Company Overview: Challenger Limited is an Australia-based investment management company. The Company operates through two segments: Life and Funds Management (FM). The Life segment includes Challenger Life Company (CLC), which provides annuities and guaranteed retirement income products, and Accurium Pty Limited, which provides self-managed superannuation fund actuarial certificates. It distributes products under the Life segment through independent financial advisors and financial advisors that are part of hubs. The FM includes Fidante Partners and Challenger Investment Partners (CIP). Fidante Partners encompasses a range of associate investments in boutique investment managers. Fidante Partners provides administration and distribution services to the boutiques and shares in the profits of these businesses. CIP develops and manages assets under the Company's brand for CLC and third-party institutional investors. The investments managed by CIP include in fixed income and commercial property.
 

CGF Details

Marginal Rise in AUM, Interim Dividend Remains Unchanged: Challenger Limited (ASX: CGF) is a mid-cap investment management company with the market capitalisation of ~$4.75 billion as on April 15, 2019. It is a leading annuity provider and is one of the largest growing funds managers in Australia. Further, the group focuses on expanding its footprint into international markets which might support its growth momentum in the long run. Its assets under management amounted to $78.4 billion in 1H FY 2019 which implies a 2% rise on prior corresponding period (or pcp). The company’s normalised net profit before tax amounted to $270 million, reflecting a fall of $5 million or 2% on pcp. Its earnings got impacted by the volatility in the investment market which resulted in the lower asset returns in life business and lower funds management performance fees. Amidst the challenging operating conditions, the company’s management is optimistic about the future. They are confident that the business is well-positioned to respond to the current market and tap the opportunities for future growth on the back of its supportive fundamentals. The company’s resilient position is reflected by solid domestic annuity sales which were achieved in 1H FY 2019. Australian annuity sales witnessed a rise of 4% as compared to the same period of the last year which reflects continued demand from the retirees for the products. The company managed to announce an interim dividend amounting to 17.5 cents (fully franked) in 1H FY 2019 which happens to be in line with the prior corresponding period, reflecting dividend pay-out ratio of 52.9% on normalised PAT. It equates that the dividend pay-out ratio was slightly above with the company’s dividend policy to maintain it in the range of 45%-50% of normalised net profit after tax.

In a nutshell, the company has an affirmative outlook on the back of its strong capital position, strategic relationship with MS&AD, decent fundamentals and balance sheet position. Also, there are expectations that Funds Management and Life businesses would be benefited from growth in superannuation system of Australia.
 

1H FY 2019 Outcomes (Source: Company Reports)

Decent Revenue CAGR Growth and Balance Sheet Management: The top line of Challenger Limited has witnessed a CAGR of 7.90% in the span of previous five years to FY 2018 (i.e., FY 2014- FY 2018) which can be considered at decent levels and further builds confidence in the company’s revenue-generating capabilities. Also, in 1H FY 2019, the company’s D/E ratio stood at 2.10x which is lower than the industry median of 2.19x reflecting that the company has been deleveraging its balance sheet when compared to the broader industry. We presume that the decent fundamentals coupled with efficient balance sheet management might support the company moving forward which might attract the attention of market players.

Strong Capital Positioning Places CGF For Future Growth: Challenger Limited is strongly capitalised with $1.4 billion in excess regulatory capital and cash above APRA’s minimum requirement. This demonstrates the ratio of 1.54 times the PCA and is towards the upper end of the company’s target PCA range of 1.3-1.6 times. The company’s capital position got supported by lower capital intensity within Life’s investment portfolio, which got reduced from 14.1% to 13.0% in 1H FY 2019. It implies recent Life portfolio changes which include increasing fixed income credit quality as well as implementing equities collar strategy.

Life’s Normalised EBIT Fell 1.8%: Challenger Limited’s Life segment’s normalised EBIT stood at $277.9 million which reflects a fall by $5.1 million (or 1.8%) because of lower normalised COE (cash operating earnings), which is down $6.5 million, and got partially offset with the operating expenses decreasing by $1.4 million (or 2.6%). Life posted normalised return on equity (pre-tax) of 17.5% which reflects a fall by 1.5 percentage points from the prior period because of lower normalised EBIT combined with the increased average net assets. However, the company managed to grow the Life book to $14.5 billion with 4.2% Life book growth in 1H FY 2019 thanks to the solid domestic sales as well as lower maturity rate. There has been increased focus towards longer-term business in recent years. As a result, long-term annuities now account for 38% of the total book (or 45% of annuity book), reflecting an increase from 18% five years ago. Total Life sales amounted to $2.7 billion reflecting a fall on pcp basis because of lower contribution from Japan and timing of institutional maturities and subsequent reinvestments. Total annuity sales amounted to $2.1 billion reflecting a fall of 7% on pcp because of decline in Japan sales.
 

