The Medibank Private Limited (MPI) of today commenced its operating life in July 1976 as a “not-for-profit” Government owned health insurer. It was created by the Whitlam Government which succeeded in passing legislation for its creation following a double dissolution of Parliament and the subsequent dual sitting of both houses. So on the passing of former Prime Minister Whitlam it is indeed a touch ironic that the Government is conducting the public sale of the now “for-profit” MPI.
The business of MPI converted to a commercial enterprise in 1998 and became a “for-profit” private insurer in 2009. From that point the seeds were sown for a float of the business, and today we are presented with an opportunity to invest in the market leader in private health insurance. The Government is selling 100% of MPI and 2.75 billion shares are being offered to the public and institutions.
Figure 1. Top 10 PHI industry market share in Australia by number of Principal Policyholders
Source. Medibank Private Share Offer Prospectus
In order to commence the review of the float and its parameters, we start with the balance sheet equity and determine the implied goodwill suggested by the offer price range. The following table discloses that the adjusted (ex dividend) equity of MPI as at 30 June 2014 was $1.03 billion. Readers will observe that the Government snared some $238 million of dividends prior to the float, the bulk of which comes from retained earnings. For some reason, the PDS offer document notes that the new public shareholders will not be entitled to any franking from the Government owned business and so it needed to be paid out.
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Figure 2. Medibank Private’s Capital Position as at 30 June 2014
Source. Medibank Private Share Offer Prospectus
From the above, we can compare the equity in MPI with the indicated sale price range. The range is $1.55 per share (or $4.26 billion market cap) to $2.00 per share (or $5.5 billion) and thus the sale price is pitched at between 4 and 5 times equity. The goodwill factor is $3.4 billion to $4.6 billion and the actual “tangible” equity becomes a mere $857 million as at the float date with none of the sale proceeds being invested in the business.
The forecast pro-forma profit is presented in the prospectus as follows:
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Figure 3. Historical & forecast consolidated income statements
Source. Medibank Private Share Offer Prospectus
The pro forma forecast NPAT of $258 million is commendable because it appears to be generated from an average capital base of $1.2 billion. MPI has paid out capital (to the Government) but it will be replenished from operating profit over the FY15 with no dividend paid until September 2015. Thus the notional return on equity is forecast at about 18%, and we believe that the normalised return (used in StocksinValue) will lift in FY16 to about 23% as franked dividends are paid to shareholders.
In subsequent years, the Board appears committed to a payout ratio of about 75% so long as MPI capital is prudently maintained at over 12% of written premiums. With premiums tracking north of $6 billion, MPI appears well capitalised and, subject to unforeseen circumstances, should be able to pay a solid level of franked dividends (albeit with a high pay out ratio). MPI is not a capital hungry business and so this enables it to support a high level of goodwill.
The first dividend of 4.9 cents is proposed to be paid in September 2015 and represents 7 months of operations. This suggests an annual dividend rate of about 8.4 cents that should grow into the future if the business grows.
Armed with the above information, we can draw some preliminary conclusions on the offer price range and MPI’s value. At the outset, it is clear that the upper end of the range at $2.00 is fantasy. Arguably it is a level set to make retail investors think that a discount on this price is a bargain. A $5.5 billion valuation and a notional $4.3 billion of goodwill is not justified when compared to the estimated return on the equity of $1.2 billion.
Think about it this way. If a private business was offered to you that made a mere $26,000 in profit on equity of $120,000 what would you pay for it? Would you be tempted to pay $550,000? If you did, would you be prepared to pay the consideration up front, or would you pay over time based on achievement of profit? Would you pay $550,000 simply because someone else, who you do not know, paid a similar price for a similar business?
By paying the top range price of $5.5 billion for MPI, an investor would be accepting a potentially low 5% return on their investment. Whilst it is enhanced by franking credits (in a year’s time) on paid dividends, the return to the investor could only reach a more desirable return of 10% if the shares traded 5% higher than the purchase price. Frankly, that is unlikely to occur based on a rational approach – however admittedly asset prices frequently behave in illogical fashion in this era of super low interest rates.
In simple terms, an investor who overpays for an asset and accepts a low return is taking on higher risk. Risk is not measured by the size of the company or its weighting in a share index. Risk is a function of the likely return, and the likely return drops if an excessive price is paid.
Further, the argument that price risk is mitigated by comparisons to market prices of other companies is flawed. That is the logic that ultimately leads to sharp market corrections where everything falls in price.
So if the top end price is unattractive, how does the low end price of $1.55 per share look?
Rational investors seek to pay the lowest possible price for an investment asset. A $1.55 price is clearly better than $2.00, as the likely return to an investor rises. The potential to achieve a 10% per annum return from MPI over the next 5 or so years is enhanced at $1.55, but it is not certain.
Apart from market price risk, the $1.55 price is also fairly full and just below our intrinsic value of about $1.65. The notional return on equity and goodwill to the new owner is about 7%. With franking credits, the return lifts towards 10% but there is not much room for error. The business would be fairly priced, but at least it is not “priced to perfection” that is represented by the $2.00 price.
In our view, MPI is a highly profitable business whose return on equity is consistent with industry wide performance. However, MPI operates in a highly regulated industry and its premium increases are subject to government control. Whilst there is an opportunity for management to enhance returns by improving underwriting margins; by managing the balance sheet equity and costs better, it is hardly logical for an investor to pay a premium on those expectations. An investor should not pay for tomorrow’s promises but should be rewarded for success.
MPI can improve and it will – but that begs the question as to what management has been doing and has government ownership impeded performance?
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Figure 4. Top 10 FY13 PHI industry net underwriting margins
Source. Medibank Private Share Offer Prospectus
MPI offers limited value at the bottom end of the price range. However, the float is a speculator’s delight with an elevated share market and the painful alternative of low bank deposit rates. Some questions include whether MPI should trade on a dividend yield of 4% or 5%? Is it another Telstra with predictable dividend flows? Is the current government going to be supportive of private health insurance? Could a future government drive premium growth lower by edict? Could future minority parties use the cost of healthcare as part of a heated political negotiation?
Then there is the crazy process of the book build, which is an investment banking construct that challenges fairness and logic. Retail investors are investing blind. They will not know the price until after an institutional book build is completed. Unlike many previous floats, there is no retail discount and there is no short term dividend proposed.
We see the following occurring (subject to a world wide share market correction). The retail bidding substantially covers the likely sale requirement of $4.5 billion. But that means little because recently we saw the $2.7 billion Commonwealth Pearls 7 covered by retail investors before it fell 3% on the opening. Then the book build managers will negotiate with the fund managers who will want as much stock as possible at the lowest price. The game is a moving feast because everyone needs to watch the US equity market to ensure market sentiment is healthy. This process is a function of greed, naivety, indexing, inside deals and a political imperative for success.
All in all, that smells like a potential stag profit to those that have an appetite for risk. However, whether the ultimate return justifies the risk taken will only become apparent after the event.
