Why Slater & Gordon Limited shares could sink lower

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Shares in tort law specialist Slater & Gordon Limited (ASX: SGH) are trading flat today at 38.5 cents as the end of financial year approaches and investors consider whether it will be able to reverse its disastrous first half to financial year 2016.

For the six months ending December 31 2015 the group posted a net operating cash outflow of $83 million with drawings of $783 million on its debt facilities versus a limit of $850 million.

Last May the group announced it had renegotiated the debt facilities it holds with lenders like National Australia Bank Ltd (ASX: NAB) and Westpac Banking Corp (ASX: WBC) with the nearest debt maturity and refinancing now due in May 2018.

The firm has also implemented an operational improvement plan that largely involves restructuring across its loss-making UK operations and in particular its legacy Quindell claims management businesses.

Given its mountainous debt pile the share price is unlikely to head anywhere but downhill until the group turns cash flow positive or at least demonstrates that cash flows are heading in the right direction and all eyes will be on its full year result when it’s revealed in late August. The main task for the six months ending June 30 2016 will be translating the substantial amount of work in progress on the firm’s balance sheet into actual cash.

I suspect the business will report another half-year of negative cash flows, although Slater & Gordon’s lenders are unlikely to extend it more credit, while they won’t want to see it go under either as most of the equity in the business is in its human capital which cannot be sold in the event of a liquidation.

This leaves the option of a capital raising or some kind of highly-dilutive debt for equity swap with its creditors if the firm cannot reverse its problems. These options could give the business the breathing space required to jettison its cash flow negative assets and start to pay down its debt.

Are law firms a good investment?

Overall though Slater & Gordon as one of the world’s first listed law firms has shown why the idea of going public is anathema to the truly high-flying legal eagles.

Top tier commercial law firms work in partnership and retain competitive advantages via their know how, reputation, and expertise in executing capital markets work, corporate advisory, or other commercial activities and high-end litigation.

The limited professional expertise in these areas gives the dozen or so ‘magic circle’ law firms a genuine competitive advantage and in turn means the powerful fee-earning partners that run them have zero inclination to share their profits with the public.

In fact the partners at these top tier corporate law businesses are famous for liking to control everything from what’s served in the staff canteen to their own profit-sharing based bonus schemes. The idea of relinquishing ownership and control to the public just to raise some capital would seem borderline insane to high-flying solicitors all seeking a maximum share of their firms’ profits in exchange for the long hours worked.

There are plenty of non top-tier listed law firms on the ASX though that include litigation funders IMF Bentham Limited (ASX: IMF) and JustKapital Limited (ASX: JKL). Litigation funding has relatively low barriers to entry, although IMF Bentham does have a pool of expertise that provides it some advantage over rivals. Moreover, litigation funding is probably one area of legal services where raising capital in exchange for giving up an ownership interest in the business makes some sense.

Elsewhere on the ASX, IPH Ltd (ASX: IPH) is primarily a holding company for patent law business Spruson & Ferguson, although it is on quite a fruity valuation and this area of law brings little competitive advantage, with low barriers to entry in my opinion.

Further down the tree is Shine Corporate Ltd (ASX: SHJ). It practices personal injury and general legal services in a similar way to Slater & Gordon. It has sunk 59% in price over the course of the past year, while personal injury law has proven to be an area vulnerable to profit-crimping reform in both Australia and the UK over the years.

Given that the truly top-quality investment grade law firms are unlikely to ever want to share their profits with you, it might be a good idea to look elsewhere for strong returns….

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Motley Fool contributor Tom Richardson has no position in any stocks mentioned.

You can find Tom on Twitter @tommyr345

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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