The Challenger Ltd (ASX: CGF) share price has taken a beating in recent years. So are Challenger shares now a buy for dividend income?
Challenger’s subsidiary, Challenger Life, is the Australian market leader in annuities with about 75% market share. Challenger’s funds management business had $85 billion in funds under management (FUM) as at their recent Q1 update. To put this into context, giant fund manager Magellan Financial Group Ltd (ASX: MFG) had $102 billion in FUM as at 30 September 2020.
What are Annuities?
Annuities are a financial product in which you exchange a lump sum of money for a guaranteed stream of payments for a fixed term or until death.
Challenger invests annuity sale proceeds into asset classes such as cash, shares, bonds, property and infrastructure as permitted under the Life Insurance Act.
Challenger takes on all the risks associated with these investments and generates profits from the difference between the investment returns it makes and the guaranteed payments made to its annuity holders.
In Australia, annuities are regulated by APRA (Australian Prudential Regulation Authority). Therefore, annuity holders can be confident they will receive promised payments.
Why the share price crashed
Challenger had a tough year in FY20, making a statutory net loss after tax of $416 million. ‘Normalised’ net profit was down 8% to $507 million. The statutory figure includes unrealised losses on Challenger Life’s investments which were exacerbated the COVID-19 market sell off.
In FY20, total annuity sales were down 12% to $3.1 billion. Australian annuity sales were down 27%, somewhat offset by the 177% growth in Japanese annuity sales.
Challenger commenced selling Australian-Dollar denominated annuities in Japan in 2016 after establishing a relationship with Mitsui Sumitomo Primary Life Insurance Company Limited.
Australian Annuity sales also dropped 4% in FY19, after being impacted by the 2019 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. Challenger’s FY19 report outlined that its annuity products were widely distributed by financial advisors employed by AMP and the major Australian banks. Findings of the Royal Commision led to “reduced customer confidence in retail financial advice and reduced the acquisition of new customers by financial advisers”.
According to Challenger’s FY20 report, institutionally-owned and aligned advisers account for just 38% of the total advice market, down from 63% five years ago. Independent final advisors now form the majority of the total advice market and continue to take share. The mix and change of this selling channel is important to understand.
Can Challenger turn it around?
Challenger has re-iterated its efforts to increase annuity sales via independent financial advisors (IFAs) by:
- Challenger is working to increase availability of its products on investment and administrative platforms used by IFAs such as Netwealth Group Limited (ASX: NWL) and Hub24 Limited (ASX: HUB).
- Challenger has also launched a number of annuity education initiatives. In 2020, Challenger recorded a doubling in the number of advisers attending their retirement planning or aged care webinars.
According to Challenger’s FY20 Report, lifetime annuity sales comprise less than 2% of the annual transfer from the retirement savings (accumulation) phase to the retirement spending (retirement) phase.
Superannuation assets totalled $2.9 trillion at the end of the June 2020 quarter (Source: The Association of Superannuation Funds of Australia). Therefore, even a small increase in annuity take-up within Australian’s superannuation funds would trigger a significant rise in Challenger’s annuity sales.
Challenger released their First quarter performance update on 14 October which revealed some positive signs.
- FUM increased 5% for the quarter ($3.6 billion).
- Annuity sales grew significantly in Australia and Japan, with total annuity sales up 46% on Q1 2019 to $1,233 million.
Are Challenger shares cheap?
In my view Challenger shares offer good value right now. FY20 normalised EPS came in at 56.5 cents. On this basis, Challenger trades on a price/earnings multiple of 8.4x.
Essentially the market is assuming no future growth, which I think is unlikely. If Challenger returns to paying interim and full year dividends per FY19, shareholders would receive 35.5 cents – reflecting an attractive theoretical yield of 7.4%.
