Medibank

Hi All (who stumble upon this blog),

I've started this blog mainly as an avenue to express my thoughts relating to the world of investing, to keep myself motivated and continuously deepening my knowledge.

We might as well start!

For my maiden blog post, a discussion on the IPO of Medibank would be as good as any.

Medibank Private

Medibank, Australia's largest private health insurer (30% market share) has been sold by the Federal government (in their efforts to sell assets and reinvest in much needed infrastructure). It was a highly anticipated float with the offer heavily oversubscribed especially in the institutional offering.

Is it a good investment?
Lets break it down:

Industry: 

Heavily regulated with revenue (insurance premiums) increases signed off annually by the Minister for Health. Historically premium increases have been in line with claim expense cost increases which helps maintain a stable gross profit ratio. Also, there is an industry risk equalisation mechanism(1) which further stabilises the gross profitability of the industry players.

This means that gross profit margin expansion is not likely to drive long term profit growth, though the CEO has indicated that they intend to flex their muscles as the largest player to get better pricing from the service providers (hospitals, dentists, etc) which if achieved would improve gross margins in the short term. The positive side to the regulated environment is that you will likely be getting yoy revenue increases (2) which makes the company a lower risk business (but not necessarily a low risk investment).

Management:

I have to admit that I tend to dedicate less than perhaps what is recommended towards knowing the management team, struggling to understanding what their multitudes of qualifications mean. What I did take out from the Medibank management team was that the CEO George Savvides has been leading the company for over 10 years (since 2002). This has a positive and negative aspect, which are that he is obviously experienced and likely has a deep understanding of the dynamics of the company and the industry. The downside is that one of the major selling points which our Finance Minister Mattias Cormann (3) has been busy trying to sell to investors is that the company is inefficiently run and that under public ownership, significant amount of costs can come out of the business.

That is nice and all, but begs the questions of why it hasn't already been done by the CEO who has been there for over a decade, either he simply did not have the incentives to do it, or that he was incapable of doing it, or there no such easy profit boosters are to be found. Commentary from the CEO appears to indicate that indeed significant management cost cutting had already been achieved, with the next phase of growth to come from flexing muscles with service providers.

The Company:

As mentioned above, the company is the largest private health insurance provider in Australia with a significant market share of 29.1% per prospectus. Customers pay insurance premiums which are invested and are held in preparation for future claims. On a very basic level, the company's profit drivers look like this:

Premium collected
less insurance claims
= Gross profit
less management expense
plus investment returns (from invested premiums)
less tax
= Net profit

How does it compare to its smaller major Rival NIB?

1. Medibank has a gross profit margin of 14.9% vs NIB 15.8% (Medibank's core business has GP margin of 13.5%) - this is where the company is likely to get some "easier" wins, by "flexing muscles" and getting the service providers to charge less than what they currently charge.

2. Medibank has a management expense ratio of 9.2% vs NIB 10.9% (Medibank CEO indicates that this is down to about 8.5% now).

3. Medibank has a net profit margin (after tax) of 4.1% vs NIB 4.7% (mainly from better Gross profit margin).

4. Medibank grew premiums at 5.7% (total revenue grew at 8.8%) while NIB achieved 15.6% premium growth.

5. Medibank grew NPAT at 6% while NIB grew at 3.9% (though NIB achieved significant top line growth, it did not translate into NPAT growth due to management expenses increasing to 10.9% of premium revenue vs 9.8% of the previous year. Such are the thin margins being earned by the players that scale, and cost management will play a significant role in the profitability of the companies.

6. Lastly, and important Medibank has no debt, compared to  15.8% gearing ratio of NIB. This allows room for some value add acquisitions (more likely), or potentially some special dividends.

The Investment Case:

Short term:
Less investment and more demand/supply driving the price in the short term especially immediately post IPO. Index funds will be scrambling to obtain sufficient amount of Medibank shares to keep to their investment mandate, especially since Medibank will likely be included in the next rebalancing of indexes due to the capitalisation of the company.

This will provide price support in the short term for stock prices, so I would not be expecting a fall in price in the short term.

Long term:
Long term is where "value" comes out in the stock price and at 23.7x next year's forecast NPAT, it is by no means a cheap stock. With organic growth slowing in the company, it is hard to see how a P/E multiple of 23.7x is justifiable especially when the faster growth (by premium revenue) NIB (8% market share) is trading at P/E of 19.7x (albeit its management cost blow out made its 2014 results look stagnant).

In the (longer) short term, I expect that earnings will be driven by better negotiated prices with service providers, and some level of better portfolio management leading to lower claims (and claim sizes) leading to an improvement in Gross profit margins, and management expenses should decrease towards 8.50% per CEO commentary, however beyond those shorter term earnings growth drivers, I struggle to see how the company might grow earnings above market averages (the private health insurance market is fairly mature), and 23.7x is a heavy price to pay for a company without a compelling long term growth story.

Personally I have put some money into the IPO to take advantage of the demand, however post IPO I will likely sell a portion/ or all of my holdings in Medibank per above reasons.

Additional notes:
(1) No one can be refused private health insurance in Australia. As a result of that, private health insurers in Australia who are deemed to have a higher risk portfolio relative to the industry norm receive payments from an industry pool which is funded by the insurers who are deemed to have a lower risk portfolio. - I wonder if this reduces the incentive for the industry, especially the players who are net receivers of fund monies from effectively managing their portfolio, with a lower incentive to improve their portfolio quality. Medibank is a net receiver of funds from the pool.

(2)  This assumes:
- Market share is maintained
- Customers levels remain stable

(3) On a slightly side note, I note that the IPO was structured in such a way as to benefit as many retail investors (voters) as possible with obvious political reasons. This helped form the result whereby retail investors paid a maximum of $2.00 per share compared to institutional who paid $2.15, a discount of 7.5% for the mum and dads.