The unbearable expectation of greatness

Health and wellness insurer Discovery warned investors on Wednesday that earnings for the six months to December 31 would be lower than they have come to expect.

Normalised headline earning (which management believes is the most relevant indicator of business performance) is expected to increase by between 5% and 10% in the current period.

This is 5-9% lower than Discovery’s historic earnings growth. According to the company this is due to an increased investment in new initiatives, including the recently awarded Bankmed medical scheme administration and managed care contract, the expansion of the business model into transactional banking and increased costs arising from growth in Ping An Health and other international partner markets. In addition there were higher than expected costs associated with moving VitalityHealth in the UK onto its own system infrastructure.

Investors were not impressed and the share price fell 4.99% during the day’s trade to R115.72. It has fallen 11.3% in the past 90 days.

“I was disappointed with the trading statement, but not disheartened,” says Anthony Rocchi, portfolio manager at Rexsolom Invest. “The curse of a growth stock is the lofty expectations the market places on every reporting period.”

That said, normalised headline earnings growth of +5 to +10% is not good enough for a stock that is trading at a permanent premium to its fair value, he says. “Despite today’s sell off the share still trades at 30% premium to our fair value estimate, which makes us cautious. We would only buy on further weakness.”

In the long run however, Discovery’s plans to export the Vitality model abroad are exciting. The internationalisation strategy is a long term one and will incur costs upfront. It now has an incredibly wide international presence, which includes its original operation in the UK, the above-mentioned 25% in Ping An Health in China, the recently announced Vitality partnership with John Hancock in the US, the Vitality partnership with Generali in Europe as well as another Vitality partnership with AIA in the Far East.

These JVs provide the base from which Discovery can build a sizeable global business, however, profits have been slower to emerge. The company does not enjoy as much influence with brokers as it does in SA, and has to ‘sweat’ these relationships harder.

Closer to home the trend towards industry consolidation will benefit Discovery. Specifically the Bankmed contract, which has been administered by MMI over the last 17 years will boost lives under administration by around 8% in FY16 and highlights how well positioned Discovery is in the SA healthcare industry.

There was some dilution in headline earnings as a result of the R5 billion rights issue, which was concluded in April 2015.

It also bears remembering that headline earnings per share and basic earnings per share for the prior period were positively impacted by the once-off accounting treatment resulting from the lapsing of the put options Prudential held in respect of its interest in the UK joint venture – this was due to Discovery’s purchase of Prudential’s remaining 25% of the joint venture in November 2014.

As this once-off increase in profits occurred during the company’s 2015 financial year, all results announcements relating to the 2015 financial year will be affected for comparative purposes.

Discovery’s results for the current period are due to be released on Sens, February 25.

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