The Government has been a little greedy on the Medibank Private IPO. Pitched on a multiple of earnings of between 21.3 times at the top of the price range of $2.00 per share, to 16.5 times at the bottom of the range of $1.55, it is no bargain compared to listed NIB Holdings, which is trading on a FY15 multiple of 18.6.
At $1.80, Medibank would be priced at a multiple of 19.1 times, and pay a normalised fully franked dividend yield of 3.9%. Interesting – but no bargain, so let’s hope the institutions succeed in talking the price down.
Comparing Medibank, the market leader in private health insurance with a share of 29.5% to the fourth placed nib, which has a share of 7.5%, is perhaps a little unfair because it doesn’t highlight the opportunity. While there is execution risk, the opportunity with Medibank is to take considerable cost out.
And with Medibank Private, essentially what you are investing in is a company with a cost out story, in an industry where revenues are reasonably predictable and profits have annuity-style characteristics.
A cost out story
In most industries, the market leader (with the scale) should have the lowest or near lowest cost base. That’s not the case with Medibank. Management expenses, which comprise salaries, occupancy, IT expenses and sales and marketing costs, are higher than the rest of the industry. As the table below shows, Medibank’s Management Expense Ratio (MER) in FY 14 was 8.7% (Australian residents only) compared to the rest of industry average of 8.4%. A 0.1% or 10 basis point decrease in the MER goes straight to the bottom line and is worth about $4.2 million in NPAT.
Management Expense Ratio – Medibank (Red) vs Industry (Blue)
The other part of the cost story is the management of claims expenses. This is a multi-faceted strategy that involves relationships with private hospitals, product design, supporting high claiming policyholders and reducing improper claims. While part of any claims expense reduction is shared with the industry, Medibank can also benefit by increasing margin, maintaining margin in the face of industry-wide cost pressures or making their polices more affordable in order to increase market share. In FY15, Medibank is forecasting that its gross margin will increase from 13.5% to 13.6%.
Health insurance premiums account for 90% of Medibank’s revenue – the other 10% is earned from ‘complementary services’, such as contracted health management services and the distribution of other lines of insurance. With a little over 3.8 million customers, there is clearly a revenue opportunity to develop this further.
Taking the costs out will be the existing management team, and while they have been making progress, you could be entitled to ask why they haven’t made more progress.
One reason is that the cost reduction program depends in part on an ‘IT Renewal Program’ – a $150 million program touching its core mainframe systems. As anyone who has been involved in IT knows, these types of programs involving heavyweights like IBM and SAP carry their own risks. As the prospectus warns on page 95: “A failure to complete the IT Renewal Program on time, within budget and with the required level of functionality…may result in a write-off of the costs and have an adverse impact on customer service, financial performance, regulatory compliance and future competitiveness”
On the revenue front, Medibank is not growing its primary brand.
Policyholders have been static in the main Medibank Private health insurance brank, while the simpler ‘ahm’ brand has been gaining customers, leaving the group largely unchanged on a market share basis. This highlights one of the key business risks – maintaining market share – which is always harder when you start as the leader. Moreover, the health insurance industry is undergoing considerable change, particularly around how it is distributed, and if online comparison websites like iSelect continue to expand share, this could place Medibank under pressure.
There are two other material risks worth noting. Firstly, as an insurance company, Medibank relies on investment income from the investment of its capital and premium revenue to boost its bottom line. With interest rates expected to stay low, the company is forecasting a decline in investment income from $113.9 million in FY14 to $89.7 million in FY15. The other risk is, of course, regulatory – the health insurance industry is highly dependent on government policy. For example, a change to the private health insurance rebate or the medicare levy surcharge could have a major impact on Medibank.
Dividend “dress up”
Before moving on to the details of the float, let me clarify one important point – Medibank’s initial dividend has arguably been dressed up. While the company is forecast to pay a final dividend of 4.9c per share for FY15 (which on a simple arithmetic basis for seven months translates to a yield of 5.4% pa (at a share price of $1.55) to 4.2% pa (at a share price of $2.00), Medibank is subject to some seasonality in its monthly profit. December and January are high profit months as hospitals/doctors wind back for Christmas/summer. On a normalised basis, the forecast dividend yield is only 4.5% at $1.55 or 3.5% at $2.00. No dividend gold mine here – although they are expected to be fully franked.
The timetable for the IPO is set out below. The Retail Offer opens next Tuesday and closes on Friday 14 November. The institutional book build will set the final price, which will be paid by all applicants except that retail investors won’t pay any more than $2.00 per share. The basis of allocation and the final price will be announced on the morning of Tuesday 25 November, with trading to commence later that day on the ASX under the stock code MPL.
The Retail Offer comprises a broker firm offer, employee offer, policyholder offer and general public offer. Policyholders (under either the Medibank or ahm brands) will receive a priority in the event of oversubscription – up to 30% more shares than an applicant under the general public offer, if they pre-registered, or up to 15% more shares if they didn’t pre-register. Pre-registrants, who aren’t policyholders, will receive up to 15% more shares than someone who didn’t.
Despite this IPO being overpriced at the top end of the range, this is still a government privatisation and the first from the Abbott government. It is hard to imagine the government wanting to disappoint circa 1,000,000 shareholders (voters). And while it is not necessarily a “must have” stock for the institutions or for that matter, most retail stock portfolios, it is a relatively low risk share investment with annuity-style characteristics. If 500,000 retail investors put in $10,000 each – the offer is more than covered by retail alone. So, if the lead managers do their job, there should be some post-listing demand.
So, I will be investing – but I’m not moving other stocks out to make room for Medibank.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
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