Challenger (ASX: CGF) shares have been falling since the start of this year. The Company has been a favourite amongst brokers for a number of years now. Is the party over or do these lower levels represent a buying opportunity?
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Challenger is Australia’s leading provider of annuities and guaranteed retirement income products. The Company’s Life division, which accounts for approximately 90% of overall revenues and operating earnings, is regulated by the Australian Prudential Regulation Authority (APRA) and broadly distributes products via financial advisers, both independent and within the major bank aligned channels.
As an independent product manufacturer, the Life division has distribution representation on all major Australian hubs and platforms. It is also supported by strong long-term macro factors, in particular, an ageing demographic seeking retirement income solutions and Australia’s mandated superannuation. The retirement phase of superannuation is a high-growth market driven by ageing demographics, rising superannuation balances from mandatory contributions (which are scheduled to increase from 9.5% of gross salaries to 12.0% by 2025) and changes in retiree risk preferences.
The Company also has a Funds Management business, which is one of Australia’s fastest growing, with FUM more than doubling to $76.5b over the last five years.
Our recent review of the Company’s fundamentals identified two key market concerns that have contributed to the weakness in the share price from around $14 in late January this year to current levels:
1. Declining Cash Operating Earnings (COE) Margin in recent periods. This is in part due to the changing mix of annuities products. In particular the increasing sales of annuities in Japan which are lower margin products. The other part is due to lower sales of domestic annuities. The latter has the highest COE margin out of Challenger’s annuity book mix. As a result of these factors, earnings growth is lagging both sales and Life annuity book growth.
While the COE margin is expected to continue to decline, there is not expected to be a material impact on profitability. This is because the margin for Japanese annuities includes distribution costs, whilst domestic annuities attract direct expenses. Nonetheless, it does temper the degree of earnings leverage to solid growth in the Life annuity book.
2. Increased Capital Intensity. In order for Challenger’s Life division to meet its regulatory and contractual obligations to its customers, the Company is required to hold a minimum amount of capital, known as Prescribed Capital Amount (PCA). Despite undertaking a capital raising in the first half of financial year 2018, which was designed to boost the PCA capital ratio (i.e. the total regulatory capital base divided by the PCA), the interim results showed a decline in the PCA capital ratio.
This was due to Challenger deploying the unutilised capital into higher-growth assets (for example: listed infrastructure, REITs) in order to generate some return for shareholders while it waits to be deployed. While these assets generate higher yields, they incur a higher asset risk charge. This in turn leads to a higher PCA, as the Company is required to hold a larger amount of prescribed capital if it increases its allocation to riskier assets.
Does the current weakness in the share price present an opportunity?
While we acknowledge the strong long-term macro factors underpinning the Challenger investment case, it is difficult to find a catalyst for the shares at present. Note that the shares are still trading around the mid-point of its 1-year forward P/E multiple trading range of 15-20x over the last 12 months. Investors may have to wait for full year results in August to see whether the Company has been able to, or is likely to, stem (or reverse) the declining trend in COE margin.
Further, recent broker reports have highlighted the challenges in Challenger implementing price increases to arrest the declining COE margin trend. They have also highlighted the possibility of declining annuity sales from the Department of Social Security’s proposed new means test rules for lifetime retirement income products.
What does the chart for Challenger look like?
CGF has fallen sharply from its recent peak and has come back to the previous low near $12. The severity of the recent fall suggests that, at best, CGF uses up a bit more time here near $12. If it can hold onto these levels for a few more weeks or so, then it may be ready to head higher again. If it falls under $12, then we would be targeting the next support zone near $11 as a better entry point.
Michael Gable is managing director of Fairmont Equities.
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