Challenger Limited (CGF) disclosed that its 1H19 result will be impacted by market volatility with both its normalised NPBT (A$270m) and normalised NPAT (A$200m) expected to be down 2-3% on the previous corresponding period (pcp). Market volatility has affected normalised earnings through:
- lower cash distributions on Life's absolute return portfolio of +A$10m (A$13m below pcp); and
- lower funds management performance fees of +A$2m (A$4m below pcp).
CGF's 1H19 reported NPAT (A$6m vs $195m in pcp) will also be heavily impacted by negative investment experience this half (-A$194m). FY19 guidance has been revised to a normalised NPBT of $545m to A$565m, approximately 8% below previous guidance.
A large downgrade
We are surprised by the size of this downgrade. Even adding back the impacts from market volatility to 1H19 normalised NPBT (-A$17m vs pcp), NPBT growth (approx. 4.5% on the pcp) was still tracking well below previous FY19 guidance of 8-12%.
While this is the first time in recent memory CGF has missed guidance, we are concerned about increasing evidence of more volatile investments affecting the life business COE and whether this reflects a heightened risk profile to maintain returns.
We note zero distribution from the absolute return portfolio this period follows the write-down of insurance linked securities in 1H18 (with no subsequent distribution in 2H18).
Investment experience largely as expected, capital level still solid
While CGF's 1H19 negative investment experience (-A$194m) is disappointing, we can broadly get to this figure back-solving from CGF's disclosed earnings sensitivities.
Positively, despite CGF recording almost no 1H19 NPAT, its PCA capital ratio remains largely unchanged on 2H18 (1.53x) and at the top of management's target range (1.3x-1.6x). This reflects benefits of reducing capital intensity (CI ratio now 13% vs 13.7% in 1H18) as CGF re-weights towards fixed income securities.
Changes to forecasts and investment view
We downgrade our FY19F/FY20F earnings per share by approximately 8%, reflecting the latest update and more conservatism on our future margin assumptions. Our share price target has also been lowered (Morgans clients can login to view), reflecting our earnings changes and more conservative valuation multiples.
We think Challenger has a solid growth story, and we see value returning to the stock, but we need more comfort regarding margin pressures to become more positive. We acknowledge material upside to our valuation, but would prefer to wait for details of the upcoming result to revisit our investment view.
We retain our Hold recommendation.
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