The Challenger rocket is still firing

Leyland Private Asset Management

We last covered Challenger in April 2016. It’s a company we have liked for some time and currently hold in a number of client portfolios. We’ve been buyers of the stock since mid-2013 when it was selling for around $4 per share. The company is now trading above $13.00 so it’s been a big ride, however, we think there is plenty more to come despite its bull run over the past four years.

Figure 1: Challenger (ASX:CGF) share price April 2016 to April 2017

A Well-Oiled Machine

Challenger is classified as a Life Company—or diversified financial Holding Group—made up of a Life annuities division and a smaller Funds Management business that accounts for roughly 10% of Challenger’s group valuation—$7.2 billion. Challenger’s Life annuities business model is straight forward. It invests money received from holders of its life annuities into bonds, fixed income securities, equities and mortgage backed securities. CGF earns considerable interest income on these securities as investment income. It then pays out a large percentage of this investment income to holders of its Life annuities according to the following scale:

Figure 2: Challenger’s coupon rates for its Life annuity product

CGF collects the margin left over as income and this spread accounts for the bulk of the company’s revenue. It also runs funds management business under the Fidante Partners brand and Challenger Investment Partners. The company earns management fees in this division for assets under management. Management has instituted a fundof- funds approach in this business and employs a select group of fund managers specialising in fixed income, Australian equities, global equities and alternative investments. This area of Challenger’s business is becoming a growth engine and slowly becoming more important to their bottom line. Challenger’s balance sheet looks similar to a bank. It has a huge amount of outstanding debt in comparison to its net equity; debt is roughly six times equity. Its liabilities consist of outstanding money owing to holders of its life annuities.

Boom Boom Shake the Room

If you want to talk about getting exposure to the huge baby boomer demographic then there is probably no more attractive play than Challenger. Baby boomers are defined as those born between 1946 and 1965. The oldest baby boomers are turning 71 this year and the youngest are turning 52. There are 5.6 million baby boomers in Australia alone and it is estimated that 800 baby boomers are turning 50 each and every day in Australia. All baby boomers will be 65 and over by 2030 and by 2020 there will be more 65 year olds than 1 year olds. It is estimated that baby boomers control 55% of the private wealth in Australia, despite accounting for less than 25% of the country’s total population. These numbers intimate that the baby boomer demographic is very real and very large, and they are hungry for investment income as they transition from full-time employment to retirement. This is where Challenger is filling a big hole. Its Life annuities products provide much needed income to those who seek a guaranteed stream of income in the form of a Life annuity. Customers are typically those who are more risk-averse and seek less volatility in their investment returns, not to mention a stable and regular payment of income month-to-month.

A Fresh Look

CGF’s model today is very focused and simplified compared to what it used to be. Management recently divested its Mortgage Management and Financial Planning businesses and is now focused on maximising its leverage to Australia’s growing superannuation sector through its two core businesses: Life and Funds Management. We think management has done a great job repositioning Challenger to benefit from growth in superannuation and the shift of baby boomers into retirement with new products and a greater distribution reach. The company’s recent trading update supports this view. Management announced it is on track to achieve net-book growth of 10% in FY17, consistent with 10% growth in FY16. More telling was the 53% growth in retail annuity sales to a total of $880 million. This is nothing short of phenomenal and was largely due to its new relationship with Mitsui Sumitomo Primary Life Insurance Company (MS Primary). We estimate this relationship contributed close to $275 million of CGF’s total sales. We believe CGF is now on track to achieve net book (total Life investments) growth of +15% from 2018 through to 2021. Accelerated growth will be supported by the pending launch of AMP and BT Financial Group annuities on their respective wrap platforms, a longer duration tenor for Challenger’s Life annuities—leads to less maturities—and the pending launch of Deferred Lifetime Annuities which remains on track for launch 1 July 2017.

Figure 3: Challenger current and estimated net book growth out to 2021

Other highlights from Challenger’s March quarter include:

• Retail annuity sales of $880 million, ahead of consensus of $740m;

• Closing Life Book of 14.9 billion, in line with estimates;

• Funds Management net-flows of $1,034m, ahead of consensus of $500m; and,

• FY17 Cash on Earnings (COE) guidance reaffirmed around midpoint range of $620m-$640m.

Notably, CGF’s CarePlus product—designed for people who have been assessed as being eligible to receive Government-subsidised aged care services—has continued to gain traction since its relaunch in August 2015 with sales of $46m during the March quarter, up 207% vs the prior period. In its funds management division, Challenger realised group net-flows of $1,034m vs $500m estimates for the quarter, including $384m of netflows into Fidante Partners, and $650m of netflows into Challenger Investment Partners. Total funds under management now total $55.1 billion.

2017 and Beyond

It is our belief that Challenger will continue to benefit from a strong age demographic that is the baby boomer generation. The wind is at its sails so to speak. Combining this with a high-quality management team lead by Managing Director and CEO, Brian Benari, we expect Challenger will offer consistent growth for the medium to long term. The company trades at a premium to the market on a PE of 20x earnings versus a market PE of 16x earnings. This is justified given the quality of Challenger’s business model and unique position in the market place—it is one of the few and certainly the most dominant player in Life annuities. Major risks for the company include the loss of key personnel, poor investment performance, interest rate and currency risk in its Life division and ongoing changes to superannuation laws. The appeal of annuities can be impacted by unfavourable government policies, particularly when it relates to tax outcomes. Management has done an outstanding job mitigating these risks and has responded well in the past to changes in superannuation laws. Challenger has achieved modest compound growth in earnings of about 5% in the past five years. This shows it’s not a wild ride by any means but if you’re looking for slow and steady growth, a high-quality business with a grossed up dividend yield of 3.7%, and exposure to the baby boomer demographic then Challenger makes for a very attractive long-term investment.


Leyland Private Asset Management

Founded in 2003, Leyland Private Asset Management is an independently owned firm specialising in Australian Stock Market and Fixed Interest Investments for individuals, companies, self-managed super funds, institutions and family offices.

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australian equities ASX:CGF

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