Medibank IPO: Healthcare’s About To Change

This story features NIB HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: NHF

– Medibank IPO: Healthcare's About To Change
– Not King Cole
– Planet Zero
– Calm Before Storm For Insurers?
– Buy-Backs Rule
– Rudi On TV: The Week Ahead
– Rudi On Tour

Medibank IPO: Healthcare's About To Change

By Rudi Filapek-Vandyck, Editor FNArena

The much talked about Medibank Private IPO essentially marks a new era for the healthcare sector in Australia leading to wide ranging changes that are yet to be appreciated by Australian investors.

Without any doubt, the most asked question by retail investors in Australia this month is: should I apply for shares in the Medibank Private IPO? Without paying much attention to pre-IPO media coverage, or the freshly released prospectus, there's a very simplistic, yet opportunistic and valid answer to that question:

Both the federal government and the underwiters, and just about everybody else inside the local industry, wants this listing to be a success. Already, expectations are building the offer will be many times oversubscribed.

No doubt, the silent strategy of the underwiters will be to squeeze as many retail and foreign institutions in as possible, and then leave the local funds managers to scramble for shares after the listing, so as to virtually guarantee a positive start for the company as a public listed entity.

On top of this, because of its size ($4.5bn-plus), Medibank Private will become a member of the ASX100 in due course, again guaranteeing buying orders from local institutions.

All of the above, in itself, can serve as sufficient reason as to why retail investors (SMSF and non-SMSF) should apply for shares in what will be the largest government privatisation since Telstra in this country.

But what about the company's fundamentals?

Medibank, being the largest private health insurer in the country, is being sold as a reliable, robust generator of lower risk, defensive profits and cash flows in a heavily regulated, but government supported healthcare sector. The timing seems right, given an overall positive sentiment towards equities and the numerous successful floats that have preceded this year, not in the least healthcare services provider Healthscope ((HSO)).

Add to this the fact the only listed peer on the ASX, nib Holdings ((NHF)), has been one of the star performers since listing in late 2008 (what timing!) while the same can be said about insurers in general since mid-2012, QBE excluded, so it appears the scene is set for far more demand than the number of shares that are about to become privately owned.

Note that what the government, and IPO underwriters, are trying to achieve is to sell Medibank as an "All-Weather Performer", relatively immune to economic cycles, interest rate variables and FX changes, belonging to the same league as Ramsay Healthcare ((RHC)), CSL ((CSL)) and Invocare ((IVC)) and nothing like the Boart Longyears, the Fleetwoods, the Myers, the Pacific Brands, the Lynases, the Atlas Irons, the QRX Pharmas and so many others that have proved themselves as supreme capital killers in the post-GFC era.

As every investor knows full well, this type of investment is rare on the local bourse, very rare. It's why stocks such as Carsales.com ((CRZ)), REA Group ((REA)), Seek ((SEK)) and Domino's Pizza ((DMP)), as well as the aforementioned healthcare stocks, enjoy above market PE multiples. This is the prime justification as to why Medibank shares are likely to be privatised at a PE multiple around 20x, which translates into a share price allocation at or near the top of the indicative $1.50-$2.00 range. At the maximum price, the PE multiple for the present year will be 21x and the dividend yield 4.2% (fully franked) if we go along with the suggestion that the first year of listing only consists of seven months instead of twelve.

A few reference points to the above:

– Ramsay Healthcare shares are trading on a forward PE of 26
– Healthscope shares are trading on forward PE of 25
– CSL shares are trading on forward PE of 22
– nib shares are on a forward PE of 20

Even Veda Group ((VED)) shares, which also function as a reference point given recent listing, and believed to possess those same "All-Weather" characteristics, are trading on forward PE of 24, despite a recent sell-off on failed attempt of the major shareholder to offload remaining equity.

As we can see from the list above, these reference points can be very powerful. Healthscope management has yet to prove itself and establish its own successful track record, but being in the slipstream of arguably the most successful business story of the past decade inside the Australian healthcare sector, Ramsay Healthcare, has already allowed for a premium valuation vis-a-vis proven success stories such as CSL, nib and others.

