Medibank and NIB: Result 2018

The healthcare sector has been on a tear the past few years, with many of our local stars taking advantage of new technologies.

Cochlear's latest processor can stream music and calls straight to your brain, while ResMed's latest CPAP machine starts slowly and then 'autoramps' once it's detected that you've fallen asleep. CSL, for its part, has developed a portfolio of vaccines and plasma-derived treatments and is spending over $1m a day to come up with more.

This pattern is being repeated all around the world, with scores of companies delivering innovations to improve and extend our lives.

There's just one problem: someone has to pay for it all. Worst of all, the people that have to pay the lion's share (young people) aren't the ones that benefit most (old people) - at least not for a while.

So the challenge for the Government is to get young people - especially relatively affluent young people - to think ahead. In the past it's done this by waving a tax stick. But with premiums growing more quickly than wages for years, and health insurance already eating up a large chunk of household income, more and more young people are downgrading to lower-cost options or jumping ship altogether.

Negative feedback

This creates a negative feedback loop: rising premiums lead to more people downgrading cover, forcing insurers to raise prices further to maintain profit margins. The system is just about holding for now, but it can't continue indefinitely.

Somehow the Government will need to become more creative about how it funds healthcare; and, for their part, providers will need to rethink how they diagnose and treat patients. But these are big issues and solutions appear to be a long way off.

In the meantime, health insurers are doing what little they can to keep claims in check - such as by encouraging healthy living and early detection of disease, and by treating more patients at home. But these are mere band-aids over gaping wounds, and the long-term trend for costs is firmly higher.

Judging by the latest results from Medibank Private and NIB Holdings, though, you might wonder what the fuss is about. Cost rises have recently lagged this long-term trend and premium increases have been able to keep up. As a result, margins are near record levels, but make no mistake that they are under threat.

Keeping customers

Medibank's problems run deeper than sector dynamics. Customers have been leaving in recent years, though 2018 showed a tiny increase. The flagship Medibank brand - products with all the bells and whistles - has been the source of customer losses, with the discount 'ahm' brand taking up some of the slack. The trouble is, though, that ahm generates lower revenue and margins.

By contrast, NIB is the industry's fastest grower, increasing market share from 8.3% to 8.5% over the past year. It still has only about a third of Medibank's share, though, so there should be more growth to come.

Given the contrasting customer growth, it's no surprise that NIB's revenue growth of 12% in 2018 comfortably outpaced Medibank's 1%.

They both made similar gross margins on those revenues (after paying out claims), with NIB achieving 17.5% and Medicare 17.3%, so NIB's gross profit also grew at the higher rate of 22%, compared to Medibank's 2.5%.

Medibank has the advantage when it comes to expenses, due to its scale, with its management expense ratio of 8.8% comparing favourably to NIB's 10.5%. But NIB's higher cost structure also reflects its growth and heavy marketing spend, so we doubt that Medibank has a material advantage even here.

Part of Medibank's growth will come beyond providing health insurance market. It already gets a bit over 8% of its revenue and earnings from a range of health management services, and future growth may also be supported by the acquisition of an in-home care provider.

NIB is more diversified with a New Zealand health insurer and travel insurance - although Australian health insurance still contributes around 85% of revenue.

Weaker outlook

Overall, it's good to see Medibank holding onto customers better than in previous years, and we support management's efforts to reduce claims costs and earn new revenue streams. However, revenue growth is likely to be slow in coming years, and there's a risk that a margin decline puts earnings under pressure. The stock isn't overly expensive on a price-earnings ratio of 18, but with these factors in mind, we're reducing our recommended Sell price from $4.00 to $3.50. Our Buy price, however, already factors in a large margin of safety and remains at $2.25. HOLD.

NIB is the superior business and has greater diversification and better growth options. It therefore justifies a premium over Medibank's valuation, although it also can't escape the challenges facing the industry. It currently trades on a price-earnings ratio of 19 times 2019 consensus earnings, and we're raising our recommended Buy price guide from $3.75 to $4.50, to reflect recent progress, but will leave the Sell price unchanged at $7.50. HOLD.