Could Slater & Gordon Limited shares suffer the same fate as Dick Smith Holdings Ltd?

The demise of Dick Smith Holdings Ltd (ASX: DSH) ultimately boiled down to two things – a lack of operating cashflow and too much debt. While this may have not been apparent to all investors just a few months ago, it is now crystal clear for all to see.

Before its collapse, suppliers had already tightened their credit terms which meant Dick Smith was forced to take on more debt to fund its working capital requirements. Despite a number of fire sales to move excess inventory, poor sales over the important Christmas period were the last straw for its bankers who were unwilling to provide additional funding to keep the business afloat.

Although management believed they had the potential to operate as a going concern, this decision appears to have been taken out of their hands and there was nothing they could do about it.

While it is never pleasant to see a company go into administration, investors must take the opportunity to learn from the lessons provided. In this case, investors should always be weary of a company that has a high debt load and poor operating cashflows.

Following a disastrous 2015, shareholders of Slater & Gordon Limited (ASX: SGH) will without a doubt be asking whether or not it is possible the company may follow in the footsteps of Dick Smith.

While I don’t believe Slater & Gordon will suffer the same fate as Dick Smith in the short term, there are a number of similar issues facing the law firm that could bring about its demise if they are not addressed promptly and competently.

The first issue that needs to be addressed is Slater & Gordon’s debt levels. According to its 2015 annual report, the company is carrying more than $716 million in long-term debt – an increase of nearly $600 million from 2014. The majority of this debt was used to finance the now infamous acquisition of the professional service division of Quindell Plc in the UK. Through this one transaction, the risk profile of the law firm has changed considerably and it is now a far more risky proposition.

As mentioned by Mike King in a previous article, investors need to remember that debt is a double edged sword and can certainly be the downfall for many companies when it’s not managed correctly.

Although Slater & Gordon have stated their bankers are fully supportive at the moment, this could easily change if the company does not deliver a decent performance during the course of FY16. The reports of an independent advisor being appointed by its banking syndicate have made investors even more nervous and cannot be viewed as a positive for shareholders.

The second issue which will determine Slater & Gordon’s fate is its cashflow or lack thereof. The market will be closely watching the cashflow update that is expected to be provided by the company sometime in January. Investors will already be aware that the company is expecting group operating cash flow will be negative in the range of $30-40 million in the first half of FY16. A subsequent update confirmed this may be worse than expected, and as a result, Slater & Gordon had no choice but to back-flip on their earlier issued profit guidance.

Management have pointed out on multiple occasions that the company has more than $100 million of headroom within its banking facilities and this headroom is expected to increase as the financial year progresses. If Slater & Gordon is unable to turn its cash flows problems around however, it is unlikely its bankers would extend the company any further financing for its working capital requirements.

Additionally, the nature of Slater & Gordon’s business means it lacks any substantial tangible assets. Unlike a company that can sell tangible assets like buildings, inventory and equipment to pay down debt, this avenue is unavailable to Slater & Gordon. Instead, the company would have to find a way to settle its legal cases more quickly – a situation that is not entirely controllable by the company and is an issue that has already impacted its ability to meets its previous guidance.

Foolish takeaway

While Slater & Gordon may not become insolvent in the short term, there remains a significant risk the company could topple if it cannot address its cashflow and debt issues.

While this analysis may be simplistic, it highlights the immediate challenges the company faces and the possible binary outcome for investors over the next 12 months. Whether or not Slater & Gordon could be a good long term investment is debatable, but it is certainly not one I could recommend with any confidence at the moment.

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Motley Fool contributor Christopher Georges owns shares in Slater & Gordon. 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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