Why Discovery needs to become boring
After being a market darling and general all-round hero of innovation and accomplishment ranging from healthcare to financial services for two decades, Discovery could end up this year losing a quarter of its value. What went wrong, and can it be fixed?
To misquote The Sound of Music, how do you solve a problem like Discovery?
The healthcare, life insurance, banking, financial services and general all-round innovation group is heading for what could easily turn out to be the worst year in its history from a share-price point of view. It’s currently down 24% this year, which puts it in the JSE Alsi-40 dogbox along with Sasol, Shoprite and Mr Price.
For Discovery, of all companies, to be in this position is remarkable. Arguably, the company is in full flight, doing what it has always done, branching out into new businesses with its normal high energy, astounding shareholders and customers with its creativity, grand savvy and ingenuity.
Among investors, Discovery has now reached the point where there is practically nobody on the fence any more; the company’s detractors and supporters are full-throttle at each other. Whom do you believe? Both sides are convincing and passionate.
One of the problems is there is no single issue you can point to as the unequivocal cause of Discovery’s share-price problem. There is no Lake Charles disaster as with Sasol, or no big fall-off in blue-collar spending, like with Shoprite. It’s all very involved.
Let me start with an anecdote. A friend of mine used to bank with FNB, but about R100,000 got stolen out of her account. Credit to them, FNB eventually paid back every cent, but it took ages and mountains of finagling. So, when Discovery announced it was going to start a “behavioural bank”, she was right in front of the queue.
The idea of a high-tech bank that was going to be path-breaking and innovative the way Discovery is and has been in the past, was intoxicating. Slightly sheepishly, she admits to being an unstoppable trend- seeker. So, she changes. Then she’s in Europe buying museum tickets with her new Discovery credit card. Turns out she can’t, because for some reason OTPs don’t get sent overseas. What?
She phones the number on her zooty Discovery app. There is no one there. Ever. In a moment of irritation, she tweets her problem. She gets DM’ed, and asked for her ID number, shortly after getting a message that Discovery Bank will never contact you about sharing your PIN, OTP or ID. Finally, weeks later, someone does call her back: professional, extremely apologetic, who acknowledges this is a problem, they are working on it. But the bank is getting a huge number of calls; it’s hard.
Having a high-tech bank seems like a fabulous idea, but now she says she does actually miss her FNB private banker who has a name and a phone number she can actually phone.
This little vignette illustrates the problem: there is a huge disparity between the ambition of the organisation and its ability to deliver.
The problem goes to the root of the disparity of views about the organisation as a whole. There is a theoretical glory in being ambitious and forward-looking. This is what we expect from Discovery and its enormously smart and impressive executives. But there are also great dangers.
On a larger scale, nothing illustrates this more than another much grander and more complicated accusation: that Discovery is pushing the boundaries of accounting rules, mainly in its insurance division.
It must be said, life insurance accounting is one of the most complicated things on Earth. At its root, the reason is simple. Life insurance is a long-term business. If you are selling life policies that will mature in the years to come, recognising the income can be done at varying rates. How you do it is an art form. The cost of selling policies is high. A proportion of people who buy life insurance policies cancel them after a while, this is called the lapse rate. That crucial lapse rate is just one of the issues.
In August 2019, some extremely smart analysts started looking more closely at the underlying assumptions involved, and discovered that Discovery Life’s assumptions on its lapse rate were somewhere between 60% and 400% (depending on how you do the calculation – it’s that complicated) lower than all the other insurance companies. All the others have lapse rates that are basically the same, and hence the contract durations were all pretty similar.
This has been going on for some time. But, with Steinhoff and all the rest, this time, the market actually sat up and took notice. In that month, the share price got thumped. Then came the announcement of the National Health Insurance scheme, which further knocked the wind out of the sails, even though it may be years before the scheme kicks into action, if ever.
