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Morningstar | Challenger's Profit Downgrade Prompts Reduction in FVE to AUD 10.80. See Updated Analyst Note from 23 Jan 2019

No-moat Challenger’s profit downgrade results in a fair value estimate cut to AUD 10.80 per share from AUD 12.60. The profit downgrade was driven by cash operating earnings margin compression as well as lower funds management fees stemming from recent market volatility. Challenger reduced underlying profit before tax guidance for fiscal 2019 by 7.8% to AUD 545 million-565 million from around AUD 591 million-613 million. Its first-half fiscal 2019 statutory profit is also expected to fall significantly due to an aftertax investment experience loss of AUD 194 million, driven primarily by lower equity market valuations. The company continues to face risks including margin compression, volatile markets, and the recent Productivity Commission report published in early January recommending a reassessment of the proposed retirement income covenant. We believe there is longer-term value at current prices but with high uncertainty.

The main driver of our fair value estimate reduction is continued cash operating earnings margin compression. COE margins (cash earnings/average investment assets) have consistently fallen from 4.37% in fiscal 2012 to 3.17% in fiscal 2018. We expect further margin compression from the increasing demand in Australia for higher-yielding assets to support the investment needs of an aging Australian population, elevating the prices of these assets as well as our expectation of more competition in the Australian annuity market. Nevertheless, the fall in margins implied by Challenger’s profit downgrade is larger than expected. This prompted a reduction in our forecast COE margins from 3.17% in fiscal 2018 to stabilise at 2.11% from fiscal 2026, from our previous forecast of stabilising at 2.41% from fiscal 2024. However, at its current price, the market appears to expect Challenger to face much steeper margin compression, stabilising in the order of circa 1.5% based on our expected growth in investment assets.

Offsetting the margin compression is what we believe will be a longer-term trend of a larger allocation of annuities in retirement portfolios. We think Challenger is well positioned to benefit from this trend, as it’s already the dominant player in the sale of annuities in Australia, with its annuity products available on investment platforms used by about 70% of Australian financial advisors. Demand for Challenger's annuities may also get a major boost from the government’s proposed covenant to be included in the Superannuation Industry (Supervision) Act 1993, which requires superannuation trustees to consider the retirement income needs of their members. This included offering a flagship comprehensive income product for retirement, or CIPR. The CIPR is expected to comprise an account-based pension and a pooled annuity-type product.

However, there is now some uncertainty as to the progress of the CIPR due to the Productivity Commission report on superannuation published Jan. 10, 2019. This report recommended a delay in introducing the retirement income covenant. It expressed concerns that the covenant may nudge members into products ill-suited to their longer-term needs. This included the requirement that all superfunds must offer a flagship risk-pooled product. The commission is concerned that this requirement would force superfunds without capacity to create such a product to acquire it from a third party (such as Challenger). The commission is concerned there is currently few choices in the market for these products. The coalition government and the opposition Labor Party indicate they do not intend to formerly respond to the Productivity Commission report until after the publication of the final Royal Commission Report on Financial Services due by Feb. 1, 2019.