Why Medibank could have more upside to come

Mathias Cormann and hundreds of thousands of investors will be feeling quite chuffed about the debut of Medibank Private on the ASX today.

With the shares settling around the $2.20 level for most of the day before sliding a few cents towards the end of trading, the $5.7 billion float has produced a 10 per cent gain for retail investors but also left institutional subscribers to the float marginally in the black despite solid turnover in the shares.

For Cormann and his government, that avoids either of the two unpleasant first-day outcomes: where he is accused of either under-pricing the sale of a significant taxpayer asset or over-pricing it and generating initial losses for the 440,000-odd retail investors/voters, who bought about 60 per cent of the offering.

The $2.20 level is the one he and his advisers would probably have chosen as their perfect outcome ahead of the listing. It is also one that appears to deliver full and fair value to taxpayers, given that the indicative range of pricing was adjusted upwards from $1.55 to $2 a share to $2 to $2.30 a share.

At least in the near term, there ought to be support for the market in Medibank's shares. With retail investors getting 60 per cent of the available shares and a sizeable proportion (about 43 per cent) of the institutional component going to offshore investors domestic institutions will be heavily short the index weighting of the stock.

Given that Medibank will be either just in or out of the ASX top 50, there will be pressure on the institutions to increase their exposure and therefore something of a floor under demand for the shares and support for their pricing.

Much has been made of how much pressure the decision to shift the range and eventually price the institutional component at $2.15 a share would impose on Medibank's management and board.

While that's not an unreasonable view of the implications of pricing the institutional offer at more than 22 times current-year earnings, it probably under-estimates the latent potential of Medibank to lift its performance.

It is well understood that the business is significantly less efficient and profitable than its competitors. Its underwriting margin has been more than 20 per cent skinnier than BUPA's, for instance.

Apart from managing its claims experience more effectively, however, there may be some less obvious upside.

Medibank's board and management have known for a long time -- more than a decade -- of the likelihood of a privatisation. While its performance has improved markedly in recent years, there are some aspects of its financials that would make one suspect they were preparing for that moment and for life immediately after it.

Medibank generates a lot of cash but has no debt. It has adopted accounting treatments of its outstanding claims liabilities policies that are more conservative than its peers. It has also invested heavily -- about $250 million over the past three years -- in its business and technology platform.

It wouldn't be difficult to fine tune the risk margins it uses to calculate its provisions for outstanding claims liabilities to something closer to its peers, which would increase reported earnings. Its investment in technology will presumably generate improved results. There is potential for both increased dividends and capital management within cash flows and its ungeared balance sheet.

There's also more straightforward cost-cutting and the harder-nosed dealings with healthcare providers that Medibank will find it easier to pursue as a privately-owned business.

Whether or not the 'hollow logs' have been tucked away for the post-privatisation era, George Savvides and his board – and he has a good board -- have a number of levers they can pull to support the value imposed on them by the market and the intelligent structuring of the offer that generated remarkable levels of demand.

The privatisation has started smoothly. Savvides will now have to deliver and should be able to deliver. If he doesn't, of course, he knows someone else would be given that opportunity, which will create more pressure to perform than today's share price.