McMillan Shakespeare well on recovery road

McMillan Shakespeare Limited (ASX:MMS), Australia’s largest salary packaging and novated lease provider, remains in the growth portfolio following the recent election and change of government.

MMS’s share price fell dramatically following the July 16 announcement by the former Labor government that it would change the concessional fringe benefits tax treatment (FBT) of vehicle usage.

MMS shares are now trading below my conservative $12.05 valuation for the 2014 financial year, and I expect 15% growth in intrinsic value to $13.85 by the end of FY15. Readers will note that I lifted the required return following the political upheaval to 13.5%. This will potentially fall again should MMS return to business as normal in the New Year.

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Source: StocksInValue.com.au

Today I am confident MMS has resumed growing its intrinsic value at double-digit rates, and I would accumulate at a suitable margin of safety (circa $11).

What does MMS do?

McMillan Shakespeare has two divisions:

• Group Remuneration Services (GRS) provides administrative and ancillary services in respect of salary packaging and facilitates the settlement of motor vehicle novated leases for customers, but does not provide financing. The revenue stream is salary packaging administration fees, which are annuity-style fees paid directly and regularly from employee salaries. In FY13 GRS enjoyed 16% net profit after tax (NPAT) growth to $46.8 million.
• Asset Management provides finance and ancillary management associated with vehicles and equipment in Australia, New Zealand and the UK. The revenue is a net interest margin on financed vehicles, fees for managing vehicles, supplier rebates on transaction volumes, and vehicle remarketing profits. In FY13 this division had 5% NPAT growth to $15 million.

MMS has several attractions

• The company has achieved average normalised return on equity (NROE) of 46% per annum since listing in 2004. This indicates low capital intensity.
• A recent overseas acquisition, before the $A depreciated, into a prospective market.
• Good underlying growth in the salary packaging market as business returns to normal.
• Potential to increase cross-sell.
• Double-digit growth in intrinsic value.
• Solid franked dividend growth potential supported by a substantial franked dividend reserve account.

Labor wanted to remove the popular ‘statutory’ measure of calculating FBT, which allows a driver to automatically claim 80% of usage for business purposes, and switch to the less-popular logbook or cost-based method, where income-producing trips are recorded over 12 weeks in the first year, which then lasts for five years. This less favourable treatment, which was introduced without industry consultation, sent the salary packaging industry into a sudden and deep downturn when it was announced.

The Australian Salary Packaging Industry Association said inquiries about salary-packaged novated leases fell instantly from 50-100 a day to fewer than 10. Hundreds of workers in the salary packaging and novated leasing industry were laid off.

An intense lobbying effort by the industry saw MMS rack up campaign costs of $1.5 million and the incoming Coalition government decided not to retain Labor’s changes. Many of the workers laid off have since been re-employed.

MMS rode out the downturn and held onto its entire staff on a view Labor’s FBT changes would not be implemented. This will result in lower profit margins being reported in the December half, but the extra capacity should hasten the company’s return to business as usual and gain market share for MMS.

After the federal election some confusion remained in the market, with a number of employers unaware of the new government’s return to the pre-July 16 policy. They are yet to restart their salary packaging programs. This has to be cleared up before the industry can return to normal.

At the October annual general meeting MMS CEO Michael Kay said the company would probably not return to business as usual until the second half of 2014. MMS averages a 42-day cycle from generating a corporate lead for a novated lease to making a sale and receiving payment. MMS’s novated lease orders fell to a third of FY13 levels after Labor’s announcement, but rebounded to 87% of FY13 after the Coalition won the election and to 95% by the AGM.

Upgraded guidance

On November 28, MMS essentially upgraded its guidance to the market when it announced trading was close to business as usual, as shown in Figure 2.

Click to enlarge

The recent guidance suggests that MMS should actually grow profits in the second half when compared to the previous corresponding period. Indeed, MMS could well go within 5% of matching last year’s reported record profit and this would be extraordinary given the problems of the first four months.

I believe this vindicates the decision to keep the MMS holding in the portfolio, and I also think there is upside to my valuation given the potential for market share gains in Australia and increased profitability from a recent acquisition in the UK. At the AGM, MMS announced the acquisition of a bolt-on, CLM Fleet Management (CLM), to its UK business for $14.4 million. CLM is well regarded and bolsters MMS’s UK fleet management capability in fleet sales, procurement, vehicle services and vehicle remarketing.

Together with Maxxia Finance, MMS now has a full suite of fleet and asset management capabilities in the UK and a platform for profitable growth. MMS acquired CLM before the $A depreciated recently, and the purchase also stakes out territory in a segment vacated by banks withdrawing from non-core operations to support their regulatory capital ratios. 

Labor’s policy change, the subsequent uncertainty, and the Coalition’s return to the pre-July 16 policy all came after June 30, the balance date for the FY13 result. This was another typically good performance by MMS, with NPAT up 15% to $62.2 million and normalised return on equity (NROE) of 47%. Declaration of the 18 cent per share final dividend was delayed until October 22 due to the uncertainty from the July 16 policy change.

One issue worth noting is the reported operating cash flows, which appear to be understated. This is because the operating cash flow is reported after the investment by MMS in car finance assets. Readers should note the substantial income tax paid by MMS ( about $25 million per annum) indicates that pre-tax cash flow is over $80 million per annum, with most of this diverted to investment in growing the asset finance business and the investment in the UK.

Figure 3. Excerpts from MMS cash flow statements FY11-13

Source: StocksInValue.com.au

John Abernethy is the Chief Investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au.

Clime Growth Portfolio Statistics

Return since June 30, 2013: 9.27%

Returns since Inception (April 19, 2012): 28.51%

Average Yield: 6.31%

Start Value: $141,128.64

Current Value: $154,209.45

Dividends accrued since June 30, 2013: $3,622.96