FINANCIAL SERVICES GROUP
Level 41, Aurora Place
88 Phillip Street
Sydney NSW 2000 Australia
GPO Box 3698
Sydney NSW 2001
09 May 2003
T 61 2 9994 7000
F 61 2 9994 7777
ABN 50 002 993 302
The Manager
Company Announcement Platform
20 Bridge Street
Sydney NSW 2001
Dear Sir
The Federal Court of Australia has today ordered that meetings of Challenger International
Limited (Challenger) shareholders, noteholders and optionholders be convened on Monday
16 June 2003 for the purposes of considering and, if thought fit, agreeing to the proposed
schemes of arrangement in relation to the proposed merger with CPH Investment Corp
(CPHIC).
Challenger is intending to dispatch the Notices of Meeting and Explanatory Statements to
Challenger securityholders on or about Thursday 15 May 2003 and is expecting to release
this documentation to the market on Monday 12 May 2003.
Attached is the Independent Expert Report by Grant Samuel & Associates Pty Limited in
relation to Challenger’s proposed merger with CPHIC.
Yours faithfully
David H Slatyer
Company Secretary
Att.
1
9 May 2003
The Directors
Challenger International Limited
Level 41 Aurora Place
88 Phillip Street
SYDNEY NSW 2000
Dear Sirs
1
Introduction
On 20 January 2003, the directors of Challenger International Limited (“Challenger”) announced that they
had agreed to merge the company with CPH Investment Corp (“CPHIC”) (the “Merger”). The Merger will
be implemented by way of schemes of arrangement (the “Schemes”) pursuant to Section 411 of the
Corporations Act 2001. Under the terms of the Merger, Challenger shareholders will receive 4.5 units in
CPHIC for each ordinary share in Challenger (the “Share Scheme”). Challenger shareholders will own
58.9% of the merged entity.1
Challenger’s convertible noteholders will be able to either retain their notes and convert them into 4.5 units
in CPHIC on conversion or exchange their notes for 5.5 units in CPHIC at the time the Merger is
implemented (the “Notes Scheme”). Challenger’s optionholders will effectively become entitled upon
exercise of the option to 4.5 units in CPHIC for every share in Challenger they would have received (the
“Options Scheme”).
CPHIC is a managed investment scheme listed on the Australian Stock Exchange (“ASX”). It holds an
investment portfolio comprising cash, income securities, listed equities and various interests in unlisted
entities. At 31 December 2002, it had cash and liquid assets of approximately $400 million and unlisted
equity investments of approximately $80 million. The responsible entity for CPHIC is CPH Management
Limited (“CPH Management”), a wholly owned subsidiary of the Consolidated Press Holdings Limited
(“CPH”) group controlled by interests associated with Mr Kerry Packer. CPH Management will continue
to be the responsible entity for the merged group.
Immediately prior to the announcement of the Merger, CPHIC had a market capitalisation of approximately
$385 million and Challenger had a market capitalisation of approximately $500 million.
The Merger is conditional upon the Share Scheme being approved by shareholders. Approval of the Notes
Scheme and Options Scheme by the relevant participants is being sought but the Merger will proceed even
if those approvals are not obtained. The Merger is subject to a number of other conditions including:
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approval of CPHIC unitholders;
the granting of approvals under relevant legislation; and
satisfactory arrangements being made with the Australian Prudential and Regulatory Authority
(“APRA”) in relation to the capital position of Challenger’s life insurance business.
Challenger has engaged Grant Samuel & Associates Pty Limited (“Grant Samuel’) to prepare an
independent expert’s report to assist the directors of Challenger in advising shareholders, convertible
noteholders and option holders (collectively “securityholders”) in relation to the Merger. This report
should not be used for any other purpose. In particular, it is not intended that this report should be used for
any purpose other than as an expression of Grant Samuel’s opinion as to whether the Merger is in the best
interests of Challenger securityholders. The report will accompany the Scheme Booklets to be sent to
Challenger securityholders.
1
Before allowing for convertible notes.
2
Summary of Opinion
In Grant Samuel’s opinion, the Merger is in the best interests of Challenger shareholders in the
absence of a superior proposal. Challenger has evolved over the last five years to become a leading
provider of investment products (primarily income based products) for individuals throughout both
their accumulation and retirement phases. The cornerstone has been Challenger’s unique and highly
successful long term annuity business. This business has grown dramatically and today has a 30%
share of the long term annuities market, more than $500 million in annual inflows and a property
portfolio of approximately $2.7 billion. However, it is a highly regulated business with substantial
capital requirements that are likely to become more stringent over time and the business model
typically involves negative cash flows during the early growth phase.
The merger with CPHIC can be regarded primarily as a major capital raising exercise. CPHIC has
cash and liquid assets of more than $400 million. The Merger therefore provides Challenger (which
will be the main business of the combined entity) with access to a much more substantial liquid
capital base, freeing it from its capital issues and enabling it to vigorously pursue growth
opportunities across its chosen areas within the financial services sector. Without the Merger,
Challenger would have to pursue a lower growth business strategy and will, in a worst case, face
additional pressures on its capital position.
The transaction can be analysed in several different ways. As a wholly scrip based equity swap of
broadly similarly sized companies, it can be thought of as a true merger. On this basis:
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the exchange ratio favours Challenger shareholders in terms of the relative contribution of
market value, at least based on recent market prices. In other words, Challenger shareholders
are receiving a premium; and
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the exchange ratio in terms of the relative contribution of the underlying value is equitable.
Both groups are contributing value commensurate with their share of the merged entity.
However, the transaction can also be properly viewed as a takeover as CPH will effectively assume
management control of the combined entity. The market value of the consideration offered by
CPHIC is equivalent to approximately $2.16-2.39 per Challenger share, which is broadly equivalent
to Grant Samuel’s estimate of the underlying value of Challenger, including a premium for control,
of $2.00-2.48. In this respect the offer by CPHIC is fair and reasonable. The offer represents a
substantial premium over the price of Challenger shares immediately prior to the announcement of
the Merger (26-47%).
There are a number of other benefits and advantages for Challenger shareholders in addition to the
strengthened financial position:
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greater market capitalisation and liquidity;
a new senior management team and additional management resources;
increase in net asset backing per share (after adjustments to Challenger); and
cost savings, albeit that they are relatively immaterial.
At the same time, there are costs, disadvantages and risks that are not inconsequential:
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the dilutive impact on shareholders’ returns of the management fee to be paid to CPH
Management which will apply to the expanded group;
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dilution of upside potential;
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crystallisation of capital gains tax liabilities for those shareholders that acquired their
Challenger shares at less than the market value of the CPHIC consideration (approximately
$2.16-2.39) if relevant legislation enabling rollover relief is not passed; and
transaction costs.
The essential question for Challenger shareholders is whether the greater growth opportunities and
reduced risk profile compensate for the change of control, the dilution of returns and upside potential,
and other disadvantages. In Grant Samuel’s view, they do by a significant margin. If the Merger is
not implemented, Challenger shares are likely to trade at levels below the current price range of
$2.00-2.30 in the absence of any alternative transaction providing a similar value proposition.
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3
Key Conclusions
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The transaction can be considered as either a merger, a takeover or a large placement.
The proposed transaction has several unusual features which make it difficult to categorise. It can be
properly regarded as a merger:
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the two entities are of broadly similar size in terms of market capitalisation;
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the transaction is entirely scrip based. There is no cash consideration;
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CPH does not materially alter its equity ownership position. It will own 23.6% of the merged
entity compared to its current 18.4% holding in Challenger; and
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the board of CPH Management will not be controlled by CPH.
In this case, the assessment is based on the equity of the exchange ratio and an evaluation of the
advantages and disadvantages of the transaction. The exchange ratio can be assessed by comparing
the relative contributions of each group of shareholders/unitholders (in terms of market value and the
estimated underlying value of their businesses) with the share of the merged entity they receive.
On the other hand, it can be fairly argued that the transaction is effectively a takeover. While CPH
will only own 23.6% of the merged entity, it will have management control through its 100%
ownership of CPH Management, the responsible entity of CPHIC. Prior to the announcement of the
Merger on 20 January 2003, CPH had three representatives on the board of Challenger and owned
18.4% of Challenger. Although it clearly had a degree of influence, it did not control Challenger. The
Merger therefore involves a change of control event from the perspective of Challenger shareholders.
In this case, the analysis involves a comparison of the value of the consideration offered by CPHIC
with the estimated underlying value of Challenger.
From an alternative perspective, it can be argued that Challenger is effectively undertaking a large
placement (albeit involving a structural change and change in control). It is in effect raising more than
$400 million in cash and liquid assets (together with a few other minor assets) in exchange for a
substantial stake (41.1%) in the business.
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Challenger shareholders receive an equitable share of the merged entity based on market value.
The sharemarket provides an objective measure of the value of the equity in each entity. Although the
share price reflects only marginal trades in portfolio interests, the price incorporates the influence of
all available information on the entity’s prospects, future earnings and risk. Prima facie, it is a fair
basis for setting merger terms as long as there is a genuinely well informed market and prices do not
reflect any other unsustainable factors such as takeover speculation.
The ratio of the two share prices over the same dates/periods can also be used to calculate a theoretical
exchange ratio for a “nil premium” merger which can be compared to the actual exchange ratio:
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Implied Exchange Ratio Based on Daily Market Prices
1 January 2002 - 30 April 2003
10.00
9.00
17 January 2003
8.00
7.00
6.00
4.5
5.00
4.00
3.00
2.00
Jan-02
Mar-02
May-02
Jul-02
Sep-02
Nov-02
Jan-03
Mar-03
Source: IRESS and Grant Samuel analysis
The analysis indicates that the exchange ratio provides Challenger shareholders with a premium
(relative to CPHIC unitholders) if it is based on prices immediately prior to the announcement. Based
on average prices for the one week and one month prior to announcement that benefit is in the order of
5-10%.
When market value is measured over any longer period it is apparent that the merger terms
disadvantage Challenger shareholders. Based on relative prices prevailing through most of 2002, the
equitable exchange ratio would be in the order of 7 times (compared to the 4.5 times proposed). This
outcome reflects the decline in the Challenger share price over the 12 months (and particularly the last
six months) prior to the merger announcement compared with the relatively stable performance over
the same period by CPHIC.
In considering this analysis, Challenger shareholders should recognise that:
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share prices in 2002 can be argued to be largely irrelevant, reflecting market conditions and
expectations that no longer prevail. The fact is that Challenger’s shares have been substantially
rerated downwards, particularly following the October 2002 profit revision;
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there is clearly considerable volatility at the present time. At some future date the market may
have a more positive view of Challenger particularly as the business model matures and becomes
cash generating. It may be that the transaction is occurring “at the bottom” and it might be more
propitious to do it at some later date. This aspect needs to be factored against Challenger’s need
to strengthen its capital position and the constraints on its ability to grow and create value if it
does not have access to adequate capital; and
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while CPHIC’s unit price strengthened over the three months prior to the announcement on
20 January 2003 (from less than 35 cents to over 40 cents), it was still trading at a substantial
discount to its stated net asset backing of approximately 53 cents.
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Challenger shareholders receive an equitable share of the merged entity based on estimates of
underlying value.
Analysis of the relative contribution of Challenger shareholders and CPHIC unitholders based on
sharemarket values is objective. However, the market value does not necessarily reflect non public
information and other factors.
Grant Samuel’s estimate of the underlying value of Challenger, including a premium for control, is
summarised below:
Challenger – Valuation Summary ($ millions)
Valuation Range
Low
High
Global Life
500.0
600.0
Funds Management/Advisory Services
215.0
250.0
31.8
37.8
Other businesses
Other assets and liabilities
15.2
22.3
(60.0)
(50.0)
(116.2)
(116.2)
Value of equity
585.8
743.9
Shares on issue (million)
292.4
292.4
Value per share – undiluted
$2.00
$2.54
Value per share – diluted
$2.00
$2.48
Capitalised overheads
Net borrowings at 31 December 2002
Grant Samuel’s estimate of the underlying value of CPHIC, including a premium for control, is
summarised below:
CPHIC – Valuation Summary ($ millions)
Valuation Range
Unlisted investments
Listed investments
Other assets and liabilities
Capitalised overheads
Net cash as at 31 December 2002
Value of equity
Units on issue (million)
Value per unit
Low
High
71.0
87.0
(5.6)
(55.0)
323.6
421.0
917.5
46¢
88.0
91.0
(5.6)
(45.0)
323.6
452.0
917.5
49¢
The pro forma underlying value of the merged entity can be summarised as follows:
Pro Forma Valuation of Merged Entity ($ millions)
Valuation Range
Low
High
Value of equity in Challenger
585.8
743.9
Value of equity in CPHIC
421.0
452.0
Pro forma combined value
1,006.8
1,195.9
Pro forma combined value per unit - undiluted
45¢
54¢
Pro forma combined value per unit – diluted
44¢
52¢
Challenger shareholders would contribute between 56.5% and 63.9% of the underlying value.2
Challenger shareholders will receive 58.9% of the merged entity (before allowing for convertible
notes). Accordingly, they receive an equitable share of the merged entity.
2
Based on matching the low case for Challenger with the high case for CPHIC and vice versa.
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If the transaction is analysed as a takeover offer by CPHIC, the offer is fair and reasonable and
provides a substantial premium for control.
The market value of the consideration offered is the relevant measure to assess the takeover offer.
This must be based on the post transaction entity. Shareholders do not receive securities in the pre bid
entity. CPHIC units have generally traded in the range 48-53 cents in the period since announcement
of the Merger to 30 April 2003. This is a reasonable proxy for the market value of the post bid entity
as the market is clearly impounding the effect of the Merger into the CPHIC price. On this basis, the
offer has a value of $2.16-2.39 per Challenger share.
Grant Samuel has estimated the underlying value of Challenger, including a premium for control, to be
in the range $2.00-2.48 per share. Accordingly, if the Merger had been implemented as a takeover
offer it would be deemed to be fair and reasonable.
The offer provides a substantial premium for shareholders. It represents premiums of:
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26-40% over the price of Challenger shares immediately prior to announcement of the Merger; and
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32-47% over the average price of Challenger shares in the week and month prior to
announcement.
Even if the Challenger share price was at a temporary low because of market overreaction to certain
issues, the premium is still meaningful.
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Challenger’s key asset is its unique long term annuity business backed by structured property
investments.
Challenger’s Global Life business comprises the long term and the short term annuity business
together with some other investment products (superannuation, insurance, bonds, allocated pensions).
Annuities are primarily sold through Challenger Life No 2 Limited (“Challenger Life No 2”) which
represents over 90% of the business of the division. Annuities are a “single premium” business where
an investor makes an upfront capital payment in return for a series of guaranteed fixed payments
(which include both a capital return and an investment return) over a number of years.
The annuity business leverages off the Australian Government’s current social security system,
whereby certain income streams are considered assets test exempt and therefore enhance the ability of
retirees to be eligible to receive the old age pension. This advantage is shared by all annuity business
participants but it is a critical feature as it enhances the effective return to the investor.
All products offer a fixed or CPI linked return and any surplus or shortfall in investment returns
accrues to Challenger. Short term annuity flows are primarily invested in fixed income securities
while long term annuities are primarily invested in structured property assets.
The key features of the property backed long term annuity model are:
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property provides a higher yield than fixed income securities (at least at present) while being
able to be structured so as to provide very secure income streams by having high quality tenants,
long term (net) leases without market rent reviews (or upwards only market reviews) and
diversification such that the risks of the net cash flows are minimised. Challenger’s property
acquisition strategy is based on buying properties with these characteristics and it has in the last
2-3 years been acquiring properties in the United Kingdom and the United States reflecting the
shortage of such properties in Australia;
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returns are enhanced through the use of debt as there is typically a positive margin between the
property yield and commercial mortgage rates. Properties are geared on a non recourse basis to
60% (or more). Any interest rate risks on the debt are eliminated by hedging for the term of the
annuity (as are currency risks) but there may still be a refinancing risk;
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the balance of the purchase price of properties comes from the annuity premiums. The cash flow
from the property after servicing debt is used to meet annuity obligations (which comprise both
an interest and a principal component); and
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at the end of the term of annuity there should be a substantial residual asset (being the property less
any remaining debt) which belongs to Challenger (as the annuity liability has been extinguished).
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Properties are purchased through a trust structure which allows the assets to be geared without
infringing the requirements of the Life Insurance Act 1995. The trust issues two types of units,
income and capital, to the Statutory Fund of Challenger Life No 2 in exchange for the investment by
the Statutory Fund of the pool of annuity premiums. Income units are entitled to the net income from
the property (after borrowing costs) for a term matching the annuities, say 15 years. This cash flow is
used by the Statutory Fund to pay the annuity liabilities. Capital units are entitled to the net income
from the property from expiry of the income units as well as to all the capital value of the trust at that
time. The capital units are held as reserves for the statutory funds for the life of the annuities and then
revert to Challenger.
From Challenger’s perspective, the model can be seen as a 100% leveraged property play similar to
the “negative gearing” strategies employed by private property investors. It acquires properties using
a combination of external debt (typically more than 50%) and policyholder funds (the remainder) and
using little or no capital of its own. Cash flow in the short term is usually negative (because the
annuity payment comprises both interest and a return of capital in a manner similar to a conventional
principal and interest mortgage and there are upfront costs) but over time positive cash flow should
arise as property rentals rise. Challenger effectively has a “free carry” of the residual asset (through
the capital unit).
The model is designed to generate substantial value for Challenger over the longer term as the
annuities run off (in contrast to all other annuity providers). The main issue with the model is that it is
long term and in the short term there is a cash deficit that requires funding. This problem diminishes
with time and in due course there will be substantial positive cash flows particularly when “equity” in
the properties can be recycled against new annuity sales. However, Challenger is presently in the
early stages of the model. Operations have been building for the last 4-5 years but the business will
not be fully mature for at least another five years.
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The value of the long term annuity business is subject to considerable uncertainty.
Grant Samuel has estimated the value of Global Life (excluding the funds management businesses
owned by it) to be in the range $500-600 million. The value of Global Life has been estimated by
reference to a number of alternative approaches and parameters including:
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the Appraisal Value of Challenger Life No 2 as at 31 December 2002 prepared by the appointed
actuary;
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alternative assumptions applied to the Appraisal Value;
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net assets of the Global Life adjusted to restate the carrying value of the investments in income
and capital units so that the aggregate investment in property trusts is adjusted to be equal to the
current market value of the properties less debt; and
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earnings of Global Life both as reported under life company accounting rules and using non life
company approaches.
The value of Global Life based on the adjusted Appraisal Value is in the range of $564.8-725.6
million. The Appraisal Value is an actuarial calculation that attributes value to both the business “in
force” (referred to as the “Embedded Value”) and the value of new business (i.e. goodwill).
A valuation based on net assets essentially assumes that Challenger is a conventional property owning
entity rather than a life company in line with the view of Challenger as a highly leveraged property
play. Grant Samuel believes there is considerable merit in taking a “non life company” approach.
Challenger is not a conventional life company. Equally, this approach has some significant
limitations. In particular, it does not recognise the way in which the capital invested in the statutory
funds is only released to shareholders over a period of time. The net assets at 31 December 2002 on
this basis are approximately $238 million, implying goodwill of approximately $262-362 million. In
Grant Samuel’s opinion, this level of goodwill is reasonable having regard to:
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the value inherent in the existing leveraged property structures already in place which should
give rise to substantial cash surpluses over time; and
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Challenger’s leadership position in the annuities market and its ability to continue to generate
annuity inflows in future (assuming it has the capital to do so).
Based on analysis undertaken by Challenger, the long term annuities business makes a profit of
approximately $20 million per annum before tax and property revaluations on a conventional non life
company accounting basis (net rent less interest on debt less interest on annuities less operating
expenses). While the implied multiples (25 to 30) seem high it needs to be recognised that:
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the revenue stream will grow as rents rise while the interest expense declines as the annuities
(and debt principal) are paid down. Over time, profits from the existing book should rise
significantly; and
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Challenger benefits from any increase in the value of properties. If the property portfolio gains 2%
per annum, this would be worth more than $50 million per annum (albeit that it is not a cash gain).
While adjusted net assets and earnings are not standard actuarial valuation approaches, Grant Samuel
believes they provide a useful insight into the valuation issues for Global Life as it is not a typical life
company.
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Howard Mortgage Trust is Challenger’s primary funds management asset.
The $2.1 billion Howard Mortgage Trust is Challenger’s largest fund and contributes the bulk of the
value of the funds management business. It has enjoyed outstanding growth in recent years although
part of this is undoubtedly attributable to the weak and volatile equity markets. The value of
Challenger’s interest has two components:
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the management of the trust itself which generates annual management fees of approximately
$20 million; and
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the organisation and management of the mortgage portfolio (part of Challenger’s Corporate
Property Lending business). This business earns approximately $9.5 million per annum in
revenue.
Grant Samuel has attributed a combined value of $140-165 million to these businesses. Apart from
the Synergy Master Trust business, the rest of Challenger’s funds management and other businesses
are a somewhat disparate collection of small operations, many of which are subscale and suffering
from weak profitability.
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CPHIC’s assets are mostly cash.
CPHIC owns a number of “private equity” type unlisted investments. However, the aggregate value
of these assets is less than $100 million. The vast majority of its assets are either cash or listed
securities and variations in value of the unlisted investments make minimal difference to the
underlying net asset value.
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The main benefit of the Merger is the access to capital and strengthening of financial position.
Challenger’s life business is capital intensive. Its success over the past five years has created challenges
for capital management. The model typically involves negative operating cash flows in the early years
following a property acquisition. Moreover, from a prudential perspective Global Life is required to
hold an additional buffer of assets to underpin the security of annuitants. Any growth in the annuity
business needs to be supported not only by new property assets but also by additional capital.
In addition, the “quality of capital” has emerged as an issue of increasing significance for APRA.
Capital units comprise the majority of the capital reserves but are illiquid. There is pressure on
Challenger to improve the liquidity of its reserves (i.e. increase the proportion of reserves/assets held
in cash and liquid securities).
Discussions with APRA are ongoing as to how much additional capital is required to be injected into
Challenger Life No 2 (and in what form) to support the current business even in the absence of the
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Merger. Challenger is also pursuing projects that will lower refinancing risk and therefore capital
requirements. Irrespective of this, future growth will require further substantial amounts of capital. In
short, Challenger has an ongoing need to strengthen its liquid capital position.
In the absence of raising capital, Challenger is likely to have to limit its pursuit of growth both in
Global Life and in other businesses (at least those needing capital). CPHIC has almost $400 million
of cash and liquid securities together with approximately $80 million of other assets. It has no main
operating business as such. The Merger therefore provides what is arguably a perfect complementary fit.
The combined group will have a very substantial capital base and cash reserves. It will have more
than enough to underpin Global Life’s current business and any likely foreseeable growth for the next
several years. CPHIC plans to inject $235 million in cash into Challenger Life No 2. It will mean
that Global Life should have the potential to fully exploit the opportunities to develop its business.
Certainly, it should be able to sell annuities at much higher levels than Challenger could as a
standalone company. This should lead to greater shareholder value being created over time.
In addition to the CPHIC cash resources potentially being available for Global Life, they are also
generally available to fund growth initiatives in other parts of Challenger’s business (assuming the
appropriate business case can be made) and to make the necessary investments in technology and
systems. Challenger has some strong niche businesses which could be expanded or used to leverage
into associated products and services.
In essence, after the Merger, Challenger’s growth opportunities should be unconstrained by issues of
financial capacity and capital adequacy.
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A new management team is being put in place.
CPH Management has employed Mr Chris Cuffe as Chief Executive Officer. He will therefore have
effective management control of the merged entity. Mr Cuffe has an outstanding track record as a
manager in the financial services/funds management industries, primarily through his role as a senior
executive in building the highly successful Colonial First State funds management business. Mr Cuffe
has also announced the appointment of eight new senior executives who will form the basis of an
entirely new management team. Accordingly, the merged entity will have access to enhanced senior
management resources (albeit with associated employment costs). These resources may be helpful in
a situation where the business has grown rapidly from a small organisation and needs to consolidate
and integrate its activities for the next stage of development.
At the same time, it should be recognised that:
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the Challenger Life business is a unique business in which Mr Cuffe has no direct experience;
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there are always risks in bringing in new management; and
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new management brings risks of upheavals within the existing management team.
CPH Management will be entitled to management fees in relation to Challenger
CPH Management is entitled to receive management fees (a base management fee and a performance
fee) from the merged entity relating to the investment in Challenger. The effect of these arrangements
is that Challenger shareholders are exchanging shares which give them a full pro rata entitlement to
any profits and gains to one where a third party (i.e. CPH Management) is entitled a share of that
profit or gain. In other words, Challenger shareholders’ income and value gain is diluted compared to
the pre merger position.
The future cost of this arrangement are not inconsequential. In this context:
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the base management fee in relation to Challenger (1.5% of its equity value or approximately
$9 million per annum) will not be paid until CPHIC units trade above 60 cents over a 10 day
period. The CPHIC unit price since announcement of the Merger to 30 April 2003 has been around
48-53 cents. Accordingly, no base management fee in relation to the initial investment in
Challenger will be payable until there has been some value accretion for Challenger shareholders
(approximately 10-20%); and
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the performance fees (20% of future gains above a hurdle rate of 10%) could result in very
substantial payments to CPH Management in time and a material dilution of future returns for
Challenger shareholders. However, the performance fees do not reduce shareholders’ current
value. They will only reduce any future gains in value from the time of the Merger.
Rollover relief is expected to be available but this is not certain.
Under current legislation Challenger shareholders would not be able to elect to “rollover” their
investment for capital gains tax purposes. This is because CPHIC is a unit trust rather than a
company. The government has announced intended changes to legislation which will extend rollover
relief to a transaction such as the Merger (and which will apply retrospectively to the Merger).
However, if the legislation is not ultimately passed, those shareholders who acquired Challenger
shares at prices below the market value of the consideration provided by CPHIC ($2.16-2.39 based on
current market prices) will incur a capital gains tax liability on this gain. While the tax is payable in
cash, the Merger will realise no cash for shareholders and hence they will be “out of pocket”. Other
shareholders will be able to crystallise a capital gains tax loss.
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Challenger has considered a number of alternatives and will pursue them if the Merger does not
proceed.
Challenger has considered a number of alternative transactions or strategies primarily with a view to
resolving the capital issues relating to long term annuity business. These have included:
ƒ
reduction in the risk profile of the property model and therefore the capital requirements through
elimination or reduction of refinancing risk;
ƒ
sale of various assets or businesses;
ƒ
a capital raising by Challenger;
ƒ
a capital raising for, or partial sale of new equity in, Challenger Life No 2; and
ƒ
reduction in the level of annuity sales.
The directors consider these to be less attractive alternatives than the Merger (although the strategy to
reduce refinancing risk is being progressed in any event). A number of these involve untested
avenues (e.g. sale of capital units) where the prospects of finding a buyer are unknown. Almost all
involve considerable uncertainties and potential for delay. Certainly, any form of significant capital
raising would be difficult in the current market.
In contrast, the Merger provides certainty of securing access to up to $400 million in cash resources
and fully resolving all of the capital issues, providing a solid foundation to exploit the growth
potential of the business.
If the Merger is not implemented:
ƒ
the Challenger share price is likely to fall from its current levels of $2.00-2.30 (in the absence of
any alternative transaction);
ƒ
the directors will need to pursue one or more of the alternatives outlined above. There is
certainly no guarantee that any of these would produce a value outcome more favourable for
shareholders than the Merger; and
ƒ
Challenger may need to secure new management.
The Merger was announced on 20 January 2003. In the following three months, no other party has
put forward an alternative proposal. There is no impediment to any party doing so until the
shareholder meeting.
Page 10
ƒ
The Options Scheme and the Notes Scheme are in the best interests of their holders.
In Grant Samuel’s opinion, the Options Scheme is in the best interests of optionholders.
Optionholders retain their current options but upon exercise will convert into CPHIC units on the
same basis as the ordinary shareholders (i.e. the same outcome as if they exercised their options now).
Accordingly, the position of optionholders is preserved in terms of their potential entitlement to value
and they are being treated fairly.
In Grant Samuel’s opinion, the Notes Scheme is in the best interests of convertible noteholders.
Noteholders will have a choice between:
ƒ
retaining their notes and ultimately converting each note into 4.5 units in CPHIC; or
ƒ
exchanging their notes now for 5.5 new units in CPHIC.
The first alternative is the same as that provided to optionholders. It preserves their position and
enables them (if they do ultimately convert) to convert their Challenger equity into CPHIC units on
the same terms as ordinary shareholders. The second alternative may be more attractive to some
noteholders. It provides approximately 50 cents in immediate value (i.e. one extra unit in CPHIC) but:
ƒ
noteholders give up the guaranteed yield on the notes. This is worth 19 cents per annum per note
for the next five years (95 cents in aggregate or about 70 cents in present value terms discounted
at 12%). At the same time, noteholders who exchanged their notes would be entitled to any
distributions on CPHIC units over the same period. There are no forecasts of CPHIC dividends
but the “breakeven” position would be an average annual distribution of approximately 1 cent
per unit. In other words, if the CPHIC distribution is expected to exceed this level, noteholders
will be better off taking this alternative from an income perspective; and
ƒ
noteholders will be giving up the downside protection of the convertible note which guarantees a
minimum of $2.00 per note upon redemption.
Noteholders will have to weigh these issues in deciding between the two alternatives.
4
Other Matters
Approval or rejection of the Merger is a matter for individual securityholders based on their own
circumstances including risk profile, liquidity preference, investment strategy, portfolio structure and tax
position. Those securityholders who are in doubt to the action they should take in relation to the Merger
should consult their own professional adviser.
The opinion is made as at the date of this letter and reflects circumstances and conditions as at that date.
This letter is a summary of Grant Samuel’s opinion. The full report from which this summary has
been extracted is attached and should be read in conjunction with, and as an integral part of, this
letter.
Yours faithfully
GRANT SAMUEL & ASSOCIATES PTY LIMITED
Page 11
Challenger International Limited
Independent Expert’s Report
in relation to the proposed merger with
CPH Investment Corp
Grant Samuel & Associates Pty Limited
(ACN 050 036 372)
9 May 2003
Table of Contents
1
Details of the Merger .................................................................................................................................... 1
2
Scope of the Report ....................................................................................................................................... 3
2.1
Purpose of the Report ........................................................................................................................ 3
2.2
Basis of Evaluation............................................................................................................................. 3
2.3
Sources of Information ...................................................................................................................... 4
2.4
Limitations and Reliance on Information........................................................................................ 5
3
Profile of Challenger International Limited ............................................................................................... 7
3.1
Background ........................................................................................................................................ 7
3.2
Global Life .......................................................................................................................................... 9
3.3
Investment Services ......................................................................................................................... 21
3.4
Group Services/Other Assets .......................................................................................................... 27
3.5
Garrisons Accounting Group Limited ........................................................................................... 28
3.6
Group Financial Performance ........................................................................................................ 29
3.7
Cash Flow ......................................................................................................................................... 31
3.8
Financial Position............................................................................................................................. 32
3.9
Tax Position ...................................................................................................................................... 33
3.10 Capital Structure and Ownership .................................................................................................. 34
3.11 Share Price History.......................................................................................................................... 35
4
Valuation of Challenger International Limited........................................................................................ 37
4.1
Summary........................................................................................................................................... 37
4.2
Global Life ........................................................................................................................................ 39
4.3
Funds Management/Advisory Services .......................................................................................... 46
4.4
Other Businesses .............................................................................................................................. 49
4.5
Other Assets and Liabilities ............................................................................................................ 49
4.6
Capitalised Overheads..................................................................................................................... 50
4.7
Net Borrowings................................................................................................................................. 50
5
Profile of CPH Investment Corp................................................................................................................ 51
5.1
Background ...................................................................................................................................... 51
5.2
Investment Portfolio ........................................................................................................................ 51
5.3
Operating Performance................................................................................................................... 54
5.4
Financial Position............................................................................................................................. 55
5.5
Capital Structure and Ownership .................................................................................................. 56
5.6
Unit Price History ............................................................................................................................ 56
5.7
Management Fees............................................................................................................................. 57
6
Valuation of CPH Investment Corp .......................................................................................................... 59
6.1
Summary........................................................................................................................................... 59
6.2
Unlisted Investments........................................................................................................................ 59
6.3
Listed Investments ........................................................................................................................... 62
6.4
Other Assets and Liabilities ............................................................................................................ 62
6.5
Capitalised Overheads..................................................................................................................... 62
7
Profile of the Merged Entity....................................................................................................................... 63
7.1
Directors and Management............................................................................................................. 63
7.2
Operations and Strategy.................................................................................................................. 63
7.3
Capital Management Plan............................................................................................................... 64
7.4
Capital Structure and Ownership .................................................................................................. 64
7.5
Financial Position............................................................................................................................. 65
7.6
Management Fee .............................................................................................................................. 66
7.7
Distribution Policy ........................................................................................................................... 66
8
Evaluation of the Merger............................................................................................................................ 67
8.1
Summary........................................................................................................................................... 67
8.2
Approach .......................................................................................................................................... 68
8.3
Relative Contributions based on Market Value ............................................................................ 70
8.4
Relative Contributions based on Underlying Value...................................................................... 74
8.5
8.6
8.7
8.8
8.9
8.10
8.11
8.12
9
Financial Impacts of the Merger .................................................................................................... 75
Advantages of the Merger ............................................................................................................... 76
Costs, Disadvantages and Risks ...................................................................................................... 79
Takeover Analysis............................................................................................................................ 82
Placement Analysis .......................................................................................................................... 83
Alternatives....................................................................................................................................... 84
Options.............................................................................................................................................. 85
Convertible Notes............................................................................................................................. 85
Qualifications, Declarations and Consents................................................................................................ 87
9.1
Qualifications ................................................................................................................................... 87
9.2
Disclaimers ....................................................................................................................................... 87
9.3
Independence.................................................................................................................................... 87
9.4
Declarations...................................................................................................................................... 88
9.5
Consents............................................................................................................................................ 88
9.6
Other ................................................................................................................................................. 88
Appendix
1.
2.
