IOOF-Australian Wealth Merger A Win-Win

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This story features INSIGNIA FINANCIAL LIMITED.
For more info SHARE ANALYSIS: IFL

By Chris Shaw

Severe declines in equity markets can have a long lasting impact on fund managers, as weak fund flows can continue for several years.  That’s why the proposed merger of Australian Wealth Management ((AUW)) and IOOF Holdings ((IFL)) makes sense, as according to Merrill Lynch, the deal provides scale and cost efficiencies, which are important for earnings.

The broker notes the deal offers as much as $20 million in cost synergies in year one, an outcome it suggests is achievable given the amount represents only 10% of the combined group’s cost base. It also doesn’t include revenue synergies, which the broker suggests are likely to be achieved in the funds management operations in particular.

The deal, which will see IOOF issue one share for each 3.73 AUW shares, appears a win-win scenario to ABN Amro. On its numbers AUW shareholders will enjoy earnings per share (EPS) accretion of 50.4% and IOOF shareholders 55.6%.

It should also set the companies up to generate strong operating leverage in coming years in the broker’s view, which leads it to suggest synergy targets may prove to be conservative over time. Credit Suisse half agrees, seeing the merger as value accretive, but questioning whether the $20 million in synergies in year one will be achievable given it implies the cost ratio at IOOF will fall from around 75% to in line with AUW at 55%. This target is a stretch, in the broker’s view, as it points out AUW has a good track record in terms of cost control.

Overall, Credit Suisse sees the rationale behind the deal. It estimates the merged stock would offer solid relative value given it would be trading on a P/E (price to earnings ratio) of around 8x compared to the peer average of 11x at present.

According to ABN Amro, the merger proposal has less risk for AUW shareholders, as any rival bidder would cut IOOF out of the deal while increasing the price paid for AUW. However, Merrill Lynch notes there appears little chance for any competing bid to emerge.

To reflect this view, ABN Amro has upgraded Australian Wealth Management to Buy from Hold, while at the same time upgrading its recommendation on IOOF Holdings to Hold from Sell reflecting recent share price moves. Credit Suisse rates both as Outperform, but takes the view the deal favours IOOF shareholders slightly. On its numbers, the new company would effectively be a 70:30 split in favour of Australian Wealth Management despite that company contributing 75% of earnings to the merged entity.

Post news of the merger proposal, Citi has upgraded IOOF to Hold from Sell as well. The broker points out the benefits of the merger proposal will help offset the cuts made to stand alone earnings forecasts for the company due to expected falls in the level of funds under management.

According to the FNArena database, Australian Wealth Management is now rated as Buy twice and Hold four times with an average price target of $1.04. This is down from $1.40 prior to the deal being announced, as brokers have adjusted earnings and targets to take account for weak markets and poor fund flows.

As an example, Macquarie has taken 20% and 24% respectively from its numbers in FY09 and FY10, while Merrill Lynch lowered its forecasts by 15% in both years.

The database shows IOOF is rated as Hold five times and Buy twice, with four of the Holds being upgrades from Sell ratings post the news of the merger proposal. The average price target on the stock falls to $3.69 from $4.57 and this again reflects lowered earnings estimates given falling funds under management. Citi is a stand out, cutting its earnings numbers by 21% in FY09 and 38% in FY10 as an example.

Shares in the two companies are moving in opposite directions in early trading and as at 11.00am, IOOF Holdings shares were up 31c or 9% at $3.61 while Australian Wealth Management shares were down 1c at $0.88.

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