We initiate coverage on McMillan Shakespeare (ASX: MMS) with a fair value estimate of $19 per share and assign the group no-moat, High Uncertainty, and Standard Capital Allocation ratings. McMillan is a business services provider with salary packaging, novated leasing, fleet management, and disability plan management as its key offerings. The shares are currently fairly valued. 

McMillan dominates Australia’s salary packaging market with no-moat-rated Smartgroup, and is Australia’s largest provider of novated leasing services by volumes, marginally ahead of Smartgroup and SG Fleet.

Shares in McMillan are currently trading broadly in line with our fair value estimate. The firm has some economies of scale, and its integrated business model provides cross-selling opportunities. However, it acts mainly as a facilitation medium for firm employees, limiting its ability to charge higher fees to its employer-clients.

We believe McMillan can continue dominating its core markets, which comprise customers in relatively defensive sectors, helping to deliver relatively stable revenue during market downturns. On the flip side, McMillan’s relatively higher cost base and inability to charge a premium will likely constrain its ability to expand margins. Its fortunes are tied to government regulations, which, if materially changed, can significantly affect its revenue.

We see McMillan as being a no-moat business. Relatively high returns on invested capital (including goodwill) of around 22% per year in the last three years—above its 8% cost of capital—reflect the group’s greater reliance on labor than fixed assets. The high returns are not due to high entry barriers or durable competitive advantages. The core salary packaging and novated leasing business is commodity-like, functioning as a facilitation medium for employers and employees. Fee pressure is persistent, given the risk of client defections.

Business strategy and outlook

McMillan Shakespeare is a business services provider, with salary packaging, novated leasing, fleet management, and disability plan management its key offerings. Together with Smartgroup, it dominates Australia’s salary packaging market, and has a sizable presence in the novated leasing market. Entities in the government, healthcare, and not-for-profit industries make up 97% of McMillan’s salary packaging client base. These industries are defensive and have favorable fringe benefits tax exemptions. They are regular users of McMillan’s services, and underpin the firm's steady revenue.

McMillan has a more capital-intensive business model than its peer Smartgroup. In our view, that greater capital intensity doesn't confer the group any competitive edge. McMillan procures fleet vehicles through a mixture of debt financing and free cash flow, and has set up a securitization program to help fund the growth in its novated leasing business. These are aimed to facilitate better customize its services, exercise more control over volume growth and lending practices, and profit from used vehicle sales. However, this entails substantial capital investments, ongoing maintenance expenses, customer-specific credit risks, and the risk of selling vehicles at a loss.

McMillan earns both recurring fees and commissions and rebate income. Its growth strategy encompasses various initiatives. These include cross-selling its services, improving staff productivity and minimizing customer service costs via technological investments, and providing greater choice of vehicles via relationships with more dealers.

We expect McMillan to continue dominating its core markets, which consist of smaller providers focusing on niche sectors. The current application of the Fringe Benefits Tax Act to novated leases provides McMillan with its largest addressable market. However, McMillan will likely face fee pressure as it’s largely a facilitation medium for firm employees and client-employers. Potential regulatory changes may disrupt McMillan’s revenue stream. We expect defensive maneuvers like cost rationalizations and/or extensions of its administration capabilities to cover more benefits.

Economic moat

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We do not believe McMillan Shakespeare has maintainable competitive advantages to warrant an economic moat. McMillan possesses limited pricing power despite the oligopoly structure of Australia’s salary packaging market (McMillan Shakespeare and Smartgroup) and McMillan’s sizable presence in the novated leasing market. The firm is largely a facilitation medium for employees, so being frictionless and cheap is crucial to customer wins and retention. Its fleet management business has multiple larger/similar-size competitors, while its plan and support services business operates in a small niche and is less material to group earnings. McMillan’s prospects also hinge on legislation being favorable to its business. This is something beyond the group's control and can change abruptly.

McMillan’s returns on invested capital, including goodwill, averaged 20% per year over the last four years. While above its weighted average cost of capital of 8.3%, this is largely due to salary packaging and novated leasing’s low capital intensity. Staff costs comprise most of McMillan’s operating expenses (around 43%), followed by vehicle management (around 23%). This suggests barriers to entry are not high, and businesses that focus on specific niche sectors such as healthcare, government, or charities can compete effectively against McMillan.

More capital investments do not always translate into higher returns. McMillan operates a more capital-intensive model compared with its peer no-moat Smartgroup because it (1) purchases vehicles for its fleet management business via a mixture of debt and cash and (2) has set up a securitization program to help fund the growth in its novated leasing business.

