SmartGroup Looks Smart For 2016

This story features SMARTGROUP CORPORATION LIMITED, and other companies. For more info SHARE ANALYSIS: SIQ

-No material re-rating likely
-Regulatory risk low but exists
-Contracts successfully renewed
 

By Eva Brocklehurst

SmartGroup Corp ((SIQ)) is one of the largest salary packaging and novated leasing providers in Australia and is expanding into adjacent services, such as workforce management for the healthcare industry.

Brokers notes the company's strong position in a growing market and the type of relationship with clients that is typically sticky. Contracts are usually of five years duration and the company is growing the number of employees under management, with opportunities to increase penetration with the federal government and win new clients emanating from a strong position with the NSW health department.

The company recently acquired Health-e Workforce Solutions, tapping a large sector opportunity and providing cross-sell opportunities, in Credit Suisse's observation. The broker likes the stock for its earnings outlook and the potential inherent in each new client. SmartGroup has a capital-light business and no debt. Margins can increase from product mix, improved supplier fees or rebates, and increased online services which provide efficiencies.

Credit Suisse takes up coverage with an Outperform rating and $3.90 target. That said, despite an undemanding headline valuation, taking into account the regulatory risk in the sector and the recent share price appreciation, the broker does not envisage a material re-rating.

Regulatory risk involves specifically any changes to fringe benefits tax (FBT) treatment for not-for-profit organisations and/or novated leases, given the company's business is centred on services which are premised on FBT.

A novated lease is a vehicle lease agreement whereby the employer agrees to pay the lease payments out of pre-tax salary. Novated leases account for around 60% of the company’s salary packaging revenue and are the highest margin product. Credit Suisse is of the view that changes to existing FBT regulations are unlikely, given proposals were neither implemented nor widely supported in the past.

Reasons for the broker's confidence lie in the reduction in supply-side stimulus to the vehicle industry, meaning the federal government is unlikely to want to negatively affect the demand side, of which novated leasing is an important contributor.

Secondly, the industry has addressed some previous misconceptions regarding a typical user of novated leases. Most are in the government, education, teaching, police, and charity sectors, rather than being high net worth individuals buying luxury vehicles.

Still, brokers concede investors do need to be aware of the risk. Other risks include SmartGroup's high and growing portion of transaction revenue, driven by supplier rebates/commissions on novated leases, and increased competition.

Fleet providers such as SG Fleet ((SGF)) are increasing their focus on novated leasing. Still, Credit Suisse notes new players are not entering the industry as there are increasing barriers in terms of scale and the capability required to deal with large clients.

A strong 2015 result is expected, amid organic growth and margin expansion. Margins increased to 37.4% at the first half result versus 33.9% for 2014, driven in part by revenue growth and operating leverage but also, as Credit Suisse observes, by negotiating better outcomes with suppliers. The broker cites the fairly recent prospectus – the company listed on ASX 18 months ago – and the fact the industry is now better understood as supporting the outlook.

A well documented risk at the time of IPO was that a material portion of contracts were up for renewal in 2015 and these have all successfully been retained. At the time of the first half results Macquarie noted the Department of Defence salary packaging contract was the largest contributor to revenue, and had been renewed. The broker expects 2016 revenue growth of 17.5% and envisages plenty of long-term growth opportunities.

One meaningful contract is up for renewal in the first half of 2016 accounting for 5.0% of revenue but Credit Suisse expects this client offers no change or, indeed, upside risk. No further material renewals are on the cards until 2017.

The stock trades in line with the median price/earnings of comparable stocks but is more expensive than its peer McMillan Shakespeare ((MMS)), Credit Suisse concludes. There are three Buy ratings on FNArena's database with a consensus target of $3.22, suggesting 14.5% downside to the last share price. The dividend yield on 2015 and 2016 estimates is 4.2% and 4.5% respectively.
 

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