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Morningstar | Structural Tailwinds Lift Challenger's FVE to AUD 13.10, Stewardship Upgraded to Exemplary

A change in analyst sees an increase in Challenger's fair value estimate to AUD 13.10 per share from AUD 12.80 and stewardship upgraded to Exemplary from Standard. At the new fair value, the firm's fiscal 2019 dividend yield is 2.8% and P/E is 17.9 times, with the multiple supported by significant tailwinds. This includes the transition of Australia's baby boomers into the pension phase, Australia's compulsory superannuation system, and annuity sales into Japan's huge retirement market. Now it is poised to benefit from the government's proposed new comprehensive income product for retirement, or CIPR. The company currently screens as moderately undervalued.

We forecast continued strong medium-term earnings growth, with Challenger in a strong position to take advantage of the new CIPR. As part of the new retirement income framework, the Australian government proposes to codify for the first time within the Superannuation Industry (Supervision) Act 1993, a covenant requiring superannuation trustees to consider the retirement income needs of their members, including offering a flagship CIPR. This CIPR will consist of an account-based pension, or ABP, and a pooled product, with a 100% allocation to an ABP not qualifying as a CIPR. Currently, ABPs receive most of the funds moving from accumulation to the pension phase, with less than 5% going into pooled annuity products.

We expect CIPRs will result in a minimum of 15% to 20% allocation to pooled products, with the government contemplating a CIPR allocating 70% to 75% to ABPs and 30% to 25% to pooled products under varying circumstances. We believe increasing numbers of retirees will now be offered annuities as part of a CIPR by trustees and CIPRs are also likely to be a benchmark used by financial advisors to meet their "best interest" duty. We forecast this to increase the sale of Challenger's annuities to superfund members transitioning to the pension phase and by advisors recommending the products to clients.

Challenger's management have done an excellent job in positioning the company to take advantage of the new CIPRs. VicSuper is already offering Australia's first CIPR backed by Challenger and we think more superfunds will distribute Challenger annuities as the expected commencement date of July 1, 2020 approaches. Management have also done an exceptional job in integrating Challenger's annuity products in all aspects of the wealth management ecosystem, making it the dominant annuity provider in Australia. This includes investing in its brand via successful advertising campaigns and strengthening its distribution reach in the key financial advisor channel by investing in educational support and tools like its Retirement Illustrator. Not only has this led to strong annuity sales growth, it has also resulted in consistent recognition from surveys like the 2017 Wealth Insights survey which rated Challenger the number one by financial advisors across areas such as technical and client services, business development, and overall advisor satisfaction.

Management is also continuing to build relationships with major dealer groups and platform administrators, with its annuities represented on platforms used by two thirds of Australia's financial advisors, and it recently being placed on AMP's platform and it is soon to be placed on BT Financial Group's platforms. BT Financial Group reported AUD 119 billion of funds under advice at March 31, 2018, representing 18% of the market. In fiscal 2017, Challenger's annuity sales via platforms increased by 80%. Importantly, Challenger has been able to achieve these strong results with a relatively low cost/income ratio, suggesting management is operating the business efficiently. This among other reasons prompted us to upgrade Challenger's stewardship rating to "Exemplary."

We forecast strong annuity sales growth and a lengthening tenor of annuities sold will increase the funding for Challenger's investment assets and generate continued strong cash operating earnings despite further expected margin pressures. While the firm's strategy to increase the tenor of its annuities is expected to generate a liquidity premium on its investment assets, we nevertheless forecast continued pressure on margins due to expected changes in its product mix, increasing competition, and high investment asset prices. We believe the new CIPRs will prompt more sales to superfunds which have strong bargaining power to negotiate higher yields for their members. In addition, we expect margin pressure from increased sales into Japan from the firm's relationship with MS Primary. We also believe the government's new retirement income framework and CIPRs will trigger increased competition in Australia's pooled retirement product market. The government wants increased competition and Challenger acknowledges this is likely to occur, with increasing competition placing further pressure on margins.

We also think Challenger's return on assets will be negatively impacted in the near term by an increase in allocation to higher-grade fixed income, and reduced allocation to commercial property. Challenger is in the process of reducing its property allocation to midteen levels over the next 12 months from a little over 20% at present. Challenger estimates property risk premiums relative to those of fixed income have been falling since fiscal 2016 due to strong international investment demand reducing capitalisation rates. Challenger is also guiding to increased exposure within its "investment-grade" fixed income allocation to higher-quality "AAA" and "AA" grade issuances. While this will reduce earnings on assets, it will also reduce the regulatory capital intensity of its assets, measured by prescribed capital amount, or PCA, divided by its investment assets. Challenger continues to maintain a 1.3-1.6 times PCA target range and estimates a 1% reduction in capital intensity will support about AUD 800 million of investments, which should assist it compensate for the lower return on assets.

We also expect continued strong growth in Challenger's funds management business, which consist of Fidante Partners, and Challenger Investment Partners, or CIP. Fidante provides administration and distribution services to several boutique global asset managers. The portfolio managers have majority equity stakes in their business, aligning their interests with investors and leaving Fidante a minority interest. They are also high conviction funds, with a strong record of beating their benchmarks. CIP is a global real estate and fixed-income manager that also benefits from the vertical integration of managing funds and co-investing with Challenger's life business in addition to some third-party client mandates. Despite the growth of cheaper passive investment styles and industry superfunds in-housing some asset management, its funds business has attracted significant net inflows, which we expect to continue.