"What do you guys think of Medibank Private?"
That's a question we've been getting a lot of the past few weeks at The Motley Fool. It's no wonder — companies of Medibank's $5 billion size don't go public very often.
The biggest game in town
Medibank enjoys market share of 29.1% and provides coverage to over 3.8 million Australians. That makes Medibank the largest private health insurer in Australia overall, and either the first or second largest in every Australian state and territory.
Its dominant market position gives Medibank big scale advantages over smaller competitors, by enabling the company to spread its fixed costs over a much wider base. The company can also squeeze better deals out of healthcare providers – a win-win that benefits both Medibank and its policyholders.
Medibank has leveraged its market position to drive growth, with annual revenues more than doubling over the past decade, from $2.5 billion to $6.4 billion. The company has been generating great returns for its government shareholder during that time, with a current return on unlevered equity of 18.4%. And its government-owned pedigree means the company is entirely debt free – a unique position for a company of Medibank's size and with such steady recurring revenues.
Those reliable cash flows also allow Medibank to pay out around 70% of profits as fully-franked dividends. At the upper end of the indicative IPO price, that puts Medibank on a juicy dividend yield of 4.2%.
A 'fixer-upper'
Medibank's IPO is a little unique. Despite the company's dominant market position and growth, most of the excitement around the IPO comes not from what Medibank is doing very well, but from what it's doing poorly.
Medibank switched to 'for-profit' mode in 2009. The company has made significant improvements to its operations since then, but there is still a lot of work to be done to bring Medibank into line with other for-profit health insurers.
On top of simply cutting costs further, management will also need to do some smart thinking to squeeze further efficiency gains out of the business.
(Source: Medibank Private Prospectus)
That room for improvement is actually a large part of why we were so keen to join the roadshow. By improving margins, Medibank should be able to take a big step up in profitability in the short run, before settling in to a more stable long-run growth rate.
What's it worth?
Which brings us to the $5 billion dollar question – how much is Medibank actually worth?
The company's management has guided for pro forma 2015 net profit of $258.2 million. That estimate assumes top line growth of 6.2% while increasing the company's health insurance operating margin half a percent, up to 4.9%.
Both of those seem to be reasonable assumptions to us, given recent trends and the more stringent management oversight that a public listing is likely to bring. The next step is to estimate what multiple of next year's estimated earnings we should pay today.
Medibank's dominance means it deserves a slightly lower discount rate than most of the market, to reflect the stability of the company's earnings. When we combine that discount rate with an expected long-run growth-rate of 4.5%, we arrive at a fair multiple of forward earnings of 22.2 times.
Plugging that back in to Medibank's offer and we arrive at an estimated fair price of around $2.08 per Medibank share. Perhaps not coincidentally this is just marginally above the high end of the company's expected IPO price range of $1.55 to $2.00.
But as value investors we don't want to pay what we think a company is worth – we want to find bargains!
After applying a fair margin of safety to Medibank, again reflecting its strong market position, we'd want to pay no more than 18 times forward earnings. That gives us a cushion in case the business falls a bit short or, more optimistically, pads our returns. That puts our preferred buy price at around the $1.66 mark.
