As you're probably aware by now, Slater & Gordon Limited (ASX: SGH)("SGH") has made headlines recently with its 50% fall last week and subsequent recovery yesterday.
But what's all the fuss about? Broadly speaking, investors are worried about two things:
- The Quindell acquisition (now known as Slater & Gordon Solutions, or 'SGS')
Investors want to be sure that the acquisition will deliver a decent rate of return for the $1.2 billion it cost to buy. The proposed changes to UK personal injury law are seen as threatening this income stream, as 95% of SGS cases are Road Traffic Accident (RTA) cases that could be affected by the new laws.
- Company cash flow
SGS' former owner, Quindell, has been in hot water in the UK over 'aggressive' accounting standards with regards to its 'work in progress' (WIP). Work In Progress is recorded as an asset on the balance sheet, but as the value of the asset goes up (i.e., more Work In Progress gets added), this is also recorded as revenue.
Readers will see in Slater & Gordon's 2015 preliminary final report that the company actually made a substantial loss for the year if 'Net movement in WIP', 'Gain on bargain purchase', and 'foreign currency translation differences' are excluded.
In fact, net movement in WIP of $65.8m accounts for the majority of the company's $82.3m profit on the statement of comprehensive income. Investors are thus worried that the company might not bring in enough cash to fund its obligations to financiers.
(Slater & Gordon recently confirmed it expected to be able to meet its obligations to financiers.)
Running the numbers
These concerns about WIP are why Slater & Gordon began using 'EBITDAW' (Earnings Before Interest, Tax, Depreciation, Amortisation, and changes in Work-In-Progress) instead of EBITDA in its announcements.
Slater & Gordon recently reaffirmed that it expected to earn A$205m+ in EBITDAW for Financial Year 2016 (FY16) and 100% of that EBITDAW would be cold hard cash.
SGH looks to pay interest of around 6-7% per annum on its interest-bearing liabilities, taking an average of the 2014 and 2015 financial year. With $720m in borrowings on the books as at 30 June 2015, we could assume Slater & Gordon will have to pay $50m (or more) in finance costs this financial year, depending on the timing of payments and effects of compounding.
Additionally, to maintain its dividend of 9 cents per share, Slater & Gordon will have to cough up a further $31m (9 cents multiplied by the 350m shares on issue as at 30 June 2015).
Factor in a tax liability of more than $30m (FY15: $27m) and my back of the envelope calculations show that Slater & Gordon could have to fork out over $110m in cash this financial year.
Can it pay?
In short, yes. As I mentioned above, according to company forecasts Slater & Gordon should earn $205m+ in EBITDAW, all of which converts into cash. A significant amount of this will come from Noise Induced Hearing Loss (NIHL) cases which SGH inherited with Quindell. Slater & Gordon also had $96m in cash at 30 June 2015.
Curiously, a number of analysts – including some with reports published on Slater & Gordon's own website – dispute these figures and estimate the company will make between $130m and $170m in cash.
Wilson Equities Research uses conservative assumptions (in a report issued prior to proposed UK regulatory changes) and believes Slater & Gordon is substantially undervalued as lower case intakes will result in significant cash savings and improved cash generation from cases. Indeed, the number of case intakes (73,000) is expected to align far more closely with number of resolutions (70,000) in 2016 compared to previous years.
What happens beyond FY16 is an open question given that Slater & Gordon looks to be distancing itself from NIHL cases, and the substantial uncertainties regarding the impact that the latest legislation will have on traffic accident cases.
As things stand, however – and assuming forecasts are met – Slater & Gordon looks financially intact.
