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Morningstar | Challenger’s Record of Strong Australian Annuity Sales Continues in 1Q 2019

The highlights of no-moat Challenger’s first-quarter fiscal 2019 results include strong annuity sales and lower maturities in the Australian market that compensated for lower sales in Australian-dollar-denominated annuities in Japan, as well as lower institutional sales, and lower inflows than expected in Challenger’s funds management business. In combination, this prompts a modest increase in our fiscal 2019 underlying net profit after tax, or NPAT, to AUD 439.5 million from 432.6 million. This is at the midpoint of Challenger’s reconfirmed guidance. Our fair value estimate is unchanged at AUD 12.60 per share, driven by longer-term tailwinds. This includes the continuing recognition of the importance of an allocation to annuities in retirement portfolios and the new comprehensive income product for retirement, or CIPR, legislation that is likely to promote a higher allocation, as well as the strength of its distributional reach. At our fair value estimate, Challenger has a fiscal 2018 P/E of 17.7 times, and we believe it's currently undervalued.

We think Challenger’s longer-term tailwinds are intact, but there are some short-term concerns that may weigh on investor sentiment--in particular, a potential fall in Australian property prices. Its primary exposure to property includes equity interests in commercial property and to residential-mortgage-backed securities in its fixed income portfolio. It's already in the process of reducing its equity interest in property and increasing its allocation to higher-grade fixed-income assets. Another concern is the higher interest rates in the U.S. relative to Australia, facilitating higher yields on USD annuities relative to AUD annuities, which is reducing its sales into Japan. There is also the potential for a delay in the CIPR legislation. Despite these genuine concerns, we believe the longer-term trend to a larger portfolio allocation to annuities has begun and will support strong earnings growth over the longer term.

Challenger is well positioned to benefit from the increasing allocation to annuities. It's already the dominant player in the sale of annuities in Australia. In fiscal 2018, we estimate that it took a little over 70% share of the transfer of funds from the accumulation phase of superannuation to the pension phase that went into pooled annuity products. Its new announcement to further expand its distributional reach by making its products available on speciality platform provider, or SPP, Netwealth, along with the previous announcement that its products will be available on Hub24, means its products will soon be available on two of the fastest-growing SPP providers. Along with the recent launch of its products on the BT Panorama platform, this means its products will soon be available on platforms used by more than 70% of Australian financial advisers. This is important because it makes it easier for financial advisers to put their clients into the company’s annuity products and should allow it to continue generating strong annuity sales in Australia.

Unlike many other organisations operating in Australia’s retirement savings industry, Challenger has not been directly affected by any major fallout from the Royal Commission. Nevertheless, sales may be indirectly affected if part of the aftermath of the Commission is that fewer people seek out financial advisors, given that Australia’s financial advisors are the major distributional channel for selling its annuities. However, the first-quarter 2019 results do not suggest this is occurring. There is also the potential for Challenger to indirectly gain from the aftermath of the Royal Commission.

We believe the advent of CIPRs will continue the trend of larger allocations to pooled annuity products in retirement income portfolios and spur more competition in the Australian annuity market. High investment asset prices and increased competition are the main reasons we expect Challenger to continue facing cash operating earnings margin pressures. The natural competitors to Challenger in this market are organisations that already have an established life business in Australia and are already regulated by the Australian Prudential Regulation Authority. However, several of these natural competitors have been directly caught up in the Royal Commission and will likely be preoccupied with responding to regulator concerns following the Commission. Additionally, there is considerable disruption in Australia’s life industry, with several organisations selling their life businesses. This may reduce the ability of these life businesses to more aggressively compete in Australia’s annuity market despite the expected higher demand for pooled annuity products, which may work in Challenger’s favour.