Australia | Jun 14 2018
Challenger is reducing property and increasing fixed income exposure, which will deliver a negative impact on margins and earnings in the near term.
-Near-term cost to earnings but more sustainable future book growth
-Opportunity to increase allocation to higher investment grade assets
-Changes to means testing rules may be less punitive to lifetime annuity sales
By Eva Brocklehurst
Challenger ((CGF)) is reducing property and increasing fixed income exposure as it juggles its portfolio for the future. This provides for a less capital intensive model and greater ability to fund its own growth. A negative impact is envisaged by brokers for margins and earnings in the near term.
Operating from a more sustainable platform should enable Challenger to better capitalise on the growth opportunity from recent regulatory changes, Citi observes, as it becomes less reliant on equity raisings to support future book growth.
This improved ability to fund growth is the main offsetting positive, the broker adds, and also signals the company is confident in future growth, and appears to be the main motivation for the change rather than relative risk premia.
Although, the broker acknowledges, the current differentials in risk premia make it relatively fortuitous to be planning such a change at this time.
UBS agrees that, while there is a near-term cost to earnings, the decision provides for a more sustainable footing for funding annuity book growth in the longer term and this is a sensible trade-off.
Ord Minnett believes tough market conditions, where yields are being compressed, has forced Challenger to provide an offset by showing considerable book growth.
This implies potentially higher funding costs than might otherwise have been the case and, in such an environment, the broker suspects there may be constrained pre-tax profit growth.
Property allocation will be reduced to the mid teens, from 21%, which represents around $700m in asset sales. Challenger believes strong demand from offshore capital is flattening the returns in that asset class.
Once the transition is completed Citi estimates an adverse impact of around -5% to earnings per share from the changed allocation, but in the longer term this is likely to be less.
Citi has previously observed book values are relatively conservative and Challenger should, therefore, be able to achieve a profit on sale from the properties on disposal. Yet, given the disposals are one-off in nature, and there is uncertainty regarding the quantum and timing, no allowances are made in estimates.
With the timing of exact book growth uncertain, Credit Suisse also makes minimal changes to assumptions, downgrading normalised net profit estimates by -3% in FY19 and -4% for FY20. Reported earnings estimates increase 7% in FY19, allowing for investment experience gains.
Upside risk exists for growth opportunities in Australia, and Credit Suisse believes recent updates from federal Treasury are more than encouraging.
Macquarie agrees that, while the recent share price performance has eroded some of the valuation upside, the benign credit environment and favourable regulatory backdrop shall continue to support the company's current multiple.
Within the fixed income portfolio, Challenger will maintain its target of 25% non-investment-grade fixed income assets. Within investment grade it envisages an opportunity to increase the allocation to AAA and AA-rated assets.
Citi has previously pointed out the relatively high exposure to the lowest investment-grade (BBB) rating and believes the improved credit quality of the book is a further, small step towards de-risking the overall business model.
New rules regarding means testing introduced in the federal budget are also likely to be slightly positive, Citi suggests, especially once lifetime annuities are combined with allocated pensions.
The broker flags that, for some reason, Challenger sought to play this down, as it indicated that new rules would result in outcomes that are broadly consistent with the old rules.
Changes to the means testing rules are also potentially less punitive to lifetime annuity sales than Morgans previously thought. The broker likes the Challenger story for the longer term but views the stock trading at fair value.
Citi also points out Challenger appears set to be the first in Australia to launch active ETFs and this makes it well placed to offer an increasingly diverse range of product. Fixed interest will be the first asset class in this area with others to follow in time.
Ord Minnett believes growth in the company's lifetime annuities will increase as a result of budget and regulatory changes, but cautions that these account for only 16% of the annuity sales today, and annuities worldwide have been unpopular in the absence of tax benefits or compulsion.
FNArena's database shows three Buy ratings, three Hold and two Sell. The consensus target is $12.23, suggesting -2.6% in downside to the last share price. Targets range from $9.50 (Ord Minnett) to $13.60 (Citi).
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