But it’s the argument over “aggressive accounting” that really hurts, because it goes to the heart of the integrity of the organisation. Discovery’s response has been equally aggressive. Hylton Kallner, the CEO of Discovery Life, told the Financial Mail that suggestions of overly aggressive accounting “are just wrong”. The reality, he says, is that the mix of Discovery’s life insurance business is not comparable with that of its peers, and its policies are, on average, just that much longer.
Essentially, the argument is that Discovery’s clientele is just different. But it goes further. The whole magical logic behind Discovery vests in incentive-based behaviour change, and when those behaviour changes take place, they improve the lives of the people involved but also, not accidentally, Discovery’s financial metrics. It’s a grand win-win, and fantastic world-beating innovation.
The simplest example is the Vitality idea, which is being sold to medical insurance companies all over the world, notably Chinese behemoth Ping An Health. It constitutes a kind of wild-card potential upside for the group reminiscent of Naspers. It’s all deliciously simple; the incentives provided by Vitality to improve your health make it less likely you will actually use the medical insurance you are paying hugely for. And that’s how you get to be over half the market ahead of organisations that have been around for a century.
The same sort of argument is at work in life insurance, hence Kallner’s argument that Discovery Life customers are just different (although he phrases his argument as a result of Discovery’s policy mix).
Discovery supporter Paul Theron, fund manager from Vestact, says he buys this argument. Think about diamond Vitality members: they are better organised, they pay attention to their lives and their health, and they are much more likely to stick with their decision to buy a life insurance product for longer. Discovery, he says, can take some credit for generating this positive feedback loop.
The problem is that since this argument has been put forward, those same clever analysts have gone back to their spreadsheets to test this theory – and they have found it wanting. Yes, Discovery Life clients are more organised, reliable and responsible etc – but not that much more.
Discovery sceptic Terence Craig, chief investment officer at Element Investment Managers, says if the contract durations were 10% or 20% better than other life insurance companies, that would be one thing.
“But when you are talking about a four-times difference, you are bound to conclude that if it walks like a duck etcetera.”
But even Craig acknowledges that it’s difficult to tell, because Discovery’s life insurance business only really reached scale a decade ago. To know with certainty who is right, you have to come back in 30 years’ time, since the implied average life span of a Discovery insurance policy is, according to the sceptics, around 40 years.
And even Theron’s support for Discovery has question marks, mainly associated with some big start-up expenses, particularly for the bank. Discovery itself has heard the criticism and has decreased its start-up expenses (possibly with the consequent problems for my friend’s museum ticket purchasing ability) and increased its provisioning. Technically, its overall debt is low, at about 25% of capital, around the same as the other insurance groups. Membership of Discovery Health, for example, is holding up, although there is some movement to cheaper packages; bank customers are rolling in, earnings look strong too. Remarkably, revenue is just a little less than Old Mutual’s, even though Discovery’s turnover is half that of the big green.
But these numbers now do have a question mark over them. According to the Financial Mail, one analyst came to the conclusion that, “If the duration [of Discovery Life policies] ends up being shorter, then Discovery’s balance sheet and retained earnings risk being overstated.” That is quite an allegation.
If it’s true – and just to repeat, we won’t know for sure for 30 years – why would Discovery be doing this? The short answer is cash. Here is the nub of the problem. Discovery is an ambitious group, and credit to it for being so. But ambitious companies have a weakness: their plans to grow can outstrip their ability to finance their vaunted ambitions.
What Discovery probably needs to do now, is to become quite boring, quite quickly, for a while. It’s astounding how many large investment companies hold tiny amounts of Discovery’s stock. That would be sad and disappointing, and very unlike the group’s ethos, never mind the culture of its formidable CEO Adrian Gore, currently trying to fix South Africa as well as Discovery. But the group needs time to settle down and finish what it has started.
If you are trying to solve a problem like Maria, the one thing you don’t do is allow her to galavant over the alps singing at the top of her voice that the hills are alive with the sound of money… sorry music. BM
Daily Maverick © All rights reserved