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Morningstar | Synergy Benefits From the Potential Eclipx Acquisition Drive an Increase in McMillan’s FVE

The proposed takeover of Eclipx Group lifts no-moat McMillan Shakespeare’s fair value estimate to AUD 16.60 per share from AUD 14.60 as a stand-alone company. Material potential synergy benefits makes the proposed takeover compelling. We also agree with the predominantly scrip structuring of the deal. McMillan shares are being issued at a significant premium to what we believe is McMillan’s stand-alone fair value estimate, with 83% of the consideration being in the form of McMillan scrip. The price McMillan is paying for Eclipx, at a fiscal 2018 acquisition P/E multiple of 11.9 times, also appears reasonable given Eclipx’s growth prospects and potential synergy benefits. Eclipx’s shareholders also stand to benefit from scrip structuring as they too will benefit from the synergies. However, at this early stage there is some uncertainty whether the takeover will proceed in its current form.

The transaction makes the combined group the leader in Australia and New Zealand in both novated leasing and fleet management. Notwithstanding, given the fragmented nature of both markets, we do not believe competition regulators will be an obstacle to the proposed transaction. Nonetheless, we think an extended fall in McMillan’s share price may place the transaction at some risk. Eclipx’s board has already rejected a takeover offer from SG Fleet valuing Eclipx at circa AUD 2.52 per share in August 2018, primarily due to an inadequate price. Notably, McMillan’s share price has fallen to about AUD 14.75 from the original price at offer of AUD 16.90, and a further fall to AUD 14.50 per share would value the consideration at about AUD 2.51 per Eclipx’s share. Therefore, we do not believe this transaction in its current form is a forgone conclusion.

Nevertheless, we believe the combination of the two business makes sense given the potential for significant synergy benefits from both economies of scale and revenue generating cross-selling opportunities.

Bringing together McMillan’s core novated lease and salary packaging business and its growing fleet management business with Eclipx’s core operating leasing and fleet management services and smaller novated leasing business means the combined group will be the market leader in both industries in Australia and New Zealand. According to the company, the combined group is expected to service 76,359 novated leases, compared with the next largest competitor SmartGroup’s 64,000, SG Fleet’s 47,265, and LeasePlan’s 16,000. It is also expected to service 125,751 fleet management vehicles in Australia and New Zealand, compared with Toyota Fleet Management’s 101,000, Custom Fleet’s and LeasePlan’s circa 100,000, and SG Fleet’s 87,515.

Consequently, we believe McMillan’s guidance of AUD 50 million earnings before interest, tax, depreciation, and amortisation (or EBITDA) per year synergies seems reasonable. This EBITDA synergy represents about 35% of EBITDA generated by McMillan as a stand-alone business in fiscal 2018. We believe the combined group’s increased size will provide procurement advantages such as higher fleet discounts, cheaper repairs and maintenance costs, and end of lease disposal savings as well as potential financing costs savings and revenue cross-selling advantages from a larger customer base. We expect other cost savings from rationalisation of the combined group’s property footprint, amalgamation of the two boards as well saving on listing fees, consolidation of information technology platforms, and a reduction in the combined group’s workforce. We believe this should allow the combined group to compete more effectively in what we expect will continue to be competitive industries.

Although we have accepted McMillan’s guidance of AUD 50 million EBITDA synergies, we believe the integration risks are high. This is primarily due to the acquisitive history of each company and the size of the transaction relative to each’s market capitalisation. Like McMillan, a key part of Eclipx’s strategy is based on inorganic growth via acquisitions. Bringing together two acquisitive small- to mid-cap companies increases the integration risks that the business segments within each company do not fit culturally, risking the expected synergies. Notably, Eclipx’s precipitous share price fall in August 2018, which was the precursor to it becoming an acquisition target, was due to a profit downgrade that was in turn primarily driven by lower-than-expected growth in two of its recent acquisitions, GraysOnline and Right2Drive. In May 2016 Eclipx acquired Right2Drive (a vehicle rental business for not-at-fault drivers that have been in accidents and have need of a car) for consideration of AUD 67 million and in August 2017 it acquired Grays eCommerce Group (online auction platform covering primarily auto vehicles, and plant and equipment) for about AUD 179 million.

For McMillan shareholders we also expect the transaction will result increased operational risks. We have accounted for these risks by discounting the expected synergy benefits at a higher weighted average cost of capital or WACC of 11%, compared with McMillan’s stand-alone WACC of 9.6%. The combination of the two companies will result in McMillan becoming a more capital-intensive business with a lower proportionate exposure to its high margin, high cash flow generating salary packaging and novated leasing business. Upon completion, the more capital-intensive asset management leasing business is expected to account for about 42% of pro forma combined group’s underlying net profit after tax, or NPAT, whereas the previously dominant capital-light and high margin salary packaging and novated leasing business is expected to account for 37% of pro forma NPAT, with consumer finance about 21%. This compares with McMillan as a stand-alone business where salary packaging and novated leasing accounted for 68% of underlying NPAT in fiscal 2018, and retail financial service 9%, with asset management accounting for 23%.

The transaction will also increase McMillan’s exposure to the private sector, making it more sensitive to macroeconomic factors like GDP growth. This compares with its current client base that are predominantly within the more defensive government, health, and charity sectors. Its increased exposure to consumer finance also makes it more sensitive to macroeconomic changes as well as potential adverse regulatory changes. However, some of these negatives will be offset by the fact it will be less sensitive to the regulatory risk of an adverse change in fringe benefits tax.

At this early stage, we have valued the combined group on a sum-of-the-parts basis until we have full financial details as provided in the scheme documentation, expected in December 2019-January 2020.