McMillan Shakespeare in trading halt due to proposed changes to salary packaging

Salary packaging services company McMillan Shakespeare (ASX: MMS) is in trading halt due to proposed changes to salary packaging announced earlier this week that would limit people from claiming a tax deduction for the private use of business cars.

Changes on the federal level have always been a risk to the company, and investors were aware of it — proposed changes have caused jitters in the past. The company has asked for the trading halt until it can examine the impact the proposed changes and make an announcement regarding the impact.

The real story here is that McMillan Shakespeare was an overvalued stock, and management has done a good job emphasizing growth. For example, when interest rates are falling, management presentations emphasize growth rates if you adjust for the lower interest earned from the float (the implied growth rate being higher). On the flipside, when interest rates were on the way up, the company did not draw attention to how this boosts growth.

The board and management have managed to sell over $120 million worth of shares and options since September 2010. The company has disclosed that directors were disposing of shares or options on 14 separate occasions since that time. There were no on-market purchases by insiders. Interestingly, the company never bothered to correct the typo on this Change of Director’s Interest Notice that implies John Bennetts sold $1,394.80 worth of shares rather than $1.39 million.

If the proposed changes are implemented, the salary packaging services industry is no doubt in for a shock. Typically, industry-wide challenges provide opportunities for stronger companies to acquire the weaker ones. However, since McMillan Shakespeare expanded into “Asset Management” it is straddled with debt. It has about $189 million of debt on the books and only $55 million in cash. I don’t think it is in a strong position to acquire its competitors.

The “Asset Management” part of the business finances the cars that are leased as part of a salary package. The company now has $282 million of assets under management on the balance sheet. It will be interesting to see if it can resell the cars for that amount. If so, the balance sheet might be OK.

Either way, I think the company is overvalued. It earned about 75 cents per share in 2012 and last traded at $15.36. It is important to look at per share statistics due to the dilution caused by the exercise of options. Between 2010 and 2012, shares on issue increased from 67.7 million to 74.5 million.

Even if the changes to salary packaging do not go through, the risk that the rules will change will not go away. That’s because under the current system people are (in effect) allowed to claim tax deductions for cars that are used mostly for personal tasks. If you forecast earnings to be 90 cents per share this year and were happy to pay a P/E of 14, then you would still only pay $12.60 for each share in this company. Personally, I wouldn’t even buy at that price.

Foolish takeaway

Long-term investors should consider whether management share the same faith in the business that they do. Watch out for consistent insider selling and be aware of the fact that directors probably understand the business better than you do. Look for companies that have cash ready when opportunities arise and don’t buy simply because the share price is going up.

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 Motley Fool contributor Claude Walker has an indirect interest in McMillan Shakespeare through a managed fund. Find him on Twitter @claudedwalker

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