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Morningstar | Medibank Private Remains in Good Shape Despite a Softer-than-Expected FY18. FVE AUD 3.10 Unchanged. See Updated Analyst Note from 23 Aug 2018

Despite a softer-than-expected fiscal 2018 result, our positive view on narrow-moat-rated Medibank Private is intact. Good progress in improving the underlying business impressed with the health insurance operating profit up 8% to AUD 536 million and the health services business, known as Medibank Health, operating profit up 33% to AUD 47 million. The group NPAT margin of 6.4% was modestly below our 6.8% forecast.

Lower-than-expected investment income, a higher tax rate, and higher other expenses contributed to the 1% decline in fiscal 2018 group NPAT to AUD 445 million, about 5% below our forecast and 3% below consensus. The final dividend was a modest disappointment at AUD 7.2 cents per share, or cps, taking total dividends to AUD 12.7 cps, below our forecast of AUD 13 cps, but still 6% higher than fiscal 2017. We maintain our AUD 3.10 fair value estimate and at current prices, the stock is fairly valued.

Our fiscal 2019 net profit forecast of AUD 461 million is lower than our previous forecast of AUD 476 million with modest declines in outer years contributing to our unchanged valuation. Despite the challenges, the health insurance margin of 8.5% impressed and is broadly in line with our five-year average. The health insurance performance was in line with expectations with gross margin of 17.3% compared with our forecast of 17.1%. The underwriting expense ratio of 8.8% was broadly in line with our 8.7% expected and the insurance operating margin of 8.5% was marginally higher than our 8.4%. The outlook statement for fiscal 2019 was typically vague with Medibank targeting modest market share gains, despite the insurer expecting flat overall private health insurance volumes to persist. Hospital utilisation growth is set to remain subdued, but ancillary utilisation growth is expected to slow. Management expenses are targeted to increase modestly above the AUD 557 million incurred in fiscal 2018. Our fiscal 2019 management expense forecast is AUD 560 million.

Medibank expects to make one to two small acquisitions in fiscal 2019 to continue building the firm's health services capability. An acquisition in the AUD 70 million price range is on the radar, beefing up the insurer's "Medibank at Home" initiative. Medibank is targeting to double the number of customers participating to approximately 2,000 in fiscal 2019 from 936 customers in fiscal 2018.

The health insurance business is targeting to increase the number of customers contacted to approximately 1.5 million in fiscal 2020 from about 500,000 in fiscal 2018. Productivity improvements are crucial to longer-term earnings growth, with the firm boosting expected savings delivered in the three-year program to AUD 60 million from AUD 50 million previously. Approximately AUD 20 million in productivity savings were achieved in fiscal 2018 with another AUD 40 million in total targeted for fiscal 2019-20.

The stock is on a fiscal 2019 P/E of 18 times, cheaper than the listed peer NIB Holdings trading at 22 times forecast fiscal 2019 earnings. Our positive view is intact as meaningful improvements in underlying business drivers will support future earnings growth. But we acknowledge, private health insurance affordability continues to constrain policyholder growth and political risks are increasing with government instability in Canberra.

Importantly, for the first time in a decade, the insurer's market share increased for a six-month period with the 0.05% increase in second-half fiscal 2018. Despite early days, we are impressed with the turnaround considering the sustained long term decline. We estimate the insurer's market share was 26.85% at June 30, broadly stable on the 26.93% at June 30, 2017. Medibank increased net policyholder numbers by 0.3% and longer term, we forecast net policyholder growth to gradually recover, averaging 2.8% in the next five years.

Medibank Health increased in operating profit to AUD 47 million, about 7% below our forecast of AUD 53 million with the operating margin up 150 basis points to 7.7% due to the change in business mix. The health services business increased its share of group operating profit to 8.1% from 6.7% a year ago. Medibank Health's segment profit is on track to achieve the goal of doubling contribution from the 4.6% achieved in fiscal 2016.

The net reported investment return of 3.7% was lower than our forecast of 3.9% resulting in investment income of AUD 96 million, about 7% below our forecast of AUD 103 million. Fiscal 2018 investment income was 31% lower than the unusually high AUD 139 million in fiscal 2017, based on a 5.8% net return. Medibank's underlying return premium was 1.7% above the Reserve Bank of Australia, or RBA, cash rate benchmark. Higher-than-expected equity returns and tighter credit spreads contributed to the fiscal 2017 outperformance. The underlying return target is 1.5%-2% above the RBA cash rate, currently at 1.5%.

Despite return on equity decreasing to 25% from 27% a year ago, the impressively high outcome is a good indicator the firm's narrow economic moat continues to provide shareholders with attractive returns well above our allocated 9% cost of capital. The capital position remains sound with capital 14% of premium revenue as at June 30, 2018 at the top end of the firm's 12%-14% target range.

The private health insurer's growth strategy is on track and the outlook is good. Medibank remains well-positioned to deliver meaningful business improvements, which will underpin future earnings growth. But we acknowledge, private health insurance affordability is a major threat and continues to constrain industry wide policyholder growth.

Political risks are increasing with the federal opposition party proposing to restrict the annual increase in private health insurance premiums to 2% for two years. The average industry premium rate increase was 3.95% for 2018 and we expect a lower increase effective April 1, 2019--probably around 3% levels.

As expected, second-half fiscal 2018 NPAT of AUD 200 million was lower than first half of AUD 246 million due to higher costs, seasonal dynamics, lower investment returns, and the cost of a one-off AUD 20 million loyalty bonus marketing initiative. Traditionally, the seasonal earnings split is 52%/48% first half/second half, but fiscal 2018 the split was 55%/45%.

Lower hospital utilisation growth rates experienced in fiscal 2018 are expected to continue into fiscal 2019. However, the utilisation benefit will be partially offset by lower receipts from the risk equalisation pool. The recent higher growth rate of ancillary, or extras, claims costs is expected to ease in fiscal 2019.

The insurer's capital position remains strong, but our total dividend forecast for fiscal 2019 of AUD 13.20 cps is modestly lower than the previously forecast AUD 13.50 cps. The forecast dividend represents a full-year payout of 79%, towards the top end of the 70%-80% target range. Longer term, we expect the payout to average around 78% per year.