Wealth manager Challenger’s ((CGF)) first half result marks a shift to longer duration annuities, supported by the company’s new relationship with Mitsui Sumitomo Primary Life to sell Australian dollar-denominated securities in Japan, amid the company’s expanding distribution partnerships domestically. Guidance for cash operating earnings (COE) in life has been re-affirmed for FY17 in a range of $620-640m.
Nevertheless, while positive for growth in assets under management, spread margins and profits, this also comes with a capital cost, the size of which is unclear to UBS. The company is expected to maintain its dividend pay-out ratio and this, along with rising asset risk charges, may require future injections of equity to fund growth, constraining value upside.
As a result, UBS maintains a Neutral rating. First half normalised net profit of $197m was 2.7% ahead of the broker’s estimates, the beat entirely due to funds management which enjoyed strong flows and a post-Brexit UK revenue rebound.
Concerns Over Capital Intensity
The company’s tier one capital ratio fell to 1.02 in the half, close to the 1.0 level UBS envisages as a minimum. At current capital intensity the company requires $225 in CET1 (1.0), and with new business strain from longer-term annuity growth the gap is likely to widen over the next 2-3 years, in the broker’s opinion.
Macquarie suggests the company has a number of levers to support growth in its life investment assets, as well as continuing to invest in the funds management division, before the growth rate will require additional equity capital. Furthermore, the broker does not expect the company will push capital to the limit, noting the regulator assesses capital on a medium-term view.
Given a focus on earnings per share and returns, Macquarie expects the company to use at least some of its levers to manage its capital position before adding more equity to support growth beyond 18-24 months.
Unchanged FY17 guidance surprised Ord Minnett, although this probably reflected some modest pressure on margins. The broker also did not expect the sharp deterioration in capital coverage. The growth story in FY18 could offer some reasonable upside, the broker acknowledges, while those worried about risks could point to margin declines and the reduction in capital coverage.
Ord Minnett also recognises Challenger has levers to alleviate any tightness in its capital position but believes spread profits are reasonably volatile and a higher discount rate is needed to reflect the risk, including the risk of forced liquidation in stressed scenarios.
The broker notes new business strain may limit normalised growth to around 7.5% per annum in the absence of external capital funding initiatives. Nevertheless, Ord Minnett’s main concern is with valuation, which leads to a Lighten rating. Another potential risk on the horizon is that the Australian government may adversely change the social security effectiveness of annuities for policy holders, as it is currently undertaking a review.
The noticeably weaker capital metrics took the gloss off an otherwise solid result, in Morgan Stanley’s view. The broker believes, with the peak of rising maturities now behind the business and the tenor of new business increasing, Challenger no longer needs "record" sales to drive growth in its book. The stock is not cheap and, while maturities have peaked, Morgan Stanley notes product margins are soft.
Credit Suisse believes margin contraction is overplayed and having absorbed interest-rate reductions, the company is in a good position to address any concerns around margin pressure. The broker also highlights that the company has the ability to fund over 20% growth in its net book in a single year before it would require additional equity.
The first half result confirms the broker’s view that volatility in its capital position is not well understood by the market. Because of lumpiness in asset purchases and sales in the company’s property asset class, capital intensity can move around from half-year to half-year.
While the capital position appears soft, after the debt raisings – Credit Suisse expects multiple – the issue is expected to be addressed. Credit Suisse is confident earnings growth will come through, noting expectations were high going into the results.
Citi simply considers the stock expensive and retains a Sell rating. While the relationship with Mitsui Sumitomo has started on a strong note, the broker’s analysis suggests momentum is slowing elsewhere, although acknowledges this may reflect the company becoming more discerning about where it allocates capital, or it may indicate that capital is now being rationed. Over time Citi believes this should be good for book growth and margins.
Regulatory and industry tailwinds remain positive for the medium to longer term and maturities should also decline in later periods, suggesting to the broker more of the sales growth could turn into earnings growth.
Morgans also likes the story for the longer term and believes an excellent job has been done opening up growth opportunities for the business. Average new annuity tenor improved to 8.7 years, with longer term annuities now representing 31% of total sales compared with the prior corresponding half at just 14%. Nevertheless, as the stock has re-rated strongly over the past 12 months, the broker considers fully valued.
FNArena’s database shows two Buy ratings, four Hold and two Sell. The consensus target is $10.69, suggesting -7.0% downside to the last share price. Targets range from $8.75 (Deutsche Bank, yet to update on the result) to $12.34 (Macquarie).