Slater & Gordon Scale and growth Outlook and review of UK operations Financial services Slater & Gordon (SGH) is the leading consumer law firm in Australia and has been expanding into the much larger UK market, which we review in detail in this note. Its differentiating features include economies of scale, work process engineering and using its brand to market directly to clients. Its UK operations appear less exposed than the market to the Jackson reforms and the Mitchell ruling and they should provide opportunities for both organic and inorganic growth. 13 June 2014 Price A$4.94 Market cap A$1,015m 0.56/A$ Net debt at December 2013 (A$m) 93.6 Shares in issue 205.5m Free float 69% Year end Revenue (A$m) PBT* (A$m) EPS* (c) 06/12 217.7 49.9 20.9 6.0 23.7 1.2 06/13 297.6 63.5 24.4 6.6 20.2 1.3 06/14e 394.3 84.8 29.4 7.5 16.8 1.5 06/15e 492.5 106.4 36.3 8.5 13.6 1.7 Note: *PBT and EPS are normalised, excluding intangible amortisation, exceptional items and share-based payments. DPS (c) P/E (x) Yield (%) Code Primary exchange Secondary exchange Share price performance SGH ASX N/A Key business model differentiators SGH achieves material economies of scale by mapping legal processes and identifying opportunities for aspects of the work to be automated and/or performed by supervised staff, who while not admitted to practice as lawyers themselves are supervised by qualified lawyers and trained to perform key components of work. For example, it is much more efficient to chase doctors for medical reports through an administration centre than having expensive lawyers do so. Developing backoffice expertise improves service levels and leads to more rapid case conclusion, which means better cash flow. SGH s scale also gives it access to capital markets, which is important for funding working capital, which can be a major constraint on business growth. SGH is also differentiated by using its brand to market direct to customers rather than relying on third-party introducers. This may prove especially advantageous in the UK, where changes in regulations may see such third-party distribution under the greatest pressure. Growth options SGH estimates it has a market share in Australian personal injury cases of c 20%. It expects this market to grow by 5% pa. Its market share of other personal legal services is around a fifth of this. SGH intends to use its brand to increase this share, with top-line growth in non PI consumer legal services expected to grow at >10% pa on average. In the UK a market considerably larger than Australia SGH s market share is now c 5%. FY14 will see the benefit of acquisitions with future organic UK revenue expected to grow c 8-10% pa. SGH is less exposed than most to regulatory reforms and pressure on weaker players is expected to see consolidation. SGH has also a successful track record of acquisitions in Australia and the UK and it is anticipated that acquisitions will add a further layer of growth. % 1m 3m 12m Abs 7.4 7.2 81.6 Rel (local) 7.8 7.0 58.4 52-week high/low A$5.10 A$2.55 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 event FY results to end June 2014 August 2014 Analysts Mark Thomas +44 (0)20 3077 5700 Martyn King +44 (0)20 3077 5745 financials@edisongroup.com Edison profile page Valuation: Modest discount to average valuation The shares are trading modestly below the average of valuation approaches. The quoted peer, Shine, trades at a 2014 P/E of 15.9x. Slater & Gordon is a research client of Edison Investment Research Limited
Investment summary In 2007 SGH became the first law firm in the world to list on a stock market. It is Australia s largest consumer law firm, specialising in plaintiff personal injury, but leveraging brand strength to expand in other areas of consumer law. In 2012 it entered the much larger UK market with the acquisition of Russell Jones Walker (now rebranded SGH UK), and has continued to build the business through organic growth and five further acquisitions in recent months. The addressable UK consumer legal market is considerably larger than the comparable Australian market and SGH has already built a substantial UK business, with geographic and product spread, and growing scale to support efficiency and brand building. It is well on its way towards its plans to build a dominant direct to consumer business based on a leading brand. Its experience and track record in the Australian market and its access to capital markets should be distinct advantages. Valuation: Shares have responded well Our DCF valuation of SGH is A$4.71 per share. We have introduced a new Gordon s growth model, which indicates a slightly higher valuation of A$5.35. The quoted peer, Shine, trades at a 2014 P/E of 15.9x. Financials: Accounting explained We have not changed our forecasts from our February report. In summary we are expecting Australian revenue growth of c 6%, UK organic growth of c 18% and the benefits of 2013/14 acquisitions in line with management guidance. We expect marketing spend to continue at 9% of revenue. In this note we also explain the accounting standards adopted by legal services businesses. In particular we note the cash flow strain from new business as expenses and disbursements are paid out well in advance of client matters settling and of receipt of proceeds. SGH s high service levels and investment in practice management and case management systems should accelerate the speed of claim settlement, meaning it has to raise less working capital funding than some in the market. This is a competitive advantage for a business such as SGH, which can readily access funding for cases. We note that revenue is recorded from the evolution of work in progress and is dependent upon case-specific assumptions including success rates and the