As NHI looms, should Adrian Gore be more worried?

It’s been one of the more challenging weeks for SA’s quintessential corporate optimist, Adrian Gore, to keep the legendary pep in his step. Gore, 55, who built Discovery into SA’s largest medical aid administrator in just 27 years, has long been the antidote to the waves of negativity that seem to assail SA every few months. At a conference last November, he spoke of how "in SA we are particularly gloomy, but we are incredibly inaccurate about our gloominess. We are confidently wrong, we are stubbornly stupid."

But with SA on the brink of a rating downgrade, unemployment having deepened to 29%, a wave of xenophobic-based looting and an inexplicably brutal spate of violence against women, has Gore changed his tune?

Speaking to the FM from the ninth floor of Discovery’s new head office, with its trademark curved façade opposite Sandton City, Gore says he hasn’t shifted an inch.

"On the contrary, I’m sticking to the view that statistically, while we always move from problem to problem, someone with a declinist mindset always believes the current problem is evidence of the inevitable demise," he says.

Of course there are intractable problems, he adds — it’s just that if you have the right mindset, these problems can be solved. "Look, I’m not a naive optimist, I just believe we’ve got to seek positive signals as well as negative ones," he says.

The problem is that sentiment is worse than the on-the-ground reality. "We see this in our businesses: the bad debt in our credit book is only slightly up, but not dramatic; the lapse rate of our policies in our insurance businesses is, ironically, very low," he says.

And President Cyril Ramaphosa has actually done a lot more things than people give him credit for. The Zondo commission on state capture is just one example, as are changes at the SA Revenue Service and the National Prosecuting Authority. "You’ve just got to be a little patient. We’re in a tough world — look at Brexit," he says.

Only, it’s not just Discovery’s home country that is stuttering, thanks partly to Ramaphosa’s leaden feet. Gore’s own business, including SA’s largest medical aid administrator, Discovery Health, is under unprecedented siege too.

For a start, the new National Health Insurance (NHI) bill proposes creating a new universal health-care system, at a cost of R450bn, which will all but wipe out private medical aids. And perhaps more trenchantly, accusations are piling up that years of "aggressive accounting" by Discovery has conspired to understate risk in the business.

In February, SBG Securities published a report titled "Looking past the narrative" which recommends that investors sell out, based on "our findings that the business has an aggressive operating strategy and accounting policy".

It adds: "Discovery’s strategy and growth narrative is highly compelling and is marketed very well to investors … [but] many investors do not understand the nuances of the accounts, similar to the lack of product understanding by consumers."

Other analysts have also questioned Gore’s shtick. Certainly, as the face of SA’s most innovative company, Gore is nothing if not a consummate salesman: believable, and able to stir the hearts of even the most apathetic and cynical.

As the pioneer of "shared value" through its Vitality programme, which is built on the principles of behavioural economics, Gore is lionised as a visionary in a sector renowned for dour actuaries. Vitality uses "rewards", including flight discounts and gym membership, to encourage customers to be healthier, which in turn drives down health costs.

But it’s clear the "Discovery story" is now under its most intense scrutiny yet. And the picture isn’t pretty.

Founded by Gore in 1992 with R10m seed capital from RMB CEO Laurie Dippenaar, Discovery has had its worst stock performance since listing on the JSE in 1999.

Over 12 months, the stock has fallen 32% to R118. It’s not exactly the trajectory Gore would want, having launched a new bank — billed as "the world’s first behavioural bank" — in the past few months.

The share price fall is due to a toxic mix of concerns about the NHI, weaker financial results and "overwhelmingly negative sentiment in SA", says Bryan Lloyd, portfolio manager at one of Discovery’s overseas shareholders, Harding Loevner.

"A lot of these issues aren’t really new. The health-care bill is something they’ve been talking about for a little over a decade, so it’s always been something that’s been hanging out there. The fact that it came to light in this way, what felt like virtually overnight, did surprise the market."

It all coalesced in uninspiring financial results for the year to June, released last week. Overall, Discovery’s operating profit fell 9% to R7.5bn (its own calculation of "normalised earnings" showed a 3% fall). But there was a R1.4bn decrease in cash, as it invested in new operations such as its bank.

At its largest arm, Discovery Health, which makes about a third of the group’s profit, earnings rose 10%; at Discovery Life, profit fell 9%. There were bright spots (its 25% share of its Chinese venture Ping An saw new business soar 76%) but overall, the financials didn’t exactly punch out the lights.

As Mazi Macquarie put it in a research note: "Several concerning past trends have continued, or increased in prominence."

