Since our recent report on Smartgroup Corporation (ASX:SIQ) in The Dynamic Investor, the trading multiple has expanded on the back of a positive market update. Notable positive included improvement in key demand indicators and an increase in the portion of orders and quotes coming from electric vehicles. With this in mind, we consider the likelihood of a further recovery in the shares back to its highs of around a year ago.
About Smartgroup Corporation
SIQ provides salary packaging administration and novated leasing services to employees of State and Federal Government departments, Public Benevolent Institutes and corporate employers. In more recent years, the group has expanded its service offering in Fleet Management, PBI Fleet Solutions, Payroll Solutions and Share Plan Administration. Since 2015, SIQ has consolidated the salary packaging sector, making seven acquisitions in the sector (and a further two outside salary packaging).
Key Fundamental Drivers
Novated Leasing Demand Set to Recover
Strong growth in leads for the 12 months to 31 December 2022 (FY22) has been offset by vehicle supply constraints. This has resulted in a reduction in leases under management. While growth in leads was particularly strong in 2H22 (+22%), this did not translate to new orders (-3%). This was due to challenges in the vehicle supply chain, insufficient staffing, as well as impacts from a funder change that added complexity to an already stretched team.
With further investment in staff in digital capability, order conversion is expected to improve in FY23 and beyond, which will be assisted by improvements in new car supply.
Strong lead volume has been maintained to start FY23 and elevated open leads were carried over from late FY22.
Well Leveraged to Higher Electric Vehicle Penetration
In November 2022, the Federal Government legislated the Electric Car Discount bill, which provides Fringe Benefits Tax (FBT) exemptions for benefits related to electric cars. Via salary sacrifice arrangements (novated lease), employees will effectively be able to run the cost of the novated lease (including running costs) on a pre-tax basis and not incur FBT.
The introduction of the Electric Car Discount Policy is expected to see the penetration of Electric Vehicles (EVs) accelerate in Australia through calendar years 2023/24. EVs represented 3.6% of Australian vehicles sales in calendar year 2022, which has increased to 7% for the March 2023 quarter, as demand for EVs has increased since the introduction of the Electric Car Discount bill.
EVs accounted for ~15% of SIQ’s total quotes in 4Q22, with corporate and government clients driving growth in EV quotes. SIQ expect strong interest in EV’s to continue into FY23, particularly as availability improves (via range and supply). In the recent trading update, this portion grew to 20%.
With limited current availability of EV models, we expect the earnings benefit for novated lease providers to come through from 2H23 (more so CY24), however potentially be in place for the several years with the Government stating the policy is to be reviewed in 2027.
Margin Expected to Recover in FY24 As Supply Issues Abate
SIQ reported EBITDA margin of 42%, which declined from 46% in FY21. This was primarily as a result of higher costs. Delayed vehicle delivery timeframes are increasing the need for credit re-approval and increased customer engagement, which along with increased on-site activities and higher labour costs, have seen costs increase. The delays in delivery timeframes are lengthening the sales cycle and as such, leasing team resourcing has been increased further to meet additional workload. Further, increased turnover among Novated Lease customers is increasing administrative and handling costs without a revenue benefit. A targeted cost review is now underway to address cost inflation pressures.
Recent industry data suggest that bottlenecks at Australian ports have increased so far this calendar year, with delivery times extended due to heightened biosecurity screening requirements for incoming vehicles. Industry estimates suggest that up to 60,000 vehicles are awaiting to be offloaded and/or cleared through quarantine, with Victoria appearing to be the most impacted (March deliveries declined by 11%).
The backlog of vehicles is expected to clear within months; and anecdotal industry estimates are for calendar year 2023 deliveries to be ~5% ahead of the prior corresponding period. Whilst demand is softening from elevated levels in calendar year 2022, it is likely to still be running at (or above) deliveries. This should have led to either growth or limited run-off of dealer order books through 1Q23.
Balance Sheet & Strong Cashflow Support Further Acquisitions
SIQ has balance sheet capacity to fully debt-fund acquisitions, which could entail either a large acquisition or a series of smaller-sized acquisitions, which are likely to be well received by the market given the Company’s track record of completing EPS-accretive acquisitions at historically attractive acquisition multiples.
Should SIQ fully utilise its available banking facilities to undertaken an acquisition/s, the gearing level would increase from a small net debt position as at 31 December 2022 to ~1.0x, which is still considered a comfortable gearing level given the Company’s typically strong cash generation. Cash flow conversion (117% in FY22) remains strong and consistent (i.e. >100% over the last five years).
Fundamental View
SIQ shares are trading on a 1-year forward P/E multiple of ~15x, which is at the top end of the range over the last five years (11-16x). Accordingly, we take a cautious view on the shares, given that improved vehicle supply is the biggest swing factor to the forecast earnings base for FY23.
Further, while the introduction of the Electric Car Discount bill has the potential to boost earnings from FY24, the flat EPS growth profile (0.1% EPS growth over FY22-25 on a CAGR basis) is: i) Unappealing in the context of the current 1-year forward P/E multiple and ii) Contingent on a strong recovery in earnings from FY24.
Charting View
Having trended higher since the start of the year, SIQ is now hitting resistance near the August high. Bearish divergence on the RSI is also suggesting that the share price could cool off from here. The next major support level down is $6.60 and then after that we are looking at $6.
Michael Gable is managing director of Fairmont Equities.
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