As I am sure you have seen in the press recently, Medibank Private is being sold, and there is a lot of discussion and commentary as to whether or not to participate in their IPO (initial public offering). I have done quite a bit of research to assist you in making an informed decision as to whether or not to participate in the offer.
In simple terms, if risk is defined as not achieving what you want to achieve, an investor who overpays for an asset, accepting a lower return is less likely to achieve their goals and is, thus, taking on higher risk. In this case, risk is not measured by the size of the company or its weighting in an index – it is a function of the likely return! This return drops if a higher price is paid. Some will argue that the risk is reduced by comparing market prices of other companies. This is flawed – this is the logic that leads to market corrections where everything falls in price.
Looking at the balance sheet, the ex-dividend equity of Medibank Private (MPI) as at 30 June 2014 was $1.03 billion after the Government paid itself a dividend of approximately $238 million, the bulk of which came from retained earnings. The PDS says that the new shareholders are not entitled to any franking credits from the Government owned business, so these retained earnings had to be paid out!
The price range for the shares is $1.55 per share (or a market capitalisation of $4.26 billion) to $2.00 per share (or $5.5 billion). This means the sale price is 4 – 5 times equity. The goodwill is $3.4 billion to $4.6 billion so the tangible equity is about $860 million. None of the sale proceeds are being invested back into the business. MPI has paid out these retained earnings but it is forecast that this amount will be “paid back” from operating profit over the FY15 as no dividend is to be paid until September 2015.
The Board appears committed to a payout ratio of approximately 75% as long as MPI capital is maintained at over 12% of written premiums – a fairly prudent level. With premiums over $6 billion per year, it appears that MPI will be well capitalised and, subject to unforeseen circumstances, should be able to pay a solid level of franked dividends, eventually. With this high payout ratio, it is good that MPI is not a capital hungry business as this means the company should be able to support this high level of goodwill.
The indicative first dividend of 4.9 cents is proposed to be paid in September 2015 after 7 months of operations. This is an annualised dividend rate of about 8.4 cents (4.2% on $2 share price) – nothing special. Based on this analysis, it is clear that the price at the upper end of the range – $2.00 – is very optimistic. It seems to have been set at this level to make retail investors think that anything below this price is a bargain.
By paying $2 per share, a capitalisation of $5.5 billion for MPI, investors will be accepting a potentially 4.2% return on their investment. While it will be enhanced by franking credits eventually, the total return to the investor will only reach a return of 10% if the shares trade at more than 5% higher than the purchase price. Frankly, I don’t think this is likely to occur based on this – BUT I also admit share prices often behave in totally illogical fashion and I’ve been known to be wrong before!!
So, how does $1.55 per share look?
$1.55 per share is clearly better than $2.00, as the possible return to investors is higher. The possibility of achieving a 10% per year return from MPI over the next 5 years is improved from $1.55, but is still not certain. The total return on equity and goodwill to the investor is about 7%. With franking credits, the return lifts towards the 10% level!
While MPI is a highly profitable business with a return on equity consistent with industry performance, it operates in a highly regulated industry. Its premium increases are subject to government control.
Also, while there may be an opportunity for management to improve returns by improving underwriting margins, by managing the balance sheet equity and costs better, why should an investor pay a premium based on those expectations? As an investor, you should not pay for tomorrow’s promises ahead of time, rather you should be rewarded for their success.
The float looks like a speculator’s dream – with an already high(-ish) share market and low bank deposit rates encouraging investors to look for alternative opportunities. There are some significant questions the answers to which should be considered before making any investment:
- Is MPI likely to trade on a dividend yield of 4% or 5%?
- Will the dividend flow be as predictable as Telstra’s?
- Once MPI is sold, will the current government continue to be as supportive of private health insurance as it is now?
- Will a future Labor government keep premium growth lower by controlling the level of premium increases?
- Will the Greens and independents use the cost of healthcare as part of a heated political negotiation, forcing premium growth down, if they continue to control one of the houses?
With the sale process set as it is, there is also the process of the book build to consider – this is an investment banking tool that effectively means retail investors are investing blind. You, as a retail investor, will not know the price you are going to pay for the MPI shares until after this institutional book build is finished. Unlike many previous floats, there is to be no retail investor discount and there is no immediate dividend proposed to soften the institutionally driven price.
Unless there is another sharp correction in world investment markets, the share sale will probably go something like this:
- the retail bid will cover the likely sale requirement of $4.5 billion – this may not mean much as we recently saw $2.7 billion of Commonwealth Pearls 7 covered by retail investors – before the price fell 3% on the opening!
- the book build managers will then negotiate with the fund managers who will want as much stock as possible at the lowest price, as they try to get as many shares as possible to reflect the weighting that MPI holds in the particular index they are trying to get close to.
All of this will be going on with one eye on the rest of the world to see whether or not share-markets are remaining buoyant to not – what’s happening to growth in China, what are resource prices doing?
While the portfolio building is going on in the early days after listing, there may be some opportunities for “stagging” – buying as many shares as you can afford, hoping that the share-price will rise sharply after listing so that you can sell your shares almost immediately, at a quick profit – a possible strategy for those with a high risk appetite but dependent on there being a sharp rise, enough to cover your disposal costs! Any gain from this strategy will be treated as taxable income but the real thing to consider is whether the return will justify the risk – and that will only be known in hind-sight!