- The CGF result was masked by goodwill write-down of the non-core banking asset and confusion around CGF’s return on equity guidance.
- Ultimately the operating environment for CGF becomes easier in a world of higher interest rates. At an underlying level, CGF delivered an ROE of 12.5% excluding losses in the bank, above the 12.2% ROE target in FY22.
- Looking into FY23, CGF will likely miss the ROE target given larger than expected losses within the Bank (~$10m), which results in low single-digit earnings downgrades across the market for FY23E. Ex-the Bank losses, we believe CGF can reach its ROE target.
- In our view, the strategic review of the bank is likely to result in the asset being shut down. The bank lacks the scale of any significance and was only there to provide optionally for CGF to broaden its product range/cross-sell annuities product. With larger than expected losses, the decision to walk away from the bank is the right one in our view. The Bank consumes ~$120m of Group capital
- The core Challenger Life Company (which accounts for ~90% of group valuation) is in a position of strength with its Core Operating Earnings (COE) spread improving and demand for its products increasing on the back of the higher interest rate environment. The Life Company grew EBIT by almost 20% in the last year and is set to grow by double digits again in FY23E.
In our view, CGF can deliver 5-8% pre-tax earnings growth in FY23E with stability in the COE spread and resumption of volume growth in the Life Book. At 13x PER, we see the prospects for CGF to rerate to 15x over FY23E. Ex bank losses, CGF can deliver low teens EPS growth into 2025E.
Investment view
CGF’s game is retirement solutions for Australians. The Group holds a leading position in providing retirement products. This gives CGF a high degree of strategic appeal, reinforced by a share register with strategic stakes from Apollo Asset Management (18%) and Japanese insurer and asset manager MS&D (14.5%).
Conceptually the provision of retirement annuity products is a simple business, and well placed to benefit given the growth of >65 yrs demographic. Whilst a simple business, the accounting is complex and results in degree of complexity in the CGF financial accounts.
The last few years of low-interest rates have been tough for CGF, reducing the appeal for core annuities and compressing the COE margin shareholders are exposed to. In a world of higher interest rates, CGF earnings should improve. 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.
Risks to investment view
The Groups earnings (and share price) are highly sensitive to changes in interest rates and interest rate expectations. Government policy can present a risk if changes adversely affected CGF’s business.
CGF currently has two large offshore strategic investors on the share register, which provide CGF will a regular and steady flow of new business. Changes to the nature of the relationship; and or moves to acquire additional ownership of CGF would be a risk to our investment view.
CGF’s earnings would be at risk if the customer base fell and/or funds under management fell.
Recommendation
We have retained our Buy recommendation.
