The 15% fall in the CGF share price this year is primarily due to investor concerns that rising corporate yield spreads and potential corporate defaults will negatively impact the CGF’s investment portfolio resulting in investment losses.
In our view, these concerns are overplayed. We see a clear opportunity in CGF share price at $6.30. In our view, CGF can grow pre-tax income >20% in FY24E, well ahead of consensus estimates which currently factor in ~15% growth.
Four Areas of Surprise
The market is currently assuming CGF pre-tax income in FY24E is $594m. We see the potential for pre-tax income to be >$620m, up $105m or 20% on FY23E. The four areas of surprise relative to the market are:
- Higher interest rates
- Removal of Challenger Bank losses
- Return of Funds Management contribution
- Life Book returns to net growth
As a reminder, CGF pre-tax ROE guidance is for the RBA Cash Rate +12%. Given the interest rate rises over the last 13 months, this implies a>30% uplift in earnings just from higher interest rates.
Higher interest rates come a at time when retail annuity sales are accelerating, whilst the new leadership team continue to make efforts to simplify both the business and message for investors. We anticipate a continued expansion in the COE (Cash Operating Earnings).
CGF normally gives year-ahead guidance at the FY Results in August. Reminding the market of just how significant the rates leverage is likely to be a key positive share price catalyst for CGF in our view.
Investment View
The last few years of low-interest rates have been tough for CGF, but these conditions have started to reverse, and we can now see CGF gaining the benefit of higher interest rates. New management continues to simplify the business, which we are supportive of.
The share price can trade on higher earnings multiples if the business can consistently earn its ROE target (RBA cash rate + 12%), something the market does not currently factor in. We rate CGF a Buy.
Four Areas of Surprise
1: INTEREST RATE LEVERAGE ONLY PARTIALLY IN FY24E EARNINGS
Higher interest rates remain the most significant tailwind for FY24E earnings. CGF guides to an ROE target of the cash rate + 12%, which consensus estimates do not have CGF meeting in FY23E or FY24E.
We believe investors are overlooking the positive earnings leverage to higher rates.
Over the past 13 months, the RBA has put through ~3.95% points of interest rate increases, which we estimate takes ~2 years to fully feed into the CGF profit before tax (PBT) line.
For every 0.25% the RBA puts through in rate rises, we estimate a ~$10m benefit for the PBT.
We expect ~45% of the interest rate benefit to fall into FY24E, contributing to an estimated ~A$75m PBT uplift. Further interest rate rises would only add to this benefit (we expect a further +0.25% rise in this RBA cycle).
We have excluded from our analysis any benefit higher interest rates provide to annuity sales, which have accelerated through 2022/23.
Figure 1: Higher cash rates take ~2 years to flow through to CGF earnings
2: REMOVAL OF CHALLENGER BANK LOSSES
CGF’s simplification program sees the divestment of the ‘Challenger Bank’ to Heartland Group (HGH) for $36m. The Bank was subscale, historically being loss-making at ~$10m PBT in FY21 and FY23.
The sale process is expected to complete in 1H24, which will see $10m pa losses removed.
An additional benefit of the sale is the release of the $100m of capital, of which $90m has already occurred. In our analysis, we do not assume any additional earnings from the redeployment of this capital.
3: FUNDS MANAGEMENT EARNINGS HEADWINDS EASE
CGF’s Fidante Funds Management experienced a ~$17m earnings headwind in FY23 as earnings fell from $83m in FY24 to $66m. The key driver of this was the loss of two mandates, which resulted in close to $11bn of new outflows. The loss of FUM was split ~$5bn from the CGF sale of Whitehelm Capital (infrastructure investors), with $6bn from the redemption of a low-margin institutional investor. Total FUM stands at $96bn.
In our view, the large one-off net outflows are not likely to repeat in FY24, whilst margins should improve. CGF’s 4Q23 net inflows up until early March were the highest in 2 years at >$2bn.
4: INVESTMENT PORTFOLIO IS LESS SUSCEPTIBLE TO CREDIT MARKET MELTDOWN
Over the past 6 years, CGF has made notable changes in de-risking the investment portfolio. In our view, as it currently stands the investment portfolio is significantly less susceptible to the impacts of a credit market meltdown.
The Group has decreased its direct property, equity, and infrastructure exposure which were segments that are heavily exposed to market volatility. Lowering these segments' exposure has played out well over the past 12 months and should play out well whilst interest rates are increasing.
The introduction of an Alternatives allocation (private equity, CAT bonds, absolute return funds) also reduces the proportion of the Life Book exposed to daily liquidity (and volatility). Whilst exposure to corporate credit has remained relatively static, today >75% of book exposure is investment grade or better.
We believe the market still has a view of CGF’s Investment portfolio as it was 6 years ago, viewing it as a higher risk than it is. Having cash and asset-backed securities as the majority of the portfolio makes CGF a much more appealing business today than it was in FY16 in our view.
Figure 2: FY16 Life Book Portfolio
Figure 3: FY22 Life Book Portfolio
Figure 4: Earnings bridge into FY24 PBT earnings.
INVESTOR DAY FEEDBACK | 30 MAY 2023
Challengers’ investor day highlighted improving operational conditions. The full impact of interest rates is expected to continue to provide an earnings benefit well into 2025. Guidance was updated to be “slightly above” the midpoint.
CGF expects life book growth to resume in FY24 due to reduced maturities and an increase in retail sales growth. The digital refresh for both the front and back end should also increase the ease of access for the annuity’s product.
The sale of the bank continues to progress with an additional A$40m capital release completed during the period. This marks a total of A$90m which has been released with an expected A$10m to be released post-completion.
Commercial property valuations are expected to come down ~5% on June 30 revaluations. We note that the impact is less significant for the group given property exposure has been significantly reduced over the past ~7 years.
INVESTMENT VIEW
The last few years of low-interest rates have been tough for CGF, but these conditions have started to reverse, and we can now see CGF gaining the benefit of higher interest rates. New management continues to simplify the business, which we are supportive of.
The share price can trade on higher earnings multiple if the business can consistently earn its ROE target (RBA cash rate + 12%), something the market does not currently factor in.
We are buyers of CGF given the pathway to improved earnings (and ROE) from clearing macro headwinds and improving operational performance. We rate CGF a Buy.
Figure 5: US banking crisis has resulted in the CGF share price underperforming the market by 20%, despite two RBA cash rate hikes since March.
Figure 6: CGF PER 11x, 1SD below the long-term average.
