Medibank IPO: prognosis negative

Medibank chief executive George Savvides tells a story of a tense wage negotiation with unions at the Australian arm of UK medical products company Smith & Nephew, which he was running in the 1990s. As the negotiations heated up, a shop steward told him that the issue was not so much the 4% wage claim, but the concern of low-paid workers that their families would be left unprotected if they fell ill or died.

So Savvides looked into the possibility of introducing income protection for all staff and discovered that it would cost about half a percent. Negotiations were quickly resolved and Savvides has introduced income protection everywhere he has worked since, including Medibank.

It's an example of Savvides using lateral thinking to solve a knotty problem – and the evidence is that he'll need all the lateral thinking he can get to overcome the looming crisis in healthcare spending. We'll come back to Savvides and Medibank in a moment, but first let's take a look at this crisis and the government's attempts to deal with it.

In 2012 Australia ranked 6th in the OECD for life expectancy at birth, with the average baby expected to live for a colossal 82.1 years – 25 more than those born 100 years ago. The trend shows no signs of stopping, due to massive and continued improvements in healthcare.

Healthcare costs on a charge

The trouble is, of course, that it comes at a considerable cost. By living longer we're tending to get more chronic diseases, and by treating them better we're tending to live with them for longer. Between 1986 and 2013, healthcare spending in Australia rose almost tenfold from $17bn to $147bn, while the average spend per person increasing sixfold from $1,072 to $6,430 (see Chart 1).

Forecasting the continuation of these trends is about as easy as it gets. What's not so obvious is how we're going to pay for it all. The trouble is that relatively few people (the elderly and the sick) account for the vast bulk of the spending and they can't possibly pay for it.

So the government has the tricky task of getting us all to contribute while we're young and healthy – and preferably without us noticing too much. Taxation is the most obvious means, but voters have indicated that they'd prefer not to pay too much tax, so the Medicare levy was introduced to give taxpayers more 'ownership' of their healthcare subsidies.

Carrot and stick

Unfortunately, though, Medicare gave people less incentive to take out private health insurance (PHI), causing coverage rates to drop from almost 80% of the population in the early 1970s to barely 30% by 1997 (see Chart 2). In a bid to turn the tide, the Howard government of the late 1990s introduced a 'carrot and stick' approach to encourage people (particularly the young and the rich) back into the private insurance pool.

The main 'carrot' was a (now means-tested) rebate on PHI premiums, while the 'sticks' included the Medicare levy surcharge for those on higher incomes who don't take out PHI and a loading on premiums for people who don't take out and maintain PHI from age 30. The combined effect was to push coverage rates back to the mid-to-high 40s by the early 2000s, where they have remained ever since.

The other big problem for PHI regulation is that left to their own devices, the providers would naturally target young and fit customers, making PHI unaffordable for the elderly people who need it most. To get around this, the industry is run on a 'community rating' system, under which people can't be excluded or charged more on account of their past claims history, age or health-risk status. To support this system, an 'equalisation fund' operates to share risks across the industry, with insurers with younger members contributing to the fund and those with older members receiving subsidies.

Regulated premiums

PHI premiums are also tightly regulated, with providers being required to submit proposed changes to the government. In practice, the government appears to be happy with providers making net underwriting margins of about 5%. With annual claims increases of about 8% and some cost savings, that has corresponded to annual premium increases of almost 6% over the past 10 years.

The 5% margin translates to a generous return on equity (ROE) in the high teens – a far better measure of a business's attractions. An ROE in the low to mid teens would be more in line with that earned by general insurers across the cycle and would be plenty enough to encourage a flourishing PHI sector. If premiums were deregulated, then we'd expect competition to drive ROEs in the sector down to this sort of level.

Indeed, one of the advantages of regulated premiums is that they provide protection against threats like the internet. As with other financial products, comparison websites are taking an increasing share of new business but, since the premiums themselves are controlled, while PHI brokers might feel the pinch, the providers themselves should be relatively insulated.

Up for grabs

Needless to say, as with any self-respecting political hot potato, healthcare funding is up for grabs at the moment, with the National Commission of Audit throwing its spanner into the works with various recommendations earlier this year. Key recommendations include expanding PHI for higher taxpayers to include primary healthcare (eg GP visits), alongside an increased Medicare Levy Surcharge; lower PHI premium rebates; reduced control over premium setting; and a relaxation of community rating to permit higher premiums for people with unhealthy lifestyles, such as smokers.