The analysts pointed out that Discovery’s reported profit differed vastly from the actual cash flowing into the company. Under the International Financial Reporting Standards (IFRS), Discovery reported R6.61bn in profit — 15% up on the previous year. Yet there was a R2.2bn cash outflow (if you exclude its net borrowings and a noncash release due to regulatory changes in July).

"The result did little to change our view on Discovery’s opaque disclosure, aggressive accounting, high financial leverage, and weak cash generation," the analysts said.

And given the group’s need to invest in its many ventures, Macquarie said: "We don’t see how Discovery can avoid a rights issue in the next few years."

The criticism clearly worries Gore.

"The market sentiment has been concerning and we take this seriously," he says. The NHI’s impact on SA’s private health-care system worries international investors, he adds, but "we don’t believe that these risks are likely to manifest and have worked hard to try to correct the perception".

It turns out this is just one of many incorrect and unhelpful perceptions — like the view within government circles that SA’s private health-care market is awash in cash and is particularly wasteful.

Says Gore: "There’s this view that people on medical aids have endless money. It’s not true. We know how hard it is for people to afford medical scheme coverage, we see it in the choices they make."

If there’s one other stereotype that gets to Gore it’s the frequent sniping about Discovery’s swish new headquarters, which cost R3bn to build. It’s impressive: made from recycled steel, with a running track on the roof, 90 indigenous trees, and a gym.

One reader of this magazine dubbed it a "message to medical aid members and policyholders as to how their inflated and hard-earned contributions are utilised". Another said: "When I drove past, I thought it might be a hotel that was originally designed for some sheikh in Dubai."

"I find it extremely upsetting," says Gore. "We did an analysis which showed that the cost of the building is 0.4% of the health-care costs. I can tell you, this building is not adding to the health-care costs."

Actually, while Zenprop and Growthpoint built it for R3bn, Discovery is paying R23m a month to rent the premises over a 15-year lease. This is 2.4% less than it paid per square metre for the five buildings it used previously.

"We’re getting 10,000 people under the same roof for the same cost, or lower than in our previous premises," says Gore.

But this is just one example of the skewed perceptions of the money washing around the SA health-care sector — the view that it’s a bottomless well which the government can easily tap through the NHI, to cover up its inability to fix public health.

In a nutshell, the NHI bill envisages a scenario where every South African will pay, through their taxes, into a government-run fund that would finance all medical care in SA. Ratings agency Fitch say it will cost R450bn by 2028, two years after the scheme is meant to be up and running.

The NHI is an attempt to address a skewed situation where R160bn is spent by the 10.6-million wealthiest South Africans on private health care, while the government spends just R183bn on the other 46-million South Africans. Walk into most state hospitals, and you’ll see decrepit facilities, manned by vanishingly few doctors and nurses, many of whom are exhausted and work virtually unsupervised with scant access to the right equipment.

But Fitch warned that the NHI faces "significant hurdles" such as the widely held view that it would open the door for "mass corruption and slow delivery of care".

A worry for Discovery is that the way the bill is drafted means private medical aids won’t be allowed to offer services covered by the NHI but only "complementary services", whatever that means.

It’s an assault on the private medical sector, which, Citi analysts showed last month, is actually remarkably efficient. Private health-care costs, on average, R16,000 a person a year in SA, against the equivalent of R60,000 for the UK’s National Health Service or R150,000 in the US.

"We do not believe SA taxpayers can currently afford to contribute much more to health care," said Citi. "If private health-care choices are restricted or costs increase, we believe that the severe medical and other skills shortage in SA could be exacerbated."

The government should instead focus on improving public-health facilities and make it more attractive for doctors and nurses to operate in that sector, Citi added.

SBG Securities also singles out the NHI as "a material risk" to the medical aid industry. For Discovery Health, which built its brand on the medical aid it administers, it may even be an existential threat.

Though the medical aid (called the Discovery Health Medical Scheme) is supposed to be a nonprofit independent entity run for the benefit of its members, it has for its entire existence paid Gore’s company for "administration" and "managed care" services every year. Discovery Health now administers more than 56% of the open medical scheme market.

But if people are forced to divert their medical aid spending into a government-run fund, many at the bottom of the income pyramid will have to forgo private medical aid. And the business model would fall apart.

Gore doesn’t think this will happen. "Look, if the NHI could replicate what people are getting now, they’d drop out and use the NHI. But it seems highly unlikely that will happen. But what does seem inevitable is that people will be paying more for health care: they’ll pay something for the NHI and they’ll pay something towards the private system," he says.

So what is likely to happen?

At this point it seems the NHI will emerge in some form, much diluted from the current nuclear option and much later than the 2026 deadline. The best case for Discovery, it would seem, is that there would still be a large "complementary" role for private medical aids under the NHI.

But if the NHI is implemented badly it would be a disaster for everyone.

