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Morningstar | McMillan Shakespeare’s FVE Reduced on Lower Earnings Guidance. See Updated Analyst Note from 18 Jun 2019

We have cut no-moat McMillan Shakespeare’s fair value estimate, or FVE, by about 5% to AUD 13.50 per share from AUD 14.20 following management’s guidance to lower net profit after tax, or NPAT, than consensus estimates. Management forecasts fiscal 2019 underlying NPAT to range from AUD 87 million to AUD 89 million, below current broker consensus of AUD 92 million. We had expected the company to face difficult operating conditions in all three of its segments and previously forecast below consensus underlying NPAT. The update suggests operating conditions were tougher than we accounted for, prompting a reduction in our fiscal 2019 underlying NPAT forecast to AUD 87.1 million, from 90.6 million. The reduction is primarily because of lower-than-expected earnings from its core group remuneration services, or GRS, business. Management blames a challenging retail car market for lower volumes and revenue in its GRS business. The company also faces ongoing headwinds in its smaller Australian and United Kingdom asset management, or AM, and its retail financial services, or RFS, businesses. According to our FVE the company has a fiscal 2019 P/E of 12.9 times and fiscal 2020 P/E of 12.1 times and fully franked dividend yield of 5.4% in both years.

The ongoing deterioration in Australian new car sales drives our forecast reduction in GRS’ underlying NPAT to a CAGR of 5.3% over the next five years from fiscal 2018, from a previous CAGR of 7.2%. The company was able to increase novated leases by 7% in the first half of fiscal 2019, which was an impressive operating performance considering new car sales in Australia fell by 7.1% during the same period. However, according to the Federal Chamber of Automotive Industries, or FCAI, new car sales in Australia have continued to trend lower in the second half of fiscal 2019, falling by 8.1% in the first five months to the end of May 2019.

We expect disappointing new car sales in Australia is the result of a combination of lower economic growth, tighter lending standards by the major banks and a more cautious approach taken by businesses in the lead-up to the May 2019 federal election. While it's still early days, we think there is the potential for a decline in the rate of new car sales to slow in the near-term after the federal election and the recent 25 basis point reduction by the Reserve Bank of Australia, or RBA, and the prospect of future RBA rate cuts. This view is supported by the FCAI, which indicated a few weeks ago it is “optimistic that the market will improve over the next few months”. Despite this optimism, we expect continuing tighter lending standards and subdued economic growth will thwart a V-shaped recovery.

We also forecast McMillan to earn fiscal 2019 statutory NPAT of about AUD 59 million. Statutory NPAT is expected to be reduced primarily by a one-off goodwill non-cash writedown of AUD 18.3 million, representing all the goodwill in the warranty business purchased as part of the Presidian Holdings acquisition in February 2015. Recent heightened regulatory scrutiny over warranties has materially hit this business, but it is less than 1% of the group’s underlying NPAT. The company’s U.K. AM business will also incur a provision of AUD 3.7 million, but management is confident this is a one-off issue relating to a customer who has been placed into administration.

Despite the reduced underlying NPAT, we expect the company to maintain its fiscal 2019 dividend at a fully franked AUD 0.73 cents per share. Management said it successfully reduced the capital intensity of its AM business and this means it has surplus capital and also excess franking credits. Surplus capital stems from the implementation of principal and agency funding in its AM business, and its strong operating cash flows are primarily generated from its capital-light GRS business. Management is now looking at capital management initiatives. While no final decision has been made, initiatives such as acquisitions and off-market share buybacks of up to AUD 100 million during the second half of calendar 2019 are being considered.