Given the substantial fall in private vehicle sales seen throughout 2018, in our view, the risk of owning Smartgroup (SIQ.ASX) into the result was greater than it has been for past periods given they are a provider of salary packaging and novated car leases. However, the performance of a business that is operating in tough industry conditions gives a much better view of just how strong its business model is.

The 2018 result

Starting with the headline numbers, SIQ posted revenue of $241.8m and EBITDA of $111.8 which on face value is slightly lower than the $250m of revenue and the $114m of EBITDA that the market was expecting. Despite being a little lower than expected, if we put that into context it equates to revenue growth of 18% and EBITDA growth of 19%. In our view, this highlights not only the resilient earnings base but also their ability to flex the cost base depending on market conditions.

Turning to the organic growth, SIQ have been a serial acquirer of other salary packing businesses in the past. Like any business that has acquired earnings, extra focus needs to be placed on the organic growth of the core business. In salary packaging, SIQ added 18,000 new packages organically during the year versus 24,500 in 2017 which translates to 5.5% growth versus the 11% growth seen last year. Similarly, in novated leasing, organic growth was 4.4% vs 5.4% from last year. So, we are looking at lower organic growth, but still in positive territory and still a number that many listed businesses would be very happy to achieve.

True to form, operating cashflow was strong and equated to 100% of net profit after tax adding back the amortisation. One of the key attributes of Smartgroup is not only the consistently strong level of cashflow, but also the fact that the business requires very little reinvestment of that cash to continue its growth.

The outlook

Overall, the result from 2018 wasn’t their best but can still probably be considered ok given the difficulties seen during the year. It is the outlook however that will depend on where the stock trades going forward and this is more of a mixed picture. On the positive side, SIQ is winning new clients and gaining share with existing clients. They also continue to outpace the fall in private car sales. On the negative side however, the major vehicle manufacturers have introduced 5 year extended warranties which will impact the warranties that SIQ can sell to customers. SIQ expect a $2m impact to NPATA which the market won’t like.

Investment view

SIQ is clearly operating in a difficult environment, however it is during these periods we can truly examine the underlying strength of the business. SIQ is a highly profitable business with an excellent management team and they appear to be taking market share whilst the trading environment is difficult and still generating organic growth. One of the key bear arguments for SIQ is that if we see a Labor Government come into power they may try and make changes to the sector as they did in 2016. Many see this as a failed policy by the Labor Government and is evidenced in a letter that Bill Shorten wrote to the sector dated 4 May 2016 that they will retain the current arrangement to all measures regarding salary packaging and related fringe benefit tax measures. While we acknowledge the party has backflipped on many policies in the past it would surprise us if they did so here given it didn’t work for them previously . In our view, SIQ could trade lower post this result and fall out of favour with some investors. The consensus earnings estimate could likely be revised lower due to softer organic growth trends and the issue around warranties. SIQ will be one to watch closely for now as once the sellers have been shaken out we could see a meaningful buying opportunity.

Important Information: This material has been prepared by NAOS Asset Management Limited (ABN 23 107 624 126, AFSL 273529 and is provided for general information purposes only and must not be construed as investment advice. It does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision, investors should consider obtaining professional investment advice that is tailored to their specific circumstances.