In a small market where real opportunities are rare, investors are prepared to buy first and ask questions later. I have little doubt the same principle applies to Medibank Private.

But what about the fun-da-men-tals, I hear you all ask. Is Medibank Private genuinely a company that deserves to trade at such high multiple on its own account?

If investors are expecting double-digit growth like most high PE stocks have been delivering, they most likely will be disappointed. Not in the least because Medibank Private has been preparing itself for this float since the last term of the John Howard and Peter Costello government (2006). In other words: the easy fat has been been cut already. This is not going to be a repeat of the QR National float when management had more fat at its disposal than it could possibly chew in the first year after listing.

But… the current environment remains supportive of reliability and predictability. Note the closest peer of Medibank, nib, only grew its earnings per share by low single digits in FY14 and there is currently no growth anticipated for the present year (FY15), but its PE multiple sits at 20. Probably no coincidence then, at the upper limit of the IPO price range, Medibank's prospective dividend yields for FY15 and FY16 look similar to what nib offers: 3.5% and 3.9% versus 3.9% and 4.1% respectively^(*).

The difference between these two is, however, that Medibank is going to shake up not only the private insurance sector, affecting nib and the other unlisted competitors, but the healthcare services sector in Australia in general.

Recent years leading into the upcoming IPO have already shown the first indications. Remember last year's stand-off between Medibank and Ramsay Healthcare about hospital costs for the private health insurer? Expect more of the same once the Medibank board and management are under daily pressure and scrutiny as a publicly listed company to grow the bottom line and to lift margins to industry standards, and above.

Note to self: last year's contract negotiations between Ramsay Healthcare and Medibank ended in favour of the latter. Is this going to be a blue print for future years? If so, does this warrant a de-rating of Ramsay Healthcare's PE given it will inescapably weigh upon margins for local operations?

Note also that healthcare services provider Primary Healthcare ((PRY)), only two months ago, acquired a small healthcare insurer, Transport Health, in what might well turn out to be the first step to buckle up against a more aggressive attitude by health insurers led by a private Medibank.

One other consideration is that dentists make up the second largest cost segment for Medibank, after hospitals, and they might prove an easier target to achieve cost savings and better margin. Is this going to be a growth problem for dental specialist 1300 Smiles ((ONT)) whose share price has gone sideways since March?

The most profound change should occur among private health insurers directly. At present, Medibank is the number one in the sector, with a market share of 29.5%. Second is BUPA. nib is fourth, but its share is only 7.7%. The five largest in the sector currently represent 83% of the market. This also means 24 of the 34 private health insurers have a share of less than one percent.

Some investors don't like the business models of G8 Education ((GEM)) and Greencross ((GXL)) which essentially are centred around gobbling up smaller players inside highly fragmented industries. Medibank CEO George Savvides has pretty much flagged that's exactly what his strategy is going to look like from the moment he's no longer operating as a government owned entity.

At face value, one would think there's more than enough fertile ground for a vicious land grab competition between Medibank and BUPA. The subsequent pressure on the rest in the sector might reflect badly on nib, which could thus face de-rating in the share market. But I think investors are likely to put nib in the basket of potential targets for the two leaders in the sector, and thus the share price is more likely to remain supported at elevated multiples.

In years to come, it is possible that we will look back from a healthcare landscape that has been seriously transformed and conclude: it all started with the privatisation of Medibank Private in late 2014.

Private health insurers have been enjoying annual premium increases of circa 6% and the industry still collectively takes care of premium cost overruns, which limits the downside and the potential for negative shocks. The big selling point, however, is the fact the Australian population is projected to continue growing in the decade ahead, with government policy directed towards more people taking up private health insurance. All this against a background of a steadily ageing population which should provide long-term tailwinds.

This is not a story that is going to evoke serious questions from the onset.

Yet, there are quite a number of negatives attached to the Medibank IPO story, including:

– the observation that growth in membership is absent for the core brand and is solely happening through the discount brand ahm (management has suggested this will change)

– no less than 25% of last year's financial result came from the investment portfolio which in itself will now become more conservative. The loss in contribution from a less aggressive investment style is co-responsible for the fact no growth should be expected for the first year of listing

– the board's policy is to pay out 70-80% of profits in the form of dividends to shareholders. At the upper limit of the range this appears high, leaving dividends vulnerable in case of a negative shock, in particular given the contribution from investments

– the sector has become reliant on steady annual premium increases, facilitated by the government, but what if government policies or attitude become less accommodative?

