Why OFX Group Ltd shareholders should follow the Royal Commission

Shares in international money transfer business OFX Group Ltd (ASX: OFX) hit a 52-week high of $2.06 this morning after the group handed in a better-than-expected trading update for the June 2018 quarter this week.

For the full year ending March 2018 OFX posted EBITDA of $29.4 million on net operating income (fee revenue) of $109.9 million, with the results being 4.6% and 7.5% higher respectively than the prior year.

At its AGM on August 7 the group also provided a trading update for the quarter ending June 30 2018 that revealed net operating income grew an impressive 13% to $30.1 million at a stable profit margin, with transaction growth also lifting 13.6%.

As a foreign exchange broker OFX earns income as a percentage of the spread on the money transfers it executes.

Typically a spread on an FX will be between 0.25% to 1.5%, whereas a bank like the Commonwealth Bank of Australia (ASX: CBA) will charge you far more.

The biggest rip off of all are the airport or high-street over-the-counter cash operators that will charge wide-eyed tourists spreads close to 5% if they can get away with it.

For OFX generally the larger the transaction the thinner the spread, with enterprise clients (importers or exporters) generally earning narrower spreads as they do larger volumes than a holiday maker or business traveller for example.

The OFX platform is also easy to use and once clients are signed up they can transact online as long as they have the relevant overseas domiciled bank accounts to send and receive money.

As such the business model is scalable or has operating leverage as there’s little extra cost to OFX each time a client transacts online and earns OFX fees in terms of its spread.

OFX has generally grown by taking market share from the big banks and there’s plenty more room to do that, which suggests on face value that the business is quite attractive.

However, there are a couple of points to note before investors get carried away.

In my opinion the business model retains one fundamental weakness in the way client-facing staff are incentivised (remunerated) with “2-5% of the Profit derived by us on each transaction” (source: OFX Financial Services Guide).

Conflicted remuneration on general advice such as this does not align clients’ interests with OFX and more importantly has been the target of regulation before via (the watered down) Future of Financial Advice Reforms (FOFA).

As an OFX investor I’d keep an eagle eye for any sign that Commissioner Hayne of the Royal Commission looks to ban this type of conflicted remuneration in response to the Commission’s findings.

If this were to happen OFX might find its fee-earning business model under significant pressure. However, given the inert regulatory environment in Australia I would not be surprised if OFX is able to operate this business model indefinitely.

The other main issue for investors is via rising competition. OFX enjoyed a first mover advantage (pre IPO) in taking market share from the banks, but is now finding more competition via other discount operators and the rise of new fintech businesses such as TransferWise that are threatening to disrupt the disruptors.

Foolish takeaway

OFX is improving operationally with a strong Q1 FY 2019 trading update and has some attractive characteristics including high margins that enable it to pay decent dividends alongside a sound balance sheet. However, for me there are better risk-adjusted returns available elsewhere in the market.

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Motley Fool contributor Tom Richardson has no position in any of the stocks mentioned.

You can find Tom on Twitter @tommyr345

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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