Slater & Gordon. Deal generates material earnings enhancement. Strategic logic. How can such an uplift to EPS be achieved?

Transcription

1 Slater & Gordon Deal generates material earnings enhancement Acquisition of Quindell PSD Financial services Slater & Gordon (SGH) has announced the terms of its acquisition of Quindell s Professional Services Division (PSD) for an initial cash consideration of 637m (A$1,225m) with a potential further 40m earnout. The deal will be financed through an A$890m equity raise and A$375m debt (both fully underwritten). The company's estimated EPS enhancement is 40%+ (our upgrade is higher), with the acquisition priced at c 7x EBITDA. Strategically, it provides further economies of scale and the opportunity to refocus PSD s business. Price Market cap (post deal) Pro forma net debt (A$m) at December 2014 Shares in issue (post deal) 7 May 2015 A$6.21 A$2,174m A$1.92/ m Year end Revenue (A$m) PBT* (A$m) EPS* (c) 06/ / /15e ** /16e Note: *PBT and EPS are normalised, excluding intangible amortisation, exceptional items and share-based payments. ** includes 58m revenue in 2015 from two months of PSD DPS (c) P/E (x) Yield Free float (est post deal) 82% Code SGH Primary exchange ASX Secondary exchange N/A Share price performance Strategic logic The Quindell business more than doubles SGH s presence in a market where it can achieve economies of scale. Quindell also brings an enhanced infrastructure with, for example, a call centre allowing SGH better communication with all its customers. It also gives an immediate, critical mass in a subsector where SGH was previously underrepresented (Fast Track portal claims). SGH will refocus the business on its historic core (road traffic accidents/employer liability and public liability), at least initially, putting new cases of hearing loss on hold. Management highlights that potential core business had been turned down as Quindell focused resource on the latter with an unproven financial outcome. How can such an uplift to EPS be achieved? Before the deal, the market was valuing the Quindell portfolio at well under half the EBITDA multiple it was willing to give to SGH, thus creating the opportunity for SGH to make such an earnings-enhancing deal. We believe this was partially due to concerns about accounting, partially due to the new management at Quindell having yet to prove itself with this company and partially around the dependence on a new product and as yet untested product area, noise-induced hearing loss (NIHL). SGH s business is much more about leveraging existing skills rather than blue sky promises. For Quindell it provides a cash exit, giving shareholders an immediate significant uplift to the pre-deal valuation. Valuation: Up from A$6.8 to A$9.1 per share We have increased 2016e EPS by 46%, materially driving up our discounted cash flow model. The Gordon s growth model benefits from the issue of equity above book value. Our valuation is still only c 14x 2016e EPS. % 1m 3m 12m Abs (19.2) Rel (local) (16.7) week high/low A$7.78 A$4.43 Business description Slater & Gordon is the leading consumer law firm in Australia. It was the first law firm in the world to list on the stock market (2007). In 2012 it entered the much larger UK market with the acquisition of Russell Jones & Walker, rebranded SGH UK. It continues to expand organically and by acquisition. Next events FY15 results (to end June) August 2015 Analysts Mark Thomas +44 (0) Martyn King +44 (0) financials@edisongroup.com Edison profile page Slater & Gordon is a research client of Edison Investment Research Limited

