This article was first published by James Carlisle on the Intelligent Investor website on 6 Aug 13.
When we last covered McMillan Shakespeare (MMS), on 23 Jan 13 (Avoid – $13.50), we wrote that ‘while most of us might merely hope they don’t do anything else dumb in Canberra, shareholders of McMillan Shakespeare rather hope the Federal Government doesn’t do something intelligent’.
And so it has proved, with Kevin Rudd’s eminently sensible proposal to close one of the tax loopholes on which McMillan Shakespeare has thrived recently causing the company’s share price to near-enough halve.
But hang on, you say, isn’t Rudd going to lose the election, so all this will just blow over? Well probably, and maybe, but to unpick the various potential outcomes, we need to start by having a look at where McMillan Shakespeare makes its money.
The company has two divisions: Interleasing and Group Remuneration Services. Interleasing provides employers with vehicle finance and fleet management services. It contributes about a quarter of profits and is growing very slowly.
Group Remuneration Services essentially provides the machinery through which employers and employees can take advantage of various tax loopholes. It contributes about three quarters of group profits and has been growing at about 20% a year. The growth in these earnings explains why the market previously saw fit to rate the stock on a price-earnings ratio of over 20, but their fragility explains our own reticence.
Kevin Rudd’s proposal to remove one loophole concerning novated leases for ‘work’ vehicles potentially affects about two-thirds of GRS profits, or about half of MMS’s total. But since this is the fast-growing part of the company, the impact on its value could be substantially higher.
That the share price has only fallen by half is due to the fact that Kevin Rudd’s odds of winning the election are currently running at about 30%. But if he was able to overcome these odds, there would no doubt be a further lurch down in the share price.
More likely, though, is that the Coalition will win the election. They have been strongly critical of the proposed changes and say they will leave things as they are if they get in. But in a sense, the cat is now out of the bag. Rudd’s proposal has begun a debate and it’s hard to find anyone – barring perhaps shareholders in McMillan Shakespeare and the Coalition apparently – that’s in favour of maintaining what at best is a fudge and at worst is a blatant rort. If the Coalition wins, as is likely, McMillan’s share price will no doubt jump sharply, but it’s hard to see it getting back to its $18 peak any time soon.
Going back to Rudd, there are a couple of further possibilities that require consideration. The first is that the impact of the changes are less severe than anticipated. Under the present system, employees with cars on novated leases can either log their travel over a 12-week period and claim the full work-related expense as a deduction, or they can claim a flat 80%. Clearly people whose usage is less than 80% will chose to use the flat rate, but the new proposal is for everyone to use the log-book approach.
For many people it won’t be worth the hassle for the reduced benefits, and for those that remain, GRS’s value proposition will be compromised. But the company’s profits from the provision of novated leases are unlikely to disappear completely.
Against this is the possibility that the other third of GRS’s profits may come under threat. These come mostly from helping health workers exploit a loophole enabling them to claim deductions for non-work expenses. As such, they’re more politically sensitive, but higher pay could be offered as compensation.
All in all, if Tony Abbott were to win the election, we’d expect McMillan to make earnings per share of about 80 cents, but we’d value those earnings at much less than the 20-plus times multiples from a few months ago. Something in the low teens would be more appropriate, giving a value around $10 per share. We’d expect the market to have moved a little closer to our thinking, but probably not all the way, so a bounce to higher levels would be likely in the short term. As we've already noted, a return to $18 looks unlikely any time soon. But the stock traded between $14 and $16 for most of this year and a return to those levels is not impossible.
If Rudd were to win, we’d expect between a quarter and a half of McMillan’s earnings to disappear in pretty short order, leading to earnings per share of about 40-60 cents. These remaining earnings would be slower growing, but they might also be more durable, so we’d settle again for a multiple in the low teens, giving a value of about $6.
At the current price of $9.07 and with the current odds on the election, to make an attractive situation out of this, you’d need to rely on that short-term bounce above $10. As members of the High Church of Value Investing, we don’t make recommendations based on short-term bounces, so we’re sticking with Avoid.
But for those of a more liberal persuasion, there’s an interesting possibility of backing a short-term mispricing of McMillan, without most of the risk, by using a bet on the election as a hedge.
For example, you could invest $1,000 in McMillan Shakespeare and simultaneously put $200 on Labor to win the election at the current odds of 2.4-to-1 (equivalent to decimal odds of 3.4).
If the Coalition won you'd gain the increase in the investment less the $200 bet, so you’d be in the money with a share price gain of 20% or more.
If Labor won you’d lose on the investment but win $480 on your bet. So long as McMillan shares didn’t fall by more than 48%, you’d make a profit.
From the current price of $9.07, we think there’s a good chance you’ll come out ahead in either scenario, but you could vary the amount of your bet if you have strong feelings on which way the election might go.
You can play around with this spreadsheet to see how various combinations might play out, along with different assumptions about where the share price might end up.
Beware other outcomes
Bear in mind that this isn’t a pure hedge (if there ever is such a thing) because there are other potential outcomes. Your worst nightmare would be that Tony Abbott suddenly endorsed Rudd’s policy and went on to win the election, so you’d lose on the investment and on your bet.
The flipside is that Rudd could abandon the policy and then get elected, giving you a win/win. Given how the last Federal Election turned out, you’d also want to check the detailed terms of what constituted a win for either side.
After that diversion into liberalism, though, we’ll return to our High Church, say a dozen ‘Hail Warrens’ and reiterate that we wouldn’t recommend being invested in McMillan Shakespeare for long. AVOID