Slater & Gordon Requires Patience

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-Revenue upgrade for FY15
-Significant opportunities ahead
-Time to earnings translation
 

By Eva Brocklehurst

Patience is required with law firm Slater & Gordon ((SGH)), brokers contend, as the company digests a large acquisition which, while providing access to a wider range of cases, has risks around integration and execution.

Slater & Gordon has upgraded its revenue target for FY15 to include a contribution from its UK personal injury business acquisitions, Leo Abse and Cohen and Walker Smith Way, a stronger performance in Australian and UK operations and favourable currency movements. However, the firm's newly acquired Professional Services Division (PSD) will be strapped for cash flow over the next 6-12 months as certain cases move through the resolution process.

The firm has provided investors with a comprehensive overview of the PSD business, expecting significantly greater access to cases amid opportunities for synergies. There are a number of positives, Macquarie observes. The company has managed to leverage scale with third party intermediaries and improvement in cash flow should be apparent in FY16. Short-term cost saving opportunities are evident and case volumes are underpinned by channel partners and market share growth. Near term, the multiples on the stock are not demanding and Macquarie believes there is potential for the valuation gap to narrow as the company demonstrates PSD can be operated profitably.

Deutsche Bank found the update a mixed offering, with some negatives. The FY15 revenue upgrade does not translate into an earnings upgrade as the PSD will not contribute because of NIHL (noise induced hearing loss) case losses, while transaction costs are higher. First half FY16 cash flows are expected to be weak, which suggests a skew to the second half. Deutsche Bank also believes there will be challenges for the share price in the near term as the register expands towards large cap investors.

Deutsche Bank observes the FY16 revenue growth outlook for 5.0% in personal injury and 8-10% in general law remains consistent with its expectations. All said, the broker considers the valuation is still compelling and accepts the firm's conviction that the PSD deal will be transformational. The addressable UK market is substantial and highly fragmented and the PSD business is considered well positioned to capitalise on opportunities. The business extends the existing direct-to-consumer channel and opens up the insurer channel. Moreover, it will broaden referrals.

PSD will operate as a standalone business but will not be run in the way of the previous owner, Quindell plc. There will be a stronger focus on case mix and selection as well as case acquisition costs and cash generation.

The recent weakness in the share price suggests some scepticism regarding the PSD transaction. UBS maintains the future performance of earnings and cash flow should ultimately remedy this sentiment. Cash flow will be weak as the NIHL settlements wash through and it may take more than a year before the business produces a regular cash base on which it can be accurately evaluated, in the broker's opinion.

While investors are required to keep the faith, UBS calls for management to improve clarity disclosing work-in-progress balances and case numbers to help them shore up their methodologies. This is particularly important given Quindell had well-publicised earnings growth and margins but challenged cash flow. UBS acknowledges Slater & Gordon will recognise revenue along more conservative accounting lines but investors are still being asked to assume cash will flow from revenue regardless.

There are four Buy ratings for the stock on FNArena's database. The consensus target is $8.30, signalling 60.1% upside to the last share price. It compares with $8.67 ahead of the update. Targets range from $7.90 to $8.98.

See also Slater & Gordon Achieving Critical Mass on February 12 2015.
 

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