2 Transaction summary SGH is buying Quindell s personal injuries business for a cash consideration of 637m (A$1,225m) and a deferred consideration based on the profitability of the run-off legacy noise-induced hearing loss (NIHL) portfolio of up to 40m. It is being financed by an equity issue of A$890m on a ratio of two new shares for three existing at a price of A$6.37 per share and A$375m of debt facilities. Management believes the deal will be 40%+ EPS accretive (on SGH s accounting basis 2016e), bought on a multiple of c 7x earnings. Strategically, it more than doubles its UK presence generating economies of scale. There is an unquantified break fee payable by Quindell in the unlikely event the deal is not approved, with completion expected in May Business being bought Quindell's PSD is a leading personal injury law firm in the UK, whose 2,400 staff provide: Legal services (c 1,400 staff, FY16 company estimated revenue 195m, EBITDA 55m): offers a broad range of specialist personal injury claims services including road traffic accident (run rate c 94k cases annually, settlement of c 77k cases), NIHL (53k cases), employers liability and public liability claims. These services are delivered through the owned legal practices of Silverbeck Rymer, Pinto Potts, The Compensation Lawyers, and Fast Claim PPI, and the legal costs practice of Compass Law. PSD Legal Services has a leading market position in the UK, with a c 7% share of the personal injury claims market including a strong presence in fast track claims (approximately 70% of PSD s cases use the portal in an area where SGH has only a modest business); and Complementary services (c 1,000 staff, FY16 company estimated revenue, 145m EBITDA 40m): the Motor Services unit provides claims management and related services (eg Accident Advice Helpline), managing motor claims from the initial incident through to final resolution. Its clients include some of the UK s leading insurance companies, as well as brokers, bodyshops and fleet companies across the UK. The Health Services unit supplies medical reporting services to legal services providers through a national panel of medical experts, as well as providing a full rehabilitation service to the insurance industry, employers and occupational health providers. The Marketing Services unit supports Legal Services through claims sourcing and aggregation. Strategic rationale The Slater and Gordon model is significantly about leveraging good operational practice to manage the non-legal costs of personal injury law cases. This has been significantly achieved in the home market and the company has been expanding into the UK market, which it estimates at over five times the size of Australia. This is a scale business and PSD will more than double SGH s presence in this market, and brings an established call centre allowing better communication. The complementary services diversify earnings and allow new business opportunities and PSD brings an expertise in the mass volume fast track claims route. Slater & Gordon 7 May

3 Exhibit 1: Current market shares Exhibit 2: Post-deal market shares PSD 7% Irwin Mitchell 6% SGH 5% Parabis 4% Minister Law 4% PSD 0% SGH 12% Irwin Mitchell 6% Parabis 4% Minister Law 4% Others 74% Source: SGH, Edison Investment Research Others 74% Source: SGH, Edison Investment Research The acquisition will transform SGH into a UK-centric business. On a pro forma basis 2014 EBITDA would be 79% UK and just 21% Australian. Consideration may in due course be given to changing the reporting currency, although we note SGH still has a significant Australian shareholder base. Exhibit 3: Dec 2014 standalone EBITDA (A$118m) Exhibit 4: Pro forma Dec 2014 EBITDA (A$284m) S&G Australia 21% S&G UK 50% S&G Australia 50% PSD 58% S&G UK 21% Source: SGH, Edison Investment research Source: SGH, Edison Investment research Financials case Before this deal, SGH was trading on nearly 13x 2015e EBITDA. With the acquisition priced at c 7x EBITDA, it is not surprising that there is significant uplift to per share estimates. We also note that earnings should benefit as the new debt facility has an implied interest cost of c 4% (including amortised establishment costs) against the previous cost of c 5.5% (the new facility is likely to be more sterling orientated, where the base rate is 0.5% vs the 2.25% RBA rate). SGH has outlined a number of scenarios for the financial case: 2014 annual (80k cases) SGH accounting basis pro forma adjusted EBITDA 70m latest run rate (annualised c 94k cases) pro forma adjusted EBITDA 86m. Management uses this measure and compares it to the 597m consideration to generate a 31% EPS enhancement and a 6.9x multiple paid. Investors should note that to get to latter multiple management uses consideration of 597m (ie 40m of NIHL earnings reduces the 637m initial consideration), although no credit for this is included in earnings in the year. FY16 (to June) pro forma adjusted EBITDA 95m. This generates a 7.1x EBITDA multiple and 40% EPS enhancement including the full earnout payment. Our own numbers give more EPS enhancement (46%) as we believe our 2016 estimates were somewhat below management s own estimates. Slater & Gordon 7 May

