Week Ending 24.10.2014
Is this bad news? Earlier this week, China reported GDP growth for the third quarter of 2014 at 7.3%. This was the slowest growth rate since 2009 but hardly supportive of the bear comments that seem to dog China in recent times. What is fair comment is that the high dependence on exports, continued retracement of the property imbalance (which is having a notable negative impact on energy demand due to decelerating production of products such as steel and cement) and containment of credit does make China’s growth outlook less stable than before.
China’s consumer spending growth at 13.8% p.a. would be the envy of every other nation, yet there are those that feel the household sector needs to make a greater contribution to the economy. Given the pullback in housing (and therefore spending in related products), it is a tough task to expect consumption growth to accelerate at this point.
Retail Sales Growth
The centrally-determined target of 7.5% GDP growth rate for 2014 may yet scrape home, however, this also places pressure on the final quarter to tick up on the run rate to date. As other central banks are discovering, micro managing the components of the economy are immensely challenging, with China aiming to restrain property and credit, yet support investment projects and consumption. In December, the Central Economic Working Conference will set the expectations for 2015. Few would be surprised to see 7% GDP growth, which itself would be a commendable effort.
Expectations of support from the European Central Bank at their next meeting are now high. Financial markets would welcome any move, which may include the purchase of corporate credit - even in the US, there is debate on the exact impact of quantitative easing and its contribution to economic revival. The ability of the Fed to manage mortgage rates and anchor low cost of capital for the corporate sector may, in the fullness of time, prove to have been critical events. The ECB cannot expect the same, as the mortgage sector is fragmented and Europe’s much greater small and medium business sector is typically not heavily involved in credit. Nonetheless, central banks can do little more than hope predictable low cost money supply and rising asset values will encourage corporates to hire labour and households to spend.
The RBA’s cruise control mode remained in place, with the minutes from their last meeting reiterating the ‘period of stability in interest rates’. The now usual issues of a too high Australian dollar and concerns on lending in the housing market were once again raised. The members, however, also spent some time discussing China and its capacity to manage risk, noting its cautious, but directed, easing in monetary policy.
Third quarter CPI was subdued, as widely expected, with the annual rate now at 2.3%. Electricity prices fell 5.1% and the lower dollar appears to have had a muted impact on goods pricing, possibly a delay, but also the competitive pricing in good markets. Prices for services (healthcare, education, etc.) rose by 2.8%, lower than previously, but the most dominant contributor to the overall inflation rate at this time.
The table below shows the weights which make up the CPI, change in Q3, contribution to the quarter (not seasonally adjusted) and the annualised rate of change in each segment.
Q3 CPI Outcomes by Major GroupEnlarge
US inflation came in at 1.7% for the quarter. Higher ‘shelter’ costs (i.e. housing), were up 3% year on year, overriding the fall in energy prices. At this stage, deflation looks highly unlikely in the US and the attention may well swing back to the question of wage inflation over the coming months. Bond yields can be expected to react sharply to any suggestion wage rates could rise, as wage rsies are likely to be sustained, compared with the variability from other components of the CPI. By the end of the week, a moderately positive tone emerged and financial markets responded accordingly. HSBC China PMI (Purchasing Managers Index) edged up and European PMI was decent enough, though both had softer undertones indicative of weak momentum. US indicators were a little mixed, however, the general trend is suggesting stable growth at this stage.
BHP Billiton (BHP) produced a solid quarterly production result, with the company’s full year forecasts remaining unchanged. The two standout divisions in the first quarter were iron ore and metallurgical coal, which were respectively 17% and 25% higher than the September quarter of last year. Overall group production growth of 9% was consistent with the target of achieving 16% total production growth over FY14 and FY15. In short, BHP is doing well in the areas within its control, that being volume and costs. BHP’s Pilbara iron ore production was tracking at a 250Mtpa run rate in the September quarter, hence the company’s full year guidance of 245Mt appears conservative at this point in time, although it should be noted that production is typically seasonally weaker in the upcoming wet season. In metallurgical coal, BHP has done a good job of reducing its unit costs through returning its production levels closer to full capacity. The downside of this strategy is that it is contributing to weakness in the coal price. With much reduced investment dollars allocated to coal across the industry, prospects for a price recovery in the medium term appears better than other commodities.
