We recently established a position in Smartgroup, a novated lease and salary-packaging company. Smartgroup generates revenue by administrating salary packaging on behalf of employers that offer it and through novated leases. A novated lease allows an employee to pay for their car lease out of their pre-tax dollars (thereby earning a tax break).
Salary packaging and novated leases are fringe benefits, essentially tax breaks that are designed to give a non-wage benefit to mostly public servants and workers in the charity sector.
The industry has been around since fringe benefits tax legislation was introduced in the late 1980s. Smartgroup has been around since 2002 and, with MacMillan Shakespeare, shares the market – they each have about 50%. It is a growing industry. Excluding acquisitions, Smartgroup has grown salary-packaging numbers organically by 12% p.a. and novated leasing by 4% p.a. in recent years.
There are two key drivers of growth for Smartgroup. The first is whitespace conversion and employee take-up (which we expect to account for 50% of Smartgroup’s growth). This aspect of the growth is about convincing organisations to outsource their salary packaging and employees to take up the offering. The key driver for this is employment. About 96% of Smartgroup’s customer base are charities and government workers. As per the chart below, employment in healthcare and social assistance has grown strongly over the past eight years. A big driver has been the rollout of the National Disability and Insurance Scheme, as well as the growth in aged care. We consider this a structural tailwind for Smartgroup.
Employment by Selected Industry (cumulative change since February 2011, trend)
Sources: ABS, RBA
The other driver of growth is gains in market share. To do this, Smartgroup has bought competitors and taken share organically as it has the best service and tech offering. It is a scale game. When Smartgroup buys small stand-alone salary-packaging and novated businesses, it buys sticky customer bases and rolls the packages onto better terms (Smartgroup gets the best rates from car dealers and financers, etc.) so it can basically double the profitability of these smaller players by rolling them onto its terms.
Generation and use of cash
Smartgroup generates phenomenal returns on invested capital because it basically doesn’t have capex or working capital needs. It fully expenses all IT spending so debt doesn’t accumulate on its balance sheet.
The core business generates a lot of cash and Smartgroup has used it since listing to acquire smaller competitors. As per below, Smartgroup could have funded these acquisitions plus an 85% payout ratio almost all through internally generated cash. The company, however, has undertaken two equity raising to keep debt to close to zero.
New vehicle sales (the key driver in any one year for novated lease sales) are down over 20% this year. With this weak industry backdrop, Smartgroup’s share price has fallen by 40%. We believe this is an opportunity to buy Smartgroup at an attractive price (11 times free cash flow, 6% dividend yield).
The chart below looks at growth in new car sales over the past three decades. Clearly, new car sales do decline from time to time but they have always rebounded.
Historical Australian new vehicle sales
Source: Morgans research, VFACTS data.
Further, despite a 20% decline in new car sales, Smartgroup’s volumes are flat, which is a solid achievement considering the market backdrop.
Vehicle sales relative to Q1 2016
Source: Smartgroup presentation
While we can’t predict the timing of a rebound in new car sales, we take comfort from Smartgroup’s low level of gearing (0.1 times net debt/earnings before interest, taxes, depreciation and amortisation), low multiple paid (11 times free cash flow), excellent management and the business model’s healthy cash flows.