4 Of course, the key issue is to understand why the market was valuing the Quindell portfolio at such a discount to the SGH portfolio, thus creating the opportunity for SGH to make such an earningsenhancing deal. We believe this was partially due to concerns about accounting, partially to the new management at Quindell having yet to prove itself with this company and partially around the dependence on a new product and as yet untested product area (NIHL). SGH s business is much more about leveraging existing skills than blue sky promises. Terms of equity issuance Around 140m new shares were offered at A$6.37 (a 10.0% discount to the theoretical ex-rights price (TERP) and a 15.6% discount to the last closing price) on a ratio of two new for three existing shares to raise A$890m. The institutional element raised A$608m through the issue of 95.5m shares. Around 80% of eligible shareholders participated in the offer with the balance offered through a book build which completed on 1 April (at an average price of $7.5). The retail offer raised A$120m through the issue of 18.8m shares. Around 41% of eligible shareholders participated in the offer with the balance offered (26.7m shares) through a book build which completed on 24 April (at an average price of $6.38). Debt issuance SGH is taking c A$375m of incremental debt and refinancing its existing A$162m obligations. The working capital requirements for a law firm are high (complex cases may involve many years of cash outflow before a settlement is achieved) and we believe being conservative in this area is very sensible. The key debt metrics are outlined below: Exhibit 5: Key debt metrics Metric SGH DEC 2014 standalone Pro forma Dec 2014 Net debt (A$m) EBITDA (A$m) Net debt/ebitda 1.4x 1.9x Gearing (net debt/equity) 34 40% Interest cover (EBITDA/net interest) 13.3x 16.1x Source: SGH, Edison investment Research Due diligence process Given the market uncertainty over Quindell s business SGH has revealed considerable detail of its due diligence process. This has included the review of 8,000 cases by 70 lawyers over six weeks, a review of the accounting (see below), material issues indemnified in the agreement and operationally reviewing IT, premises and insurance policies. The whole process has taken the best part of three months and used both internal SGH staff and external specialists. Accounting more conservative Quindell accounting has been subject to considerable debate. We believe SGH was not exposed to the risks in the Quindell assumptions and indeed it is valuing the business on its own assumptions rather than Quindell s historic ones. This is particularly important with regard to NIHL, which SGH has at least initially put into run-off. It is interesting to note that the assumed run-off value of 80m Slater & Gordon 7 May

5 ( 40m each for SGH and Quindell) is materially less than the gross profit Quindell would have been recognising in 2014 alone ( 210m). Some of the key issues for SGH are shown in Exhibit 7 below. Exhibit 6: Comparison of accounting polices Quindell Revenue recognised on time-lapsed basis for all cases. More aggressive estimate of effort required to reach each milestone and potential case success rates. Attribute significant value in absence of resolution track record. Case acquisition costs deferred to match revenue profile. Accrued internal costs required to settle cases. Source: SGH, Edison Investment Research Slater and Gordon Revenue recognised case by case based on performance. More measured estimate of effort required to reach each milestone and potential case success rates. N/A Case acquisition costs expensed in period incurred. Expense internal costs required to settle cases. The biggest impact is on the NIHL portfolio, which SGH views as too untested to justify the results reported by Quindell. It has thus excluded all NIHL-related revenue and costs, reducing revenue by 278m, gross profit by 2,120m and EBITDA by 201m. The effects on other businesses are modest. Pro forma on SGH s policies, the 2014 revenue was 368m (Quindell basis 645m), gross profit 99m (Quindell basis 328m) and EBITDA 70m (Quindell basis 289m). In Appendix 1 we repeat our recent analysis of SGH s accounting so that investors can see the process it follows. Post-acquisition plans We see a number of key trends: De-emphasis focus on NIHL, refocus on RTA: SGH also notes that the more aggressive accounting adopted by Quindell could have been a factor in its investment in NIHL, which under SGH s accounting appears less attractive. Accordingly, it has imposed a moratorium on new NIHL cases and will use the freed-up resources to focus on road traffic and employer liability and public liability businesses. SGH advises that PSD only takes c 80% of available road traffic business so there would appear to be demand for these services. The existing NIHL portfolio will be managed for cash with the earnings (after limited pre-agreed costs) split equally between Quindell and SGH. A further up to 40m is payable through to the second anniversary in summer Portal cases typically settle in six to nine months (ie better cash flow than complex cases) and SGH believes that by taking more volume the 810 per case acquisition cost can be reduced. Staff can look to business, not survival: we believe that PSD management and staff will have been affected by the well-publicised issues around Quindell, which have created great uncertainty over its future viability. Having a new and focused parent should remove these uncertainties, allowing PSD staff to focus on the business itself. Additionally SGH will take steps to reinvigorate the brand. We believe management has been conservative in its assumptions. The 2016 assumed revenue ( 340m) is lower than the pro forma 2014 revenue ( 368m), primarily we understand due to conservative assumptions in the complementary services unit. EBITDA rises as the cost of acquisition is expected to fall in the legal services unit. We note that management has not included in FY16 any cost synergies that may be expected to be generated on expenses such as IT, premises etc. Valuation The average of our valuation approaches indicates a fair value of A$9.1 per share (up from A$6.8) and equivalent to 14x FY16e earnings. The increase is due to upgrades to cash flow forecasts Slater & Gordon 7 May

