Questions About Medibank Private’s Margin Sustainability

This story features MEDIBANK PRIVATE LIMITED. For more info SHARE ANALYSIS: MPL

-Competitors also likely to re-submit increases
-Major uncertainties continue with govt review
-Closing in on optimal margins, soft earnings growth
 

By Eva Brocklehurst

Medibank Private ((MPL)) surprised brokers by announcing a substantial upgrade to earnings guidance for FY16 but questions are raised about the sustainability of margins and, therefore, how long growth can continue.

The company has increased its operating profit guidance to $470m from $370m, driven by lower claims expenses and reserve releases. The revised guidance recognises a lower level of claims as a consequence of the payment integrity program, improved hospital contracting and favourable industry trends, as well as increased marketing and brand investment.

Credit Suisse suspects this action by Medibank Private is probably a one-off, although positive industry trends should continue. The broker upgrades profit forecasts by 23% for FY16 and by 1.0% for FY17. In FY17 the company reaches the broker’s target of a 6.5% net margin, earlier than expected, but this is offset by lower premium growth assumptions.

Medibank Private will re-submit its premium increase application in order to share some of the benefits with policy holders but Credit Suisse believes, with the company now producing a record net margin, there is minimal case, if any, for a rate increase in coming years.

The broker warns, while some investors may be tempted to assume this places Medibank Private at a competitive advantage, a number of insurers are expected to re-submit applications for lower premiums.

The company has traded at a significant premium to the market over the past year, which reflects strong earnings growth but as this is expected to slow in FY17, on peaking margins and regulatory pressure. Credit Suisse considers the stock no longer deserves such a premium and maintains an Underperform rating.

UBS concedes its Sell rating is challenged by the latest upgrade to FY16 guidance and that it probably underestimated the flow through to gross margins. Momentum may carry into FY17 but the broker is resolute that margins above 7.0% are not sustainable. Key uncertainties lie with the government reviews under way.

The broker highlights the lack of detail on the reasons quoted for raising guidance and asks: How can $100m drop into the numbers over a couple of months? The emphasis appears to be on product mix, which in turn favoured higher margin business, as well as a soft half in hospital utilisation rates and underlying inflation. Still, UBS warns against chasing the momentum and retains a Sell rating.

The other question is regarding the uncertainty surrounding the industry review and how long that will continue. UBS suspects the government may make its intentions clearer in coming months but changes may be controversial and have long dates for implementation. UBS does not expect Medibank Private's brand will start growing in line with the market over the next 12-18 months.

A similar theme is playing out at Macquarie, with a downgrade to Neutral from Outperform. The broker considers the balance of risks is now more neutral, with the reviews that are ongoing presenting the single biggest risk to the sector outlook. Morgan Stanley also notes the company is a step closer to optimal margins and mid single digit earnings growth.

Regulatory risks are expected to neutralise any earnings surprise while other health funds are also expected to re-submit their filing to the health minister, to counter any advantage Medibank Private seeks to gain. Benign claims inflation is driving the improvements but Morgan Stanley also highlights that this means lower top line growth.

Citi is more buoyed by the upgrade, maintaining a Buy rating and continuing to envisage the potential for further cost savings, while Morgans believes the key is whether the company can hold onto, or improve, its margins.

Margins are near historically high levels and if they cannot be maintained the broker suspects the earnings growth profile will quickly become subdued. Morgans believes the company's efforts to improve hospital gross profit margins are bearing fruit, with the benefits from recent hospital re-contracting likely to flow further.

The broker acknowledges the fist half was assisted by abnormally low hospital utilisation, something which the company expects will normalise going forward. Overall, the regulatory risk remains at the forefront and Morgans sticks with a Hold rating.

FNArena's database has two Buy ratings – the second one is Deutsche Bank which is yet to update on the latest upgrade. There are three Hold and two Sell ratings. The consensus target is $2.47, signalling 0.7% downside to the last share price. This compares with $2.32 ahead of the announcement. Targets range from $2.10 (Morgan Stanley) to $2.90 (Citi).

Goldman Sachs, not one of the eight brokers monitored daily on the FNArena database, suspects Medibank Private will report a record net margin comparable to its closest peer, Bupa Australia, in FY16. Guidance implies a gross margin of 16%, in line with previous records in FY08 and FY11.

Given the company's history of following up record gross margins with a large retracement the following year, Goldman Sachs retains a cautious element to its forecasts.

The broker has a Neutral rating but does observe that the company is progressing with its efforts to roll out new contracting terms with hospitals. The company has also stated it is not budgeting for a structural slowdown in admissions growth.

The question for Goldman is the extent to which Medibank Private can sustain this margin in the future, given its desire to reinvest part into lower premium growth, as well as what the government considers is an appropriate margin and return in a highly regulated industry.

Disclosure: The author has shares in the company.

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