Challenger International Chairman on Strategy

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    Challenger International Chairman on Strategy
    Wednesday, November 13, 2002
    Challenger International Limited has under-performed the ASX200 for the last two years despite buoyant reported profits and above-average underlying growth in annuity sales. What do you accept has been the reason for this under-performance and what does the company need to do to restore confidence?

    Chairman Gil Hoskins
    We accept that we need to restore confidence and we’ve done a number of things to achieve that. For example, we’ve separated the roles of chairman and managing director and appointed new non-executive directors. We know the market felt non-executive directors would better guide the company. And of course we’ve announced a capital raising, which comes with strong shareholder support, with major shareholders sub-underwriting the issue.

    From the market’s perspective, our profit methodology is still not well understood. We need to spend more time explaining it. And to be candid, the re-statement of our profit hasn’t helped us in the current market environment. In my view, the re-statement should be looked on as good news, because now our profit methodology and the profit that emerges from it have been confirmed by outside experts. And the re-statement didn’t lose profit, just deferred it to later years.

    The other issue is that we’ve grown the business fast and had negative cash flow for the last couple of years. Not to a large extent, but enough to make some investors uncomfortable. The good news is we’re now reaching critical mass, and most of our main product lines will turn cash-flow positive in the near term.

    So we need to get those messages across, and prove them up by performing. That should do a lot to restore confidence and our share price.
    At the current level of $1.66, Challenger shares are trading on a PE of 3.0 times the 2002 EPS of 56.6 cents per share. This suggests the market doesn’t rate reported earnings as a reliable measure of value. Do you intend to maintain the current reporting methodology?

    Chairman Gil Hoskins
    Our current methodology is supported by external experts, so we’re comfortable with it. However, we certainly intend to keep it under constant review and of course we’re obliged to mark to market within the life company. The objective is accurate profit reporting with appropriate disclosure.
    Challenger has been criticised for having a high-risk business model in that it backs the long-term annuity obligations with earning streams from property investments and depends on rising property prices. Is the current business model sustainable?

    Chairman Gil Hoskins
    We believe our model is absolutely the most appropriate for supporting long-term liabilities. We’re certainly not dependent on rising property prices. In fact, the model works well with steady property prices. If prices rise, that’s cream on the cake.

    Our long-term annuity liabilities have a duration of about 15 years. Conventional instruments are shorter dated. Which means you’d have reinvestment risk, which is difficult to cover because you don’t know what interest rates might be when it’s time to reinvest.

    And the recent bear market has surely shown that ordinary equities are an inappropriate backing.

    In our view, a good quality property portfolio is the best form of backing. But it’s got to be a diversified portfolio with quality tenants and sound risk management. The main risk with property is that a tenant won’t pay the rent. We’ve found being in control of the properties and having an active process of management, a rigorous risk management system, a diversified portfolio, and good quality tenants under long-term leases the best way to ameliorate that risk. About 30 percent of our property is let to government, and the majority of the remainder to high investment grade companies, so the rent income is very secure. For the US and UK properties, all cash flows are fully hedged back to the Australian dollar.

    I should also say that long-term business is about half of our in-force annuity business. We back our short-term annuities, those up to about 5 years in length, with conventional financial instruments. And as we speak, about two thirds of our new business is short term, which means our portfolio overall is coming back into what some people would call a more comfortable balance.
    There’s a perception among investors that the property-backed model works only because of a mis-pricing between property and fixed-interest instruments, against which annuities are benchmarked. Such anomalies typically don’t last. Could your model work if property yields fell?

    Chairman Gil Hoskins
    We’ve certainly been able to find properties with the yields we require, and lock those yields in. And we think the model is sustainable going forward. But if for some reason property yields were to fall, I’d suspect yields on other backing assets would also fall, so you’d face the same problem. At the same time, if yields fall generally, the pricing of new annuities would change, so instead of offering tax-free rates of somewhere between 5 and 6 percent, we’d be offering say 4 to 5 percent. There’s no simple answer. All we know is that to compete in this market you have to find a yield structure that’s viable and allows you to offer annuities the public will buy.
    Challenger’s business model is also seen by many investors as too complex, with the funds management business formed via a series of acquisitions seen as a drain on cash flow in recent years. What’s your strategy for generating value from this business?

    Chairman Gil Hoskins
    We’re very close to reaching critical mass and being cash-flow positive in a number of our businesses. That doesn’t mean we should simply keep everything we have. The board takes the view that the business has grown big enough, with assets of over $8 billion under management, that we can afford to fine it down, provide a bit more focus, and possibly eliminate businesses that don’t contribute as much as they could. I believe this is our task for the next few months. Coming out of that, we’ll be comfortably placed in the fund management business, with positive cash flow going forward.
    In spite of the board’s statement that Challenger has adequate capital to fund its current business plan, the recent announcement of a $75 million convertible note issue seems to some an admission of a funding short-fall. What are the funds to be used for?

    Chairman Gil Hoskins
    We’ve done an analysis out to beyond June of next year, taking our actuary’s advice, and believe our capital resources under the current capital adequacy and solvency regimes are adequate to continue writing business at the current pace with only a modest capital usage.

    However we had one concern, arising from the change in actuarial standards as of July this year, which raised our capital requirement by about $130 million. We still have adequate capital under this requirement, but because our capital is essentially the unrealised gains on our properties, we felt its quality wasn’t as good as it should be. We took the view we should take on more cash so we could better withstand shocks that may or may not occur in the future.

    So the cash won’t be used on acquisitions. It will be used to strengthen our reserves both in volume, and in quality.
    Can the company maintain its rapid growth without raising further funds?

    Chairman Gil Hoskins
    We have to strike a balance between rates of growth, quality of investments and quality of book. So we’re moving toward a model to calculate capital usage under various parameters. One parameter is the growth of the book, another is the term of the annuities we’re writing. Others might be the quality of the properties and backing instruments we have. Obviously, the actuarial requirements are very tight, so if the quality of the investment were weaker, we’d be forced to hold more capital in reserves.

    This capital model should enable us to go forward at a sensible rate. It should tell us whether our current growth rate is sustainable or whether we should reduce the volume of sales to some extent. That’s a very different model from one focussed on marketing hard and bringing in as much business as possible.
    Challenger recently announced a restructure of its board, which now comprises eight non-executive directors, many of whom have substantial holdings in the company, and one executive director, Managing Director Bill Ireland. What are the immediate priorities of the restructured board?

    Chairman Gil Hoskins
    First is a review of all of our operations, looking at those that are adding value and those that need to add more value. That may lead to some decisions about fining our operations down, or not focussing so hard on some parts of our business.

    Capital and risk management is an overwhelming priority, as is moving to a cash-flow positive position. On top of that, we need to ensure we’re building a business that’s sustainable in every way, and also is accepted as such by the market. If we can achieve those objectives, the board would be well satisfied.

    As a board, we have enormous confidence in the company going forward. We’ve done some tremendous things in a very sort space of time, we have terrific staff and we’re confident the business model is sound. What we have to do now is refine the whole thing, increase the focus and move forward.

    Chairman Gil Hoskins
    Thank you Gil.

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