Discovery looks cheap, good results

On Thursday we had interim results for the 6 months ended 31 December 2011 from Discovery who have managed to yet again produce fantastic results. Highlights include a 20% increase in headline earnings to R1.1bn whilst embedded value per share which is how the in house actuaries value the company has increased 18% to R51.20. An interim dividend of 50c was announced. Since listing in 2000 this company has managed around 35% compound return. So how is this business made up? Let's look at the divisions separately.

Discovery Health, the medical scheme managed to grow earnings by 10% in what is supposed to be a mature market. This division is responsible for 38% of earnings. We really like this sector as medical technology improves and more people enter the income bracket to afford such services. Discovery have been extremely innovative in order to grasp market share from other competitors in South Africa. This will continue as management carry on investing in technological and service innovations. They also have some positive things to stay about the state of the market they operate in which bodes well for the future.

"It is important to state Discovery Health`s belief that our private healthcare system, while having room for further improvement, is excellent, sustainable and an important national asset. This may seem in stark contrast to common views of waste and inevitable decline in the private healthcare system. A rigorous analysis of the facts suggests the opposite. Access to care for those covered by medical schemes is comparable to the best healthcare systems found in developed markets."

Discovery Life which is the life insurance business and is responsible for 48% of earnings managed to grow these earnings by 12%. Again product innovation and quality services were responsible for this growth as engagement with Vitality in terms of premium calculations helped with pricing. This business is extremely cash generative and what is done with the monthly premiums has a huge impact on earnings. The Discovery team boast a return of capital in excess of 27% since inception. Quality companies attract quality employees as Sasha so often points out.

The Vitality initiative is doing fantastically as members become more proactive and Discovery can track the activities of their members. Not only does it keep members fit and healthy which decreases fatalities and health issues but it also allows for fantastic pricing information.

"The Vitality model is powerful: it creates a virtuous actuarial cycle wherein rewards are used to incentivise the appropriate behavioural change; behaviour change leads to a reduction of mortality and morbidity, thereby reducing claims costs; and the reduction in claims costs ensures that the system remains in balance, and so on. The benefits of this cycle are experienced by all stakeholders: clients, Discovery and society. It is this cycle that Discovery aims to replicate in a number of markets." So lots of potential to take this fantastic model into China and the UK.

Talking about the UK they finally seem to be gaining some traction, turning a R5 million loss into a R162 million profit. With their vision to build pretty much what they have done in South Africa they reckon there is a lot of potential for scale and profits. It's always nice to have the international diversification. Inroads are being made with a similar strategy with their 20% stake in Ping An Health in China.

Furthermore, Discovery recently rolled out Discovery insure where expectations have already been exceeded with nearly 8000 policies being written. They see a gap in this market and you would have to back them to implement it properly.

So what do the valuations look like for such a well run company that has very exciting prospects. They made 198c for the half on a share that trades at R48. According to forward earnings expectations they are trading at less than 10. We like the company and back the management to carry on implementing the right decisions. I suppose the biggest risks lies with regulation and the NHI plans. I don't think that people will sacrifice medical security and again you would back Discovery to stand up to the challenge. A solid buy at these levels.