Whether all this ends up being enacted is anyone's guess and we could have a new government in a couple of years in any case, so it makes sense to focus on the forest rather than the trees.

On that basis, we see industry upsides from the virtual certainty of increased healthcare spending and the likelihood that PHI will be required to cover an increasing share of it, whichever party is in power (because of our reluctance to pay taxes).

On the downside is the small possibility that coverage rates fall again, and the much larger possibility of government squeezing premiums as healthcare costs continue their upward march or, if premiums are deregulated, of competition via the internet doing it for them.

On balance, we'd say that the omens are mildly favourable, but the industry is not as defensive as it is sometimes made out to be.

Investment risks

Adding to the risks is that a large chunk of PHI providers' profits comes from investment returns on the capital they're required to hold to back their policies. The money is invested conservatively, with Medibank Private aiming for 75% in cash and fixed interest, but even so in recent years its investment return has ranged from a loss of $54m in 2009 (a negative return of 3%) to a profit of $162m in 2011 (a positive return of almost 8%).

The company is expecting a 4% return from its $2.2bn investment portfolio in 2015, to give investment profits of $90m out of total profit before tax (PBT) of $363m. However, a year like 2009 would knock this down by 43% to $207m and a year like 2011 would bump it up by 24% to $449m.

Needless to say, these are big swings and, if you're looking for safety, then you might find more joy in something like Woolworths. This has implications for valuation, which we'll return to shortly.

Attacking the costs

For now, though, it's time to get back to Medibank and George Savvides' imagination. Savvides is the first to concede that the current trajectory of healthcare spending is unsustainable. So rather than sit back and watch to see how long it will take for the music to stop, he has plans to attack the costs.

Claims account for 87% of PHI premiums, so they're the natural place to start. Savvides' main aim here is to get more closely involved with the provision of primary care, to reduce chronic disease and keep people out of hospital, particularly 'frequent flyers' – the 2% of policyholders who make up more than a third of claims.

Although claims are partially shared across the industry through the equalisation fund, Medibank gets the full benefit of reduced claims for under-55s while for over-55s it benefits from reducing the overall industry pool of which it contributes such a large part. The company estimates that overall it retains 70% of the benefit of any claims savings it makes.

As areas ripe for improvement, Savvides highlights unnecessary repetition in tests and treatment and the poor sharing of information about previous healthcare experience. He's also making moves to help members get appropriate treatment at the right time. One such initiative is Mi Health, which the company added to its national triage service in 2012, and which gives members access to a 24x7 health advice line staffed by nurses equipped with detailed information on members through their claims profile.

Savvides also has plans to develop new ways for people to pay their premiums, such as through a lump sum to be paid out of superannuation that would then cover people for the rest of their lives – a move that would effectively take Medibank into the realms of wealth management.

Market muscle

It's hard to put numbers on the potential of these plans, but they could be significant in the long run – at least they show how Medibank can continue to add value. In the short run, however, improvements are likely to come from a simple flexing of market muscle. With 1.9m principal policyholders – a market share of 29% – Medibank is the biggest provider of PHI in the country, ahead of Bupa with 27% (see Chart 3). And this is an industry where size matters, because it allows more negotiating power with healthcare providers as well as economies of scale in marketing and claims handling.

Despite this advantage, Medibank's net underwriting margin lags the industry, averaging 4.5% over the past 10 years (on numbers from the Private Health Insurance Administration Council (PHIAC)), compared to 6.5% for Bupa, 5.6% for NIB Holdings and an average of 5.8% for for-profit providers. In 2014 Medibank's underwriting margin on this basis would have been about 4.5% (after stripping out 'complementary services revenue') and it's forecast to edge about 0.2 percentage points higher in 2015. Still, it has some way to go to match the competition and private shareholders might be just the tonic.

The lower margins also reflect the fact that Medibank has relatively old (ie expensive) customers. That makes it a net beneficiary of the equalisation fund, but those payments don't go all the way to counteracting the higher age profile. Again, there's an opportunity for improvement here – but only on account of a relatively weak existing business. And the existing business certainly does look weak. Overall its market share slipped from 29.5% to 29.1% in 2014, but that's despite 20% growth from its 'no-frills' ahm brand – Medibank-branded policies actually fell 1%.

