Netwealth’s (NWL) all script offer for Praemium (PPS) this morning follows Hub24’s 97% script offer for Class (CL1) two weeks ago in what is a much anticipated consolidation of the industry. PPS has rejected the NWL offer as undervaluing it on several grounds and it will be interesting to see if HUB joins the fray or lets NWL take what will possibly be an uncatchable lead in the financial platform industry.

At NWL’s current share price $17.15 the 1 NWL share for every 11.96 PPS script offer for PPS is worth $1.43 with a possible upside should the sale of the UK business provide more than $50m. PPS shareholders would end up with 14.8% of the combined business.

The talk with PPS is that once the UK business was sold it would be an attractive take over target, but it seems NWL has chosen to act pre-emptively to this and opportunistically given HUB is going to be distracted by the CL1 acquisition. A cunning move by NWL, but it looks like the PPS board is awake to this and still hopping to create an auction with several bidders.

Grab the popcorn and get comfortable…

NB: the takeover was discussed at the beginning of The Call today (Gary Glover & Howard Coleman)

Disc: I own PPS and CL1

I have updated my previous valuation for the full year results just released and the likely impact of the sale of the International business and will walk through the key assumptions of the valuation attached and any changes to previous valuation assumptions. 

IV = $1.40 (19/8/21 - base case), up from $1.30 (16/4/21)

Assumptions (details in straw):

·         Sale of Int Business: We have no indication of likely valuation of this business, but could guess a sales multiple or split of the PPS value on a ratio of sales which would give us around $90m, but then we need to also ask what is done with those funds (distribute/acquire/spend).  So, I am going to assume that the funds are invested to replace the sold FUM and Sales.  Either by generating organic or acquired growth to replace the FUM and sales of the International business but at the better operating performance of the Australian business.  Hence, I assume FUM and Sales are replaced (about the same time for simplicity) but operating costs improve by 7m which would be the savings if the International business was operating at the same EBITDA% as the Australian business.

·         FUM: Growth from inflows and market value increases provides for high rates of growth for many more years and a high level of base growth on a perpetual basis.  This is part of the attraction of the business model.  I see projections of FUM dubbing by 2025 and tripling by 2030 as modest.

·         Sales: To grow in line with FUM, but at a reducing rate due to margin squeeze in the industry.  At 18% of average FUM in FY21 I seen this drifting to as low at 14% by 2030.  This is something to keep an eye on as it is a drag on the benefits of high FUM growth.

·         Margins: Currently at 70% but pre-Powerwrap acquisition it was 80%.  I am looking for it to return to the 80% level by 2028 and stay there going forward.  Competition will put pressure on margins but this impact is factored in with reduced Sales/FUM.  Scale and systems improvements should assist in reducing COS% and increasing margin.

·         EBITDA: Banking a 7m drop in Opex from the sale of the International business and setting Opex growth at 75% of sales growth, EBITDA% reaches 40% by 2024 and high 40% by end of the decade due to operating leverage from high margins.  Management indicate Opex will grow modestly going forward, so better EBITDA margins are possible but I expect heavy investment in growth and maintaining product relevance.

·         Capex: Mostly in the form of capitalised software development costs it was $7.2m in FY21, I have this growing at 5% at a flat rate as an arbitrary assumption.

·         Cash & FCF: FY21 was the first negative FCF cash flow year in over 5 years, there is debt but a positive net cash position of +$13m.  I expect positive FCF to return in FY22 and for the business to maintain adequate cash holdings but a large acquisition my require a capital raise which I assume will be EPS accretive so will ignore.

·         Share count: currently just over 500m, I allow for a 1% growth from ESOP.

·         Discount/Terminal Value: Assume a long-term average market return rate of 10% as a discount rate.  Due to the favourable long term growth economics of the business model, I assume a Terminal Value based on a 5% perpetual growth rate which is around an EV/EBITDA of 13 and a P/E of around 20.

·         Risks & Opportunities: Those I adjust value for are:

o   Regulatory Risk (-5%): Downside risk of regulatory changes that impose additional costs or limit growth to PPS and the industry.

o   Reputational Risk (-5%): Downside risk of PPS specific issues around security, legal matters or high profile issues with customers.

o   Acquisition Opportunity (+20%): A premium that allows for PPS being acquired and also for PPS to make EPS accretive acquisitions it’s self.

