Challenger’s (CGF) score card on funds management and the life investing business continues to tick the right boxes for brokers. Moreover, regulatory changes are expected which will allow for deferred lifetime annuities (DLAs) and this supports a positive outlook, along with the company’s investment in platforms, industry funds and Link.
Challenger is doing its job well, Credit Suisse asserts. The company expects a June quarter record in lifetime annuity sales, which the broker suspects will address some of the concerns around the difficulty of selling annuities in a low interest rate environment.
While not reflecting directly on its cash operating earnings (COE) margin, Challenger highlighted the risk premium currently available in the market across all asset classes was above long-term averages. This supports a view the company will maintain its COE margin, easing another concern in the broker’s opinion.
The company’s credit exposure to resources and mining industries is less than 1%, the same for agriculture, with no exposure to residential property developers. This signals to Credit Suisse why bad debts have been below the major banks recently. The broker is also not worried about valuation, calculating the stock is currently trading at around a 20% price/earnings (PE) discount to the market.
Hence, Credit Suisse considers the stock undervalued, given the compelling growth opportunity that is underpinned by industry changes in asset allocation and government support for annuities.
Ord Minnett is more circumspect, noting a $6m pre-tax profit hit to the funds management division in the second half. The Dexion business is the main culprit, a European alternative investments group bought in 2015. The broker also acknowledges the company’s view that DLAs will be easier to sell than standard lifetime annuities.
Yet Ord Minnett highlights a risk to growth, in that federal Treasury explicitly stated social security means testing needs to be amended to make sure it takes into account the capital that is returned, rather than the current treatment which is only designed for full lifetime annuity products.
While Challenger provided detail on processes to deal with investment risks, the broker suspects some disclosures may cause a misunderstanding of the risks shareholders take. An example is the case of Challenger’s sub-investment grade credit risk being similar to the banks, with the broker pointing out that the latter have lenders mortgage insurance to significantly reduce their risk.
Also, Ord Minnett does not believe the company provided enough comfort on the credit risk for property, equity and infrastructure, which remain very volatile classes and around 37% of the company’s life assets. The broker estimates it only takes around a 3.25% fall in life asset values to reduce Challenger’s target surplus to below its target range.
Ord Minnett retains a Lighten rating and believes the life business, at around 2.6 times net tangible assets, is too expensive. UBS is not overly concerned, believing that while falling rates could place some pressure on investment income in the life business, margins should be supported by the attractive risk premium for credit and property.
The flagged reduction in the funds management division flows through as a 2% earnings downgrade at the group level, UBS maintains, and subdued UK listing activity is assumed in the first half of FY17 before a pick up in the second.
Moreover, tangible evidence is now emerging to support upside from the expansion of distribution and the broker also flags the tailwinds from regulatory changes and a lack of competition. Admittedly, the strong share price performance has lifted the bar for growth amid heightened downside sensitivity but, on balance, UBS believes data points should remain positive over the medium term and retains a Buy rating.
Deutsche Bank also believes the distribution initiatives are outweighing the impact of lower rates. The improving momentum in lifetime annuity sales should start to support better retail book growth, which the broker observes has recently been hampered by more rapid fixed term annuities being run off, reflecting a shortening sales duration.
As such, while the prospect of even lower interest rates remain a risk factor, the enhanced initiatives the company has undertaken suggest to the broker this is more than offset. Nonetheless, Deutsche Bank considers the stock fully priced and sticks by a Hold rating.
The broker also notes Challenger has made good early progress in exporting its successful Fidante model to Europe, gaining $400m in net flows to date. Still, as per the broader asset management market in the UK, Deutsche Bank suggests the uncertainties over Britain’s potential exit from the EU has halted alternative fund transaction activity.
Morgans found the briefing upbeat, suspecting the government’s review of retirement income streams has provided an opportunity for a whole new category of product, with DLAs likely to be just the start of product innovation. The broker remains impressed by management’s ability to continually deliver against guidance metrics and by the quality of the first half result, with few credit default losses.
On the subject of credit quality, Morgans notes the company has a significant risk management framework in place and an experienced investment team.The broker expects the stock to offer a mid-to-high single digit growth profile over the medium term, given its skew to strong growth industries. Morgans considers the FY17 PE multiple of 14.5 undemanding and maintains an Add call.
FNArena’s database has four Buy ratings, three Hold and one Sell (Ord Minnett). The consensus target is $9.22, suggesting 2% downside to the last share price. This compares with $8.96 ahead of the briefing. Targets range from $7.10 (Ord Minnett) to $10.23 (Macquarie).