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Morningstar | NIB’s 1H19 Result Highlights Challenges Facing Private Health Insurers. No Change to AUD 6.20 FVE

Narrow-moat-rated private health insurer NIB Holdings delivered a solid first-half fiscal 2019 performance with reported NPAT up 5% on previous corresponding period, or pcp, to AUD 74 million, in line with our expectations. But the make-up of the result surprised. A strong insurance underwriting result was partially offset by a weak performance from the firm’s travel insurance business and a sharp fall in investment returns. We were impressed with the modest guidance upgrade for fiscal 2019. NIB’s consolidated group underlying operating profit (profit before amortisation, M&A costs, interest expense, investment income and tax) guidance for fiscal 2019 is for at least AUD 195 million, up from previous guidance of at least AUD 190 million.

Our fiscal 2019 underlying operating profit forecast is AUD 196 million, and if achieved, will be 6% higher than fiscal 2018. At current levels, NIB is trading 8% below our valuation, at around 20 times forecast fiscal 2019 earnings. We forecast strong earnings growth with EPS to grow an average of 9% per year until fiscal 2023.

We modestly upgrade our fiscal 2019 underlying operating profit to just above guidance, incorporating lower health insurance claims expenses partially offset by lower World Nomads net operating profit. We slash our full-year investment return forecast to AUD 19 million from AUD 32 million previously with our forecast reported NPAT forecast falling to AUD 133 million from AUD 140 million previously. Our fully franked dividend forecast for fiscal 2019 is AUD 20 cents per share, flat on fiscal 2018. We expect the fiscal 2019 dividend payout to be 69% towards the top of the 60%-70% target range.

Solid top line revenue growth and weak claims inflation drove the strong performance from the Australian resident health insurance business with underlying profit up 33% to AUD 88 million on the back of an impressive net margin of 8.8% for the half, well up on 7.3% in pcp.

The Australian resident health insurance performance benefited from a full six months contribution from the GU Health acquisition compared with two months contribution in pcp. The international inbound students and workers private health insurance business performed strongly with double-digit top line and earnings growth underpinned by strong policyholders growth and the GU acquisition. The underlying operating profit increased 16% to AUD 18 million with net margins for this business steady at 33%. The international inbound business continues to impress, and we expect further solid growth going forward.

New Zealand operations suffered a sharp 28% decline in underlying operating profit to AUD 10 million down from AUD 13 million in pcp. Claims expense increased 10% and the net margin declined 430 basis points to a disappointing 9.1%.

The travel insurance business, World Nomads, disappointed again and is under pressure to generate an acceptable return on investment. Underlying operating profit of just AUD 2.3 million was down 51% on the pcp. Domestic sales declined 22%, savaged by strong competitor activity in the online channel. Internal sales were strong, up 14%, led by North America, which accounted for over 40%. Operating expenses increased due to continued investment in the business to support further international expansion. The QBE Travel acquisition is expected to complete during the June 2019 quarter and should bolster domestic sales. World Nomads cost about AUD 97 million in 2015 and needs to improve quickly or be sold.

Net earnings on the AUD 864 million investment portfolio plummeted to just AUD 1.5 million for the half down 91% from the AUD 17 million made in pcp. Capital levels remain strong, but potential Australian Prudential Regulation Authority, or APRA, changes to regulatory settings could dictate an increase in capital. APRA’s private health insurance capital review is expected to complete by the end of calendar 2019. NIB Holdings has alternatives to cope with any potential changes to capital requirements. The firm could reduce the current 60-70% dividend payout ratio to generate capital organically, replace some senior debt with subordinated debt, and retain capital by offering a dividend reinvestment plan.

The poor investment performance reflects weaker investment markets, particularly domestic and global equity markets in the first half. We now forecast second-half net investment returns of AUD 17.5 million compared with just AUD 1.5 million in the first half. Poor returns are cyclical, depending on the market, and have rebounded in January in line with the investment market recovery.

Based on full-year guidance, second-half group underlying operating profit is now expected to be AUD 82 million, substantially lower than the first-half underlying operating result of AUD 114 million. Seasonality is a feature of the private health insurance sector, with second-half expenses typically higher than first half due to higher ancillary claims costs and advertising and marketing expenses.

A change of government, weak industry growth rates, margin pressure and increased investment across the business are short-term risks. Private health insurance affordability continues to constrain policyholder growth and political risks are increasing with government instability in Canberra. Political risks are increasing with the federal opposition proposing to restrict the annual increase in private health insurance premiums to 2% for two years. The negative impact from limiting premium growth to 2% per year is partially offset by further expected declines in the claims costs and hospital utilisation rates and expected improvements in productivity. But, lower premium increases may result in increased participation and utilisation rates.

NIB increased net policyholders in the key Australian resident health insurance business by 1.1% during the six months to Dec. 31, 2018 and a net 2.9% in 12 months to Dec. 31, 2018 to 601,000. This is below NIB’s average of 4% per year during the past five years, but still accounted for 33% of industry growth for the six months to Dec. 31, 2018. Group policyholder numbers increased 5.6% to 863,000 during the 12 months to December 2018. We forecast NIB increases group policyholder numbers an average of 3.7% per year to end fiscal 2023, leveraging its expanding distribution capability and niche targeting to grow its policyholder base.

We expect a strong performance from the key Australian operations in fiscal 2019 and the first full-year contribution from GU Health that was acquired in September 2017. We continue to forecast good growth in net policyholders, increased market share, a benign claims environment and lower, but still impressive, net margins. We expect sold growth from the third party health insurance distribution arrangements, but World Nomads and New Zealand will likely continue to struggle. The inbound international workers and student’s health insurance business is performing very well and will make a solid contribution to second-half underlying operating profit.

Growth in the “partners” distribution channel is needed to underpin our forecast volumes. We expect return on equity to remain at impressively high levels around 24% during the next five years despite the higher capital base following the GU Health acquisition and future participation in the dividend reinvestment plan. Negatives included increased uncertainty around future regulatory capital requirements, higher spend on marketing, technology and underwriting expenses, and a modestly softer outlook for dividend growth.