This morning personal injury and tort law specialist Slater & Gordon Limited (ASX: SGH) posted a net loss of more than $1 billion for its 2016 financial year after an annus horriblis featuring write downs, accounting blunders, ASIC investigations, and proposed new adverse regulatory changes.
Quindell
The majority of the headline loss is attributable to an $814 million write down the firm took on the value of its controversially acquired ex-AIM-listed insurance claims management business Quindell.
At the time of the $1.1 billion Quindell acquisition Slater & Gordon's CEO Andrew Grech assured investors the due diligence into the purchase could not have been better in what promised to be a "transformational" deal. As it turned out the only thing Grech got correct on the Quindell deal was the "transformational" description, with Slater & Gordon subsequently posting a cash outflow of $83.3 million in the first half of FY16 and today recording a cash outflow of $20.9 million for the second half of FY16.
The disastrous numbers due to the shocking overvaluation of the Quindell business and separately enforced revisions to its accounting treatment of work in progress (WIP) or accruals on its balance sheet across the entire Australian and UK operations.
Financials
For the whole group over the second half EBITDAW (earnings before interest, depreciation, amortisation and movement in work in progress) was presented as $9 million, compared to a $58.3 million loss in the first half.
The company's Australian operations delivered a "normalised" EBITDAW of $35.9 million for the full year, while the UK general legal services business's downturn has coincided with the fallout from the Quindell acquisition to add to the firm's problems.
The UK legal business (excluding Quindell) swung from EBITDAW of $33 million in FY15 to a $2.6 million loss over FY16 primarily due to falling fee income. Slater & Gordon Solutions (SGS the ex-Quindell business) delivered full year EBITDAW of $3.3 million on the back of a strong improvement in the second half.
Debt
As at June 30 2016 net debt stood at $682.3 million with gross debt of $764.8 million. Much of the downward revision to the debt is related to Brexit and the approximate 10% weakening of sterling versus the Australian dollar which effectively reduced the Australian dollar value of the debt, although not the nominal value.
The interest on this debt mountain alone is likely to be savaging the firm's post EBITDAW cash flows and means it remains in a rocky operating position. It remains that if the company cannot deliver significant free cash flow in FY17 to pay down its debt it faces serious problems as it could end up buried under its mountain of debt.
In order to escape the debt problem it could try to raise capital on an extremely dilutory basis, attempt a debt for equity swap, or go back to its bankers (including Westpac Banking Corp (AX: WBC)) cap in hand who are unlikely to extend it anymore credit.
Valuation
Being generous you could accept that the firm just posted a normalised (excluding one off costs, etc) FY16 EBITDAW of $36.6 million for the full year (notably this excludes interest), however, that would still place it on an Enterprise Value to EBITDAW ratio of 24x. Hardly cheap when you factor in that debt is around 4x the market value so it's hard to see much upside for the share price until the firm provides a further update on its operating position.
Outlook
The stock is down 11% to 49.5 cents this morning and the firm will be relying on its cost cutting, reorganisation and accelerated fee earning plans across its UK operations to produce a vastly improved FY17, while the uncertainty around proposed reforms to UK personal injury legislation is another unknown for investors that management will have to work through in the year ahead.
This firm looks to be facing an uphill battle and does not look investment grade, with bottom fishers far better off looking elsewhere in my opinion.
