Challengers’ Challenge

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Challenger Financial services has two main products. The first is the selling of income streams (annuities) to retirees. The second is funds management. Over the last 3-4 years these divisions have experienced strong growth and the share price had performed accordingly.

Late last year the government moved to change the rules on the treatment of some annuities when assessing eligibility for the age pension. The reaction to Challengers share price was savage and swift as investors felt the political regulatory risk on the company had increased significantly. After a few days of thought and I dare say, lobbying, the Government reversed its decision – Challengers share price didn’t reverse as quickly and has somewhat stagnated since. The question we wonder is, can the growth continue?

There are two components to the growth of the annuities business. The first is generating new business (or sales). The word is that Challenger is very close to having it annuities made available through retail super provider Colonial First State. This would open a large market for them that has, until now, been unavailable with their key market self-managed super fund or those with a few hundred thousand outside of super looking for a ‘secure’ home. A deal with Colonial would mark their second superannuation provider. This is a clear opportunity for Challenger.

The second is the margin on their annuities. Challenger will for example, sign up an annuity to pay a return of 4.5% and then invest the proceeds in low risk yielding bonds, notes and other cash products to generate a return greater than the 4.5% they agreed to pay out. This margin is the key profit driver for this division and in a low interest rate environment such as the one we are in can make maintaining their margin difficult. Challenger announced last week that their is a chance they may not offer a rollover on some products that expire later this year as they believe the margin isn’t maintainable. This is prudent management but the risk is that the business doesn’t come back to other products and that their annuity book declines. Ultimately I believe this is a low risk possibility, the appetite for low risk income products is still very high.

The other business unit, funds management, is a simple business unit. Put simply it earns a percent of funds under management. Funds have been seen net inflows however a fall in the market like that we have seen in the last month can hurt.

The concerns on Challenger see it trade on a price/earnings ratio well below its peers. The crystal ball we have suggests that the steady earnings growth that Challenger has delivered over the last 3 years is sustainable (with the current 2015 year being the exception). Growth of 6-9%pa over then next few years coupled with a 4.5% dividend yield would provide a satisfactory return alone.

A re-rating of PE to match the industry average would see even greater returns and is likely if Challenger can prove they can maintain growth.