Jonathan Wilson

Written by Jonathan Wilson, Analyst, StocksInValue

Original article first published in StocksInValue

In a mixed AGM, Medibank Private – MPL.AX (See our valuation) announced CEO George Savvides’s 13 year tenure would end in March next year, 15 months earlier than expected, and less than a year since the company listed.
Notwithstanding the curious timing of Savvides’s departure the meeting highlighted MPL’s strong full year result with higher than expected earnings and net margin expansion resulting from improved claims management. The upbeat guidance at the AGM suggested operating momentum should carry through FY16, though the affordability issue was raised again as a potential headwind in coming years.
Shares are back to trading around $2.50 (the price when we last updated) after dipping to $2.00 leading into the result. Our thesis is essentially the same, though our FY16 valuation increased to $2.02 from $1.58 previously after we increased our forecast profitability (NROE) to align the recent performance and FY16 guidance. MPL’s revenue growth is stable so the NROE increase mainly reflects the outlook for net margins.
Our valuation assumes net margins (the margin MPL achieves on premiums after claims and management expenses) expands over the near term above the 5.5% achieved in FY15 (the highest level since FY11). In our view MPL should continue strong claims performance resulting from tracking over-servicing through its improved data collection and analytics capabilities, and the introduction of performance-based hospital contracting focusing on health outcomes to limit waste.
MPL is attractive for its leading market share of ~30% in an industry growing faster than the economy due to the aging population, however it is overvalued. The share price assumes MPL achieves an NROE of 35% into perpetuity, which boils down to unrealistic expectations for margins.
MPL’s margins are likely to come under pressure over the medium term. Private health cover is becoming increasingly unaffordable as reflected in the current trend of customer churn and product downgrades. In line with government approved price increases industry premiums have compounded at 6% pa between 2004 and 2011, well above inflation and consistently faster than claims. Since 2012, however, underwriting margins decreased across the industry as premium increases struggled to keep up with benefits inflation above 7% pa. With affordability worsening the government is unlikely to allow premiums to rise faster than claims, especially since taxpayers no longer own equity in MPL. Further, Government policy is to increase competition in private health insurance.
So despite industry growth tailwinds and scale advantages that enable MPL to negotiate lower healthcare costs with private hospitals and improve claims management, it is constrained in its ability to increase profitability.

Our adopted NROE of 30% is in-line with near term guidance and slightly below consensus. The NROE assumes stable revenue growth at ~4.5% pa, and further net margin expansion over the near term from further improvements in claims management.
Our required return, which represents a percentage measure of the risks to the realisation of our adopted NROE, is 11.0%. We reduced the RR from 11.5% after the first full year result. The low RR reflects MPL’s large scale and dominant market share that drives its cost-leadership position.
We split the NROE 24%/6% between dividends and earnings reinvested, consistent with the company’s payout ratio (ex-franking) of 70% to 75% of underlying profit. This reflects a long term view of MPL’s ability to reinvest at high rates of return. We derive an equity multiple of 3.7 times, which is multiplied by FY16 and FY17 equity per share of $0.55 and $0.59 to produce intrinsic value of $2.02 in FY16 growing to $2.15 in FY17. These metrics imply value growth of ~6% pa.
Sensitivities to the MPL’s valuation are:

The bullish case (right side) includes revenues increasing faster than claims resulting in higher than expected net margins. This could come from higher government approved price increases and/or better than expected claims management by MPL.
The bearish case (left side) includes net margin compression from customers reducing their cover (eg customers shifting from Medibank Private policies to lower margin AHM policies) in the face of premium rate increases, unfavourable outcomes in agreements with major hospitals such as Calvary, or lower government approved price increases.

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