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Morningstar | Underlying Momentum Building for Medibank Private Despite a Soft First-Half 2019; FVE Intact

Narrow-moat Medibank Private’s strong underlying performance for first-half fiscal 2019 was offset by a sharp drop in investment income, with NPAT of AUD 208 million down 15% on first half fiscal 2018 but up 4% on second-half fiscal 2018. Core businesses continue to deliver sound results with a small net increase in policyholder numbers, improved health insurance operating profit of AUD 282 million, and a strong uplift in Medibank Health operating profit to AUD 29 million. Despite lower investment in the half, we expect a rebound in second-half fiscal 2019 in line with strong global and domestic equity markets. We reduce our fiscal 2019 NPAT forecast to AUD 430 million from AUD 455 million previously, reflecting lower-than-expected investment returns. Our AUD 2.95 per share fair value estimate is unchanged as forecast earnings in outer years is broadly intact. At current prices the stock is fairly valued. Despite a softer-than-expected fiscal 2019 result our positive view is intact, and we liked the progress made in improving the underlying business. The stock is trading on a fiscal 2019 P/E of 18 times, modestly cheaper than the listed peer NIB Holdings trading at 19 times forecast fiscal 2019 earnings.

Robust net health insurance margins of 8.7% were underpinned by a good expense performance with the MER down modestly to 8.5% from 8.6% a year ago and 9.0% six months ago. Solid momentum supports a bright outlook for Medibank’s private health insurance business, but the potential for a change in government in 2019 could limit premium increases to a maximum of 2% during the next few years. Interestingly, management noted its willingness to consider buying a smaller private health insurer in a stressed operating environment. Recent Minister approval for a 3.30% average increase across all Medibank and ahm insurance products is effective 1 April 2019. Previous premium increases for Medibank were 3.88% for 2018, 4.6% in 2017, 5.64% in 2016, and 6.59% in 2015.

Medibank highlighted possible unintended consequences of Labor’s policy to limit premium increases to a maximum of 2% for two years from April 2020 could potentially put smaller not-for-profit health insurers under financial stress as some in this cohort already operate on very slim insurance underwriting margins. Market leader Medibank’s net insurance underwriting margin is 8.7% as at Dec. 31, 2018, and the industry average is about 5%. The industry regulator, Australian Prudential Regulation Authority, would likely force consolidation on funds that making underwriting losses.

Fiscal 2020 will likely be a challenging operating environment for private health insurers with a potentially lower premium rate rise environment. Due to its scale and active focus on improving customer experience and outcomes, we think Medibank is well placed to cope with the headwinds, but the government of the day needs to continue system reform to ensure sustainability across the industry. Despite political and regulatory challenges, we expect Medibank to eke out small increases in policyholder volumes at margins only modestly lower than fiscal 2019 levels. To achieve this outcome management must maintain ongoing tight control of operating expenses. Guidance was confirmed for AUD 20 million in productivity savings in each of fiscal 2019 and fiscal 2020.

The interim fully franked dividend of AUD 5.7 cents per share is up 3.6% on pcp based on a 67% payout of the underlying EPS of AUD 8.5 cents per share. Full year payout ratio guidance remains at the top end of the 70%-80% range. Despite our lower forecast NPAT for fiscal 2019 we maintain our AUD 13 cents per share forecast dividend.

CEO Craig Drummond confirmed no change to the outlook for fiscal 2019, with private health insurance market volumes expected to remain flat. Medibank Insurance delivered a AUD 536 million pretax operating profit in fiscal 2018, and we forecast a modestly higher result for fiscal 2019. In the past the Medibank Private brand has struggled to retain policyholders, but the insurer is targeting a flat outcome in policyholders in fiscal 2019 compared with a 2.2% decline in fiscal 2018 and a 4.1% in fiscal 2017. If achieved this will be a good outcome. Medibank expects utilisation growth rates for both hospital and ancillary to remain subdued for the remainder of fiscal 2019. In the short to medium term expect 1-2 more small acquisitions to continue to build health services capability.

Management expenses are being tightly managed and are broadly stable of pcp and declined 3% on prior period. Management expenses for fiscal 2019 are targeted to be modestly above the AUD 557 million incurred in fiscal 2018. We forecast a MER of 8.7% for fiscal 2019 compared with 8.8% in fiscal 2018. Medibank’s strong market position and focus on customer retention and improved productivity is expected to underpin high health insurance operating margins of 8.3% in fiscal 2019, modestly lower than 8.5% in fiscal 2018.

Positively, Medibank’s overall market share has started to increase, with a 2-basis-point increase in the half following a 5-basis-point increase in second-half fiscal 2018. Medibank is targeting modest market share growth in fiscal 2019 with approximately 6,400 net policyholders added in first half fiscal 2019. We forecast net increase in policyholder numbers of 0.5%, or 10,000 in fiscal 2019 and 1.5%, or 27,500 in fiscal 2020. We expect flat overall PHI market volumes to persist during the next 12 months at least.