Mixed Responses To Challenger’s New Deal

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Challenger is meeting the pressures on domestic demand by expanding its arrangements to include US-dollar denominated annuities in Japan.

-The deal puts a floor under Japanese annuity sales
-Amid rising risk to domestic demand from lower interest rates
-But has there been too much focus on the 10-year government bond rate?
 

By Eva Brocklehurst

Diversified financial services provider, Challenger ((CGF)), will expand its relationship with Japan's MS&AD Insurance, via subsidiary MS Primary, to provide guaranteed investment returns on US-dollar denominated annuities.

The new deal is simply extending the arrangement for Australian dollar guarantees to the US dollar. MS Primary will guarantee a base level of reinsurance of $640m for five years across both Australian and US-dollar denominated annuities.

As a result, MS&AD will seek to increase its stake in Challenger to more than 15%. The target start date for the arrangement is July 1, 2019, when Challenger will commence a quota sharing reinsurance of these annuities issued in the Japanese market by MS Primary.

Morgans considers the deal a good outcome, although remains cautious about near-term earnings pressures. At the very least the deal puts a floor under Japanese annuity sales.

Demand for Australian dollar annuities in Japan has softened as the gap to US yields has widened. As a global macro environment becomes more dovish, Morgans finds it hard to envisage some of the pressures unwinding any time soon, although Challenger has a good long-term growth story.

The expanded sales relationship provides increased conviction in Challenger's ability to deliver double-digit medium-term life asset growth, UBS suggests. This is particularly so with rising risk to domestic demand from lower interest rates.

Reflecting the long duration of the sales, UBS lifts its growth estimates for life average investment assets to 11% compound over the next 3-5 years. Renewed growth support from Japan is considered timely, as the lower interest-rate outlook in Australia could weigh on domestic demand as annuity rates fall.

Nevertheless, the issue for equity investors, Ord Minnett believes, should be whether Challenger's high guaranteed rates to wholesale investors leave enough on the plate for shareholders. In particular, the broker questions whether it makes economic sense for an Australian manager to be providing hedged US dollar returns.

The company's annuity sales of slowed recently, affected by the Hayne Royal Commission and the disruption it has caused a financial planners, as well as the higher US dollar yields in Japan. Now, Credit Suisse assesses this annuity agreement offers an opportunity worth $640m to over $3bn per annum, providing Challenger with base annuity book growth of 10-15%.

Hence, the broker considers the risk is skewed to the upside if domestic and/or Japanese annuity sales exceed expectations and capital restraint is unlikely to be an issue for the company initially. Ord Minnett agrees the book growth should never be an issue for Challenger.

Future Buy-out?

Morgan Stanley questions whether MS&AD's decision to seek increased ownership of Challenger may raise longer-term buy-out prospects for Challenger. On the other hand, Ord Minnett suspects it reflects a desire to watch the decisions that Challenger makes in order to provide its investment guarantees for 20 years, rather than indicating real takeover potential.

The broker ascertains MS&AD would not be comfortable with Challenger's 30%-plus exposure to risk assets. Challenger, therefore, offers an excellent deal, with 1.8% guaranteed returns, above what is offered to policy holders.

Ord Minnett asserts the risk for shareholders is too high and out of step with annuity writers globally and continues to believe Challenger will struggle to make its cost of capital after adjusting for historical levels of underperformance. The broker concedes markets have been strong and capital levels are likely to be replenished, while there is scope for further risking up of the book at a later date.

Bell Potter, not one of the eight stockbrokers monitored daily on the FNArena database, retains a Buy rating with a $14.07 target. The broker believes there is a clear message to the broader market that the recent volatility in asset prices is not of concern to the Japanese firm, which appears interested in long-term quality assets that are well run.

Too much of the recent commentary on Challenger has been preoccupied with one negative asset price movement, in the broker's view, namely the 10-year government bond rate, to the exclusion of other assets which are improving. Bell Potter calculates Challenger is on track to achieve its FY19 guidance of pre-tax profit of $545-565m.

FNArena's database shows one Buy (Macquarie, yet to comment on the update), five Hold and two Sell. The consensus target is $8.09, signalling -3.1% downside to the last share price. Targets range from $7.00 (Ord Minnett, Deutsche Bank) to $9.60 (Macquarie).

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