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Growth Continues But Challenger Looking Stretched

Australia | Oct 19 2016

This story features CHALLENGER LIMITED. For more info SHARE ANALYSIS: CGF

Challenger Financial Services is benefitting from new distribution agreements and strong annuity sales. That said, several broker consider the valuation stretched.

-Uncertainty in margins and looming competition from banks clouds the outlook
-Favourable move in mix to longer-dated annuities
-Sales momentum impresses Citi but translation to earnings growth less clear


By Eva Brocklehurst

Growth has accelerated for Challenger Financial Services ((CGF)) as the business benefits from new distribution agreements and strong annuity sales in the September quarter. Importantly, brokers observe the sales mix continues to improve with longer duration and more profitable annuities.

Sales are strong across a variety of channels and Goldman Sachs believes this is the combination of annuities being included in more model portfolios, strategic marketing and a broadening of distribution partners. That said, the broker notes growth is capital intensive and Challenger has flagged plans to issue more tier 1 capital notes before the end of FY17. Goldman, not one of the eight monitored daily on the FNArena database, has a Neutral rating and $9.60 target.

Ord Minnett believes strongly in the company's ability to grow but remains concerned that the risks being taken to achieve targeted returns on equity are not being reflected in the share price. Annuity sales in the September quarter were $1.0bn, up 46%, and lifetime net book growth was 3.1%. The company has retained its normalised lifetime cash operating earnings guidance of $620-640m but the broker suspects this could prove conservative, given a more favourable outlook for cash rates and growth.

The growing distribution footprint is generating annuity sales growth and Bell Potter expects this momentum should continue, given new platform partnerships that are due to launch in the first half. This broker also believes the lifetime guidance is conservative and expects it may be upgraded at the upcoming AGM or the first half result in February.

Bell Potter has a positive view on the stock and expects catalysts for the company will come amid clarity from the federal government on the introduction of both Deferred Lifetime Annuities (DLAs) and Comprehensive Income Products for Retirement (CIPRs). Bell Potter, not one of the eight brokers monitored daily on the database, reiterates a Buy rating and has a $11.90 target.

Credit Suisse turns its attention to considering how much growth Challenger can fund. The broker estimates the company could theoretically fund $3.9bn, or 40% growth in its annuity book, before it would require an equity raising. This includes around 20% growth from utilising excess capital, 10% from retained earnings and 10% from hybrid availability. Credit Suisse expects high single-digit growth in earnings per share despite margin headwinds from lower interest rates, and believes the stock's current multiples are undemanding, considering the growth profile.

Challenger is the purest play on the under developed retirement income market but there is uncertainty in the margin outlook, which weighs on Morgan Stanley's view. The outlook for lifetime sales is uncertain and competition looms from the banking quarter in terms of annuities. The value drivers for the stock include the attractive yield opportunities and the risk/reward profiles of non-annuity products, as well as net flows from funds management.

Contributing factors to the lifetime annuities sales include allocations in model portfolios via the Colonial platform and greater traction from CarePlus following the product's re-launch. Morgan Stanley notes a 28.7% mix to longer-dated annuities compares favourably to 19.5% in the June quarter. The broker believes it is getting harder to deliver a 3.0% guaranteed return to customers, particularly with around 40% of the term book involving annuities under a year.

Morgan Stanley calculates bonus rates are probably sustaining the short-term roll-over rate in annuities at the expense of margins, while the shift in sales mix to longer duration and the planned FY17 capital raising are likely to insulate the downside risk. The broker retains an Equal-weight rating and considers the stock fairly valued. Morgan Stanley expects pension eligibility changes will remain supportive for Challenger's volumes and mix and help insulate margins.

Citi finds, while the sales momentum is impressive, the translation to earnings growth is less clear. Investment assets were up only slightly in the quarter and there is pressure on normalised capital growth and yield. The broker believes the stock has run too hard and downgrades to Sell from Neutral. Citi expected strong growth in lifetime annuity sales but the result was even stronger than its forecasts implied. Platform sales are now comprising 50% lifetime annuities with both Colonial and VicSuper contributing.

Tempering the impact on book growth was an elevated level of maturities but, even so, the quarterly outcome was reasonable, in Citi's view. The fact that Challenger only reiterated prior guidance suggests to the broker that strong sales are already incorporated in the numbers.

Morgans also downgrades, to Hold from Add, believing with the stock up 33% this year valuation metrics are becoming more stretched. The broker retains some caution in its outlook regarding the potential margin contraction implied by FY17 guidance.

FNArena's database has three Buy ratings, three Hold and two Sell. The consensus target is $9.83, suggesting 5.0% downside to the last share price. Targets range from $7.33 (Ord Minnett) to $11.50 (Credit Suisse).

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