Property Portfolio as at 31 December 2002
Market Evidence
1
Details of the Merger
On 20 January 2003, the directors of Challenger International Limited (“Challenger”) announced that
they had agreed to merge the company with CPH Investment Corp (“CPHIC”) (“the Merger”). On
9 April 2003, the parties executed a detailed agreement setting out the terms of the Merger, the process to
implement the Merger, the conditions and various obligations and rights (“the Implementation
Agreement”). The Merger will be implemented by way of three schemes of arrangement (“the Schemes”)
under Section 411 of the Corporations Act to be approved respectively by Challenger shareholders,
convertible noteholders and optionholders. Under the terms of the Merger:
ƒ
ordinary shareholders will receive 4.5 units in CPHIC for each ordinary share in Challenger (the
“Share Scheme”);
ƒ
the scheme for convertible noteholders (the “Notes Scheme”) provides noteholders with the choice
to either:
•
retain their convertible notes but exchange the Challenger ordinary shares issued upon
conversion of any notes for units in CPHIC on the basis of 4.5 new units in CPHIC for each
Challenger share (the “Retention Alternative”); or
•
exchange their convertible notes for units in CPHIC on the basis of 5.5 new units in CPHIC
for each Challenger convertible note (the “Exchange Alternative”).
This election must be made by the Effective Date of the Notes Scheme. If a noteholder does not
make an election and the Notes Scheme is approved then the noteholder will be deemed to have
selected the Exchange Alternative; and
ƒ
optionholders will retain their options but will exchange the Challenger shares issued upon
subsequent exercise of any Challenger option for units in CPHIC on the basis of 4.5 new units in
CPHIC for each Challenger share (the “Options Scheme”).
Challenger shareholders will own 58.9%1 of the merged entity which will be renamed Challenger
Financial Services Group.
CPHIC is a managed investment scheme listed on the Australian Stock Exchange (“ASX”). It holds an
investment portfolio comprising mostly cash and listed securities assets (more than $400 million) as well
as various private equity type interests in unlisted entities. The responsible entity for CPHIC is CPH
Management Limited (“CPH Management”), a wholly owned subsidiary of the Consolidated Press
Holdings Limited (“CPH”) group which is controlled by interests associated with Mr Kerry Packer. The
CPH group has a substantial shareholding in Challenger (18.4%) and a substantial unitholding in CPHIC
(31.1%).
CPH Management will continue to act as responsible entity for the merged entity. Certain changes are to
be made to the calculation of management fees paid to CPH Management including the following:
ƒ
the base management fee of 1.5% per annum will only be payable in respect of CPHIC’s
investment in Challenger under the Schemes if CPHIC’s unit price (on a volume weighted basis) is
above 60 cents over a period of 10 days; and
ƒ
the base management fee related to the investment in Challenger will be effectively determined by
reference to the equity investment in Challenger (rather than gross assets as required under the
Trust Deed at present). For the period to 30 June 2005, this will be based on cost (using the value
of CPHIC units issued as consideration). Thereafter, it will be based on the value of the
investment as determined by an independent valuation to be conducted by an internationally
recognised investment bank.
CPH Management announced on 20 January 2003 that it had appointed Mr Chris Cuffe as Chief
Executive Officer (“CEO”). Mr Cuffe will act as CEO of the merged entity and was appointed as Acting
1
Assuming no convertible noteholders elect to exchange their notes for 5.5 CPHIC units.
Page
1
CEO of Challenger on 9 April 2003. His employment costs will be met by CPH Management. Mr Cuffe
has also announced a number of new senior management appointees for the merged entity.
It is proposed that two of Challenger’s non executive directors will become directors of CPH
Management.
If the Share Scheme is approved then the Merger will proceed notwithstanding that either or both the
Notes Scheme or Options Scheme are not approved. The Merger is subject to a number of other
conditions including:
ƒ
approval of CPHIC unitholders;
ƒ
ASX listing being granted to the new CPHIC units to be issued;
ƒ
the granting of all necessary approvals in relation to the acquisition of Challenger securities by
CPHIC in accordance with the requirements of the Financial Sector (Shareholding) Act, the
Insurance Acquisition and Takeovers Act and the Financial Services and Markets Act (UK);
ƒ
the Implementation Agreement not being terminated by either party;
ƒ
the Australian Prudential and Regulatory Authority (“APRA”) not giving any direction under the
Life Insurance Act 1995 (“Life Insurance Act”) to either of Challenger’s two life company
subsidiaries or giving a notice to show cause why a direction should not be issued; and
ƒ
APRA confirming that it is satisfied that implementation of a capital management plan prepared
by CPH Management will be consistent with the obligations of Challenger’s two life company
subsidiaries under the Life Insurance Act and will not give rise to any prudential concerns.
The Implementation Agreement allows for a number of termination events and is subject to a sunset date
of 31 July 2003 by which date, the conditions must be satisfied or waived.
Page
2
2
Scope of the Report
2.1
Purpose of the Report
The Schemes which will implement the Merger will be effected pursuant to Section 411 of the
Corporations Act. Part 3 of Schedule 8 to the Corporations Regulations prescribes the information
to be sent to shareholders in relation to schemes of arrangement pursuant to Section 411. Part 3 of
Schedule 8 requires an independent expert’s report in relation to a scheme of arrangement to be
prepared when a party to a scheme of arrangement has a prescribed shareholding in the company
subject to the scheme, or where any of its directors are also directors of the company subject to the
scheme. CPHIC does not hold any shares, convertible notes or options in Challenger but at the
date of the announcement of the Merger there were common directors between CPHIC and
Challenger. Accordingly, there is a requirement for an independent expert’s report to be prepared
for Challenger shareholders pursuant to Section 411. The independent expert’s report is required
to state for each class of securityholder (i.e. shareholders, convertible noteholders and
optionholders) whether the relevant scheme for that class is in the best interests of those
securityholders and the reasons for that opinion. Challenger has engaged Grant Samuel &
Associates Pty Limited (“Grant Samuel”) to prepare a report to meet this requirement.
This report has been prepared for the benefit of Challenger directors (and no other person) to assist
them in advising shareholders, convertible noteholders and optionholders (collectively
“securityholders”) as to the merits of the proposed Merger. It will accompany each of the Scheme
Booklets to be sent to Challenger securityholders. The sole purpose of this report is as an
expression of Grant Samuel’s opinion as to whether the Merger is in the best interests of each class
of Challenger securityholders.
Approval or rejection of the Merger is a matter for individual Challenger securityholders based on
their expectations as to value and future market conditions and their particular circumstances
including risk profile, liquidity preference, investment strategy, portfolio structure and tax
position. Securityholders who are in doubt as to the action they should take in relation to the
Merger should consult their own professional adviser.
2.2
Basis of Evaluation
There is no legal definition of the expression “in the best interests”. The Australian Securities
Commission (now the Australian Securities & Investments Commission) issued Policy Statement
75 which established certain guidelines in respect of independent expert’s reports prepared for the
purposes of the Corporations Act. Policy Statement 75 is primarily directed towards reports
prepared for the purpose of what is now Section 640 of the Corporations Act and comments on the
meaning of “fair and reasonable” in the context of a takeover offer. The statement gives limited
guidance as to the regulatory interpretation or meaning of “in the best interests” other than to
imply that it is similar to “fair and reasonable”.
Schemes of arrangement pursuant to Section 411 can encompass a wide range of transactions.
Accordingly, “in the best interests” must be capable of a broad interpretation to meet the
particular circumstances of each transaction. This involves a judgement on the part of the expert
as to the overall commercial effect of the transaction, the circumstances that have led to the
proposal and the alternatives available. The expert must weigh up the advantages and
disadvantages of the proposal and form an overall view as to whether the securityholders are likely
to be better off if the proposal is implemented than if it is not.
In Grant Samuel’s opinion, the most appropriate basis on which to evaluate the Merger is to assess
its overall impact on each class of securityholders of Challenger and to form a judgement as to
whether the expected benefits to the securityholders outweigh any disadvantages and risks that
might result.
The following factors, inter alia, have been considered in determining whether the Merger is in the
best interests of Challenger securityholders:
Page
3
2.3
ƒ
the terms of the Merger;
ƒ
the estimated underlying value of both Challenger and CPHIC;
ƒ
the relative value contributions in terms of parameters such as market value and estimated
underlying value compared to the shares of the merged entity to be held by each group;
ƒ
the impact on earnings, dividends and assets;
ƒ
the impact on financial position and, in particular, the capital and solvency issues related to
Challenger’s annuity business;
ƒ
potential merger synergies;
ƒ
likely impact on liquidity and market price of shareholders interests;
ƒ
any other advantages and benefits arising from the Merger;
ƒ
any disadvantages, costs and risks; and
ƒ
the likelihood of alternative transactions which could realise better value.
Sources of Information
The following information was utilised and relied upon, without independent verification, in
preparing this report:
Publicly Available Information
ƒ
the Scheme Booklets relating to the Merger issued by Challenger (including earlier drafts);
ƒ
draft Notice of Meeting and Explanatory Memorandum issued by CPHIC;
ƒ
annual reports of Challenger and CPHIC for the three years ended 30 June 2002;
ƒ
half yearly reports for Challenger and CPHIC for the six months ended 31 December 2002;
ƒ
corporate brochures, product material (e.g. prospectuses) and other publicly available
information on the business operations of Challenger including information available on
Challenger’s website;
ƒ
press releases, public announcements, media and analyst presentation material and other
public filings by both Challenger and CPHIC;
ƒ
industry data and reports for the financial services industry;
ƒ
recent press articles on Challenger and CPHIC and their competitors;
ƒ
recent brokers reports on Challenger and CPHIC and comparable publicly listed companies
from a variety of stockbroking firms and investment banks; and
ƒ
other information on the funds management and annuity industries and publicly listed
companies with operations broadly comparable to Challenger including annual reports,
interim financial results, websites, broker analyst reports, press reports, industry studies and
information regarding the prospective financial performance of companies in Australia and
overseas.
Non Public Information provided by Challenger
ƒ
management accounts and monthly management reports for periods up to 31 December
2002;
ƒ
board papers up to 27 February 2003;
ƒ
Challenger’s budget for the year ending 30 June 2003 and revised forecasts for the same
period for some business units (however no up to date forecast for 2003 for the Challenger
group was provided);
Page
4
ƒ
detailed forecasts on a property by property basis for a period of approximately 20 years,
flowing through to valuation calculations for capital and income units held by Global Life;
ƒ
detailed reports in relation to Challenger Life Limited and Challenger Life No 2 Limited as
at 30 June 2002 by the appointed actuary, David Goodsall of Ernst & Young Actuarial
Business Consultants;
ƒ
summary Appraisal Report for Challenger Life No 2 Limited as at 31 December 2002 by
the appointed actuary, David Goodsall of Ernst & Young Actuarial Business Consultants;
ƒ
independent reports on discount rates related to Challenger’s Global Life business;
ƒ
independent valuations of properties owned by Challenger’s Global Life business;
ƒ
independent valuations of various Challenger fund management rights; and
ƒ
other confidential documents, presentations and working papers provided by Challenger in
its due diligence data room.
Non Public Information provided by CPHIC
ƒ
management accounts and monthly management reports for periods up to 31 December
2002;
ƒ
board papers up to 31 December 2002;
ƒ
various documents relating to investee companies including management reports, annual
accounts and shareholders agreements; and
ƒ
other confidential documents, presentations and working papers provided by CPHIC in its
due diligence data room.
Grant Samuel has also held discussions with, and obtained information from, directors and senior
management of Challenger, senior management of CPH Management and their advisers.
2.4
Limitations and Reliance on Information
Grant Samuel believes that its opinion must be considered as a whole and that selecting portions of
the analysis or factors considered by it, without considering all factors and analyses together, could
create a misleading view of the process underlying the opinion. The preparation of an opinion is a
complex process and is not necessarily susceptible to partial analysis or summary.
Grant Samuel’s opinion is based on economic, sharemarket, business trading, financial and other
conditions and expectations prevailing at the date of this report. These conditions can change
significantly over relatively short periods of time. If they did change materially, subsequent to the
date of this report, the opinion could be different in these changed circumstances. However, Grant
Samuel has no obligation or undertaking to advise any person of any change in circumstances
which has come to its attention after the date of this report or to review, revise or update its report
or opinion.
This report is also based upon financial and other information provided by Challenger and CPHIC
and their advisers. Grant Samuel has considered and relied upon this information. Challenger has
represented in writing to Grant Samuel that to its knowledge the information provided by it was
complete and not incorrect or misleading in any material aspect. CPHIC has provided a similar
representation. Grant Samuel has no reason to believe that any material facts have been withheld.
The information provided to Grant Samuel has been evaluated through analysis, inquiry and
review for the purposes of forming an opinion as to whether the Merger is in the best interests of
Challenger securityholders. However, Grant Samuel does not warrant that its inquiries have
identified or verified all of the matters that an audit, extensive examination or “due diligence”
investigation might disclose. “Due diligence” is the responsibility of each company and its
management and is beyond the scope of an independent expert. Challenger and CPHIC have
Page
5
undertaken due diligence on each other. Challenger has confirmed to Grant Samuel that it is
satisfied with the outcome of its investigations in relation to CPHIC. In any event, an opinion of
the kind expressed in this report is more in the nature of an overall review rather than a detailed
audit or investigation.
An important part of the information used in forming an opinion of the kind expressed in this
report is comprised of the opinions and judgement of management. This type of information was
also evaluated through analysis, inquiry and review to the extent practical. However, such
information is often not capable of external verification or validation.
Preparation of this report does not imply that Grant Samuel has audited in any way the
management accounts or other records of Challenger or CPHIC. It is understood that the
accounting information that was provided was prepared in accordance with generally accepted
accounting principles and in a manner consistent with the method of accounting in previous years
(except where noted).
The information provided to Grant Samuel included budgets, forecasts and projections for
Challenger and CPHIC’s investee companies prepared by management of Challenger and
CPHIC’s investees respectively. These parties are responsible for the budgets, forecasts and
projections. Grant Samuel has used and relied on these budgets, forecasts and projections for the
purposes of its analysis. Grant Samuel has assumed that these budgets, forecasts and projections
were prepared appropriately and accurately based on the information available to management at
the time and within the practical constraints and limitations of such estimates. Grant Samuel has
assumed that these forecasts do not reflect any material bias, either positive or negative. Grant
Samuel has no reason to believe otherwise. The major assumptions underlying these budgets,
forecasts and projections were reviewed by Grant Samuel in the context of current economic,
financial and other conditions. The achievability of these budgets, forecasts and projections is not
warranted or guaranteed by Grant Samuel. Future profits and cash flows are inherently uncertain.
They are predictions by management of future events that cannot be assured and are necessarily
based on assumptions, many of which are beyond the control of Challenger, CPHIC or their
management respectively. Actual results may be significantly more or less favourable.
Challenger has decided not to include any forecasts in the documents to be sent to shareholders.
Accordingly, at the request of Challenger this report does not include any forecast information.
In forming its opinion, Grant Samuel has also assumed that:
ƒ
matters such as title, compliance with laws and regulations and contracts in place are in
good standing and will remain so and that there are no material legal proceedings, other
than as publicly disclosed;
ƒ
the information set out in the Scheme Booklets sent by Challenger to its securityholders is
complete, accurate and fairly presented in all material respects;
ƒ
the publicly available information relied on by Grant Samuel in its analysis was accurate
and not misleading;
ƒ
the Schemes will be implemented in accordance with their terms; and
ƒ
the legal mechanisms to implement the Merger are correct and will be effective.
To the extent that there are legal issues relating to assets, properties, or business interests or issues
relating to compliance with applicable laws, regulations, and policies, Grant Samuel assumes no
responsibility and offers no legal opinion or interpretation on any issue.
Page
6
3
Profile of Challenger International Limited
3.1
Background
Challenger is an Australian based financial services organisation listed on the ASX with a market
capitalisation prior to announcement of the Merger of approximately $500 million.
Challenger commenced operations in the 1980’s as an investment bank that specialised in the
development of a number of niche capital markets products. It was a pioneer in the development of
the endowment warrants market in Australia. The group has evolved and changed substantially over
the last few years through organic growth, the development of new business and through acquisition.
It is now a broadly based provider of investment products (primarily income products) to individuals
throughout both their accumulation and retirement phases. The cornerstone has been Challenger’s
unique and highly successful long term annuity business backed by structured property investments
which now has a portfolio valued at approximately $2.7 billion. The annuity business is conducted
through a regulated life company. This business is complemented by:
ƒ
a short term annuity business backed by fixed interest securities;
ƒ
diversified funds management activities encompassing fixed interest, equities, specialised
investments, administration services and corporate superannuation. Challenger’s flagship
product is the $2.1 billion Howard Mortgage Trust;
ƒ
financial planning advisory services; and
ƒ
other activities including corporate finance, property syndication and property and other lending.
Most of the non annuity businesses have developed through acquisition, with much of this
occurring over the last four years. These acquisitions included:
ƒ
the management rights to Village Entertainment Property Trust in August 1999. Full
unitholder buyout of the trust was completed in August 2000 and the property assets were
backed into Challenger’s Global Life business;
ƒ
the management rights to the Norwich Mortgage Trusts in August 1999 for $6 million,
adding $297 million in mortgage funds under management;
ƒ
Garrisons Pty Limited and the Synergy Master Trust in November 1999 for $37 million,
building Challenger’s planning network to 55 offices throughout Australia (now 70
Garrisons offices and 26 affiliated offices);
ƒ
the Beston Pacific Group and the management rights to the Beston Wine Industry Trust for
$4.3 million in December 1999;
ƒ
the Citibank share finance business in February 2000;
ƒ
Deutsche Life Limited in March 2000 for $45.6 million; and
ƒ
a 46.6% interest (now 23%) in David Garry Holdings Limited in November 2000,
establishing what is now Garrisons Accounting Group Limited.
Challenger entered the United Kingdom market in 2001, establishing an office based in London
and acquiring Neville James Holdings Limited to provide a distribution base to financial planners.
In April 2002, Challenger was granted a life insurance licence by the United Kingdom Financial
Services Authority, with the intention of expand its Australian property asset model into the
United Kingdom pension market. In late 2002, Challenger decided to put the United Kingdom life
insurance activities on hold indefinitely and to wind back its United Kingdom infrastructure.
Challenger acquired the private client stockbroking business of Credit Suisse First Boston in
February 2002. This business, which traded as Challenger First Pacific, was divested to Bell
Potter Group Pty Limited in January 2003 for an undisclosed sum.
Page
7
Challenger’s activities are now structured from an operational perspective into two principal
divisions, Global Life and Investment Services. In turn, Investment Services encompasses funds
management and a variety of other businesses:
Challenger Corporate Structure
Challenger
International Limited
Global Life
Short Term Annuities
Long Term Annuities
Investment Services
Funds Management
Other
Synergy Master Trust
Garrisons Financial Planning
Income Products
Corporate Advisory
Equity Products
Property and Other Lending
Leveraged Products
Group Services
Alternate Investments
Corporate Superannuation
Property Asset Management
Source: Challenger
It should be noted that while the businesses are operated under the structure outlined above the
actual corporate structure is different. A number of the funds management activities are owned by
Challenger’s Global Life business and form part of the capital base that underpins the capital
adequacy and solvency of the life company activities.
At 31 December 2002, Challenger had $9.6 billion net funds under advice and management plus a
further $1.9 billion in loans. These funds can be summarised as follows:
Challenger – Funds Under Advice and Management ($ millions)
Business
As at 31 December 2002
Gross
Crossholdings
Net
Global Life
4,041.7
(279.6)
3,762.1
Funds Management
7,950.0
(2,057.1)
5,892.9
Other
1,810.8
-
1,810.8
Total
13,802.5
(2,336.7)
11,465.8
Less: Loans2
(1,861.7)
-
(1,861.7)
Total (excluding loans)
11,940.8
(2,336.7)
9,604.1
Source: Challenger
Challenger’s net funds under advice and management has grown from $6.6 billion at
30 September 2001 to $7.9 billion at 30 June 2002 (a 19.7% increase) and to $9.6 billion at
31 December 2002. This growth has primarily been in Global Life (approximately $1.9 billion)
2
Loans represent loans made by Howard Mortgage Trust, Howard Finance and Howard Pacific ($1,810.8 million) and by Global Life
($50.8 million).
Page
8
and in the Howard Mortgage Trust (approximately $0.8 billion) although there has been organic
growth in other areas and considerable consolidation in funds offered by Challenger.
An important contributor to Challenger’s success to date, particularly for the annuities business,
has been its strong distribution network. Challenger’s products are distributed by approximately
2,500 financial planners and other intermediaries (excluding Challenger’s in-house planners).
Challenger has a dedicated distribution group for developing and managing relationships with
intermediaries and has utilised a number of strategies including extensive use of seminars and
education programs and loyalty programs involving equity in Challenger.
Challenger’s own financial planning and corporate superannuation businesses are a significant
source of funds inflow for both the annuity business and the funds management businesses.
The funds management activities have been built through acquisition fairly recently and are
somewhat disparate. They have tended to operate separately and are, in reality, a collection of
businesses rather than a cohesive business unit. Only in the past 12 months has there been a
significant effort to commence integration to achieve efficiencies of scale. There remains
considerable opportunity for the extraction of synergies.
Challenger has recently announced its intention to implement a cost reduction program targeted at
achieving operating cost savings of $20 million per annum.
Challenger’s overall capital base has grown steadily but with the rapid growth of the long term
annuity business in the past 2-3 years it has had to undertake more substantial capital raisings:
3.2
ƒ
in July 2001, Challenger conducted a 1 for 9 rights issue, raising approximately $85
million. A significant portion of these funds was intended to be applied to fund prudential
requirements in the United Kingdom and to launch a range of annuity products in that
market. However, a large portion of the proceeds were ultimately used for working capital
purposes and applied to statutory reserves backing the Global Life business in Australia; and
ƒ
in December 2002, Challenger undertook a convertible note issue underwritten by Bell
Potter Securities Limited and sub-underwritten by major shareholders, the CPH group and
Hudson Conway Investments Pty Limited, raising $75 million. A significant proportion of
the proceeds were applied to increasing statutory reserves in the Global Life business.
Global Life
3.2.1 Overview
Challenger’s Global Life business comprises the long term and the short term annuity
business together with some other investment products (superannuation, insurance, bonds,
allocated pensions). Annuities represents over 90% of the business of the division.
Annuities are a “single premium” business where an investor makes an upfront capital
payment in return for a series of guaranteed fixed payments (which include both a capital
return and an investment return) over a number of years. Short term annuities generally
involve payments over periods of up to five years while long term annuities generally
involve periods of five to twenty years.
Key features of Challenger’s annuity business include:
ƒ
all products offer a fixed or CPI linked return. To the extent returns on investments
are less than or more than the rate necessary to cover this return (and the expenses of
the business), the loss or gain ultimately accrues to Challenger;
ƒ
while the vast majority of policies are fixed term, Challenger sells some “whole of
life” policies where the investor receives payments for the entire term of their
remaining lives. However, Challenger effectively reinsures this mortality risk with
MunichRe. Accordingly, while the business is conducted through a life company,
Page
9
Challenger carries no life risks3. Its policy liabilities are fully determined except that
for a proportion of policies that are indexed for inflation;
ƒ
short term annuity flows are primarily invested in fixed income securities; and
ƒ
long term annuities are primarily invested in structured property assets. This model
is described in more detail in Section 3.2.4 below and has been the foundation of
Challenger’s success as the higher yields on property enables Challenger to offer
annuities on more attractive terms than its competitors. Challenger’s competitors
primarily back their annuities with fixed income securities.
The main buyers of annuities are retirees seeking secure income streams. The annuity
business leverages off the Australian Government’s current social security system, whereby
certain income streams are considered assets test exempt and therefore enhance the ability
of retirees to be eligible to receive the old age pension. This advantage is shared by all
annuity business participants but it is a critical feature as it enhances the effective return to
the investor. Without this benefit, the demand for annuities would probably be substantially
lower (as it is in places such as New Zealand).
The annuity business has grown rapidly over the past four years with total annual annuity
sales growing from less than $100 million in 1998/99 to well over $500 million in 2002/03.
Future demand is widely expected to continue to grow strongly (assuming current rules
continue to apply) in view of Australia’s ageing population and the resultant surge in the
number of retirees, combined with the overall growth in superannuation savings anticipated
over the next decade.
3.2.2 Corporate Structure
The annuity (and other ancillary businesses) are conducted through Challenger’s two life
insurance companies. In turn, the life insurance companies conduct their business through
statutory funds which issue the products (referred to as policies) and which hold the assets
on behalf of the investors (policyholders). The life company has a residual interest in the
statutory fund after all liabilities have been met.
The structure of Challenger’s Global Life division is set out below:
3
There is a small amount of mortality risk in relation to the lifetime option on the performance annuity bond. There were 50 policies
with lifetime options in force at 30 June 2002 and the option was withdrawn from the market in 1995.
Page 10
Global Life Structure
Statutory Fund 1
Superannuation Capital
Guaranteed
Statutory Fund 2
Superannuation Investment
Linked
Statutory Fund 3
Insurance Bond Investment
Linked (closed to new business)
Global Life
Statutory Fund 4
Insurance Bond with
Guarantee (closed)
Challenger Life Limited
Statutory Fund 5
Annuity with Performance
Guarantee (closed)
100%
Statutory Fund 2
Annuities
Challenger Life No 2 Limited
Statutory Fund 6
Annuities, Fixed Rate
Allocated Pension
Various Property Trusts
Statutory Fund 7
Super Fixed Rate
Statutory Fund 8
Allocated Pensions
Investment Linked
Source: Challenger
Challenger Life Limited (“Challenger Life No 1”) offers annuity, insurance bonds,
superannuation and allocated pension products. All of these funds, with the exception of
Statutory Fund 6, are relatively small (total funds of less than $100 million) and several of
them are now closed. A number of them (e.g. Statutory Funds 1, 2, 3, 4 and 8) are
investment linked products where policyholders earn the investment returns less a margin.
In these cases, the position of Challenger Life No 1 is equivalent to a fund manager earning
a management fee. Statutory Fund 6 was the original vehicle for Challenger’s main
annuities business, however, its business has now effectively transferred to Statutory Fund
2 of Challenger Life No 2 Limited (“Challenger Life No 2”) through a reinsurance
arrangement. Challenger Life No 2 offers short and long term annuity products, reinsures
all the Challenger Life No 1/Statutory Fund 6 annuity products and manages the asset
portfolios backing the annuity products. Challenger Life No 2 accounts for over 90% of
Challenger’s total life insurance business.
3.2.3 Sales and Distribution
Annuity sales, particularly long term annuity sales, have grown rapidly over the past 2-3
years underpinned by the more attractive underlying investment rate that Challenger is able
to offer:
Global Life – Inflows ($ millions)
2000
2001
2002
Six months
ended
31 December
2002
Long term annuities
na
216.6
351.2
238.9
Short term annuities
na
255.2
273.9
286.2
194.4
471.8
625.1
525.1
10.3
37.5
42.4
50.2
204.7
509.3
665.5
575.3
Year ended 30 June
Total annuity inflows
Other (Challenger Life No 1 except SF6)
Total inflows
Page 11
Annuities are distributed through independent financial planners via Challenger’s extensive
distribution network. Challenger also has relationships with Zurich Australia Limited
(Challenger reinsures Zurich annuities on a wholesale basis) and Deutsche Financial
Planning (owned by National Australia Bank) where it provides a specially tailored
product.
Since 2001 Challenger has been the clear market leader in long term annuities with a share
of inflows of approximately 30%. Other active participants in this product sector include
AMP Limited, AXA Australia Pacific Holdings Limited and Tower Limited. Challenger is
the only participant adopting the property investment model. The others use fixed income
securities. Challenger’s strong market position reflects its effective distribution network
but also its yield advantage. Because of its structured property investment focus it has been
able to offer rates above competitors (e.g. 15 year rates were 5.9% in late 2002 whereas
competitors were less than 5%). Since then Challenger has reduced its rates to closer to its
competitors. Challenger is also the second largest participant in short term annuities market
behind Citigroup.
Products are sold in a variety of forms (allocated pensions, annuities) and under a number
of different brand names (Guaranteed Income Plan, Income Choice, RetireEasy). Over
80% of annuities sold by Challenger are for capital sums of less than $100,000. In terms of
policy numbers slightly under 50% are short term (i.e. less than five years) but these also
tend to be smaller in value. The most popular long term policies are in the 10-15 year
range. Approximately 25% of long term policies are CPI indexed.
As at 31 December 2002, Global Life’s total book stood at $1.7 billion:
Global Life – Liabilities
Policy Liabilities4
($ millions)
Long term annuities
944.5
Short term annuities
670.0
Other (Challenger Life No 1 except SF6)
Total
108.7
1,723.2
3.2.4 The Property Investment Model
(i)
Overview
The essence of Challenger’s property investment model for long term annuities is that
rather than investing in fixed income securities (or equities) to provide the income and
capital to service long term annuities it invests (pools of annuities) in properties. Moreover,
it invests in properties that are leveraged using non recourse external debt (at up to 60% of
the property value or in some cases even higher).
The benefits of this model are:
4
ƒ
property provides a higher yield than fixed income securities (at least at present)
while being able to be structured so as to provide very secure income streams by
having high quality tenants, long term leases without market rent reviews (or with
upwards only market reviews) and diversification such that the risks of the net cash
flows are minimised and more than compensated by the extra income;
ƒ
returns are enhanced through the use of debt as there is typically a positive margin
between the property yield and commercial mortgage rates. Any interest rate risk on
the debt can be largely eliminated by hedging for the term of the annuity;
Policy liabilities are an actuarial calculation representing the net present value of future annuity payments plus expenses related to the
policies.
Page 12
ƒ
property income streams are usually indexed for inflation providing a growing
income stream that over the course of the annuity is sufficient (after payment of
interest on debt) to service the total annuity payments;
ƒ
at the end of the term of annuity there should be a substantial residual asset (being
the property less any remaining debt) which belongs to Challenger (as the annuity
liability has been extinguished). In contrast, competitors that back annuities with
fixed income securities “consume” the capital value of the asset in making the
annuity payments.
From the perspective of the policyholder there is a predictable and secure cash flow stream
that is sufficient to meet the annuity liabilities.
From Challenger’s perspective, the model can be seen as a 100% leveraged property play
similar to the “negative gearing” strategies employed by private property investors. It
acquires properties using a combination of external debt (typically around 60%) and
policyholder funds (the remainder) and using little or no capital of its own. Cash flow in
the short term is usually negative (because the annuity payment involves both interest and a
return of capital in a manner similar to a conventional principal and interest mortgage and
there are upfront costs) but over time positive cash should arise as property rentals rise.
More importantly, it effectively has a “free carry” of the residual asset.
The model is designed to generate substantial value for Challenger over the longer term as
the annuities run off. The main issue with the model is that it is long term and in the short
term there is a cash deficit that requires funding. This cash requirement is exacerbated if,
as Challenger’s have been, the annuity inflows are growing (requiring continual investment
in new properties). This problem diminishes with time and in due course there will be
substantial positive cash flows particularly when “equity” in the properties can be recycled
against new annuity sales. However, Challenger is presently in the early stages of the
model. Operations have been building for the last 4-5 years but the business will not be
fully mature for at least another five years.
(ii) Structure
Properties are purchased through a trust structure which allows the assets to be geared
without infringing the requirements of the Life Insurance Act. The trust issues two types of
units, income and capital, to the Statutory Fund in exchange for the investment by the
Statutory Fund of the pool of annuity premiums. The investment outlay is for the income
unit. The consideration for the capital unit is negligible. Income units are entitled to the
net cash flow from the property (after borrowing costs) for a term matching the annuities,
say 15 years. This cash flow is used by the Statutory Fund to pay the annuity liabilities.
Capital units are entitled to the net income from the property from expiry of the income
units as well as to all the capital value of the trust at that time. The capital units are not
needed to service the annuity (and in any event do not generate any cash income during the
life of the annuity) but are held as reserves for the statutory funds for the life of the
annuities. Once the annuity liabilities are repaid, the capital units are no longer required to
be held as reserves and revert to Challenger.
Page 13
Global Life – Annuities
Challenger
Life No. 2
Policyholder
periodic payment
premium
excess assets and profits
Statutory Fund
Policyholder Funds
dividend
and
interest
investment
Other
Investments
net cash
flow
after
interest
Reserves
residual value
investment (40%)
Income
Units
Capital
Units
interest and principal
Banks
Property Trusts
loan (60%)
rent (net of expenses)
first mortgage
Gearing for the properties is sourced from a variety of lenders each with their own terms,
structures and covenants. Borrowings are generally at maximum allowable loan to value
ratios (“LVR”), typically 60% (or more in some cases), and are all structured so that they
are non-recourse to Challenger. Challenger enters into various swap transactions to
effectively fix the interest rates for full the term of the structure. For foreign properties the
net cash flows are all hedged back into Australian dollars for the full term. Challenger also
hedges the currency risk relating to the capital value of most of its offshore properties.
(iii) Property Acquisition Strategy
Challenger looks to purchase high quality commercial property with long term tenants to
maximise the security of income to meet annuity liabilities. Challenger’s selection criteria
for property purchases incorporates:
ƒ
strong tenant covenants, predominantly government and listed and rated corporate
entities (market capitalisation >$300 million) to minimise tenant default risk:
ƒ
long term leases that match the annuity term and do not have early termination
provisions;
ƒ
ƒ
fixed or CPI rental growth with upwards only market review provisions;
ƒ
net leases (i.e. the tenant bears outgoings) or, ideally, “triple net” leases where the
tenant also covers all capital expenditure;
ƒ
ƒ
new, near new or refurbished property;
ƒ
ƒ
sector concentration on commercial, office, retail and industrial; and
initial passing pre-acquisition cost yield of generally 8% or greater. However this is
subject to the prevailing interest rate environment, funding options, length of lease
and rental growth;
concentration on Australian Eastern seaboards in prime capital city locations and
major population centres in first world countries with similar legal and financial
systems, such as the United Kingdom and the United States;
generally greater than $15 million in value.
Page 14
These aspects are designed to minimise risks for policyholders and essentially lock in the
future cash flows so that it as close as possible to a guaranteed income stream. At the same
time it limits the properties that can be acquired and narrows the pool of investment
opportunities. The focus is less on seeking properties with value creating opportunities
such as refurbishment, additions, tenant replacement or rental restructuring. In this respect
the portfolio is intended to have a quite different risk/return profile to typical investment
portfolios (e.g. those held by listed property trusts).
