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It is easy to underestimate industry risk for small-cap stocks when markets are rising. High exposure to a growth sector puts a rocket under a small-cap share’s price, until an industry slowdown or unexpected regulatory change exposes its vulnerabilities.

McMillan Shakespeare is an example. The salary packager more than quadrupled to $16 over 2010-13 as the industry grew rapidly. But when the former Labor Federal government announced changes to fringe-benefits tax (FBT) in mid-2013, McMillan more than halved.

The news surprised the market, even though there had been a longstanding threat that the Government would change the taxation regime for FBT exemptions for employees for not-for-profit enterprises, and for employees who take out novated leases on cars.  

The Coalition government dropped the change and McMillan rallied from an $8 low in 2013 to $12. Although the FBT threat remains, McMillan is doing a good job of diversifying its operation to rely less on tax exemptions, and is well placed to recover to its previous high in the next few years.

This column covered McMillan for The Bull in early April 2014, at $9.62. It is now $11.92. I wrote: “McMillan deserves a prime spot on portfolio watch lists. This is a high-quality, well-run company trading at half its peak valuation, largely over speculation of  FBT changes that are still far from certain, and most likely years away from full implementation should they proceed.”

Chart 1: McMillan Shakespeare

Source: ASX

I also nominated McMillan’s closest listed peer, SG Fleet Group, as one of six Initial Public Offerings from 2013 to watch in this column for The Bull. SG Fleet has rallied from $1.72 in early March to $2.26 and, like McMillan, looks poised for further medium-term gains.

This column covered a smaller salary-packaging provider, SmartGroup Corporation, for The Bull in September 2014, at $1.59. After sinking to $1.22 in December, SmartGroup has rallied to $1.54, just below the $1.60 issue price for its 2014 IPO.

McMillan is easily the pick of the salary packagers. It has the best-quality business, is diversifying through astute acquisitions, has excellent long-term growth prospects in the United Kingdom and a valuation that is not demanding, despite recent share-price gains.

However, no discussion about McMillan can avoid the FBT threat. It remains a major market concern and the company will not recover its premium valuation rating until it demonstrates it can weather any changes to FBT legislation, if or when they finally arrive.

As 2014 ended, the Federal Government foreshadowed the twin White Paper processes for Tax Reform and the Reform of the Federation. The Federation paper has been deferred and it is not clear when the formal Tax Reform process will start. Funny how crucial reforms get delayed or deferred when a Government is in crisis, as was the case in early 2015.

Tax observers are starting to question whether there is time for meaningful tax debate, let alone for the Government to review the proposals and make its public case for overhauling the tax system, given the next Federal election is expected between August 2016 and January 2017.

The Henry Taxation Review took 18 months and the Howard/Costello tax changes took two years. With the Coalition likely to tread warily with any tax changes, particularly after its Budget fiasco, the odds of significant tax reform being taken to the next election are lengthening.

For McMillan, that means at least another 18 months of the status quo, possibly longer if the tax-reform process is delayed.

This column said in April for The Bull: “I’m plumping for the medium-case scenario – proposed taxation changes taken to the 2016 election, implemented the following year, and some FBT exemptions phased out or wound back over a few years after that. Potentially, any significant changes to McMillan’s earnings could be years away. And there is still a fair chance that the status quo will continue, meaning the market is too pessimistic on McMillan.”

Even that view could be too pessimistic if tax reform is pushed back further in the Government’s second term, assuming it has one. Although regulatory risk remains, it might not be as big a problem for McMillan as the market feared – reflected in a rising share price this year.

Clearly, the company is not waiting for any change. Its $115 million acquisition in February of Presidian is a smart move. Presidian is an independent provider of finance, warranty and insurance products and a specialist in used cars. The acquisition bolsters McMillan’s presence in consumer finance in new and used cars and makes it less reliant on FBT exemptions.

McMillan’s United Kingdom operations, expected to turn profitable in 2014-15, are another long-term growth engine. A bigger offshore presence reduces the company’s exposure to Australian regulatory risk and the UK market in new-car salary sacrificing has excellent prospects.

McMillan reported first-half net profit of $31.1 million for 2014-15, slightly below consensus estimates. The company said “it is entering a new stage of stgelopment, profitability and growth… and using (its) financial strength and strong cash generation to build a stronger and diversified business.”

It’s hard to disagree. As the market focuses on FBT risks for McMillan, it might be underestimating its growth profile in new markets, here and overseas. It is a stronger business than it was in 2013, but has a share price still well below its previous high.

Credit Suisse has a $13.15 price target in 12 months and outperform recommendation. It says McMillan is trading at a 20 per cent to the average Price Earnings (PE) multiple in the Small Industries index, compared to a valuation premium or more than 40 per cent at its peak. It does not expect McMillan to re-rating to its former premium, but sees potential for solid gains.

As a mid-cap stock, McMillan suits long-term investors comfortable with higher risk.

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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 March 20, 2015.