August 11th, 2015: Transurban published strong FY15 results in regards to equity but weak credit-wise,…
Sales momentum has stalled in the key retail annuity sales product (ex-CARE) up only 5% on the year. The second half of the year was particularly weak with retail annuity sales growth being negative. This is the lowest growth in 3 years and suggests that the low interest rate environment is forcing retirees to take more risk in order to get the income they require. Although EBIT was up strongly (~13.5%) it was offset by higher costs (as a result of high growth profile but medium term guidance of 32 to 36% cost to income ratio) and lower funds management earnings. Guidance is f or net book growth to 11%-13% for the full year. As we expected Challenger increased its asset risk (composition of its investment portfolio) over the year which was particularly bad timing given the recent market volatility. The group’s key focus over the coming year seems to be driven by success of the new platform distribution initiatives and relaunch of CARE annuities. While this is a good retail strategy we remain cautious on the take-up given the low yields and lack of knowledge in retirement products for platform users. Overall, earnings growth is likely to continue at a solid pace (albeit the recent annuity sales growth has reduced) which will support the credit profile of the group. However, not all things are equal with the capital intensity of the investment book increasing and capital buffer reducing.
The earnings growth profile of the business comes from a projected in increase in product volume. As a result we are wary of the strain on Challengers capital adequacy. In FY2015 the group raised $290m of common equity and $345m of additional Tier 1 capital which translated into a Prescribed Capital Amount (PCA) multiple of 1.49x (up from 1.44x in FY2014). While this increase in the PCA multiple is positive the second half of 2015 was a very different story as the asset and insurance risk charges (similar to risk weighted assets) increased substantially as the composition of the investment portfolio changed. This is only the start of what we see as a reasonably large increase in the PCA. As all the transitional capital benefits (~$210m) expire in FY16 and assuming the dividend payout ratio of 50% is maintained in years ahead we forecast the PCA multiple will fall below the minimum 1.40x PCA target and hence the target is likely to reduce. The common equity PCA multiple is also at risk of falling below 1.0x using the same assumptions and although the Life and General Insurance Capital (LAGIC) framework does not currently have a capital conservation buffer we are reasonably confident that it will be introduced at some point in the near future and APRA would be very uncomfortable with a common equity PCA multiple below 1.0x (APRA’s capital standards require that life insurers hold at least 60% of their PCA in Core Tier 1 equity and at least 80% in Tier 1 instruments.). So although the group has a strong structural growth profile they are doing this at the expense of capital which is a risky strategy for Challenger Capital Note holders. We acknowledge that the funds management business is not as capital intensive and will slowly increase as a proportion of overall EBIT but this does not change the fact that the composition of the investment book is directly linked to the group capital adequacy. In fact the newly established dividend reinvestment plan will do little to increase common equity capital except help maintain the dividend payout ratio. Overall, the fall in the PCA will necessitate further regulatory capital transactions (Tier 1 and/or Tier 2) or a reduction in the dividend payout ratio to maintain a buffer over the current internal PCA capital target. As a final note there is still some uncertainty around possible capital buffers which could be introduced by APRA for the insurance industry (this would bring ti into line with the banking sector).
There is no doubt that earnings growth of the group has has been strong over the past few years. The projections for retail sales (in fixed term and lifetime annuities products) in the coming year are in the double digits so its s difficult to see where challenger can go wrong. It is this substantial growth profile over coming years which is causing some concern due to a required increased risk tolerance and an expectation of slightly higher capital leverage to meet the requirements of the product growth.