In addition, as the business has grown the portfolio has been able to become much more
diversified in terms of property type, location and tenant mix thus lowering the overall risk
profile.
(iv) Profile of Current Portfolio
At 31 December 2002, Challenger owned approximately $2.7 billion of property
comprising 51 properties across the commercial, retail, industrial and entertainment sectors.
A listing of the major properties is set out in Appendix 1.
A review of the portfolio shows a number of important features.
ƒ
the average size of property acquisitions has increased significantly in recent years
with individual acquisitions now in the order of $100-250 million. This increase
reflects the growth in inflows. Larger properties are needed to be able to effectively
invest the funds;
ƒ
since 1999, Challenger has been acquiring properties in the United Kingdom. In
2002 it also started acquiring properties in the United States. This trend reflects the
increasing size of the portfolio and the limited availability of suitable properties in
the Australian domestic market. In these much bigger markets there is more scope
to find suitable properties. As noted above, Challenger hedges all currency risks in
relation to the cash flows for the term of the policies; and
ƒ
the portfolio has a high level of diversification by geographic area, tenant and
industry exposure.
Various characteristics of the portfolio are shown graphically below:
Challenger Property Portfolio - By Location
Western Australia
1.48%
Queensland
2.19%
United States
15.04%
Tasmania
1.65%
South Australia
1.79%
United Kingdom
27.30%
ACT
8.40%
New South Wales
20.13%
Victoria
22.02%
Source: Challenger
Page 15
Challenger Property Portfolio - By Sector
Retail
0.98%
Industrial
5.52%
Entertainment/
Cinemas
10.41%
Commercial
83.09%
Source: Challenger
Challenger Property Portfolio by Entity (by rent)
Federal Government
12.68%
State Government
8.79%
Major Private
Corporation
5.84%
Small Private
Corporation
4.72%
Listed Entities
67.97%
Source: Challenger
Challenger Property Portfolio by Industry (by rent)
Tourism & Leisure
0.17%
Transport &
Distribution
3.36%
Agriculture
2.93% Banks & Finance
10.63%
Telecommunications
12.45%
Retail
7.50%
Cinemas
9.07%
Education
1.27%
Paper & Packaging
2.26%
Energy
7.49%
Manufacturing
0.62%
Investment &
Financial Services
4.05%
Insurance
7.87%
Engineering
0.88%
Healthcare &
Biotechnology
0.94%
Government
16.35%
Food & Household
Goods
12.16%
Source: Challenger
Page 16
Challenger Property Portfolio by Rated Entity (by rent)
B
32.40%
A
52.59%
A
B
C
A credits and above, major corporations
B to BBB credits, substantial corporations
Unrated, SME corporation
C
15.01%
Source: Challenger
Since 31 December 2002, Challenger has acquired another substantial property in the
United States, the Invesco building in Denver, Colarado for a price of $97 million. This
property evidences Challenger’s strategy:
ƒ
a high quality tenant;
ƒ
non cancellable lease that matches the full term of the annuity; and
ƒ
lease with built in escalation and no market rent reviews.
Nevertheless, there are risks that remain:
ƒ
there is inevitably some credit risk relating to tenants, albeit that the risks are
relatively low;
ƒ
not all leases run for the full term of the policies and either expire or have break
clauses (at the lessee’s option). Approximately 10-15% of leases by value will have
a potential termination event prior to 2010; and
ƒ
not all finance facilities have terms to the end of the policy liability and some
facilities have maximum LVR covenants that must be met during their lives.
Accordingly, while the interest rate is hedged for the full term:
•
there is a refinancing risk which could result in an increase in margins or a
reduction in facilities at the loan maturity/rollover date; and
•
there is a risk of LVR covenants being breached resulting in a need to inject
capital into the trust.
In summary, the net income streams from the property trusts are low risk but are not risk
free.
(v) Borrowings
Historically, Challenger has arranged facilities on an individual basis for each property.
In July 2002, it implemented a Commercial Mortgage Backed Securities (“CMBS”)
program to provide an umbrella financing vehicle and to lower borrowings costs. At 31
December 2002, $510 million was drawn under this facility. CMBS borrowings have a
term of 3-5 years. The CMBS program which replaced some bank loans allowed higher
borrowing on some assets thereby enabling cash to be released back to the Statutory Fund.
Challenger is presently investigating two options relating to its borrowing program to
reduce refinancing risks and costs. They are:
Page 17
ƒ
ƒ
an underwriting of the rollover of the CMBS program; and
a more comprehensive long dated securitised loan facility for the entire portfolio
which apart from reducing costs and entirely eliminating refinancing risks (by
covering the full term of the policies) would enable gearing to be increased.
However, this project is still at a relatively early stage.
3.2.5 Accounting Issues
The accounting for the life business (particularly for the long term annuity business) is
complex and can be confusing. Life companies are required to mark all assets to their
market value.
Challenger Life No 2’s accounts therefore reflect the following features:
ƒ
the Statutory Fund does not own the properties. Rather it owns the income and
capital units in the trusts, each of which is valued separately;
ƒ
Challenger Life No 2 does not show the debt in the trusts on its (unconsolidated)
balance sheet;
ƒ
the income units are valued by discounting the future cash flow from the trusts (net
rent less outgoings less debt servicing cost) at discount rates that from 30 June 2002
were established by an independent investment bank. These rates incorporate a base
rate and adjustments to reflect the risk characteristics of each trust. The average rate
used to value the income units at 31 December 2002 was approximately 8.6%. The
aggregate carrying value of Global Life’s income units at 31 December 2002 was
$710 million. The value of the income units is roughly equivalent to the long term
annuity policy liabilities;
ƒ
the capital units are valued by projecting the expected value of the property at the
end of the annuity period (say, 15 years), deducting the projected external debt at
that time and discounting the net value at a discount rate. Challenger obtained
independent expert advice from another investment bank on the discount rate for its
accounts to 30 June 2002 and now uses a rate of 11% per annum. The aggregate
carrying value of Global Life’s capital units at 31 December 2002 was $515 million
($502 million for Challenger Life No 2).
Any changes to the value of the income and the capital units are charged/credited to
earnings and flow through to consolidated group earnings. It is critical to note that this
treatment means that a substantial profit is typically booked in the year of acquisition of a
property when the capital units are first valued. Their cost is $1 but the valuation
methodology will attribute a value because of the elimination of the annuity liability by the
end of the term (i.e. roughly, there is a 40% residual equity). Further value is created if it is
assumed that property values will rise over the term of the structure (say, 15 years).
Effectively the treatment “front ends” the present value of the expected margin on new
business (i.e. the future annual cash flow surplus and the gain on the ultimate wind up of
the trust in 15 years time). This treatment is justified on the grounds that the cash flows,
both incoming and outgoing, are virtually certain and therefore the ultimate position is
“locked in” through the structuring (assuming future property values can be reliably
predicted). Accordingly, economic value is created at the point in time that the investment
is made (with the risk inherent in the terminal value estimate reflected in the discount rate).
The periodic revaluation of capital units will also capture:
ƒ
the “release” of the discounting used to value business already “in force” (i.e.
existing property trust investments); and
ƒ
any increment/decrements in the value of investments (i.e. changes in the projected
terminal value of properties which might flow from changes in current market
value).
This approach means that the accounting profit emerges in a quite different pattern to the
Page 18
pattern in which the cash flows emerge. Cash flows are negative in the initial years but
accelerate towards the end of the policy term whereas reported profits show a significant
profit at the outset. Moreover, it means that reported profits are impacted by the amount
and timing of property purchases.
At the Challenger Life No 1 level, the investment in its wholly owned subsidiary,
Challenger Life No 2, also has to be “marked to market”. This valuation is undertaken by
the appointed actuary who assesses the Appraisal Value of Challenger Life No 2. This
Appraisal Value at 31 December 2002 was in the range of $650-805 million and a midpoint
estimate of $721.5 million was adopted in the Challenger accounts. The Appraisal Value is
essentially a value of the business as a whole and includes a “goodwill” element (referred to
as the value of new business).
At the consolidated Challenger level (i.e. the published group accounts), the treatment is
different as it is not a life company. At this level, the balance sheet consolidates all
controlled entities and therefore shows the full book value of properties (at cost not current
market value) and the associated borrowings. The extent to which the Appraisal Value
exceeds the net carrying value of the properties and other investments is recorded as
“Excess of Net Market Value over the Net Book Value of Life Insurance Subsidiaries” in
the balance sheet. This excess has two components, Property Trusts and Controlled
Entities. The component attributed to “Property Trusts” represents the excess of the value
of income and capital units over the net carrying value (essentially cost) of the property
trusts. The component of this excess attributed to controlled entities represents a
combination of operating subsidiaries owned directly by Challenger Life No 1 (e.g. Howard
Mortgage Management Limited) and the difference between the Appraisal Value and the
value of income and capital units and other investments of Challenger No 2. The net effect
is that Challenger’s group accounts reflect the full Appraisal Value of the Global Life
business.
3.2.6 Financial Performance
The following table set out key performance parameters for the Global Life business:
Global Life – Financial Performance ($ millions)
Year ended 30 June
Six months
ended
31 December 2002
51.3
2001
174.9
2002
152.7
Revaluation of capital units included in profit
(before tax effect)
130.0
132.4
73.95
Net assets (per Challenger statutory accounts)
332.4
531.3
535.3
Appraisal Value (at period end)6
371.6
546.3
721.5
304.0
421.3
579.3
Contribution before tax (per Challenger
statutory accounts)
Embedded Value (at period end)
6
The sector contribution of Global Life in the annual accounts is based on business
operations and therefore excludes the result of funds management businesses actually
owned by Global Life (e.g. Howard Mortgage Management Limited, Synergy/Galaxy
Master Trust).
The result for 2001/02 includes a one-off impact from the change in valuation methodology
(discount rates) as result of advice from independent experts.
The profit of $51.3 million for the six months to 31 December 2002 includes writedowns in
relation to Challenger Life UK of $13.7 million.
5
This represents the underlying movement in capital units after allowing for cost base reductions through the refinancing. The reported
movement in capital units between 30 June 2002 and 31 December 2002 was substantially less than this amount.
6
Includes funds management businesses not included in sector net assets per statutory accounts.
Page 19
3.2.7 Regulatory and Capital Requirements
Each statutory fund is backed by reserves (essentially the surplus of fund assets over policy
and other liabilities) in accordance with prudential requirements set by APRA under the
Life Insurance Act. These reserves act as a guarantee of investors’ funds. The Life
Insurance Act requires life insurance companies operating in Australia to comply with
capital adequacy standards. In order to increase the certainty of complying with the capital
adequacy standards at all times, all life insurance companies tend to carry an excess in
reserves over those required by the standards.
There are a number of issues relating to capital adequacy for Challenger. At the outset it
should be noted that the unusual nature of its operations (e.g. no mortality risks) means it is
not certain exactly how some of the capital adequacy guidelines apply to Challenger.
The growth in the annuity business has resulted in substantial increases in the required level
of capital reserves of the Statutory Fund to support the growth in assets and policy
liabilities. Challenger has met this need both by raising capital (e.g. the convertible note
raising) which has been injected into Challenger Life No 2 and by transferring to it
ownership of various operating subsidiaries such as the Synergy/Galaxy Master Trust
business. Continued annuity sales at current levels and the resultant growth in the size of
the portfolio will require further capital reserves and, in fact, Challenger has reduced its
annuity rates since late 2002 and annuity sales have slowed.
In any event, there are ongoing discussions with APRA as to both the amount and quality
of the capital reserves for Challenger Life No 2. This partly reflects the ongoing regulatory
pressure to strengthen the capital position of all insurance companies. Quality of capital is
not a formal requirement under regulatory guidelines but is a concept that APRA is now
pursuing. The quality issue for Challenger centres on the nature of Challenger’s capital
reserve. Under its structure, most of the capital reserves are held in the form of capital units
in the property trusts or shares in operating subsidiaries. These are illiquid and value is
based on judgment rather than direct market evidence. APRA wishes to see a greater
proportion of reserves held in cash or liquid securities (particularly in view of the negative
cash flows in the early years of the property investment model).
Page 20
3.3
Investment Services
3.3.1 Funds Management
Challenger operates in all parts of the funds management chain - as an asset manager,
product manufacturer and platform provider. At 31 December 2002, Challenger had $7.95
billion funds under advice and management (excluding the property portfolio owned by the
Global Life but before the elimination of crossholdings) up from $6.5 billion at 30 June
2002.
Funds managed by product categories are as follows:
Challenger – Funds under Advice and Management7 ($ millions)
At 30 June 2002
Product
Category
Description
Wealth
Management
Synergy/Galaxy Master
Trusts
Income
Products
Gross
Gross
Crossholdings
1,314.6
1,374.4
-
1,374.4
Cash Management Trust
471.2
706.3
(671.8)
34.5
Howard Mortgage Trust
2,183.6
2,859.6
(759.2)
2,100.4
140.5
129.8
-
129.8
Challenger Mortgage Plus
Enhanced Fixed Interest
-
10.0
(10.0)
-
330.9
(6.0)
324.9
2,921.3
4,036.6
(1,447.0)
2,589.6
912.6
918.0
(269.4)
648.6
Margin Lending
148.5
177.4
-
177.4
Warrants
Equity Products
Alternate
Investments
284.9
229.1
-
229.1
Beston Wine Industry Trust
43.4
96.8
-
96.8
Biotech Capital Limited
39.8
39.8
-
39.8
Blue Peak Venture Capital
23.8
21.4
-
21.4
Blue Peak Long Short
25.8
50.9
(3.1)
47.8
Income Plus
18.1
18.1
-
18.1
8
eFinancial Capital Limited
Corporate
Superannuation
Property
Management9
Net
126.0
High Yield Fund
Leveraged
Products
At 31 December 2002
12.8
-
-
-
448.6
456.1
(3.1)
453.0
638.0
756.0
(309.0)
447.0
-
28.6
(28.6)
-
91.2
202.9
-
202.9
Australian Property Fund
Property Syndicates
Total Funds under Advice and Management
91.2
231.5
(28.6)
202.9
6,474.8
7,950.0
(2,057.1)
5,892.9
Source: Challenger
The Funds Management business has grown strongly in recent years primarily as a
7
Funds under management and advice is gross of debt included in the Beston Wine Industry Trust and the property syndicates.
8
eFinancial Capital Limited (“eFinancial”) was listed on the ASX in April 2000 to invest in companies developing information
technology and internet based solutions for financial services applications. A Challenger subsidiary was the manager of the company
and Challenger was the major shareholder. Following the downturn in the technology sector Challenger made a takeover offer for
eFinancial and it is now a company within the Challenger group.
9
Property Management also manages the Global Life’s $2.7 billion property portfolio.
Page 21
consequence of the performance of the Howard Mortgage Trust and the Synergy/Galaxy
Master Trusts but also through acquisition. Challenger’s funds management strength has
historically been in income products (particularly mortgage trusts) and warrants although,
more recently, Challenger has placed significant emphasis on the development of equity
product offerings. To date, Challenger’s success in equity funds management has been
moderate with growth constrained by volatile equity markets, a wide range of offerings and
a lack of integrated platforms and systems. Considerable focus and effort has been put in
the last 12 months on consolidating and focussing Challenger’s disparate funds
management offerings and to rationalise the numerous backroom systems in order to
develop a cohesive funds management business and achieve efficiencies and economies of
scale.
A brief description of Challenger’s fund management activities follows:
ƒ
Cash Management Trust
The Challenger Cash Management Trust had approximately $706.3 million cash
under management at 31 December 2002 with the majority being funds sourced
from Global Life and other Challenger businesses. It was relaunched in August
2002 following enhancement with the objective of attracting increased retail funds
through financial planners and stockbrokers.
ƒ
Howard Mortgage Trust/Challenger Mortgage Plus
Howard Mortgage Trust was established in 1985 and is the largest mortgage trust in
Australia with an estimated 23% market share. Howard Mortgage Trust invests in
commercial mortgage loans and short term securities and has been designed to
provide investors with regular income. It sources funds from retail and wholesale
investors.
Challenger acquired the management rights to the Howard Mortgage Trusts in July
1998 when it had funds under management of approximately $600 million. At 31
December 2002, Howard Mortgage Trust had $2.1 billion external funds under
management and the portfolio comprised some 2,870 mortgages of which
approximately 68% were located in New South Wales. Challenger is entitled to a
base management fee of 1.153% per annum calculated on the average daily capital
value of the Howard Mortgage Trust, redemption and distribution fees and
reimbursement of certain expenses.
Howard Mortgage Trust has enjoyed strong inflows in recent years as a consequence
of the downturn and volatility in equity markets and access to increased wholesale
funds inflows from master trust/wrap account providers and jointly funded mortgage
facilities. At 31 December 2002 wholesale funds comprised approximately 27% of
funds under management up from 5% in April 2001. Wholesale funds are expected
to continue to grow as a proportion of funds under management.
Challenger acquired the management rights to the Norwich Union Mortgage Trusts
in August 1999 and renamed them the Challenger Mortgage Plus trusts. These trusts
retain an existing retail book but now invest new funds in the Howard Mortgage
Trust.
The Australian mortgage trust industry is concentrated with the top ten mortgage
trusts accounting for 76% of the market. Howard Mortgage Trust’s major
competitors are AXA, Perpetual and Sandhurst (a subsidiary of Bendigo Bank).
ƒ
Synergy/Galaxy Master Trust
Synergy/Galaxy is a master trust investment platform with a discretionary master
funds market share at 31 December 2002 estimated at 1.6%. Synergy is offered
through Challenger’s financial planning network while Galaxy has been developed
as a platform to reach a wider range of financial planners. At 31 December 2002
Synergy/Galaxy had $1.374 billion funds under advice and approximately 24,000
Page 22
member clients. Challenger is entitled to receive gross fees of approximately 1.1%
from member clients. Approximately 12% of inflows into Synergy/Galaxy are
invested in other Challenger product offerings.
ƒ
High Yield Fund
The Challenger High Yield Fund was launched as a wholesale fund in July 2001 and
invests in hybrid equity–income units such as reset preference shares and
convertible securities. In August 2002 the fund was made available to retail
investors. The High Yield Fund is the clear leader in this sector, particularly in
wholesale funds.
ƒ
Equity Products
At 31 December 2002, Challenger had $648.6 million invested in its equity products
range. Challenger’s equity product offerings includes a wide range of products
primarily in Australian and New Zealand equities. During 2001/02 Challenger
reviewed its equity activities which resulted in significant restructuring and
simplification of its retail and wholesale offerings in order to improve the efficiency
of its equity operations. Existing equity fund offerings include the Wealthlink suite
of funds (originally acquired from EquitiLink in 1998), the Australian Share Fund, a
small company fund, a socially responsive fund and the Custom Choice suite of
funds. A number of these funds have not yet achieved a size whereby Challenger
would breakeven before overheads. Challenger is also considering developing an
international equities offering.
ƒ
Margin Lending
Challenger Share Finance provides a margin lending facility to clients. This
business represents a high growth opportunity for Challenger but growth has been
constrained since its acquisition in February 2000 by the need to install new
systems, reduce overhead costs and improve operational efficiency. Challenger
believes it is now in a position to market the product to investors. At 31 December
2002 the total loan book stood at $177 million.
ƒ
Warrants
Challenger developed and launched endowment warrants as an investment product
in 1996. Endowment warrants are products which allow investors to purchase
shares in a variety of publicly listed companies by making an initial payment today
with a final payment to be made at any time before expiry of the warrant. Warrants
provide investors with an opportunity to take a long term leveraged interest in the
underlying share, without exposure to margin calls. Since then Challenger has
launched a series of Bank Endowment Warrants, Portfolio Endowment Warrants
and individual stock warrants. At 31 December 2002, Challenger managed a
warrant product book totalling $229 million.
ƒ
Beston Wine Industry Trust
Challenger owns the responsible entity and investment manager of The Beston Wine
Industry Trust (“Beston”), an ASX listed unit trust which owns and leases vineyards
and wine infrastructure assets. At 31 December 2002, Beston had total assets of
$97.3 million and net assets of $47.8 million. Beston closed an oversubscribed
capital raising of $21.2 million on 20 March 2003. Together with new debt, these
funds have enabled Beston to increase total assets to approximately $135 million.
Challenger is entitled to a monthly management fee of 0.75% per annum of total
asset value of the Trust, a property management fee of 2% of the gross annual
income of the Trust plus other fees as agreed from time to time. Global Life is the
largest unitholder in Beston.
Page 23
ƒ
Biotech Capital Limited
A Challenger subsidiary manages Biotech Capital Limited (“Biotech”), an ASX
listed company which invests in entities developing biotechnology solutions for
science applications. At 31 December 2002, Biotech has net assets of $39 million.
Under its management agreement Challenger derives an annual fee equal to 2% of
the net value of Biotech and is entitled to performance fees on realisation of an
investment. The management agreement expires in August 2005 and the manager
has the option to extend the agreement for another five years. This option may be
exercised repeatedly. After the initial term of five years Biotech (with shareholder
approval) can terminate the agreement on three months notice. Challenger is the
largest shareholder in Biotech.
ƒ
Blue Peak Venture Capital
The Blue Peak Venture Capital Technology Fund is a closed 10 year term fund
which holds investments in a portfolio of emerging Australian and New Zealand
technology companies.
ƒ
Blue Peak Long Short
The Blue Peak Long Short Australia Fund applies a quantitative stock selection
strategy to purchase shares of ASX listed top 100 entities that are anticipated to rise
in value and to short sell shares from the same pool that are anticipated to fall in
value. The objective is to generate a combined return from both rising and falling
share prices. Challenger is entitled to a management fee of 2.2% per annum of the
net assets of the fund, a performance fee of 20% of the value of the net increase in
adjusted net asset value of the fund, an entry fee of 2.2% of the application fee and
reimbursement of certain costs.
ƒ
Income Plus
Income Plus derives returns from investments in global commodity and interest rate
markets. It seeks arbitrage opportunities in these markets.
ƒ
Corporate Superannuation
Challenger provides superannuation administration services to superannuation
trustees in corporates, industry funds and small to medium sized businesses. It also
provides asset consulting services. At 31 December 2002, Challenger had $756
million of corporate superannuation funds under management of which
approximately 40% were invested in other Challenger funds management products.
ƒ
Property Management
Property Management provides property asset management services to Global Life,
managing its $2.7 billion property portfolio. Property Management receives fees
from Global Life on the acquisition of properties and management of the portfolio.
Property Management also manages seven unlisted fixed term property syndicates
with a value at 31 December 2002 of $202.9 million. The syndicates are managed
by Challenger’s property management group which is also responsible for the
Global Life property portfolio. These syndicates own commercial or retail
properties in Sydney, Melbourne and Brisbane. Investors derive equity returns in
excess of 8% per annum and taxation benefits. Challenger has recently announced
the acquisition and syndication of a new $63 million property in western Sydney.
Property Management receives fees from each syndicate on the acquisition of the
property and the syndication and for ongoing management of the syndicates.
As a consequence of the extent of acquisitions made, restructuring undertaken and
recategorisation for reporting purposes it is not possible to present a comprehensive history
of the financial performance of the Funds Management business in recent years:
Page 24
Funds Management – Financial Performance ($ millions)
Year ended 30 June
Funds under Advice and Management (gross)
2001
na
2002
6,474.8
Net income
Wealth Management
Income Products
Equity Products
Leveraged Products
Alternate Investments
Corporate Superannuation
Property Management
6 months
ended
31 December
2002
7,950.0
6.8
10.4
2.4
1.3
2.9
1.4
2.8
Total net income
Contributions before overheads
Wealth Management
Income Products
Equity Products
Leveraged Products
Alternate Investments
Corporate Superannuation
Property Management
Sales and support
na
na
28.0
Contribution before overheads
Allocated overheads
Contribution after overheads
Revaluation of management rights
Contribution before tax (per
Challenger statutory accounts)
na
na
(10.7)
40.3
na
na
(7.4)
67.3
13.9
(10.9)
3.0
25.9
29.6
59.9
28.9
4.2
9.2
0.1
0.5
2.0
(0.8)
1.4
(2.7)
Source: Challenger
It should be noted that aggregate profits for the division in 2000/01 and 2001/02 are not
comparable to the six months to 31 December 2002 because of differing composition of the
business units that make up the division.
The funds management sales and support teams provide services to a number of the product
categories. Overheads comprise an allocation of Challenger support services including
information technology, human resources, facilities costs, company secretarial and
compliance services. The basis of allocation to individual business units has changed over
time.
At 31 December 2002, the Funds Management division has net assets of $199.2 million and
net tangible assets of $3.7 million (after adjusting for intangible assets and the deferred tax
applicable to those intangible assets) (see Section 3.8). Intangible assets primarily
represent the values attributed by directors to the management rights associated with the
Howard Mortgage Trust and the Synergy/Galaxy Master Trust. However, the value
attributed to the management rights of the Howard Mortgage Trust includes the rights for
the Corporate Property Lending business unit (which is part of the Corporate Financial
Services division) to provide mortgage origination and management services to Howard
Mortgage Trust.
The Funds Management business as a whole is not generating an adequate return given the
size of the funds under advice and management. As previously discussed considerable
effort has been put in refocussing and rationalising the funds management operations in
order to develop a cohesive and efficient business with significant capacity to grow.
However, to date the potential benefits of that effort have not emerged and further work is
required.
Page 25
3.3.2 Other Businesses
Challenger’s other business activities include:
ƒ
Advisory Services
Advisory Services primarily represent the Garrisons Financial Planning activities
which provide support services to Garrisons financial planners. Garrisons was
established in 1984 and in March 2003 had 96 franchise and aligned planning firms
servicing approximately 227 proper authority holders. In 2002 Money Management
magazine rated Garrisons the 27th largest dealer group in Australia up from 32nd in
2001. Garrisons represents a source of funds inflows for Challenger’s Global Life
annuity business and the Funds Management division.
At March 2003
approximately 12% of Garrisons funds under advice represented funds managed by
the Funds Management business. Advisory Services also includes the independent
investments research house 5Di which provides services to financial planners and
Challenger generally.
ƒ
Corporate Financial Services
Corporate Financial Services comprises:
•
Corporate Finance and Advisory
The corporate finance and advisory business has offices in Sydney and
Melbourne. With a team of 14 executives its target market is mid-market
companies. This business unit has not been profitable so far in 2002/03
although there is an expectation that a number of transactions may complete
in the near future and generate fees to offset operating expenses.
•
Corporate Property Lending
Corporate Property Lending provides mortgage origination and management
services to Howard Mortgage Trust. Mortgages arise as a consequence of a
database of over 1,000 introducers, the majority of which are mortgage
brokers but also include accountants or solicitors. In addition, Corporate
Property Lending has a strategic alliance with Westpac Banking Corporation
under which a variety of commercial loans are funded by the Howard
Mortgage Trust. Approximately 63% of mortgages are located in New South
Wales although a national presence is being developed.
Corporate Property Lending also manages Howard Pacific, a securitised
home loan business which is funded via Australian Mortgage Securities
Limited. It has a loan book at 31 December 2002 of $140 million.
•
Howard Finance
Howard Finance is a finance company which raises retail funds through the
fixed rate debenture market. The funds raised are invested in property, fixed
interest securities and equities. In recent years it has facilitated Challenger
generated transactions by providing funding (e.g. funding for Garrisons
Accounting Group Limited and its associated accounting practices). Under
its debenture trust deeds, Howard Finance must ensure that there is a 20%
buffer between its debenture book and its total assets. At 31 December 2002
Howard Finance had total assets of $70.3 million, a debenture book totalling
$54.9 million and net assets of $3.9 million. Therefore, Howard Finance is
unable to raise further debenture funds unless its capital base increases either
as a result of profit generated or by increased equity investment.
As with Funds Management division it is not possible to present a comprehensive history of
the financial performance for Challenger’s other businesses:
Page 26
Other Businesses – Operating Performance ($ millions)
Year ended 30 June
2001
2002
Net income
Advisory Services
Corporate Finance & Advisory
Corporate Property Lending
Howard Finance
Discontinued businesses10
6 months
ended
31 December
2002
2.2
0.8
5.5
(1.1)
6.6
Total net income
Contributions before overheads
Advisory Services
Corporate Finance & Advisory
Corporate Property Lending
Howard Finance
Discontinued businesses
na
na
14.0
Contribution before overheads
Allocated overheads
Contribution before tax (per
Challenger statutory accounts)
na
na
na
na
(2.5)
(2.2)
2.3
(1.3)
(4.7)
(2.4)
(0.8)
3.8
(1.2)
(1.9)
Source: Challenger
Contribution before overhead from Howard Finance and Corporate Property Lending is
after interest income and expense which are integral components of each business.
At 31 December 2002, Advisory Services business had net assets of $13.1 million and net
tangible assets of $(3.2) million and Corporate Financial Services had net assets of $3.1
million (see Section 3.8). Intangible assets of Advisory Services represent the value
attributed by directors to Garrisons Financial Planning.
3.4
Group Services/Other Assets
Group Services provides support services to the Challenger group and also accounts for corporate
costs. The support services provided include facilities, human resources, information technology,
company secretarial, compliance services, legal services, treasury services and the executive team.
Almost all of the support services costs incurred by Group Services are reallocated as overheads to
Challenger’s operating divisions based on either direct costs or agreed bases of allocation.
Corporate costs are not allocated to the operating divisions. These costs typically include certain
executive costs, net interest on corporate/unallocated borrowings, finance and legal costs,
employee share scheme costs and listed company costs. In recent years, the annual unallocated
corporate costs (including net interest) have been approximately $20 million per annum. In the six
months ended 31 December 2002 Challenger has recognised a number of one-off items as
corporate costs including a writedown in goodwill for Challenger First Pacific and provisions for
excess lease space and restructuring. In addition, the dealer loyalty program was terminated on 31
December 2002.
10
Discontinued businesses include Equity Capital Markets which was closed during the six months ended 31 December 2002 and
Challenger First Pacific which was sold in January 2003.
Page 27
Group Services/Other Assets – Operating Performance ($ millions)
2002
(9.8)
(5.1)
(5.2)
(0.2)
na
6 months
ended
31 December
2002
(7.3)
(2.9)
(7.6)
(0.2)
(1.9)
(20.3)
(1.4)
(1.5)
(1.5)
(24.3)
Year ended 30 June
2001
Unallocated corporate costs
Net interest on corporate/unallocated borrowings
Loyalty program
Amortisation
Costs yet to be allocated to operating divisions
Additional costs:
- Writedown of goodwill
- Excess space provision
- Restructure provision
Contribution before tax (per Challenger statutory accounts)
(22.0)
Source: Challenger
At 31 December 2002 Group Services/Other Assets had net assets of $(76.6) million and net
tangible assets of $(79.6) million including net borrowings of $123.4 million. The funds
employed by Group Services includes corporate investments, head office assets and liabilities and
group shared assets and liabilities.
3.5
Garrisons Accounting Group Limited
Challenger invested in David Garry Holdings Limited, an ASX listed company, in November 2000
with the objective of consolidating accounting practices in order to expand Challenger’s financial
planning business and thereby increase funds under advice and management. Following
Challenger’s equity investment the company acquired the businesses of five accounting practices
and changed its name to Garrisons Accounting Group Limited (“Garrisons Accounting”). Over
time various parts of Challenger have provided funding to both the company and accounting
practices. Garrisons has significantly underperformed expectations and at 31 December 2002
Challenger’s exposure to Garrisons Accounting was:
Challenger – Garrisons Accounting Group Limited ($ millions)
As at 31 December
Entity
Investment
Cost
Provision
Book Value
Global Life
23.99% interest in ordinary share in
Garrisons Accounting
6.4
(5.0)
1.4
Global Life
Loan to Garrisons Accounting
4.7
(2.0)
2.7
Global Life
Convertible Note in Garrisons Accounting
5.0
(3.3)
1.7
Howard Finance
Loan to Garrisons Accounting
5.2
(2.1)
3.1
Howard Finance
Working capital finance facility to
accounting practices. Secured over work
in progress and debtors
6.9
-
6.9
28.2
(12.3)
15.8
Total
The secured working capital facility provided to the accounting practices by Howard Finance is
considered to be fully recoverable. However, Challenger has recognised significant provisions
against its equity and debt exposures to Garrisons Accounting as at 31 December 2002.
On 10 April 2003, the Board of Garrisons Accounting appointed a voluntary administrator and its
shares were suspended from quotation on the ASX. Challenger has advised that the appointment
of a voluntary administrator is not expected to impact the working capital finance facility provided
by Howard Finance to the accounting practices owned by Garrisons Accounting as it is secured
over the work in progress and debtors of those practices.
Page 28
3.6
Group Financial Performance
The reported consolidated earnings of Challenger have increased significantly since 1997:
Challenger – Consolidated Earnings History ($ million)
1998
1999
2000
2001
2002
Six months
ended
31 December
2002
audited
audited
audited
audited
audited
unaudited
(4.3)
11.0
6.7
(4.7)
(1.2)
(5.9)
(0.3)
(6.2)
6.8
0.6
0.2
0.8
-
49.7
3.8
17.1
5.8
76.4
36.6
(1.3)
35.3
(0.3)
35.0
4.6
39.6
(6.3)
33.3
-
138.5
4.0
29.3
2.1
173.9
89.6
(1.7)
87.9
(0.4)
87.5
(2.9)
84.6
(4.0)
80.6
-
299.4
4.5
65.2
31.6
400.7
212.2
(3.3)
208.9
(0.5)
208.4
(23.6)
184.8
(30.7)
154.1
-
387.7
6.1
101.6
43.8
539.2
267.4
(6.6)
260.8
(0.6)
260.2
(69.2)
191.0
(32.4)
158.6
-
212.3
8.1
51.5
14.5
286.4
95.0
(4.3)
90.7
(0.6)
90.1
(38.9)
51.2
(15.4)
35.8
-
0.8
33.3
80.6
154.1
158.6
35.8
23.8¢
11.0¢
21.7%
100%
>100%
41.2¢
7.5¢
19.5%
>100%
62.5¢
8.5¢
14.8%
>100%
56.6¢
9.0¢
16.3%
35%
12.4¢
na
Year ended 30 June
Revenue
Investment income
Establishment fees
Management fee income
Other
Total revenue
EBITDA11
Depreciation and amortisation
EBITA12
Goodwill amortisation
EBIT13
Net interest income/(expense)
Profit before tax
Income tax
Profit after tax
Outside equity interests14
Profit attributable to Challenger
shareholders
Statistics
Earnings per share
Dividends per share
Dividend payout ratio
Percentage of dividends franked
Revenue growth
3.1¢
na15
Source: Challenger
The extent of acquisitions, growth of the annuities business and complexities of life insurance
accounting make it difficult to meaningfully analyse the Challenger historical financial results. In
considering the results it should be noted that:
ƒ
the substantial growth in revenues and annual earnings since 1998 is primarily attributable
to the annuities business which started to escalate in 1999;
ƒ
at the Challenger group level all entities are consolidated. Accordingly, the results include
both rental and interest on debt of the property trusts owned by Challenger Life No 2. This
explains the substantial rise in interest expense (non life borrowings are less than $400
million including convertible notes and borrowings by Howard Finance etc);
ƒ
under the Life Insurance Act, Challenger Life No 1 and Challenger Life No 2 are required
to mark to market all of their assets and liabilities, the unrealised profit or loss being
brought to account in the profit and loss statement (included in investment income).
