Potential takeover target, page-40

When the market does fall & if for some reason CGF was under serious balance sheet pressure, could this detachment between book value & market value lead to CGF trading insolvent? Pure hypothetical.

Challenger does have business risks, but balance sheet pressure is not one of them, and nor will it be if the share price falls. Because, when it comes to Challenger's solvency position, how its book value compares to its market value is totally irrelevant to its abilities to pay its creditors.

And on that score the company is in rude financial health, with Net Debt (including ~800m in Challenger Notes) of $1.1bn being easily supported by annual cash flows from operations exceeding $300mpa. EBIT covers the Interest Expense by a factor of 12x, and there are limited stay-in-business calls on capital, with PP&E expenditure a mere ~$20m pa.

So, in terms of day-to-day, week-to-week and month-to-month capital flows, Challenger clearly generates significant surplus capital from which it is easily able to services its interest-bearing liabilities at the corporate level (as opposed to the client level).


As for the risk of Challenger not being able to service its Life book liabilities, its $15.7bn of Life Assets exceed its $10.3bn annuity book by a margin of 52%, meaning that there is significant prudential buffering (Even if the $1.7bn of guaranteed investment liabilities are included, the company's Life Assets exceed its Liabilities by a still- healthy 30% margin.


To summarise: From a business model point of view, Challenger does not come with zero operating risk; but risks around internal liquidity are low.

Of the things might worry about as a Challenger shareholder, the question of solvency would rank way down near the bottom of those things.


"I still tend to disagree about valuing CGF with a component of market risk. My view stems from volatility, market volatility leading to earnings volatility. As we well know uneven and there for less predictable earnings are worth less than stable or 'known' earnings. Think IVC vs STO."

Sure, but either one is a long-term investor, which means that - demonstrably, short-term earnings volatility shouldn't matter - or one is an investor with a potential short-term time-frame, who might indeed seek to sell at any given point in time, and in that case the year-to-year earnings volatility would matter to you.

But I can't see the logic of your saying, while I'm a long-term investor, I do get worried about earnings volatility along the way, especially when that short term volatility is purely driven by exogenous technical factors.

Your IVC vs STO analogy is spot-on. Like IVC, we can form a reasonably high level of conviction that CGF's earnings in 5, or 7, or 10 years' time will be meaningfully higher than it is today.

But, unlike IVC or CGF, STO's business model is capital-intensive, involves an asset base that is finite, and has zero pricing power. So if you bought STO today, you have zero idea what its Revenue and Profits could be in 5 years' time.

So the mindset when investing in CGF should therefore be no different to the mindset of investing in IVC. That is, if you are investing to create wealth for yourself through the increase in the intrinsic value of the business.


There will also come a time when annuities are truly a competitive market. Where market share is harder to come by & margins are squeezed. When? Maybe within the next 5 years?

Will there definitely come such a time, though? I often wonder to myself why it hasn't already happened years ago, especially since the world has been awash with very cheap capital for the past decade since the GFC.

The reason I suspect it hasn't happened is because the business of structuring long-dated annuities and designing comprehensive risk management strategies around them, looks to me like it is the sort of business that has quite demanding barriers to entry.

It is very tightly regulated by APRA and the government and various other industry watchdogs. Besides, its a very complex business [*], requiring a significant amount of actuarial IP that needs to be built up with the passage of time, and I'm not sure that sort of IP can simply be acquired off some sort of skills shelf somewhere.

This annuities lark is not retailing or coal mining or widget manufacturing or distribution.


[*] As a crude proxy for business complexity, I often look at what it costs to audit the books of a company. Challenger's audit fees cost more than $3.0m pa, which is a big number for a company that has no real fixed assets and no international operations. For context, AZJ, a similar size company, audit expenses come to a mere $350k pa, and for ASX, also a financial services business like CGF, but even larger in market cap, has audit expenses of $1.0mpa.