Small Caps | Aug 21 2019
Smartgroup Corp has proved resilient in the first half of 2019, recording growth in novated leasing and salary packaging despite a difficult macro environment.
-Two small Victorian health contracts not renewed
-Yet new business has more favourable pricing
-Risk remains for ASIC placing lower cap on trailing commissions
By Eva Brocklehurst
Brokers were impressed as salary packaging and novated leasing company Smartgroup Corp ((SIQ)) seemed to cruise through a tough first half. The established businesses performed well, given no acquisitions made contributions.
While growth was below the double digits usually recorded by the company, at 2.7% for novated leasing it was delivered not only with no contribution from acquisitions but against a decline of -9% in new car sales over the six months period.
Both salary packaging (up 4.3%) and novated leasing were affected by the non-renewal of some contracts late in the half. Yet, while two small contracts were not renewed, brokers note new business has more favourable pricing. There was some yield compression, although increased cross selling and new products helped offset the impact Credit Suisse points out, highlighting the 20% increase in clients using two or more services.
The full impact of vehicle manufacturers extending their mechanical warranties and a skew towards lower-priced vehicles contributed to a decline in novated lease revenue yields of around -2%, Macquarie assesses.
No explicit guidance was provided but the interim result implies an earnings skew of 50:50 for H1:H2, Morgan Stanley calculates. This compares with 48:52 historically, and indicates acquisitions made in the first half will support the second half to the tune of $700,000.
Partially offsetting this is the loss of two Victorian health contracts, which the broker estimates creates a -$1-1.5m drag on the second half as the contracts were only lost in March and June. These contracts will be fully cycled in June 2020. Macquarie notes Smartgroup has lost only three contracts since it listed on ASX. Its third largest client, comprising around 3% of revenue, has recently been secured to 2022.
Citi will scrutinise the Victorian health market in more detail to determine if customer losses were one-off or indicative of competitive pressures. The broker's upgrades to earnings estimates are driven purely by margin expansion as top-line forecasts are unchanged.
The company has entered five new partnerships in the first half although no meaningful earnings are expected to emerge in the near term. Ord Minnett continues to believe there are further accretive acquisitions in the pipeline, providing a source of potential upside. Pricing in particular was above the broker's expectations but volumes in novated leasing and salary packaging as well as margins and distributions were all better than expected.
Credit Suisse expects similar growth figures in the second half and this should accelerate in 2020 as conditions become easier, upgrading to Outperform from Neutral. Citi reiterates a Buy call with increased vigour, given the resilience shown in the first half. However, the broker lowers the target slightly because of more modest longer-term assumptions.
Morgans also upgrades, to Add from Hold, assessing there to be upside risk over the next 12-18 months from potential acquisitions or capital management. This is based on strong cash flow and modest gearing.
Demand is resilient, as the company appears to have benefited from increased penetration of the existing novated lease market with products that pay trailing commissions. In the longer term, however, the broker has some reservations around the sustainability of earnings from add-on insurance commissions. Market expectations centre on the insurance commission of 20%, currently recommended by the industry, being implemented.
Morgans asserts the risk of a lower cap will not disappear until the Australian Securities and Investments Commission actually finalises and introduces the cap, timing of which is unknown. While company does not provide specific revenue details regarding add-on insurance, which includes extended warranties, earnings are likely to be significant. Morgans estimates this to be around 20%.
Smartgroup has reduced the number of premises to 6 from 17 over the past 18 months and reduced personnel by -4%. Citi notes, while any remaining acquisition targets may be smaller, the company's ability to extract synergies has never been higher. The broker calculates acquisitions up to $155m could be funded by debt before net debt/operating earnings reaches 1.5x, and there remain a number of organic opportunities in the industry.
FNArena's database has five Buy ratings and one Hold (Morgan Stanley). The consensus target is $10.84, signalling -2.7% downside to the last share price. Targets range from $9.80 (Credit Suisse) to $11.83 (Citi).
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