Why Slater & Gordon Limited shares were smashed 10% today

According to the Daily Gross Short Sale reports from the ASX, as much as 16% of Slater & Gordon Limited‘s (ASX: SGH) total shares on issue were held for short-sale last week.

Given that short sellers borrow stock to sell it, hoping to buy it back later at a lower price (and pocket the difference), this means that 16% of the shares on issue have been sold in the belief the share price will fall further in the near term.

This is a significant percentage, and given the performance of Slater & Gordon shares this year, appears large enough to become a self-fulfilling prophecy.

Of course, Slater & Gordon itself shoulders some of the blame with poor performance so far this year, revealed in a Friday Annual General Meeting (AGM) presentation that was marked as ‘not market sensitive’.

The subsequent performance of its shares suggests that, in fact, the contents of the AGM are market sensitive, and the recent rash of comments from analysts and broking houses reported this morning practically confirms it.

Cash flow woes

As reported in Fairfax media, Deutsche Bank suggested that Group EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) will need to more than double to hit the $205m guidance that Slater & Gordon confirmed at its AGM.

Broking house UBS questioned Slater & Gordon’s ability to hit its guidance, while a CLSA analyst believed that Slater & Gordon would require six years of gross cash flow in the second half of the year to hit its full-year targets.

Some analysts have questioned whether this means the company will have trouble meeting its sales forecasts.

As management announced on Friday, the business was expected to post negative operating cash flow (i.e., the company is spending more than it makes at the operating level) of $30-40 million in the first half of 2016, before a ‘strong recovery’ in the second half.

‘We are confident that we will remain in compliance with our obligations to financiers’

Those were the words of Managing Director, Andrew Grech, who acted to reassure nervous investors last week. Mr Grech also confirmed that the company would meet its previous guidance of A$1,150+ million in fees and Group Earnings Before Interest, Tax, Depreciation, Amortisation and changes in Work-in-progress (EBITDAW) of A$205+ million.

I wrote in this article on Friday, the issues look to be short-term and related to integration troubles and slower than expected business in the UK.

However, if the cash flow crunch leads to significant financial stress or if the company fails to meet its earnings guidance for the year, it could lead to significant long-term consequences for shareholders.

I stand by what I said last week and again suggest that bargain hunters wait to see that “a slow start to the year isn’t just a ‘new normal'” before buying shares in Slater & Gordon. Existing shareholders should strongly think about whether they are comfortable with the company’s projections, financial position, and strategy.

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Motley Fool contributor Sean O'Neill doesn't own shares in any company mentioned. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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