The listing of health insurer Medibank Private Limited (ASX:MPL) on the ASX on Tuesday provided an instant win for the 440,000 retail investors who signed up for the offer.
Those retail investors paid $2.00 per share for their allocations, and shares opened 10% higher at $2.20. Within the first hour and a half, more than 288 million shares changed hands, roughly 10% of Medibank's shares on issue.
But many retail investors will have trouble selling their shares until next week. Huge volumes could again change hands throughout the week ahead, as investors are sent official confirmation on the number of shares they have been allocated, and many opt to cash out their profit. Others, especially large-cap fund managers, will be looking to buy in.
Priced for perfection
Now many investors will be wondering whether taking the gain (around 6.5% at the time of writing) is worth it, or whether they should hold on for the long term — particularly given that Medibank shares aren't exactly cheap, trading on a forecast price/earnings multiple of 23.4 times, and forecast to pay only one dividend next year, rather than the usual two.
While the prospectus had forecast a fully franked yield of 4.2%; that was based on a share price of $2.00 and annualising the 4.9 cents in dividends the health insurer is expected to pay in 2015.
So far it appears that investors are ignoring the high apparent valuation, in the hope that Medibank can grow its profits by cutting costs and improving margins.
Where's the upside?
The insurer doesn't have a lot of scope to raise premiums. Private health insurers have to submit proposed premium rises to the federal Minister for Health for approval – a key reason why premiums have risen by 8.4% annually over the past decade, while claims expenses are tracking slightly lower at 8.3% annually. That's the reason Medibank will be going after the expenses it can control.
Medibank's management expenses as a percentage of contribution income stand at 9.2%, compared to NIB Holdings Limited (ASX: NHF) 8.2%, and Australia's second-largest private health insurer BUPA's of 8.5%. Medibank suffers from lower profit margins as a result, being 4.7% of total revenue compared to BUPA's 5.8% and NIB's 5.2%.
Another area Medibank is likely to focus on is its higher cost members. 2% of members have been responsible for 35% of claims expenses in the past three years and the insurer intends to provide more support to these members, in an effort to reduce their claims.
There's two sides to that argument
Of course there are risks that Medibank is unable to cut its expenses as much as it would like, which would result in continued lower profit margins than its competitors.
Medibank also derived around 31% of its profit before tax from investment income. As an insurer, premiums paid up front can be invested to earn income for the group and is commonly referred to as 'float'.
Investment income is expected to fall to 25% of profits in the 2015 financial year, and is heavily dependent on interest rates, and with 18% of the Medibank's $2.2 billion investment portfolio held in growth assets, also at the mercy of the stock market. Medibank's board approved a change in July this year, allowing the company to invest up to 25% of the portfolio in growth assets, meaning an even larger percentage of investment income can be exposed to higher risk assets.
Many other things can go wrong which would affect profits, and with shares priced so highly, any misstep by management is likely to be given a black mark by the market.
Foolish takeaway
If Medibank can cut costs and improve its margins in line with its peers, then shares may well be worth holding onto over the long term.
But when you consider that the company is trading on a higher P/E valuation than blood plasma group CSL Limited (ASX: CSL), arguably one of the best businesses on the ASX, there's also a case to take the money and run.
