UK Blow Injures Confidence In Slater & Gordon

This story features SGH LIMITED, and other companies. For more info SHARE ANALYSIS: SGH

-Heightened FY17 financial risk
-Uncertainty clouds outlook
-Little balance sheet flexibility
 

By Eva Brocklehurst

Investors now require the patience of Job when it comes to law firm Slater & Gordon ((SGH)). The lawyer group has been dealt a blow from the direction of the UK, with the government there outlining a proposal to reduce claims for minor injuries from road traffic accidents.

Changes will only be made next year following a consultation process but, brokers maintain, the UK government's intentions are clear and, if implemented, would be a major negative for the company's earnings.

The sudden announcement – altogether unforeseen by Slater & Gordon – came as a jolt to brokers, given they were already concerned about difficulties being faced by the company in absorbing its large UK acquisitions. The broking community is also awaiting the outcome of a review by the Australian Securities and Investments Commission (ASIC) to ensure there are no further accounting issues to waylay the firm.

FNArena's database has no Buy ratings where previously there were three. There are now three Hold and one Sell. The consensus target has fallen to $1.14, suggesting 34.6% upside to the last share price, and compares with $4.01 previously. The dividend yield on FY16 forecasts is 11.2% and 12.4% on FY17, but brokers are not yet confirming earnings cuts prior to confirmation. In other words, such yields are not fixed.

Macquarie believes the proposals are a deliberate attempt to reduce cash compensation for minor soft tissue injuries. The two main proposals are to remove the right to general damages for minor soft tissue injuries and increase the small claims limit for personal injury to GBP5,000 from GBP1,000, transferring the claims to the Small Claims Court. No impact is expected on FY16 but in FY17, brokers expect UK case volumes are at risk.

Macquarie notes the acquisition of Quindell's PSD division, now Slater & Gordon Solutions (SGS), has significantly increased the firm's exposure to a low value, lower margin, high volume case load. Moreover, with over $650m in debt, the balance sheet does not afford the flexibility to withstand a significant earnings hit.

The broker makes no changes to forecasts at this point, conceding earnings visibility is low given the uncertainty. Nevertheless, with further downside if the reforms are implemented and until the issues are resolved, Macquarie reduces its target to $1.00 from $4.59 and downgrades to Underperform from Outperform.

Deutsche Bank also greets the news with alarm, reducing its rating to Hold from Buy. Target is lowered to $1.65 from $3.35. Despite the re-affirmation of FY16 earnings guidance, there is significant risk to FY17 and beyond, and the broker's bear case scenario envisages a 21% fall in FY17 earnings.

Deutsche Bank does point out that these proposed regulatory changes have been put forward and withdrawn before, most recently in November 2013. The main barrier to implementation has been the ability of the Small Claims Court to handle the expected increase in the volume of road traffic accident injury cases.

UBS reduces its target to 90c from $2.80 and retains a Neutral rating. The broker assesses the SGS exposure to such road traffic accident cases represent 90% of its business. FY17-18 earnings estimates are reduced by 44%.

Moving to Hold from Add, Morgans acknowledges the financial risk profile has become elevated to the extent it cannot continue to recommend buying the stock. The broker accepts the company has proven it can adapt and benefit from regulatory changes over the years, but debt and the overhang of the ASIC review are of concern.

The broker maintains forecasts at this juncture but changes its valuation methodology because of the uncertainty over future earnings. This means the target is lowered to $1.33 from $5.31.

See also, Patience Required For Slater & Gordon on November 24, 2015 (noting the UK bombshell was yet to be dropped at publication).
 

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