Medibank Private – Quality at a reasonable price
The big surprise from the recent reporting season was Medibank Private (ASX:MPL). Guidance suggests the health insurance operating profit will increase by more than 12 per cent in FY16 to over A$370m on revenue growth of 5.5 per cent. The company also guided to a reduction in the MER to 8.3 per cent and below 8 per cent in 2017. This is a lot better than we had forecast and the market had been of the opinion that most of the margin expansion from a falling MER had been realised.
Following the full year results for Medibank Private (ASX:MPL), we believe the upside potential for the company has materially improved relative to our previous base case. This is partly because management have offered guidance for the company’s MER (Management Expense Ratio) to fall from 8.6 per cent in FY15 to 8.3 per cent in FY16 and below 8 per cent in FY17.
Importantly, over the last few years, the amortization of customer acquisition costs has been rising and it will continue to do so. What that means is that the real reductions in the management expense ratio are meaningfully higher.
We had previously and conservatively believed that that most of the available net cost reductions available from management expenses had already been realized. Clearly this is not the case and as a result the Montgomery Intrinsic Value base case rises to A$2.51 and that is with our volume and revenue growth assumptions remaining below management’s guidance and below recent historical performance.
That’s the base case. Our upside case has always been expected to come from an improved claims ratio and management’s progress in FY15 provided some reasons for confidence in the upside potential. A lower claims expense ratio (see note below) of 85.8 per cent for the year (we were forecasting 86.2 per cent) delivered A$20m higher underwriting profit and a margin of 5.5 per cent compared to our forecast of 5.2 per cent.
And while our upside valuation has increased only marginally to A$2.95, fewer positive variables are required to deliver that outcome. Those variables are an improvement in the claim ratio between FY17 and FY21 and a marginally better volume outcome.
The majority of the gains however are still expected to be realised from FY17 onwards due to the timing of the contract renegotiations with the major hospital operators.
Investors should also reign in their enthusiasm for immediate gains because of the weakening outlook for investment returns due to lower interest rates and lower equity markets (15 per cent of the investment portfolio), which will negatively impact near term earnings forecasts, not to mention constrain the share price performance directly.
And while the underlying insurance result was better than expected due to claims management, the market will remain concerned about the weak revenue growth outcome and a significant step up in the lapse rate for the Medibank Private brand in 2H15. Growth in total policyholder numbers was just 0.9 per cent in FY15 and 0.6 per cent in the six months to 30 June despite a big lift in marketing spend.
Policyholder numbers in the core Medibank brand fell 2 per cent year on year, offset by a 21.5 per cent increase in (lower revenue per policy) ‘ahm’ policyholders.
Lapse rates for Medibank continued to rise, reaching 10.9 per cent in FY15. Lapse rates increased from 9 per cent in 1H14 to 12 per cent in 2H15 and reflect a problem with customer retention rather than the acquisition rate, which has remained reasonably consistent for the Medibank brand over the last two years. A revamped marketing and deal campaign to get new customers is a high cost way to fix this problem, so it should be accompanied by efforts to retain existing customers with better products and options.
It’s worth noting that the price/benefit equation could also be part of management’s focus with average revenue per policy increasing 5.1 per cent in 2H15 and average price increases of around 6.25 per cent.
Overall we believe we have invested in a quality company, with bright prospects and it remains, at the time of writing, at a discount to our estimate of its intrinsic value.
Glossary
If you’ve never thought about investing in an insurance company, the terminology can be a little daunting. Here’s a list of terms that you will inevitably come across:
Claims ratio
Net claims incurred as a percentage of net earned premium.
Combined operating ratio
The sum of the claims ratio, commission ratio and expense ratio. A combined operating ratio below 100% indicates profitable underwriting results. A combined operating ratio over 100% indicates unprofitable underwriting results.
Gross earned premium (GEP)
The total premium on insurance earned by an insurer or reinsurer during a specified period on premiums underwritten in the current and previous underwriting years.
Gross written premium (GWP)
The total premium on insurance underwritten by an insurer or reinsurer during a specified period, before deduction of reinsurance premium.
Insurance profit
The sum of the underwriting profit (loss), and the investment income.
Insurance profit margin
The ratio of insurance profit to net earned premium.
Net earned premium (NEP)
Net written premium adjusted by the change in net unearned premium for a year.
Net written premium (NWP)
The total premium on insurance underwritten by an insurer during a specified period after the deduction of premium applicable to reinsurance.
Outstanding claims provision
The amount of provision established for claims and related claims expenses that have occurred but have not been paid.
Underwriting result
The amount of profit or loss from insurance activities exclusive of net investment income and capital gains or losses.
Unearned premium
The portion of a premium representing the unexpired portion of the contract term as of a certain date.
Written premium
Premiums written, whether or not earned, during a given period.
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
John E
:
I’m one of those Medibank policyholders who jumped to another insurer last financial year. Large churn is to be expected given the massive yearly rate increases. They publish something like an annual average increase of 6% and it works out 10% on top hospitable cover.
Interestingly, as a shareholder, I tried to get a better deal with them as I wanted to stay but had found a much cheaper policy with similar cover.
What they told me is that government regulations prevent them from offering incentives such as a free month on a renewing policy. This seems bizarre to me. They really didn’t try hard to keep my business and I hardly ever claim!!
So unless regulations change so they can look after good (risks) customers, churn will continue on a large scale no matter how much marketing they do. Why isn’t there a no claim bonus such as with general insurance for example?
Guy Davis
:
Hi Roger, thanks again for a very useful article. It will be interesting to see how patient many of the mum and dad investors who bought in the float will be, particularly if the share price comes under pressure in the near term.
I was thinking a good topic for a blog post would be your thoughts on managing the price to value relationship in fully valued markets, like we’ve had for the last couple of years. There very few quality stocks trading anywhere near their intrinsic values on a traditional DCF basis and I’m curious how you have tweaked your approach to allow you to buy companies like Ansell, Henderson and REA Group at prices that would appear to be above traditional value-investing levels (at least to my amateur eye).
Are you concerned that these higher prices to participate in the current market might leave you vulnerable in a fall? I have been transitioning from largely holding ETFs in the past to active value investing in the last couple of years and have found it a really frustrating time with only turnarounds and cigar butt style opportunities seeming to be in the offing.
Regards,
Guy Davis
Roger Montgomery
:
How patient will they be? They were very patient with Telstra. With respect to your question about higher prices leaving one vulnerable to a fall remember the basis rule of investing: The higher the price you pay, the lower you returns.