Australia | Jun 14 2019
Disruptions to the adviser group and ultra-low interest rates are providing significant headwinds for Challenger. Brokers, while disappointed, welcome the re-setting of targets.
-Offsetting pressures in retail channel via expenditure on consumer education and improving processes with independent advisers
-Difficult to ascertain timing of a recovery in domestic sales
-Heightened margin pressure unlikely to abate in low interest rate environment
By Eva Brocklehurst
A difficult operating environment continues to hobble Challenger ((CGF)). The company has disclosed further details on its front book margin and the impact of disruptions to advice. Brokers suspect a large earnings headwind will not dissipate in the near future.
Challenger now expects FY19 pre-tax profit at the lower end of the prior guidance of $545-565m. For FY20 the company has guided to pre-tax profit of $500-550m. This reflects lower normalised growth assumptions for equities and lower interest rates on shareholder capital.
Headwinds consist of significant disruption to the adviser group which has affected the company sales, along with the increased allocation of superannuation funds to the industry sector where the company has a low penetration. A prolonged low interest rate environment has also thinned investment spreads.
Bell Potter points out the prospect of a three-month BBSW (bank bill swap) rate approaching zero is a real possibility, as it currently sits at 1.35%. Moreover, the adviser disruption appears to be worsening. Hence, the broker, not one of the eight brokers monitored daily on the FNArena database, downgrades to Hold from Buy and lowers the target to $7.34 from $13.77.
The company is seeking to offset the pressures in the retail channel by increasing expenditure on consumer education and improving its processes with independent financial advisers. Ord Minnett is surprised the company is pushing growth in retail and believes it will take some time to benefit from the actions to drive sales. Regardless of the efforts to re-set earnings, the risk-adjusted returns envisaged are also considered likely to be insufficient.
Deutsche Bank, on the other hand, welcomes the update to targets and considers the company is taking a more sensible approach to earnings expectations in the new interest rate environment. Although disappointed, Macquarie acknowledges a re-set was necessary and considers the medium-term growth prospects remain attractive.
Credit Suisse had estimates that were already below consensus and makes no changes to its FY19 forecasts, although decreases expectations for net profit in FY20 by -5%. The broker had expected this downgrade and re-set were looming. The valuation has become more appealing but, for the market to regain confidence in the growth story, domestic sales need to demonstrate signs of a recovery and the broker considers the timing for such remains unclear.
UBS notes the company has reacted to insulate product margins by lowering annuities rates but these reductions have lagged lower bond yields and estimates spread margins could fall to 3.15% over the next three years.
Credit Suisse notes there were a lot of questions around the front book margin over recent years and a large driver of the contraction has been the run-off in very high margin bonds. Besides this, the product spread, which has held constant at 3% for some time, has now deteriorated.
This is largely from a change in asset mix – away from the higher margin property class – but also because of some margin pressure from low interest rates, the broker assesses.
Macquarie had expected around -25 basis points of margin decline over the next three years and therefore retains unchanged expectations, given the average duration of around five years.
The company has set its return-on-equity (ROE) target to the Reserve Bank cash rate plus 14%, which compares with a prior target of 18% through the cycle. Brokers calculate this implies an 11% normalised ROE target, post tax. Equity capital growth assumptions have also been reduced to 3.5% from 4.5%.
Credit Suisse appreciates the company's willingness to provide an ROE target but calculates that, given where its capital sits at the moment, this will be a struggle to achieve.
Macquarie had suspected the company would reduce capital growth assumptions for equities, albeit more likely at the FY19 result. The broker calculates the -1% reduction in the growth assumption reduces normalised earnings by around -4%.
UBS believes the pressure on the life spread margins and domestic sales prospects will constrain improvements in earnings, despite any one-off annuity distribution sales initiatives in FY20. The broker estimates life spread margins could fall below 3.2% by FY22. Moreover, as annuity rates decline there are downside risks to sales volumes, which is a trend that played out in the US after the GFC.
FNArena's database shows one Buy rating (Macquarie), six Hold and one Sell (Ord Minnett). The consensus target is $7.36, suggesting 10.5% upside to the last share price. This compares with $8.14 ahead of the update.
See also Mixed Responses To Challenger's New Deal on March 27, 2019.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
FNArena is proud about its track record and past achievements: Ten Years On