As Gore puts it, SA’s debt would spiral out of control, income tax rates would rocket to pay for the R450bn the NHI will cost, doctors and specialists would flee and wealthier citizens would become disenchanted. "The sentiment is overdone but this is what worries me far more than the reality. It’s going to be a long process and I don’t believe we’ll end up with an extreme."

Or rather, fingers crossed that we don’t end up there.

If the NHI is the greatest external risk to Discovery, the view in some circles that it employs "aggressive accounting" to gild the lily is the biggest internal risk. It’s a perception that has been mounting among some analysts for months, and is now being openly expressed.

As SBG Securities put it: "Discovery’s disclosures are sometimes impenetrable even to some of the most technically inclined investors. We also find that the accounting practices, while rational and sensible, make for very aggressive earnings reporting relative to peers."

Here it gets complicated, in part because insurance profits are complicated. The way it works is, companies sell long-term insurance policies, where they collect premiums over many years, but take the costs (such as paying brokers) of selling those policies upfront. To get around this, insurers typically report "embedded value" in their profit — which is really just putting a present value on the profit it expects to make over time.

And as you can imagine, there are many moving parts in such a projection, so it’s hard to say something is right or wrong. And, it should be pointed out, Discovery’s accounts have been signed off by PwC.

The controversy lies mainly in Discovery Life, which has been around for only two decades but which accounts for about a third of all new death and disability products sold to SA’s affluent market.

Musa Malwandla, who wrote the SBG Securities report but who has set up his own fund, Differential Capital, with partners, says Discovery Life has been quite aggressive in its projections on its future profits.

"There are certain assumptions made, for example on the mortality rates, which affect its calculations of embedded value. If these are overly positive, it creates a distorted picture of its prospects. And I’m not sure investors are on top of these numbers."

Others agree. In a report in March, Citi analyst Francois du Toit rated Discovery "high risk" for a number of reasons, not least its "unusual accounting" marked by "fast and aggressive profit recognition".

"Investors might be surprised that expectations rather than actual experience are reflected in Discovery Life earnings under IFRS. But ... it smooths out variances and basis changes from its earnings with the help of intangible assets, which effectively gets it to report its expected profits (rather than its actual profits)," it said.

Citi argues that while Discovery Life showed R3bn in earnings the previous year using the IFRS calculation, the actual cash profits were close to zero. (As a relatively young life insurer, this isn’t that unusual: most life companies only begin making cash as policies mature later. Nonetheless, Discovery says the life arm has actually returned cash to the group.)

Says Citi: "Our problem with Discovery’s accounting is that there is currently effectively no amortisation of any past costs, because it resets its intangible assets at the end of each year based on prospective margin forecasts." Other companies, Citi says, would spread the costs of this business over the duration of the insurance policy.

Mazi Macquarie raises similar concerns. For example, in a 36-page industry report on August 5, analysts said Discovery is the "notable exception" among its peers as it recognises income based on life policies that can be up to 40 years in duration.

"If the duration ends up being shorter, then Discovery’s balance sheet and retained earnings risk being overstated. The fact is that we won’t know for another three decades. But from an investment perspective, we consider the risk of waiting that long very high," it said.

However, Discovery Life CEO Hylton Kallner says you cannot compare Discovery’s business to that of rivals, as its policies really are that much longer. What makes Discovery seem out of step, partly, is that it only offers longer-dated life insurance policies, while its rivals include shorter-dated policies, such as funeral insurance.

Says Kallner: "Macquarie ignores the fundamental issue, which is that our policies should be valued for the full contract term, which can be for decades, not just the first 12 years. To not take the full term into account would just be incorrect from a valuation and accounting perspective."

Other analysts, however, don’t think Discovery’s accounting is flawed.

Warwick Bam, research head at Avior Capital, says it’s fair to say Discovery Life’s profits include more "assumption risk" than that of its peers. But Bam says: "Discovery is still funding 19 years of acquisition costs (cumulatively more than R40bn) which reduces the net cash flow from the life insurance business, but should have limited impact on the actual profit calculation."

Lloyd also doesn’t think Discovery Life is doing anything wrong. "It was a start-up that completely disrupted an existing industry, and to account for the way value is created in this business, if you followed pure cash profits or if you follow accounting rules that closely match cash flow, you’re going to be missing the longer-term story," he says.

Gore says that Discovery’s accounting policy has been consistently applied from the start. "We accept and embrace the fact that markets today interrogate every aspect of the business. But our response has to be to listen to every critique, and we have to respond properly to it. We have to be utterly transparent," he says.

He says Discovery has responded to every point raised by the analysts, and has published a "technical paper" on its website responding to every point. (Not all the analysts agree that Discovery properly answered these questions, however.)