6 pushing up the DCF model and the issue of equity above book value pushing up the Gordon s growth model. Peers Shine Corporate (ASX: SHJ) is a quoted Australian law firm and trades at 17.1x 2015e earnings. In November 2014, IPH (an Australian intellectual property services company and patent lawyer) floated on ASX and now trades at a prospective P/E of 24.9x. We note that Fairpoint (AIM: FRP) has been moving into the PI legal services space through acquisition, but remains predominantly a debt advice and solutions business. There are a range of litigation funders (eg Bentham IMF [ASX: IMF] and Burford Capital [AIM: BUR]), but their earnings streams are highly volatile and unpredictable and we do not consider them good comparators. National Accident Helpline (AIM: NAH), while focused on the personal injury market, may be considered more of a UK consumer marketing business than a legal services business. DCF value (A$8.05 from A$7.44) We have generated a discounted cash flow valuation (DCF) for SGH of A$8.05 per share. Our model uses two years of forecasts and 10 years growth, with the terminal value calculated on a multiple of 15x cash flow (a rating reflecting that this is free cash flow not an EBITDA measure) and cash flows are discounted at a rate of 10%. The uplift from our last valuation reflects the higher earnings and cash generation expected. Gordon s growth model (A$10.18 from A$6.23) To capture the value added by the business, we use Gordon s growth model, which measures longterm returns on equity against cost of equity and growth. Overall we assume a long-run ROE of 15%, which is broadly in line with medium-term experience and forecast levels. The cost of equity should be relatively low given the low earnings volatility (near-term high predictability as generated from a stock of WIP see below) and we assume 10%. We have assumed long-term equity growth of 5%, somewhat above nominal GDP, reflecting further material UK market share opportunities for several years. While the forecast ROE is around our long-run average, the near-term growth is above and we build in a premium for this growth. The sensitivity to these assumptions is given in Exhibit 8 below. Since our last note the key driver has been the issue of equity at well above book value with only a modest benefit from the higher earnings forecast generating additional equity. Exhibit 8: Gordon s growth model and sensitivity Central ROE +1% COE -1% G+1% Return on equity Cost of equity Growth Implied P/BV NAV 2016e (A$) Implied price (A$) Discount/premium re ST growth performance 15% 15% 15% 15% Implied price (A$) Source: Edison Investment Research Financials At this stage we have increased our estimates in line with management guidance for this deal. We have also made a small currency adjustment for the existing business in FY16 (A$1: 0.54 to A$1: 0.52), but the effect is minor. We have thus added 340m to revenue, 245m to costs and 95m to EBITDA. Funding costs have been increased to reflect both the volume of new debt, but Slater & Gordon 7 May

7 Exhibit 9: Changes to forecasts also lowering its cost as detailed earlier in this note. We believe the uplift to our EPS (46%) is more than the company s as our previous 2016 earnings estimates were below those of the company. Revenue (A$m) Adj pre-tax profit (A$m) EPS (c) DPS (c) Old New Change Old New Change Old New Change Old New Change FY15e % % % N/A FY16e , % % % N/A Source: Edison Investment Research Exhibit 10: Financial summary Year ended June A$000s e 2016e PROFIT & LOSS Revenue 297, , ,971 1,277,910 Cost of Sales Gross Profit 297, , ,971 1,277,910 Normalised EBITDA 74, , , ,257 Operating Profit (before amort. and except.) 73,967 99, , ,910 Intangible Amortisation (431) (1,462) 0 0 Depreciation and amortisation of IT (4,542) (4,357) (8,800) (12,000) Operating Profit 68,994 93, , ,910 Net Interest (7,653) (4,943) (4,000) (21,400) Profit Before Tax (norm) 63,431 89, , ,090 Profit Before Tax (FRS 3) 61,341 84, , ,910 Tax (19,820) (23,344) (25,747) (64,647) Minority interests (35) (159) (100) (100) Profit After Tax (norm) 42,901 64, , ,737 Profit After Tax (FRS 3) 41,521 61,105 79, ,264 Average Number of Shares Outstanding (m) EPS - normalised (c) EPS - normalised and fully diluted (c) EPS - (IFRS) (c) Dividend per share (c) Gross Margin 100% 100% 100% 100% EBITDA Margin 24.9% 24.4% 24.0% 25.5% Operating Margin (before GW and except.) 24.8% 23.9% 19.3% 25.4% BALANCE SHEET Fixed Assets 138, ,728 1,031,750 1,030,750 Intangible Assets 108, ,190 1,000,000 1,000,000 Tangible Assets 12,219 12,964 21,000 22,000 WIP 2,337 2,730 1,000 1,000 Other 16,108 11,844 9,750 7,750 Current Assets 459, ,650 1,921,889 2,127,349 WIP 299, ,609 1,100,000 1,265,000 Debtors 130, , , ,750 Cash 20,056 25,270 81,889 87,599 Other 9,548 12,403 45,000 45,000 Current Liabilities (129,931) (232,848) (736,045) (762,295) Creditors & other (109,829) (223,381) (726,045) (752,295) Short term borrowings (20,102) (9,467) (10,000) (10,000) Long Term Liabilities (119,790) (239,450) (836,814) (812,853) Long term borrowings (32,032) (116,864) (671,794) (605,358) Other (87,758) (122,586) (165,020) (207,496) Net Assets 349, ,080 1,380,780 1,582,951 CASH FLOW Operating Cash Flow 39,131 67, , ,174 Net Interest (5,877) (4,943) (8,500) (21,719) Tax (537) (8,006) (8,830) (22,171) Capex (2,311) (4,769) (20,000) (14,000) Acquisitions/disposals (16,467) (120,827) (1,362,500) (61,000) Source: SGH, Edison Investment Research Slater & Gordon 7 May

