically integrated companies, leading to "the exit of advisers in the hundreds per month from the formerly large fully-integrated organisations." The Royal Commission into misconduct in the financial service industry has helped to accelerate this shift from old incumbent products and platforms to the more modern and independent Netwealth, enabling it to achieve faster growth. 

While Bell Potter acknowledges that price competition will cap Netwealth's profitability, nevertheless, "we see this as a major competitive advantage to NWL as they have a relatively small adjustment to make to its back-book versus the likes of AMP/IFL/BT Panorama/Macquarie/Colonial/MLC, and its newer more efficient technology can better capture the benefits of scale."

However, other brokers aren't so optimistic given declining margins. Macquarie Wealth Management says its "expectations are that the upgraded FUA does not materially change profitability." While Netwealth's opportunities to increase market share remain robust, recent pricing arrangements mean long-run revenue margins will fall to 30 basis points or below and cash account fees look unsustainable. That will likely see Netwealth's share price fall, with Macquarie the most downbeat with a $6.00 target price.  "We struggle with valuation on NWL given the implied value in optimistic outer year and terminal earnings." 

Morgans says Netwealth is an attractive business, benefiting from strong leadership and high cash generation. However, short-term pressures exist around pricing and the potential for a lower RBA cash rate. The broker is maintaining a Hold recommendation with the stock trading near its valuation of $8.05.  Furthermore, it is forecasting around a -30% fall in revenue margin to 33bps in FY22 from 48bps in FY19, driven by downward fee pressure, a lower cash allocation and lower front book pricing due to competition and a shift in back book to front book pricing.

UBS has the stock as a Sell with a $7.65 price target. Netwealth has cautioned that the stronger FUA outlook won't result in a significant change to its profitability given the pricing pressures - new client wins are being priced below the retail rate card combined with back book transitions to new pricing and accelerated cost reinvestment. As a result, despite upgrading net flow outlook to $9bn in FY20 and $8bn in FY21, the broker's earnings forecast is relatively unchanged.

Jarden too expects Netwealth to underperform, forecasting around a -30% fall in the revenue margin to 33bps in FY22 and a price target of $7.40. It is predicting a fall in revenue margins with pressure on fee revenue due to greater competition and lower cash allocations. The cash allocation fell to 7.0% (spot) in the first half from 8.2% (average) in the second half last year, "which implies a -1.7bps drop in the revenue margin (full period impact)."

Even Citi is forecasting a decline in margins of 13bps to 36bps in FY22 due to competition from incumbents and new platform players representing a risk, though stronger flows till prop up Netwealth's earnings.

According to FNArena's database, the consensus target price is $7.82, suggesting -5.7% downside to the last share price of $8.29. Targets range from $6.00 (Macquarie) to $9.65 (Citi).

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