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How Moody’s rated Discovery for the first time

Oct 22 2017 17:36
Lameez Omarjee

Discovery CEO, Adrian Gore. (Picture supplied).

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Johannesburg – Just days after Discovery [JSE: DSY] received approval from the Registrar of Banks for a banking licence, ratings agency Moody’s has given the financial services group it a credit rating for the first time.

According to a statement issued by Moody’s on Friday afternoon, Discovery was assigned a Ba1 global scale (a speculative grade rating) and a national scale rating. The outlook for the group is negative, in line with that of South Africa’s sovereign rating outlook.

Moody’s explained that the ratings reflect the group's very strong franchise in South Africa and its growing global footprint.

The group also has a strong profitability and significant non-insurance fee income from Discovery Health. Other strengths include its moderate exposure to local investments because of the “capital-light nature” of its business, and its good capitalisation on both a regulatory and economic basis, said Moody's.

Risky execution

However these strengths are offset by the group’s business exposure to South Africa and the challenging operating environment.

Other challenges include the complexity inherent in its shared value insurance model, its ambitious expansion initiatives that present execution risk and require significant amounts of external funding, Moody’s explained.

“The group's ambitious expansion strategy, and development of new business lines, relies on external debt funding, serviced by cash generated from its mature and profitable existing businesses.

“Given the group's large investments expected in Vitality Life (UK), Vitality Partner Markets, and the Discovery Bank over the next three years, we expect debt leverage to increase over the next two to three years before gradually returning closer to current levels,” said Moody’s.

Moody’s acknowledged the role of Discovery’s shared value model which provides incentives through Vitality in recruiting more customers and encouraging them to purchase more Discovery products. “The group's profitability is strong, driven by its product mix, market leading franchise and customer appeal of the Vitality program and benefits.”

Moody’s expects the group to increase the diversification of its business. The ratings agency however said that investment in new business may suppress return on capital for the next two to three years. This is despite expectations of absolute profitability to increase meaningfully.

With the business plans to launch a bank Moody’s indicated that this may link its insurance financial strength rating (IFSR) to that of the sovereign. Potentially the groups IFSR will become more constrained by the sovereign.

“We consider local banks to be inextricably linked to the sovereign, and as such their baseline credit assessments (bca) are capped by the sovereign rating. As Discovery's bank - expected to launch during 2018 - grows, we will monitor the size of the bank's assets relative to the rest of the group.”

But this situation may be offset by expected growth in its non-South African business.

“The negative outlook on the South African sovereign reflects Moody's view that the risks to growth and fiscal strength arising from the political outlook are tilted to the downside,” Moody’s explained.

Factors that could improve the rating would be if there is an upgrade in the sovereign rating. As well as increased geographic diversification, with the majority of the group's profits being generated outside of South Africa on a sustainable basis.

NHI a risk

Factors that could bring the rating down would be a downgrade to the sovereign’s rating.

Other factors include material uncertainty about the sustainability of the fee income generated by Discovery Health. This includes the loss of the management contract with Discovery Health Medical Scheme (DHMS). The implementation of the National health Insurance which may impact earnings is another risk.

A sustained increase in the group’s financial leverage and the rapid growth in banking assets that may decrease the group's resilience to sovereign-related stress scenarios are among other risks.

Potentially, evidence that may cast doubt on the viability of the groups' shared value model is also a risk, Moody's concluded.

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