Medibank investors must read the fine print

With overseas markets strong last night, Medibank Private is floating at a wonderful time for the government. And there is likely to be a short-term profit to retail subscribers. But long-term investors need to study the small print in the prospectus because there are a few traps.

Chief executive George Savvides is a good operator who will improve what is already a sound business. Finance minister Mathias Cormann is one of the better performing cabinet ministers. I am therefore disappointed that they set the traps for the unwary, although the prospectus has the necessary information for those who study it. 

The first trap is in the dividend rate. Almost every article about Medibank promises a minimum 4.2 per cent yield for shareholders in Medibank (plus franking credits). That promise is on the basis of a $2 share price and the fact next September the company says it will pay a dividend at the annual rate of 8.4c a share (4.9c for seven months).

Nothing misleading about that. Then go to the small print. Medibank has as a target a payout ratio of roughly 75 per cent of profits but in 2014-15, its payout ratio will be around 89 per cent of the 9.4c a share expected earnings.

If you read it carefully, the prospectus says that if the company paid a 2014-15 dividend at the expected payout ratio of 75 per cent, the yield at $2 a share would be only 3.5 per cent (a 7c a share annual rate).

So for 2015-16, for Medibank to maintain the 4.2 per cent yield, the company has to continue to pay out a higher rate of dividend than the prospectus says is prudent or increase earnings by 19 per cent to 11.2c. In other words a yield of 4.2 per cent for the long term is under jeopardy from day one. 

In my view, George and Mathias should have made the 2014-15-dividend payout at an annual rate that reflected long-term policy, but had they done that, the price to the government would have been much less.

Secondly, did you notice that Medibank's actual expected net profit does not rise in 2014-15 despite an improvement in operating earnings? The reason is that directors expect a fall in investment earnings reflecting lower interest rates and the fact that big dividends were paid to the Commonwealth before the float. Medibank, which now has about 18 per cent of its $2billion portfolio of investments in risk (equity) assets, plans to lift that percentage to 25 per cent by December.

Medibank promotes itself as a ‘health' company and that's why, at $2 a share, its price earnings ratio is over 21. Why has a ‘health' company got such a large investment portfolio? More accurately, Medibank Private is an insurance company that operates in the heath sector. Insurance companies have big investment portfolios and lower price earnings multiples than 'health' companies.

And as an insurance company, Medibank Private carries some of the risks of many insurance companies (claims can rise unexpectedly). More importantly, its insurance premiums are regulated. Previously, the government was taking money out of its own pocket when it regulated fee levels at a low level because it owned the largest player.

 Private health insurance fees to customers reflect the costs of hospitals and the medical system. They normally rise by around 5 to 6 per cent. If that rate of increase keeps up, I suspect many more Australians may be forced to take the risk and not insure, particularly if some future federal or state government improves the ‘free' health service. On the other hand, Medibank can reduce its costs once it is privatised. 

The institutions are likely to be starved of stock so I think there will be a profit on Medibank Private. Longer term you are buying a good business, but we don't yet know what the price is. Stating the obvious, at the minimum level of $1.55 a share Medibank is better value than at $2.