– at what point exactly do annual increases in insurance premiums lead to increased attrition amongst members?

– in similar vein, is a backlash awaiting for a sector that is about to put profits and shareholders ahead of care, service and members?

– the IPO prospectus has revealed a material contract with the Australian Defence Force, but without sharing any details. Contracts can be lost or subjected to a tender prior to expiry in 2016 (no details have been disclosed to date). See also: loss of Immigration Contract as mentioned in prospectus

– retail investors are expected to sign up without knowing what the price of the shares will be. Better to assume the price will be the maximum $2 per share then

I doubt, however, whether any of the above considerations will matter in the short to medium term.

Two of few truly independent researchers in the local market, Morningstar and Lonsec, have put their initial valuations for Medibank shares at $2.10 and at $2.33 respectively, well above the maximum price for the IPO. Lonsec is working off an average 6% annual growth pace for Medibank in the three years ahead, excluding acquisitions.

Unsurprisingly, both Morningstar and Lonsec have advised investors should apply for stock in the initial public offering (IPO), which remains open until midnight, 14 November 2014. Minimum size is $2000. Investors should expect to be scaled back when shares are allocated.

^(*) I am relying on Lonsec calculations and predictions which I think are more accurate than the oft cited 4%+ yield on a shortened first "year" of seven months only.

Not King Cole

Some 2.5 years ago, I returned from a two weeks trip to Canada and reported green activists are increasingly making headwinds into the world of finance and investing. It was but one of future trends I highlighted at that time, but it certainly is one that has the global mining community's attention. When BHP Billiton ((BHP)) started seeking media attention about how the world will still be relying on coal for cheap energy for many decades to come, I knew this new threat was real and serious.

Coal is the new Satan, there's no two ways about it. Forget about a tiny university in coal-protective Australia which attracts far too much attention, and criticism, for relying on inaccurate analysis in its decision to abandon all investment in polluting companies. This is a story about global conscience driving politicians, and money flows, into action. And the ball has only just started rolling.

Planet Zero

Up and down, up and down. Asset prices are moving every day and the latest trend, so it appears, is for global equities to rally really hard, leaving the scare that dominated in September and most of October behind. But look beyond the daily noise and media coverage and what do we see?

Investment strategists at BA-Merrill Lynch see a world wherein investment returns appear increasingly lower and more difficult to achieve. Last week they observed some equities like the US large caps, are now back in positive territory for the running calendar year, but many other markets (Europe, UK, Japan, small caps, etc) are not. Assuming a globally diversified investment funds' methodology thus leads to the observation that, on balance, many an equities investor is not enjoying much in terms of actual return.

Things are not made easier by the added observation that commodities, as a group, are down double digits so far this year while total return from government bonds is 3.1%. Who would've expected that! It gets even more surprising. The 30-year US Treasury bond has returned more than 20%, making it one of the best returning assets in 2014.

So far, argues BA-ML, 2014 has been the year of pain for global investors "with consensus trades going awry almost every month". What we are experiencing, according to BA-ML's prognosis, is a world transitioning away from low growth & high liquidity to higher growth and lower liquidity. Market leadership is thus also transitioning away from Zero Interest Rates Policy (or ZIRP) winners to ZIRP losers. The first group, argue the strategists, consists of gold, high yield bonds, carry-trades and small cap stocks. ZIRP losers turning into the new winners include US dollar, banks and volatility.

BA-ML's strategic asset allocation favours long USD, long real estate, short commodities and a preference for stocks over bonds and credit. Investors in Australia have to take into account that both the Aussie dollar and Australian banks have been among the winners of ZIRP in recent years.

Calm Before Storm For Insurers?

Shares in insurance companies Suncorp ((SUN)) and Insurance Australia Group ((IAG)) have proven resilient in 2014, even despite the global carry trade inspired correction of September-October. All in all, returns for both remain solidly in positive territory for the year and day-to-day volatility has remained on the low side. In other words: the ideal pattern for yield seeking investors.