These measures help better customize McMillan's services, exercise more control over volume growth and lending practices, and profit from used vehicle sales. In contrast, most of Smartgroup's novated leasing and fleet management programs operate capital-light principal and agent agreements. Notwithstanding this, Smartgroup has frequently narrowed the gap to (and occasionally overtook) McMillan on salary packaging and novated leasing volumes while also achieving similar returns on capital than McMillan over the last four years—averaging 21% per year.

McMillan and Smartgroup command roughly 80% of Australia’s outsourced salary packaging market (by volumes), with McMillan having slightly more than half in share (404,810 volumes). McMillan’s novated lease fleet (76,770 carparks) is roughly 38% of itself, Smartgroup, SG Fleet, and FleetPartners (all ASX-listed) novated fleets combined.

Overall, McMillan’s business scale provides bargaining power against car dealers when originating motor vehicle deals and prices for customers. McMillan is also a vertically integrated business that commonly cross-sells services, like selling its novated leasing services to customers who salary package or selling its salary package offerings to fleet management customers.

However, McMillan faces fee pressure despite having a sizable share of Australia’s salary packaging and novated leasing market. Notwithstanding long-term client relationships, these clients tend to put projects to tender after a contract with a provider (like McMillan) ends. McMillan has often had to reduce its fees to retain its customers for another contract cycle. Specifically, management fees per unit of salary packaging volume for fiscal 2023 ($169) is below fiscal 2018 ($186), despite salary packaging volumes increasing to 394,200 from 334,850 over this period. Growing customer concentration—with the largest contract making up 15% of group revenue in fiscal 2023, from 10% in fiscal 2018—amplifies the risk of fee compression.

Importantly, the fact that McMillan has to lower fees to retain clients—despite having more client support staff and greater product uptake rates than Smartgroup—suggests clients see it as more of a medium to facilitate financial transactions for employees rather than delivering tangible monetary benefits to an employer client. Employer clients are often expected to offer salary packaging to their employees, but the financial benefits to the employer from this arrangement remain unclear to us.

Cost cuts and digital investments have helped McMillan to be competitive on fees to win and retain clients, as well as improve lead generation and conversion (for novated leases). But they are insufficient to establish an economic moat. Cost cuts and digital investments are likely defensive measures in response to competitive pressures and have similarly been executed by its rivals like Smartgroup and FleetPartners. If a price war were to eventuate, we think Smartgroup, with its relatively leaner operations and higher operating margins, would be better-positioned than McMillan to compete. At present, McMillan’s revenue per unit of salary package and novated lease (around $550) is higher than Smartgroup's ($508). Still, its earnings before interest, taxes, depreciation and amortisation ("EBITDA") margin for these business lines (43% for the year to December 2023) is lower than Smartgroup’s (50%).

We also don’t think McMillan has maintainable competitive advantages in fleet management. Its fleet management business competes with various similar and larger-size firms, including SG Fleet, FleetPartners, and Japanese-owned Orix Australia. McMillan’s larger competitors likely have a bigger scale that allows them to source vehicles at lower costs and offer more competitive rates to clients. These rivals also typically specialize in fleet management and are potentially better equipped to service more complex fleet requirements. Moreover, clients have been known to buy and managed their own fleet in-house (rather than lease a fleet externally), particularly when interest rates are low, or pare back their investment in fleet vehicles when economic conditions are uncertain.

McMillan’s plan and support services business, which manages individual plans for participants under the National Disability Insurance Scheme, also lacks a moat. McMillan is largely a supplemental service provider lacking pricing power or cost advantage. We note there are multiple ways for NDIS participants to manage their funding—by themselves, through the National Disability Insurance Agency, or a variety of plan managers like McMillan. The availability of multiple alternatives points to McMillan’s offering being a commodity.

McMillan’s fortunes are tied to federal government legislation, which can change. The most important are the key aspects of the fringe benefits tax concessions. If materially changed, it may negatively affect McMillan’s business, notably the demand for novated leases. The then Rudd Labor government promised in July 2013 to change how FBT was calculated on novated leases to only allow the operating cost method, which would be unfavorable to the vast majority of employees purchasing a car via a novated lease. This proposal was ultimately not enacted, but a future government could revisit the FBT regime in the face of federal budget deficits. This probability is presently low as such legislation would be politically unpopular with the employed masses, including the healthcare, charity, or education staff McMillan services.

Other regulations include the deferred sales model for add-on insurance, which may lead to some loss of commissions and rebate income. Meanwhile, prospective changes to the NDIS, which will be implemented within the decade starting in 2024, could bring downside risks to McMillan’s plan and support services business that are presently hard to quantify. There could be increased competition, the need to incur additional maintenance expenditure, more regulatory scrutiny, or even reduced attractiveness of outsourced plan management. In the meantime, McMillan could look to originate more electric vehicle deals (which may be FBT-exempt) or extend salary packaging to cover other forms of benefit. However, these actions are unlikely to be sufficient to offset regulation-induced downside risks.