Life Segment Results (Source: Company Reports)

Analysing CGF’s Funds Management Business: The funds management segment’s average funds under management witnessed a rise of 9% and stood at $77.4 billion. In 1H FY 2019, the business witnessed net flows of -$1.0 billion and got weighed by large Australian institutional fixed income mandate redemption.  During the same period, the funds management business got impacted by the market conditions which resulted in lower performance fees. The segment’s net income witnessed the rise of $3 million or 4% and stood at $75 million with performance fees of $2 million, reflecting $4 million falls on pcp. The earnings before interest and tax amounted to $26 million implying a fall of $1 million on pcp.


Funds Management Result (Source: Company Reports)

Challenger Capital Notes Newsletter: In February 2019, Challenger Limited had released its Capital Notes newsletter in which the company stated that they are retaining robust capital position and are having $1.4 billion of excess regulatory capital and group cash. The company also stated that they are seeking to ensure that there is an appropriate balance between the profits paid to the shareholders as dividends and the profits retained for business growth. The company has been making progress towards implementing the strategy to reap the benefits of broad demographic tailwinds behind the growing retirement income market of Australia.

The company has been expanding the distribution reach with the launch on BT Panorama platform in 1H FY 2019 followed by new relationships formed with the independent platforms. CGF has been continuing to grow the funds management business via new product and distribution initiatives.

Expansion of Strategic Relationship With MS&AD: Challenger had made an announcement that they have further progressed the strategic relationship with MS&AD Insurance Group Holdings Inc. (MS&AD) so that CGF’s strategy for growth in Australia and internationally can be supported. As per the new arrangement, CGF would be commencing a quota share reinsurance of US dollar denominated annuities issued in the Japanese market by Mitsui Sumitomo Primary Life Insurance Company Limited (MS Primary), and there is an expectation that it would commence from July 1, 2019. MS Primary is the subsidiary of MS&AD. As per the release, MS Primary will now provide to Challenger Life an annual amount of reinsurance, across both Australian and US dollar annuities, of at least ¥ 50bn (or ~$640m, based on the exchange rate of 0.012839 as at 25 March 2019) per year for a minimum of five years. This is subject to review in the event of any material adverse change for either of the parties.

MS&AD plans to increase its Challenger shareholding to more than 15% of issued capital and seek representation on the Board of Challenger Limited, subject to regulatory approvals and market conditions. The top management of CGF had stated that the expanded alliance leverages the strengths of both the businesses to create opportunities for the continued growth.

What Might Drive Growth For Challenger: Challenger Limited had stated that there are anticipations that normalised net profit before tax would be in the range of $545 million- $565 million in FY 2019 due to numerous factors which includes lower than expected 1H19 earnings and flow on effects in 2H FY 2019, and impact from reduction in capital intensity throughout Life’s investment portfolio. The company is not expected to reach the 18% normalised return on equity before tax target in FY19 because of the lower earnings. However, amidst this, the company has been targeting dividend pay-out ratio in the range of 45%- 50% of the normalised net profit after tax which might be considered at decent levels considering the challenging operating environment.

As stated by Challenger in 2019 interim financial report, the growth in Australia’s superannuation system is backed by the mandatory contributions, and there are expectations that they would witness a rise from 9.5% of gross salaries to 12.0% by 2025. The superannuation system is anticipated to witness growth from $2.8 trillion to more than $10 trillion by 2035. The growth in superannuation system is helped by the changing demographics and Government is also enhancing the retirement phase of superannuation. There are expectations that Life and Funds Management businesses would be benefited from growth in superannuation system of Australia. On April 17, 2019, the company would be releasing its assets and funds under management update for Q3 FY19.

Stock Recommendation: The stock of Challenger Limited has delivered the return of -26.97% in the span of the previous six months while, in the time frame of three months, the return stood at -16.09%. The company’s stock is presently trading slightly towards the 52-week lower level and the company possesses decent fundamentals and strong capital position which might help it achieving growth and places it well to tackle the industry-wide challenges. Therefore, it can be said that the current trading level is providing a decent opportunity to make an entry.

From the valuations perspective, the company’s stock seems to be pretty attractive as its P/E ratio stood at 35.480x which is lower than the peer mean of 50.67x reflecting that the stock is relatively undervalued. Also, the company’s P/B ratio stood at 1.39x which is lower than the peer median of 1.44x, suggesting that the stock is slightly undervalued. On the other hand, the company’s Life business has been diversifying the range of products and expanding the distribution relationships in Australia and Japan. The Life business happens to be resilient and is well placed to tap long-term growth opportunity. Moreover, the company's funds management business is witnessing faster growth than the broader funds management market. There are expectations that funds management business would be benefited from overall growth in Australia’s superannuation system and the company’s expansion into the international markets. Taking into the consideration of aforesaid facts and the current trading level, we give a “Buy” recommendation on the stock at the current market price of A$7.800 per share (up 0.386% on April 15, 2019).
 
 
CGF Daily Chart (Source: Thomson Reuters)

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