The float of Medibank Private was one of corporate Australia’s good news stories last year.
In a little more than 10 weeks since floating, retail investors have seen their punt return a paper profit of around 20 per cent.
The big institutional investors are well ahead too, as are a legion of brokers and lawyers who sold the deal.
Even the Federal Government – which can’t seem to take a budgetary trick at the moment – trousered a better-than-expected $5.7 billion.
What’s not to like about a game where everyone’s a winner?
The trouble is the game has just started – it’s still in the first quarter to be precise – and UBS’s highly rated team of insurance and healthcare analysts have just dropped a nasty dose of reality into play.
UBS has initiated coverage of Medibank Private with a weighty 70 page research note and slapped a “sell” call on the stock.
“In simple terms, this reflects our view that the share’s post-IPO performance appears to have captured virtually every positive theme but no negative ones,” the UBS team argued.
The UBS thesis is that there are many variables in the business models of private health insurers that they don’t control.
That begs the question why investors are currently prepared to pay a hefty 50 per cent premium for Medibank over the broader market.
On UBS’s figures, Medibank will be trading on 24 times earnings, while the market is on an average price of 16 times earnings.
In the short term, UBS said the news flow should remain positive in the afterglow of the IPO honeymoon with a conservative prospectus earnings per share forecast for the 2015 financial year likely to beaten by more than 7 per cent.
‘A loveless marriage’
While Medibank looks set to benefit from a major uplift in hospital spending growth in coming years, the hospitals’ game plan is to expand what the insurers are trying to rein in – patients’ claims.
The Medibank game plan is to boost margins by reducing claims.
“To state the obvious, the hospital operators’ revenue line is Medibank’s claims line and this introduces unique tensions for two fundamentally different businesses – a ‘loveless marriage’ is how one industry contact recently described the relationship,” UBS noted.
The importance of the relationship is difficult to understate, with almost half of Medibank’s $4.7 billion of claims in 2014 being paid to private hospitals.
The bad news for the private health insurers is that the hospitals exert considerable muscle over the most important variables in claims and price setting mechanisms.
‘No low hanging fruit’
Part of Medibank’s sales pitch was, when freed from the shackles of Government ownership, it would achieve greater efficiencies and higher margins.
UBS agrees to an extent, but said “there are no free lunches or low hanging fruit” for the new ownership structure.
Medibank’s margins are currently a fair bit skinnier than its peers.
In the previous year Medibank’s reported net margin was 3.6 per cent.
The second biggest insurer, Bupa, managed 6.6 per cent, while the industry average was 4.3 per cent.
“It is clearly too simplistic to assume that Medibank can gradually shift towards the same profitability level as its major competitor Bupa,” UBS noted.
“There are structural differences, regional differences and likely established behavioural differences that won’t converge overnight.
“Over the past decade, Medibank hasn’t been able to consistently demonstrate an ability to leverage the benefits of scale through either lower overall claims ratios or superior MERs (Management Expense Ratios).”
On the other side of the margin ledger, the Federal Government keeps a steely control on increases in premiums which have averaged around 5 or 6 per cent in recent years.
It would be clearly politically unpalatable to allow premiums to grow at a greater rate.
Still in the Government’s grasp
While UBS doesn’t see significant risks in regulatory price setting, it notes relationships with the Government are very different now.
“2016 is a federal election year and the game has changed – Government no longer has a direct ownership stake in Medibank yet heavily subsidises the industry and therefore has no incentive to allow it to over-earn,” the analysts noted.
“Affordability challenges (especially for insurance spend) are well understood and easy vote-getters.
“We see too many recent examples of Government allowing ideology and self-interest to trump commercial logic for risks on this front to be overlooked entirely (superannuation the best example).”
It’s not all bad though.
UBS said Medibank sits well with what’s currently in favour with investors.
“Defensive growth (especially through industries that resemble regulated utilities), no gearing, minimal linkages to the Australian economy’s weak spots and limited potential for negative surprises are all compelling features in current equity markets,” they observed.
It is also is a strong “brand”, isn’t capital heavy and has a degree of certainty about its dividends.
However, after punching in all the data into its spread sheet, UBS has come up with a 12 month share price target of $2.00 a share.
That’s pretty well flat-lining for retail investors and not exactly ensuring a healthy return.