Regulatory Blow For Challenger But Stock Remains Attractive

This story features CHALLENGER LIMITED. For more info SHARE ANALYSIS: CGF

-Abandons retail book guidance
-Questions over further regulatory risk
-Setback but there are offsets
 

By Eva Brocklehurst

Australia's Department of Social Security has dealt a blow to Challenger Financial ((CGF)), signalling an intention to reverse the favourable means testing – ruled in 2012 – of the company's aged care annuity product. Challenger has reduced its guidance for life cash earnings by $10m to $525-535m and effectively abandoned retail annuity book growth guidance of 10-12%, stating it was not in a position to confirm growth at this stage.

The product allowed those in residential aged care to benefit from reduced aged care costs and increased age pension payments. These benefits rose as a result of the product being deemed a capital return, providing a deduction under social security means tests. Clients, now, would likely experience a reduction in their age pension and an increase in care fees, making the product unattractive. Challenger suspended sales on November 28, pending an appeal of the decision.

In FY14 Challenger sold $279m of these annuities, accounting for 46% of the total sales in lifetime annuities and 10% of total retail annuity sales. With an enlarged market opportunity in FY15, extended to those in home care, this was the company's fastest growing annuity product. The implementation of the new rules is not backdated and will commence on January 1, 2015. Technically, the product has a penalty and policy cancellations are an earnings benefit to Challenger but, in good faith, brokers expect the company will return funds if the ruling is not reversed.

Despite the uncertainty created by the tax issue most are reasonably upbeat about the stock, with the exception of Deutsche Bank which retains the only Sell rating on the FNArena database. Otherwise, there are three Buy and four Hold ratings. The consensus target is $7.39, suggesting 17.9% upside to the last share price, and compares with $7.67 ahead of the announcement. Targets range from $6.20 to $8.70 and the dividend yield on FY15 and FY16 forecasts is 4.7% and 5.1% respectively.

This is – or was – Challenger's highest growth, highest margin product and, while Deutsche Bank has no doubt the company will pursue all avenues to overturn the decision, it will put a significant dent in future earnings outlook. While the company estimates a worst case FY15 earnings impact of negative 2.3%, outer year profit implications are greater, in the broker's opinion. Deutsche Bank was always suspicious of the risks in this product, given the average purchase age of 87 meant the recipients were likely to die within the first 10 years and the product offered a 100% capital return on death.

Worst case scenario is where liquid lifetime annuities are also scrutinised by the government, although JP Morgan considers this is unlikely as the customer base is very different, and the risk of residual values being understated is much smaller. The broker considers the company has many offsetting positives, none the least being the upcoming Financial Systems Inquiry, and, given the underperformance of the stock in recent months, upgrades to Neutral from Underperform.

Morgans also considers the share price decline has made the stock more attractive, although given the uncertainty around a key product, retains a cautious outlook and Hold recommendation. The broker notes initial aged care annuity sales were impressive and a strong contributor to recent annuity sales growth. More significant, in this broker's opinion, is the potential for the ruling to raise customer/financial planner concerns about regulatory risks associated with structured annuities.

It is the hit to reputation that has potential to do the most damage, in Credit Suisse's view, as questions will be raised regarding further potential regulatory risk. That said, and while regulatory risk is to the upside, the broker considers the stock attractive at current levels and maintains an Outperform rating. Morgan Stanley also believes brand damage is the greater concern. With the government able to review the rulings, uncertainty regarding future income and asset treatment could be a headwind to future sales. The risks to the value of lifetime annuity sales now reduces some of the margin cushion the company enjoyed. These products lengthen duration, allowing Challenger to extract a premium in longer-dated property infrastructure assets.

The decision is a setback, given the knock-on impact for retail liability growth, in Citi's view. Challenger's capital levels are now elevated and the necessary investments to deliver sales growth will increase shorter term costs. Longer term, rowth potential remains intact because of the relatively short average duration of aged care annuities relative to the liquid lifetime annuity product. Citi also notes that, given sales of aged care annuities were expected to accelerate in FY15 because of reforms which became effective from July 1 2014, overall retail annuity sales are now growing at a slower rate. Still, the broker believes the company's dividend should hold up and provide some yield support.
 

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