Why investors have swamped the Medibank float

Can an initial public offering be too successful? Not in the eyes of the vendor.

The federal government's decision to lift the top end of the indicative range of prices for the Medibank Private float confirms what was already obvious: demand for the shares massively exceeds the available supply.

When the initial pricing was disclosed, the $1.55 to $2 a share range valued Medibank at between $4.3 billion and $5.5bn. Today the range was shifted to $5.5bn to $6.3bn. Given that it remains indicative, it is conceivable (albeit unlikely) that the final price institutions pay for their shares could be even higher. Shares allocated to retail investors are capped at $2.

It was obvious from the moment the float was launched that the government had a success on its hands.

‘'Broker firm'' demand on behalf of the firms' clients was a staggering $12bn, which has been scaled back by the government and its advisers to between $1.2bn and $1.5bn. Demand from the general public, policyholders and employees was more than $4.8bn.

In other words, without any institutional allocations at all, Medibank could be sold in its entirety to retail investors.

That's not, of course, going to happen and it is obvious that there will have to be a lot of scaling back of applications.

The cap on the retail price, coupled with the strength of demand, however, means that the first box the government would want ticked -- a guarantee that it would receive a demonstrably good price for the business while ensuring that it did no harm to retail investors/voters -- will be ticked.

While that might endear it to the retail investors, it is going to cause considerable angst among the institutions now scrambling to get stock via the book-build. A 'too successful' float means they have been forced to pay more for their stock than they would have wanted to.

The government's business adviser, Lazard, and the joint lead managers for the float, Deutsche Bank, Goldman Sachs and Macquarie, put a lot of pressure on fund managers to bid hard and early by making it clear that preference would be given to those that bid at or above what would eventually be the final price within the first 24 hours.

While the institutions aren't happy about that pressure, the lifting of the indicative range today says very clearly that it has worked to force the institutions to bid early and aggressively in the hope of securing an allocation.

There will be a lot of disgruntled and dissatisfied institutions when the book-build ends at noon tomorrow, which is good news for the government and retail investors.

There is an obvious risk, given the extraordinary depth of demand and the pressure the managers have imposed on the institutions that the competition for the shares pushes the price to levels that can't be sustained in the after-market, albeit that retail investors have a significant cushion against that outcome.

The top end of the new range, however (assuming it isn't lifted when Mathias Cormann announced the final pricing at the weekend) can be justified even though, at $2.30 a share, Medibank would appear to be priced on a frothy forward price-earnings multiple of about 24 times. By comparison, the listed health insurer, NIB, trades on a multiple of 20 times.

Medibank, however, is coming out of public ownership and it is well understood that it has a lot of upside, given that it is materially less efficient than its main competitors despite being the largest business in the sector.

 NIB and BUPA generate underwriting margins far fatter than Medibank's even though Medibank's profitability has been improving strongly in the past couple of years. The prospectus forecasts another 20 per cent increase in earnings in the 2015 financial year.

Medibank, at just under 30 per cent, has nearly four times the market share of NIB, has no debt, has very conservative accounting and balance sheet policies, has invested about $250 million in its business and technology platform over the past three years and will be an ASX top 50 company, forcing institutions with index-related investment strategies to hold its shares.

Perhaps the better benchmark for its pricing might be the listed hospital and healthcare groups like Ramsay and Healthscope, which have price-earnings multiples in the mid-20s, but they are managed very efficiently and don't have the privatisation upside that is generally a feature of floats of government-owned enterprises.

It is interesting that NIB's share price has more than trebled since its demutualisation and listing in 2007, in what could be regarded as an analogous process.

In any event, the government and its advisers can rationalise a decision to price the float at the top end of the revised range, or higher, and the institutions can justify bids at that level. It will then be up to George Savvides and his management team to generate the improved performance that will be capitalised into Medibank's share price.

The sheer appetite for the stock among retail and institutional investors guarantees a successful float and, for the government, the option of fully pricing the sale while remaining confident that there will be unsatisfied demand on the sidelines to provide support for the aftermarket.

The buffer for retail investors provided by the retail price cap means that the political risk associated with the possibility that the shares under-perform the final institutional price is much-reduced, allowing the government to lean towards maximising the taxpayer value released by the sale.

The institutions, as sophisticated investors, ought to be capable of coming to their own conclusions on value and taking responsibility for them even if they might grumble about a process that is forcing them to put a fairly optimistic view of Medibank's value on the table. The louder those grumbles, the more confident the government can be that the taxpayers' interests have been well-served