Are Medibank Private Ltd shares cheap?

Medibank Private Ltd (ASX: MPL) listed on the stock exchange in November last year after being snapped up by retail investors at an issue price of $2 per share. Almost a year on from the mammoth $5.7 billion initial public offering, Medibank Private shares currently change hands at $2.42 and are trading well off their all-time highs posted earlier this year.

With the stock down over 25% since June, and offering a solid 4.5% fully-franked yield, I thought it might be time to take a closer look at Australia’s largest private health insurer.

Past performance

In its short history as a listed company, Medibank has exceeded expectations by achieving better-than-expected cost-cuts and larger-than-anticipated headline profits.

For the full-year ended 30 June 2016, Medibank reported net profit after tax (NPAT) was up a whopping 46% to $417.6 million, as lower-than-expected growth in hospital utilisation rates and better claims management increased health insurance operating profits.

Gross margins in its largest division, health insurance, grew 2.4% to 16.6%. This uptick was despite slower than average industry growth rates and increasing competition in the sector – a formidable result.

Management shared the spoils with investors by paying 71% of NPAT as dividends for the year and bringing the annual amount to 11 cents per share. This trend is expected to continue over the 2017 full-year with the company possessing plenty of headroom to lift its payout ratio after management increased its FY17 payout target range to 70% – 80% of NPAT (from the current 70% – 75% target).

Future expectations

Despite such an illustrious past, Medibank’s share price, and the broader private health insurance industry in general, faces severe headwinds (which could explain the sector-wide pullback).

Intense competition from the likes of UK giant BUPA and Australian-listed heavyweight NIB Holdings Limited (ASX: NHF) is chipping away at Medibank’s industry leading market share, resulting in management having to respond through aggressive value propositions and increased investment in customer service – both of which are precursors to decreased profitability.

With companies like Qantas Airways Limited (ASX: QAN) and Commonwealth Bank of Australia (ASX: CBA) also trying their hand at private health insurance (with their respective Qantas Assure and CBHS brands), Medibank faces a tough fight to maintain market share and margins.

Foolish takeaway

By operating in a heavily regulated market, where annual premium increases are subject to ministerial approval, Medibank lacks pricing power over its various products and services. The increased industry competition also chipping away at its market share means the outlook for Medibank appears tough in the current operating environment.

Accordingly, with Medibank’s shares currently trading on a forward price-earnings of about 15x consensus forecast earnings, investors might find a better entry point in the future. I think shares are a Hold.

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Motley Fool contributor Rachit Dudhwala owns shares of Medibank Private Ltd. 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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