Like Rio Tinto (RIO), iron ore has dominated the group’s growth in production, and will continue to do so in the medium term. One of the key differentiators with Rio, however, is the growth in other parts of its portfolio, particularly in petroleum through its US shale gas business. At BHP’s AGM this week, the company also poured cold water on the idea of imminent increased capital returns, with this limited by further commodity weakness experienced in this financial year. We see the company as a core exposure to the long term thematic of increasing commodity demand, with high quality assets that enable it to ride out various commodity cycles.
Oil Search (OSH) announced the conclusions of a strategic review that it had been undertaking. In light of the commencement of production at the company-transforming PNG LNG project, OSH conducted the review to plan for how it can find an appropriate balance between retaining capital for further growth and increasing dividend payments to shareholders. To this end, commencing in the current six month period, OSH will now be targeting a payout ratio of 35-50% of net profit after tax. This policy will be subject to review in the event of a substantial change in the oil price. Based on consensus forecasts for 2015 earnings per share of US60c, this could represent a forward yield of up to 4%.
Importantly for shareholders though, this will allow OSH the opportunity to further invest in expanding the PNG LNG operations. OSH believes that PNG has sufficient resources to deliver at least two more trains (i.e. doubling the initial two train investment), with potential for a third with further exploration success.
OSH is well placed to participate in expansion opportunities, with interests in onshore gas fields, as well as its recent acquired interest in the offshore Elk/Antelope discoveries. Cooperation between these different projects would unlock value for all parties, although we note that this has been lacking from other LNG development hubs, such as Gladstone. As we have highlighted in the past, from an investment return perspective, PNG LNG is a standout in the region, and the returns from expansion trains that can leverage the existing infrastructure would further improve this. As the map below of new LNG suppliers shows, there is no shortage of competition in the growing LNG market, with the shale revolution in the US looking to account for a large portion of the overall pie:
New LNG Supply Growth
Of course, all of these projects will not reach development phase (the experience in Australia will attest to this – e.g. Woodside’s Pluto expansion plans and Arrow LNG), but the likelihood of PNG LNG is greater given the aforementioned favourable economics of expansion and proximity to fast-growing Asian markets. The chart below from OSH indicates a possible production growth profile for the company over the next decade.
Oil Search: Possible Production Growth Profile
Asciano’s (AIO) volume update for the first quarter showed similar trends to that seen through FY14 – solid coal haulage volumes but subdued conditions across its intermodal rail and ports businesses. Despite the weakening coal prices this year, volumes have held up well for AIO with a 5% increase on last year and rising utilisation rates. Outside of resources markets, however, flat volumes reflect a domestic economy growing at sub-trend. This was also evident in the AGM update of Toll Holdings (TOL), which noted that its first quarter was “weaker than expected” and it experienced “down trading in a number of sectors”.
While AIO and TOL are on a similar P/E multiple, AIO has the better earnings growth profile in the medium term, underpinned by a cost-out program. The company is targeting double-digit growth in EBIT over the five years to FY16 and confirmed it had, despite the benign environment, recorded good margin expansion in the first quarter of FY15. We retain the stock in our model portfolio.
G8 Education (GEM) this week announced the acquisition of a further 20 childcare centres for a total of $37m, along with a capital raising of $100m. Given the company’s past and future growth has been driven by acquiring additional centres at prices that translated to earnings per share accretion, periodic equity raisings such as these have been common for GEM.
Of the 20 centres acquired, the price was consistent with what the company has historically paid and its target – a multiple of 4X forward earnings before interest and tax. Three of the 20, however, were priced at a higher multiple – 6.2X, and described as ‘premium’ centres that the company had the option to purchase as a result of its acquisition of Sterling Early Education earlier this year. This should give rise to a minor mark against management given their stated acquisition discipline of not paying in excess of 4X EBIT. However, the company did confirm that this was the last of the centres that related to the opportunistic Sterling transaction, in which it paid a premium. We believe that GEM deserves its valuation premium to the market given its track record of execution and the significant pipeline of consolidation opportunities still available in the childcare market.
