Patience Required For Slater & Gordon

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-Stronger skew to second half cash flow
-ASIC review overhang ongoing
-Will first half dividend be suspended?
 

By Eva Brocklehurst

Confidence is slow to re-build in law firm Slater & Gordon ((SGH)), with the AGM update suggesting that some of the more meaty challenges in the UK Slater and Gordon Solutions business are taking longer to resolve.

Deutsche Bank received mixed signals from the AGM briefing. The start to FY16 in the UK has been notably soft, featuring staff integration issues as the Manchester office is consolidated and new practice software installed. Resolution rates across personal injuries law have also been slower with the introduction of Medco earlier this year.

This increases the skew in earnings to the second half and puts a shadow over the company's ability to meet its guidance, at least in the UK, the broker contends. Group FY16 cash earnings guidance has been re-affirmed, with forecasts for group fees to be over $1.15bn.

Valuation grounds compel Deutsche Bank to retain a Buy rating, but the broker expects the share price to remain under pressure while the company restores investor confidence.

The company has reduced case intake expectations, which translates to a negative net movement in work in progress in the UK of GBP20m. Hence, Morgans downgrades earnings forecasts by 14%. The broker notes the company is still under an ASIC (Australian Securities and Investments Commission) review and therefore a meaningful share price re-rating is unlikely until the investigation is concluded.

Morgans highlights the company's decision to take quality cases rather than quantity and an intention to bring intake and resolution levels into closer alignment. The broker believes this decision is important, as it will not only balance cash flow but also the mix of cases on its files. Still, the extent of the fall in case intake in the near term has more to do with cash-flow management than ensuring quality cases, the broker contends.

Morgans believes the stock has deep value and patient investors will be rewarded but accepts that the uncertainty surrounding accounting issues needs to be removed and Slater and Gordon Solutions (SGS, formerly Quindell's PSD) needs to demonstrate not only profits but also cash flow.

Given the hefty skew to the second half the broker expects the market will remain sceptical of the company’s ability to meet expectations and continue to question the servicing of its debt requirements. Morgans remains optimistic that ASIC will sign of on the accounts but suspects this review could take until April next year.

The Australian lawyers branch is performing well and one of the highlights, Macquarie observes. Operations are on track to meet performance targets in this realm but the turnaround in the UK acquisition is taking longer to achieve and the SGS business is disappointing, the broker maintains, negatively affected by weaker settlement rates.

That said, Macquarie notes management remains convinced about the strategic merit of this business and acknowledges the progress being made in repairing relationships with counterparties, including insurers, and suppliers of business.

The company has completed a review of Noise Induced Hearing Loss (NIHL) cases it acquired and has structured a new profit sharing arrangement with the vendors. The company expects 40-50% of cases should be settled. Macquarie suspects these cases will result in material earnings and operating cash inflow in FY16 and FY17 but there will be a moratorium on new cases while the existing book is run down.

The broker also suspects management may delay the interim dividend in February and, if FY16 targets are achieved for operating cash flow of $205m, then reinstate it for the full year.

UBS also queries the ability to meet FY16 guidance, given the conditions in the UK point to a weak first half. The primary reason has been the changes in the Fast Track Road Traffic Accident practice which has resulted in lower case volumes.

The company faces a number of hurdles and delivering on guidance is required to justify its accrual accounting policies, in the broker’s opinion. If second half cash flow falls substantially below guidance the market will intensify its focus on net debt. Hence, UBS does not expect the the stock to outperform and retains a Neutral rating.

In sum, FNArena's database has three Buy ratings and one Hold (UBS). The consensus target is $4.01, suggesting 97.7% upside to the last share price. The dividend yield on FY16 and FY17 forecasts is 4.7% and 5.7% respectively. Targets range from $2.80 (UBS) to $5.31 (Morgans).
 

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