Consequently, a large proportion of earnings in any particular year comprises unrealised
gains/losses on assets. In particular, there has been a very substantial profit contribution
11
EBITDA is earnings before net interest, tax, depreciation, amortisation and significant items.
12
EBITA is earnings before net interest, tax, goodwill amortisation and significant items.
13
EBIT is earnings before net interest, tax and significant items.
14
Outside equity interests are less than $100,000.
15
na = not available.
Page 29
arising on the revaluation of the capital units held by Global Life. This revaluation has
several components including:
•
release of discounting on “in force” business;
•
changes to the terminal value of existing properties; and
•
recognition of initial profit from properties acquired during the year.
The contribution from capital unit revaluations and revaluations of operating businesses in
annual profits is shown below:
Revaluation Contribution ($ millions)
Year ended 30 June
Revaluations
Capital units
Appraisal Value
Operating subsidiaries (goodwill, management
rights, other)
2000
2001
2002
60.3
130.0
132.4
Six months
ended
31 December
2002
73.9
-
43.0
76.0
-
30.0
38.9
72.8
12.7
Clearly without these contributions, reported profit would have been substantially lower (if
not a loss). At the same time, they are a reflection of the economic value that has been
added during the course of the year.
ƒ
the 2001/02 results reflect changes to the valuation methodology for the income and capital
units of Challenger Life No 2 (specifically an upwards revision to the discount rates used to
calculate values). These changes had a one off impact of $74.7 million on the reported
earnings in that year;
ƒ
the results to 31 December 2002 reflect a number of one off items totalling $32.8 million (pre
tax). These include:
ƒ
•
costs associated with closure of Challenger Life UK of $14.6 million;
•
losses arising from the sale of Challenger First Pacific;
•
writedowns of the interests in Garrisons Accounting; and
•
various restructuring costs.
Challenger’s low reported tax rate is largely attributable to the low tax rates enjoyed by the
various statutory funds of Global Life. The amount of tax paid in cash by Challenger is
minimal.
Page 30
3.7
Cash Flow
Challenger’s consolidated cash flow for the five and a half years ended 31 December 2002 is
summarised below:
Challenger – Consolidated Cash Flow Statement ($ millions)
1998
1999
2000
2001
2002
Six months
ended
31 December
2002
audited
audited
audited
audited
audited
unaudited
(4.7)
36.6
89.6
212.2
Year ended 30 June
EBITDA
Non cash income, working capital and
other adjustments
Dividend income
Interest (net)
Tax paid (net)
Policy sales less payments
Investments (net)
Acquisitions (net)
Customer loans/underwriting (net)
Property, plant and equipment (net)
Loyalty program (net)
Proceeds from share/option issues
Other
Dividends paid to Challenger shareholders
Net cash generated / (used)
Net cash/(borrowing) – opening
Net cash/(borrowings) - closing
(55.3) 16 (82.7)
2.2
3.5
7.3
6.6
0.1
(2.8)
(46.9)
47.4
(5.9)
(97.3)
72.2
(26.3)
(4.1)
(0.5)
(0.8)
17.6
32.0
(5.0)
(2.2)
(18.9)
(90.1)
(18.2)
0.716
(18.2)
(108.3)
267.4
95.0
(70.9)
(190.7) (127.5)
6.5
2.4
12.8
6.3
(15.8)
(46.4)
(2.7)
3.8
0.9
115.8
244.6
360.2
(373.7) (1,034.7) (915.2)
103.1
(12.4)
(6.2)
(87.2)
(18.0) (120.2)
(3.6)
(14.4)
(6.4)
(6.9)
(4.6)
3.1
96.1
17.5
98.9
(3.3)
(4.6)
(2.2)
(14.2)
(135.5)
(812.3) (492.8)
(108.3)
(243.8) (1,056.1)
(243.8) (1,056.1) (1,548.9)
(82.1)
5.2
(59.0)
2.8
358.1
(658.7)
(42.1)
(2.2)
0.4
(0.8)
(13.9)
(397.3)
(1,548.9)
(1,946.2)
Source: Challenger
The consolidated cash flows include the life insurance business and accordingly are difficult to
interpret. They include the gross property investment and the drawdown of external loans into the
statutory funds. However, the table does reveal that operating cash flows are much lower than
reported operating profit. This reflects the substantial contribution to reported profits from non
cash profits such as the revaluation of capital units and other items. In fact, after payment of
interest, operating cash flows have been close to zero except in the year ended 30 June 2002. The
table also indicates the cash flow deficit that arises after payment to policy holders (prior to new
premium inflows). Gross policy payments were over $200 million in the six months to 31
December 2002.
16
Challenger acquired a life insurance company on 1 July 1997. At 30 June 1997 Challenger did not consolidate that company and
therefore opening net cash in 1998 does not include net cash/(borrowings) of the life insurance company. This accounting policy was
changed at 30 June 1999 and the balance sheet at 30 June 1998 was restated to consolidate the life insurance company. The restated
net borrowings for 1998 are used in the above table and therefore the line in the table working capital and other adjustments amount in
1998 includes the full impact of consolidation of the life insurance company for the first time.
Page 31
3.8
Financial Position
The reported consolidated financial position of Challenger at 30 June 2002 and 31 December 2002
is summarised below:
Challenger – Consolidated Financial Position ($ millions)
Receivables
Prepayments
Trade creditors and provisions
Net working capital
Global Life investment assets
Policy liabilities
Plant and equipment (net)
Investments
Intangibles
Deferred tax assets/liabilities (net)
Other (net)
Total funds employed
Cash
Borrowings
Net borrowings
Outside equity interests
Shareholders’ funds attributable to Challenger shareholders
Statistics
Net assets per share
Gearing (net borrowings/net borrowings plus shareholders’ fund)
30 June 2002
31 December 2002
audited
unaudited
285.8
25.3
(155.3)
155.8
3,392.9
(1,314.3)
20.3
108.0
7.5
(65.9)
7.3
2,311.6
224.6
(1,773.5)
(1,548.9)
(0.1)
762.6
$2.63
67%
286.8
49.2
(101.9)
234.1
4,187.5
(1,723.2)
24.8
104.1
8.8
(86.3)
3.1
2,752.9
278.5
(2,224.7)
(1,946.2)
806.7
$2.76
71%
Source: Challenger
Challenger is required to apply life insurance financial reporting and actuarial standards to its life
insurance controlled entities. As a consequence, Global Life investment assets are required to be
recorded at a net market value (including an allowance for estimated realisation costs) and policy
liabilities are reported under the margin on services methodology, which is designed to recognise
profits on life insurance as services are provided to policyholders and income is received.
The consolidated balance sheet reflects the consolidation of Global Life’s property trusts and
therefore includes both the properties (at cost) and the associated debt. Of the $2.2 billion in total
debt, $1.8 billion is attributable to Challenger Life No 2’s Statutory Fund 2. Further it should be
noted that the balance sheet reflects a carrying value of Challenger Life No 2 in the consolidated
balance sheet of $721.5 million based on its Appraisal Value.
For purposes of this report, Grant Samuel has analysed Challenger’s net assets at 31 December
2002 on a divisional basis. In doing so, Grant Samuel has made adjustments to the divisional
balance sheets to move discontinued businesses and other assets and liabilities from operating
divisions into the other/unallocated segment. In addition, for valuation purposes, Grant Samuel
has aggregated the net assets of the Funds Management and Advisory Services divisions. As a
consequence, the divisional net assets presented by Grant Samuel below do not agree to the
segment information reported by Challenger in its half yearly report but are fully reconcilable to
that disclosure.
Page 32
Challenger – Divisional Financial Position ($ millions)
At 31 December 2002
Investment Services
Receivables
Prepayments
Trade creditors and provisions
Other (net)
Interdivision balances
Net working capital
Global Life investment assets
Policy liabilities
Plant and equipment (net)
Investments
Intangibles
Deferred tax assets/(liabilities) (net)
Other (net)
Total funds employed
Cash
Borrowings
Net borrowings
Net assets
Net tangible assets17
Global
Life
Funds
Management/
Advisory
Services
Corporate
Financial
Services
34.2
45.9
(56.4)
75.3
99.0
3,910.1
(1,723.2)
7.1
(47.5)
22.5
2,268.0
226.3
(1,836.0)
(1,609.7)
658.3
658.3
205.9
0.8
(11.5)
17.0
(93.9)
118.3
0.9
56.1
282.6
(62.7)
(23.6)
371.6
5.7
(165.0)
(159.3)
212.3
0.5
25.4
(3.0)
(2.4)
20.0
0.2
35.3
2.8
8.2
66.5
2.2
(56.0)
(53.8)
12.7
12.7
Group
Services
/Other
Assets
21.3
2.5
(48.0)
21.0
(3.2)
16.6
12.7
3.0
21.1
(3.4)
46.8
44.3
(167.7)
(123.4)
(76.6)
(79.6)
Total
of
49.2
(118.9)
17.0
234.1
3,910.1
(1,723.2)
24.8
104.1
285.6
(86.3)
3.7
2,752.9
278.5
(2,224.7)
(1,946.2)
806.7
591.9
The Appraisal Value of Challenger Life No 2 incorporated in the consolidated accounts includes
the value of non life operating subsidiaries owned by Challenger Life No 2. In the divisional
balance sheets these assets have been reallocated. Accordingly, the carrying value of $721.5
million cannot be compared directly to the net assets of Global Life of $658.3 million.
Investments include warrant stock held by the Funds Management/Advisory Services division, the
investments held by Howard Finance, the investment in associated entities and corporate
investments in various entities.
Intangibles primarily comprise the values attributed by directors to the management rights for
Howard Mortgage Trust and the Synergy Master Trust and to Garrisons Financial Planning, the
costs of acquired management rights and goodwill on acquisition. The debt in Funds
Management/Advisory Services relates primarily to the Share Finance business unit. Debt in
Group Services/Other Assets includes a corporate loan facility of $85 million and the convertible
notes of $75 million.
3.9
Tax Position
At 31 December 2002, Challenger had estimated gross carried forward income tax losses of $89.7
million and gross carried forward capital losses of $5.7 million. The accumulated franking credits
of Challenger at 30 June 2002 were minimal ($2 million).
17
Excluding intangible assets and associated deferred income tax liabilities.
Page 33
3.10 Capital Structure and Ownership
At 31 March 2003, Challenger had the following securities on issue:
ƒ
292,402,595 ordinary shares;
ƒ
22,077,499 options over unissued ordinary shares; and
ƒ
37,500,000 convertible notes.
At 31 March 2003, there were 9,753 registered shareholders in Challenger.
shareholders accounted for 48.7% of the ordinary shares on issue:
The top ten
Challenger – Major Shareholders at 31 March 2003
Shareholder
Number of Shares
Cavalane Holdings Pty Limited
Westpac Custodian Nominees Limited
ANZ Nominees Limited
Universal Equity Pty Limited18
National Nominees Ltd
Invia Custodian Pty Limited
Audant Investments Pty Limited
JP Morgan Nominees Australia Limited
Credit Suisse First Boston Australia Financial Products Limited
Merrill Lynch (Australia) Nominees Pty Limited
Subtotal – Top 10 shareholders
Other shareholders (9,742 shareholders)
Total
53,720,598
24,380,849
14,271,135
14,109,518
7,546,738
7,430,173
5,937,658
5,917,041
5,372,398
4,046,030
142,732,138
149,670,457
292,402,595
Percentage
18.4%
8.3%
4.9%
4.8%
2.6%
2.5%
2.0%
2.0%
1.8%
1.4%
48.7%
51.3%
100.0%
Source: Challenger
Challenger has received substantial shareholder notices from the following shareholders:
Challenger – Substantial Shareholders
Shareholders
Cavalane Holdings Pty Limited
Universal Equity Pty Limited
Bell Securities Limited
Hudson Conway Investments Pty Limited
Number of Shares
53,720,598
23,431,333
18,676,690
18,384,964
Percentage
18.4%
8.0%
6.4%
6.3%
Source: Challenger
Cavalane Holdings Pty Limited is associated with CPH, while Universal Equities Pty Limited is
associated with the previous Managing Director of Challenger, Mr Bill Ireland. Bell Securities
Limited is associated with Challenger director, Colin Bell and Hudson Conway Investments Pty
Limited is associated with former Challenger director Lloyd Williams.
18
Represents aggregate holdings of Universal Equity Pty Limited within the top ten registered shareholders. This total does not include
holdings held in other registered names.
Page 34
All the options are out of the money:
Challenger – Options on Issue at 31 March 2003
Exercise Price
Number of Options
Expiry
1,400,000
6,600,000
700,000
9,250,000
3,500,000
54,171
143,859
109,879
149,936
169,654
31 Jul 2003
31 Jul 2003
31 Jul 2004
31 Jul 2004
1 Feb 2005
31 Jan 2005
31 Jan 2005
31 Jan 2005
31 Jan 2005
31 Jan 2005
$4.176
$3.923
$3.320
$3.660
$3.450
$3.499
$2.872
$4.256
$3.517
$3.240
Source: Challenger
The convertible notes were issued in December 2002 and have an issue price of $2.00 per note, a
five year term and a coupon rate of 9.5% per annum. Coupon payments are payable semi-annually
in arrears and investors can elect to reinvest the coupons into Challenger ordinary shares at 95% of
the volume weighted average price for the 20 days prior to the coupon payment date if allowed by
Challenger. Convertible notes may be converted into one Challenger ordinary share on specified
conversion dates. The first conversion date is 1 July 2003 and thereafter 1 January and 1 July of
each year to maturity.
Two of Challenger’s substantial shareholders participated in the convertible note issue:
Challenger – Substantial Convertible Noteholders
Noteholders
Number of Notes
Cavalane Holdings Pty Limited
Hudson Conway Investments Pty Limited
15,000,000
3,750,000
Percentage
40.0%
10.0%
Source: Challenger
3.11 Share Price History
A summary of the Challenger share price history since 1 January 1998 is set out below:
Challenger – Share Price History
Low
Close
Average Weekly
Volume
(000’s)
0.47
1.15
2.59
2.30
1.55
1.36
3.68
4.10
3.44
1.69
1,930
2,327
1,266
1,356
1,725
37
300
312
394
418
1.54
2.01
1.86
2.00
2.14
2.23
1.98
2.28
8,938
4,553
4,957
3,504
860
731
710
587
Share Price
High
Year ended 31 December
1998
1.40
1999
4.69
2000
4.57
2001
4.37
2002
3.70
Month ended
January 2003
2.14
February 2003
2.33
March 2003
2.23
April 2003
2.37
Average
Weekly
Transactions
Source: IRESS
Page 35
This share price and trading volume history is depicted graphically below:
Challenger Share Price & Trading Volume
January 1998 - April 2003
$5.00
16,000
$4.50
14,000
12,000
$3.50
$3.00
10,000
$2.50
8,000
$2.00
6,000
$1.50
4,000
$1.00
2,000
$0.50
$0.00
Jan-98
Volume (000s)
Share Price ($)
$4.00
0
Jul-98
Feb-99
Sep-99
Apr-00
Nov-00
Jun-01
Jan-02
Aug-02
Mar-03
Source: IRESS
Following the acquisition of Equity Life Limited in November 1997 (now Challenger Life No 1)
and commencing its annuity business, Challenger set about making other acquisitions to broaden
its product base and generate additional earnings. In June 1998, Challenger announced the
acquisition of Howard Financial Holdings Limited, which at that time had $600 million of funds
under management.
During this period, while Challenger was still effectively “under
construction”, there was little movement in Challenger’s share price. It was not until the release of
its financial results for the six months ended 31 December 1998 with a profit of $21.8 million that
Challenger’s share price began to rise sharply. Challenger’s share price peaked at $4.69 per share
in September 1999 following announcement of its full year result.
The company’s acquisition spree continued through 1999 and 2000 and it announced a bonus issue
to shareholders in September 2000. During this time, Challenger’s share price fluctuated as the
market and analysts became concerned about Challenger’s aggressive expansion strategy and had
difficulty understanding Challenger’s accounting and profit recognition methodology. This
uncertainty continued throughout 2002 significantly affecting Challenger’s share price which
continued to fall despite growing net asset backing and the success in annuity sales.
In October 2002, Challenger’s share price fell to $1.55 per share following the announcement of a
writedown in Global Life’s property asset entitlements following the independent review of its
methodology thereby restating profit before tax to $191.0 million (from an earlier announced
profit before tax of $227.1 million). In November 2002, Challenger announced a restructure of its
board and three new directors, including Mr Kerry Packer, were appointed. At the same time,
Challenger announced a convertible note issue which was required to improve the quality of
reserves underpinning the annuities. The perception of capital constraints and the need for further
capital put downward pressure on the share price and it reached a three year low of $1.54 in the
week before the Merger was announced.
When Challenger and CPHIC announced the Merger on 20 January 2003, the Challenger share
price was around $1.70. The price rose after the announcement and has subsequently generally
traded in the $2.00-2.30 range.
Page 36
4
Valuation of Challenger International Limited
4.1
Summary
Grant Samuel estimates the value of Challenger to be in the range $586-744 million which
corresponds to a value of $2.00-2.48 per share. The valuation represents the full underlying value
of Challenger assuming 100% of the company was available to be acquired and includes a
premium for control. The value exceeds the price at which, based on current market conditions,
Grant Samuel would expect Challenger shares to trade on the stock exchange in the absence of the
Merger or an alternative takeover offer.
The value has been calculated by aggregating the estimated market value of Challenger’s
businesses, investments, cash and other assets less non-trading liabilities. The valuation is
summarised below:
Challenger – Valuation Summary ($ millions)
Valuation Range
Report
Section
Reference
Low
High
Global Life
4.2
500.0
600.0
Funds Management/Advisory Services
4.3
215.0
250.0
Other businesses
4.4
31.8
37.8
Other assets and liabilities
4.5
15.2
22.3
Capitalised overheads
4.6
(60.0)
(50.0)
Net borrowings at 31 December 2002
4.7
(116.2)
(116.2)
Value of equity
585.8
743.9
Shares on issue (millions)
292.4
292.4
Value per share - undiluted
$2.00
$2.54
Value per share - diluted
$2.00
$2.48
The value is based on the Challenger balance sheet as at 31 December 2002. For the purposes of
the valuation, the funds management businesses have been valued together, separately from
Life/annuity business, reflecting the basis on which they are run for management purposes. Some
of these funds management businesses are actually owned by Global Life. The value attributed to
Global Life excludes these assets.
The valuation of Challenger is subject to considerable uncertainty:
ƒ
ƒ
the valuation of Global Life involves complex measurement issues such as policy
liabilities. Life insurance accounting is not amenable to intuitive understanding by those
unfamiliar with its intricacies. There are substantial issues of judgement often involving
long term forecasts. In Challenger’s case these include judgements/forecasts as to:
•
future investment earnings over the term of the policies;
•
long term discount rates for highly unusual securities such as the income and capital
units;
•
property values at the termination of the policies which may be 10-20 years into the
future; and
•
other detailed assumptions;
the uncertainty is exacerbated by the degree of leverage inherent in the business. From a
Challenger shareholder’s perspective, it is an investment in a business with an asset base of
more than $4.0 billion ($2.7 billion of properties) and external liabilities of more than $3.5
billion. This leverage magnifies the net effect on the business value;
Page 37
ƒ
there are no companies directly comparable to the Global Life Business from which to
derive meaningful benchmarks such as multiples of earnings and/or net assets;
ƒ
the funds management business is a disparate collection of businesses which, in aggregate,
are currently generating inadequate profits after overheads; and
ƒ
the earnings picture is further clouded by the major cost cutting initiatives being
implemented across the group. Challenger has prepared but has not yet finalised (or
provided to Grant Samuel) a reforecast for the period to 30 June 2003.
The value range represents a premium of 17-45% to the Challenger share price immediately prior
to announcement of the Merger of $1.71. The weighted average price over the previous month
was $1.64. The premium implicit in the valuation incorporates, in part, a premium for control.
However, it is also important to recognise that the Challenger share price had been under
considerable pressure over the previous 12 months with the price falling from over $3.00. The
decline is clearly partly due to the generally weak sharemarket and, in particular, the negative
sentiment in the financial services sector (AMP, writedowns by banks of wealth management
acquisitions etc). However, it would also appear to reflect a number of adverse market perceptions
and concerns about Challenger (e.g. capital requirements, accounting treatment). It is conceivable
that the market overreacted to these issues although it could be equally argued that CPH’s
presence on the register and participation in capital raisings would have helped underpin the share
price over this period.
While most market participants, analysts and commentators believe Challenger’s property
investment model is a powerful value creator over the longer term, they are cautious about
attributing value to that today and, perhaps because of some degree of opacity in Challenger’s
financial reporting, have tended to heavily discount the reported earnings and asset values (as is
evident from analysis of implied multiples of earnings and asset backing). In Grant Samuel’s
opinion, a degree of caution is warranted but it believes the valuation adequately takes this into
account.
The valuation reflects the following implied multiples:
Valuation of Challenger – Implied Multiples
Parameter
($ millions)
Value Range
Net assets at 31 December 2002
Value Range
Low
High
585.9
744.0
806.7
0.7
0.9
Earnings per share
- for the year ended 30 June 2002
158.6
3.7
4.7
- six months to 31 December 2002 annualised
71.6
8.2
10.4
- six months to 31 December 2002 annualised
and adjusted for one-off items
117.6
5.0
6.3
These are low earnings multiples but this reflects the issues about the nature of reported profit for
the Global Life business (as required under life insurance accounting rules).
Page 38
4.2
Global Life
4.2.1 Approach
In forming its view on value, Grant Samuel considered a variety of valuation approaches
and methodologies including:
ƒ
the Appraisal Value conducted by Challenger’s appointed actuary as at 31
December 2002;
ƒ
multiples of adjusted net assets at 31 December 2003; and
ƒ
multiples of adjusted net profits.
The Appraisal Value is obviously a key benchmark and Grant Samuel has carefully
considered this value. It has been determined by an actuarial expert based on actuarial
standards and valuation techniques and approaches which are widely adopted and used as
the valuation basis across the life insurance industry in Australia and internationally. The
Appraisal Value includes both a value of the current business that has been written (referred
to as “In Force Business”) together with an allowance for the goodwill of the business
(referred to as “Value of New Business”).
In particular, it should be noted that the actuarial approach specifically recognises the way
in which capital is tied up in statutory funds and only becomes available over time.
However, it needs to be recognised that:
ƒ
the Appraisal Value incorporates the value of the income and capital units in the
property trust held by Challenger Life No 2/Statutory Fund 2. These are unusual
assets and the separate values reflect what might be argued to be a non traditional
approach for accounting purposes. At the same time, it is an attempt to measure the
economic reality and simply reflect the present value of the economic returns that
are forecast to accrue to Challenger over the life of the asset. However, the bottom
line is that the combined investments in the property trusts are carried in the books
at more than the current market value of the property less debt;
ƒ
the appointed actuary does not himself value the income and capital units but relies
on the company valuation, albeit that the valuation is based on cash flows that can
be forecast with some degree of accuracy and discount rates that have been provided
by independent experts;
ƒ
Challenger is not a traditional life insurance company. It sells fixed term, fixed
return annuities and carries virtually no mortality risk. The investment portfolio is
also non standard. In this sense, Challenger is not really a life insurance company at
all. It can be argued to be more like a fully leveraged property investor. It can
therefore be questioned whether the traditional life insurance accounting/valuation
procedures are the exclusively appropriate valuation technique.
Accordingly, Grant Samuel has considered other valuation approaches based on financial
parameters measured on a non life company accounting basis. This involves restating the
financial performance and financial position to a basis where rather than recording the
values and movements in capital and income units, the results are restated using actual cash
flows and the current market values of properties (i.e. as if Challenger was a typical
property investment company).
The analysis is set out in Section 4.2.4 and 4.2.5. At the same time, it needs to be
recognised that this approach has limitations. In particular, the net assets of Global Life are
primarily held in the reserves of the statutory funds and these are only available to the
shareholder over time as obligations to policyholders run down. The opportunity cost of
this deferral is not explicitly recognised in a net assets calculation.
Page 39
4.2.2 Appraisal Value
The Appraisal Values of Challenger Life No 2 are summarised below:
Challenger Life No 2 – Appraisal Value ($ millions)
30 June 2002
Low
High
31 December 2002
Book
Value
Adopted
Low
High
Book
Value
Adopted
Adjusted Net Worth
113.5
113.5
113.5
246.4
246.4
246.4
Value of Business In Force
307.8
315.4
307.8
332.9
332.9
332.9
Embedded Value
421.3
428.9
421.3
579.3
579.3
579.3
Value of New Business
121.3
263.5
125.0
70.3
226.3
142.2
Appraisal Value
542.6
692.3
546.3
649.5
805.3
721.5
The adjusted net worth has two main components:
ƒ
the shareholders’ funds of Challenger Life No 2; and
ƒ
the excess of assets over liabilities in Statutory Fund 2.
There are two important elements in the calculation of adjusted net worth:
ƒ
the assets of Statutory Fund 2 include the assessed value of the income and capital
units (see section 3.2.5 for more details) except that the actuary has used a rate of
11.25% (rather than the 11% adopted by Challenger) to value the capital units; and
ƒ
the policy liabilities figure used to calculate excess assets in Statutory Fund 2
includes various adjustments which result in a much higher figure than appears in
the financial statements. The policy liabilities are stated at their “capital adequacy
requirement” which includes a resilience reserve at 31 December 2002 amounting to
more than $250 million. In effect, the excess assets/capital reserves of the statutory
fund are reduced by this amount.
The value of “In Force Business” represents the net present value of the future profits
expected to be earned from existing policies (i.e. investment returns less policy payments
less expenses). Expected future profits are calculated at the outset of the policy and
amortised to profit over the life of the policy pro rata to the policy payments (with
adjustments on the way through). The calculation effectively also incorporates the present
value of the release or unwinding over time of the resilience reserve.
In calculating the present value of future profits, a pre tax discount rate of 10.75% was
used. The cash flows include tax but an allowance of 70% for the imputation credits
generated was allowed (the Appraisal Value incudes $55-78 million for imputation credits).
It is also assumed that the properties are sold at the maturity of the policies creating a tax
liability at that point.
The Embedded Value is therefore a valuation of the current book of business held by
Challenger Life No 2.
The Value of New Business is effectively a value of the goodwill of the business and the
Appraisal Value is a total business value. The Value of New Business was based on
multiples of 2-3 times the expected profit margin (including capital units) at varying levels
of annuity sales and property trust investment.
Other factors to note include:
ƒ
in the Value of New Business all of the profit contributions comes from the
structured property investments (i.e. capital units);
Page 40
ƒ
allowance has been made for the value dilutive effect of having to introduce
additional capital into Challenger Life No 2 to support the business; and
ƒ
the increase in the Embedded Value between 30 June 2002 and 31 December 2002
reflects in large part the injections of capital during the period (cash plus the transfer
in of Synergy/Garrisons).
Several adjustments are required to calculate a value for Global Life:
Global Life – Adjusted Appraisal Value ($ millions)
As at 31 December 2002
Appraisal Value of Challenger Life No 2
Non Life Businesses owned by Challenger Life No 2 and included in
Appraisal Value (Challenger Life UK, Garrisons/Synergy etc)
Low
High
649.5
805.3
(103.7)
(103.7)
Writedown of Garrisons Accounting investment
(6.0)
(6.0)
Challenger Life No 1 (shareholders’ funds plus excess of assets in
Statutory Funds)
25.0
30.0
Adjusted Global Life value (based on Appraisal Value)
564.8
725.6
Adjusted Global Life value (based on Embedded Value)
494.5
583.4
The Challenger Life No 1 value has been calculated by Grant Samuel based on the balance
sheet of Challenger Life No 1 at 31 December 2002. There was no actuarial valuation of
Challenger Life No 1 (because of its small size). The value excludes Challenger Life
No 1’s interests in fund management subsidiaries.
4.2.3 Valuation of Capital Units
There has been some market concern about the Challenger valuation methodology. This
appears to relate largely to the issues surrounding the valuation of the capital units. The
valuation, while logical, is uncommon reflecting Challenger’s unique structure and
strategy. There is no doubt it is a highly sensitive calculation. The carrying value of the
capital units at 31 December 2002 was $514 million (before associated tax liabilities). A
1% change in the discount rate used to calculate the value of the capital units changes the
value by approximately $50-60 million (before tax). The main concerns appears to be:
ƒ
the manner in which it “front ends” the ultimate residual value; and
ƒ
the use of forecast property values at the maturity of the policies (say, year 15).
In Grant Samuel’s opinion it is a valid theoretical approach. There is a reasonably high
level of certainty attached to the cash inflows and outflows. It is therefore appropriate to
recognise the economic value that is generated when the annuities are sold and the
structured property investment is made.
However, there must be doubts as to whether it represents a value that is realisable today.
In particular, an acquirer is likely to be extremely cautious about paying now for forecast
increases in the value of the property. A more conservative alternative approach would be
to value the capital units assuming that the terminal value (at say Year 15) is equal only to
the current market value of the property.
In other words, no valuation uplift is assumed but value is attributed to the leverage and the
locked in cash flow structure (i.e. that over time the annuity is extinguished and residual
equity interest arises).
This is shown conceptually below:
Page 41
Current
Approach
Alternative
Approach
Terminal Value of
Property (Yr 15)
Terminal Value of
Property (Yr 15)
Future
Gain
Future
Gain
Current
Value
Value of
Capital Unit
(discounted to
present value)
Current
Value
Value of
Capital Unit
(discounted to
present value)
Debt
Debt
Based on Challenger’s valuation model this alternative approach would reduce the carrying
value of the capital units by approximately $140-150 million (after tax). However, it is
important to note that:
ƒ
while this is a practical, conservative approach it is internally inconsistent with other
assumptions; and
ƒ
this adjustment does not translate into a “dollar for dollar” effect on the Appraisal
Value (because of timing impacts and the effect on the value of new business).
4.2.4 Adjusted Net Assets
Grant Samuel has analysed the net assets of Global Life using a conventional non life
company balance sheet approach. Under this approach:
ƒ
the aggregate value of the income and capital units held by Statutory Fund 2 are
written down to an amount equal to:
Less
Current market value of properties
Net external borrowings in the property trusts and swap positions
ƒ
all other investment assets remain at their book values (which are market values);
and
ƒ
policy liabilities remain unchanged.
The effect of using this approach (based on the 31 December 2002 balance sheet) has been
calculated by Challenger for the purposes of the pro forma accounts prepared by CPH
Management which are set out in Scheme Booklet. The effect of this alternative policy on
Global Life is set out below:
Challenger – Adjusted Net Assets
$ millions
Challenger Life No 2 net assets
Non Life operating businesses (book value)
Writedown of capital and income units (net of tax effect)
585.3
(94.6)
(282.7)
208.0
Challenger Life No 1 (book value excluding funds management subsidiaries)
Total adjusted net assets of Global Life
30.0
238.0
Page 42
This analysis is necessarily approximate. The adjustments to the income and capital units
involve a number of estimates and assumptions which are not precise.
The adjusted net assets is not a valuation as such but rather a benchmark that can be
compared to a valuation. In particular, it does not recognise that:
ƒ
ƒ
the net assets in the Statutory Funds are only released over time;
ƒ
there is value that Challenger has “locked in” through its property investment
structures; and
ƒ
there is goodwill inherent in the Global Life business from the ability to continue to
sell annuities.
property valuations are undertaken on a rolling basis and at 31 December 2002 some
of them were more than 12 months old;
4.2.5 Adjusted Earnings
Grant Samuel has also considered the earnings of the long term annuity business restated to
a conventional non life company basis. Rather than being based on Margin on Services life
company accounting (i.e. spreading projected profit margins across the term of the policy)
and picking up revaluations of the income and capital units, the profits are restated to a
conventional property owning basis (rent less interest costs less expenses) consistent with
the alternative view of Global Life as a leveraged property play. These estimates for long
term annuities for the period since 30 June 2001 are summarised below:
Long Term Annuity Business – Restated Earnings ($millions)
Year ended
30 June
2002
Annualised earnings using
results for six months ended
31 December 2002
Rent (less outgoings)
155.4
191.8
Interest on debt
(99.7)
(126.7)
55.7
65.1
(28.3)
(36.1)
27.4
29.0
Profit of property trusts
Interest component of annuities
Profit before expenses
Operating expenses
(9.6)
(9.6)
Profit before revaluation and acquisition costs
17.8
19.4
Revaluation gain on properties
93.7
42.2
Amortisation of acquisition costs
(6.8)
Profit after revaluation and acquisition costs
104.8
(8.2)
53.2
In calculating these estimates:
ƒ
interest on annuities represents the implied interest component on long term annuity
payments related to property investments;
ƒ
operating expenses represent:
ƒ
•
maintenance expenses (including commissions) related to long term annuities
only; and
•
acquisition expenses of long term annuities amortised over the life of the
policy;
revaluations reflect movements in market value between the beginning and end of
the period. For the six months to 31 December 2002:
•
the actual included a writedown of some UK properties; and
•
the six month figure was simply doubled for the purposes of annualising.
