By Paul Rickard

In the past, I have been a little bit of a critic about the cost of lifetime annuities. That’s from a retiree’s perspective, not a shareholder’s. But shareholders who got on board with Challenger (ASX: CGF), including those who have followed my model growth portfolio in the Switzer Super Report, have been highly rewarded.

And Tuesday’s September quarter sales update from Challenger demonstrated the tailwinds helping this company on its growth trajectory. With absolutely no disrespect intended to the seven astronauts who tragically lost their lives in the Challenger space shuttle disaster, this company is “shooting for the stars”.

That’s not to say that the stock hasn’t become a little expensive - but let’s have a look at the growth story, what the analysts say, and where to from here.

A growth story

Challenger is the leading provider of annuities of and guaranteed retirement income solutions in Australia. Products offer certainty of guaranteed cash flows with protection against market, inflation and longevity risks. It ranks number one by share in a market where there is only a handful of competitors.

It also has a funds management business, where it co-owns and partners with separately branded active investment managers. This business contributed EBIT of $37m in FY16 - around 10% of Challenger’s normalised EBIT.

The annuities business is run out of Challenger’s APRA regulated life insurance company, Challenger Life Company. It has investment assets of $14.3bn supporting a life annuity book of $10.0bn, and guaranteed index return products of $1.3bn.

In the September quarter, Challenger sold $1,033m of annuities, an increase of 46% on the corresponding quarter in 2015. The table below shows sales of annuities over the last six quarters:

Annuity Sales

Industry tailwinds for Challenger are the structural growth of Australia’s superannuation system, and in particular, the changing demographics driving the shift of monies in the accumulation phase to the retirement phase. Further, it is expected that the Government will change regulations to allow the development of deferred lifetime annuities, which could be purchased both pre-retirement and post retirement, and should prove popular with retirees who operate their own SMSF. The development of CIPRs (comprehensive income products for retirement) was strongly supported by David Murray’s Financial Systems Inquiry, which recommended that “super fund trustees pre-select for their members a CIRP”, potentially offering super fund members a seamless transition to retirement.

Another potential tailwind, and one that has supported Challenger’s share price over the last couple of months, has been the rise in bond yields. With fixed income assets making up the bulk of Challenger’s investment assets, higher bond yields will, over time, increase investment returns. Not only does this make the sale of new annuities a more attractive customer proposition, Challenger is required by the regulator (APRA) to hold considerable capital that it invests in these markets.

Challenger’s key financial metrics are shown in the table below. While NPAT, EPS and dividends have been growing, the rate of growth is respectable, rather than outstanding. Return on equity has also declined marginally.

Key Financial Metrics

And despite the strong first quarter result, Challenger maintained guidance at a range of $620m to $640m for normalised cash operating earnings for Challenger Life (compared with $592m in FY16), and a normalised return on equity (pre-tax) of 18%.

The Brokers

In the main, the major brokers are marginally negative on Challenger, feeling it is a touch expensive. Following the release of the quarterly sales result, brokers updated their forecasts. While this resulted in the consensus target price rising from $9.33 to $9.83, this is still $0.55, or 5.3% below yesterday’s closing price of $10.38. And two brokers downgraded the stock, with Morgans going from add to hold, and Citi from neutral to sell.

While liking the sales momentum, some feel that the valuation metrics are becoming a little stretched, and have concerns about the sustainability of Challenger’s margin. For the life business, the product cash margin fell from 2.9% in FY15 to 2.7% in FY16. A couple of brokers were surprised that Challenger did not change guidance for the year.

Recommendations and target prices for the major brokers (source FN Arena) are listed in the table below. These range from $7.33 to $11.50.

Major Broker Recommendations

Bottom Line

I really like stocks with industry tailwinds, dominant market share and where Management is delivering. Challenger fits this bill.

But, I agree with the Brokers that it may have run a little hard. At $10.37, the brokers have it trading on a multiple of 15.9 times FY17 earnings and 14.6 times FY18 earnings. It is forecast to pay a dividend of 34.5c in FY17, placing it on a yield of 3.3%. These numbers are not stratospheric, but they do place Challenger towards the top of range for diversified financials sector.

Buy in weakness.