PORTFOLIO POINT: McMillan Shakespeare is well positioned to drive solid returns over the coming year.
It is pleasing to note that my Growth Model Portfolio has returned 15.62% since June 30 (7.07% since inception in late April), with the performance having already exceeded my yearly return target of 12%. This performance supports my investment philosophy of seeking out those companies that have exhibited a high return on equity, are well-funded, managed by honest executives, and who’s business is easily understood.
The rise in the Australian sharemarket continued unabated this week, and it is has resulted in many investors and commentators questioning its basis and sustainability.
In my view this rally is not based on a general positive outlook for earnings growth. Indeed, there are very few large companies that are confident of achieving earnings growth of greater than 10% this financial year. Rather, this rally has more to do with asset allocation on a large scale following a slight uptick in confidence pursuant to the great debt workout in Europe.
Clearly, major international funds, including those domiciled in Australia, had been easing down their exposure to Australian equities for a few years. Now, following a sustained rally in Australian bond yields, there is a clear need to seek out returns from other asset classes, and so Australian equities have come back into favour – even if there are very few real growth opportunities.
Whilst short-term earnings growth is hard to see across the market there is one stock in my growth portfolio that can I can confidently forecast will generate earnings growth this year of significantly greater than 10%. That stock is McMillan Shakespeare Limited (MMS). Further, this year will be a continuation of a remarkable seven-year period for MMS, which has seen:
- Average normalised return on equity of over 50%;
- Compound earnings growth of about 40%; and
- Average compound dividend growth of about 37%.
MMS was a unique beneficiary of the GFC. At a time when many leading companies were forced to raise capital to repay debt, MMS utilised a cashed-up balance sheet in 2010 to buy Holden Inter Leasing from the General Motors (US), which was being bailed out by the US government. The acquisition was made at a distressed price, with MMS paying a substantial discount to book value. In other words MMS bought a significant car leasing business (finance leasing) at “negative goodwill”, which had tremendous synergies with its established salary packaging business (partly novated leasing). Very few acquisitions generate excellent returns for acquirers in such a short time, but this one did and the recent profit history is testament to this.
Even today there remains tremendous cross-selling opportunities across customers and product bases. Indeed, operating the two divisions in unison is slowly bringing diversification to the customer base, which was previously public health care centric. Today, 79% of new business and cross-sell wins come from the private sector.
It is interesting to reflect that some analysts in 2010 questioned the resultant debt that appeared on the balance sheet of MMS. However, these analysts simply did not understand that MMS assumed the funding of the leasing book. The funding of such a loan book should not be done with equity, and so the resultant consolidated debt was both sensible and logical.
What does MMS do?
MMS operates two divisions:
- Remuneration services (salary packaging) trading under Remserv and Maxxia; and
- The asset management business, or the Holden Inter Leasing business.
Apart from an impressive profit record, productivity and customer satisfaction have both increased considerably during the last five years. The remarkable track record of growth and profitability suggests MMS is able to consistently provide a service that others struggle to replicate.
The recent 2011/12 result showed strong profit growth. Remuneration services increased 27% over the year, with group NPAT of $40.3 million. Asset management delivered 6% grow in NPAT to $14.3 million. Cash flow generation was very strong and allowed the payment of $31 million of franked dividends to shareholders.
Key Operating Metrics of 2011/12
Up from $43.5m to $54.3m
Down from 57.8% to 51.5%
Up from 26.9% to 28.7%
Up from 16.1% to 18.1%
Net Debt to Equity
Down from 99.9% to 60.3%
Up from $0.22 to $0.25
The financial strength of the business has been increasing, which is adding a further competitive advantage. Net debt to equity has been reducing for the last two years as the parent company continues to repay down debt raised to fund the Inter Leasing acquisition. MMS is able to obtain bank guarantees while their competitors struggle, and this provides a strong edge particularly when tendering for government contacts. This is supported by Maxxia, which recently won a six-year contract as the sole provider of salary packaging and novated leasing services to the South Australian government. This contract win provides a strong outlook for increasing organic growth as MMS can expand its core operations across new customer bases.
So those are the positives, what are the negatives I hear you ask?
The key risk to the business model is the possibility of an adverse change to the salary packaging rules. I do not think this risk is confronting in the near term, especially as an election year approaches. Further, salary packaging in the health care sector actually helps keep employee costs down. In any case, this risk can be mitigated by an investor through portfolio weightings and by adopting a large margin of safety in the purchase price.
What is the value of MMS?
The current market consensus forecast profit for MMS for 2012/13 is just over $62 million, and this represents a rise of 15% from 2011/12. On the assumption of this profit being achieved, then the valuation as at June 2013 is $13.60. This is not an optimistic forecast of value, because I have retained a relatively high required return for MMS of 14%. Those readers who believe that a lower required return is justified for MMS, and especially given the rally in bond yields, will likely see a higher value. In any case, MMS sits nicely in value and well deserves its position in my portfolio.
John Abernethy is the chief investment officer at Clime Investment Management. If you are a wholesale investor and you would like to have a no obligation private meeting with John Abernethy, please click here.
Clime Growth Portfolio
Return since June 30, 2012: 15.62%
Returns since Inception (April 19, 2012): 7.07%
Average Yield: 6.76%
Start value: $111580.24
Current value: $129,008.19
Clime Growth Portfolio - Prices as at close on 18th October 2012
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