Historically, Challenger has not revalued properties every year so the amount
recognised depends on which properties were reassessed; and
Page 43
ƒ
property acquisition costs are amortised over the life of the property trust (i.e. term
of the policies)
It should be noted that the restated earnings for the long term annuity business have been
calculated by Challenger for the purposes of this report but have not been subject to
external review or audit. Accordingly, they should be treated as broad estimates rather than
precise numbers but the figures appear to be reasonable. For example, it can be compared
to the following notional pro forma calculation going forward using the balance sheet at 31
December 2002:
Long Term Annuities – Notional Profitability
$ millions
Net rent on properties - $2.7 billion @ 8% net yield
Interest on debt - $1.8 billion @ 7.5%
Profit of property trusts
Interest on annuities - $0.9 billion @ 5.0%
Profit before operating expenses
216.0
(135.0)
81.0
(45.0)
36.0
The results are quite different to those determined using life company accounting. The
basis of life company accounting is to estimate a total lifetime profit from the initial
transaction and then spread it over the life of the product, theoretically creating a fairly
smooth profit distribution. The approach set out above is different, but might be more
intuitively obvious. It is a snapshot of the “here and now” earnings. It is based on the cash
profits actually generated during the year plus the gain or loss over the year in the property
portfolio. This approach will result in a different profit recognition pattern with minimal
profits in early years but growing over time as rental grows and the interest bill diminishes
as annuities (and debt) are paid down.
While the restated earnings show a cash profit, the overall investment model creates a cash
deficit in the early years because the total payment to annuity holders is much higher as it
also includes a substantial principal repayment component (and there are also debt principal
repayments).
Challenger has advised that the short term annuity business makes only small profit
contribution so the above earnings are indicative of the total Global Life.
4.2.6 Analysis and Conclusion
Having regard to all of these approaches (each of which has its limitations) Grant Samuel
has estimated the value of the Global Life to be in the range of $500-600 million. The
range is relatively wide but, as discussed above, precise valuation is not possible
particularly in the current circumstances. It is very much a matter of judgement.
Overall, Grant Samuel believes that the lower end of the range is realistic even given
Challenger’s capital issues. It can be considered more of a standalone value where growth
is constrained but it does assume the capital issues are manageable. The upper end of the
range is more reflective of the potential of the business if it is assumed that the capital
issues are resolved or that a potential acquirer is prepared to pay a price assuming that it
will do so. Certainly, there is substantial potential for the business if it has more than
adequate capital. In those circumstances, the value is significantly above its value where it
does not.
The value is lower than the Adjusted Appraisal Value but is in line with the Adjusted
Embedded Value. Grant Samuel is aware that many international life insurance companies
are now trading at about one times Embedded Value, having fallen from previous levels
that effectively attributed multiples up to 20 times in the Value of New Business.
However, in Grant Samuel’s opinion, Global Life is so fundamentally different to life
Page 44
insurers that any comparison on this basis is potentially misleading. The discount to
Appraisal Value reflects several factors:
ƒ
uncertainty as to whether the value attributed to the capital units is one that could
actually be realised today in the current market conditions;
ƒ
the impact of capital issues on the ability to write new business; and
ƒ
the limited profitability of new business (i.e. the value is in the structured property
investment).
The value range is not inconsistent with an approach where the capital unit value was
reduced to only reflect current market values on termination.
The value is substantially above the adjusted net assets, implying goodwill of $262-362
million. Any attribution of goodwill is inevitably highly subjective. Some degree of
caution is warranted. In addition to the capital issue:
ƒ
the future development of the business relies on continuation of:
•
the positive arbitrage between property yields and interest and annuity rates.
In different economic environments, interest rates could exceed property
yields (and have done so in the past); and
•
the favourable treatment of annuities for taxation/social security purposes
which enables annuities to be attractive investments despite the low implicit
interest rate.
Neither of these are certain to continue.
ƒ
the availability of suitable properties that meet all of the necessary criteria is limited.
While the move into the UK and United States has widened the potential pool, it is
still an issue;
ƒ
the “pay off” is really only in the long term once annuities are paid down and
properties can be recycled. Positive cash flow is some time away; and
ƒ
Global Life has weaknesses such as the lack of an S&P/Moody’s rating, the need for
improvement in systems and risk management and high expense levels.
Nevertheless, the implied level of goodwill is considered justifiable having regard to:
ƒ
the value that has been “locked in” through the property trust structures that are in
place for the current portfolio. The forecast positive cash flow has a reasonably high
level of certainty (even if some years away);
ƒ
the leverage inherent in the model that magnifies the gains from growth in the
property assets; and
ƒ
Challenger’s leadership position in the long term annuities market (30% market
share) combined with its strong distribution network. It has a position that should
enable it to be able to sell up to $500 million in long term annuities per annum for
investment in structured property assets (assuming appropriate capital is available).
The long term annuity market has excellent prospects, particularly as the ageing
population moves into a retirement phase. It would be extremely difficult to build
up a comparable business from scratch. Once the business matures, it should
become an enormously powerful “cash cow”.
The value range of $500-600 million for Global Life represents relatively high multiples of
profit before revaluations but modest multiples if revaluations are included:
Page 45
Valuation of Global Life - Implied Multiples (times)
Profit on non life company basis
Profit before revaluations and acquisition costs
Profit after revaluations and acquisition costs
Year ended
30 June 2002
Annualised earnings using
results for six months to
31 December 2002
28.1-33.7
25.8-30.9
4.8-5.7
9.4-11.3
These multiples need to be considered in the context of:
ƒ
the likely growth in profit before revaluation over time as rents grow and interest
expense declines (depending on the extent of annuity sales and new property
investments); and
ƒ
the non cash nature of revaluation gains and the time delay before Challenger
shareholders are able to access the value created.
In a broad sense, the business provides a “running” profit (similar to a running yield on
property) of roughly $20 million per annum and the potential to capture uplifts on a $2.7
billon property portfolio. If that uplift was to be 2% per annum (similar to the long run
growth in property values), it would generate value of $54 million per annum (and
growing).
While it is acknowledged that these valuation approaches above are not actuarially based,
Grant Samuel believes they provide some insight into the value dynamics of the Global
Life business.
4.3
Funds Management/Advisory Services
Grant Samuel has estimated the combined value of Challenger’s Funds Management and Advisory
Services divisions to be in the range of $215-250 million. This value range implies the following
valuation parameters:
Funds Management – Implied Valuation Parameters
Parameter
($ millions)
Value range ($ millions)
Value Range
Low
High
215.0
250.0
Percentage of net funds under advice and management
(excluding Global Life property portfolio)
5,892.9
3.6%
4.2%
Percentage of net funds under advice and management
(including Global Life property portfolio)
8,542.9
2.5%
2.9%
Multiple of contribution before overheads
23.019
9.3 times
10.9 times
Multiple of contribution after overheads20
1.619
134.4 times
156.3 times
Valuation of Funds Management/Advisory Services is difficult as the Funds Management division
is currently a collection of individual funds management activities and not a cohesive integrated
funds management operation.
The percentage of net funds under advice and management implied by the value range are
reasonable in comparison to recent market evidence as set out in Appendix 2. Although at the low
end of the market evidence, this would be reasonable given the low cohesion and profitability of
the division. The multiple of earnings implied by the value range clearly indicates the lack of
19
Six months ended 31 December 2002 annualised. This basis may understate future contribution from Funds Management/Advisory
Services as the benefits of recent restructuring are yet to emerge and the restructuring announced in November 2002 is expected to
result in cost savings.
20
Contribution after overheads is before interest and tax.
Page 46
profitability of the division particularly after overheads. While there is an expectation that profits
will emerge over the next 12 months (largely through the planned reduction in the cost base) there
is still considerable work to be undertaken (and therefore cost to be incurred) to generate the
expected benefits. While individual businesses appear profitable (particularly before overheads)
the fact is that the total division is barely profitable after overheads. This must act as a constraint
on value even if:
ƒ
many of the businesses could be sold individually. At one level it could be argued that the
sum of the parts is higher than the whole but there is some lack of clarity in the cost
structure that makes it difficult to be definitive;
ƒ
the values appear reasonable based on other criteria such as fund under management; and
ƒ
there are cost savings initiatives under way which should lead to materially improved
earnings.
Inevitably, a buyer would apply a discount to the potential value to reflect the work yet to be done.
The value range represents an excess over net tangible assets of $214.5-249.5 million. This is
typical of a funds management business and is attributable to the management rights held by the
Funds Management division.
Grant Samuel has valued Funds Management/Advisory Services primarily having regard to the
rule of thumb – percentage of funds under advice and management. In doing so Grant Samuel has
had reference to recent market evidence (see Appendix 2). As a valuation methodology, this
approach is unsatisfactory as it generally fails to take account of the substantial differences in
profitability that fund managers enjoy depending on factors such as type of fund (wholesale,
retail), product line (which impacts staff levels and costs) and scale. However, given the lack of
comprehensive, consistent historical financial information or any up to date forecast information
for Funds Management/Advisory Services it is the only available valuation approach.
Notwithstanding that, even if detailed and consistent financial information had been available it
may not have been useful as:
ƒ
Funds Management/Advisory Services carry substantial overhead allocations which may be
higher than that of a standalone funds management/financial planning operation;
ƒ
the current funds management activities are not generating an adequate return and a number
are subscale; and
ƒ
considerable work remains to be done to rationalise and integrate the Funds Management
activities in order to extract economies of scale.
Consequently, the percentage of funds under advice and management is as good as any other
approach to the valuation of Funds Management/Advisory Service. Some useful earnings
information was available for the larger operations and was utilised where possible.
The market evidence set out in Appendix 2 implies that during the last five years purchasers of
predominantly retail funds management and financial planning businesses (without significant
other activities) have been willing to pay prices implying:
ƒ
1.1-8.5% of funds under advice and management;
ƒ
9.5-24.3 times historical EBIT; and
ƒ
15.7-26.6 times historical net profit after tax.
The high end of these value parameters reflect transactions with significant strategic value.
However, recent market activity and events such as the writedowns by banks of their wealth
management businesses would indicate that prices in this sector have peaked and a purchaser
today is likely to pay prices implying lower parameters (even for a substantially strategic
purchase). In using this market evidence to value individual funds management/financial planning
Page 47
offering of Challenger, Grant Samuel has, to the extent possible, considered the transaction
evidence most appropriate to the particular activity (e.g. management of equity product offerings
as compared to property management, venture capital or master trust/wrap funds activities).
The value range of $215-250 million substantially reflects the value attributed to the management
rights for the Howard Mortgage Trust ($110-130 million) and the Synergy/Galaxy Master
Trust/Garrisons Financial Planning activities ($65-75 million).
The Howard Mortgage Trust activities (i.e. including wholesale activities and Challenger
Mortgage Plus) is the jewel in the Fund Management division’s activities. Howard Mortgage
Trust is the largest mortgage trust in Australia achieving significant economies of scale and
profitability. This business would be attractive to a wide range of funds management sector
participants, particularly given the current equity market conditions. Howard Mortgage Trust has
experienced strong funds inflows in recent years (a 65% increase in funds under management
since September 2001) as a consequence of its leading market position, recent equity market
conditions and the recent strategy to access wholesale funds. There is significant operating
leverage in this funds management activity. Revenue from managing Howard Mortgage Trust in
the year ended 31 December 2002 was approximately $20 million, a 100% increase in revenue
since 30 June 2001. In comparison, expenses before overhead allocation have increased only
marginally. At the same time, it needs to be recognised that the growth currently being enjoyed
may well tail off if equity markets recover strongly.
The value range attributed to Howard Mortgage Trust of $110-130 million relates only to the
funds management function and excludes the origination/management activity that Challenger
undertakes through its separate Corporate Property Lending division (see Section 4.4). The value
range represents 5-5.9% of funds under management at 31 December 2002 (excluding Corporate
Property Lending). The value range also represents multiples of:
ƒ
14.8-17.4 times net profit for the year ended 30 June 2002 (after allowing for overhead
allocation and tax of 30%); and
ƒ
12.6-14.9 times annualised net profit for the six months ended 31 December 2002 (after
allowing for overhead allocation and tax of 30%).
These multiples are high reflecting the quality, scale and operating leverage of this operation and
the full year flow through to profits from the recent growth in funds.
KPMG Corporate Finance (Aust) Pty Limited (“KPMG Corporate Finance”) was appointed to
value the rights relating to Howard Mortgage Trust and the services provided by Corporate
Property Lending to assist Challenger directors in assessing the carrying value of the rights at 31
December 2002. KPMG Corporate Finance assessed the value of the combined rights to be in the
range of $150-170 million with the high end of the range implying a historical multiple of adjusted
net profit after tax of 14.5 times and 7.8% of funds under management. In reaching this
conclusion KPMG Corporate Finance reduced the amount of overheads allocated to the activities
on the basis they are considered excessive on a standalone basis.
The value attributed by Grant Samuel to the combined activities of Howard Mortgage Trust and
Corporate Property Lending is $140-165 million. This is approximately 3-7% lower than the
value range assessed by KPMG Corporate Finance. This difference relates to the fact that no
adjustment has been made to overheads allocated to these business activities. Individually
divisions may be able to justify a view that the overheads are excessive and they could operate
without them on a standalone basis or as part of some other organisation. However, overheads are
reality for large corporate organisations. The Challenger overheads allocations exclude corporate
costs and do include functions such as human resources and IT. Overheads have to be taken
account somewhere, either across the operations or as a separate pool of costs.
The Synergy/Galaxy Master Trust with $1.374 billion funds under advice and 24,000 client
members is a significant funds management business and would represent an attractive acquisition
for other market participants. At the same time, Synergy/Galaxy is currently a master trust
primarily servicing Garrisons Financial Planners (although it has recently been relaunched in a
Page 48
form expected to be attractive to external financial planners) and only represents approximately
1.6% of the discretionary master fund market21. Grant Samuel has valued the combined
Synergy/Galaxy and Garrisons Financial Planning activities as they are so closely related. The
value range attributed to Synergy/Galaxy Master Trust/Garrisons Financial Planning ($65-75
million) represents 4.7-5.5% of funds under advice at 31 December 2002 which is reasonable
when compared to recent market evidence. The value range implies multiples of 30.6-34.1 times
annualised net profit for the six months ended 31 December 2002 (after allowing for overhead
allocation and tax at 30%). The combined activities generated a loss in the six months ended 31
December 2002 and therefore it is not possible to calculate an implied multiple of net profit after
tax. Notwithstanding that, the value attributed reflects that Synergy/Galaxy is a growing master
trust. Funds under advice increased 25% in the period 30 September 2001 to 31 December 2002
and 4.5% in the six months to 31 December 2002.
A number of other product offerings of the Funds Management division have significant growth
opportunities (e.g. Margin Lending, Warrants, management of the Beston Wine Industry Trust and
the High Yield Fund and the Corporate Superannuation activities). However, these are
comparatively small operations with low profits or even losses and therefore do not represent a
significant proportion of the value attributed to Funds Management/Advisory Service by Grant
Samuel. The services provided to the Global Life property portfolio by the Funds Management
division are a source of reasonable net profits for the Funds Management division however it
uncertain whether these activities would be outsourced by Global Life if it was not part of the
Challenger group. These activities were valued individually and have been attributed an aggregate
value of $40-45 million.
4.4
Other Businesses
Grant Samuel has estimated the value of Challenger’s other businesses in the range of $31.8-37.8
million. This range primarily reflects the value of Corporate Property Lending ($30-35 million).
Corporate Property Lending is an efficient and profitable mortgage origination and management
business. Its activities are closely linked to those of the Howard Mortgage Trust and faces similar
growth prospects. The value range of $30-35 million represents 1.3-1.5% of the mortgage and
loan book managed at 31 December 2002 and 12.8-14.9 times net profit after tax for the year
ended 30 June 2002.
Howard Finance has been valued at net assets at 31 December 2002 adjusted for an additional
provision related to its exposure to Garrisons Accounting.
4.5
Other Assets and Liabilities
Grant Samuel has estimated the value of Challenger’s other assets and liabilities to be in the range
of $15.2-22.3 million. This range accounts for a number of items including:
ƒ
ƒ
ƒ
ƒ
the outstanding sale proceeds of Challenger First Pacific (as at 31 December 2002);
ƒ
the Loyalty Program.
the net proceeds expected from the windback of Challenger Life (United Kingdom);
provisions for excess lease space, restructuring and prepaid rent incentive;
a small share portfolio including shareholdings in Biotech, Homeloans Limited, Telstra
Corporation Limited and MIM Holdings Limited; and
No value has been attributed to the net assets of Group Services related to business operations as
that is reflected in the values attributed to each division.
No value has been attributed to carried forward tax losses.
21
“ASSIRT Market Share Report – December 2000”, ASSIRT Pty Limited, March 2003.
Page 49
4.6
Capitalised Overheads
Challenger incurs corporate costs which are not allocated to the operating divisions. These costs
include certain senior executive costs, employee share scheme costs, listed company costs and
other overheads. It is expected that corporate costs will reduce as a consequence of the
restructuring announced in November 2002 and that an acquirer of Challenger would eliminate a
proportion of these costs. An allowance of $50-60 million has been made in the valuation for the
capitalised value of these overheads.
4.7
Net Borrowings
Net borrowings for valuation purposes at 31 December 2002 total $116.2 million:
Net Borrowings at 31 December 2002
$ millions
Corporate facility
Convertible notes
Lease liabilities
Other loans
Dealer deposits (Funds Management)
Cash and deposits
Net borrowings
(85.0)
(75.0)
(4.2)
(2.0)
5.1
44.9
(116.2)
Borrowings and cash and liquid investments in Global Life have been excluded as they are already
taken into account in the valuation of that division.
In addition, the following items have been excluded:
ƒ
debt and cash allocated to the Funds Management division insofar as they relate the Margin
Lending and the Warrants businesses that have been valued separately on a net assets basis
(i.e. the equity in the Margin Lending and Warrants businesses have been valued); and
ƒ
debt and cash allocated to Corporate Financial Services insofar as they relate to Howard
Finance that has been valued separately on a net assets basis (i.e. the equity is Howard
Finance has been valued).
Page 50
5
Profile of CPH Investment Corp
5.1
Background
CPHIC was established by Publishing and Broadcasting Limited (“PBL”) as the FXF Trust to hold
PBL’s investment in John Fairfax Holdings Limited (“Fairfax”). In December 1997, under a
scheme of arrangement, PBL distributed units in the FXF Trust to PBL shareholders and the units
were listed on the ASX.
In March 2000, unitholders approved an expansion of the FXF Trust’s investment strategy, a
capital raising to fund further investment, a change of name to CPHIC and amendments to the
management fee arrangements for CPH Management. The investment strategy expansion was
intended to allow investment in the technology and telecommunications sectors and old economy
sectors. CPH Management intended to raise up to $600 million through an issue of $1.00 units,
partly paid to 60 cents. In April 2000, following the sharp deterioration in equity markets, the
terms of the issue were amended. The units were repriced to 60 cents (with an initial instalment of
50 cents) and the issue size was reduced to $240 million with the capacity for oversubscriptions of
$60 million. The revised offer terms were approved by unitholders in May 2000. The offer raised
a total of $245 million, $204 million of which was received as part of the first instalment. The
remaining funds were received in October 2001.
In July 2001, CPHIC sold its entire interest of 14.97% in Fairfax, resulting in net proceeds of
approximately $428 million. The proceeds were used to repay bank debt and to supplement
CPHIC’s cash reserves for investment opportunities.
CPHIC subsequently amended its investment strategy to only take significant interests in operating
businesses with positive cash flow and growth potential and where, in CPH Management’s
opinion, prices are realistic. Since CPH Management amended its investment strategy it has made
limited investments. Volatility in the global equity markets over the past two years has caused
CPH Management to be selective and cautious when evaluating investment opportunities. As a
result, a significant proportion of the capital raised in 2000 remains in cash.
In addition to cash, CPHIC’s current portfolio includes four major and several smaller unlisted
investments and portfolio interests in listed entities including ordinary shares, options and
convertible securities. The four major unlisted investments are Jurlique International Pty Limited
(“Jurlique”), Australian Fast Foods Pty Limited (“Australian Fast Foods”), Australian Vinyls
Corporation Limited (“Australian Vinyls”) and Endeavour Healthcare Limited (“Endeavour”).
On 24 December 2002, CPH Management received a requisition from 135 unitholders for a
meeting of CPHIC unitholders to consider several proposed resolutions. One of the proposed
resolutions suggested that CPHIC be wound up and the net proceeds be distributed to unitholders
primarily because CPHIC has traded at a discount to the May 2000 issue price of 60 cents during
the last two years. The meeting of unitholders was held on 24 February 2003 at which all of the
proposed resolutions were rejected.
5.2
Investment Portfolio
5.2.1 Unlisted Investments
Jurlique International Pty Limited
Jurlique is a South Australian based manufacturer, distributor and retailer of over 250
natural skin, hair and body care products as well aromatherapy essential oils and herbal
medicines. Jurlique differentiates itself by offering products that are made from completely
natural plant based ingredients with the majority of herbal ingredients grown organically
and biodynamically on a farm in the Adelaide Hills. Jurlique’s products are sold in
Australia and more than 20 countries worldwide through various channels including
concept, department, franchise, pharmacy and health food stores. Jurlique is also used in
day and resort spas throughout the world.
Page 51
Jurlique has experienced compound annual sales growth and compound annual EBIT
growth of 30% and 40% respectively in the three years ended 30 June 2002. This growth is
attributed to well branded and effective products with distribution through word-of-mouth
advertising being a significant contributor to sales.
CPHIC acquired a 25% interest in Jurlique in September 2002 for $25 million together with
two options each to acquire a further 25% of equity. This investment reflected a multiple of
approximately 6.5 times operating earnings for the year ended 30 June 2002. The two
options are exercisable based on the results of the two years ending 30 June 2003 and 30
June 2004 respectively. The consideration payable upon exercise of each option is
dependent on a number of factors including the earnings of Jurlique in the period prior to
exercise and outstanding debt. Different multiples are to be applied depending on the level
of earnings.
A portion of the funds raised from CPHIC’s initial investment have been committed to
accelerate Jurlique’s international expansion. International expansion is progressing,
including the opening of a number of concept stores in late 2002 in the United States and
increasing distribution throughout Asia and Europe.
Earnings in the current year are continuing the strong growth trend. Trading over the
Christmas 2002 period was strong and Jurlique is on track to generate revenue and
underlying EBIT in the 2002/03 year in line with expectations and recent growth trends.
Jurlique has a small cash surplus.
Australian Fast Foods Pty Limited
Australian Fast Foods was formed in the 1980’s by the merger of the Chicken Treat and
Big Rooster barbeque chicken chains. Chicken Treat was based in Western Australia while
Big Rooster operated in Queensland, New South Wales and Victoria. The Big Rooster
stores were sold to Coles Myer Limited and renamed Red Rooster. In 2002 Australian
Fast Foods re-acquired the enlarged Red Rooster chain from Coles Myer expanding its
national coverage of barbeque chicken outlets by 295 stores. Australian Fast Foods is
currently the fourth largest fast food and takeaway food operator in Australia with 383
stores and more than 6,500 staff.
For the year ending 30 June 2003 Australian Fast Foods is forecasting EBITDA of
approximately $18 million. 2002/2003 is regarded as a transition year as the Red Rooster
chain is integrated into the group. Following some implementation issues early in the
financial year, performance in the last few months had been stronger and in line with
expectations. Australian Fast Foods had net debt (excluding convertible notes) of
approximately $30 million at 31 December 2002.
CPHIC invested $9.0 million in convertible notes issued by Australian Fast Foods in May
2002. The minimum interest rate payable on these notes is 12% to 30 June 2005 and 9%
thereafter. CPHIC has the ability to convert its notes into a minimum of 16.36% of the
total equity in Australian Fast Foods on or after 1 July 2005. The convertible notes may
convert into more than 16.36% of total equity if Australian Fast Foods underperforms target
earnings for 2004 and 2005 based on certain thresholds. There are also provisions allowing
redemption of the convertible notes at the option of either Australian Fast Foods (at a
specified multiple of earnings) or CPHIC (at par) at certain periods.
Australian Vinyls Corporation Limited
In February 2002, CPHIC participated in the $40 million management buyout of Australian
Vinyls from Orica Limited and PolyOne Corporation by AVC Holdings Pty Limited
(“AVC Holdings”). Additional payments to the vendors may be payable if certain
profitability targets are met. CPHIC invested $7.5 million for a 50% interest in AVC
Holdings. CPHIC holds all the A class shares in AVC Holdings with management of
Australian Vinyls holding all the B class shares. The main difference in the rights
Page 52
attributable to each class of shares is in relation to dividend preference and distribution
upon an exit event. In both instances, A class shareholders have priority over B class
shareholders to payments up to a set amount. CPHIC can also appoint half the board of
directors of AVC Holdings as long as it continues to hold a minimum 30% interest.
CPHIC has granted two unrelated parties options to purchase a proportion of its shares in
AVC Holdings, equating to 7% of total capital. The options are exercisable from the date
of issue until the fifth anniversary of CPHIC’s purchase of its interest in AVC Holdings at
CPHIC’s original cost. These options are likely to be exercised and, as a consequence,
CPHIC only recognises a 43% (instead of 50%) interest in AVC Holdings.
Australian Vinyls owned the only two manufacturing plants producing poly vinyl chloride
(“PVC”) resin in Australia. As a condition of the management buyout, Australian Vinyl’s
older plant at Altona, Victoria was closed prior to settlement. As a result, Australian
Vinyls’ current annual capacity of 130,000 tonnes of PVC resin (and therefore Australia’s
total PVC production capacity) is now less than historical domestic demand ensuring full
capacity utilisation of the plant. Australian Vinyls imports PVC resin from international
manufacturers to meet demand in excess of its production capacity.
Today, Australian Vinyls has two businesses, vinyl resin and specialty products, operating
from its plant in Laverton, Victoria. The resin business supplies products to a range of
wholesale customers who use PVC for the manufacture of pipes for potable water and
sewage, electrical cable, flooring, medical products, packaging, stationery, footwear and a
host of other applications, while the speciality products business trades in products
servicing the PVC compound and rubber industries.
Since the management buyout Australian Vinyls has reported earnings growth and
generated healthy cash flows. This has been largely attributable to the restructuring of
supply and manufacturing arrangements as well as an improvement in capacity utilisation.
Australian Vinyls is forecasting EBITDA of approximately $13 million in the 2002/03
year.
Endeavour Healthcare Limited
Endeavour is a vertically integrated healthcare provider. It currently operates 24 general
practice medical centres in Western Australia and New South Wales (incorporating around
220 general practitioners), the Accord Pathology business in Western Australia and New
South Wales and Prime Occupational Health in Western Australia. Endeavour sold its loss
making Victorian Medical centres in April 2003.
Endeavour has experienced difficulties in integrating acquired medical practices, which has
resulted in delays in achieving efficiencies. Endeavour underwent a reorganisation in early
2002, resulting in several changes to its board, management and operating structure. The
business strategy since that time has been to consolidate existing acquisitions, focus on the
New South Wales and Western Australian markets, divest non-core assets and reduce
overheads. The pathology business has also been actively developing a number of new
relationships with groups of doctors.
The financial performance of Endeavour has not been in line with initial expectations.
Endeavour reported revenue for the year to 30 June 2002 of $66.7 million and an EBITDA
loss of $6.5 million. Endeavour has performed in line with budget to December 2002 and
was EBITDA positive. Cash reserves at 31 December 2002 were approximately $3
million.
CPHIC acquired Endeavour ordinary shares in the period between September 2000 and
March 2001. In December 2001, CPHIC invested a further $3 million by way of
convertible loan notes. CPHIC’s aggregate holding in Endeavour equity is 25.2% on a
fully diluted basis.
Page 53
Other Unlisted Investments
CPHIC has a number of portfolio interests in small unlisted companies including a 15.5%
interest in Future Fibre Technologies Pty Limited (“Future Fibre Technologies”), which
develops and commercialises fibre optic sensing technology. Details of other unlisted
investments are not disclosed in this report due to CPH Management’s confidentiality
obligations to the investee companies and co-investors.
5.2.2 Listed Investments
CPHIC holds a portfolio of investments in securities listed on the ASX and international
stock exchanges including ordinary shares, reset convertible preference shares and options.
These investments are recorded by CPHIC at market value.
At 31 December 2002, CPHIC held a current listed investment portfolio with a book value
of $79.1 million and long term investments in two Australian listed companies as follows:
CPHIC – Listed Investments
As at 31 December 2002
Listed Entity
Number of shares
(million)
Percentage of issued
capital
Book value
($ millions)
QPSX Limited
10.75
8.02%
4.8
Solution 6 Limited
17.50
6.96%
4.8
Total
9.6
Source: CPHIC
5.3
Operating Performance
CPHIC’s historical operating performance since 1998 is summarised below:
CPHIC – Operating Performance ($ millions)
1998
1999
2000
2001
2002
Six months
ended
31 December
2002
audited
audited
audited
audited
audited
unaudited
4.1
0.1
4.2
5.6
11.7
0.3
17.6
12.0
1.6
13.6
9.8
13.2
9.4
7.9
40.3
(3.6)
0.4
17.5
(2.7)
6.4
18.0
9.7
0.3
10.2
(1.2)
2.5
21.5
(6.7)
(0.2)
(0.4)
(7.3)
(3.1)
(12.3)
(0.5)
(0.7)
(13.5)
4.1
(10.6)
(4.4)
(0.9)
(15.9)
(2.3)
(11.9)
(7.0)
(1.4)
(20.3)
20.0
(5.1)
(3.7)
(1.6)
(10.4)
7.6
(0.4)
(1.8)
(1.0)
(3.2)
18.3
-
-
(0.2)
(0.1)
1.1
(4.1)
(3.1)
4.1
(2.5)
19.9
8.7
14.2
-
-
152.9
(112.2)
(10.1)
(4.1)
(3.1)
4.1
150.4
(92.3)
(1.4)
10.1
(1.2)¢
na
0.8¢
1.0¢
na
(0.5)¢
na
2.3¢
na
1.0¢
na
1.5¢
1.0¢
100%
Year ended 30 June
Revenue
Profit/(loss) on sale of investments
Dividend income
Interest income
Unrealised gains/(losses)
Share of net profits of associates
Total revenue
Expenses
Interest expense
Management/performance fees
Other
Total expenses
Profit/(loss) before tax
Income tax expense
Profit attributable to unitholders
Net increase/(decrease) in asset
revaluation reserve
Net change in unitholders’ funds
Statistics
Earnings per unit
Distribution per unit
Amount of distribution franked
Source: CPHIC
Page 54
Unrealised gains/(losses) represent movements in the value of current investments. Changes in the
value of non-current investments are generally reflected in asset revaluations reserve. The
substantial movements in the asset revaluation reserve in 2000 and 2001 primarily reflect changes
in the market value of Fairfax in that period.
Share of net profits from associates represents CPHIC’s 43% net interest in AVC Holdings which
was acquired in February 2002 and the 25% interest in Jurlique which was acquired in September
2002.
Management fees decreased in the year ended 30 June 2002 as CPH Management decided to
waive its entitlement to a management fee for the first half of the year. Further, in the six months
ended 31 December 2002 CPH Management elected to receive only 50% of the management fee to
which it was entitled. The basis upon which management fees are paid to CPH Management is set
out in Section 5.7 of this report.
CPHIC has been classified as a corporate unit trust since 1 July 2000. Prior to this date, CPHIC
was not subject to income tax provided all income of the trust was distributed to unitholders at the
end of the income year (although its controlled entities were subject to tax). CPHIC is now taxed
in the same way as a company and is able to pay franked distributions.
CPHIC has announced an interim fully franked distribution of 1 cent per unit for the six months to
31 December 2002. This is the first earnings distribution CPHIC has paid since listing. The
distribution paid in 1999 was a capital return to unitholders.
5.4
Financial Position
CPHIC’s financial position as at 30 June 2002 and 31 December 2002 is summarised below:
CPHIC – Financial Position ($ millions)
30 June 2002
31 December 2002
audited
unaudited
Debtors and prepayments
1.0
7.9
Creditors and provisions
(4.4)
(3.8)
Unlisted investments
102.5
77.0
Listed investments
30.4
88.7
Net tax liabilities
(7.8)
(0.5)
Net cash
361.2
323.6
Unitholders’ funds
482.9
492.9
Units on issue (million)
917.5
917.5
53¢
54¢
Net assets per unit (cents)
Source: CPHIC
Listed investments are generally carried at market value while unlisted investments are carried at
fair value as determined by CPH Management. There is no provision for the 1 cent per unit
interim distribution as at 31 December 2002.
At 31 December 2002, CPHIC had $22.9 million in accumulated franking credits (after allowing
for the payment of the fully franked interim distribution) and no carried forward income tax or
capital losses.
Page 55
5.5
Capital Structure and Ownership
CPHIC had 917,522,392 units on issue and over 29,985 registered unitholders at 31 March 2003.
The top ten unitholders account for 56.9% of units on issue:
CPHIC – Major Unitholders at 31 March 2003
Unitholder
Number of Units
Consolidated Press Holdings Limited22
RBC Global Services Australia Nominees Pty Ltd23
Perpetual Trustee Company Ltd
National Nominees Ltd
ANZ Nominees Ltd
JP Morgan Nominees Australia Ltd
WIN Television NSW Pty Ltd
Caledonia Investments Ltd
Alfred Street Nominees Pty Ltd
Cardiac Jolt Pty Ltd
Subtotal - Top 10 unitholders
Other unitholders (29,973 unitholders)
Total
285,698,690
69,727,894
49,677,468
27,481,479
24,138,575
22,235,701
20,001,334
10,172,551
6,478,800
6,213,857
521,826,349
395,696,043
917,522,392
Percentage
31.1%
7.6%
5.4%
3.0%
2.7%
2.4%
2.2%
1.1%
0.7%
0.7%
56.9%
43.1%
100.0%
Source: CPHIC
CPHIC’s substantial unitholders are CPH (31.14%), Perpetual Trustees Australia Limited
(“Perpetual”) (9.98%) and LFG Holdings Pty Ltd (5.01%).
