The following is an extract from our weekly client research report:
McMillan Shakespeare Limited is a provider of salary packaging and vehicle leasing administration. The Company is engaged in the provision of remuneration, asset management and finance services to public and private organizations in Australia. The Company operates in two segments: Group Remuneration Services and Asset Management. Group Remuneration Services segment provides administrative services in respect of salary packaging and facilitates the settlement of motor vehicle novated leases for customers, but does not provide financing. The segment also provides ancillary services associated with motor vehicle novated lease products. Asset Management segment provides financing and ancillary management services associated with motor vehicles, commercial vehicles and equipment.
REGULATORY RISKS DISAPPEAR
McMillan (MMS) began its life as a salary packaging business, operating under the RemServ and Maxxia brands across Australia. During the global financial crisis the company opportunistically acquired the vehicle leasing business of GMAC (General Motors) at 11% discount to NTA. MMS now operates two business segments, group remuneration services, Australia’s largest salary packaging provider contribute about 70% of pre-tax profits, and the asset management division which is its vehicle fleet leasing business makes up the balance.
The salary packaging division largely services the government health and not for profit sector where employees can take advantage of favourable FBT tax rates to pay for a vehicle leasing and related ancillary service costs using their pre-tax salary. The differential between the employee’s marginal tax rate and the favourable FBT rate minus any administration costs (fees charged by MMS) is the amount of benefit that an employee can gain from salary packaging. Salary packaging only provides administration, compliance and ancillary services but do not provide lease financing. The division leverages its focus on superior customer service and continued investment in IT systems to drive growth in the business. Because the division is incredibly asset light with minimal fixed costs it is able to generate above average returns from incremental customer wins. In July 2013, the incumbent Labour government changed federal regulation regarding FBT rules and made salary packaging uneconomic. Fortunately for MMS the September 2013 election delivered a decisive win for the Tony Abbott led Coalition. The incoming Abbot government formally repealed the Labor FBT changes in November 2013, and promised to not make any future changes to the FBT rules, providing certainty for MMS as a viable business. Now that regulatory risks have disappeared, MMS can continue to grow in its core markets (the public health sector). MMS has a dominant position in the QLD, South Australia and WA health markets. The NSW health sector presents a significant opportunity for MMS, it is the last remaining state which still manages the majority of its salary packaging function in house. Assuming a 60% customer penetration rate MMS is able to add approximately $25m or 28% of operating earnings based on FY13 reported numbers should it win the NSW contract.
The fleet leasing business is capital heavy providing financing to customers, the division operates like a bank. MMS earns a net interest margin based on the difference between what it charges on lease rates and the cost at which it can fund that lease. Important drivers for the asset management division include: the resale value of vehicles in the secondary market, the reliable supply of vehicles from Thailand, and the quality of the asset portfolio (credit losses on leases). Due to the low cost of labour and the considerable government tax incentives offered to manufacturers a majority of motor vehicles are now manufactured in Thailand. The 2011 Thailand floods presented significant challenges for MMS where latent demand for new vehicles via the leasing channel could not be satisfied due to the delay of new vehicle deliveries. As the recovery of the floods took pace the strong growth of vehicle leases allowed MMS to deliver a record year in profit growth in FY12. Given that MMS offers both salary packaging and vehicle leasing services there is tremendous opportunity to cross sell to both existing and new customers.
The back tracking of FBT legislation will unfortunately impact MMS’s FY14 earnings, with consensus earnings expected to fall by 16.7% on the prior year. However markets tend to look forward and we expect investors to based their investment outlook on FY15 earnings, which is a more normalised year without any regulatory risk. For a high growth company such as MMS (21% return on assets) which trades on 12.9X normalised earnings (FY15), we feel now presents a timely opportunity for the astute investor.
GOOD GROWTH BUT POOR CAPITAL MANAGEMENT
Despite the strong growth in returns and cash flows generated by the salary packaging business, the vehicle leasing business is capital hungry and a drain on operating cash flows. Unlike a typical finance company MMS appears to be funding the bulk of new vehicle leases from cash flows generated by the salary packaging business. Going forward we would like to see the company utilise more of its credit facilities to fund further growth in the lease book. Conversely the company’s leasing division has managed the credit quality at comfortable levels (credit losses are 0.06% of total lease value). Compare that to the bad debt charge of 0.2% for CBA, considered the best quality Australian bank. The acquisition a UK leasing business (CLM) although small provides MMS a way to diversify its revenue sources geographically and seek alternative means for future earnings growth.
The chart pattern of MMS is looking very bullish here. From the low to high between July and September, MMS staged a rally of over 100%. As a result, the stock required some breathing space before getting ready to head higher again. Profit takers came in, but there has been strong enough buying to ensure that the share price has hovered around the $12 mark. As you can see on the chart, the last few months has seen the stock track sideways in a continuation pattern. The most likely place for it to go here is in the direction of the preceding trend, which is upwards. So if it were to break to the upside, we could see the stock strive towards $18. Obvious resistance will be around $15.35 which is where we will fill the large gap caused in July.
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