Gore says the issues raised by analysts are "relevant", but the company has addressed them all comprehensively. "You can’t compare us to another company that writes funeral or investment business, for example. When it comes to accounting issues, there’s a completely structured way of doing things and we do that strictly according to the rules."

But when it comes to calculations of Discovery’s future profit — its "embedded value" — there are far more variables. Even then, Gore is confident Discovery is making the correct calls on valuations.

"Look, we don’t value things aggressively. Our assumptions are based on best estimates. Of a group of policies for people aged 45, our assumption is that 80% of them will have lapsed within 20 years. [It is] based on evidence. In addition, the IFRS assumptions on which the financial statements are prepared have additional margins for prudence, which are substantial," he says.

In part, he says, Discovery Life’s policy books may look so good because of its Vitality programme, which provides discounts to policyholders who act in a healthier way and so are likely to live longer.

"But I can tell you we’re not ignoring these issues. The governance processes are also robust, and the audit committee monitors all of the issues carefully. In the past year, they had their own separate independent external review done, and they’re comfortable with where we are."

Where Discovery does fall short, Gore admits, is when it comes to its complex products. SBG Securities defined this as an "aggressive operating strategy" where "complex product designs" and an "aggressive sales strategy" means that sometimes customers aren’t aware of some of the drawbacks of the products.

It’s a risk, since customers who later feel they’re getting the short end of the stick can let their policies lapse.

For Discovery Life, for example, your life insurance premium can shift up or down depending on your Vitality status.

Malwandla argues that many customers who aren’t hitting their Vitality targets are seeing their premiums rising north of 10% at a time when few can afford it. "How many households can afford that? Remember, half of Discovery’s Vitality members are still the lowest rung, blue status, so they’re seeing the largest premium increases. Now, is Discovery taking this into account?" he asks.

Gore says the complexity criticism is valid. "We should make our products simpler to use, and this is something that we focus on, but the truth is, they have the largest market share and competitors have followed our lead … Look at our actual lapse rates, which are 4.7% in health care; look at our mortality rates, and you’ll see the actual performance of our customers is remarkable."

Discovery has for years been seen as different from its peers — the smartest guys in the room. And to some extent, this is justified: Gore’s concept of the "medical savings account", which he launched back in 1993, helped shift part of the responsibility for managing medical aid spending onto the customer, thus lowering costs.

Gore says he meets people all the time who are inspired by the "Discovery story".

"I feel that people think of us as a force for good, in general. I might be looking at all this through rose-tinted glasses, but I really get that impression," he says.

Some investors, who may have looked at Discovery through rose-tinted glasses in years gone by, have taken off the shades.

Old Mutual Equities, for example, sold its shares in Discovery three months ago.

Says portfolio manager Neelash Hansjee: "NHI had not hit the news yet. We were concerned about the length of time and the amount of capital it was taking to roll out the bank, to build it into a sizeable player with 500,000 to 1-million clients."

Hansjee says that while Discovery has a unique "growth-driven culture", it has become more tricky to balance that with solid risk management. "Its generous recognition of life profits reflects this growth-focused approach, but it has been approved by auditors," says Hansjee.

Nor are many SA investment houses, like Allan Gray or Coronation, still listed among Discovery’s top 10 shareholders. PSG Asset Management and the state-owned Public Investment Corp, which manages government employees’ pensions, are the only two SA fund managers in that list.

Neill Young, an analyst at Coronation, says that in an environment with so many cheap shares, Discovery isn’t a priority buy. "FirstRand is trading on a less demanding p:e multiple, yet it is delivering more consistently. An 11% profit improvement from FNB in this environment is superb," says Young.

Others believe that with Discovery stock available for a 30% discount, compared to a year ago, now is the time to buy.

What it means: Health care is a great sector to be in because costs will keep rising and the demand will always grow, says Adrian Gore

—  What it means

Vestact, for example, said after the results that it still sees it as a buy.

"We have to give Discovery the benefit of the doubt to turn the bank into a big profitable machine," it said.

Lloyd also believes that Discovery is "now as cheap as it has ever been".

Quite how the debate around accounting will play out is unclear, but the problem seems largely confined to Discovery Life.

And there’s no escaping the fact that Discovery’s health-care arm is still a fantastically strong franchise. As much as the government is attacking this through the NHI, it’s unlikely to disappear any time soon.

As Gore puts it: "Health care is the biggest industry in the world, and you can’t contain the costs. No matter what the issue is, health-care costs will grow because demand is always there. So in every growing economy with a growing middle class, you’ll see health-care costs rising."

Which should be good for Discovery, unless the government does something silly. In which case, it won’t be the only corporate casualty.