And yield is, and has been, the main attraction for local insurers. On current market consensus, IAG shares offer 5% (fully franked) for the year ahead and Suncorp's yield sits at an even more attractive 6.4%, also 100% franked. And there's more. Suncorp is swimming with cash and has been paying out special dividends for the past three financial years. Bell Potter's insurance analyst, on Monday, joined many of his peers by stating Queensland's bank-insurer should be in a position to continue paying out special dividends of some 15c per annum in each of the next three years – assuming underlying trends prevail.

It seems like it's Happy Days forever for shareholders in insurers, but all is not what it looks like on the surface.

Deutsche Bank insurance analysts, by far the most prolific on the industry's underlying dynamics over the past two years, have published yet another sector update and it definitely makes one wonder how long before investors start paying attention?

Local insurance companies are on occasion put on the same pedestal as the cosy oligopoly that exists among the major banks. The idea is that the likes of IAG, Suncorp and AMP ((AMP)) should be seen as solid, defensive, must-own, through-the-cycle portfolio stocks, but whether this image will hold up in the years to come remains one big question mark. In layman's terms: all is not well inside insurance land.

Competition, in the form of the banks and foreign challengers, continues to make inroads and market leaders IAG and Suncorp are shedding market share. Say the analysts at Deutsche Bank: "Over the last 5 years, we estimate IAG and SUN have lost a collective 7% market share across Home and Motor. A continuation of this trend would eventually undermine the scale advantage of this duopoly."

It is Deutsche Bank's view things will only be getting worse as both market leaders will start defending their market positions, which means lower prices, downward pressure on margins and deteriorating financial metrics such as Return on Equity (ROE). All this should translate in no bottom line growth by FY17. And a likely de-rating from the market, as FY15 (this year) will likely prove the peak in dividend yields for respective shareholders.

On Deutsche Bank's projections, total investment returns for both IAG and Suncorp will not match the prospective yields between this year and FY17. Which then leads to the conclusion that beaten down QBE Insurance ((QBE)), maligned and cursed by many by now, offers the superior potential in the sector. The latter assumes, of course, there's not one cockroach left in any of the filthy-moist corners of what has been a pest-infected QBE kitchen in years past.
 

Buy-Backs Rule

I've labeled it the Americanisation of the Australian share market. Economic momentum might be patchy, and the Aussie dollar still very much too high. No real help can be expected from Canberra and top line growth is still a demanding target. But none of this stops boards rewarding shareholders, just like their corporate peers have done on Wall Street in years past.

International research suggests a strong causation between companies who buy in their own capital and share price outperformance. At the very least, share buy-backs provide support to the downside in case of a defensive policy.

Here at FNArena, we've put together a list of companies that have announced buy backs:

Ansell ((ANN))
Aveo Group ((AOG))
Cape Lambert Resources ((CFE))
CSL ((CSL))
Dexus Property ((DXS))
Donaco International ((DNA))
Helloworld ((HLO))
Hills ((HIL))
Karoon Gas ((KAR))
Logicamms ((LCM))
Telstra ((TLS))

Companies believed to potentially announce buy backs in the not too distant future:

Aurizon ((AZJ))
BHP Billiton ((BHP))
Rio Tinto ((RIO))

If you know of any more companies, do tell us and we'll investigate and add them to the list. Our address, as per usual, is info@fnarena.com

Rudi On TV: The Week Ahead

On request from readers and subscribers, from now onwards this Weekly Insights story will carry my scheduled TV appearances for the seven days ahead:

– Wednesday – Sky Business, Market Moves – 5.30-6pm
– Thursday – Sky Business, Lunch Money – noon-12.45pm
– Thursday – Sky Business, Switzer TV – between 7-8pm
– Friday – Sky Business, Your Money, Your Call. Bonds versus Equities, with Roger Montgomery

Rudi On Tour

I have accepted an invitation to present to the Sydney chapter of the ATAA, in Sydney, on November 17th.

(This story was written on Monday, 27 October 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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