I think the IFL investment thesis is very simple:
There are four cylinders in the IFL Earnings Engine:
1. Margin
2. Market Movements
3. Fund Flows
4. Acquisitoons
Over time, secular pressure on Gross Margin hurts IFL's Revenue line by 4% or 5% pa.
This is offset by market movements that add 6% to 7% pa, and fund Inflows that add a further 3% pa.
Meaning that you've got ~5% pa secular growth in the top line.
Given the operating leverage in the P&L means that translates into 6% pa or 7% pa growth at the NPAT line.
On top of that, every other year they make an acquisition, which adds 5% or 6% growth in that year, in other words adding a further 2% pa or 3% pa NPAT growth.
And then there's the 5% pa dividend yield.
Adding the above gives you a 13% pa to 15% pa total investment return.
That's the thesis which has held to be largely evident for most of the past decade.
However, every now and then there's a perfect storm when things don't go exactly according to the script.
In the case of the DH2016:
- the margin pressure fell by 7.5%, (~250bp negative variance from the theoretical model... at the top line)
- the average level of the market was largely unchanged (up just 2%, so ~400bp negative variance from model ... again, at the top line) and
- no acquisition earnings or acquisition-related synergies were being cycled through the result (~250 bp negative variance at the bottom line)
In other words, 3 out of the 4 cylinders in IFL's engine weren't firing in DH2016.
Adding the impact of all of those negative variances together gives you the 17% NPAT crunch that we saw today.
(Remember, two of occur at the Revenue line, and one occurs at the NPAT line, so you can't just add them up.)
The question going forward, however, is where might the theoretical model be wrong?
Could the 5% pa expected reduction in margin be too low? Possibly. This is the biggest risk, I believe.
Could the market not appreciate in value ever again in our lifetimes? I strongly doubt it.
Could fund inflows go to zero? With mandated superannuation,I also doubt that.
Could IFL never make another value-accretive acquisition again? That, I also, doubt.
So, I think that if I was to re-calibrate my theoretical model, by increasing the rate of margin decay by an extra 250bp pa (i.e., to a hefty 7.5% pa), and reducing fund flows by 100bps pa (to 2% pa), this would lop off growth of some 5% at the NPAT line. [*]
In that case, the Total Investment Return would be between 8% and 10%.
Not quite as attractive, admittedly, as the base case model, but still better than a poke in the eye with a blunt stick, and certainly way ahead of inflation and returns from cash in the bank, even on a risk-adjusted basis.
Given the vagaries of markets, it can be expected that at times not all four of IFL's cylinders are all firing at the same time. But to have just one cylinder contributing in any financial period - like we have just had happen - is somewhat unusual, I think.
For that reason, I expect I will be adding to my IFL holdings in coming days as the cacophony of noise from the media and the stockbroking community dies down, and once the 10%-12% NPAT forecasts for FY2017 permeate through the market.
[*] Of course, it should not be lost on anyone that the scenario sketched above, namely one of 7.5% pa reduction in industry margins, will not make for a very pleasant business conditions for the sorts of companies IFL would like to buy, which should increase the size of IFL's acquisition opportunity set, as well as greatly moderate the pricing expectations of the vendors of businesses that IFL might seek to acquire.
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