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Morningstar | Challenger’s FVE Cut on Reduced Equity Growth Assumption and Intensifying Adviser Disruptions

We have cut no-moat Challenger Group’s fair value estimate to AUD 8.20 per share from AUD 9.25 primarily because of a reduction in the firm’s growth assumption for its equity portfolio from fiscal 2020 and disruptions in its key financial adviser distribution channel. Challenger’s updated guidance results in only a minor reduction in fiscal 2019 underlying net profit after tax, or NPAT, to AUD 398 million from the previous AUD 402 million. The damage occurs from fiscal 2020, with underlying NPAT forecast at AUD 369 million from the previous AUD 402 million. Lower earnings in fiscal 2020 is because of management’s new lower equity growth assumption and guidance for a one-off incremental investment of AUD 15 million during fiscal 2020 for marketing, products and distribution. Earnings are also being hit by lower interest rates, resulting in lower asset returns, and being reduced by a higher normalised tax rate from fiscal 2020. At our fair value estimate the firm has a fiscal 2019 P/E of 12.7 times and 13.7 times in fiscal 2020 and a fully-franked dividend yield of 4.3% in both years.

We expect the lower interest-rate environment and disruption to its financial adviser distributional channel will continue to be headwinds to earnings growth over the next few years. However, Challenger is well positioned to take advantage of the long-term structural tailwinds of an ageing demographic and roughly AUD 67 billion being transferred each year to the pension phase from the allocation phase of superannuation in Australia. Its new agreement with MS Primary to sell USD annuities in Japan from July 1, 2019, in addition to the current sale of AUD annuities, should also support annuity sales. Management’s confidence in Challenger’s long-term prospects is reflected in their willingness to overlook near-term headwinds and maintain dividends at fiscal 2019 levels during fiscal 2020, despite lower-than-expected underlying NPAT and a payout moderately above its target ratio of 50%.

The company’s reduced its equity portfolio growth assumption to 3.5% from 4.5%, which is the long-term return assumption on capital in excess of cash earnings. It came as a surprise because management indicated they were comfortable with their normalised growth assumptions only a few months ago. A change in the composition of its equity portfolio to investments with a lower sensitivity to overall equity markets is the reason for the lower growth assumption. The portfolio will have more than 80% low-beta investments and absolute return funds. Low-beta investments, which include an increase in its recently instituted cap-and-collar strategy, are expected to participate in 60% of the upside and only 40% in the downside of equity market increases and decreases respectively. This new portfolio composition aims to generate returns generally in line with broader equity markets but with less volatility. While this change will have no impact on statutory NPAT or regulatory capital requirements, it is expected to reduce underlying NPAT by about AUD 23 million in fiscal 2020.

We expect the company to average a pre-tax return of equity, or ROE, of 14.4% in the next five years. We had already expected management not to meet its 18% pre-tax ROE target in the next few years, so it was not overly surprising it changed this target despite committing to it only a few months ago. The new ROE target is the Reserve Bank Cash Rate (currently 1.25%) plus 14%. The rationale for the new target is management’s expectation that there has been a structural change in interest rates, that is interest rates will stay lower for longer. The company’s new ROE target removes the effect of interest rates. Lower interest rates make it difficult to price annuities so that asset returns are sufficiently above annuity payments to meet the absolute 18% ROE target.

As expected, the disruption to Australia’s financial advice industry, which is Challenger’s major distribution channel when selling its annuities in Australia, is continuing. However, disappointingly, management indicates that market disruptions intensified in the fourth quarter of fiscal 2019. Over the next few years, we expect large financial adviser hubs operated by the major banks will be less focused on writing new business, including Challenger annuities, and more focused on exiting their wealth management businesses and remediating customers, as well as improving corporate governance and risk management procedures.

Regulatory changes, including stronger educational requirements for advisers and the removal of grandfathered commissions is also likely to see more advisers leave the industry and higher levels of adviser churn in major advice hubs. Challenger was not implicated in the Royal Commission and its strong reputation among advisers and the broader community remains intact. However, the company continues to face the aftermath of the Royal Commission. Annuity sales at major advice hubs in second and third quarter of fiscal 2019 were 25% lower than the prior corresponding period, or pcp. The company is addressing these issues by growing sales to independent financial advisers, or IFAs, including via its new agreement with speciality platform providers Netwealth and Hub24. Sales of annuities via IFAs in the second and third quarter of fiscal 2019 increased by 26% on the pcp. However, although IFAs are growing rapidly and are likely to continue growing in the aftermath of the Royal Commission, they still only represent small proportion of the adviser market and are unlikely to compensate for the reduction in annuity sales at major advice hubs over the next few years.

Noticeably, new management continues to invest for the long-term despite the near-term headwinds. Management could have taken a more short-term approach by reducing costs, but is instead doing the opposite by investing an extra AUD 15 million in fiscal 2020 to build bottom-up customer demand for annuities by increasing direct customer engagement and improving brand recognition via new television advertisements. Part of the AUD 15 million incremental expense in fiscal 2020 will also include new customer tools and simplification of product offerings. In general, these investments aim to make annuities a mainstream part of retirement income portfolios and simpler for financial advisers to sell. While underlying NPAT will be hit during fiscal 2020 as a result of these incremental expenses, it will build on Challenger’s strong reputation among financial advisers and the public. We support this approach and these investments should assist Challenger capture more of the large long-term opportunities from the movement of funds from the allocation phase to the pension phase from an ageing demographic.