Growth businesses

Medibank acquired ahm in 2009 and repositioned it as a 'no-frills' brand distributed to younger people through comparison websites, its own website and call centres. Policy numbers have risen by 11% a year over the past three years, although it still only represents 12% of Medibank's total policies and its pared-back nature may not help margins in the long run.

In recent years, Medibank has also developed a 'complementary services' business which, amongst other things, offers 'population health management' for groups whose healthcare needs are met by a single funder. The most significant such contract is for the Australian Defence Force, but other customers include Rio Tinto. This division also houses 'Telehealth' activities, including the Mi Health and national triage services already mentioned.

Further growth in these peripheral activities seems likely, possibly with the help of acquisitions, although at just 10% of revenue, it will need big moves to make much difference to the bottom line. Medibank also has aspirations to expand in Asia, and has made a start with an office in Singapore, but with so much on its plate in Australia, we'd rather it focused its efforts here.

All in all, Medibank is in one of those glass half-full situations where it faces some immense challenges, but they're precisely what provide the opportunity for improvement. Investors in the company are being asked to take some of these improvements on trust, but they may take a while to show up in the bottom line. Perhaps the biggest problem for investors is that if and when any improvements do show up, the company may be forced to pass on much of any benefit to policyholders, either through regulated premiums, greater competition, or both.

NIB the opposite

As much as you can get one in an industry as tightly controlled as this, NIB Holdings is the polar opposite of Medibank. Its relatively young customer demographic makes it a net contributor to the equalisation fund, but enables superior margins (and a return on equity of 21% compared to 18% for Medibank and the overall industry). It's also been increasing market share – from 7.3% in 2010 to 7.7% in 2013. You can read more about the company in NIB Holdings: Result 2014 from 11 Sep 14 (Hold – $3.13) but let's return to the question of valuation.

Over the long term we'd anticipate earnings per share growth of about 5% from these two stocks, slightly ahead of economic growth, reflecting the favourable, though somewhat gusty, tailwinds. NIB is in the better position currently, but lacks Medibank's opportunities for improvement. It also lacks its larger peer's scale and is therefore perhaps a little more risky.

By contrast, we'd expect to see growth in the high single digits from Woolworths, which we'd also consider to be more reliable (not least due to the absence of investment profits). As a result, we'd expect both stocks to offer a premium to Woolworths' prospective 2015 dividend yield of 4.0% at our Buy price and 2.9% at our Sell price. For both Medibank and NIB, we'd want to see a dividend yield of at least 4.5% to encourage us to buy, and we'd be inclined to Sell at 3.0% or below.

With a proposed payout ratio of about 75%, that gives a Buy price for Medibank of $1.57 and a Sell price of $2.35 (note that the company is proposing a higher payout ratio for the current year, but only as a one-off, so we'll use the underlying level for our valuation). We won't pinch pennies, though, and will start the stock with a Hold range of $1.60 to $2.40 (corresponding to a price-earnings range of 17 to 25).

Mushroom tactics

With the indicative price range stretching from $1.55 to $2.00, we're not tempted by the offer – especially since retail investors are being asked to stump up their money without knowing the price – we could say plenty about such mushroom tactics (keep 'em in the dark and feed them …) but we're trying to keep this clean and to the point.

In all likelihood, the stock will be priced near the top of the range and will jump a little after listing (that's how the bankers will be planning it), so some 'stag profits' may be available. If you're tempted to subscribe to the offer on this basis, then watch out that you don't get caught in the rush for the exits.

Our recommendations, though, are based on value and it's hard to be confident of any at anywhere other than the bottom of the indicative price range. It's a high-quality business, however, with some tailwinds behind it, so we'll start the stock as a HOLD and hope for an opportunity if the price falls.

NIB had a slightly lower payout ratio of 69% in 2014 (excluding a special dividend), but that's maybe what will allow for a slightly higher potential growth rate. We won't quibble, though, and get a Buy price of $2.60 based on the 16.6 cents of earnings per share forecast for 2015 and a Sell price around $3.80 (corresponding to a slightly lower PER range of 15–23). That's a significant increase from our previous range of $2.00 to $3.20 and reflects a slightly more upbeat assessment of industry prospects. HOLD.