Law firm Slater & Gordon Limited (ASX: SGH) has been in the news for all the wrong reasons lately. Here are four reasons why the current share price is no bargain.
Regulatory issues and aggressive accounting
Accounting errors, reports of share price manipulation by hedge funds, an investigation by the Australian Securities and Investments Commission (ASIC) and issues with its most recent acquisition, UK firm Quindell.
British regulators are reportedly investigating Quindell too, which sold its professional services division to Slater & Gordon for $1.3 billion. Both Quindell and Slater & Gordon have been criticised for 'overly-aggressive' accounting practices. That's not illegal, but it does mean that the company could be overstating its profit. The additional problem is that investigations could reveal further issues.
One area to watch with companies with future earnings such as Slater & Gordon is their conversion of Work in Progress (WIP) into revenue. For many companies, including contractors with multi-year contracts, revenues might be accounted for as they arrive, or they could be split into a number of periods and accounted for on the basis of what is 'expected'. Slater & Gordon might not get paid for some of their fees until some years down the track, while at the same time they are forced to account for their expenses incurred. Taking a conservative approach is a much 'safer' option.
Unsustainable growth
Looking at the company's financials clearly shows the problem with Slater & Gordon. As Tony Hansen from Eternal Growth Partners has pointed out, "A business that is trying to build scale should show characteristics of operating leverage, or in simple terms, a 10% increase in revenue should lead to a more than 10% increase in profits".
Since 2009, Slater & Gordon have grown revenues at a compound annual rate (CAGR) of 32%. Unfortunately, over the same period, net profit after tax has grown at a lower rate of 29%. That is mainly because the company's expenses have increased at a faster rate. As an example, advertising and marketing fees have grown at a compound rate of 54%, and administration fees have soared from $8.7 million in 2009 to $36.4 million in 2014. That's a compound annual rate of 33%.
You would think that a company such as Slater & Gordon would be able to achieve some synergies through its acquisitions particularly in admin costs, even if it was minimal. Clearly, it has not and profit margins have suffered as a result too.
| CAGR | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 | |
| Fee Revenue | 32% | 101.0 | 122.2 | 178.0 | 213.8 | 294.2 | 411.8 |
| Net profit after tax (reported) | 29% | 17.0 | 19.8 | 27.9 | 25.0 | 41.5 | 61.1 |
| Earnings per share (reported) | 14% | 15.8 | 17.9 | 19.1 | 16.2 | 24.0 | 30.4 |
Source: Company reports
Negative free cash flows
Taking operating cash flow and subtracting capital expenses such as acquisitions leaves Slater & Gordon with a free cash flow figure of minus $161 million in the past 6 years. In other words, the company has generated zero value for shareholders and has actually gone backwards. To fund the shortfall, Slater & Gordon has also raised an additional $180 million from shareholders.
That is shown in the lower growth in earnings per share (EPS), which has grown at a compound rate of 14% as shares have virtually doubled from 108 million in 2009 to 201 million currently.
| Total | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 | |
| Operating cash flow | 147.2 | -0.8 | 24.7 | 20.0 | 16.0 | 32.7 | 54.5 |
| Free cash flow | -160.9 | -11.6 | 9.2 | -47.0 | -54.4 | 13.9 | -71.1 |
Source: Company reports
Either those acquisitions will need to start producing whopping cash flows in the next few years, or shareholders can expect to cough up more funds in the near future and the debt balance to increase.
Are management doing their job?
A host of accounting issues, questions over aggressive accounting, concerns over its latest and biggest acquisition Quindell and evidence that management have so far achieved very little through ongoing acquisitions raises a number of red flags. Virtually no focus on cutting costs or driving synergies adds another element of concern, and one wonders whether investors can trust management.
Foolish takeaway
Here's what I'd need before I considered an investment in Slater & Gordon:
- Management adopting very conservative accounting practices, no matter if that means a hit to earnings in the short term.
- Ceasing acquisitions and focusing on generating organic growth and cutting costs, particularly administration expenses and then growing profit margins and free cash flow.
- Management acknowledging the issues mentioned above and refocusing their pay packages on meaningful measurements like earnings per share growth higher than revenue growth and returns on capital and equity.
