Challenger Limited

Company Overview: Challenger Limited (ASX: CGF) is a multi-faceted financial services organization, with core businesses in annuities, funds management and administration platforms. It is one of the largest annuity providers and fastest growing fund managers in Australia with offices in Australia, London, New York and Tokyo. Challenger’s activities are also subject to supervision by other regulatory agencies. CGF’s principal activities are divided into two operating segments, Life Management and Funds Management. The Life operating segment is serviced by the Distribution, Product and Marketing team whereas the Funds Management segment focuses on the retirement savings phase of Australia’s superannuation system.


CGF Details

 
Steady Earnings and Stable Expenses: Challenger Limited (ASX: CGF) is a multi-faceted financial services organization, with core businesses in annuities, funds management and administration platforms. As on 20 April 2020, the market capitalization of the company stood at ~$2.93 billion. Despite a challenging environment, the company reported steady normalized earnings highlighting the resilience of the business. Despite hitting record lows in retail flows across the sector, CGF has continued to attract strong retail inflows in both Life and Funds Management. During FY19, normalized EBIT of the company witnessed an increase of $1 million and stood at $564 million, reflecting stable normalized cash operating earnings of $670 million and stable expenses. In the same time span, normalized net profit after tax stood at $396 million and group assets under management (AUM) were slightly up on FY18 at $82 billion. During the year, the company reported a record low cost to income ratio of 32.6% with a decline of $1 million in expenses to $267 million, reflecting the efficiency of the business. Over the span of 4 years from FY15 to FY19, the company witnessed a CAGR of 8.87% in revenue and a CAGR of 8.67% in gross profit. The company also reported a robust capital position with excess regulatory capital and group cash of $1.5 billion. This strengthens the future growth in the company’s annuity book and confirms the resilience of the business in the period of uncertainty. Reflecting the strength in the business and strong capital position, the company paid a full year, fully franked dividend of 35.5 cents per share, reflecting a payout ratio of 54.2%. This payout ratio indicates the trust of the Board in its position to return to growth as circumstances improve.

The company has released its interim results for the period ending 31 December 2019 wherein it reported strong growth in assets under management driving earnings growth. It has made considerable changes in its planned priorities and continued to remain as the number one retirement income brand with a solid reputation amongst its customers and advisers. 

The company has increased its attention on direct engagement with customers in order to build bottom-up customer demand and has also introduced a new brand campaign to create awareness about the company and the advantages of annuities. Increased accessibility of company’s annuities through superannuation and investment platforms resulted in the shift towards a more diverse and dispersed adviser market. The business is in a decent position to steer the current uncertain environment and is well-positioned to capture opportunities as and when they arise. 


FY19 Financial Highlights (Source: Company Reports)

Details of Top 10 Shareholders: The following table provides an overview of the top 10 shareholders of Challenger Limited. Caledonia (Private) Investments Pty Limited is the largest shareholder in the company, with a percentage holding of 16.17%.


Top 10 Shareholders (Source: Thomson Reuters)
 
Well Management of Costs and Stability in Balance Sheet: During 1H20, gross margin of the company witnessed an increase over the previous year and stood at 91.1%, up from 87.6% in 1H19. In the same time span, net margin of the company stood at 18.2%, higher than the industry median of 17%. The higher gross margin and net margin indicates that the company is managing its costs well and is able to convert its revenue into profits. During 1H20, EBITDA margin of the company went up to 35.8% from 13% in 1H19, reflecting increased profitability. During 1H20, Return on Equity of the company stood at 6%, slightly higher than the industry median of 5.7%. This indicates the company is well managing the capital of its shareholders and is capable of generating profits internally. In the same time span, Assets/Equity Ratio and Debt/ Equity Ratio of the company stood at 7.55x and 1.90x, as compared to 7.63x and 1.97x in 2H19. This indicates that the business is financed with a more significant proportion of investor funding and a small amount of debt, resulting in a financially stable balance sheet.


Key Margins (Source: Thomson Reuters)
 
Boosted Earnings Momentum and Strong Capital Position: The company has recently released its interim results for the period ending 31 December 2019 wherein it executed its planned strategy and continued to maintain a decent position to optimize performance in the current environment. During 1H20, the company witnessed remarkable retail flows in its fund management along with improved earnings momentum with net flows of $1.9 billion. During 1H20, groups’ Asset Under Management went up by 10% to $86 billion, and normalized net profit before tax witnessed a slight increase of 3% over the previous period and stood at $279 million. The company has also retained a robust capital position with an excess of $1.5 billion in Challenger Life company Limited regulatory capital above APRA’s minimum requirement and group cash. The decent financial and operational performance of the company enabled the Board to declare a fully franked interim dividend of 17.5 cents per share.

Segment Performance: During 1H20, a strong contribution from Japanese partnership and Australian institutional sales resulted in an increase of 15% in total Life sales to $3.1 billion. In the same time span, Life cash operating earnings were up 5% to $345 million reflecting growth in investment assets. The company made substantial progress in building Life’s wholesale longevity business with the completion of three transactions in the UK pension market. During the half, strong growth in retail and institutional flows supported the earnings of Fund Management and reported an increase of 7% in EBIT to $28 million.


1H20 Life Result (Source: Company Reports)

Future Expectations and Growth Opportunities: The company is well responding to the challenges and is well-positioned to capture the opportunities. It is prioritizing to improve adviser experience and is focused on strengthening its relationships with profit-for-member funds. The company is leveraging MS&AD strategic alliance and is building on FM product and distribution offering. CGF maintains financial discipline and retains a strong capital position. 

It has provided guidance for FY20 and expects normalized net profit after tax to be in the range of $500 million to $550 million. It is also targeting cost to income ratio in between 30% to 34% and pre-tax return on equity (ROE) of RBA cash rate plus 14% margin. The company has added financial flexibility and liquidity and has effectively adjusted its investment portfolio in order to maintain capital strength. Amidst the extreme volatility in the market, the company has given a high weightage to investment grade fixed income. It will continue to reposition the portfolio in order to benefit when conditions stabilize, and relative value opportunities emerge.


Key Valuation Metrics (Source: Thomson Reuters)

Valuation Methodology: Price to Book Value multiple based relative valuation approach (Illustrative)

Price to Book Value multiple based relative valuation approach (Source: Thomson Reuters)

Note: All the forecasted figures are taken from Thomson Reuters, NTM: Next Twelve Months

Stock Recommendation: As per ASX, the stock of CGF is trading close to its 52-weeks’ low level of $2.820, proffering a decent opportunity to enter the market. The company is in an upright position to enhance its performance in the current environment. The business has continued to be strong and has presented consistent earnings despite considerable and continued challenges in the operating environment due to COVID-19. Considering the trading levels, improvement in margins, resilient financials despite the uncertain environment and decent outlook in the long run, we have valued the stock using the Price to Book Value based relative valuation approach and have arrived at an indicative target price offering an upside of lower double-digit (in percentage terms). For the said purposes, we have considered Pendal Group Ltd (ASX: PDL), IOOF Holdings Ltd (ASX: IFL) etc. as peers. Hence, we see potential in the stock and recommend a ‘Buy’ rating at the current market price of $4.56, down by 4.802% on 20 April 2020.
 
 
CGF Daily Technical Chart (Source: Thomson Reuters)

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