Challenger: growth on the horizon
In last week’s Investment Matters we illustrated that despite volatility in its share price, Challenger has delivered a consistent growth in earnings over the past 16 years.
Source: First Samuel, Company reports, IRESS
We now wish to deepen this research, reflecting on the drivers of this growth.
Challenger’s primary business segment is its Life business (81.5% of pro forma FY-18 net income).
The Life business provides annuities – products that provide a guaranteed income primarily to retirees who are in the de-accumulation (or pension phase) of their investment life cycle.
Challenger is the largest provider of annuity products in Australia (and has recently begun selling its products into the much larger Japanese market).
While the compulsory superannuation system has ensured that Australians have accumulated savings for retirement, there are few structures in place to guarantee these savings provide a certain income for the duration of their lives.
Retirees face three primary risks when it comes to managing their retirement savings:
- Investment risk - the risk that the returns earned on their savings do not meet their expectation
- Longevity risk - the risk that they outlive their accumulated savings
- Inflation risk - the risk that rising prices erode the purchasing power of their accumulated savings
While retirees can seek professional advice to help manage these risks, they remain 'under-managed' for a large number of retirees.
The annuities offered by Challenger offer a simple and efficient method by which retirees can reduce these risks and ensure they have a guaranteed income to see them through retirement.
There is thus a pressing and growing need for Challenger’s products, which will continue to grow as populations age and a larger number of people (and a larger dollar amount of assets) transition to pension phase (as highlighted below).
Projected superannuation assets in retirement phase (2014 dollars)
Source: Financial System Inquiry 2014
Despite this pressing need, a large structural gap in the uptake of retirement products still remains, as evident by:
- Government efforts to promote the uptake of comprehensive retirement products such as annuities
- Significant under-penetration of annuities in Australia relative to comparable countries, as illustrated below:
Source: OECD, ABS, Financial Conduct Authority, American Council of Life Insurers, Canadian Life and Health Insurance Association, German Insurance Association, First Samuel
Note: Australian figure is Net Assets backing policy liabilities (ABS data), UK figure is based on annuity payout during 2017 assuming a value weighted payout of 5% of total annuities payable (Financial Conduct Authority data), US figure is based on annuity reserves (American Council of Life Insurers data), Canadian figure is based on assets managed (Canadian Life and Health Insurance Association data), German figure is based on annuities payable (German Insurance Association data).
Challenger’s outlook for growth is therefore promising: it is the biggest player in an underpenetrated, large and growing addressable market.
Why own Challenger when you could own the banks?
Source: Reuters Eikon, IRESS
The table above shows Challenger’s current valuation relative to the big four banks the market's expectation (analyst consensus numbers) around its growth outlook.
Contrary to these figures, we assess that it is difficult to justify a growth rate for the banks comparable to that of Challenger, based on the underlying drivers of returns and the risk around these drivers.
While Challenger represents similar value to the big 4 banks based on simple valuation metrics (such as consensus forward p/e and price to book), we assess that is it has significantly more potential for growth moving forward.
As highlighted, the drivers underlying Challenger’s growth include:
- An aging population
- Growing superannuation balances
- Greater penetration of annuity products
- Regulation and government policies (currently favourable)
These drivers, in our assessment, have a higher degree of certainty than those that underlie the growth of the banking sector:
- Asset prices
- Interest rates
- Wholesale funding costs
- Capital requirements
- Regulation and government policies
- Economic growth
The current growth rates for the banks forecast by analysts (and therefore likely implied in share prices) are in our opinion therefore highly unlikely to eventuate (given the low credit growth, regulatory changes likely to occur, weak economic conditions etc), and as evidenced by CBA's H1FY-19 result released this week.
Thus, in our assessment Challenger continues to present an attractive investment opportunity for clients.
- Paul Grace