Should you buy, hold or sell shares in Smartgroup?

Smartgroup (ASX:SIQ) provides salary packaging services along with novated leases and fleet management services.

Salary packaging enables employers to help their employees to maximise their take-home pay and gain access to other benefits.

This helps them attract and retain talent. It is particularly relevant in the not-for-profit sector such as government, education, healthcare and charities where employees can have certain expenses paid out of their pre-tax salary.

The rise of novated leasing

The other big component of salary packaging is the inclusion of a vehicle. During 2023 the number of salary packages provided increased by 4%.

Which leads into the other major components of Smartgroup's business, novated leases and fleet management services.

Novated leases are an attractive benefit offered by employers to their staff. It enables employees to acquire the car of their choice, whilst accessing tax advantages and lowering the overall cost of car ownership. Should the employee leave, they are responsible for the lease, not the employer.

Over the past 12 months the leasing side of the business has experienced strong growth.

There was a 21% increase in new lease vehicle orders and a 20% increase in lease settlements. In addition lease yields increased by 9% due to supply chain renegotiations, increased volumes of electric vehicles (EV) and a higher proportion of leases being for new cars and therefore of higher value.

FBT exemptions

Changes to fringe benefits tax for electric and low emission vehicles have made it far more attractive to lease these types of cars. With the FBT exemption, a $66,000 Tesla effectively costs about the same to own and operate as a $40,000 Mazda. This has made EVs a far more competitive option.

In 2023 battery EVs made up 7.2% of total new car sales which was more than double the 3.1% in 2002. But with the tax benefits, the impact in the leasing industry was turbo charged (not a great metaphor as EVs don't have turbos).

For Smartgroup, EVs made up 36% of all new car novated lease orders in 2023. It was 41% in the second half, as the trend accelerated. The corporate sector led the way with over 50% of orders in the second half for EVs, with government clients close behind. Education, hospital and not for profit clients are also increasingly choosing EVs as more affordable options become available.

In addition to the growth in novated leases, they also saw strong growth in fleet management with the number of vehicles in their managed fleet increasing by 16%. This included the acquisition of one large client who accounted for 45% of the growth.

Average vehicle delivery times remain much higher than pre-pandemic levels however they have declined marginally from the peak levels in 2022. In 2019 it was about 17 days whereas now it is just under 80 days. This means that the pipeline of future revenue is about $18 million compared to $4 million.

The delays can result in credit approvals needing to be reworked.

Growth in revenue

Overall revenue growth for the year was 12%. However, overheads grew by 15% primarily driven by a 19% increase in staff costs due to wage inflation and increased headcount to meet novated leasing demand and expand in-house IT capability.

The net result of this was that earnings before interest, tax, depreciation and amortisation (EBITDA) only increased 7%. Earnings per share (EPS) was further reduced to an increase of 5%.

SIQ has a very solid Stockopedia Quality Score of 94 which rose following the full year results release. Strong margins are contributing to this with an operating margin of 36%. This is backed up by very high returns on equity and capital of 26% and 29% respectively.

The balance sheet is very solid with a net debt to equity ratio of 13% and a very low risk of bankruptcy. Cash flow is very strong with operating cash flow exceeding reported EPS on a consistent basis.

Outlook

There is an expectation that the momentum in revenue and earnings witnessed in the second half of 2023 will continue into 2024 with a forecast for EPS growth of 13%. Leasing orders and settlements were up on the prior period for January. They have also signed a contract with the South Australian government which commences in July.

Salary packaging and leasing business rely heavily on the regulatory environment, especially around taxation. As such they are subject to high levels of regulatory risk. Lately that risk has been a positive influence, with the FBT changes for EVs and low emissions vehicles.

However regulations can also change in a negative way depending on the political whims of the time.

18 months ago the shares were trading at a price around $4.50. The most recent close was $9.59. Whilst the profits have been improving, the rate of improvement in the share price has far outstripped profits.

This has meant that valuation metrics like the PE ratio have increased with the forecast PE ratio having reach 17.3. This is a bit on the high side, but not excessively so. It is supported by a fully franked dividend yield of 5.0%. With the government committed to making low emissions cars more attractive, EVs may continue to keep this car leasing business revved up for a while.

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