Challenger faces stiffer competition
The annuity provider remains dominant and undervalued but an ageing population and low barriers to entry could mean skinnier margins.
Mentioned: Challenger Ltd (CGF)
Challenger’s prospects are strong, and the annuity provider remains at a big discount, but it may be forced to boost payment rates as competition heats up.
That’s according to Morningstar analyst Shaun Ler, who in a recent update says sales partnerships with super funds will be crucial to growth.
On Wednesday afternoon, Challenger (ASX: CGF) was trading at $5.36, a roughly 30 per cent discount to Ler’s fair value estimate of $7.50. The company has a forward dividend yield of 3.54 per cent. It paid a fully franked dividend of 9 cents earlier this year.
Despite its no-moat rating, Challenger will likely stay as the leading annuity seller in Australia over the next decade, Ler says.
But to do so, it will need to cede some profitability.
“We implicitly assume Challenger will capture about two-thirds of all funds allocated to annuities from 1 July 2022, assuming a 15 per cent allocation to a comprehensive income product for retirement.
“A core driver of this will be growing partnerships with more super funds, where Challenger sells them annuities before helping design retirement income solutions for fund members.
“But it will have to offer higher payment rates and sell shorter-dated products to win them over, as institutional clients often shop around and commit money more slowly. Some can create their own retirement products at competitive rates.
Challenger’s annuity products provide investors guaranteed regular payments over an agreed term for an up-front lump sum investment.
Annuities are designed primarily to protect investors in the event they outlive their savings.
Challenger (CGF) v Morningstar fair value - 1YR
Source: Morningstar Premium; data as of 23 June 2021.
Ler expects partnerships with super funds will generate strong sales volumes once the government’s retirement income covenant comes into force on 1 July this year.
Under the retirement income covenant, trustees must have a strategy in place to generate higher retirement incomes for members.
Challenger accounts for roughly 90 per cent of yearly annuity sales in Australia, while its products are represented on platforms used by more than 70 per cent of Australia’s financial advisers.
It will seek to increase sales through various channels, particularly those that were unaffected by the banking royal commission. These channels include independent advisers, speciality platforms, industry funds and institutional clients.
Challenger also relies on its tie-up with Japanese insurer MS Primary to sell Australian- and US-dollar-denominated annuities into Japan.
In addition, Challenger operates a funds management business, Fidante Partners, which has minority stakes in several boutique global investment managers, and CIP Asset Management, which primarily manages investments supporting its annuities business.
Challenger's sales volumes are recovering from covid-19 and from the shake-up of Australia’s financial advice industry following a string of scandals, which culminated in the banking royal commission.
Ler anticipates the company faces slimmer margins because as competition increases it will likely need to increase future payment rates.
“Earnings prospects are strong nonetheless,” Ler says.
“Challenger is positioned to benefit from Australian baby boomers transitioning to retirement. It currently captures less than 5 per cent of the circa $70 billion in funds shifting annually into the Australian post-retirement segment, and we expect this share to increase.”
Risks beyond its control
Despite strong earnings prospects, Challenger faces several risks beyond its control, which prevent it from having a narrow moat, or ten-year competitive advantage.
- It is restrained by the types of assets in which it can invest (and therefore the returns it can generate)
- Its products are easy to replicate and thus vulnerable to competition
- Margins are tied to fluctuating interest rate movements (low rates mean lower yield for customers)
- An ageing population and growing super system will trigger more competition
Ler forecasts the annuities or life business to increase normalised pre-tax earnings at a compound annual growth rate of 8 per cent over the next five years from fiscal 2020, above the five-year average.
Challenger’s funds management arm is less prone to competition as it has intangible assets and switching costs, Ler says.
“Funds under management grew by close to 7 per cent per year over the five years to fiscal 2020, with net inflows averaging about 3 per cent per year—considerably above pure-play listed asset manager peers. This is supported by the business’ strong investment track record.”