Slater & Gordon Limited: Shares not for the faint hearted

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Slater & Gordon Limited (ASX: SGH) is one of two listed law firms on the ASX, the other being Integrated Legal Holdings Limited (ASX: IAW). This writer has long been very sceptical of SGH's business model.  This caution continues with the release of SGH's half yearly report on 14 February 2012.

Even though revenues were up 17.3% to $99.4m, net profit dropped by 11.3% to $11.8m. Management explained that the acquisition of Keddies "proved slower to bring up to speed than anticipated" and "revenue is down approximately $4m in H1 FY12".

The law firm Keddies was the subject of billing controversies prior to its acquisition by SGH. Management explained that the poor half yearly result was also affected by acquisition costs for the UK business, and significant investments in Family Law and Conveyancing. In other words, money is being spent upfront to generate growth.

Low Cashflow

Operating cashflow was anaemic at $4m, and cash from investing activities chewed up a massive $23m.  Curiously, despite this cashflow situation, SGH paid nearly $5m in dividends, and declared a further $5m of dividends payable this half.

Below is a table summarising the cashflow situation for the last five years.  Readers can make their own judgment as to whether the financial statements of the business reflect actual economic reality.

2007 2008 2009 2010 2011 HY 2012
Revenue 63 79.7 103 122 178 99.4
NPAT 10.6 15 17 19.8 27.9 11.8
Operating Cashflow 8.5 11.5 -0.7 24.7 20 4
FreeCashflow 4 -3 -11 9 -47 -19

To top it all, management has indicated that operating cashflow for the full year will only be about 70% of net profit.

Increasing Debt

The latest cashflow deficiency was plugged by an increase in borrowings.  The total liabilities of SGH started at $55m on listing. This has increased 4 fold to $191m five years later as at 31 December 2011. There is a corresponding increase in assets on the balance sheet. As at 31 December 2011, the asset side of the balance sheet contains $93m in accounts receivables, and $201m comprising "Work-In-Progress".

Acquisitions, Dilutions, and UK Overseas Foray

In the grand tradition of illustrious peers such National Australia Bank (ASX: NAB) and Insurance Australia Group (ASX: IAG), SGH is blazing a path of glory into the UK market via the intended acquisition of a UK law firm for approximately AUD$80m.

SGH will hand over AUD$41m in cash on completion, a further $13m in deferred consideration payments, and equity issue of AUD$25.7m.

Barring a miracle increase in operating cashflow, the acquisition will have to be funded by more debt. Shareholders can also look forward to a further dilution of their shareholdings, which has increased from 82 million shares on listing to 154 million shares in 5 short years since listing. The share dilution shows up in lower EPS growth of 42% despite net profit growth of 168%.

Management has indicated "no further forecast material acquisitions in Australia or UK." They probably do not have much of a choice, as I fail to see how any further material acquisition could be funded based on the current state of its balance sheet and cashflow.

ROE and ROIC versus Money in the bank

As at 31 December 2011, SGH has total assets of $395m and net assets/equity of $205m. It made $11.8m in net profits.  This is about 3% return on total assets, and 5.75% return on equity, for the last six months.  Last time I checked, depositors can get at least 5% per annum return from their bank. At these rates of return, shareholders are not compensated for the additional risks involved.

Market not stupid

Mr Market may have wild mood swings, but he is not stupid. The SGH share price dropped by over 10% in the last 2 days.  Current prices imply a market valuation of about $250m for SGH. We see neither quality nor bargain.

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Motley Fool contributor Peter Phan does not own shares in Slater & Gordon. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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