Medibank & NIB: Interim results 2015

In the lead up to its $5.7bn float, Medibank Private was trumpeted as a cost-cutting story. Management pitched that it could use Medibank's scale and negotiating power to push down the cost of healthcare, reducing claims, while at the same time strip out operating costs.

True to its word, Australia's largest private health insurer reduced administrative costs as a proportion of premiums received from 9.2% to 8.0% for the six months to December, and management confirmed Medibank is on track for a full-year profit of $258m.

Still, two numbers in the interim result worry us – probably the same numbers that caused the stock to dive 8% immediately after the result was released, though it has now recovered somewhat.

The first is that while Medibank's profit margin increased slightly to 4.6%, the underlying gross margin fell from 13.6% to 13.4%. The company may be successfully cutting fat on the administrative side of the business, but it's losing ground when it comes to managing claims.

Medibank pays out roughly 86 cents in claims for every dollar of premium it receives, so reducing claims and the actual cost of healthcare is far more important than administrative expenses – but it's easier said than done.

Doctors are paid for each service, so they deliver as many as possible, while healthcare providers, pharmaceutical companies and medical device makers are out to increase their own revenue by negotiating higher prices.

Furthermore, just two companies, Ramsay Health Care and Healthscope, control nearly half the private hospital industry. Medibank has 3.9 million members so Ramsay and Healthscope can't walk away from the negotiating table; but neither can Medibank.  

Australia's other listed health insurer, NIB, had a similar experience in the six months to December, with its gross margin falling from 16.6% to 16.5% due to a 17% increase in payouts for hospital care. 

Lapse rate

Nonetheless, Medibank and NIB are usually able to pass on rising costs to members through regulated premium increases, which is why the companies have relatively stable margins and revenue growth.

In recent years, however, premiums have been growing faster than wages, making affordability an issue. And that brings us to our second concern: the proportion of members who let their Medibank policies lapse during the half increased from 4.6% to 5.0%, causing the number of policyholders under the core brand to fall 1.5%.

The overall market is still growing, so it follows that Medibank is losing market share. This undermines its negotiating position with the hospitals, though it is still the largest insurer with a 29% share. Declining policyholder numbers are also an anchor on revenue, which increased just 3.7% to $3.3bn for the half-year.

Growth in the company's cheaper AHM brand offset the loss of policyholders in the core Medibank brand, but this has a few drawbacks. For one, the cost of acquiring a new AHM customer is higher as the brand relies heavily on brokers, which take a 30% cut of the first-year's premium. As AHM products become a larger slice of Medibank's business, all things being equal, margins will decline.

Secondly, it suggests people are downgrading from the Medibank brand to cheaper products, which makes it harder to grow the top line.

Finally, AHM's lapse rate of 14.5% is nearly three times that of Medibank as a whole, which suggests a lack of customer loyalty and means it will be more difficult to upgrade members to high-margin products in future years.

It's also easy to see where ex-Medibank customers are going. NIB's market share has increased every year for the past 14. Policyholder numbers increased 1.5% in the six months to December, and its lapse rate of 5.7% is far better than AHM's despite a similar target customer. 

New normal

Medibank's management said it 'expects health insurance industry headwinds to continue with rising healthcare costs challenging affordability for customers, resulting in further product downgrades and churn'. NIB's management echoed the sentiment saying high rates of customer switching is the 'new normal'.

What's more, the Reserve Bank's recent decision to reduce interest rates to their lowest level since the 1960s will hold down returns from both insurers' investment portfolios, so their underwriting results are more important than ever. Medibank's investment income fell 33% this half. While NIB's increased 21%, if you strip out the $5.5m earned from selling its stake in Pacific Smiles Group, the underlying result was down 12%.

The health insurance industry is in the midst of a regulatory overhaul, with many proposals, such as the removal of 'risk equalisation', favouring NIB and its younger member base (see Medibank IPO: prognosis negative from 3 Nov 14 (Hold – $2.00)).

Ironically, if Medibank achieves its cost-cutting goals and increases its profitability, the Government may be even more tempted to let claims growth outstrip premium rises – squeezing Medibank's margins – to ensure health insurance remains affordable for older voters. And as the Government no longer has an equity stake in Medibank, it has little to lose.

Bottom line

Medibank is a high-quality company but it's still underperforming its peers – NIB's revenue increased 9% this half, with a profit margin of 5.1%, due to price rises and the increase in policyholders, including an uptick at its small New Zealand business for the first time in 10 years.

Policy downgrades, the loss of market share and declining gross margins make it hard to imagine long-term earnings growth for Medibank above 5% a year. But the stock is up 14% since Medibank jumps 7% on debut from 25 Nov 14 (Hold – $2.14) and now trades on a forward price-earnings ratio of 26. Consistent with the prospectus, the board expects to declare its first dividend of 4.9 cents in September and maintain a payout ratio of 70-75%, for a forecast yield of around 2.8%. There's no margin of safety at today's price so we're downgrading to SELL. 

NIB's management expects net profit at the lower end of its $75–82m range for the 2015 financial year and, with the stock up 12% since Medibank IPO: prognosis negative from 3 Nov 14 (Hold – $3.27), its forward price-earnings ratio comes to about 20. We're closer to selling than buying but, for now, we recommend you HOLD.