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Morningstar | Challenger’s Disappointing 1H Fiscal 2019 Results Prompts FVE Reduction. See Updated Analyst Note from 12 Feb 2019

No-moat Challenger’s lower-than-expected annuity sales along with continuing margin pressure were the key takeaways from its poor first-half fiscal 2019 results. Lower annuity sales were due to disruptions caused by the Financial Services Royal Commission to its core financial advisor distributional channel. In addition, Australia’s low interest rates relative to the United States led to a preference by Japanese investors for USD annuities over AUD annuities and weighed more than expected on its AUD annuity sales into Japan. Although we believe Challenger’s long-term investment case remains intact, we now expect these headwinds to sales to persevere over the next few years and combine with continuing margin pressures to be a drag on earnings. This has prompted a reduction in the company’s fair value estimate to AUD 9.25 per share from AUD 10.80. At the fair value estimate it has a fiscal 2019 P/E of 14.3 times and dividend yield of 3.8%.

We believe the recently concluded Royal Commission will negatively impact Challenger’s annuity sales in Australia over the next few years more than previously assumed. The company did not face any direct fallout from the Royal Commission and unlike many of its life company competitors its good reputation remains intact. Nevertheless, the reputational damage done to financial advisors more generally and to specific wealth managers that distribute its annuities, such as AMP, is likely to reduce public demand for their services, which we expect will indirectly impact Challenger’s annuity sales. Furthermore, major Australian wealth managers are likely to focus investment on systems and compliance upgrades in response to the Commission’s recommendations as opposed to investing in acquiring customers. On this point, management indicate the Royal Commission resulted in lower annuity sales from Australian financial advisors aligned to major institutions, partly compensated by increased sales via independent financial advisors.

We now forecast normalised fiscal 2019 net profit before tax, or NPBT, of AUD 546.6 million, at the lower-end of company guidance of AUD 545-565 million. This leads to a normalised net profit after tax, or NPAT, forecast of AUD 401.7 million in fiscal 2019, slightly higher than our previous AUD 399 million forecast due to a lower effective tax rate than expected. However, the main change to our forecast is in the outer years, with normalised NPAT in fiscal 2020 of AUD 401.8 million, down from the previous forecast of AUD 435.2 million. This is primarily driven by lower expected annuity sales and continuing margin pressure.

In aggregate, total annuity and other life sales for first-half fiscal 2019 were circa 17.6% lower than first-half fiscal 2018, with sales slowing markedly in the second quarter of fiscal 2019. The impact on cash operating earnings was further exacerbated by ongoing margin pressure. Lower margins were driven by lower-than-expected distributions from an absolute return fund (lowering margins by 11 basis points from second-half 2018) and from the repositioning of its investment portfolio to lower returning high-grade fixed income assets, by reducing allocation to its higher-returning property portfolio (lowering margins by 7 basis points). We expect continuing margin pressure in second half of fiscal 2019 as the company continues to reduce allocation to its property portfolio.

Despite these near-term issues, we still expect Challenger to benefit from the longer-term trend of a larger allocation of annuities in retirement portfolios. We believe the allocation to annuities will continue to be supported by the general direction of public policy which we think will focus more attention on the retirement income phase of superannuation. However, we expect public policy in this area to be delayed given the upcoming federal election due in May 2019. We also believe legislators will more likely focus on implementing the Royal Commission recommendations.

Consequently, we do not expect the company to benefit from a boost in annuity sales in the near term from a change in public policy. In particular, there is likely to be a delay and potential reassessment in the government’s proposed covenant to be included in the Superannuation Industry (Supervision) Act 1993, requiring superannuation trustees to consider the retirement income needs of their members. This includes offering a flagship comprehensive income product for retirement, or CIPR, (expected to comprise an account-based pension and a pooled annuity type product). Notably, the recent Productivity Commission Report on Superannuation published Jan. 10, 2019, threw a spanner in the works by recommending a delay in introducing the retirement income covenant. It also expressed concerns that the covenant may nudge members into products ill-suited to their longer-term needs and expressed concerns that there is currently only a few choices in the market for these products--with Challenger being the dominant player.

On a more positive note, the company continues to maintain a strong balance sheet, with the life company’s regulatory capital base being 1.54 times higher than its prescribed capital amount, or PCA, at Dec. 31, 2018. This is at the higher-end of its target PCA ratio of 1.3-1.6 times and slightly above its PCA ratio of 1.53 times at June 30, 2018. The PCA ratio primarily benefited from a reduction in capital intensity (AUD 204 million) due to its investment portfolio’s increased allocation to higher-grade fixed income assets and implementation of a collar strategy on AUD 500 million of its equity portfolio. This compensated for lower statutory earnings that was impacted by a significant aftertax experience loss of AUD 194 million. The experience loss was primarily driven by lower equity markets, expanding credit spreads and new business strain. We believe its strong capital position will allow it to maintain its dividend, despite being slightly above its dividend payout ratio target of 45% to 50% of normalised NPAT.