10/01/2023

My previous valuation of $8 per share from six months ago needs revising.

Over the past six months the outlook for Smart Group (SIQ) has vastly improved.

Contract Win

On the 11 December 2023 SIQ announced that the South Australian Government appointed the SIQ subsidiary, Smartsalary, as its exclusive administrator of salary packaging services and novated leasing services under an initial 5-year agreement (10 years including extensions). The contract was previously held by McMillan Shakespeare (MMS). Given the mid-2024 contract start date and typical novated leasing sales cycles, SIQ does not expect a meaningful earnings uplift from this contract in 2024. However this will boost SIQs earnings from 2025 to 2030, and possibly to 2035 if the contract is extended.

EV Tailwinds

For the 5 years prior to FY2023, earnings growth was relatively flat. The novated leasing businesses struggled during COVID due to the delayed delivery of new vehicles. This is turning around as new vehicle deliveries normalise. In addition, EV novated leases have escalated due to the Government’s carbon emission targets, EV rebates, fuel prices and a pent up demand for vehicles. During 1H23 EVs made up 30% of all new novated leases and this trend is likely to continue boosting SIQ’s earnings for some time to come.

Source: SIQ 1H23 Results Presentation

Analysts (a consensus of 7 analysts, Simply Wall Street data) are forecasting over 10% earnings growth over the next 3 years, and I think this is feasible.

Share Buy Back

SIQ has continued buying back shares since 6th March 2023. The number of shares to be bought back represents only 1.3% of the total outstanding shares. Share buybacks are not always a good use of capital, however SIQ was well undervalued at the start of the buy back (c. $6 per share) and the business ROE was high and is improving. Based on analyst forecasts the current ROE of 24% should lift to more than 30% over the next 3 years.

Source: Commsec

ASX 200 inclusion

On the 1st December SIQ was added to the ASX 200 list. This doesn’t change the fundamentals or valuation of the business, however, it can give a boost to the share price as more institutions include SIQ in their portfolios.

Valuation

Analysts are forecasting FY23 earnings of 48cps up from 45cps in FY22 (consensus of 3 analysts on Simply Wall Street).

If SIQ continues to grow earning at 10% per year over the next 3 years earnings could be over 60cps in 2026 (Forward PE of 15).

SIQs average PE ratio over the last 5 years has been approx 18x. At the current share price of $9, that puts the SIQ on a forecast FY23 PE of close to 19x. I think this is reasonable given the forecast 10% earnings growth.

Using McNiven’s formula which estimates future owners annual return by considering forecast normalised ROE as the internal rate of return (IRR), the percentage of reinvested earnings, the current equity value, and dividends paid to shareholders (including franking credits), I get a forward annual return to shareholders of c. 11%. For businesses with variable earnings I would prefer a higher required return (closer to 15%).

I think SIQ is fairly valued at $9 per share, and given SIQs business model relies heavily on favourable government salary sacrificing policies, I would be reluctant to pay a high premium for the business.

Unlike McMillan Shakespeare, SIQs balance sheet looks good with a net debt to equity of c. 17%.

I think SIQ is a great business with high ROE and yields a 4% fully franked dividend (at a 70% payout ratio). However, given its vulnerability to government salary sacrificing taxation policies I would be reluctant to add more SIQ at the current share price. I am a happy holder at the current share price.

Held IRL (4%)

July 2023

See my Straw “Back to growth” for justification. At $8 Smart Group should return investors c. 10% per year including franking credits.