8 Appendix 1: Understanding the accounting We believe it is important that clients understand the accounting for a legal services firm where revenue is derived from assumptions on the work in progress (which is recorded in the balance sheet). The key business messages are that there is material cash flow strain from growing work in progress (and access to funding is an advantage for SGH, as is a workflow management that accelerates claim settlement); most earnings evolve from existing WIP so there is a good predictability for the near term; and earnings are not cash, although the historic conversion has been strong at 70-80% (H115: 78.6%). In Exhibit 11 below we have taken a case where the expected remuneration to SGH is 35,000 and disbursements 4,500 and it is expected to take three years to settle, with the expenses for the case evenly spread over the period. As time progresses the probability of success increases from 85% to 100% at settlement. The accountants recognise the value of the case in the balance sheet work in progress (WIP) (line four below) by taking the expected remuneration (35,000) x the stage of completion (line one) x the probability of success (line two). The change in WIP (line eight) is recognised as revenue in the P&L (line 14) where, in this example, it more than offsets the expenses incurred (line 17), thus generating a profit (line 18 and also retained earnings in the balance sheet, line seven). However, cash is leaving the business to pay expenses (line 21) and disbursements (line 20), resulting in a worsening cash position (line three) until completion. On completion the cash is received from the client. The financial position is thus critically dependent on assumptions of how long cases take to complete and success rates. New business incurs a cash flow strain, which has to be financed. On a like-for-like basis, changes in these assumptions between years have not been material, although changes in mix of business (eg more longer-term, complex UK cases) will have had an effect. Exhibit 11: Illustrative example of the accounting for legal services Line Period 1 Period 2 Period 3 Period 4 Total Stage of completion 1 33% 66% 100% Probability of success 2 85% 90% 100% Balance sheet Cash 3 (9,667) (19,333) (29,000) 10,500 10,500 WIP 4 9,818 20, Debtors 5 1,500 3,000 39,500 35,000 0 Creditors Net assets 7 1,651 4,457 10,500 45,500 10,500 Change in balance sheet WIP 8 9,818 10,973 (20,790) 0 Dr debtors 9 35,000 (35,000) 0 Cash 10 (9,667) (9,667) (9,667) 39,500 10,500 Paid disbursements 11 1,500 1,500 1,500 (4,500) 0 Legal creditors 12 (2,000) (2,000) Dr anticipated disbursements 13 2,000 2,000 Profit & loss Movement in WIP 14 9,818 10,973 (20,790) 0 0 Fees 15 35,000 35,000 Total revenue 16 9,818 10,973 14,210 35,000 Expenses 17 (8,167) (8,167) (8,167) (24,500) Net profit 18 1,651 2,806 6, ,500 Cash flow Receipts from customers 19 35,000 35,000 Disbursements 20 (1,500) (1,500) (1,500) 4,500 0 Profit & loss (expenses) 21 (8,167) (8,167) (8,167) (24,500) Net cash-flow 22 (9,667) (9,667) (9,667) 39,500 10,500 Source: Edison Investment Research. Note: By way of sensitivity if this illustrative deal completed in two years and not three, the end year one cash position would be -14,500, and net assets 2,625. Slater & Gordon 7 May

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