I tend to avoid shares in companies that exhibit the following traits:
- Weak cash flows
- Roll-up business models
Slater & Gordon Limited (ASX: SGH) satisfies both of these criteria and so I initially dismissed it as an investment. On closer inspection, it has more qualities than I gave it credit for.
The reason for its lagging cash flows is due to consistent growth in its work in progress (WIP) asset. Measuring WIP is subjective because it represents the total work done on cases that are not yet billable. It is quite possible for WIP to be inaccurate and this could lead to large profit write downs in future periods. In particular, a growing WIP account could mean that some work is never getting to the stage where it is billed.
I don't believe this is the case with Slater and Gordon because over the last five years, WIP has grown in line with revenues. This suggests that the lagging cash flows are a consequence of business growth, and will improve in future periods. It also makes sense that the company would have high WIP levels given cases can take up to three years to complete.
Slater and Gordon has made a number of sizeable acquisitions over the past few years and this can be risky. The main problem is that sellers have more information than buyers, which puts them at an advantage when negotiating price.
Legal services is a segmented industry making growth by acquisition an attractive strategy. Management has been disciplined in its approach and maintained a respectable return on equity of around 15% between 2010 and 2014.
Historically the picture looks good, but there are a couple of major risks on the horizon.
Regulatory risk
Slater and Gordon will become the market leader in UK personal injury law following the acquisition of Quindell PLC's Professional Services Division (PSD). The industry is highly profitable both in the UK and Australia, and this explains why Slater and Gordon have been able to consistently record high earnings before interest tax depreciation and amortisation (EBITDA) margins of around 25% over the last six years.
In April 2013, the British government adopted civil litigation funding reforms due to concerns with the way cases are funded. Changes included the capping of success fees in no win no fee cases to 25% of damages recovered. To date, neither Slater and Gordon nor PSD seem to have been affected, but there is a risk that the rules could be tightened further in the future.
Acquisition of PSD
Slater and Gordon recently announced its intention to acquire PSD for $1.2 billion which has an unusual financial history.
For example, PSD's revenues went from GBP 300 million in 2013, to GBP 293 million for just the first half of 2014. Profits were even more striking, growing from GBP 64 million for the whole of 2013, to GBP 92 million in the first half of 2014.
Despite this, the whole of Quindell generated negative cash flows of GBP 43 million in the first half of 2014, even though its other divisions were also highly profitable.
It seems the market stopped believing the Quindell story in 2014 and the share price fell from 627 pence on 11 April 2014, to 38 pence on 19 December 2014. It has since recovered to 126 pence on the back of the PSD divestment.
Slater and Gordon's CEO, Andrew Grech, is a brave man for going after such a controversial target, and it may be that he has seized a good opportunity. Slater and Gordon are only paying for GBP 70 million of annualised EBITDA, compared to GBP 289 million stated in Quindell's 2014 result.
Grech has lots of experience doing acquisitions and had 8,000 of PSD's cases reviewed during the due diligence process. Given Slater and Gordon shareholders have limited visibility of the true economic value of PSD, they must trust that Grech has got this one right.
