Australia | Dec 17 2019
Vehicle leasing and salary packaging business Smartgroup has succumbed to earnings pressure as its add-on insurance underwriter makes changes to product terms.
-Changes likely to have emanated from regulatory scrutiny of insurers
-Stronger growth path likely reliant on acquisitions outside of salary packaging
-Raises questions about whether earnings for novated leases have normalised
By Eva Brocklehurst
A confluence of negatives has beset Smartgroup Corp ((SIQ)) recently and several brokers, disappointed by the latest news, have downgraded the stock. New car sales data remains weak and a headwind, while long-serving CEO Deven Billimoria intends to retire at the end of February.
Major shareholder, Malaysia's Smart Packages, also exited the stock in October. Now, the company's insurance underwriter has made changes to the product terms, effective July 1, 2020.
Smartgroup expects a reduction to net profit of -$4m in 2020. The annualised impact is a -10% downgrade based on 2019 earnings. This means lower insurance product pricing will generate lower commissions for Smartgroup. There is also reduction to the revenue the company derives from providing services to the underwriter.
Brokers assess the regulatory scrutiny on add-on insurers means this earnings reduction will be permanent. Morgan Stanley points out the modest loss ratios on some insurance products that are sold as part of lease offerings probably caught the attention of regulators.
The response of the underwriter, therefore, was to broaden what is claimable whilst reducing premiums. Ord Minnett, surprised by the announcement, finds it difficult to understand where the company can mitigate the impact and downgrades to Hold.
Credit Suisse notes potential mitigation, if any, is yet to be discussed with the underwriter and does not expected it to be material. The broker downgrades to Neutral, having believe that the company had been at the 20% commission cap for add-on insurance for some time. This turns out not to be the case.
The broker is also surprised by the quantum of the hit to earnings, and the fact that there are service fees that appear to be outside of the commission structure. Credit Suisse had believed the stock was oversold following the departure announcement by the CEO and stood to benefit from efficiency gains, as well as small acquisitions and a cyclical recovery in new car sales in 2020.
While still retaining much of this view, the update, following on from the yield pressure reported by McMillan Shakespeare ((MMS)) recently, raises questions for the broker regarding whether earnings for novated leases have normalised and whether there is more downside to come.
Morgans suspects a return to a stronger growth path will require the company to execute on acquisitions outside of the core salary packaging sector. There are risks from a fall in novated lease demand and heightened competitive pressure.
Macquarie is extremely disappointed with the changes and downgrades to Neutral, applying a -25% discount to the stock versus the PE multiples of peers for FY20. This reflects a lack of clarity and expectations for no earnings growth from 2019-21.
Further disclosure that provides clarity on product pricing and the company's exposure to commissions and service fees across the business, the broker acknowledges, could mean confidence in the outlook improves.
Morgan Stanley agrees the risks from insurance commissions are skewed to the downside and, given soft vehicle sales and pressure on insurance margins, finds few near-term catalysts for the stock.
There are five Hold ratings and one Buy (Citi, yet to update on the news) on FNArena's database. The consensus target is $9.00, suggesting 25.7% upside to the last share price. However, this target includes Citi's target at the top of the range at $11.83 with the lowest being Macquarie's $7.66.
See also, Smartgroup Cruising Comfortably on August 21, 2019.
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