Resmed (RMD) faces more ongoing scrutiny than the majority of Australian-listed stocks, with the US-based company reporting quarterly earnings in line with the convention of the US market. It can be difficult to gain a read on longer-term trends from the quarterly figures, particularly as these can be influenced in a significant way by the product launch pipeline of RMD and its competitors. After a number of quarters without any notable product launch, the company released a new platform this quarter that should see it well placed to record a solid top line result in coming quarters. In the first quarter of FY15, RMD reported 11% revenue growth from international markets and 3% in the Americas. Margins were lower as a result of higher marketing spend to support its new product releases, however, the benefits from this investment should be realised in coming quarters. Following a difficult FY14, which was impacted by changes to the reimbursement of medicare patients in the US, the outlook for RMD for FY15 is more promising, although some pricing pressures remain in the market.
Super Retail Group (SUL) provided a trading update at their AGM. Sales are best described as patchy, with relatively large swings in momentum in the financial year to date. Gross margins are under pressure due to discounting, mostly in the leisure division. The weaker currency also does not help. While the stock has performed poorly in the past year, the valuation at 14.5X FY15 PE and a yield of 5% represents good value for a small position to participate in better retail spending with a group that has been disciplined in its approach to its business for some time. We have SUL in our models representing discretionary retail.
Company Focus: Medibank
Medibank is one of the more anticipated floats in recent times, given the size of the company, its high level of brand awareness and the fact that it is being sold by the government. The following is a summary of the key points of the float and our thoughts on the company as an investment.
With an indicative price range of between $4.3bn and $5.5bn, there is every chance that Medibank will be the largest privatisation since the float of Telstra, including the Queensland government’s sale of Queensland Rail (now named Aurizon). Investors have generally done well out of investing in some government privatisations, with examples such as Commonwealth Bank, CSL and Aurizon.
While this is likely a function of a more profit-driven organisation in private hands, we believe the industry in which the company operates in as more important (witness the troubles of Qantas as an example). The prospects for success for Medibank are reasonable, given the long-term high growth forecast for the Australian healthcare sector and solid government support, albeit with a high level of regulatory oversight.
The Australian health insurance market is fairly concentrated, with the five largest insurers accounting for 82% of the market. Medibank and BUPA are the two clear leaders, with 29% and 27% share respectively.
The private health insurance industry is well supported by government incentives and penalties for consumers through rebates for lower income earners, the Medicare Levy Surcharge (MLS) for those on high incomes without health cover, and lifetime health cover, which penalises those who commence hospital cover after their 31st birthday. While some of these incentives have been wound back in the last few years (e.g. the rebate is now means tested, while MLS thresholds are expected to be frozen for three years from 1 July 2015), for many policyholders, the MLS is still a significant disincentive in itself to warrant retaining insurance. Hospital cover across the population has trended slightly up over the last decade, from sitting in the low 40% range to now around 47%. In short, while some incentives have been dialled down, these have not had any noticeable impact on overall insurance coverage across the population and with health care expenditure tracking well ahead of GDP growth, it is in the government’s interest to promote, and at least sustain, current coverage levels.
The above has translated to overall industry policy growth of around 3% p.a. over the last five years; half of this is attributable to population growth while the other half is from increased penetration. There is no real reason to expect much deviation from this trend over the medium to longer term.
Premiums are reviewed on an annual basis, with insurers submitting their applications to the regulator. Historically, annual premium growth has closely tracked that of growth in claims expenses – around 5-6%.
The National Commission of Audit Report, released earlier this year, has foreshadowed an expanded role for the Australian private health insurance industry and this would be favourable to health insurers should these recommendations be adopted.
There are two main challenges that Medibank faces:
- while being the largest player in the market at 29% share, it has also lost around 2.5% of market share over the last five years.
- affordability of health insurance is becoming a big issue, with many consumers trading down to cheaper products without the bells and whistles (such as hospital cover with no extras). This is showing no signs of abating, with claims inflation generally running at around twice the rate of CPI. Medibank has addressed this issue through its lower-cost ‘ahm’ brand, but its primary insurance product is high margin.
