Our view on Challenger
At the end of January, the market took a sledgehammer to the share price of Challenger (ASX:CGF) following a trading update. Clearly, many investors did not like what they saw. But was the update really that bad?
In this blog post, I will attempt to dissect the update. First, let’s look at the headlines from the release:
- In total, Challenger expects to report normalized net profit before tax of $270 million for the six months to December 2018 and $545-565 million for the year to June 2019.
- This guidance has been negatively impacted by a couple of factors since the Annual General Meeting on 26 October 2018 when management expected growth of normalized profit before tax of 8-12 per cent which implied a result between $591- $612 million for the year to June 2019.
- For the six months to December 2018, it also compares to the consensus forecast (the average of the sell side analysts) of $293 million for 1H19.
- The factors impacting the results in 1H19 are:
- Lower yield cash distributions from the absolute return portfolio of approximately $13 million. This portfolio has historically generated a cash yield of 6 per cent per annum and contains both complete market neutral funds and long-short funds that can have a long/short bias. This portfolio is around $800 million in size and for the six months to December 2018 only achieved a yield of 1.3 per cent which resulted in the $13 million short-fall.
- Lower performance fees in their fund management operations of about $4 million.
- They have also experienced some impact from entering into a collar arrangement on part of their equity portfolio (a couple of $m) and some lower return from them moving the portfolio towards higher rated fixed income assets and exiting some property investments.
- In addition, they announced that they anticipate an investment experience loss of about $194 million in 1H19 meaning that the statutory reported results are likely to be just $6m.
- In total, the impact in 1H19 vs. their budget/consensus was around $23 million compared to the normalized profits. It looks like management basically doubled that figure to arrive at the ~$45 million downgrade to annual profits they communicated in the trading update.
Before we look at each of these factors, it is worth reminding ourselves of the way that Challenger reports their results:
- They start by applying an expected return on each of the different asset classes in their investment portfolio. The expected return is based on the long-term performance of the different asset classes (equities, fixed income, property, infrastructure etc.)
- The purpose of this is to be able to show what the underlying performance of the business is disregarding short term movement in asset prices which can drown out the underlying performance of the business. Given that Challenger matches the duration of its assets (its investments) and liabilities (the annuities it writes), short term asset price movements which leads to mark-to-market movements in the results are of less importance over time, it should adjust towards a long-term average. This is why the company gives guidance based on a “normalized” basis.
- Challenger then reports an “investment experience” item which shows the mark-to-market gains or losses they actually experience in the period based on what asset prices have actually done.
Let’s now analyse each of the above listed factors impacting the results:
- The $13 million impact from lower return on the absolute return portfolios.
- This can at first sight be a bit confusing. Why was this not reported through the investment experience line? The reason for this is that this is actual cash distributions they receive and not a change in value of an asset that they hold which can change in the future and hence it is reported as part of the underlying performance.
- There was clearly a long bias to some of the funds included in this portfolio and the very weak equity markets towards the end of 2018 had a negative impact on these funds which impacted the cash that they paid out. We should though note that equity markets in January were generally very strong and if the funds continued to be long biased, a lot of this could reverse in 2H19 if markets hold steady from here.
- The $4 million lower performance fee from the fund management operations.
- About 21 per cent of the FUM that Challenger manages is subject to performance fees.
- Challenger has not said anything about their investment performance in the period (they normally only comment at full release of results) but with equity markets falling sharply in late 2018, even if the relative performance is still good, there are usually clauses preventing a payout of performance fees in a down market.
- Either way, performance fees are a very small part of the overall income for Challenger and not something that the market is putting a high value on.
- The cost of entering into an equity collar (basically an option strategy that limits both the upside and the downside of a portfolio) and the move of their fixed income portfolio to higher rated fixed income securities and exiting some properties.
- This is in my mind the most interesting part of the announcement.
- It is clear that it impacts the immediate results as the expected return of higher rated fixed income securities is by nature lower than that of lower rated securities and indeed commercial property.
- The counter side of this is that it lowers the volatility and default risk of the investment portfolio. This means that the capital that Challenger must set aside to cover their future liabilities (the annuities they write) is lower and it frees up capital either as an additional buffer or enables a higher rate of future growth without having to ask shareholders to put in more money to fund the growth.
- This should have the effect of lowering the cost of equity for Challenger and increasing the price that investors should be prepared to pay for the share and counteract the lower profitability resulting from the move to more secure investments.
- Finally, the investment experience loss of $196 million.
- This is predominantly related to equities ($117 million) due to lower equity markets and some to fixed income ($34 million) as credit spreads widened some in 1H19.
- Again, this is not realized a loss and given the strong equity market in January, a reasonable portion of the equity related loss is likely to have reversed already, meaning that we could see a positive investment experience result at the full year results if equity markets stay at a current level.
If we look at the market’s reaction to the trading update, Challenger has lost about $1 billion in market capitalization. This means that the market has put about a 32x P/E on the downgrade of $45million pre-tax which equates to $33 million post-tax. Given that the lower realized distributions from the absolute return portfolio and the lower performance fees which totals $34 million on an annualized basis and which can possibly be considered “one-offs”, we can alternatively say that the market has put a P/E of well over 100x on the reduced profits from the rest of the downgraded guidance (being $45 million-$34 million = $11 million pre-tax or just over $8 million after tax). I will leave it up to the reader to judge if you think this is appropriate.
The Montgomery Funds own Montgomery Global Funds own shares in Challenger. This article was prepared 07 February with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade Challenger you should seek financial advice.