Australia | Jun 21 2021
This story features CHALLENGER LIMITED. For more info SHARE ANALYSIS: CGF
Challenger has decided to raise capital targets to sustain its earnings base, reducing return on equity target and deploying more cash into fixed income
-Net profit guidance for FY22 provides on significant change to asset allocation
-Carrying additional capital may be prudent given market dislocation
-Is a lower ROE an adequate return for the risk of holding Challenger shares?
By Eva Brocklehurst
The pandemic has forced Challenger ((CGF)) to reduce asset risk and preserve capital, which in turn lowers the leverage to a subsequent recovery. In order to sustain earnings, a decision has been made to raise capital targets.
Challenger reports a positive investment experience to date in the second half and raises its capital target, extending the operating range to 1.3-1.7x PCA (principal component analysis) from 1.3-1.6x, while lowering its pre-tax return on equity (ROE) target to cash +12%.
The company's net profit guidance of $430-480m for FY22 provides no significant change to asset allocation after the full deployment of excess cash in FY21. Jarden calculates this implies more than a 15% increase on FY21. The company expects to sustain a dividend payout of 45-50%.
Jarden envisages higher capital levels in FY21 while a $150m capital release pushes out risks beyond FY22. Life spread margins are expected to hold at second half levels of 2.45%, as elevated cash and liquid assets are redeployed into non-investment grade fixed income.
At first glance, Morgan Stanley assesses the lift in targeted capital is modest. Meanwhile, the bank acquisition is on track for completion in June/July and will be rebranded to Challenger in FY23. Funds management is also winning mandates in the UK and Challenger will open a Singapore office.
The main positive Citi derives from the investor briefing is the effort made in building up new distribution channels amid good growth in institutional annuity sales, which appears to be the main driver of the guidance for growth in net profit in FY22.
Life earnings are weaker than many brokers expected while funds management is stronger. Credit Suisse upgrades estimates for FY22-23 by 2-4% to allow for higher funds management earnings and despite the lower life earnings.
Carrying additional capital is a prudent move, Morgans asserts, given the large impact from market dislocation on the business. The flat life spread margin may signal it is stabilising, although the broker concedes some market scepticism given the difficult investment conditions.
UBS downgrades to Neutral from Buy, noting the growth opportunities across institutional life sales, funds management and the recently-acquired bank are offset by the lowering of the return on equity. Growing the front book in life, therefore, remains an issue from a value accretion perspective, the broker suggests and the stock is now trading at fair value.
Citi points out this is the second cut to the target ROE in two years, although accepts a more conservative capital position reduces the risk to the earnings stream and lowers the likelihood Challenger will have to lock in negative investment returns during market shocks, as was the case in March 2020.
Still, the broker questions whether an 8.5% post-tax ROE can be considered an adequate return for the risk of holding Challenger shares. Citi assesses the stock is currently trading at a superficially attractive -10% discount to book and with the reduction in the target ROE there may be reasons for this discount to remain.
Credit Suisse's analysis shows the increase in the capital target equates to a -180 basis points drop in the ROE if it is fully funded by equity and if additional capital is invested in cash. Some asset classes are below the ROE target, the broker points out, noting that after allocation of costs the Equity, Infrastructure and Alternatives portfolio is at a pre-tax ROE of just 10% while fixed income is 11%.
The broker continues to believe there is upside to the ROE in the medium to longer term as credit spreads widen, while assessing the stock is fair value at current levels. The proportion of valuation attributable to funds management is now higher while the life business valuation is lowered to reflect a reduced post-ROE profile of 6.7%.
The reduced guidance for ROE on the surface is negative, although Ord Minnett asserts this has improved the resilience of the leveraged spread model when markets fall and reduces the probability of an expensive capital raising.
The broker agrees with Citi that post tax, costs and investment experience, the ROE may not clear a reasonable cost of capital. Ord Minnett was also hoping for faster expansion of the bank, in order to lower group funding costs. Macquarie agrees the valuation looks fair, continuing to like the long-term growth outlook, coupled with the capital benefits of the acquisition of a bank licence.
Although ROE targets have been lowered to reflect higher target capital levels, Jarden argues this enhances earnings stability while markets are volatile. The broker anticipates upside risk if spreads lift off current lows and believes Challenger is on a stronger footing heading into FY22.
Jarden, not one of the seven stockbrokers monitored daily on the FNArena database, has an Overweight rating and $6.10 target and assesses the main risks to the outlook include lower asset yields and credit spreads, with prolonged low interest rates affecting product demand as well as a lack of retirement reform support.
Retirement Income Covenant
The company has indicated the government is committed to the Retirement Income Covenant (RIC) with an effective date of July 1, 2022. UBS notes, the timing around an exposure draft of the legislation has been delayed and is now likely at the end of the year.
While the covenant is a potential positive catalyst for net book growth it does not impact the broker's view of valuation, given front book ROE targets simply meet the cost of equity. Until Challenger can demonstrate ROE improvement or other growth options the broker suspects such opportunities from RIC are diminished in terms of the valuation benefit.
FNArena's database has one Buy (Morgans) and six Hold ratings. The consensus target is $5.92, signalling 12.0% upside to the last share price. The dividend yield on FY21 and FY22 forecasts is 3.8% and 4.3%, respectively.
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