Strong capital and market position for Medibank Private

Medibank Private (ASX:MPL) Closing share price 11-10-16: $2.510 52-week high: $3.320 52-week low: $2.060 Most recent dividend: 6c

Annual dividend yield: 4.4%

Franking: 100%

While Medibank Private has been in the news a lot of late for various reasons, it has been the release of the company's 2016 financial year results and the subsequent changes to the executive leadership team that are of most interest to us.

Unfortunately for Medibank Private and its shareholders, neither of these announcements has been able to reverse the downward trend in the company's share price that has been in place since the record high reached in May 2016.

Starting with the recent executive changes, the key point to note is Medibank Private's intent to improve its customer service, reflected through the addition of a chief customer officer to the leadership team.

This makes sense to us, given both the damage (perceived or otherwise) that Medibank Private's brand has sustained over the past 12 months or so and the competitive nature of the private health insurance industry.

The other key point to note is the departure of the company's chief financial officer. While a search for a replacement has begun, this remains a work in progress. This is not an ideal scenario, but nonetheless indicates the new CEO's intent to ensure Medibank Private has "the right team in place with clear accountabilities" to deliver on the company's "big agenda".

While it remains unclear exactly what new management's "big agenda" entails, it seems reasonable to conclude that it revolves around shoring up Medibank Private's market position by improving its customer offering and brand image.

The good news for shareholders is that the recent adverse media coverage does not appear to be having a material impact on headline earnings, due to an exceptional performance on claims and operating costs.

For the 12 months ending June 30, 2016, Medibank Private reported a 53.7% increase in its core health insurance operating profit on the back of a 4% increase in premium revenues and a 74.6% increase in its complementary services operating profit despite an 11.2% decline in segment revenue.

This, in our view, highlights that Medibank Private is continuing to benefit from both regulated premium increases and the optimisation of its value chain.

However, peeling back the layers, we see one glaring shortcoming with Medibank Private's results - that is, the continued erosion of the company's core policyholder base.

This is evident in the fact that reported revenue growth for 2015-16 is below the weighted average regulated increase in premiums. This is due to a 3.8% decline in higher-margin Medibank policyholders, which more than offset a 5% increase in lower-margin ahm policyholders.

Outlook

The good news in our view is that Medibank Private has a very strong capital and market position from which to navigate what has been, and is likely to continue to be, a difficult period for the company (both from an operating and investment returns perspective).

In terms of Medibank Private's prospects for the 2017 financial year, we note that while management has not provided any explicit earnings guidance, it does expect the current financial year to be similar to the second half of 2016, which was below the first half of 2016.

Price

Based on consensus estimates for 2017, Medibank Private is trading at 16.4 times and yielding 4.7% with a return on equity of 24.9%.

In comparison, NIB Holdings is trading at 19.6 times with a yield of 3.4%.

In our view, Medibank Private's reasonably compelling relative value is supplemented by what we consider to be a robust technical set-up, with both the 50-day moving average and the relative strength indicator being indicative of an exhaustion of near-term selling.

Worth buying?

We view Medibank Private's declining policyholder base as being more cyclical than structural.

Having arguably been too effective at expanding, Medibank's profit margins through tighter control of claims and operating cost at the expense of its value proposition, we now expect management to seek a more optimal balance between the two earnings levers.

Notwithstanding the potential for some near-term earnings weakness, we remain positive on Medibank Private's long-term thematic.

Disclosure: Medibank Private is held within the Fat Prophets concentrated Australian share, income and small/mid-cap models.

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