Discovery gears up for a new era

Discovery is entering a new growth phase, which should be characterised by improved cash generation and less spending on new initiatives such as its bank, which is expected to become profitable in the next financial year. 

This third phase of growth follows an eight-year investment cycle, during which the company invested heavily in creating its bank and expanding Vitality globally. 

CEO Adrian Gore said this marked an end to the first phase of unfettered growth, where Discovery went from strength to strength and produced an annual growth rate of 22.3%. 

This first phase was characterised by Discovery pioneering and growing its Vitality shared-value model within life insurance and medical aid provision. 

The company experienced tremendous organic growth, albeit off a small base, and began investing in new initiatives on a small scale. 

Towards the end of the first phase, Gore explained that a company begins to plateau and enters what some call the ‘Valley of Death’, where growth flatlines, and the business stagnates. 

Gore told Daily Investor in an interview that this naturally occurs in every business and requires plenty of work to break out of. 

Gore explained that to break out of this natural plateau, a company has to decide whether to grow by purchasing other businesses or organically by improving its own offerings. 

Discovery chose the latter and began to invest heavily in expanding its own offering and implementing the Vitality shared-value model in other areas. 

This marked the beginning of the second phase, where Discovery spent heavily on expanding its offerings. As a result, profit growth took a knock, and debt levels rose. 

In particular, the group pumped money into the formation of its own bank. So far, it has spent R14.5 billion building Discovery Bank, expected to achieve profitability in the next financial year. 

Operating profit growth over this period averaged an annual rate of 9.1% – a far cry from the 22.3% experienced in the preceding decade. 

Gore explained that Discovery’s debt levels rose and cash generation slowed slightly as the company realised that it could not grow organically by starting small businesses. It had to go big to fundamentally impact its bottom line.

However, the company thought this was necessary to ensure its future growth as it set the platform for its third phase of scaled organic growth. 

Gore emphasised the importance of Discovery taking a long-term view. “We are not traders. We are operators. We do not take a single view on anything for the immediate benefit. We look at things over the long term.” 

The graph below reflects these three distinct phases of growth, with Discovery entering the third phase in this financial year. 

The third phase is critically important for any company to become a mature business that can have sustained growth over the long term. 

It also requires the investments made in the second phase to be based on sound business principles and not an endless pit that drains the company’s resources. 

The key to whether Discovery achieves sustained organic growth is the profitability of its bank. Gore said this is central to the company’s future as it opens up tremendous growth opportunities. 

As the bank achieves profitability in the next financial year, it will require significantly less funding from the centre, resulting in much-improved cash generation. 

Another key focus area for Gore in this new phase is ensuring its established businesses grow at CPI + 2% to 5% annually. With less cash burn in its new ventures, this will again boost cash generation. 

Improved cash generation will enable the bank to pay down its debt, reduce its gearing, and invest strategically to tap into new growth opportunities. 

The company entered this phase in the past financial year, with spending on new initiatives declining, debt being paid off, and cash being returned to shareholders. 

Ultimately, as Discovery’s new initiatives become profitable, its earnings will begin to grow at a rate closer to what it experienced in phase one. It expects earnings to compound at an annual rate between 15-20% over this phase. 

Spending on new initiatives will decline to around 5% of total costs. In the past financial year, the share was closer to 8%. 

Return on equity will also improve as the company’s cash conversion becomes more efficient. 

Gore admitted there may be short-term knocks across some of its business, as seen in the UK division over the past year, but due to the company’s diversified offering, these will not derail the overall group’s performance. 

To derail the company’s momentum, Gore said there would have to be a massive change over a short period of time in one of its businesses, which is unlikely. 

Furthermore, Discovery should be able to offset this with strong performances from other areas of its business, as it is highly unlikely such a shock would happen across several of its units at the same time. 

The expected financial performance of Discovery through this new phase of growth is shown in the graphic below.