“We trim our fair value estimate for no-moat Smartgroup to AUD...

“We trim our fair value estimate for no-moat Smartgroup to AUD 7.80 per share, from AUD 8.10, after increasing our expense forecasts. Net profit after tax for first-half 2022 was up 16% from a year ago, though EBITDA was flat. Multiple earnings pressure points are expected to persist over the medium term. Notably, vehicle supply disruptions, alongside rising rates and inflationary pressures, are dampening orders for motor vehicles. Cost inflation—especially wages—was also higher than expected.

Smartgroup can pull some earnings levers, but their benefits won't manifest immediately, nor will they improve its competitive position. The firm will onboard more internal staff, rather than hire costlier contractors. It is also improving customer engagement, notably by revamping its website—commendable, but it will take time to alleviate customer friction. While new leads to its website were strong, conversion (customers proceeding to order) was not, due to customers' uncertainty on their budgets. The labour market is tight, so we don't anticipate much cost savings from new full-time hires. We expected faster improvements in operating leverage from the firm's digitisation initiatives, but it appears we underestimated its labour intensity and the time required to build a scalable platform.

Shares still screen as undervalued. The vehicle supply shortage—and the delay in settlement revenue—is cyclical and we expect this to normalise sometime in 2024.

The rise in website leads from both halves in 2021 illustrates Smartgroup's new digital assets are successfully attracting traffic. They also indicate growing interest in novated leases, rather than buying a car outright due to elevated vehicle prices. This is supportive of future volumes. Product uptake among existing customers improved too. If this trends persists while Smartgroup minimises cost growth, operating margins should expand. We forecast operating margins averaging 42% from 2022-26, above the five-year average of 38%.”

An excerpt from the latest Morningstar analysis

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