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Morningstar | Challenger’s Disappointing Fiscal 2018 Results Prompt a Modest FVE Reduction to AUD 12.60

We decrease our fair value estimate for no-moat Challenger to AUD 12.60 per share from AUD 13.10 following disappointing fiscal 2018 results. Normalised net profit after tax, or NPAT, of AUD 406 million was 5% below our forecast and at the lower end of guided net profit before tax, or NPBT, growth of 8%-12%. Lower investment yields on policyholder funds in its core annuities business and a higher effective tax rate were the primary drivers of the lower-than-expected normalised NPAT results. Nevertheless, the company’s final dividend of AUD 18 cents per share was in line with our forecast and results in a fully franked total dividend of AUD 35.5 cents per share for the year. At current prices, the stock screens as moderately undervalued.

While we expected normalised cash operating earnings, or COE, margins to continue contracting in fiscal 2018, the size of the fall was somewhat concerning, particularly in the second half. COE margins fell 36 basis points in fiscal 2018, higher than our forecast contraction of 27 basis points. Margin compression was due to lower interest rates and asset returns and lower other income, primarily due to a one-off life risk fee and income from its insurance linked securities being lower than expected. Margin pressure is also due to continued product diversification, including a higher proportion of lower-margin institutional Guaranteed Index Return and Index Plus products, as well as Japanese annuities. The normalised NPAT was also affected by a higher effective tax rate, increasing 2% to 25.8% in fiscal 2018. The higher tax rate was primarily driven by interest payments on Challenger Notes not being tax-deductible, a lower proportion of offshore earnings, and a reduction in the level of franked dividends received.

Following the results, our forecast normalised NPAT in fiscal 2019 falls to AUD 432.6 million from AUD 453.3 million. Our forecast is at the lower end of the company’s guidance of normalised NPBT growth of 8%-12%.

Although we believe the larger-than-expected margin contraction and the company’s guidance to a moderately higher effective tax rate warrant a modest reduction in Challenger’s fair value estimate, its longer-term growth drivers are intact. Tailwinds such as Australian baby boomers continuing to transition into the pension phase of retirement and the firm’s access to the huge Japanese retirement market via its relationship with MS Primary, as well as the Australian government’s proposed new comprehensive income product for retirement, position Challenger for continued strong annuity sales growth. The company is also continuing to strengthen its distributional reach of its annuities by announcing a new relationship with fast-growing specialty platform provider Hub 24. We expect these factors, in combination with its strategy to increase the tenor of annuities sold, will drive strong growth in assets under management, compensating for continued margin contraction. The business has also proven scalable, progressively reducing its cost/income ratio and increasing operating margins. Notably, operating margins have increased to 67.3% in fiscal 2018 from 65.4% in fiscal 2016, despite COE margin pressures. We forecast this to continue, with operating margins expected to expand to 68.2% in fiscal 2023 despite continued COE margin contraction.

Challenger’s statutory results were also affected by negative pretax asset and policy liability experience of AUD 45 million, primarily driven by poor market performance in its equity investment portfolio, alternatives, and infrastructure assets. It also incurred negative pretax new business strain of AUD 59 million, but this is a noncash accounting consequence of expanding its business that should reverse over time. The company maintains a sound balance sheet, with the life company’s excess capital above the Australian Prudential Regulation Authority’s prescribed capital amount, totalling AUD 1.3 billion as at June 30, 2018. This represents a PCA ratio of 1.53 times, at the higher end of the company’s target range of 1.3 times-1.6 times.