Ann: Third quarter performance, page-28

I really like this company, and have been an owner before and now looking for a re-entry, what do you think is fair value currently for this?

@edb11

The last attempt I made at valuing CGF was on January 20th (see the second paragraph of https://hotcopper.com.au/posts/42468888/single); starting from a 500m$-550m$ FY20 Normalised NPBT guidance, I saw 7.80$-8.80$ as a reasonable Fair Value range, relative to the prevailing set of risks. Because Management subsequently narrowed their guidance to “close to the top end” of the range previously provided, Fair Value was arguably (according to the same logic) in the high 8$s before market turmoil started.

Since then, and despite that Normalised NPBT guidance being maintained, I think the Company’s future earnings picture has deteriorated in a number of ways:

1) On the Funds Management side, the recent equity market ructions have increased the risk of sustained outflows and of a significant reduction in management/performance fees, due to the drop in AUM.

2) On the Life side, Cash Earnings are going to be under pressure because of:

a) Lower (or nil) cash distributions from the Absolute Return portfolio (which is part of the Life Equity portfolio).

b) Cancellation/deferral of dividend payments from companies directly owned in the Life Equity/Infrastructure portfolio.

c) Loss of rental income due to tenant defaults in the Life Property portfolio, where as of 31 Dec 2019 only 28% of total income originated from Government, and 41% was derived from tenants rated Sub-investment-grade.

d) Loss of Interest/Principal due to possible credit defaults within the Life Fixed Income portfolio.

e) Lower overall income from Life Investment Assets, even before any cancellations/deferrals/delinquencies/defaults, because of the recent portfolio re-positioning from Equities/Infrastructure/High-Yield to Investment-Grade Fixed Income.

f) Increased risk of negative Life Book growth, due to intensified disruption in the Financial Advice distribution channel.

So, while the stock looks optically very cheap right now, at just ~5.0x FY20 NPBT and ~7.0x FY20 NPAT (from the low end of Normalised guidance), I am afraid that such earnings base might not be overly meaningful, given that i) there is a considerably higher risk of guidance being missed, ii) even if FY20 guidance is met, there is a high risk of effects a) to f) above spilling over into FY21, and iii) as observed earlier in this thread, in order to sustain that level of earnings going forward, the Company is likely to need a capital injection to support a higher allocation into riskier assets.

Plus, there is a non-negligible chance that CGF may have to raise capital anyway, to protect their solvency ratios from a further drop in the market value of their Life Investment Portfolio, irrespective of asset allocation considerations.

Thus, if Fair Value was in the high 8$s before the current set of circumstances materialised, I personally feel that a 20%-25% discount to that valuation wouldn’t be inappropriate to factor in short- to medium-term earnings risk and the possible dilutive impact of a capital raise. That would leave us with a 6.50$-7.00$ new Fair Value range, which is still considerably higher than Friday’s closing price of 4.05$.

So, overall, I do see value in the stock at its current levels, which is why I have taken advantage of the recent wild sell-off to re-establish a small position (just over 1% of my investable capital) after my January sale, at an average cost not very far from today’s price.

The main reason why I am not buying more, at this stage, is that I see a CR as being more likely than not, so I’d rather wait for that to happen and take maximum advantage of the associated SPP (or oversubscription facility); if it then turns out that a capital injection is actually not necessary, I will be happy to increase my holding at a higher price (within reason).

Another reason is that I have encountered opportunities in the same sector at even more depressed valuations outside Australia, so I have been giving priority to those for capital allocation, while the CGF situation becomes clearer.

To conclude, and in more big-picture terms: the peculiar appeal I see in CGF at its current price, irrespective of macro market moves, is that (despite some short- and medium-term headwinds) the penetration rate of annuity products in the Australian market is still well below the average of advanced economies, representing only ~5% of the annual switch from the accumulation to the retirement phase of the superannuation system. Therefore, being CGF by far the dominant player in this market, I feel there is an embedded long-term growth optionality in the stock that is worth owning and that the market today is basically giving away for free.

Hope this helps. As always my two cents only, and all the usual disclaimers apply.