With the exception of CPH and WIN Television NSW Pty Ltd, unitholders holding more than a
1% interest in CPHIC are fund managers or share custodians that are likely to hold those units on
behalf of a range of beneficial owners.
5.6
Unit Price History
A summary of the price history of CPHIC units since listing on 10 December 1997 is set out
below:
CPHIC – Unit Price History
Low
Close
Average Weekly
Volume
(000’s)
0.26
0.18
0.28
0.50
0.34
0.33
0.26
0.30
0.60
0.59
0.40
0.38
4,364
6,145
3,498
5,088
3,868
3,621
Unit Price ($)
High
Year ended 31 December
1997
0.35
1998
0.30
1999
0.70
2000
2.55
2001
0.60
2002
0.45
Month ended
0.50
January 2003
February 2003
March 2003
April 2003
Average
Weekly
Transactions
66
130
165
762
316
417
0.38
0.50
30,539
773
0.57
0.55
0.48
0.45
13,812
8,147
543
330
0.55
0.47
0.54
0.47
0.53
8,636
333
Source: IRESS
This unit price and trading volume history is depicted in the following graph:
22
Combined holdings of Conpress Holdings Pty Limited (29.6%) and Consolidated Press Holdings Limited (1.5%).
23
Represents aggregate holdings of the two RCB Global Services Australia nominee accounts within the top 10 unitholders.
Page 56
CPHIC - Unit Price and Trading Volume
December 1997 - April 2003
70,000
$2.50
60,000
$2.00
$1.50
40,000
30,000
$1.00
Volume (000s)
Unit Price ($)
50,000
20,000
$0.50
$0.00
Dec-97 Jun-98 Dec-98
10,000
0
Jul-99
Jan-00
Jul-00
Jan-01 Aug-01 Feb-02 Aug-02 Feb-03
Source: IRESS
Units in CPHIC closed at 34 cents on the first day of listing and generally remained within a range
of 20-60 cents until early 2000. The unit price rose to a record high of $2.55 in trading on the 29
March 2000 following CPHIC’s announcement to expand its investment strategy and capital base.
However, this price level was short lived returning to more realistic levels following the
deterioration in global equity markets in April 2000. Following the repriced capital raising in May
2000, the CPHIC unit price declined from over 60 cents to around 40 cents by March 2001.
Since then CPHIC units have consistently traded at around 35-40 cents, despite CPHIC having net
asset backing in excess of 50 cents with a cash asset backing (since June 2001) of around 40 cents
per share. However, this kind of discount (albeit perhaps not as substantial) is not uncommon for
many listed investment vehicles (eg because of management fees). In CPHIC’s case, it may also
have reflected the lack of operating cash flows, uncertainty as to how the cash would be invested
and a perceived inability to access the cash reserves. The price did strengthen from mid 2002
(when it reached a low of 33 cents) to just over 40 cents in early January 2003 on the back of
buying by investors such as Perpetual who perceived that the value gap was excessive. Trading
volumes have generally been modest with peaks at Perpetual’s acquisition of a substantial
shareholding in February 2002 and its later purchases in September 2002.
Following the announcement of the Merger, the CPHIC unit price has risen to over 50 cents and
units have generally traded in the range 48 to 53 cents. Trading volumes have also increased.
5.7
Management Fees
Under CPHIC’s constitution, CPH Management as responsible entity is entitled to:
ƒ
an annual management fee of 1.5% of CPHIC’s gross asset value, adjusted to reflect the
market value of any listed securities and the most recent valuation of any unlisted securities
(historical cost or the “five year” gross asset value of CPHIC as assessed by a valuer) at the
end of June and December each year. The first “five year” assessment for unlisted assets
will occur on 30 June 2005. The fee is payable to CPH Management half-yearly in arrears.
CPH Management pays a number of expenses out of this management fee including
directors fees, company secretarial costs and administration costs (rent etc);
ƒ
realisation performance fees, equal to 20% of any returns on gross asset value which
CPHIC achieves over a hurdle rate of return of 10% compounded per annum (pre-tax).
Page 57
This fee is payable once investments are realised subject to the making up of any shortfall
on returns from previously realised investments or unrealised investment valuations; and
ƒ
five year performance fees, which allow CPH Management to be rewarded for successful
unrealised investments for returns achieved over the hurdle rate across the entire portfolio
once every five years. This five year performance fee is based on an independent valuation
of the portfolio by an internationally recognised investment bank. As the performance fees
relate to unrealised gains, only 70% of the normal performance fee will be payable, with
payment of the balance of 30% being dependent on the ultimate realised value. The first
assessment of these fees will occur on 30 June 2005 and will be every five years thereafter.
There is no clawback on the fees paid to CPH Management except in the event of the termination
of CPHIC. However, if an investment is realised which does not achieve the hurdle rate of return
or the entire portfolio of CPHIC has not achieved the hurdle rate of return when valued every five
years, no further performance fees will be payable until the shortfall is made up.
CPH Management elected not to receive the management fee for the six months ended 31
December 2001 unless CPHIC generated sufficient income in the year to 30 June 2002 such that
after charging the six months to 31 December 2001 management fee CPHIC remained profitable
before tax. While these conditions were satisfied, CPH Management still elected not to receive the
fee. Further, CPH Management elected to receive only 50% of the management fee to which it
was entitled for the six months ended 31 December 2002 (i.e. CPH Management received $1.8
million for that period rather than $3.7 million).
Page 58
6
Valuation of CPH Investment Corp
6.1
Summary
Grant Samuel estimates the underlying value of CPHIC to be in the range $421-452 million which
corresponds to a value of 46-49 cents per unit. The valuation represents the full underlying net
asset value of CPHIC assuming 100% of the capital was available to be acquired and includes a
premium for control. The value exceeds the price at which, based on current market conditions,
Grant Samuel would expect CPHIC units to trade on the stock exchange in the absence of the
Merger.
The value of CPHIC is the aggregate of the estimated market value of CPHIC’s investments, cash
and other assets less non-trading liabilities. The valuation is summarised below:
CPHIC – Valuation Summary ($ millions)
Unlisted investments:
Jurlique
Australian Fast Foods
Australian Vinyls
Endeavour
Other unlisted investments
Valuation Range
Report
Section
Reference
Low
High
6.2.1
6.2.2
6.2.3
6.2.4
6.2.5
30.0
9.0
15.0
10.0
7.0
35.0
12.0
20.0
12.0
9.0
71.0
88.0
Listed investments
6.3
87.0
91.0
Other assets and liabilities
6.4
(5.6)
(5.6)
Capitalised overheads
6.5
(55.0)
(45.0)
Net cash as at 31 December 2002
323.6
323.6
Value of equity
421.0
452.0
Units on issue (millions)
917.5
917.5
46¢
49¢
Value per unit
The vast majority of CPHIC’s assets are cash or listed investments where the value can be
determined with a reasonable degree of precision. The value of unlisted investments is subject to
far greater uncertainty but, given the relatively small size of these investments, variations in value
have a fairly minor impact on overall value. Even if the values of these investments were restated
by a factor of, say, 25%, the impact on CPHIC’s net asset value would be in the order of 2 cents
per unit.
In determining a value for CPHIC’s unlisted investments, Grant Samuel has considered different
valuation methodologies when valuing different investments, due to the diverse nature of the
investments, the wide range of sectors that the investees operate in, the nature of the investments
and the performance of the investees.
The valuation is based on CPHIC’s financial position as at 31 December 2002 but account has
been taken of any material changes since then.
The net asset value does allow for the effect of the base management fee but does not allow for the
performance fees (both realised and five yearly) payable to CPH Management. The performance
fee takes part of the upside potential on investments and therefore dilutes the ultimate returns to
unitholders. CPHIC has advised that, based on the current carrying values, the amount of
“accrued” performance fees is negligible.
6.2
Unlisted Investments
6.2.1 Jurlique
Grant Samuel has valued CPHIC’s interest in Jurlique at $30-35 million, a small premium
to cost of $27 million. This valuation incorporates CPHIC’s 25% shareholding, the call
Page 59
option to increase its shareholding by 25% (to 50% shareholding), and the second and
subsequent call option to increase this shareholding again by 25% (to 75% shareholding).
This valuation also takes into account that CPHIC’s investment is in an unlisted company
with a minority interest, although it has the ability to become a controlling majority
shareholder.
This value implies multiples of approximately 7.5-8.8 times historical operating earnings
and lower prospective multiples given the expected earnings growth. While these multiples
appear to be conservative for a company enjoying the levels of growth exhibited by
Jurlique and the potential in overseas markets, it needs to be recognised that:
ƒ
CPHIC only acquired its stake in September 2002 (i.e. six months ago). This
transaction was the result of arm’s length negotiations. In the absence of substantial
changes in the business, cost is a reasonable guide to valuation where an asset has
only recently been acquired. It would be imprudent to assume there had been a
substantial uplift in such a short period;
ƒ
while the business is performing strongly, it is not significantly ahead of CPH
Management’s expectations at the time of investment;
ƒ
ƒ
net tangible assets are only approximately $20 million; and
the investment is a minority shareholding and illiquid.
There is some value to CPHIC in the options although this is highly subjective. Exercise of
the options will give control to CPHIC but the exercise price is based on EBITA multiples
which are materially higher than the original acquisition multiple albeit using trailing
earnings. Accordingly, it is difficult to attribute a substantial value to the options.
At the same time, while caution is warranted in attributing value significantly above cost at
the present time, it is clear that there is considerable upside potential which could be
realised over the next 3-5 years.
6.2.2 Australian Fast Foods
Grant Samuel has valued CPHIC’s convertible notes in Australian Fast Foods at $9-12
million. The low end of this range reflects the face value of the convertible notes at
redemption and CPHIC’s ability to sell the notes back to Australian Fast Foods on or after
30 June 2005 at this value. Based on Australian Fast Foods performance to 31 December
2002, balance sheet as at 31 December 2002 and budgeted performance to 30 June 2003,
the risk of Australian Fast Foods not having access to sufficient funding to buy back the
notes is relatively low.
The high end of the valuation range recognises that, if the business performs well, the
convertible notes will have a value well above face value. This value will depend on future
earnings and whether CPHIC converts the notes or whether Australian Fast Foods exercises
its rights to redeem them. If targeted earnings are achieved even the redemption value
(which is more relevant than the potentially higher conversion value) would be almost
twice the face value. However, at this point in time caution is warranted. The Red Rooster
business is still being integrated. While the signs are generally positive there is as yet no
clear indication of the underlying earnings from the combined business. Accordingly, the
upside value has been limited to $12 million.
6.2.3 Australian Vinyls
Grant Samuel has valued CPHIC’s interest in Australian Vinyls at $15-20 million. This
valuation reflects CPHIC’s 50% interest in AVC Holdings (the holding company for
Australian Vinyls), the rights associated with its particular class of shares, the options it has
written to third parties equating to approximately 7% interest in Australian Vinyls and the
potential liability to the vendors if certain profitability objectives are met. This valuation
also takes into account that CPHIC’s investment is in an unlisted company with a 50%
interest, with the ability to have an equal representation on the board of directors until its
interest in AVC Holdings decreases to 30%.
Page 60
The value reflects multiples of approximately 5-6 times EBITDA and 6.0-7.2 times EBITA
for the year ending 30 June 2003. Grant Samuel believes these multiples to be reasonable
for a business with Australian Vinyls’ characteristics. While it is a relatively low growth
manufacturing business, it has an effective domestic monopoly and has been generating
solid cash flows.
6.2.4 Endeavour
Grant Samuel has valued CPHIC’s shares and convertible loan notes in Endeavour at
$10-12 million. The valuation of CPHIC’s investment in Endeavour is subject to
considerable uncertainty as a result of its current financial performance. The pathway to
reasonable profitability is not clear. Given its breakeven earnings it cannot be valued by
reference to conventional earnings parameters. Nevertheless, the business clearly has some
value:
ƒ
the three business units are individually profitable. It is the group overheads that
reduce profit which suggests that Endeavour needs greater scale to operate
effectively;
ƒ
the three business units could be sold individually. They are each easily separable
from the group;
ƒ
existing industry participants could either:
•
acquire the whole business and probably eliminate almost all of the
overheads; or
•
acquire any of the individual business units without needing to add to its own
overhead.
Closure costs for the head office would not be substantial.
ƒ
an existing pathology business operator could acquire Endeavour’s business and
eliminate much of the central processing/testing infrastructure by utilising its own
infrastructure. This could generate margins for the acquirer of at least 50% of the
incremental revenues;
ƒ
both the medical centre and pathology businesses are strategic in that they represent
one of the few operations of meaningful size in Australia available for acquisition
(e.g. the medical centres generate almost $50 million in revenues);
ƒ
the pathology business is presently generating margins below industry norms. The
Western Australian business is considered to be efficiently run but lacks scale. The
New South Wales business has been performing poorly but is improving
significantly. A number of new initiatives appear to be working well, albeit that
they are at an early stage; and
ƒ
the occupational health business is small and quite distinct but is regarded as a solid
standalone operation.
The valuation range adopted by Grant Samuel reflects these factors. A separate value was
ascribed to each business based on their respective revenue and earnings or earnings
potential. The value of the medical centre business represents approximately 0.5 times
revenue. The value range for the pathology business reflects both standalone earnings and
the value to another operator.
6.2.5 Other Unlisted Investments
CPHIC has a range of portfolio interests in smaller unlisted companies. Grant Samuel has
attributed an aggregate value of $7-9 million to these investments. Given these investments
are relatively immaterial and were made relatively recently, Grant Samuel has valued them
at around book value. Grant Samuel has been advised that each of these businesses is
trading broadly in line with expectations at the time the investment was made.
Page 61
6.3
Listed Investments
Grant Samuel has attributed a valuation range of $87-91 million to CPHIC’s listed investments
(current and non current). This compares to the market value of CPHIC’s listed investment
portfolio as at 31 December 2002 of $89 million (based on closing prices for each investment
security as at that date). The range allows for:
6.4
ƒ
movements in the market value of these investments between 31 December 2002 and the
date of this report. Grant Samuel has been advised that these movements are not material;
and
ƒ
securities sold and new securities acquired since 31 December 2002.
Other Assets and Liabilities
The value of CPHIC’s other assets and liabilities are summarised below:
CPHIC – Other Assets and Liabilities ($ millions)
Book Value
as at
31 December 2002
Distribution payable
Net working capital
Net tax liabilities
Total other assets and liabilities
4.1
(0.5)
3.6
Valuation Range
Low
High
(9.2)
4.1
(0.5)
(5.6)
(9.2)
4.1
(0.5)
(5.6)
The interim distribution of 1 cent per unit, totalling $9.2 million, was not provided for as at 31
December 2002. All other assets and liabilities were taken at book value as at 31 December 2001.
6.5
Capitalised Overheads
CPHIC incurs a number of overhead costs in managing its asset portfolio. The major component
is the management fees paid to CPH Management. Based on the position at 31 December 2002,
the annual base management fee that CPH Management is entitled to is approximately $7.4
million per annum. The fee effectively includes both compensation for expenses incurred by CPH
Management and a profit margin. CPHIC also incurs approximately $1.5-2.0 million per annum
of other expenses.
The appropriate value adjustments for these expenses is always open to some debate. In this
context:
ƒ
ƒ
ƒ
CPH Management has voluntarily forgone 50% of its fee entitlement in recent periods;
ƒ
ƒ
there is continual downward pressure on management fees generally; and
in any winding up of CPHIC, the obligation evaporates;
the upheavals in the property trust industry over the past 12 months have shown that there
is little security in external management arrangements. A number of property trust
managers have lost (or face the prospect of losing) their positions without any (or minimal)
compensation;
some of the operating costs may be one-off in nature.
It is likely that if there was a takeover offer for CPHIC, investors would expect to receive the full
net asset value before allowing for management fees. However, in relation to the Merger the fees
are an ongoing impost. From the perspective of Challenger shareholders, while they do inherit the
underlying assets, they also clearly inherit a liability to keep paying these fees (i.e. the contribution
of CPHIC unitholders to the merged entity is diminished by the cost imposition) and other
overhead costs. In fact, they also inherit the obligation to pay performance fees if any should
arise. An allowance of $45-55 million has been made for the capitalised value of these costs.
Page 62
7
Profile of the Merged Entity
7.1
Directors and Management
The merged entity will be managed through CPH Management. The board of CPH Management
after the Merger is implemented will initially be:
James Packer (Chairman)
Chris Cuffe (CEO)
Peter Polson
Ashok Jacob
Mike Tilley
Jim Service
Brenda Shanahan
Russell Hooper
James Packer and Ashok Jacob are associated with CPH. Jim Service and Brenda Shanahan are
presently non executive directors of Challenger.
A new senior management team for the merged entity has been announced. It includes a number
of executives who previously worked with Mr Cuffe at Colonial First State. The existing senior
management team of Challenger (Bill Ireland, Rodger Bacon, John Barry) will not continue with
the merged entity.
7.2
Operations and Strategy
The operations of the merged entity can be depicted graphically as follows:
Merged Entity – Group Structure
CPHIC
Principal
Investments
Cash
Listed
Equities
Private Equity
Investments
Challenger
Investment
Services
Global
Life
Jurlique
Australian Vinyls
Australian Fast Foods
Endeavour
Others
The group structure may be different following implementation of the capital management plan
and a thorough review of all services/products offered.
Page 63
The CEO of CPH Management, Mr Chris Cuffe, has indicated that Challenger’s two divisions will
be the principal business operations of the merged entity and will be the focus of efforts for growth
and development (albeit that they may be restructured for management and reporting purposes).
The strategies will be based around:
ƒ
strengthening the management structure;
ƒ
achieving cost efficiencies across the entire group;
ƒ
strengthening, integrating and rationalising the technology platforms and business and
administration services systems;
ƒ
building on the strength of the long term annuities business; and
ƒ
focussing the funds management offerings (both in terms of products and in sectors that
offer scale and profitability).
It is not expected that the merged entity will actively pursue further private equity investments but
it may increase its position in existing investments (eg. through exercise of options).
The merged entity will also have some $400 million of cash and liquid securities after the Merger.
Irrespective of how much of this has to be invested into the Global Life business to support its
capital adequacy, the full amount needs to be invested. Mr Cuffe intends that this pool of funds
(together with any other Challenger investments) be actively managed as a “principal book”. It
may be invested across a wide range of investments including taking significant equity positions as
well as being used to improve the existing property portfolio.
7.3
Capital Management Plan
CPH Management has submitted a capital management plan for the merged entity to APRA for its
consideration. The plan is designed to resolve all of the capital issues relating to the annuity
business of Challenger Life No 2 and to ensure the Global Life business has sufficient capital to
support its short term growth objectives.
The key features of the plan are:
7.4
ƒ
the injection of $235 million in cash into Challenger Life No 2 Statutory Fund 2 (including
$35 million to fund new business);
ƒ
the removal of the Synergy/Garrison assets from Statutory Fund 2 (leading to a reduction in
excess assets of approximately $70 million) but with the transfer of approximately $77
million of CPHIC private equity investments into the shareholders’ funds of Challenger
Life No 2;
ƒ
the adoption of a policy of valuing the combined income and capital units at a maximum
level equal to the current market value of the properties less the debt in the property trusts;
ƒ
a continuation of the strategy to minimise risks and thereby reduce capital requirements.
For example:
•
focus on properties with risk characteristics similar to the recent Invesco acquisition; and
•
implement the plans to eliminate refinancing risk through underwriting the rollover
of the CMBS program and the larger global securitisation project.
Capital Structure and Ownership
Assuming the Challenger convertible noteholders retain their notes, the capital structure of the
merged entity will be:
ƒ
ƒ
ƒ
2,233.3 million ordinary units;
37.5 million convertible notes, convertible into 168.75 million new units in CPHIC; and
22.1 million options exercisable into 99.3 million new units in CPHIC.
Page 64
Challenger shareholders will own 58.9% of the merged entity before allowing for convertible
notes. If all of the convertible noteholders elect to accept the Exchange Alternative, the number of
ordinary units on issue will be 2,439.6 million.
CPH and its associates presently own:
ƒ
ƒ
ƒ
18.4% of Challenger’s ordinary shares;
40% of Challenger’s convertible notes; and
31.1% of CPHIC’s ordinary units.
Following the Merger, it will own 23.6% of the merged entity’s ordinary units before allowing for
convertible notes. If all noteholders choose the Retention Alternative it will own 24.8% of the
diluted capital (assuming all convertible notes are ultimately converted but ignoring options). If
all noteholders accept the Exchange Alternative, CPH will own 25.0% of the ordinary units.
7.5
Financial Position
The table below sets out the pro forma balance sheet for the merged entity as at 31 December
2002:
Pro Forma Balance Sheet as at 31 December 2002 ($ millions)
Actual
Challenger
CPHIC
Pro Forma
Merged Entity
Receivables
Trade creditors and provisions
Global Life property investments
Global Life other investments
Global Life excess of net market value
Policy liabilities
Other liabilities
Plant and equipment (net)
Investments
Management rights
Intangibles
Deferred tax assets/liabilities (net)
Other (net)
Total funds employed
297
(130)
2,600
790
797
(1,723)
25
104
9
(88)
72
2,753
8
(4)
165
169
302
(215)
2,704
1,097
136
(1,627)
(106)
19
193
271
201
(16)
50
3,009
Cash
Borrowings
Net borrowings
Net assets
279
(2,225)
(1,946)
807
324
324
493
356
(2,155)
(1,799)
1,210
Statistics
Net assets per share (per Challenger share)
Net tangible assets per share (per Challenger share)
Gearing (net borrowings/net borrowings plus net assets)
$2.76
$2.73
71%
$2.14
$1.82
60%
The pro forma balance sheet has been derived from the pro forma analysis set out in Section 6 of
the Scheme Booklet. It assumes that the Merger occurred on 31 December 2002. A number of
adjustments have been made to Challenger’s assets and liabilities by CPH Management. These
adjustments include CPH Management’s proposed accounting policies and the proposed
restructuring and recapitalisation of Challenger in accordance with the capital management plan
which CPH Management has provided to APRA. The adjustments include:
ƒ
a writedown in the value of income and capital units so that the combined value represents
an amount equal to the current market value of the properties less debt and swap positions.
This writedown is $371 million;
Page 65
ƒ
an increase in the current market value of properties by $41 million which offsets the
writedown above;
ƒ
an adjustment of $106 million to reflect the reclassification as other liabilities of the mark
to market of all interest rate swaps held in relation to the debt in the property trusts
(previously incorporated in the value of income units);
ƒ
ƒ
ƒ
a write off of certain intangible assets;
a writedown of management rights by $23.6 million; and
an increase in provisions of $46 million including allowances for transaction costs ($15
million) and for Garrisons Accounting ($9 million).
It is also assumed, for accounting purposes, that:
7.6
ƒ
the capital injection of $235 million set out in the capital management plan will be
implemented;
ƒ
ƒ
the cost of the units issued by CPHIC as consideration under the Merger is 47 cents;
ƒ
the Options Scheme is approved and all options are acquired for $1.7 million.
the Notes Scheme is approved and all convertible noteholders accept the Exchange
Alternative; and
Management Fee
As part of the Merger, CPH Management has agreed to certain changes to its fee arrangements.
These are set out in detail in the Scheme Booklet. The main effect of the changes is that the base
management fee of 1.5% of gross assets of CPHIC will continue to apply but in respect of the fees
relating to the investment in Challenger under the Schemes:
ƒ
the fees will be calculated by reference to the equity value in Challenger acquired under the
Schemes rather than the gross assets of Challenger (which would be permitted under the
current arrangements for a controlled entity);
ƒ
for the period to 30 June 2005 the equity value will be based on the cost of the investment
to CPHIC calculated by reference to the value of the units issued by CPHIC as
consideration for the five days prior to the announcement of the Merger on 20 January 2003
(40.5 cents per unit or approximately $532 million before convertible notes or $616 million
including convertible notes). From 30 June 2005, it will be based on the assessed value of
the investment as determined by an independent valuation to be conducted by an
internationally recognised investment bank (and every five years thereafter); and
ƒ
no fee will be payable until the volume weighted average price of CPHIC units on the ASX
over a 10 day period exceeds 60 cents.
No changes are to be made to the basis of calculating the realisation or five year performance fees.
However, the performance fee in relation to Challenger will be based on the same cost as that used
to calculate the base management fee.
7.7
Distribution Policy
The distribution policy for the merged entity is to make regular distributions of a significant
proportion of net profit after tax subject to periodic review by the board of CPH Management. It
is anticipated that any distribution made will be fully franked.
Page 66
8
Evaluation of the Merger
8.1
Summary
In Grant Samuel’s opinion, the Merger is in the best interests of Challenger shareholders in the
absence of a superior proposal.
The Merger can be regarded primarily as a major capital raising exercise. CPHIC has cash and
liquid assets of more than $400 million. The Merger therefore provides Challenger (which will be
the main business of the combined entity) with access to a much more substantial liquid capital
base, freeing it from its current capital issues and enabling it to vigorously pursue growth
opportunities across its chosen areas within the financial services sector. Without the Merger, or
some other transaction, Challenger would have to pursue a lower growth business strategy and
will, in a worst case, face additional pressures on its capital position. This is the fundamental
benefit of the Merger. A “do nothing” alternative would lead to substantial losses of shareholder
value over time (compared to the Merger). The alternatives to the Merger that have been
considered by Challenger all generally involve some form of capital raising or sale of assets to
release capital. A number of these involve untested avenues (e.g. partial sale of capital units) and
all involve considerable uncertainties and potential for delay. There is certainly no guarantee that
any such transaction would provide a better value outcome for Challenger shareholders. In the
three months since the Merger was announced, no other party has put forward any alternative
proposal. The Merger provides the certainty of a very large amount of additional capital (in cash).
The transaction can be analysed from several different perspectives. As a wholly scrip based
equity swap of broadly similarly sized companies, it can be thought of as a true merger. Analysed
as a merger:
ƒ
the exchange ratio favours Challenger shareholders in terms of the relative contribution of
market value, at least based on recent market prices. In other words, Challenger
shareholders are receiving a premium; and
ƒ
the exchange ratio in terms of relative contribution of underlying value is equitable.
Challenger shareholders are contributing between 56.5% and 63.9% of the underlying value
of the merged entity. They will own 58.9% of the merged entity.
However, the transaction, can also be properly viewed as a takeover as the CPH group will
effectively assume management control of the combined entity. The market value of the
consideration offered by CPHIC is approximately 48-53 cents per unit (equivalent to $2.16-2.39
per Challenger share). Grant Samuel has estimated the underlying value of Challenger, including a
premium for control, to be in the range of $2.00-2.48 per share. On this basis, the effective
takeover offer is “fair and reasonable”. The offer also provides a very substantial premium to the
price of Challenger shares immediately prior to the announcement of the Merger (26-47%).
There are a number of other benefits and advantages for Challenger shareholders in addition to the
substantially strengthened financial position:
ƒ
ƒ
ƒ
greater market capitalisation and liquidity;
ƒ
an increase in net tangible assets per share (after adjusted Challenger’s balance sheet for the
proposed writedown of capital units);
ƒ
ƒ
a greater likelihood of dividends; and
additional management resources and a new management team;
crystallisation of tax losses for those shareholders that acquired their shares at prices above
the value of the CPHIC consideration (approximately $2.16-2.39);
cost savings, albeit that they are relatively immaterial.
At the same time, there are costs, disadvantages and risks that are not inconsequential:
ƒ
the dilutive impact on shareholders’ returns of the management fee to be paid to CPH
Management which will apply to the expanded group;
Page 67
ƒ
ƒ
ƒ
dilution of upside potential;
transaction costs; and
crystallisation of capital gains tax liabilities for those shareholders that acquired their
Challenger shares at less than the value of the CPHIC consideration (approximately $2.162.39) if the relevant legislation is not passed.
In Grant Samuel’s opinion, Challenger shareholders are receiving a fair value exchange in the
Merger. The benefits, particularly the greater growth opportunities and reduced risk profile, far
outweigh change of control, management fees and the dilution of upside potential.
In fact, there is a strong argument that even if the exchange ratio was not equitable or if the value
of the offer was less than the estimated underlying value of Challenger, the Merger would still be
in the best interests of Challenger shareholders (depending, of course, on the extent of the value
shortfall). This is because the value of Challenger’s business, at least the Global Life business,
will have a greater value as part of the merged entity. With the access to capital arising from the
Merger, Global Life will be able to grow more quickly than it could as a standalone entity.
Challenger shareholders would share (albeit only to the extent of 58.9%) in the incremental value
added. This may well more than outweigh the short term loss of value arising from any
disadvantageous aspects of the Merger (e.g. it is likely to more than offset the capitalised value of
the management fees of approximately $9 million per annum payable to CPH Management).
8.2
Approach
The Merger has several unusual features which makes it difficult to categorise. It can be properly
regarded as a merger of the two entities. The reasons are:
ƒ
the proposal involves a direct swap by Challenger shareholders for new units in CPHIC. No
cash payments are involved;
ƒ
the two entities are of broadly comparable size in terms of market capitalisation.
Challenger shareholders will hold 58.9% of the merged group and CPHIC unitholders will
hold 41.1% of the merged group (before allowing for convertible notes);
ƒ
CPH does not materially alter its equity ownership position. It currently owns 31.1% of
CPHIC and 18.4% of Challenger. It will own approximately 23.6% of the merged entity
(24.8% assuming conversion of all convertible notes but ignoring options); and
ƒ
the board of CPH Management which will act as responsible entity for the merged entity
will initially include two directors from Challenger and only two directors associated with
CPH. The other directors will be either management or new independent non executive
directors.
As a merger, Grant Samuel believes that the assessment of whether the transaction is in the best
interests of the shareholders of Challenger has four elements:
ƒ
consideration of whether the proportion of the merged entity to be held by each group of
shareholders is equitable;
ƒ
consideration of the financial impact of the Merger on Challenger shareholders;
ƒ
consideration of the advantages, benefits, costs, disadvantages and risks of the Merger; and
ƒ
consideration of alternatives realistically available to Challenger.
The principal financial criterion of assessing whether the proportions of the merged group received
by Challenger shareholders is equitable has been addressed by comparing the proportion received
with the relative contribution of Challenger shareholders in terms of measures such as:
ƒ
the market value based on share prices (see Section 8.3); and
ƒ
the estimated underlying value of each entities businesses and assets (see Section 8.4).
Page 68
The second element of the assessment involves analysis of the impact of the Merger on each group
of shareholders in terms of financial parameters such as earnings, dividends, asset backing and
financial gearing. This involves a comparison of the position of Challenger shareholders assuming
the Merger is implemented with the position if it is not (see Section 8.5).
The third element of the analysis is set out in Section 8.6 and 8.7 and involves consideration of a
wide range of other factors including:
ƒ
the expected benefits of the merger in terms of strategic and competitive position, capital
support for business operations, market and growth opportunities, cost savings and
financial strength;
ƒ
the impact of the management contract with CPH Management;
ƒ
the expected tax consequences; and
ƒ
the market for shares in the merged entity and its attractiveness to investors.
In a transaction of this nature there will be advantages and disadvantages. It is necessary to form
an overall view of the trade-off for shareholders. These do not necessarily apply equally to each
shareholder in Challenger.
Finally, it is necessary to consider whether the Merger is likely to preclude alternative transactions
that could be more advantageous to shareholders.
In Grant Samuel’s opinion, the Merger is in the best interests of Challenger shareholders if:
ƒ
the financial terms of the merger are equitable;
ƒ
the benefits and advantages of the proposal outweigh any disadvantages; and
ƒ
the Merger does not preclude alternative transactions which are likely to occur and which
would be more advantageous.
On the other hand, it can be fairly argued that the transaction is effectively a takeover. CPH will
own only 23.6% of the merged entity (and potentially up to 25%) which is not substantially
different to its current ownership of 18.4% of Challenger (21% diluted for convertible notes).
However, after the Merger, CPH will have management control of the merged entity through its
100% ownership of CPH Management. CPHIC is a unit trust and the management of its affairs
rest with CPH Management under the terms of its constitution. This position contrasts with the
current position of Challenger shareholders. Prior to the announcement of the Merger on 20
January 2003, CPH had three representatives on the board of Challenger and an 18.4%
shareholding. While this clearly provided a significant degree of influence, CPH did not control
Challenger. The Chairman and Managing Director were not CPH associates and there were
several other parties with significant shareholdings. It is therefore arguable that from the
perspective of Challenger shareholders other than CPH, the Merger involves a change of control.
This is arguably apparent from the changes in management of Challenger that have already been
announced.
On this basis, the transaction needs to be analysed on the same basis as a takeover. Takeovers are
typically assessed by comparing the value of the consideration offered with the estimated value of
the target based on the underlying value of its businesses and assets. If securities are offered as
consideration, it is necessary to assess the market value of those securities. Under ASIC policy
guidelines if the value of the consideration is above the low point of the estimated value range, the
offer is considered “fair”. A takeover offer could be considered “reasonable” if there were valid
reasons to accept the offer notwithstanding that it was not “fair”.
For example, a takeover offer that is in excess of the pre-bid market prices but less than underlying
value will not be fair but may be reasonable if shareholders are otherwise unlikely in the
foreseeable future to realise an amount for their shares in excess of the bid price. This is
commonly the case in takeover offers where the bidder already controls the target company. In
Page 69
that situation the minority shareholders have little prospect of receiving full value from a third
party offeror unless the controlling shareholder is prepared to sell its controlling shareholding.
A “takeover” analysis is set out in Section 8.8.
A third way of analysing the transaction is to consider the transaction as Challenger undertaking a
large placement. Ignoring the structural change (i.e. the swap into CPHIC units) and the change in
management control, Challenger is effectively issuing a 41.1% stake in its business in exchange
for approximately $400 million in cash and liquid assets together with some other relatively minor
assets (approximately $480 million in total). This could be considered in the context of:
ƒ
Challenger’s need to strengthen its capital position in relation to its long term annuity
business; and
ƒ
the alternatives available to Challenger to raise the necessary cash and on what terms such
funding might be available.
This analysis is set out in Section 8.9.
8.3
Relative Contributions based on Market Value
The sharemarket provides an objective measure of the value of the equity in each entity. Although
the share price reflects only marginal trades in portfolio interests, the price incorporates the
influences of all available information on the company’s prospects, future earnings and risk.
