Unpacking The Salary Packaging Sector

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A review of recent broker research on salary packing companies, following new coverage by Citi for McMillan Shakespeare and Smartgroup Corp.

-Citi initiates coverage with Buy ratings for McMillan Shakespeare and Smartgroup
-McMillan is preferred for greater diversification and NDIS-related growth
-Both companies should benefit from electric car discount legislation
-Current share prices imply material upside to broker targets
-Additional ASX-listed salary packaging companies

By Mark Woodruff

For investors seeking relative earnings safety on the ASX in the face of macroeconomic headwinds, Citi recommends leading salary packaging providers McMillan Shakespeare ((MMS) and Smartgroup Corp ((SIQ)). 

The broker initiates coverage with a Buy rating for both companies that each have a defensive customer base in industries such as healthcare, public administration, education and defence.

The National Skills Commission expects key industries in the salary packaging industry in Australia will grow by around 6.4% to 15.8% between 2021-2026.

McMillan is a provider of salary packaging services (including novated leasing), disability plan management and support coordination, asset management and related financial products and services, with operations in Australia and the United Kingdom.

As well as providing employee benefits and workforce optimisation services, Smartgroup offers fleet management and software services and has risen to become the number one salary packaging provider and number two novated leasing provider in Australia.

Citi prefers McMillan Shakespeare over Smartgroup due to its more diversified business model, with around 22% of revenue derived from novated leases, compared to 58% for Smartgroup.  

Mind you, should new vehicle supply improve, Smartgroup is the more leveraged play, with a 10% increase in volume potentially adding $10m to earnings, according to the broker. It’s felt consensus is underestimating novated leasing volumes for the company in FY23, and the operating leverage from volumes, which can help offset wage pressures.

Global original equipment manufacturer (OEM) production remains depressed, and given recent OEM and automotive semiconductor company commentary, current conditions are expected to persist. While the semiconductor companies see improved conditions, some products are still in short supply. Citi forecasts FY23 will be a relatively stagnant year for lease volumes before rebounding in FY24, when new car supply should start to improve.

The broker also likes McMillan Shakespeare for the growth potential of its Plan and Support Services (PSS) division. The company is the number two plan manager in Australia, with only 25,900 customers and an estimated market share of 8.6%.

National Disability Insurance Scheme (NDIS) participants are expected to grow at an around 6% compound annual growth rate (CAGR) out to FY30 and the highly fragmented plan management industry is thought to provide inorganic growth opportunities.

Citi envisages a large runway for the company to increase its customer base both organically and via acquisitions, with the plan management industry highly fragmented, with the top ten only accounting for 38% of market share.

Both McMillan Shakespeare and Smartgroup also have an opportunity for an expanded customer base, suggests Citi, due to the Federal government’s Electric Car Discount Bill, which is set to be legislated following its approval in the Senate.

The Bill removes the fringe benefits tax on cars made available by employers to current employees that are zero or low emissions vehicles with a value at first retail sale below the luxury car tax threshold for fuel efficient vehicles ($84,916). Potential savings to corporate employees of $6,300-$13,100 per year are forecast by the broker, though potential uptake of the discount may be impacted by semiconductor shortages, which are constraining new car supply.

By setting a $16.40 target for McMillan Shakespeare, Citi raises the average target price in the FNArena database to $15.65 from $15.46, while the broker’s $6.60 Smartgroup target lifts the average to $6.04 from $5.93.

These average target prices suggest 13.7% and 20.8% upside from the current share prices for McMillan Shakespeare and Smartgroup, respectively.

Additional ASX-listed salary packaging companies

Other companies in the ASX Salary Packaging sector include SG Fleet ((SGF)) and Eclipx Group ((ECX)) which both provide fleet management and leasing solutions.

While no earnings guidance was issued by SG Fleet in a late October first quarter trading update, Overweight-rated Morgan Stanley (target $3.40) pointed to strong tender activity with novated leads well ahead of expectations, though the UK was experiencing some tapering of activity.

The broker noted supply constraints led to existing assets being sweated for much longer than planned, citing a fleet refresh that had already been deferred. This dynamic is, however, expected to be supportive of future growth and earnings even with increasing macro headwinds.

Immediately after August FY22 results for SG Fleet, that were broadly in line with expectations, both Canaccord Genuity and Macquarie commented upon constrained supply. This circumstance revealed itself in increased pipelines for Corporate Fleet and Novated Lease of 11.7% and 15.4%, respectively.

Canaccord also noted solid cash generation and felt the company’s market position had been strengthened by the LeasePlan transaction. Management noted the integration was progressing well after the completed purchase in September 2021 of Australian and New Zealand subsidiaries of LeasePlan Corp in exchange for $273m in cash and a 13% equity interest in SG Fleet.

Cannacord has a Buy rating for SG Fleet with a $3.51 target, while Outperform-rated Macquarie has a target of $2.90. These targets are well in advance of the recent $1.83 share price.

After Eclipx Group released FY22 results in line with consensus expectations just over a month ago, brokers found no definitive reason to justify the resulting negative share price reaction, and shares have since traded at higher levels than prior to the announcement.

All three brokers in the FNArena database have Buy (or equivalent) ratings for the company. Credit Suisse noted maximum cash generation had continued via elevated end-of-lease (EOL) income and new business, while Macquarie observed operating expenses remained flat for the third consecutive year, despite inflationary pressures.

Morgan Stanley chose to highlight an elevated backlog and 113% cash conversion, and pointed to an undemanding valuation, strong balance sheet, buybacks and organic opportunities.

The average 12-month target price in the database for Eclipx is $2.56, suggesting 30.8% upside to the latest share price. For a recent article on Eclipx please refer to https://www.fnarena.com/index.php/2022/11/09/eclipx-group-cutting-costs-looking-for-catalysts/.

Other broker opinions on McMillan Shakespeare

Of the five covering brokers in the FNArena database, Overweight-rated Morgan Stanley has set the highest target of $17.50.

Following a first quarter trading update on October 31, this broker noted robust novated demand and retention. More generally, the analyst liked exposure to the company’s inorganic optionality and lower-volatility public novated exposure.

Buy-rated Macquarie also approved of the trading update and raised its target to $14.84 from $11.20 after reducing its multiple discount for two reasons. Contemplation by management of an exit strategy for the UK segment in FY23 and capital management announcements, including a higher dividend payout and a 10% off-market buyback.

Credit Suisse (Outperform) was similarly positive on capital management and raised its target to $15.60 from $14.25, while Hold-rated Ord Minnett, which has the lowest target of $13.90, still had some reservations.

A slight beat on earnings was attributed to the UK business, which the company is looking to exit, while a decline for the Group Remuneration Services segment was also noted by the analyst.

Other broker opinions on Smartgroup 

Six brokers now cover Smartgoup in the FNArena database, equally divided between the equivalent of Buy and Hold ratings.

Average EPS forecasts for FY23 and FY24 in the database fell when management released FY22 profit guidance on November 23 that missed the consensus estimate by -8%.

At the time, Macquarie downgraded its rating to Neutral from Outperform and cut its target to $4.75 from $7.10, noting supply-chain constraints on new-vehicle deliveries, despite signs of growing demand for novated leases.

In commenting on guidance, Ord Minnett observed headwinds included not only interest rates and lack of car supply but also wages inflation and lowered its target to $6.30 from $7.50.

While Morgans lowered profit estimates in reaction to new guidance, its rating was upgraded to Add from Hold, given the company’s strong balance sheet, solid forward revenue pipeline, contract opportunities and potential for high electric vehicle lease demand.

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