Medibank: Interim result 2016

Medibank Private, Australia's largest health insurer, has reported a strong interim result with insurance operating profit increasing 59% to $271m for the six months to December.

Premium revenue rose 4.6% to $3.1bn due to regulated price increases. However, total claims expense was flat at $2.6bn thanks to better claims management and a new 'payment integrity program', which aims to reduce improper benefit claims. The company's gross margin expanded from 13.9% to 17.2%.

Administrative costs as a proportion of premiums received increased from 8.1% to 8.4% but, thanks to the excellent claims management and a shift in the sales mix to higher margin ancillary products, the overall operating margin was still able to improve from 5.8% to 8.8%.

In the lead up to its $5.7bn float, Medibank's management pitched that it could use the company's scale and negotiating power to push down the cost of healthcare and reduce claims, while at the same time strip out operating costs.

While there is still some work to do on administrative costs, we're impressed by how well the company has improved claims expense. The underlying net operating margin of 8.1% (excluding a $21m claims release) is a vast improvement on the 4.4% achieved in 2014 prior to listing. Medibank's profitability is now in line with BUPA and slightly ahead of NIB.

Margin too high

A gross margin of 17% and net margin of 8%, however, is unlikely to be sustained. To increase premiums, Medibank and other private health insurers must seek approval from the Minister of Health.

Though never explicitly stated, gross and net margins for the industry over the past 10 years have been extremely stable at around 14% and 5% respectively, which suggests that this is the level of profitability targeted by the Department of Health – high enough to ensure an adequate return to shareholders, and stable to see that premium growth is kept to a minimum. Affordability is becoming an issue and the last thing the Government wants is for the public to shift back to the overburdened public health system.

In January Medibank resubmitted its 2016 premium round application at an undisclosed lower level so that 'members share in the benefits of its strong performance'. In other words, management recognises that the company is overearning and won't push for premium growth while claims expenses are flat.

We expect the net margin to revert to around 5% in the medium term and premium growth to slow. This isn't altogether a bad thing, though, as it makes for more competitive pricing – and Medibank needs it more than ever.

The number of members who let their policies lapse increased 15% compared to the prior year, which caused the total policyholders to fall 0.6% to 1.8 million. Declining member numbers has been an ongoing issue for Medibank in recent years and it slowly undermines the company's negotiating power with private hospitals, while also anchoring revenue growth.

Equities bite

Prior to Medibank's listing, we warned that management's aggressive asset allocation target for its investment portfolio added risk: 'Medibank's investment portfolio has twice the exposure to equities as NIB so it has benefited from a rising sharemarket. However, if stocks fall materially, Medibank's earnings will be hit hard' (see Medibank's risky investment portfolio).

Unfortunately, that's exactly how it has played out. Declining equity markets caused Medibank's investment income to fall by 57% this half to $18.6m – an embarrassingly low return of 0.8% given the company's portfolio is worth $2.3bn.

Management shows no desire to change its aggressive portfolio strategy. The company's target allocation to risky assets, including equities and property, is 25%. NIB has taken a more conservative approach, with a heavier weighting to defensive assets, such as bonds and cash. Risky assets make up only 18% of NIB's portfolio.

Low interest rates mean that investment returns are likely to be paltry for some time to come, but Medibank's higher weighting to risky assets exposes shareholders to bigger swings in earnings – indeed, Medibank's investment portfolio made a loss of $54m in 2009.

Outlook

Management recently reduced its forecast for full-year growth in premium revenue from 'above 5.5%' to between 4.5% and 5.0% (see Medibank's improving outlook from 22 Jan 16 (Hold – $2.48)). The target for operating profit, however, was revised to 'above $470m' – $100m more than the previous estimate – due to improving claims management.

'These targets anticipate that the second half operating profit will be lower than the first half due to increased marketing and brand investment, and some normalisation of the growth in hospital utilisation rates,' said management.

The board declared a fully franked interim dividend of 5.0 cents a share, giving a yield of 4.0%. This was a strong interim result but, with a price-earnings ratio of 19, Medibank isn't cheap – especially given that margins are likely to contract and revenue growth to slow in coming years. We note our recommended maximum portfolio weighting of 5%. HOLD