Thursday, 12 March 2015

Value Investing: Medibank Private

As an IM analyst at Investing for Charity, I’m constantly exposed to the concept of value investing. The value investor essentially follows the proverb of buying “a dollar for 50 cents” by purchasing undervalued stocks, so that their market price is less than their true worth. Even if their perceived intrinsic value of the stock is inflated, a high margin of safety protects against capital loss.

Bull Analysis

I believe value investing can be applied to the IPO of Medibank Private, Australia’s largest private health insurer. The Australian Government provided a per share price range of $1.55 to $2.00 before its listing. The role of value investors then was to evaluate whether $2.00 per share was below Medibank’s fair equity value divided by number of shares outstanding. This therefore ensures a safety margin. In calculating the fair value of the stock, it is required that future earnings are forecasted based on the quality of the firm. At $2 per share, Medibank’s PE ratio should be 21.3 for this financial year. This means one must invest $21.30 in order to achieve a $1.00 return. However, value investors should have incorporated Medibank into their portfolio using a strategic analysis.

Medibank exists in our stable private health insurance industry that is growing faster than the economy given the ageing population. Based on market share, this industry is very concentrated and therefore competition is rarely a threat. Medibank, being reputed as the largest player with 30% market share, attracts heavier bargaining power than competing healthcare providers. This scale enables them to drive cost advantages over competitors and negotiate lower healthcare costs with private hospitals to mitigate regulatory risks over earnings growth. It can also afford to employ more marketing to reinforce such dominance and better data analytics, the benefits of which Mary has included in her first blog post. Basically in this way Medibank can deliver services efficiently and better adapt business strategies according to insights from collected data. In doing so, profit margins are likely to be improved.

For instance, Medibank announced that for claims this financial year, it will pay out 86 cents for every dollar of premium earned. This should be, and is, the largest cost it faces, although this also implies that by taking advantage of smarter prevention techniques and innovative healthcare delivery, Medibank is able to minimise its claims expenses in order to significantly improve earnings. These earnings are likely to increase in the future to an extent that the current PE ratio seems overweight. This process of utilising technological advancements in healthcare delivery is not uncommon, particularly as private health insurers have large incentive to create better outcomes at lower costs. Otherwise, if healthcare becomes overpriced, due to ‘health consumerism’ where the healthy look elsewhere, the imbalance creates uncertainty over the sustainability of Medibank.

Nevertheless globally healthcare clinics have introduced pilots of smart healthcare delivery techniques and processes, creating cost savings of over 25%. Furthermore in its prospectus, it reads “2.2% of the Medibank-branded policy-holders accounted for 35.2% of the Medibank-branded claims expenses relating to hospital and medical claims.” Hence Medibank has demonstrated knowledge of which customer demographic should be focussed on to stimulate the most significant impact on claims expenses. If over the next decade these cost savings can be applied to the aforementioned policyholders, combined with organic revenue growth and further overhead cuts, Medibank’s EPS will be economically higher than it is presently.

With this industry and company analysis, the retail investor should identify Medibank’s high earnings growth potential and realised the 19% gain as the stock peaked on the 19th and 27th of February, a dozen or so weeks after its listing at $2.15. For long term investors, I do believe Medibank Private offers potential for even more attractive returns as innovations in healthcare start to prevail.

Some examples of smart healthcare that Medibank can capitalise on:

Bear Analysis

However private health cover is becoming increasingly expensive, with subdued operational metrics results in the first reporting season of 2015. MPL’s privatisation means the government incentive to cause premiums to increase faster than claims has reduced, with these passed onto members. This supported stability in revenues and margins but now government policy is focussed on increased competition in private health insurance. Analysts therefore adopt NROE as 25%, with 8% of this sustainably reinvested. The required rate of return for this NROE is 11.5% (relatively lower risk). This results in MPL being worth 3 times equity per share, falling into the band of $1.40 to $1.90. The current share price implies NROE should be 37% however this is unlikely given the regulated capital structure.

The reported 1% growth in overall principle policyholders is a result of a 1.5% decrease in Medibank policies. These policies account for 87% of principle policyholders. Nonetheless cheaper AHM policies (an entity of MPL) experienced a 20% increase in holders. Furthermore gross margin fell by 0.3% to 13.4%, highlighting the price sensitivity of consumers. Industry conditions such as these create difficulty in MPL’s attempt to convert savings into higher margins. Furthermore project and marketing expenses were skewed to the second reporting season thereby inflating the earnings figure for January.

MPL has introduced a health cost leadership initiative focussed on efficiency and reduction in management expense. Cost savings in management expenses have been achieved in the first reporting season of this year as total management expenses were $235 million, which represents a 9% reduction from last year. Management expense ratio fell by 1.2% to 8% which is lower than its peers. This trend is also present in the industry where MER has fallen from 13.1% in 2000 to 8.8% in 2013 as insurers expand profits and reduce operational leverage. Industry growth also implies a 5% annual growth for MPL. However in order to achieve 37% profit expansion implied by the current share price MER must be 2% which is unlikely to be achieved in the medium term.

Per capital healthcare costs have compounded at 6.2% pa over the last decade whilst Australia’s GDP growth has averaged around 3.5%. This rise in healthcare expenditure is likely to be sustained given our population growth and ageing population. As costs rise, private health insurance will play an larger role in covering national healthcare costs (currently 8% are covered while the rest is met by the government). However this does introduce pressure for MPL to seek a longer term profit driver as most management expenses have already been cut.

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