Netwealth's 7 per cent share price jump following its first-half result is a sign the market is underestimating the threat of rising competition, says Morningstar. 

Netwealth (ASX: NWL) shares lifted yesterday in response to the reported 21.2 per cent increase in underlying net profit to $17 million. 

Total revenue was up 19 per cent to $48.2 million as margins edged 0.7 per cent higher to 35.4 per cent.

Netwealth Result H1

Source: Netwealth 1H 2019 Results Presentation

Morningstar equity analyst Gareth James said he was surprised at the uptick in Netwealth's share price following the result, considering it lacked any big surprises and came in slightly below his expectations.

"We expect the market was more focused on strong profit growth and that Netwealth remains the most popular of the independent platforms," he says.

Netwealth provides financial products and online tools to help non-bank financial advisers organise and manage clients’ investments.

Management says it sees several opportunities stemming from the banking royal commission, which delivered its final report at the start of the month. It believes the removal of grandfathered commissions – a central recommendation of the Hayne inquiry – will see Netwealth benefit as other advice companies sell off large parts of their client businesses.

Some $189 billion in funds under management is currently subject to grandfathered commissions, according to research house DEXX&R. Less than 3.5 per cent of Netwealth's funds under management are currently subject.

Management also believes increased disclosure requirements for bank-aligned advisers will benefit Netwealth, whose adviser network are not affiliated with banks.

Absence of economic moat is holding Netwealth back, says Morningstar

Morningstar's James notes that while funds under management and administration grew by 24 per cent, this was well down on the 63 per cent achieved a year earlier.

"Revenue growth of 19 per cent was worse than FUMA growth and sharply down on the 40 per cent achieved in the previous corresponding period."

Netwealth's platform revenue and average funds under administration over the half fell more than 56 per cent to 49.3 basis points.

James agrees the company should benefit from the abolition of "grandfathered" trail commissions, as these changes favour independent players and will reduce client switching costs.

But he believes the bigger story here is the downward pricing pressure of increased competition.

"We expect the market is underestimating the long-term impact of price-based competition on earnings growth, particularly as Netwealth lacks an economic moat," James says.

"We expect platform providers to quickly copy competitor's innovations and the reduction in industry switching costs is likely to impact all providers in the very long term."

Netwealth's revenue margin is falling year-on-year, highlighting the effect of rising competition, James says.

Netwealth has several competitors with similar offerings, including Hub 24 (ASX: HUB), Praemium (ASX: PPS), Onevue (ASX: OVH), Managed Accounts (ASX: MGP), and Powerwrap.

The vertically integrated incumbent platform providers also continue to develop their platforms, which poses a long-term competitive threat to Netwealth.

James has maintained Morningstar's earnings forecast but increased the fair value estimate by 4 per cent to $5.50 due to the time value of money impact on the financial model.

At the share price of $7.49 as at 11am, the company tracks as overvalued relative to Morningstar's FVE.

Outlook

Netwealth expects further movement of financial advisers from larger institutions as regulatory changes take effect, along with a significant number of large new client transitions, which could benefit its platform business.

"We remain confident that our full year funds and administration net inflows for FY2019 will be greater than FY2018," the company said.

Netwealth expects earnings before interest, tax, depreciation and amortisation margin percentage for fiscal-2019 to remain at similar levels to fiscal-2018.

James is forecasting 25 per cent revenue growth in fiscal 2019, implying a normalisation of markets in the second half and a 13 per cent revenue compound annual growth rate over the next decade, implying slowing revenue growth as the business matures.

He says this isn't necessarily a concern, but adds that Netwealth's price/earnings ratio of 46 implies it is a high-growth stock, which isn't supported by Morningstar's earnings growth forecast.

Netwealth declared a fully franked interim dividend of 5.5 cents a share.