Prima facie it is a fair basis for setting merger terms as long as there is a generally well informed
market and prices do not reflect any other unsustainable factors such as takeover speculation.
Shares and units in Challenger and CPHIC respectively are reasonably well traded (even if
liquidity is somewhat limited) and Challenger is reasonably well followed by analysts. It is
reasonable to assume that the share prices represent assessments of value by a reasonably well
informed market. Subject to the issues discussed below, the market prices of both companies do
not appear to be affected by any unsustainable factors. Accordingly, Grant Samuel believes the
analysis of relative market value contributions to be a fundamental test of the fairness of the
exchange ratio in any merger as it reflects unbiased estimates of value. Arguably, it is the most
appropriate measure of the value contributed, certainly in comparison to subjective estimates of
value.
The contribution of each group of shareholders and unitholders in terms of the market value of the
equity they currently hold can be compared with the proportion of the merged entity that each
group of shareholders and unitholders will hold after the merger. Challenger shareholders will
hold 58.9% of the equity in the merged company and CPHIC unitholders will hold 41.1% of the
equity in the merged company.
The share price on a particular day may be affected by a range of one off factors. Accordingly, the
market values at a number of different dates and the average prices over a number of different
periods were examined, including:
ƒ
closing prices on 17 January 2003, the day prior to the public announcement of the Merger;
and
ƒ
average prices for the following periods ending 17 January 2003:
•
one week;
•
one month;
•
three months;
•
six months; and
•
twelve months.
The average prices have been calculated on both a volume weighted average price basis and a
simple daily average. While volume weighted averages properly reflect the concentration of
Page 70
trading prices, simple averages can, in some circumstances, better reflect prices over a time period
(as they will not be distorted by unusually heavy trading in a short period).
Prior to an announcement of a possible transaction between companies, there is often already
speculation of a transaction. This may arise due to information leakage, broker analysis or even
government or regulator imposed requirements. There is no precise date from which prior prices
can be guaranteed to be untainted by speculation and simply reflects the market’s view of the
intrinsic value of each company. Prices subsequent to 17 January 2003 should be given little
weight, as they will be influenced by the proposed terms set out in public releases (which
contemplated an exchange ratio of 4.5 CPHIC units for each Challenger ordinary share). For the
purposes of the analysis, Grant Samuel has adopted 17 January 2003 as the prime reference date
although it is acknowledged that there may have been speculation prior to this date as to CPH’s
intentions in relation to its investment in Challenger.
The relative contributions based on prices over these periods is summarised below:
Market Value Contributions24
Challenger
(%)
CPHIC
(%)
Proposed Shareholdings at Exchange Ratio
As at close of business on 17 January 2003
Volume Weighted Average for periods to and including 17 January 2003:
58.9
56.4
41.1
43.7
1 week
1 month
3 months
6 months
56.3
57.2
61.1
62.8
43.7
42.8
38.9
37.2
12 months
Simple Daily Average for periods prior to and including 17 January 2003:
65.7
34.3
1 week
1 month
3 months
6 months
56.3
57.7
60.6
63.7
43.7
42.3
39.4
36.3
12 months
68.0
32.0
Date/Period
Source: IRESS and Grant Samuel analysis
Another way of analysing the market value data is to examine the ratio of the Challenger share
price to the CPHIC unit price. This ratio equals the exchange ratio that would be appropriate in a
merger based on market values (i.e. a “nil premium” merger). This implied ratio can be compared
to the actual exchange ratio of 4.525. The table below sets out the relevant prices for the date or
period and calculates the theoretical exchange ratio for a “nil premium” merger implied by share
prices for the same dates and/or periods as the previous analysis:
24
The market value contributions are based on the issued shares of each company as at the date of the announcement. Any subsequent
share or unit issues have been ignored for the purposes of this analysis.
25
Not adjusted for the CPHIC interim dividend of 1 cent per share.
Page 71
Exchange Ratios Implied by Sharemarket Prices – Market Value Analysis
Share Price ($)
Date/Period
As at close of business on 17 January 2003
Challenger
CPHIC
1.71
Implied
Exchange
Ratio
0.42
4.07
Volume Weighted Average for periods prior to and including 17 January 2003:
1 week
1.62
1 month
1.64
3 months
1.78
6 months
1.91
0.40
0.39
0.36
0.36
4.05
4.21
4.94
5.31
12 months
0.39
6.05
Simple Daily Average for periods prior to and including 17 January 2003:
1 week
1.62
1 month
1.68
2.36
0.40
0.39
4.05
4.31
3 months
6 months
1.74
2.04
0.36
0.37
4.83
5.51
12 months
2.62
0.39
6.72
Source: IRESS
The relationship can also been shown graphically. The following graph shows the theoretical
exchange ratio based on daily share prices (rather than average prices):
Implied Exchange Ratio Based on Daily Market Prices
1 January 2002 - 30 April 2003
10.00
9.00
17 January 2003
8.00
7.00
6.00
4.5
5.00
4.00
3.00
2.00
Jan-02
Mar-02
May-02
Jul-02
Sep-02
Nov-02
Jan-03
Mar-03
Source: IRESS and Grant Samuel analysis
The analysis indicates that the exchange ratio provides Challenger shareholders with a premium
(relative to CPHIC unitholders) if it is based on prices immediately prior to the announcement.
Based on average prices for the one week and one month prior to announcement that benefit is in
the order of 5-10%.
When market value is measured over any longer period it is apparent that the merger terms
disadvantage Challenger shareholders. Based on relative prices prevailing through most of 2002,
the equitable exchange ratio would be in the order of 7 times (compared to the 4.5 times
proposed).
This outcome reflects the decline in the Challenger share price over the 12 months (and
particularly the last six months) prior to the merger announcement compared with the relatively
stable performance over the same period by CPHIC:
Page 72
Challenger vs CPHIC -Relative Market Performance
1 January 2002 - 30 April 2003
160
17 January 2003
140
120
100
80
60
40
20
0
Jan-02
Mar-02
May-02
Jul-02
Sep-02
Challenger
Nov-02
Jan-03
Mar-03
CPHIC
Source: IRESS
In considering this analysis, Challenger shareholders should recognise that:
ƒ
share prices in 2002 can be argued to be largely irrelevant, reflecting market conditions and
expectations that no longer prevail. The fact is that Challenger’s shares have been
substantially rerated downwards. This may or may not be justified. The shares are trading
at well below the stated book value of net assets and there may have been some “contagion
effect” from the difficulties being experienced by other financial services companies (e.g.
AMP, the wealth management related issues with the major trading banks). On the other
hand, the ongoing capital demands of the business growth are real and are undoubtedly a
significant contributing negative factor.
Market concern and/or confusion about
Challenger’s accounting treatment may also have had an impact. The profit revision in
October 2002 also had a significant adverse impact on the share price. In any event, the
share price represents the market’s current view on value and is the current reality. If
anything, in the period just prior to the announcement, the share price appeared to be
continuing to weaken;
ƒ
there is clearly considerable volatility at the present time. At some future date the market
may have a more positive view of Challenger particularly as the business model matures
and becomes cash generating. It may be that the transaction is occurring “at the bottom”
and it might be more propitious to do it at some later date. This aspect needs to be factored
against Challenger’s need to strengthen its capital position and the constraints on its ability
to grow and create value if it does not have access to adequate capital. The capital pressure
will continue to weigh on the share price (i.e. it will not necessarily go away in the near
future) and deferral of action may result in a permanent loss of value from forgone growth
opportunities (compared to those available through the Merger); and
ƒ
while CPHIC’s unit price strengthened over the three months prior to the announcement on
20 January 2003 (from less than 35 cents to over 40 cents), it was still trading at a
substantial discount to its stated net asset backing of approximately 53 cents. Given that
this was largely cash and liquid assets (worth 45 cents per unit alone), it could be argued
that the CPHIC units were trading at well below a fair value (particularly given that there is
little doubt over the asset values).
In summary, Grant Samuel believes that, based on “merger analysis”, Challenger shareholders are
receiving an equitable share of the merged entity relative to their contributions of market value.
Page 73
8.4
Relative Contributions based on Underlying Value
Analysis of the relative contribution of Challenger shareholders and CPHIC unitholders based on
sharemarket values is objective. However:
ƒ
ƒ
the market value does not necessarily reflect non public information such as:
•
forecasts for the period to 30 June 2003;
•
detailed projections for the long term annuity business;
•
management strategies; and
the discount from the underlying value of the businesses at which the shares in each entity
trades may be different.
Accordingly, Grant Samuel has estimated the underlying values of Challenger and CPHIC in order
to compare the relative contributions of the shareholders/unitholder groups in terms of underlying
value. Underlying values represent the estimated value of each of the businesses if they were to be
sold as a whole. This analysis is subjective and is theoretical in as much as neither business is
being sold.
The valuations of Challenger and CPHIC are set out in Sections 4 and 6 of this report respectively.
The valuation of Challenger is summarised below:
Challenger – Valuation Summary ($ millions)
Valuation Range
Low
High
Global Life
500.0
600.0
Funds Management/Advisory Services
215.0
250.0
Other businesses
31.8
37.8
Other assets and liabilities
15.2
22.3
(60.0)
(50.0)
Net borrowings
(116.2)
(116.2)
Value of equity
585.8
743.9
Shares on issue (million)
292.4
292.4
Value per share – undiluted
$2.00
$2.54
Value per share – diluted
$2.00
$2.48
Capitalised overheads
The value of CPHIC is summarised below:
CPHIC – Valuation Summary ($ millions)
Valuation Range
Low
High
Unlisted investments
71.0
88.0
Listed investments
87.0
91.0
Other assets and liabilities
(5.6)
(5.6)
(55.0)
(45.0)
Net cash as at 31 December 2002
323.6
323.6
Net value of equity
421.0
452.0
Units on issue (million)
917.5
917.5
46¢
49¢
Capitalised overheads
Value per unit
Page 74
The pro forma underlying value of the merged entity can be summarised as follows:
Pro Forma Valuation of Merged Entity ($ millions)
Valuation Range
Low
High
Value of equity in Challenger
585.8
743.9
Value of equity in CPHIC
421.0
452.0
Pro forma combined value
1,006.8
1,195.9
Pro forma combined value per unit - undiluted
45¢
54¢
Pro forma combined value per unit – diluted
44¢
52¢
Challenger shareholders would contribute between 56.5% and 63.9% of the underlying value26.
Based on the mid point of each valuation range, they contribute 60.4% of the underlying value.
Challenger shareholders will receive 58.9% of the merged entity (before allowing for convertible
notes).
Allowing for the convertible notes and assuming the convertible noteholders all accept the
Exchange Alternative, the ordinary Challenger shareholders will contribute between 52.6% and
58.5% and will receive 54% of the merged entity.
On this basis of this analysis, it is Grant Samuel’s opinion that Challenger shareholders will
receive an equitable share of the merged company. Challenger shareholders will contribute shares
with an underlying value of $2.00-2.48 and receive units with an equivalent underlying value (on a
pro forma combined basis) of $1.98-$2.34. This analysis is based only on the standalone values of
each business. It could be argued that value of the merged entity should be higher reflecting the
greater growth potential of Global Life once it has access to the expanded capital resources.
8.5
Financial Impacts of the Merger
8.5.1 Asset Backing
The pro forma balance sheet for the merged entity was summarised in Section 7.5. The
balance sheet shows the transformed financial position of the business as a result of the
combination with CPHIC’s cash resources.
In terms of net asset backing, the impact is summarised below:
Net Asset Backing ($ per Challenger share equivalent)
Net assets
A
Challenger - per statutory accounts
B
CPH Management adjustments and accounting policy changes
C
Net tangible
assets27
2.76
2.73
(1.17)
(1.14)
Sub total
1.59
1.59
D
Merger adjustments
0.55
0.23
E
Pro forma after Merger
Increase (E÷C)
2.14
35%
1.82
14%
The table shows that Challenger shareholders will receive an uplift in asset backing as a
result of the Merger if the comparison is done on a “like for like” basis (i.e. after CPH
Management adjustments).
26
Based on matching the low case for Challenger with the high case for CPHIC and vice versa.
27
Note that net tangible assets include certain management rights owned by fund management subsidiaries of Challenger.
Page 75
8.5.2 Earnings
No pro forma combined earnings have been prepared by Challenger or CPHIC for the
merged entity. In view of the changed accounting practices that are intended to be adopted
by the merged entity it was not considered practical or appropriate to prepare them.
In broad terms, there is likely to be a substantial dilution of earnings for Challenger
shareholders. However:
ƒ
it is clear that the sharemarket placed little weight on Challenger’s reported
earnings, valuing Challenger shares immediately prior to the Merger at a price
earnings multiple of less than four times historical (2001/02); and
ƒ
shareholders probably faced earnings dilution in any event. It would be an
inevitable consequence of any substantial capital raising particularly where that cash
raised is required to be maintained largely in liquid assets.
8.5.3 Dividends
Challenger has paid dividends for each of the last four years. No dividend was paid in
respect of the six months ended 31 December 2002.
In the absence of a capital raising or other restructuring Challenger would have faced
increasing constraints on its ability to pay significant dividends, at least until such time as
the property investment model had started to become cash positive.
It is proposed that the merged entity will make regular distributions of a significant
proportion of net profit after tax.
8.6
Advantages of the Merger
8.6.1 Strengthening of the Financial and Capital Position
The major benefit of, and rationale for, the Merger is the substantial strengthening of
Challenger’s financial and capital position.
Challenger’s life business is capital intensive. Its enormous success over the past five years
has created challenges for capital management. Global Life’s long term annuity business is
primarily backed by the properties in which it invests. The net cash flow from these
properties (after servicing external debt) is designed to cover the payment to annuitants.
However, the model typically involves negative operating cash flows in the early years.
Moreover, from a prudential perspective Global Life is required to hold an additional buffer
of assets to underpin the security of annuitants. Any growth in the annuity business needs
to be supported not only by new property assets but also by an additional capital buffer.
The lack of certainty as to exactly how some of the actuarial standards apply (because of
Challenger’s unique business model) have caused some issues but the sheer scale of the
growth in annuity sales has led to a substantial increase in the amount of capital required
(being a function of policy liabilities and risk factors),
In addition, the “quality of capital” has emerged as an issue that APRA is placing
increasing significance on. Challenger’s reserves comprise a range of cash and liquid
investments as well as ownership of a number of Challenger’s funds management
businesses and, in particular, ownership of the capital units in the property trusts. Capital
units are illiquid (and value is based on judgement). Challenger faces an ongoing need to
improve the liquidity of its reserves (i.e. increase the proportion of reserves held in cash and
liquid securities).
These factors have required Challenger to secure additional capital as its long term annuity
business has grown. In the last 18 months, Challenger has:
Page 76
ƒ
raised $85 million by way of a rights issue in July 2001;
ƒ
raised $24 million through dividend reinvestment;
ƒ
raised $75 million through a convertible note raising in December 2002; and
ƒ
transferred ownership of some assets to Challenger Life No 2.
Discussions with APRA are ongoing as to how much additional capital is required to be
injected into Challenger Life No 2 (and in what form) to support the current business even
in the absence of the Merger. Irrespective of this, future growth will require further
substantial amounts of capital. In short, Challenger has an ongoing need to strengthen its
liquid capital position. Indeed, the capital management plan lodged by CPH Management
with APRA for the Merger is indicative of the extent of the issue. CPHIC has agreed to
inject $235 million cash into Statutory Fund 2 which after other adjustments will increase
its net assets by $165 million.
In the absence of raising capital or otherwise addressing the capital issues, Challenger is
likely to have to limit its pursuit of growth both in Global Life and in other businesses (at
least those needing capital). Indeed, there has been a slowing of annuity sales in recent
months. CPHIC has almost $400 million of cash and liquid securities together with
approximately $80 million of other assets. It has no main operating business as such. The
Merger therefore provides what is arguably a perfect complementary fit.
The combined group will have a very substantial capital base and cash reserves. It will
have more than enough to underpin Global Life’s current business and any likely
foreseeable growth for the next several years. It will mean that Global Life should have the
potential to fully exploit the opportunities to develop its business. Certainly, it should be
able to sell annuities at much higher levels than Challenger could as a standalone company.
This should lead to greater shareholder value being created over time.
All of the CPHIC cash resources will not automatically be available to Global Life. Any
injections greater than $235 million will only be injected as necessary to the extent agreed
by CPH Management. From a group perspective, there will be some reluctance to inject
any more capital than is absolutely necessary into Challenger Life. While there is no loss
of value (the funds would be invested in appropriate assets), there is a loss of flexibility and
control over where the funds are invested. Extracting the capital from Challenger Life
would be difficult until the businesses matures. CPHIC would therefore need to be
satisfied that any injection was likely to generate a satisfactory return from the investment
and the annuity business it underpinned.
In addition to the CPHIC cash resources potentially being available for Global Life, they
are also generally available to fund growth initiatives in other parts of Challenger’s
business (assuming the appropriate business case can be made). Despite the current
environment, the funds management/investment services sector has outstanding growth
prospects over the medium to longer term. Challenger has some strong niche businesses
which could be expanded or used to leverage into associated products and services. There
are also some existing operations that need strengthening and developing and investment is
needed in technology platforms and systems.
In essence, after the Merger, Challenger’s growth opportunities should be unconstrained by
issues of financial capacity and capital adequacy.
Moreover, in Grant Samuel’s view, the transformation of the financial position may well
lead to a market rerating of the core Challenger business. It is clear that one of the
sharemarket’s key concerns overhanging the Challenger group and weighing on its share
price has been expectations about the continuing need to raise capital and the company’s
financial risk profile.
Page 77
8.6.2 Liquidity and Investor Demand
Both Challenger and CPHIC are relatively small entities in terms of market capitalisation.
Challenger is included in the S&P/ASX 200 index while CPHIC is only included in the All
Ordinaries index.
Based on a CPHIC unit price of 48-53 cents, the merged entity will have a pro forma
market capitalisation of approximately $1.1-1.2 billion (excluding convertible notes)
ranking it approximately 90 by market capitalisation. It is expected that the merged entity
will be included in the S&P/ASX 100 index in time and depending on liquidity.
Accordingly, it is reasonable to expect an increased level of investor interest in the
combined group and greater liquidity. The increased size of the group and the removal of
any capital constraints/demand issues may attract new investors or persuade those who
were previously concerned about Challenger’s risk profile. It should also lead to greater
interest from analysts. A move into the S&P/ASX 100 index would bring additional
buying from local index funds and other investors who tend to closely track indices. The
free float (i.e. non CPH unitholdings) will be approximately $800-900 million (based on a
unit price of 48-53 cents), substantially greater than the free float of either entity at present.
This increase should result in improved liquidity.
8.6.3 Enhanced Management Resources
CPH Management has employed Mr Chris Cuffe as CEO. He will therefore have effective
management control of the merged entity. Mr Cuffe has an outstanding track record as a
manager in the financial services/funds management industries, primarily through his role
as a senior executive in building the highly successful Colonial First State funds
management business. As Challenger will be the merged entity’s primary business, it will
clearly be a major focus for him.
Mr Cuffe has also announced the appointment of eight new senior executives who will
form the basis of an entirely new management team. A number of these executives
previously worked with Mr Cuffe at Colonial First State and they all have extensive
experience in the financial services industry.
Accordingly, the merged entity will have access to enhanced senior management resources
(albeit with associated employment costs but with savings from departing executives).
These resources may be extremely helpful in a situation where the business has grown
rapidly from a small organisation and needs to consolidate and integrate its activities for the
next stage of development.
At the same time, it should be recognised that:
ƒ
the Global Life business is a unique business in which Mr Cuffe has no direct
experience;
ƒ
there are always risks in bringing in new management. They may not be able to
repeat their previous successes. They may bring different management styles,
decision making processes and strategic visions which do not fit with the current
culture or approach and cause adverse reactions throughout the organisation. Often,
issues cannot be identified until some time later; and
ƒ
new management brings risks of upheavals within the existing management teams.
A number of senior Challenger executives are leaving the group. These executives
have substantial experience and knowledge of the business. There may be further
losses of valuable employees although, equally, a new team of proven operators
combined with the financial strength from the Merger may be attractive to existing
and potential management and staff.
Page 78
8.6.4 Crystallisation of Tax Losses
CPHIC is a unit trust. While it is treated as a company for tax purposes, under current
legislation Challenger shareholders will not receive capital gains tax rollover relief under
the Income Tax Assessment Act when they exchange their shares in Challenger for units in
CPHIC because it is a trust and not a company. However, the Commonwealth Government
has recently announced intended changes to the legislation which will extend rollover relief
to a transaction such as the Merger effective from 1 July 2003. Therefore, it is expected
that the legislation will apply to the Merger and Challenger shareholders may receive
capital gains tax rollover relief.
If this change is not made, CGT rollover relief will not be available. In this case, for those
Australian resident shareholders holding their shares on capital account, the Merger will be
a capital gains tax event. The value of the consideration received for the sale of their shares
will be based on the market value of the CPHIC units at the time of issue (expected to be 1
July 2003). If the CPHIC price remains around 48-53 cents, the consideration will be
valued at $2.16-2.39 per Challenger share. Any shareholder subject to capital gains tax that
acquired their shares for prices above this level will therefore crystallise a capital loss that
can be used to offset any other capital gains in the 2003/2004 income year (or carried
forward to future years). Even if the legislation is passed shareholders can still elect not to
rollover and therefore still crystallise their loss.
Challenger does not have data on shareholders tax positions but it would appear that, based
on the Challenger share price on the ASX, any shareholder that acquired their shares
between March 1999 and October 2002 will be able to crystallise a capital loss.
8.6.5 Distributions
The merged entity’s greater financial strength enhances the ability to pay distributions to
unitholders compared to the dividend paying capacity of Challenger on a standalone basis.
8.6.6 Cost Savings
The Merger should generate some cost savings, although they are relatively minor in the
context of group earnings and assets. These savings primarily relate to duplicated corporate
administration costs including:
8.7
ƒ
boards of directors;
ƒ
annual reports;
ƒ
annual meetings; and
ƒ
company secretarial.
Costs, Disadvantages and Risks
8.7.1 Management Fees
CPHIC is a unit trust managed by CPH Management. The existing management fee
arrangements are set out in Section 5.7. In summary, CPH Management is entitled to
receive:
ƒ
ƒ
an annual management fee of 1.5% of CPHIC’s gross asset value;
ƒ
performance fees on unrealised investments every five years.
a performance fee equal to 20% of realised gains on individual investments achieved
in excess of 10% per annum; and
Management fees will continue to apply to the merged entity after the Merger has been
implemented but certain amendments have been agreed to be made (see Section 7.6).
Page 79
The effect of these management fee arrangements is that Challenger shareholders are
exchanging shares which give them a full pro rata entitlement to any profits and gains for
units where a third party (i.e. CPH Management) is entitled to a share of that profit or gain.
CPH Management will be entitled to receive:
ƒ
1.5% of Challenger’s net assets. Based on an equity value of $616 million (i.e.
including the convertible notes) this is equivalent to an amount of approximately $9
million per annum effectively paid by Challenger shareholders; and
ƒ
20% of future gains (above a hurdle rate of 10%) in the value of the Challenger
business (based on valuations if Challenger is not sold).
In other words, Challenger shareholders’ income and value gain is diluted compared to the
pre merger position. The costs of this arrangement to Challenger shareholders are not
inconsequential. Issues that need to be considered include:
ƒ
no base fee is to be paid until CPHIC units trade above 60 cents over a 10 day
period. The CPHIC unit price since the announcement to 30 April 2003 has been
around 48-53 cents, broadly consistent with CPHIC’s net assets. The analysis of the
Merger is based on these parameters. Accordingly, no base management fee will be
payable until there has been some value accretion for Challenger shareholders (more
than 10%) although share prices are volatile and the price could easily trade above
60 cents and then fall back;
ƒ
there is a slight “benefit” in so far as Challenger’s net assets for calculating the base
management fee are based on 40.5 cents per unit ($1.82 per Challenger share).
Accordingly, the fee is less than it might have been using other bases;
ƒ
some direct value is provided for the base management fee. The total annual base
management fee for the merged entity will be approximately $16 million per annum
($9 million in relation to the equity in Challenger and $7 million for CPHIC’s other
assets). Out of this amount, CPH Management will pay a number of costs which
would otherwise be borne by the merged entity. These include:
•
the employment costs of Chris Cuffe. All other senior executives will be
employed by relevant operating entities;
•
directors fees and other costs associated with the board of directors; and
•
secretarial costs.
Grant Samuel is not aware of Mr Cuffe’s salary package but it appears likely that
there will be a substantial profit margin for CPH Management; and
ƒ
the performance fees could result in very substantial payments to CPH Management
in time and a material dilution of future returns for Challenger shareholders. By
way of example, the following table shows the total performance fees and share of
the gain payable to CPH Management over the seven years to 2010 (two
revaluations) for various growth rates in the value of Challenger based on the
following assumptions:
•
initial equity value $616 million; and
•
100% of performance fees are payable (while only 70% is paid in cash CPH
Management has an ultimate entitlement to 100%).
Page 80
Management Fee Sharing
Per annum growth
in value of Challenger
10%
Fees to
CPH Management
($ millions)
-
Share of Increase in Value
to CPH Management
(%)
-
15%
88
8.6%
20%
201
12.7%
25%
347
15.0%
However:
ƒ
•
the performance fees do not reduce shareholders’ current value. They will
only reduce any future gains in value from the time of the Merger; and
•
these performance fees are consistent with those paid to managers of private
equity funds; and
for the purposes of calculating the performance fees, the cost base for the investment
in Challenger will be 40.5 cents per unit issued (approximately $532 million before
convertible notes and $616 million afterwards). This is approximately $180 million
less than it would be than if it had been based on the market value of CPHIC units to
30 April 2003. CPH Management will therefore be advantaged by having a lower
cost base from which to calculate its 20% performance fee. However, there is
currently a deficit in relation to the performance of CPHIC’s existing investment
portfolio of $137 million which must be first made up before the performance fee
starts to accrue. This will largely offset the low starting value for the Challenger
investment.
8.7.2 Dilution of Upside
One effect of the Merger is that Challenger shareholders will, in aggregate, now only have a
58.9% shares (54-55% after allowing for convertible notes) in the long term gains from the
business, in particular the value that should be created over the long term from the capital
units. If there was no Merger they would retain a 100% exposure to this value. Moreover,
CPHIC unitholders contribute largely cash rather than a business with upside.
However, shareholders need to recognise that they would have faced some form of dilution
from any capital raising. It is doubtful that risk reduction of the portfolio (e.g. by removing
refinancing risk) would have entirely eliminated Challenger’s need for capital.
The essential risk for Challenger shareholders is that they are effectively selling (part of)
Challenger too cheaply. It is clear that Challenger has the potential to create substantial
value over the longer term. With hindsight it may well appear that shareholders diluted
themselves unnecessarily. On the other hand;
ƒ
ƒ
value realisation is a considerable way off; and
the current situation is a cash negative business model and there are capital
pressures. This is likely to prevail for some time.
The realistically achievable value today must reflect these circumstances. This may well
lead to discounts against theoretically justifiable values. Moreover, there are also
considerable downside risks to the business and these are now shared with CPHIC
unitholders through the Merger.
8.7.3 Transaction Costs
The transaction costs to be incurred by Challenger in implementing the Merger are
expected to be approximately $5 million, a significant proportion of which will be incurred
subsequent to the shareholder meeting.
In addition, costs will be incurred in relation to the termination of employment of the senior
Page 81
executives that will be leaving Challenger group as a result of the Merger.
8.7.4 Tax Crystallisation
If the relevant legislation to provide capital gains tax rollover relief in situations such as the
Merger is not enacted, Australian resident shareholders holding their Challenger shares on
capital account whose cost base for their shares is less than $2.16-2.39 (assuming today’s
CPHIC unit prices also prevail at the effective date of the Merger) will incur a capital gains
tax liability.
This tax payable could be a substantial amount for some shareholders depending on when
the shares were acquired. Up until 1999, Challenger shares were trading at less than 40
cents. The disadvantage is compounded by the fact that while the tax is payable in cash, the
Merger itself realises no cash for shareholders. On the other hand, it is only a bringing
forward of tax that will ultimately be payable albeit that the deferral could have been for an
indefinite period.
8.7.5 Tax Consolidation
Under current legislation, CPHIC is not able to become the head of a tax consolidated
group. If the government announcement relating to the treatment of trusts becomes
legislation and the changes are effected then CPHIC will be able to become a tax
consolidated group. If the legislation is not passed in the form proposed there may be some
inefficiencies for the merged group in terms of tax grouping (although Challenger will be
able to form its own tax consolidated group within the CPHIC structure).
8.8
Takeover Analysis
This section considers the transaction as if it were a conventional takeover offer made by CPHIC
to acquire control of Challenger (“the CPHIC Offer”).
Grant Samuel has attributed a value of $2.16-2.39 to the consideration offered by CPHIC based on
a value of 48-53 cents per CPHIC units. This assessment is based on the recent trading range of
CPHIC units. This is the relevant measure as it represents the market value of the consideration.
It is not appropriate to utilise either:
ƒ
the trading price prior to the transaction being announced; or
ƒ
assessments of the underlying value of the offeror.
Challenger shareholders are receiving securities in the merged entity not the pre bid entity. It is
the value of the securities they receive that is relevant not what they were worth in the absence of
the transaction. Similarly, the pre bid underlying value does not represent values related to what
Challenger shareholders receive and, in any event, the underlying values are not accessible by
shareholders. It is the market value of the securities that measures the cash equivalent of what is
being offered.
There are however two tests:
ƒ
is there any reason why the share price is not a fair reflection of true market value? and
ƒ
will the transaction have an impact on the price?
The Merger will have a significant impact on CPHIC and on its market price. In Grant Samuel’s
opinion the market has already impounded much of this impact into the price already. This is
evidenced by the rise from pre announcement levels of around 40 cents. Part of this increase is
likely to be also due to the appointment of Chris Cuffe but this can also be seen as an integral part
of the Merger. It might reasonably be argued that the market is not yet fully informed about the
Merger and its impacts and will only be so once the Scheme Booklets are released. On the other
hand, Challenger is a publicly listed company so there is plenty of information readily available.
Other than for this issue there is no reason to believe that the market for CPHIC units is not a fair
and fully informed market.
Page 82
Grant Samuel regards the recent trading price as the best proxy for the value of the consideration.
Grant Samuel has estimated the full underlying value of Challenger to be in the range of $2.002.48 per share (allowing for dilution from convertible notes). This value includes a premium for
control. On this basis, the CPHIC Offer is fair and reasonable. The valuation range for Challenger
overlaps with the value of the CPHIC Offer.
The CPHIC offer provides a substantial premium for control:
Challenger Share Price vs. CPHIC Offer
September 2002 - April 2003
$3.00
Merger announced
20 January
$2.75
Share price ($)
$2.50
$2.25
Value of CPHIC Offer
$2.00
$1.75
$1.50
$1.25
$1.00
Sep-02
Oct-02
Nov-02
Dec-02
Dec-02
Jan-03
Mar-03
Mar-03
Apr-03
The CPHIC Offer represents a premium of 26-40% over the Challenger share price on the day
prior to the announcement on 20 January 2003. It represents a premium of 32-47% over the
average price in the previous week and previous month. These are substantial premiums and are
consistent with, if not more than, those typically observed in takeover transactions. These
premiums are, in part, reflective of:
8.9
ƒ
the weakness in the Challenger shares price in the weeks preceding the announcement; and
ƒ
the strengthening of the CPHIC unit price since the announcement. CPHIC units were
previously trading at a very substantial discount to its net asset backing (which was mostly
cash). The transformation of CPHIC into an operating business as a result of the
transaction has eliminated the “investment company discount”.
Placement Analysis
The transaction can be viewed as a large placement. If the fact that shareholders are swapping
their shares for CPHIC units and that CPH Management is taking management control are ignored,
then the transaction effectively involves Challenger issuing a 41.1% stake in its business in
exchange for cash and liquid assets of approximately $400 million together with some other
smaller assets.
This is equivalent to Challenger issuing new shares at $2.06-2.22 (of which approximately $2 per
share is received in cash and liquid securities). The composition (based on the 31 December 2002
balance sheet) is summarised below:
Page 83
Placement Analysis
Estimated Value of CPHIC
($millions)
Low
Cash
Listed investments
Cash and liquid investments
Equivalent Value per
Challenger Share ($)
High
Low
High
323.6
323.6
1.59
1.59
87.0
91.0
0.43
0.44
2.03
410.6
414.6
2.02
Unlisted investments
71.0
88.0
0.35
0.43
Other assets and liabilities
(5.6)
(5.6)
(0.03)
(0.03)
Capitalised overheads
(55.0)
(45.0)
(0.27)
(0.22)
Total
421.0
452.0
2.06
2.22
In the month preceding the announcement of the Merger, Challenger shares traded in the range
$1.54-1.75, with a weighted average price of $1.64.
Accordingly, as a placement, the transaction is taking place on very favourable terms. New capital
is being raised at prices well above the prevailing market price. It is similarly well above the price
at which Challenger would be able to raise money by undertaking a large equity raising by way of
placement and/or rights issue. Any equity raising will normally take place at some discount to the
market price at the time. Even a tightly priced issue would involve discounts of up to 5%.
Given Challenger’s likely need for capital on an ongoing basis to support its growth, a large equity
raising by way of placement or rights issue/placement combination was an alternative that
Challenger may have faced. To the extent the raising involves external parties (i.e. is non pro rata)
the pricing of the new equity is relevant to existing shareholders. In this context:
ƒ
this placement is to a diverse body of new investors with the exception of CPH (which
slightly increases its equity ownership by effectively participating in 31% of the issue
compared to its existing 18% interest); and
ƒ
in the current market environment, Challenger would in fact have considerable difficulty
raising a substantial amount of new equity capital whether by way of placement or other
means (and certainly not to the extent of $400 million).
Of course, the issues of structural change and the change in management control cannot be ignored
but this analysis nevertheless provides some perspective on the issues shareholders might face if
the Merger is not approved.
