The risk of banking on Medibank

The hoopla surrounding Medibank's IPO, worth up to $5.51 billion, reached a crescendo today with finance minister Mathias Cormann's release of the prospectus for the fast-tracked November float.

Attention has focused on the health insurer's opportunity for cost cutting and potential for acquisitions to bump up market share.

At the indicative price range of $1.55-to-$2 a share, the float is worth $4.269bn to $5.508bn and values Medibank at 16.5 to 21.3 times forecast earnings. The only listed private health insurer, NIB Holdings, is trading at just under 18 times.

So far so good – it's an uncontroversial, broad range in which the government can't be accused of giving it away, or overcharging and turning off potential investors.

Expectations are that Medibank is less efficient than its main competitors -- BUPA, HCF and NIB -- and privatisation will give it more flexibility to cut costs and increase productivity.

Garnering less attention is the outlook for Medibank's sizable investment portfolio -- the premium pool it invests which for half decade or so has generated substantial earnings for the insurer and accounts for as much as 40 per cent of pre-tax earnings.

This may be about to change, however.

There's the danger that markets tank, a disquietingly real possibility as the recent sharemarket slump demonstrated. And Medibank itself has voted to target a higher 25 per cent exposure to growth assets by the end of 2014, as page 70 of the Medibank Private Share Offer document spells out.

At June 30 2014, Medibank had 18 per cent of a $2.2 billion portfiolio in growth assets and the rest in conservative asset classes.

While recent years have been wins, Medibank's lost $54 million on its 2009 investment portfolio, seeing its net profit fall by $96 million from a year earlier, and today's prospectus clearly warns that “lower-than-expected investment returns may affect Medibank Private's financial performance in any given year”.

Even if Medibank were to adopt a significantly more conservative approach if markets became unfavourable, a negative side-effect of stabilising its earnings flow would be to also anchor profit growth -- particularly with interest rates at record lows, reducing returns from bonds and other lower risk prospects.

Medibank's investment portfolio is larger and has twice the exposure to equities of listed insurer NIB, and Intelligent Investor analyst Graham Witcomb warns Medibank's earnings “will be hit hard” if stocks fall materially.

“As equities are a more volatile asset class, this leads to lumpier investment income for Medibank, so investors should be prepared for more volatile overall profits too,” he says.

And on the flipside, a more conservative mix would probably curtail profit growth.

Cormann announced plans to lodge the prospectus with ASIC last week, within hours of a 450 point slump in the DJIA in a sell-off that saw the S&P 500 index drop 9 per cent from its September high.

Investment bank sources nevertheless remain confident the buoyant IPO market is sustainable, and $5bn will easily be absorbed.  And if the float goes well, there's a good chance demand from institutions at the back of the queue won't be met, an opportunity for smaller hopefuls on the IPO calendar to satisfy that unsatisfied appetite.

Cormann said pre-registrations for the Medibank offer exceeded expectations, with around 750,000 people lodging interest, and he brought forward the listing date from early December.

Even without that momentum, government sellers are fundamentally price takers. Poor market conditions would not stop this mega privatisation now -- a super tanker that cannot be turned around, as one investment banker aptly put it.