What should you do with your Medibank Private Ltd shares?

Medibank Private Ltd (ASX: MPL) shares have risen over 20% since mid-January following strong results and a profit upgrade. Today, the Federal Government approved a 5.64% increase to premiums across Medibank and ahm Health insurance policies, effective 1 April 2016.

This has given Medibank shares another leg up and many investors, myself included, are beginning to wonder what the future holds for this health insurance giant.

I, for one, believe the company still has a bright future and consider it a hold for the following reasons.

A changed company

It is important to note that Medibank is no longer the same company it was when it listed in November 2014.

Before its IPO, Medibank was government run which meant inefficiencies were likely to exist throughout its businesses (aka “government slack”). However, under the guidance of managing director George Savvides, Medibank appears to have cut the government slack and reigned in costs.

In its first half results for 2016, Medibank reported health insurance profits increased a whopping 58% (on prior corresponding period) to $271.7 million, driven by the success of a range of health cost management initiatives.

Group net profit after tax (NPAT) was also up 58.3%, but notably included a $23.2 million one-off tax benefit which is unlikely to be repeated in future years. Stripping this out, Medibank would have posted a formidable $204.4 million underlying group NPAT, implying solid growth of 42% (assuming nothing else changed).

Whilst its management expense ratio increased to 8.4% (from 8.1%), the pleasing fact was that premium revenue grew 4.6%, whilst health benefit claims growth was limited to 0.6%. This is impressive given slowing industry growth rates and is largely cultivated by Medibank’s ability to use its market position to negotiate (or as some may describe “bully”) better hospital contracts from health services providers. Since Medibank is no longer government run (hence no longer has political stigma attached to its commercial decisions), this is a benefit Medibank uses to its advantage which evidently augurs well for bottom line profits.

Future growth

It is important to remember that Medibank operates in a highly regulated industry, meaning any changes to its premiums need to be approved by the Federal Minister for Health.

Today, Medibank announced just that, with the government approving an increase to its premiums by an average 5.64%. This bodes well for Medibank given its health insurance premium revenue was $3.08 billion in its half year report. Accordingly, assuming all else remains equal, premium revenue should grow by another $173 million this financial year.

Admittedly, this growth in revenue won’t all translate to profit as costs are likely to increase as well (hence the need for premium increases). However, if Medibank maintains its gross margin of 17.2% (from 1H16), the increased premium revenues should deliver a further $29.8 million to profit (if everything else is to stay the same).

Key risks

Investors must remain cognisant of the fact that if costs increase more than revenue, these premium increases won’t necessarily correlate to higher profits.

Another key factor is increased competition within the saturated health insurance market. As was seen with NIB Holdings Ltd’s (ASX: NHF) announcement today, health premiums will increase by 5.55% on all of its products, implying that NIB should be able to provide cheaper health insurance.

Medibank also revealed that its ahm Health Insurance arm grew strongly in the first half of 2016, indicating that Medibank’s premium namesake brand might be getting cannibalised by its cheaper offering. This is something Medibank must address to ensure it remains profitable going into the future, which is why I am not jumping to buy the stock at current prices.

Foolish takeaway

As Commonwealth Bank of Australia (ASX: CBA), CSL Limited (ASX: CSL) and Telstra Corporation Ltd (ASX: TLS) have shown over the years, privatised companies that were previously government owned generally flourish after listing. It is the fact that they are given a helping hand by the government during their infancy which sets them up for long-term, sustainable growth. Accordingly, whilst today’s jump in share price makes Medibank no longer cheap, I believe the company still has years of profitable growth ahead of it. Therefore, I believe investors should sit back and continue to hold the stock.

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Motley Fool contributor Rachit Dudhwala owns shares of Medibank Private Ltd. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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