Health insurance stocks in good shape

There are many reasons not to buy health insurance stocks. Policy coverage is falling, premium costs are rising and younger generations are questioning this form of insurance. But sometimes the best opportunities emerge in industries in structural decline.

Health insurance is copping it from all angles. About 10,000 Australians are quitting health insurance each month – a figure that will rise this year and next as more consumers feel the pinch from record-low wages growth and rising utilities costs.

This exodus, and an ageing population, is contributing to higher health-cover costs. Fewer people are paying premiums, as demand for healthcare products and services from older policy members rises. Insurers must lift policy costs faster than inflation, a trend that exacerbates policy drop-out rates, particularly among younger members and those who are single.

To compound the problem, younger generations see less value in health insurance or the need for it. About 60% of people surveyed in an Essential Media poll this month said health insurance was not worth it. Some insurers must offer bigger discounts to attract younger members or add in extra policy benefits, such as covering gym memberships that appeal to this demographic.

One can imagine price-conscious consumers switching between insurers as they search for a better deal, or downgrading ancillary benefits to lower policy costs. Many consumers were once ambivalent about policy details; now, many look at cover in fine detail and use what’s available.

Then there’s the recurring threat of political and regulatory decisions that could damage industry profitability. Protecting Medicare at all costs is a political vote winner, as Opposition Leader Bill Shorten demonstrated in the Federal election. But someone must fund rising healthcare costs, and a bigger contribution from the private sector is a possible solution.

Market disruption

As large insurers face market headwinds, a growing bank of disrupters, notably iSelect, are encouraging consumers to switch policies and save costs. Higher rates of customer churn are never good for incumbents, for it usually means clients moving to cheaper providers.

Medibank’s high customer lapse rate is costly. It’s always harder to recruit new customers than keep existing ones who pay higher premiums each year.

The confluence of these trends will take a toll on insurance providers. Health-insurance giant Medibank Private in August said its falling market share would not stabilise for at least two years amid declining health-insurance participation and falling overall policy volumes.

The market, however, appears less concerned by the problems, or has already factored them into valuations. Medibank Private has a one-year total return (including dividends) of 22% and has been a good stock since its 2014 float at $2.15 a share. It’s now $2.95.

Mid-cap NIB Holdings has impressed with a five-year annualised total return of 32%. If there’s a larger problem in health insurance, the market is not showing it. Or perhaps the market is underestimating the magnitude of health-insurance challenges ahead.

I believe the market has it right on health insurers and that the long-term industry outlook is better than it appears. That is not to downplay the sector’s many challenges over the next few years, but private insurance has a critical role in healthcare.

An expanding population and ageing workforce should add to long-term demand for healthcare policies and partly stem the decline in policy participation rates. As Australians live longer, the need for an effective health-insurance policy has never been greater.

The industry has reasonable pricing power with the government regulator rejecting few price rises in its annual review of health funds, over the years. Tying premium growth to healthcare costs provides a level of earnings defensiveness from the big health insurers.

The regulatory outlook could also be more favourable than expected. The last thing the Federal Government can afford is for sharply higher drop-out rates in private health insurance and an escalating burden on the public healthcare sector.  Or to force millions of health-insurance policy holders to pay sharply higher premiums at a time when energy costs are soaring.

Less considered is the scope for technology to improve sector efficiencies, and tighter controls to reduce over-ordering of medical procedures – all of which add to private hospital costs and policy premiums. Attacking inefficiencies in healthcare, principally through better use of technology, is needed to lower policy costs and win back members.

Playing the sector

Medibank Private is the obvious (and only) choice for large-cap health-insurance exposure. Its FY17 result beat market expectation and there is a lot to like about Medibank’s new brands, innovation and efficiency drives. A solid balance sheet and 4% yield, fully franked, are other attractions.

My hesitation is Medibank’s rising customer churn rate. A parallel is Telstra Corporation and the many customers who switched to smaller providers to get a better deal or because they were unhappy with the telco’s service. Medibank, too, has had customer-service issues.

Like Telstra, Medibank has a massive customer base: about 3.7 million members under the Medibank and AHM brands. A high churn rate on a customer base that size potentially means hundreds of thousands of people changing providers and lower policy margins.

Chart 1 Medibank Private

Source: nabtrade

That is good news for smaller health-insurance providers, such as NIB, that attract new customers from large rivals. NIB’s market share, 6.6% when it floated almost 10 years ago, is now 8.3% and it has delivered double-digit annual profit growth on average.

Although the market-share gains seem small, they equate to a lot of customers, given the millions of health-insurance policy holders in Australia.

NIB’s FY17 result impressed. After-tax net profit rose 31% to $120 million, broadly in line with market expectation. The company’s FY18 guidance was a touch weaker than anticipated, suggesting this year is one of consolidation after two years of strong growth.

NIB’s acquisition in September of GU Health is a good move. GU Health is Australia’s only established specialist corporate group health insurer, servicing over 34,000 policyholders across more than 260 corporate clients. NIB is paying $155 million for GU.

The business expands NIB’s footprint in corporate health insurance and the deal is expected to be earnings-per-share accretive immediately (3% EPS accretion in FY18).

GU looks like a straightforward bolt-on acquisition for the well-run NIB. I reckon there’s more behind the strategic rationale: as health-insurance costs rise and affordability becomes a bigger issue, some Australian corporates might offer health cover as an employment benefit to attract and keep staff, a model that many US corporates have embraced.

The proposed acquisition is not large enough to transform NIB (or cripple it if things go wrong). Still, GU could become a decent growth engine for NIB over the next five years, support a higher share price and diversify earnings.

The key issue is valuation. Most analysts have a hold recommendation and an average target of $5.77, based on the consensus of 12 firms, suggests NIB is fully valued at the current $5.73.

The market is too cautious on NIB.  I see the stock re-testing its 52-week high of $6.48 later in FY18; the interim result in February being the likeliest catalyst to re-rate the share price.

I don’t fully buy the market narrative that FY18 is a year of consolidation for NIB; the GU acquisition shows NIB has its eye firmly on growth and expanding in newer markets.

Longer term, NIB has traits of exceptional companies: a high and rising Return on Equity (26.8 in FY18, from 19.1% in FY13); strong growth in net operating cash flow and a low debt-to-equity ratio. NIB is clearly among the market’s best managed mid-cap companies.

The main issue is whether NIB’s growth spurt, reflected in the forecast Price Earnings (PE) multiple of FY18 of 21 times, is moderating and the best is behind the company, for now. And whether the market’s expectation, reinforced by weaker guidance from NIB, is already baked into the share price.

NIB, now 10% below its price high this year, looks reasonable value for long-term investors who want to benefit from continuing customer migration from the market’s biggest health-insurance providers to smaller players.

Chart 2 - NIB Holdings

Source: nabtrade