Challenger: Result 2013

Challenger has reported a 2% rise in normalised earnings per share (EPS) to 58.6 cents. The result was about 4% ahead of the consensus forecast and has sent the stock up about 7%.

There was good news on the dividend as well, with an unchanged final dividend giving an 11% increase in the full-year payout to 20.0 cents (unfranked, ex date 2 Sep). The company also increased its targeted dividend payout ratio from 30-35% to 35-40% of earnings (or about 50% including share buybacks) and said it expected the 2014 dividend to be 40-50% franked.

In the life division, net sales of $598m (up 3%) led to a 13% increase in average investment assets to $10.2bn. However the margin on these products fell from 3.6% to 3.3%, mainly due to lower returns on the assets backing them (as anticipated, see Challenger: mind the gap from 29 May 13 (Hold – $4.17)), to give a 'product margin' of $337m.

After adding the investment yield on shareholders' funds ($79m) and normalised capital growth ($36m), normalised cash operating earnings (COE) rose 4% to $452m, giving a net COE margin of 4.5%, compared to guidance of 4.4-4.5%. This combined with a stable cost-to-income ratio of 15.5% (down from 15.6%) to give a 4% rise in normalised earnings before interest and tax (EBIT) to $382m.

Big difference

The big difference with last year, though, was in the investment experience. Last year, the investments supporting Challenger's annuity products suffered capital losses of $195m before tax; this year they gained $138m.

The gains were mainly from fixed interest investments, which provided capital growth of 1.9% compared to the normalised expectation for a loss of about 0.35%. Property and infrastructure did slightly worse than normalised levels, while equities did a little better.

After including the investment experience, the life division's profit tripled from $173m to $520m.

At the end of the year, the life operations had excess capital and cash balances of $1,074m, up from $813m in 2012. Excluding funds set aside for the transition to the new 'LAGIC' capital standards, Challenger has 1.4 times the required capital, at the bottom end of its target of 1.4-1.6. That looks comfortable enough, as reflected by the share buybacks and increased dividend payout ratio.

The group's fund management operations delivered an excellent result, with total net fee income rising 20% to $99m (split almost 50/50 between Fidante Partners and Aligned Investments). Expenses rose 5% to $65m to leave EBIT 62% higher at $34m. Funds under management (FUM) rose 33% over the year to $41bn at the end of June, giving a 29% rise in average FUM to $36bn.

Threat from banks

Management expects average life assets under management to rise about 3% in 2014, with a COE margin steady at 4.5% to give a 4% rise in normalised COE to about $470m. Plugging in $50m of EBIT for the fund management division would give overall normalised group profit growth of about 7%.

As ever, though, the actual result will depend on investment performance. We also remain concerned that if the annuities market really took off, the big banks would arrive to spoil the party, thereby capping much of the upside for Challenger. The stock is up 12% since 29 May. HOLD.