One of the major developments in the distribution of health insurance in Australia over the last five years has been the rise of comparison websites (e.g. iSelect and Compare the Market), with consumers becoming much more price-focused. The health insurers have effectively increasingly been paying away some of their margin in commissions to these various websites. Medibank has chosen not to participate in this delivery channel, as it believes that it hurts its brand value and thus this appears to have been a contributor to its market share loss in recent years. Instead it has elected to sell its ahm brand through this channel, and has been growing at a fast pace (albeit off a low base and on lower margins). In terms of policy holder numbers, Medibank has 3.4m, while ahm has 0.4m.
Expectations of Medibank’s growth in profitability in the medium term are expected to be largely driven by margin improvement. Specifically, through a better cost performance via lowering its MER (management expense ratio) and secondly, through a better claims experience. The low margin nature of the business means that small changes in either of these can translate to a much larger impact (in terms of percentage change) to profitability.
As the largest insurer, it is natural to think that Medibank should have the lowest overhead expense ratio, given the benefits of scale. The group’s MER of 9.2%, however, is higher than the industry average of 8.8%. The company is currently undertaking a cost reduction program, which over the past two years has reduced its MER from 10.2%. Medibank’s prospectus shows that it is targeting a MER of 8.7% in FY15, which should further improve year-on-year through fixed cost leverage. Savings are expected through rationalising its employee base, consolidating its office locations and reducing advertising and marketing spend.
Better claims management looks to be a more significant opportunity for margin expansion for Medibank. At present, there is an approximate 200bp gap between Medibank’s gross margins and Bupa’s market-leading margins. Medibank could close this gap via several avenues – negotiating better rates with the private hospitals and other providers, reducing improper claims (i.e. fraud or hospital readmission through the fault of the hospital) and working more closely with individuals who are frequent claimers (2% of policyholders account for 35% of overall claims expense).
Negotiating with the big private hospital operators (Ramsay and Healthscope) may prove to be quite challenging, however Medibank has already made some ground on reduced rates for public hospitals (where private patients are sometimes treated) and other providers. The risk from extending this too far will be a potential loss of policyholders, particularly if their out of pocket expenses are increased as a result. The current upgrade of the company’s IT systems (consolidating a number of legacy systems) is expected to be completed in 2016.
Like other insurance companies, Medibank invests the premium it collects into a $2.2bn investment portfolio. As at 30 June 2014, this was 82% invested into cash and fixed interest (cash 46% and fixed interest 35%), with the rest across equities, property and infrastructure. The group is moving towards a more aggressive asset allocation, with a target of 75% cash and fixed interest (25% cash and 50% fixed interest) and 25% in growth assets. The move to a more aggressive asset allocation should allow for improved returns from the portfolio, albeit with a higher level of volatility.
While the drivers of profitability are likely to be different over the next couple of years, in any given year the performance of Medibank’s investment portfolio will largely determine the group’s profit growth. In the context of NPAT of $258m in FY14, investment income from FY12-FY15 (forecast) reads: $43m, $144m, $114m and $90m.
Valuation and Summary
NIB is the only listed health insurance comparable and is approximately a quarter the size of Medicare. It has successfully targeted a younger demographic, consistently recording above system policyholder growth. It likely has less opportunity for margin growth than Medibank and trades on a FY15 P/E of 18.7X.
With more predictable short-term claims and better top line growth, private health insurers should trade at a premium to the general insurance industry, which can be subject to large one-off events. IAG trades on an FY15 P/E of 12.9X, while Suncorp is on 13.5X. Although subject to the same long term macro thematic, comparisons with private hospital operators are not really applicable given their different asset requirements and lower regulatory risk.
As its performance is tied to that of investment markets, it could be argued that a more appropriate comparable would be investment management firms such as Perpetual or AMP.
Despite its underperformance of the sector, Medibank has still been able to grow its policyholder numbers over the past three years. The company will have no debt on its balance sheet upon listing and is expected to earn an attractive ROE in the high teens. The stock will have a high payout ratio, however, depending on final pricing, will more than likely have a yield marginally below that of the market. The successful execution of its cost out and claims management strategy should see it free up capital to offer more competitive pricing and/or invest in marketing to protect the company’s market share. Given the risks in achieving this outcome, the top end of the valuation range of $2/share (or 21.5X FY15 earnings) looks a little excessive, however, on balance, looks to be a good proposition at the low to mid-point of the target range (16.5X -18.9X FY15 earnings).