Investor cheat sheet: Challenger Ltd

A combination of income and growth potential makes Challenger Ltd (ASX:CGF) an appealing investment for exposure to Australia’s aging population.

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Who are they and what do they do? Challenger Ltd (ASX: CGF) is an investment management firm that operates a fund management arm and specialises in products that generate a retirement income stream.

Challenger’s fund management arm counts more than $60 billion in assets under the Fidante Partners brand but the retirement income stream products are what get investors excited.

Challenger is the Australian market leader in the retail annuities market. An annuity is an investment product that entitles the investor to a series of annual payments, typically for the rest of the investor’s life. Challenger owns an estimated 80% of this market, which is growing as more Australians transition to retirement.

Challenger makes money from the sale of its annuity products and performance fees from its funds management business.

How do the numbers look?

Challenger expects an estimated $74 billion in super fund assets will move from the accumulation phase to the drawdown (or income) phase in 2015, with growth expected to exceed 10% each year. This can be expected to boost Challenger’s profit from annuity sales and fund inflows, which has grown from an earnings per share of 38 cents in 2009 to 60.6 cents in the 2014 financial year.

Challenger’s return on equity has averaged 16 over the last five years, in line with that of the big four banks and rivals such as AMP Limited (ASX: AMP).

The company is trading on a trailing dividend yield of 3.9%, slightly below the sector average of 4.2%, however the payout is expected to increase by over 10% this year to 30 cents, from 26 cents last year.

What’s the outlook?

Analysts expect Challenger’s earnings to dip by up to 5% this year, from 60.6 cents to around 57.5 cents, as a result of a higher tax bill in the first half, higher staff costs, and lower performance fees, particularly in the first half of the financial year.

Based on these estimates, Challenger is trading on a 2015 financial year price to earnings ratio of 12.4 and dividend yield of 4.1%, 85% franked.

Is it worth investigating further?

There are a few things investors need to consider:

  • A point worth noting is that Challenger’s dividend payout ratio is increasing meaningfully. Starting at just 32% in 2012, Challenger’s payout ratio will increase to over 51% this year, implying that it has less to invest into the business when it appears to still be on the hunt for acquisitions.
  • Like all financial firms, Challenger operates in a heavily regulated environment, which makes Challenger’s APRA-regulated funds appealing (viewed as low risk), however it also opens the company up to the detrimental effects of regulatory changes.
  • Increased volatility in investment markets will increase demand for the relative stability of annuity products, however it will also have an impact on Challenger’s fund management performance.
  • Challenger is heavily reliant on the annuities business, which has had poor press in the past. Some poor performances or unhappy customers could spell an end to rising profits.

Overall, Challenger remains a good exposure to the increasing number of older Australians heading into retirement. Much like investing in hospitals or aged care facilities, there are execution risks when investing in challenger, however so far the company is doing a good job at attracting customers.

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Motley Fool contributor Andrew Mudie has no position in any stocks mentioned. You can find Andrew on Twitter @andrewmudie The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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