This column favoured salary-packaging stocks, notably McMillan Shakespeare, this year. My logic: the market had overestimated the near-term threat of tax changes on novated car leases and on fringe-benefit exemptions in the not-for-profit sector.

I covered McMillan Shakespeare for The Bull on April 7, writing: “McMillan looks reasonable value for long-term investors who can tolerate higher risk, and keep a close watch on any talk about changes to FBT exemptions. They will need to move quickly if the market becomes spooked that FBT changes are back on the agenda.”

McMillan has rallied from $9.50 in April to $11.16 after a stronger-than-expected FY14 result. The pick-up in its second-half earnings signalled salary packaging was recovering from the industry disruption when the Federal Government proposed changes to FBT exemptions on company cars last year. The shock decision saw McMillan shares more than halve.  

Chart 1: McMillan Shakespeare

Source: ASX

The latest full-year result suggests McMillan’s growth trajectory is getting back on track, despite the risk of legislative changes to FBT laws. This threat has circulated for years and is something McMillan needs to address by relying less on tax concessions on cars. There will always be question marks over the stock until the company shows it is not hostage to tax reform.

Still, the salary-packaging industry has solid long-term prospects for two reasons. As outlined in April, I favour a medium-case scenario for changes to FBT exemptions: they are phased out a few years after the Federal government takes its tax proposal to the 2016 election.

The second is solid industry conditions. Growth in the education and health sectors, higher car sales, greater outsourcing of fleet management, and new salary-packaging and fleet-management services bode well for the industry’s growth. Moreover, McMillan has good potential to expand in the United Kingdom, although this will take time.

Macquarie Equities Research lifted its price target for McMillan from $12.31 to $13.10 after the result. I expect other brokers to lift their valuations for the company. At $11.16, McMillan could have potential for a 20 per cent total shareholder return (including dividends) over 12 months.

McMillan’s small rivals also look interesting at current prices. SG Fleet Group listed in March 2014 after raising $188 million at $1.85 a share. It trades at $1.80, after reporting a FY14 result that was slightly ahead of prospectus forecasts.

Chart 2: SG Fleet Group

Source: ASX

SG Fleet looks marginally undervalued. But the market was probably looking for a stronger maiden result as a listed company, especially with some other recent floats exceeding their prospectus forecasts by larger margins. SG Fleet looks a solid company.

Smartgroup Corp, another recent Initial Public Offering, appeals. It raised $112 million at a $1.60 issue price, quickly dropping on debut to $1.49. It has since recovered to $1.59.

Chart 3: Smartgroup Corp

Source: ASX

Smartgroup had a good win this month, adding St Vincent’s Hospital in Melbourne as a client, and tying up the St Vincent’s hospital network. The Melbourne operation has 5,800 employees and around 4,500 salary packages. Smartgroup looks well placed to beat prospectus forecast on salary-packaging numbers.

Like other salary packagers, it reported a recovery in novated leasing orders. Smartgroup’s daily orders for salary packaging are back to the 2012-13 levels before the sharp drop after the previous Federal government dropped its FBT bombshell on the industry.

Smartgroup is no McMillan Shakespeare. But its high win rate in tenders and high client retention suggest a strong product and healthy organisation culture. Smartgroup should continue to grow as more clients are added, other products are cross-sold to customers, and as greater scale improves efficiencies and lowers costs.

Like other salary packagers, Smartgroup would be crunched by any adverse change to FBT treatment of novated leases. As a $157 million newly listed micro-cap company, it suits experienced investors comfortable with higher risk.

Assuming the legislative setting for salary packagers remains stable, Smartgroup could head towards $2 within 12-18 months. An implied Price Earnings (PE) multiple of about 10 times looks a touch low for a growth company with a good foothold in an industry that produces high returns for established players.

Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at September 3, 2014. 

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