Challenger Snagged By Weak Yields

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

Wealth manager Challenger has potential for growth in the longer term but the short term is considered to be difficult.

-Challenges in finding yield in a low interest rate environment
-Japanese annuity growth could offset the disruption to domestic sales
-Adviser disruption may delay the benefits of demographic trends, means testing
 

By Eva Brocklehurst

The main concern for brokers in the FY19 results from wealth manager Challenger ((CGF)) lies with the use of capital, as lower bond yields in FY20 are expected to place further pressure on domestic annuity demand.

The range for FY20 pre-tax profit guidance of $500-550m is unusually wide, which Citi believes reflects the level of uncertainty overhanging the operating environment. It also allows for lower normalised growth assumptions for equities, distribution, product and marketing initiatives.

There is potential for growth in the longer term but brokers suggest the short-term is difficult. Ord Minnett's main concern is whether there is an appropriate risk-adjusted return to shareholders. Management has asserted that lower interest rates are not necessarily an issue for annuity sales, although there are challenges in the shape of the yield curve where cash rates are higher than one-year swap rates.

Growth outside of Japan is softer for the company because of structurally lower yields and industry disruption. While the balance sheet is robust, Morgan Stanley, too, finds it hard to believe shareholder funds will not suffer as yields decline.

For now, as term annuities roll off, and the tenor of the company's book is extended, there will be support from lower costs and the benefits of mix, the broker acknowledges, noting Challenger still expects to deliver a post-tax return on equity of more than 10.7%.

UBS is not so sure this will be achieved easily, and suspects Challenger is looking to ease pressures from lower interest rates by either supporting spread margins or recycling higher risk asset returns into annuities in order to assist sales.

Macquarie agrees and suspects management has been searching for higher yields, given portfolio allocation changes. While management reiterated a focus on return on equity (ROE) and asset risk premiums the broker believes now is an "interesting time in the cycle" to start increasing the risk profile.

While disappointed with Japanese sales of $38m in the fourth quarter, Macquarie is heartened by management's revelation that the trend has reversed in July following the start of a new US dollar product. Sales in July have already exceeded total sales for the fourth quarter of FY19. Macquarie anticipates net book growth of 5% in FY20 as longer-duration Japanese annuities more than offset the disruption to domestic sales.

Adviser Disruption

Sales were worse than Citi expected in the fourth quarter, reflecting adviser disruption. The broker suspects this may worsen in the near term, creating uncertainty for the growth trajectory and delaying the benefits of upside from demographic trends and new means-testing rules. Retail annuity sales were down -22% in the fourth quarter. The company noted significant adviser churn, with a -9% reduction in adviser numbers since December 2018 and the major hubs down -16%.

Morgans is increasingly confident that the earnings profile has largely re-based but concedes the stock faces headwinds as sales momentum in Australia deteriorates on the impact of adviser disruption. The downside risks, in the broker's view, include an inability to maintain strong sales and net growth in its book.

Credit Suisse concedes the valuation of the stock is starting to become more appealing but to obtain further confidence in the growth story domestic sales need to demonstrate signs of recovery, and the timing of this is unclear.

Capital Intensity

Given Challenger had promised to invest proceeds from the disposal of property in high-grade fixed income, thereby implying a reduction in capital intensity, Citi was surprised to find capital intensity rose 80 basis points in the second half.

This appears to be on the back of a sharp reduction in liquid assets in the fixed income portfolio over the second half. Citi suspects that most of the sell-down of property has gone to equities/alternatives, limiting the reduction in capital intensity. Further property sales should take the allocation to property down slightly to 17% in FY20 but Citi is wary of predicting a corresponding reduction in capital intensity.

Net profit was at the lower end of the company's target range, at $548m in FY19. Losses in retail property valuations turned property investment negative, despite gains on office buildings. To Citi, this implies downside risks to the asset book, which are borne solely by shareholders.

Citi expects margins to contract -13 basis points in FY20 and at a reduced pace thereafter. The difference between front and back book margins now appears to be around 30 basis points, which signals to to the broker there is only limited margin downside going forward – unless credit spreads contract further.

While recognising the challenges of low interest rates, Macquarie believes offsets will come on the funding side as margin pressures will be less significant going forward. Moreover, while domestic sales remain anaemic because of industry disruption, net book growth will still benefit from Japanese sales volumes increasing materially in FY20.

Challenger has one Buy rating (Macquarie), five Hold and one Sell (Ord Minnett) on FNArena's database. The consensus target is $7.22, signalling 5.8% upside to the last share price. The dividend yield on FY20 and FY20 one forecasts is 5.1% and 5.0% respectively.

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