Conclusion

PPS may be a take over target on sale of the UK business, if not I expect it to continue to acquire growth in FUM from any sale proceeds, using these to generate better returns in the Australian business and enhance value. This is the principle reason for an increase in my IV from $1.30 to $1.40.

Management is experienced, the new CEO is a solid choice and skin in the game is reasonable at around 5%.  I am banking on them maintaining the competitive offering they have with appropriate investment and to use capital well – issues in this area would be a red flag.

I have held PPS since early 2019 at an average price of $0.46 and plan on continuing to hold at current prices and information.

Attached is my results analysis that highlight key points and the ASX announcement which mostly distracts from them. I will run through the result, but it seems that the market (me included) expected profit growth from favourable operating leverage resulting from revenue growth given a significant increase in FUM.  The share price movement reflects the disappointment but it’s not all bad.

FY and H2 Results:

·         FUM: updated in July it’s up 105% YoY, excluding the Powerwrap acquisition it’s still up around a very healthy 64%.

·         Revenue: Up +29% YoY, +38% PCP and +7% HoH, did not grow at the rate FUM grew.  This has been dropping as the attached table shows from 0.41% FY19 to 0.25% FY20 now 0.18% in FY21.  Last year’s drop was due to low revenue VMAAS increasing as a % of FUM, but this year it is down despite VMAAS down as a % of FUM, so the addition of Powerwrap seems to be the driver.  The drop is expected but it being due to Powerwrap FUM additions was unexpected.

·         Margin: down to 70%, -9.1% YoY, -10.5% PCP but in line with H1.  Again, Powerwrap is the reason, it’s cost to provide is significantly higher than the Praemium product, which is hopefully something that can improve… Margin $ up 15% but I want to see it increase in line with or ahead of revenue growth of 29%.

·         EBITDA (Underlying): Flat YoY, the additional 5.8m in Gross Margin $ was eaten away by additional operating costs – growth spending.  Thankfully we have a comment on this that provides some reassurance of improved operating leverage going forward: CEO Anthony Wamsteker stated “…I am confident that the need for the expense base to grow as fast as revenue was a one-off in this year of transition and that underlying EBITDA will resume growing at a rate that is well above the rate of revenue growth…”

·         Net Profit: 1.5m, down from 4.9m last year is mostly attributable to higher depreciation and amortisation (up 3.4m YoY), some of this is due to intangibles acquired from Powerwrap, but most is increased capitalised database and software costs generated internally.

·         Cash and Cashflow: Cash is up 10.7m to 26.7m but debt is up 13.6m so net cash is down -2.8m to a balance of 13.1m which is plenty of cash, but the issue is the -1.3m in FCF for the year Vs +7.0m last year.

·         Conclusion: Profit and cashflow going backwards due to reduced margins and increased costs is in contrast with the expectation that high growth rates would see operating leverage lead to profits and cashflows growing faster than revenue.  HOWEVER… the margin drop has been stable both halves of the year, so it is reasonable to expect that the Powerwrap addition impact is baked in.  Also, if we believe managements assertion that expense growth will drop below revenue growth going forward, then we can accept that favourable operating leverage will return.  We are also waiting for a sale of the UK business, in addition to a welcome cash injection it should improve the profitability of the business overall given it’s EBITDA contribution is -3.9m in FY21 Vs Australia which is +19.0m…

Valuation Implications

I will update my valuation this week, at this stage the impact is lower cash flows from FY21 of around 7m and a flow on effect from this.  However, I will need to look at how much they may get for the UK business and how it’s removal will change the future cash generation capacity of the business.  FUM growth looks solid, it’s about how much they can profit from it!

Praemium released it’s June 2021 quarterly update today (attached) with flashy figures to report, but note that YoY figures highlighted are cycling against pre-Powerwrap acquisition figures, so overstate organic growth.  None the less QoQ growth of 10% in FUA is very good. Also announced was the decision to divest it’s international business (included in the attachment) which has failed to achieve scale for the market and been an anchor on performance.

Currently up 13% to $1.10 it is still short of my valuation of $1.30 which I will review once the full year financials are out and hopefully progress is made on the sale of the international division.  We may also have a takeover offer appear soon, any interest parties may wish to strike before a take over premium on the current price becomes too expensive.

I have held PPS since early 2019 at an average price of $0.46 and plan on continuing to hold at current prices and information.

Details for Praemium valuation just posted.