Broker slaps sell rating on Challenger Ltd flags potential capital raising

The Challenger Group Ltd (ASX:CGF) share price has come under pressure over the last week.

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The Challenger Group Ltd (ASX: CGF) share price has fallen nearly 4 per cent over the past week, compared to a near 1 per cent rise for the S&P/ASX 200 (Index: ^AJXO) (ASX: XJO).

The share price fall may be related to a report out of analysts Morgan Stanley that (according to the News Corp press) values the stock at just $11.50, or around 10% lower than the current share price of $12.80.

The Morgan Stanley analysts reportedly believe that Challenger's entry into the eye-wateringly large Japanese pensions market could be a growth driver for the business of such size that it would require it to raise up to $500 million in capital in FY 2019 to manage a ballooning balance sheet.

Challenger must offset its annuity payments to customers by investing in money markets, other debt, or capital markets, and aims to achieve returns on the margin spread between its assets and liabilities.

Generally if companies are able to generate a high return on invested capital then it makes sense to raise capital, which is at odds with Morgan Stanley's conclusion that Challenger is less valuable due to its potential need to raise capital to invest.

Should you buy?

Challenger has several genuine tailwinds including Australia's growing superannuation balance, the wealth of the baby boomer generation, and its widening distribution network that is now stretching into mega-markets like Japan. It is also a dominant market leader with a narrow moat due to the complexities and capital requirements of operating an annuities business.

As such I think the stock looks reasonable long-term value at $12.80 given the rates of its annuities sales growth, with the company due to post full year results in the middle of August. Other high-quality wealth management businesses on reasonable valuations I would consider include Janus Henderson Group (ASX: JHG) or Macquarie Group Ltd (ASX: MQG).

Motley Fool contributor Tom Richardson owns shares of Challenger Limited and Macquarie Group Limited. You can find Tom on Twitter @tommyr345 The Motley Fool Australia owns shares of Challenger Limited. 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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