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Uncertainty Prevails At Link Administration

Australia | Jun 03 2019

Earnings uncertainty for Link Administration is heightened and the stock is expected to trade at a discount to valuation for some time.

-Downgrade to FY19 earnings as Brexit uncertainty continues
-Lack of clarity on cost impact from superannuation changes
-Structural growth story remains intact, FY20 likely trough

By Eva Brocklehurst

Dysfunction in the UK resulting from Brexit and changes to Australian legislation have sideswiped Link Administration Holdings ((LNK)) and earnings predictability has taken a hit. Investors are also concerned about the quality of information provided by the company, and the stock is expected to trade at a discount to valuation for some time.

The company now guides to operating earnings for FY19 in the range of $350-360m, around -9% below prior consensus estimates. Two major aspects contributed to the downgrade, the Brexit overhang on sentiment, which particularly affects Link Market Services and the soon-to-be-disposed corporate and private clients business.

A large portion is also attributed to higher costs and revenue headwinds in funds administration as some superannuation funds are pre-emptively applying regulatory changes occurring from July 1 for account consolidation in FY19.

The delay in Brexit to the end of October appears to have hurt the company in ways it was not expecting and it is unclear if other factors are at play as well. For example, Link Market Services in the UK has won a number of IPO mandates that have subsequently been postponed because of Brexit.

The main impact of the Protecting Your Super legislation, designed to pass inactive accounts to the Australian Taxation Office, was due in FY20 but initial transfers are occurring in FY19 to facilitate early consolidation. There are also further costs from increased call centre activity and client migration activity.

Citi lowers estimates for earnings per share by -12% in FY19 and -16% in FY20. The downgrade was predominantly because of one-off factors and largely outside the company's control, yet, combined with the lack of revenue growth in funds administration, the issues provide cause for doubt and Citi downgrades to Neutral from Buy.

The investment briefing in London on June 18 will more than likely have a positive spin and focus on the potential in fund solutions and opportunities available in UK workplace pension schemes as well as the expansion into Luxembourg, Citi suggests. The company is also expected to emphasise growth opportunities in banking and credit management. Whether this will be enough to sway a sceptical investor base remains to be seen, the broker adds.

Morgans also highlights uncertainty, noting the funds administration impact from client migration activity and higher resourcing costs will not fully roll off until around the end of October.

Cost Savings Critical

A period of elevated costs and reduced visibility is likely. Higher costs are expected to continue until at least October but the company has not been prepared to disclose the level of additional costs incurred so far. Citi accepts there is some reluctance because of difficulties in predicting the levels of member engagement but finds it disappointing nonetheless. Several other brokers agree that some of the reasons behind the downgrade were not explained adequately.

Credit Suisse observes Link Administration is joining a growing list of Australian financial service companies that have downgraded recently, affected by difficult operating environment, elevated costs and regulatory changes. While the magnitude of the impact on earnings is greater than the broker expected, Link Administration is still expected to offer earnings growth if it can successfully achieve its targeted cost savings.

While envisaging significant valuation upside in retaining a Buy rating, UBS acknowledges realising value could take some time and there are concerns around management credibility in setting reliable expectations. While management's disclosure on the size of the cost impact from Australian regulatory changes was quite ambiguous, Morgans still envisages longer-term upside from acquisition synergies, expansion for Link Asset Services and growth in PEXA.

The company will need to engage in renewing contracts with its five largest superannuation fund customers over the next two years, commencing with AusSuper where the existing contract ends in December. While the risk of Link losing contracts outright is low, Citi concedes it will be a source of investor concern until the decks are cleared. The broker suspects the initial market reaction to the downgrade was overly dramatic but points out solid growth in Australian funds administration has failed to materialise.

Long-term Value Remains

Macquarie also recognises the stock is unlikely to re-rate in the near term yet maintains an Outperform rating as there is fundamental value in the stock. The broker forecasts a recovery in Link Market Services revenue growth in FY21 from improved market activity.

Morgan Stanley is disappointed with two downgrades in as many years but considers the stock cheap and the structural growth story intact. The operating environment in Europe appears to be more cyclical than previously considered and the broker does not find the trading update changes its view regarding funds administration.

The funds administration business is currently over-earning, Morgan Stanley assesses, given the number of superannuation accounts is likely to decline by around -30% and  because outsourcing businesses are inherently deflationary in the longer term. Yet the FY19 downgrade is largely a 6-9-month pulling forward of the impact of reforms and the broker assumes revenue should trough in FY20.

FNArena's database shows six Buy ratings, one Hold (Citi) and one Sell (Deutsche Bank). The consensus target is $7.18, signalling 24.7% upside to the last share price. This compares with $8.06 ahead of the update. Targets range from $6.00 (Citi) to $8.20 (Morgan Stanley).

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