Challenger’s normalised earnings increased 4% to AUD 309 million for fiscal 2013 on the back of strong annuity sales (up 18%), solid growth in the retail annuities portfolio (up 9%), impressive funds management performance (earnings before interest and taxes up 62%) and tight cost control (up 2%). The solid overall performance is in line with expectations, and positive underlying industry trends bode well for future earnings growth. The highlight is the strong funds management divisional performance with funds under management, or FUM, up 33% to AUD 41 billion, and divisional pretax profit up 62% to AUD 34 million. The final unfranked dividend of AUD 10.5 cents per share, or cps, takes fiscal 2013 dividend to AUD 20 cps unfranked, up an impressive 11% on 2012. The dividend payout of 34% is at the top end of the 30% to 35% target range. Challenger is expected to fully utilise carried-forward tax losses in 2014 and is guiding for partial franking with fiscal 2014’s final dividend.
Normalised operating earnings in the Life business of AUD 452 million marginally beat Challenger’s most recent guidance of “at the upper end of the AUD 440 million to AUD 450 million range”. The retail annuity book increased to AUD 7.1 billion, benefiting from seasonally strong fourth quarter sales. Our positive view is bolstered by a growing demand for “secure” retirement income products and Challenger is well placed to continue its market-leading position in this growing segment. We expect further improvement in operating conditions, with likely increases in long-term bond rates enabling Challenger to offer higher returns for more profitable long-term annuity products.
Management earnings guidance for the life business is normalised cash operating earnings between AUD 465 million and AUD 475 million for 2014, up from AUD 452 million in 2013. We increase our normalised 2014 net operating income forecast to AUD 483 million, with pressure on net margins in the annuity book less than previously expected. Margin pressure in the life business is a key risk, with overall margins currently at the higher end of the longterm historic range of 4% to 5%. The life core operating margin of 4.9% in 2012 declined 40 basis points in 2013, reflecting lower asset and capital returns. We expect the operating margin to stabilise at 4.5% in 2014, before gradually declining to around 4.10% by 2018. Longer-term weakness may be conservative if the company can hit its guidance for a minimum 18% pretax return on equity hurdle to be maintained over the medium term. The operating margin represents the weighted average interest rate paid on annuities issued to investors, earnings on the portfolio assets, contributions from capital growth and earnings on Challenger’s capital. The annuities business is part of the wholly-owned life subsidiary and total assets under management, or AUM, stood at AUD 10.8 billion at June 2013, up an impressive 10% on 2012.
Attractive growth in the funds management business is underwritten by strong net flows across the 11 boutique “partner” funds and aligned investments, as well as positive market revaluations. Challenger announced the addition of two new boutique managers, further diversifying the investment strategies offered. Aligned investments, which provide opportunities for institutional clients to co-invest with Challenger in absolute-return investment strategies, totaled AUD 11.4 billion at June 2013.
Analysts support the focus on selling more profitable, long-term annuities at the expense of short-term annuities. Concerns surrounding margins and capital are overdone, and we remain positive on the stock. Challenger carries higher risk than traditional asset managers due to long-term return guarantees provided to annuity holders and the higher risk/ return profile on the AUD 10.8 billion of investments supporting the annuity portfolio. Analysts consider the firm well placed to take advantage of long-term growth opportunities in the retirement income sector as Challenger dominates the Australian annuity market. Challenger benefits from a strong and trusted brand, and a broad distribution network through either independent or aligned financial advisers.
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