8.10 Alternatives
Challenger has considered a number of alternative transactions or strategies primarily with a view
to resolving the capital issues relating to the long term annuity business. These have included:
ƒ
reduction in the risk profile of the property model and therefore the capital requirements
through elimination or reduction of refinancing risk;
ƒ
sale of Challenger Life No 2 as a passive property investment structure with Challenger
Life No 1 remaining as an annuity provider;
ƒ
sale of capital units;
ƒ
sale of properties in the portfolio;
ƒ
sale of non life businesses;
ƒ
a capital raising by Challenger;
ƒ
a capital raising for, or partial sale of new equity in, Challenger Life No 2; and
ƒ
reduction in the level of annuity sales.
Page 84
The directors consider these to be less attractive alternatives than the Merger (although Challenger
will be progressing the refinancing projects in any event). A number of these involve untested
avenues (e.g. sale of capital units) where the prospects of finding a buyer are unknown. Almost all
involve considerable uncertainties and potential for delay. The major refinancing is a very large
project to which substantial uncertainty attaches. In any event, elimination of refinancing risk on
its own may not entirely resolve the capital issues.
In relation to the possibility of raising capital:
ƒ
equity markets are relatively weak at the present time and raising capital in such
circumstances is inherently difficult;
ƒ
Challenger’s business model is long term. The substantial gains that accrue to shareholders
become more “tangible” in time but in the short to medium term there is a cash flow
deficiency. This is not attractive to a market with a focus on short term paybacks; and
ƒ
Challenger has already raised significant sums from the market. Its ability to keep “going
back to the well” is limited, at least before positive cash flows start to arise and, arguably,
until there is some real prospect of consistent dividends.
In contrast, the Merger provides certainty of securing $400 million in cash resources and of fully
resolving all of the capital issues, providing a solid foundation to exploit the growth potential of
the business.
If the Merger is not implemented:
ƒ
the Challenger share price is likely to fall significantly from its current levels of $2.00-2.30
(in the absence of any alternative transaction); and
ƒ
the directors will need to pursue one or more of the alternatives outlined above. There is
certainly no guarantee that any of these would produce a value outcome for shareholders
more favourable than the Merger; and
ƒ
Challenger may need to secure new management. Mr Cuffe and the new senior team are
presently employed by CPH Management.
The Merger was announced on 20 January 2003. In the following three months no other party has
put forward an alternative proposal. There is no impediment to any party doing so.
8.11 Options
In Grant Samuel’s opinion, the Options Scheme is in the best interests of optionholders.
Optionholders retain their current options but upon exercise will convert into CPHIC units on the
same basis as the ordinary shareholders (i.e. the same outcome as if they exercised their options
now). Accordingly, the position of optionholders is preserved in terms of their potential
entitlement to value and they are being treated fairly. If the Options Scheme is not approved
optionholders would end up (if they exercised their options) with shares in Challenger. This
would be an unlisted entity controlled by CPHIC. There would be no market for the shares.
CPHIC would in any event probably own more than 90% of Challenger and be in a position to
compulsorily acquire the shares received. It is far from certain that this acquisition would be on
more favourable terms than the terms of the Options Scheme.
8.12 Convertible Notes
In Grant Samuel’s opinion, the Notes Scheme is in the best interests of convertible noteholders.
Noteholders will have a choice between:
ƒ
the Retention Alternative - retaining their notes and ultimately converting each note into 4.5
units in CPHIC; or
ƒ
the Exchange Alternative - exchanging their notes now for 5.5 new units in CPHIC.
Page 85
The first alternative is the same as that provided to optionholders. It preserves their position and
enables noteholders (if they do ultimately convert) to convert their Challenger equity on the same
terms as the ordinary shareholders receive under the Share Scheme. The Exchange Alternative
provides an additional alternative to noteholders which may be more attractive to some
noteholders. The Exchange Alternative is worth approximately 50 cents (i.e. one extra unit in
CPHIC) but:
ƒ
noteholders give up the guaranteed yield on the notes. This is worth 19 cents per annum
per note for the next five years (95 cents in aggregate or about 70 cents in present value
terms discounted at 12%). At the same time, noteholders who exchanged their notes would
be entitled to any distributions on CPHIC units over the same period. There are no
forecasts of CPHIC distributions but the “breakeven” position would be an average annual
distribution of approximately 1 cent per unit (equal to total dividends of approximately
$22-24 million). In other words, if the CPHIC distribution is expected to exceed this level,
noteholders will be better off taking this alternative in terms of the income they will
receive. In this context, it is proposed that the merged entity will on a regular basis
distribute a significant proportion of net profit after tax; and
ƒ
noteholders will be giving up the downside protection of the convertible note which
guarantees a minimum of $2.00 upon redemption. Accordingly, if the CPHIC price falls
below 36 cents the value of their CPHIC unitholding will fall below $2.00 (5.5 x 36 cents).
If a noteholder elects the Retention Alternative they will have what is effectively a 9.5% bond and
a five year option to acquire 4.5 CPHIC units at a price of 44 cents per unit.
Noteholders will have to weigh these issues in deciding between the two alternatives and should
note that they will be deemed to have selected the Exchange Alternative if they fail to make an
election and the Notes Scheme is approved.
If the Notes Scheme is not approved, noteholders face the prospect of converting into shares in an
unlisted Challenger controlled by CPHIC. Depending on the extent of conversions, they may hold
more or less than 10% of Challenger. The value that could be extracted in these circumstances is
not clear and there is no guarantee it would be more favourable than the Note Scheme.
Page 86
9
Qualifications, Declarations and Consents
9.1
Qualifications
The Grant Samuel group of companies provide corporate advisory services (in relation to mergers
and acquisitions, capital raisings, corporate restructurings and financial matters generally),
property advisory services and manages private equity and property development funds. The
primary activity of Grant Samuel & Associates Pty Limited is the preparation of corporate and
business valuations and the provision of independent advice and expert’s reports in connection
with mergers and acquisitions, takeovers and capital reconstructions. Since inception in 1988,
Grant Samuel and its related companies have prepared more than 270 public expert and appraisal
reports.
The persons responsible for preparing this report on behalf of Grant Samuel are Stephen Wilson
MCom(Hons) CA(NZ) FSIA, Caleena Stilwell BBus CA ASIA, Daniel Gerber BCom LLB ASIA
and Marisa Leone BBus(EcoFin) ASIA. Each has a significant number of years of experience in
relevant corporate advisory matters. Alison Long BCom CFA CA and Scott Kirkby BCom LLB
assisted in the preparation of parts of this report. Each of the above persons is an authorised
representative of Grant Samuel pursuant to its Dealers Licence under Part 7.3 of the Corporations
Act.
9.2
Disclaimers
It is not intended that this report should be used or relied upon for any purpose other than as an
expression of Grant Samuel’s opinion as to whether the Merger is in the best interests of
Challenger securityholders. Grant Samuel expressly disclaims any liability to any Challenger
securityholder who relies or purports to rely on the report for any other purpose and to any other
party who relies or purports to rely on the report for any purpose whatsoever.
This report has been prepared by Grant Samuel with care and diligence and the statements and
opinions given by Grant Samuel in this report are given in good faith and in the belief on
reasonable grounds that such statements and opinions are correct and not misleading. However,
no responsibility is accepted by Grant Samuel or any of its officers or employees for errors or
omissions however arising in the preparation of this report, provided that this shall not absolve
Grant Samuel from liability arising from an opinion expressed recklessly or in bad faith.
Grant Samuel has had no involvement in the preparation of the Scheme Booklets issued by
Challenger and has not verified or approved any of the contents of the Scheme Booklets. Grant
Samuel does not accept any responsibility for the contents of the Scheme Booklets (except for this
report).
Grant Samuel has had no involvement in Challenger’s due diligence investigation of CPHIC and
does not accept any responsibility for the completeness or reliability of this process which is the
responsibility of Challenger.
9.3
Independence
Grant Samuel and its related entities do not have at the date of this report, and have not had within
the previous two years, any shareholding in or other relationship with Challenger or CPHIC, that
could reasonably be regarded as capable of affecting its ability to provide an unbiased opinion in
relation to the Merger. A subsidiary of CPH is a minor investor in a property development fund
managed by a member of the Grant Samuel group of companies. Grant Samuel had no part in the
formulation of the Merger. Its only role has been the preparation of this report.
Grant Samuel will receive a fixed fee of $425,000 for the preparation of this report. This fee is not
contingent on the outcome of the Merger. Grant Samuel will receive no other benefit for the
preparation of this report.
Grant Samuel considers itself to be independent in terms of Practice Note 42 issued by the ASIC
(previously known as Australian Securities Commission) on 8 December 1993.
Page 87
9.4
Declarations
Challenger has agreed that, Challenger will indemnify Grant Samuel and its employees and
officers in respect of any liability suffered or incurred as a result of or in connection with the
preparation of the report. This indemnity will not apply in respect of the proportion of any liability
found by a court to be primarily caused by any conduct involving gross negligence or wilful
misconduct by Grant Samuel. Challenger has also agreed to indemnify Grant Samuel and its
employees and officers for time spent and reasonable legal costs and expenses incurred in relation
to any inquiry or proceeding initiated by any person. Where Grant Samuel or its employees and
officers are found to have been grossly negligent or engaged in wilful misconduct Grant Samuel
shall bear the proportion of such costs caused by its action. Any claims by Challenger are limited
to an amount equal to the fees paid to Grant Samuel.
Advance drafts of this report were provided to Challenger and its advisers. Parts of the report
relating to CPHIC were provided to CPH Management and its advisers. Certain changes were
made to the drafting of the report as a result of the circulation of the draft report. There was no
alteration to the methodology, evaluation or conclusions as a result of issuing the drafts.
9.5
Consents
Grant Samuel consents to the issuing of this report in the form and context in which it is to be
included in the Scheme Booklets to be sent to securityholders of Challenger. Neither the whole
nor any part of this report nor any reference thereto may be included in any other document
without the prior written consent of Grant Samuel as to the form and context in which it appears.
9.6
Other
The accompanying letter dated 9 May 2003 and the Appendices form part of this report.
GRANT SAMUEL & ASSOCIATES PTY LIMITED
9 May 2003
Page 88
Appendix 1
Challenger Property Portfolio as at 31 December 2002
Property
Discovery House
Bird Cameron Building
Vodafone, Kingston
Rexel, North Ryde
ABS Building
Heidelberg, Bowen Hills
Heidelberg, Waterloo
County Court
Makerston
The Forum, Cisco
The Forum, Uunet
Goodman Fielder, North Ryde
Executive Building, Hobart
Taylor’s Institute, Waterloo
Senator House
CSIRO
Minister Court
Hayes Park
DIMIA Building
World Business Centre
Elder House
Mobil House
Kraft, Port Melbourne
Las Cimas II & III
50 Milk St
Globe, Port Melbourne
Commercial Total
Albury Cinema Centre
Century City Walk
Jam Factory
Rivoli
Village City Centre
Village Geelong
Village Hobart
Village Hoyts Cinema Centre
Village Launceston
Innaloo Cinema Centre
Entertainment/Cinemas Total
Auto Group, Enfield
Wesfarmers Woolstore, Brooklyn
Elders Woolstore, Gillman
APP Richlands
CPI Braeside Park
CPI Wetherill Park
Spicers, Cannington
Spotlight, Laverton North
Tyco
12-30 Toll Drive, Altona North
1-9 Toll Drive, Altona North
2-10 Toll Drive, Altona North
Tetra Pak, Fairfield
Industrial Total
Chapel Street Airrights
Kings Langley
Retail Total
Total
Source: Challenger
ACT
WA
TAS
NSW
ACT
QLD
NSW
VIC
QLD
NSW
NSW
NSW
TAS
NSW
United Kingdom
NSW
United Kingdom
United Kingdom
ACT
UK
SA
VIC
VIC
United States
United States
VIC
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Commercial
Acquisition
Date
28/4/1998
23/11/1998
19/3/1999
18/12/1999
1/1/2000
7/1/2000
7/1/2000
30/6/2000
14/12/2000
5/1/2001
5/1/2001
23/2/2001
30/3/2001
16/5/2001
3/5/2001
27/6/2001
7/7/2001
1/12/2001
14/12/2001
22/3/2002
21/6/2002
27/6/2002
28/6/2002
15/7/2002
15/10/2002
30/9/2002
NSW
VIC
VIC
VIC
VIC
VIC
TAS
NSW
TAS
WA
Entertainment/Cinemas
Entertainment/Cinemas
Entertainment/Cinemas
Entertainment/Cinemas
Entertainment/Cinemas
Entertainment/Cinemas
Entertainment/Cinemas
Entertainment/Cinemas
Entertainment/Cinemas
Entertainment/Cinemas
4/7/2000
4/7/2000
4/7/2000
4/7/2000
4/7/2000
4/7/2000
4/7/2000
4/7/2000
4/7/2000
17/12/2001
NSW
VIC
SA
QLD
VIC
NSW
WA
VIC
QLD
VIC
VIC
VIC
NSW
Industrial
Industrial
Industrial
Industrial
Industrial
Industrial
Industrial
Industrial
Industrial
Industrial
Industrial
Industrial
Industrial
17/2/1999
28/5/1999
25/6/1999
29/12/1999
29/12/1999
29/12/1999
29/12/1999
11/5/2000
1/12/2000
31/1/2001
31/1/2001
31/1/2001
9/5/2002
VIC
NSW
Retail
Retail
State/Country
Sector
15/5/2001
29/8/2001
Acquisition Price
30,550,000
10,050,000
12,800,000
15,120,000
106,000,000
1,950,000
12,800,000
176,000,000
38,000,000
96,000,000
61,000,000
37,000,000
20,650,000
35,000,000
241,700,000
140,000,000
235,000,000
211,089,220
86,000,000
67,825,000
40,200,000
73,000,000
24,140,000
113,802,315
200,238,000
17,260,000
2,103,174,535
5,100,000
24,100,000
74,900,000
12,700,000
21,200,000
7,700,000
10,000,000
68,500,000
2,000,000
20,300,000
246,500,000
15,600,000
26,250,000
8,640,000
10,500,000
21,000,000
21,200,000
7,250,000
12,100,000
6,500,000
10,850,000
2,800,000
5,250,000
17,400,000
165,340,000
6,100,000
14,100,000
20,200,000
2,535,214,535
Appendix 2
Market Evidence
1
Introduction
Application of the capitalisation of earnings methodology involves analysis of earnings multiples that other buyers
have been prepared to pay for similar businesses in the recent past and a review of the multiples at which shares in
comparable listed companies trade on the sharemarket. In reviewing valuation parameters that may apply to the funds
management and financial planning operations of Challenger, Grant Samuel has concentrated on comparable
transactions and sharemarket process for Australian businesses in those sectors. Market evidence in relation to
businesses in different countries can be analysed for comparative purposes but it is necessary to give consideration to
differences in overall sharemarket levels and ratings between countries, economic factors and market structures. In
the case of funds management and financial planning sectors Grant Samuel considers there is sufficient market
evidence in Australia and therefore it is not necessary to analyse international market evidence.
Regard has also been given to market capitalisation or consideration paid as a percentage of funds under
management, administration and advice (“FUM”) which is a rule of thumb used to assess value for funds management
and financial planning businesses. However, the resulting percentage of FUM can be significantly affected by the
mix of activities of a company or business particularly where there is a significant component of non funds
management /financial planning activities. Further, the percentage of FUM does not necessarily reflect the future
earnings growth of the particular business.
2
Valuation Evidence from Transactions
There has been considerable transaction activity in the Australian funds management and financial planning industries
in recent years. Such transactions provide some guidance as to the prices that potential acquirers of Challenger’s fund
management and financial planning operations may be willing to pay. A selection of relevant Australian transactions
since 1998 is set out below:
Recent Australian Transaction Evidence
Date
Feb
2003
Feb
2003
Target
AM Corporation
Limited’s Lifetrack
operations.
Tyndall Investments
(Australia) Limited
Oct
2002
Aug
2002
Aug
2002
State Super Financial
Services Limited
BT Financial Group
Aug
2002
Permanent Trustees
Company Limited
Hastings Funds
Management Limited
Transaction
Consideration1
($millions)
Acquisition by IOOF
Holdings Ltd
Acquisition by James
Fielding Holdings
Limited
Acquisition of 15% by
CSS/PSS Boards
Acquisition by Westpac
Banking Corporation
Acquisition of 51% by
Westpac Banking
Corporation
Acquisition by Trust
Company of Australia
Limited
FUM2
($millions)
Consideration
/FUM
(%)
1.8
Price Earnings
Multiple3 (times)
Forecast
Historical
Forecast
6
na
na
na
4.3
na
na
na
na
3,501
4.3
18.9
na
13.6
na
900.0
20,100
4.5
na
na
na
na
70.6
2,000
3.5
na
na
na
na
108.0
na
na
26.5
na
11.9
na
5
2,800
22.7
534
150.0
50.0
1
Implied value if 100% of company or business had been acquired.
2
Funds under management, administration and advice.
Historical
EBIT Multiple4
(times)
na
3
Represents consideration divided by net profit after tax.
4
Represents gross consideration divided by EBIT. The gross consideration is the sum of the equity and/or cash consideration plus borrowings
net of cash.
5
This is rumoured consideration. No public announcement has been made.
6
na = not available.
Recent Australian Transaction Evidence
Date
133.0
1,700
Consideration
/FUM
(%)
7.8
Acquisition by AXA
205.0
Asia Pacific Holdings
Limited
Rothschild Australian Acquisition by Westpac
323.0
Asset Management
Banking Corporation
na
Formation of ANZ/ING 3,753.07
Funds Management
Joint Venture
Sterling Grace Portfolio Acquisition by AXA
220.0
Management Limited Asia Pacific Holdings
Limited
DFS Financial
Acquisition by
7.5
Planning
Stockford Limited
115.0
Deutsche’s Financial Acquisition by National
Planning and Portfolio Australia Bank Limited
Management
Businesses
County Investment
Acquisition by
110.0
Management
Amvescap Plc
4,700
Target
Jul
2002
IOOF Holdings Ltd
Jul
2002
IPAC Securities
Limited
Apr
2002
Apr
2002
Oct
2001
Jul
2001
Feb
2001
Dec
2000
Transaction
Acquisition of 8.16% by
Bendigo Bank Limited
Consideration
($millions)
FUM
($millions)
Price Earnings
Multiple (times)
Historical
Forecast
EBIT Multiple
(times)
Historical
Forecast
na
na
na
na
4.4
na
13-17
na
na
10,600
3.1
23.9
na
na
na
38,300
9.8
20.1
na
na
na
2,600
8.5
26.6
na
18.3
na
650
1.2
na
na
na
na
5,200
2.2
23.0
na
na
na
14,100
0.8
78.6
na
na
na
Oct
2000
AXA Trustees
Acquisition by
Perpetual Trustees
Australia Limited
24.0
430
5.6
na
na
na
na
Sep
2000
Apr
2000
Bridges Financial
Services
MLC Limited
Acquisition by Tower
168.0
Limited
Acquisition by National 4,560.0
Australia Bank Limited
4,700
3.6
25.3
na
na
na
33,800
13.5
23.6
20.7
20.8
8.1
Mar
2000
Deutsche Life
Limited
Acquisition by
Challenger International
Limited
45.6
250
18.2
na
na
na
na
Mar
2000
Colonial Limited
Acquisition by
Commonwealth Bank
of Australia Limited
8,911.0
62,700
14.2
19.6
na
na
na
Nov
1999
Garrisons Pty Ltd and
Synergy Master
Trusts
Acquisition by
Challenger International
Limited
37.0
565
6.5
na
na
na
na
Sep
1999
Heine Management
Limited
Acquisition by
Mercantile Mutual
Holdings Limited
110.7
2,700
4.1
15.7
na
9.5
na
Aug
1999
Schroders Australian
Property Funds
Management
Acquisition by AMP
Asset Management
112.5
3,000
3.8
na
na
na
na
Aug
1999
Norwich Union Trust
Management Rights
Acquisition by
Challenger International
Limited
6.0
297
2.0
na
na
na
na
Jul
1999
Symetry Ltd
Acquisition of 60% by
9.2
Perpetual Trustees
Australia Limited
Godfrey Pembroke
Acquisition by MLC
40.6
Limited
Limited
BT Funds Management Acquisition by Principal 2,100.0
Financial Group
250
3.7
na
na
na
na
3,200
1.3
79.7
na
38.1
na
37,600
5.6
25.0
na
na
na
Jun
1999
Jun
1999
7
Consideration represents the total value attributed to the joint venture at the time of formation.
Page 2
Recent Australian Transaction Evidence
Date
Target
Transaction
Consideration
($millions)
FUM
($millions)
Consideration
/FUM
(%)
Price Earnings
Multiple (times)
Historical
Forecast
EBIT Multiple
(times)
Historical
Forecast
Feb
1999
Tyndall Australia Ltd
Acquisition by Royal &
Sun Alliance Life
Assurance Australia
Limited
738.0
7,550
9.8
21.7
20.9
20.6
na
Dec
1998
Wilson Dilworth
Acquisition of 60% by
Perpetual Trustees
Australia Limited
37.2
585
6.4
22.5
na
na
na
Sep
1998
Aug
1998
Portfolio Partners
Acquisition by Norwich 125.0-187.08
Union Plc
Acquisition by Colonial 1,250.0
Limited
May
1998
Prudential
Corporation’s
Australian & New
Zealand operations
Howard Financial
Holdings Limited
May
1998
EquitiLink Unit Trust
operations
May
1998
Hartley Poynton’s
fund management
operations
Legal & General
Australia
SEALCORP
Holdings Limited
May
1998
Jan
1998
Acquisition by
Challenger International
Limited
Acquisition by
Challenger International
Limited
Acquisition by
Challenger International
Limited
Acquisition by Colonial
Limited
Acquisition by St
George Bank Limited
5,300
2.4-3.5
14.6-21.8 11.5-17.2
8,200
15.2
16.4
33.6
600
5.6
24.8
4.1
225
1.8
1.9
176
892.0
271.6
11.7-17.69
9.6-14.3 7.5-11.2
na
na
na
24.3
na
na
na
na
na
1.1
na
na
na
na
6,400
13.9
16.2
13.9
na
na
3,600
7.5
27.4
22.8
18.5
17.9
Source: Bloomberg, IRESS, Company Reports, Brokers’ Reports.
These transactions imply the following multiples for funds management and financial planning businesses in
Australia:
ƒ
historical multiples in the range of 14.6-27.4 times net profit after tax and 9.5 -24.3 times EBIT (after excluding
MLC’s acquisition of Godfrey Pembroke Limited in June 1999 which was at multiples of 79.7 and 38.1 times
respectively);
ƒ
ƒ
forecast multiples in the range of 11.5-22.8 times net profit after tax and 7.5-17.9 times EBIT; and
0.8-18.2% of FUM.
However, in considering these multiples the following factors should be taken into account:
ƒ
a number of the transactions (eg. Tyndall Australia, MLC, Colonial, ANZ/ING Funds Management Joint
Venture, Deutsche Life, Prudential Corporation and Legal & General) involve businesses with significant non
fund management operations (in particular, life and income insurance activities). As a consequence the
multiples of FUM implied by these transactions are at the high end of the range - in the range of 9.8-18.2 times;
ƒ
many of the acquisitions have been strategic either by providing the acquirer an entry into the Australian market,
(eg. Principal’s acquisition of BT Funds Management and Amvescap’s acquisition of County Investment
Management) or by achieving a quantum leap in the acquirer’s funds under management (eg. St George Bank’s
acquisition of SEALCORP, Westpac’s acquisitions of Rothschild Australian Asset Management and BT
Financial Group and AXA’s acquisition of Sterling Grace) or by strengthening existing alliances (eg. Bendigo
Bank’s minority investment in IOOF);
8
This is rumoured consideration. No public announcement has been made.
9
Range based on estimates of forecast net profit after tax by market commentators at the time.
Page 3
ƒ
businesses with a high proportion of retail funds under management (eg. Bridges (100%), BT Financial Group
(57%), Sterling Grace (100%) and IPAC Securities (70%)) have commanded higher prices than businesses with
predominantly wholesale funds under management (such as County Investment Management (98%) and
Rothschild Australian Asset Management (72%)); and
ƒ
a number of the above transactions involve businesses primarily involved in property funds management (eg.
Schroders Australian Property Funds Management, Heine Management Limited and Tyndall Investments) or
infrastructure funds management (eg. Hastings Funds Management).
Consequently, the transaction evidence implies that during the last five years purchasers of predominantly retail funds
management and financial planning businesses (without significant other activities) have been willing to pay multiples
in the following ranges:
ƒ
ƒ
ƒ
15.7-26.6 times historical net profit after tax;
9.5-24.3 times historical EBIT; and
1.1-8.5% of FUM.
The top ends of these valuation parameter ranges reflect transactions with significant strategic value. However,
during the last year (particularly following the downturn in equity markets) a number of the strategic acquirers (eg.
Commonwealth Bank) have recognised writedowns against the carrying values of their funds management and
financial planning businesses. These acquisitions have not necessarily performed at the level the acquirers expected
and the outlook for improved in profitability is restrained. Consequently, multiples implied by the recent transaction
evidence set out above may overstate the price that an acquirer may be willing to pay at the current time.
3
Valuation Evidence from Sharemarket Prices
Valuation parameters that may apply to Challenger’s funds management and financial planning operations include the
sharemarket ratings of listed companies in those sectors in Australia. While the operations of these companies are not
directly comparable to Challenger, they provide some support for the multiples implied by the valuation:
Sharemarket Ratings of Selected Listed Companies
Company
Market
Capitalisation
FUM
($millions) ($millions)
AMP Limited
AXA Asia Pacific Holdings Limited
Perpetual Trustees Australia Limited
Tower Limited
City Pacific Limited
Trust Company of Australia Limited
Investor Group Limited
Count Financial Limited
Equity Trustees Limited
Hartleys Limited
Fiducian Portfolio Services Limited
MFS Leveraged Investments and
Securities Trust
10,201.7 255,600
3,879.9
51,777
1,213.5
16,500
NZ351.3 NZ20,675
173.9
350
171.2
8,189
102.2
3,900
89.9
5,000
30.0
839
26.6
2,900
19.2
500
17.6
440
Market
Capitalisation
/FUM
(%)
Price Earnings Multiple10
(times)
EBIT Multiple11
(times)
2002
2003
2004
2002
2003
2004
Historical
Forecast
Forecast
Historical
Forecast
Forecast
4.0%
7.5%
7.4%
1.7%
49.7%
2.1%
2.6%
1.8%
3.6%
1.0%
3.8%
20.6
12.1
15.1
nmf12
33.4
18.1
10.4
18.8
8.4
nmf
16.5
4.0%
nmf
12.6
10.7
16.9
8.0
na
na
10.0
17.2
na
na
47.9
10.1
8.8
15.8
5.4
na
na
8.7
13.9
na
na
23.9
na
na
13.2
na
25.8
12.2
9.1
13.5
18.1
nmf
14.2
na
na
11.4
na
na
na
9.9
10.7
na
na
nmf
na
na
10.9
na
na
na
8.3
9.9
na
na
20.2
na
na
nmf
na
na
Source: Bloomberg, IRESS, Company Reports, Brokers’ Reports.
10
Represents market capitalisation divided by net profit after tax before goodwill amortisation.
11
Represents enterprise value (that is, the sum of market capitalisation adjusted for minorities, plus borrowing less cash as at the latest balance
date) divided by EBIT.
12
nmf = not meaningful
Page 4
All of Australia’s listed retail banks provide funds management and financial planning activities as part of wider
banking and financial service offerings. Multiples have not been prepared for these companies as they would not
provide a meaningful comparison for the valuation of Challenger’s activities.
In analysing the table above, the following factors should be taken into account:
ƒ
the multiples in the table are based on share market prices as at 30 April 2003 and do not reflect a premium for
control;
ƒ
all of the companies have a 30 June year end with the exception of AXA Asia Pacific Holdings Limited
(“AXA”) and AMP Limited (“AMP”) which have a 31 December year end, Trust Company of Australia Limited
(“Trust Company”) which has a 28 February year end, MFS Leveraged Investments and Securities Trust
(“MFS”) which has a 31 July year end and Tower Limited (“Tower”) which has a 30 September year end. The
historical multiples for the companies are based on results for the 2002 financial year;
ƒ
AMP is an international financial services organisation focused on wealth management. Its activities include
retirement savings and incomes, funds management, life insurance and general insurance, financial planning and
banking services. AMP incurred a loss of $896 million for the year to December 2002, compared to a net profit
of $690 million in the prior year. This loss was the result of one-off restructuring costs and a significant erosion
of value of the United Kingdom life insurance operations which have been directly impacted by falling United
Kingdom equity markets. AMP’s share price fell from $19.76 in March 2002 to a low of $5.86 in March 2003
as a result of the losses, management upheaval and fears that further cash would be required to be invested in the
United Kingdom life operations to remain above regulatory requirements. During April 2003 the share price
recovered to a price of $8.73 on 30 April 2003. On 1 May 2003 AMP announced a major restructuring
including a demerger along geographic lines (Australasia and United Kingdom), a $1.5 billion capital raising
through an institutional placement (at $5.50 – a 37% discount to market) and a share purchase plan and
writedowns of approximately $2.6 million. When trading recommenced on 5 May 2003 the AMP share price
declined to around the level of the placement. The market capitalisation and brokers’ forecasts used to prepare
the table above are pre-announcement and therefore the forecast multiples are high;
ƒ
AXA’s activities comprise life and income insurance, retirement annuities, funds management and related
financial services in Australasia and Hong Kong. It incurred a full-year result in 2002 well above expectations
due to substantial increases in investment income from the China Region and a 50% rise in earnings in Australia
and New Zealand (after excluding the health insurance business which was sold during the period);
ƒ
Perpetual Trustees Australia Limited (“Perpetual”) is a provider of financial services offering funds
management, retirement savings and incomes, portfolio management, financial planning, trustee, responsible
entity and compliance services, executor services, investment administration and custody services. It offers
managed investment funds services to both retail and wholesale to individuals and institutional investors.
Approximately 80% of funds under management at 30 June 2002 were retail in nature;
ƒ
Tower is a New Zealand company with activities in Australia and New Zealand. Its activities include life
insurance, financial planning, funds management and superannuation services. Tower incurred a loss of
NZ$75million in the year to 30 September 2002. Weak investment markets, significant restructuring costs, a
write-down in the carrying value of Bridges and poor performance in Australia were the major contributors to
the loss;
ƒ
City Pacific Limited (“City Pacific”) is a finance and investment manager in Australia which invests largely in
mortgage backed securities. At December 2002, City Pacific had $350 million in funds under management.
The company loan books are mezzanine and short term in nature. In October 2002, City Pacific launched a
Diversified Property Trust, which principally invests in property assets that are linked with City Pacific's
property development investments. City Pacific’s valuation parameters are comparatively high as a
consequence of its share price which may reflect an expectation that of substantial growth in the future;
ƒ
Trust Company completed a merger with Permanent Trustee Company Limited in December 2002. The merged
company provides funds management, superannuation, financial planning, accounting services, corporate
services, wills and estates services, custody, compliance and securitisation services. The combined company
has $1.4 billion funds under management and $6.8 billion funds under trusteeship. Market capitalisation as a
Page 5
percentage of funds under management is comparatively low at 1.9% reflecting the extent of funds under
trusteeship rather than management. The 2002 historical multiples are based on proforma 2002 earnings as set
out in the merger information memorandum;
ƒ
Equity Trustees Limited (“Equity Trustees”) provides trustee services to private clients and managed funds.
The company has ten investor funds targeting retail and estate clients. Total funds under management at 30
September 2002 was $839 million. In 2002 Equity Trustee derived approximately 28% of revenue from funds
management activities and 28% of revenues from trustee services in the year ended 30 June 2002;
ƒ
MFS is a trust which primarily invests in mortgage and property related securities and direct investments. It is
managed by McLaughlins Financial Services Limited. The Trust has both a short-term and long-term
investment strategy, where the short-term strategy includes investing in risk-assessed mezzanine loans secured
by mortgages. In December 2002, MFS substantially restructured its capital base by issuing 11.1 million units
and 11.1 million bonus options which entitled holders to subscribe for one unit in MFS at an exercise price of
$1.50 per unit. Consequently, MFS’s historical multiples are not a meaningful comparison;
ƒ
Fiducian Portfolio Services Limited (“Fiducian”) provides funds management, client administration and
financial planning services to financial adviser groups in Australia. Fiducian aims to become a full 'wrap'
service provider by expanding its distribution network and increasing the number of dealer groups and financial
planners that support Fiducian products. In the year ended 30 June 2002, the funds management division
accounted for 88% of total revenues with the remainder coming from financial planning. Operating
performance in 2003 has been poor and funds under advice have declined by 10% to $500 million. Fiducian is
expected to make an EBIT loss and a small net profit after tax in 2003. Some improvement in profitability is
expected in 2004. Consequently, forecast multiples calculated in the above table are high;
ƒ
Investor Group Limited (“Investor Group”) is primarily involved in accounting advisory, taxation, financial
planning, personnel superannuation and rollover investment advice. The financial services division has $3.9
billion funds under advice. In the year ended 30 June 2002 Investor Group reported a $6.3 million net profit
which was a 56% improvement over the previous year. During March and April 203 Investor Group acquired a
number of accounting businesses from Stockford Limited which is in voluntary administration. The brokers’
forecasts used in the table above do not reflect all of the acquisitions made and therefore the forecast multiples
(particularly for 2004) are high;
ƒ
Count Financial Limited (“Count”) is an accountant-based financial and investment advice group with over $5
billion of funds under advice. Count’s profitability increased in the 2002 year due to significant increases in
investment income and an increase in the number of franchisees; and
ƒ
Hartleys Limited (“Hartleys”), formerly HP JDV Limited, provides wealth management, corporate finance and
research services. At 30 June 2002, Hartleys had $2.9 billion in funds under advice. Hartleys is 28.7% owned
by Westpac Banking Corporation and 28.7% owned by Royal Bank of Canada. It has undertaken significant
restructuring during 2002 including the closure of its Investment Baking operations in Melbourne and Sydney.
Hartleys reported a loss of $12.7 million for the year to June 2002 and therefore its historical earnings multiples
are not meaningful.
The above sharemarket rating analysis provides little consistency in valuation parameters given the range of size and
activities of the selected companies and the volatile performance of some of them in recent periods.
Page 6