A healthy prognosis for Medibank's float

Last weekend Mathias Cormann dropped the starter’s flag for the big initial public offering of the year, the $4 billion-plus privatisation of Medibank Private. While it might be a decade late in occurring, it will be a welcome addition to the ASX lists and a positive change to the health insurance industry’s structure.

Assuming the float price captures the value of the cash flows to government from dividends foregone (as a government business enterprise Medibank already pays tax) there is no rational argument for retaining it in public ownership given that it operates in an otherwise commercial and competitive sector that is intensely regulated.

Indeed, the fact that the sector is regulated -- its premiums have to be approved by the Federal government and its economics are heavily influenced by specific taxation policies -- creates a conflict of interest for the government that the privatisation will finally remove.

That does, obviously, point to a potential future risk for Medibank and its peers. Without the same economic exposure to the industry -- Medibank has almost 30 per cent of the health insurance market -- a future government might view the annual requests for high single-digit increases in premiums somewhat differently.

Limiting premium increases could be used as a policy lever to force downward pressure on costs through the entire health sector, given that the insurers would inevitably look to healthcare providers to absorb some of the pressure on margins. There is, however, a natural growth in the sector given the combination of demographics and rising healthcare costs.

That’s the kind of risk, however, that investors in all regulated sectors have had to live with -- Telstra is a good example -- and regulated companies have to deal with.

Medibank, as has been widely noted, does have considerable capacity to absorb some pressure, or increase its profitability.

It is less efficient than its main competitors -- BUPA, HCF and NIB -- despite its scale. Privatisation will give it more flexibility to improve its management expense ratio -- cut costs and increase productivity -- and create the pressure from investors and incentives for management to do so.

It ought to start its privatised life with a very clean balance sheet and a lot of cash flow. Traditionally Medibank has had no borrowings and, while its earnings have been quite volatile, it has been solidly profitable.

Its ability to generate cash has been highlighted by the fact that over the three financial years to 2012-13 it not only paid $314 million of dividends to the government but also paid about $640 million of special dividends during Wayne Swan’s futile attempts to produce a budget surplus.

Medibank will be under some pressure to simply behave as a cash cow, returning cash to shareholders, but beyond the structural improvement in earnings it would get from matching its peers’ management expense ratios, it will presumably be looking for top-line growth.

There’s not much, if anything, that it could acquire within the domestic health insurance market that it would be allowed to acquire, although it has already been expanding into adjacent insurance segments and could possible diversify its income streams further. There is also, perhaps, some longer-term potential for it to become more vertically integrated within the healthcare sector.

There was an interesting development recently when Ed Bateman’s Primary Health Care bought itself a (very) small health insurer, which could be a step towards vertical integration in the other direction.

In any event, Medibank will be a strong addition to the stock exchange lists, as one of only two listed health insurers (NIB is the other), with relatively limited downside given the way the sector is currently regulated and considerable near-term potential upside from efficiency gains.

It might be nearly a decade overdue (the Howard Government came close to privatising it in 2006) but the float ought to be good, not just for the federal Treasury, but for Medibank itself, the market and the broader health insurance and healthcare sectors.