Morningstar has tempered its outlook for Challenger Financial, on the back of management's slashed earnings guidance for the first-half of fiscal 2019 and regulatory uncertainty stemming from a Productivity Commission report.

The annuities product provider's fair value estimate has been reduced by 14 per cent, to $10.80 from $12.60, says Morningstar equity analyst Chanaka Gunasekera.

Challenger (ASX: CGF) yesterday said it expected a first-half statutory profit of just $6 million, compared to $195 million a year ago, largely because of poorly performing equity markets and policy liabilities in its life division.

In adjusted terms, this amounts to a 7.8 per cent reduction in its forecast profits.

This is based on projected underlying earnings of between $545 million and $565 million, down from the prior forecast of between $591 million and $613 million.

Challenger's Australian retirement pension products are its core revenue generator, sold by about 70 per cent of financial advisers. These had placed it in a dominant position, given Australia's ageing demographics driving high demand for such vehicles.

But Challenger faces several risks, including market volatility and the recent negative Productivity Commission report on the government's proposed retirement income regime, alongside the structural tailwinds.

 

retirement

Market volatility and uncertainty from the recent PC report are headwinds

Downward pressure on margins earned from its annuities are the main driver of Morningstar's reduced fair value estimate reduction, says Gunasekera.

"Margins have been compressing since around 2012, and the outlook is even worse than we and the market initially thought," he says.

The margins on cash earnings have consistently fallen in recent years, from 4.3 per cent in 2012 to 3.17 per cent last fiscal year. Gunasekera projects further falls to about 2 per cent before they stabilise from fiscal 2026.

He also highlights the federal government's plan to legislate a requirement for superannuation trustees to consider the retirement income needs of their members, beyond the accumulation phase. A flagship comprehensive income product for retirement was to be a core underpinning of this, but this has been thrown into doubt by the 10 January PC report.

This cited potential competition concerns in the supply of retirement-income products, particularly to smaller super funds, which could face significant pressure to adopt third-party solutions such as those of Challenger.

"This report recommended a delay in introducing the retirement income covenant. It expressed concerns that the covenant may nudge members into products ill-suited to their longer-term needs," says Gunasekera. "The commission is concerned there are currently few choices in the market for these products."

However, Challenger continues to trade at a substantial discount to Morningstar's $10.80 FVE, opening at $7.36 today. A longer-term trend of a larger allocation to annuities in retirement portfolios will go some way toward offsetting the margin compression, says Gunasekera.

The Coalition and opposition Labor Party have indicated they will formally respond after the final report from the banking royal commission is tabled – which is due next Friday 1 February.