timing of cases to completion. We understand that, like for like, these assumptions have not shown material changes, but variations in business mix will affect accounting revenue growth and the conversion of profit into cash. Sensitivities Regulatory: Legal services are highly regulated and the UK is undergoing significant change. The effects on the whole market are unclear, but we expect a modest shrinkage in volumes. Brand: Brand strength and perception is the leading customer acquisition tool for SGH. It is investing heavily both in the marketing of the brand but also the technology to deliver quality service to support the brand. Acquisition risk: Acquisition integration is a challenge, noting SGH s considerable experience. Accounting assumptions: We detail below how the group recognises revenue from work in progress and the cash flow strain of new business. Case funding: SGH s scale gives it an advantage in funding working capital. Should litigation funding companies effectively enter the UK PI market, this advantage could be reduced. FX: SGH reports in Australian dollars, but now has a significant earnings flow in sterling. The cost of hedging has been viewed as excessive relative to advantages gained bearing in mind that sterling debt acts as a natural hedge. Slater & Gordon 13 June 2014 2
Company description When Australia-based SGH listed on the Australian Stock Exchange in 2007, it was the first quoted law firm anywhere in the world to do so. The business has a long history dating back to1935, but deregulation of the Australian legal services market (permitting the incorporation of legal firms in 2001 and allowing non-legal practitioners to become owners of legal practices in 2004) set the scene for a period of rapid organic and acquisition-led growth within a consolidating market. SGH is Australia s largest consumer law firm and has established a number of differentiating competitive advantages. First, it has scale, thereby generating operating efficiencies and better than peer access to financing. Second, it has adopted workflow systems that segregate legal from non-legal tasks. By using scale to offer specialist services it is also able to improve client outcomes and experiences. Third, it has built a brand-led distribution direct to customers rather than relying on third-party intermediaries. Fourth it has successfully integrated a number of acquisitions. The implementation of the UK Legal Services Act in early 2012, introducing new forms of legal services ownership to the UK, provided SGH with the opportunity to enter the much larger UK consumer legal services market. In April 2012 SGH acquired Russell Jones Walker (RJW, since rebranded SGH UK), a top 100 UK national group. The acquisition included RJW s Claims Direct claims management brand. The introduction of a number of reforms recommended by Lord Justice Jackson in his 2009 report (The Jackson Report) from April of 2013 seems likely to hasten the consolidation of the UK personal legal sector as players with weaker balance sheets and less efficient systems face pressure from lower fees. SGH s has actively participated in this. We expect the experience and track record in the Australian market, to be replicated in the UK with all the same competitive advantages. Australian market leadership Following a period of rapid organic growth and acquisition over the past 10 years or so, SGH has become Australia s largest consumer law firm, operating in most states and territories, and employing more than 1,200 people in 69 offices (more than any other law firm in Australia). In the Australian business, plaintiff personal injury (PI) in total represents c 80% of revenue, which is performed on a no win, no fee basis where the fees are paid on the successful conclusion of the claim. Within PI, litigation in motor vehicle accidents and workplace accidents accounts for some 54% of group H1 revenue and SGH portfolio is spread over thousands of active PI cases. In H1 of FY14 its achieved revenue growth in excess of its 5% target with a strong performance in Victoria, and improving performances in New South Wales (post state legislative changes) and Queensland. Outside of PI, SGH is active in a range of general legal services, which in H1 of FY14 generated 11% of group revenue. Its Personal Legal Services (PLS, covering wills, probate, conveyancing and family law) saw revenue growth in H1 of FY14 in excess of 10% as it used the brand and service recognition gained in PI to cross-sell other consumer products. In late 2011 (ie during FY12) SGH acquired Conveyancing Works, the largest specialist conveyancing firm in Australia, and has subsequently rolled out the model nationally. The model seeks to combine scale, brand and the security of operating within a legal services business. SGH believes it is now the largest family law practice in Australia. In its Business and Specialised Litigation Services (B&SLS, covering industrial law, commercial litigation, business law with specialist areas in estate litigation, criminal defence and employment law). SGH has a long history of involvement in class or group legal actions where it is regarded as a market leader and pioneer in Australia. The financial returns to SGH are potentially strong and the strengthened public profile and brand awareness are also very valuable. This business is lumpy in returns and the pipeline is currently being re-built after recent case completions. Slater & Gordon 13 June 2014 3
Exhibit 1: SGH domestic (Australian) market positioning and targets Personal injury Person legal services Business & specialised litigation Market size (A$m) 550-700 1,100-1,300 N/A SGH current market share c 25% c 1% N/A 2015 company target market share 25-30% 3% N/A Source: SGH Exhibit 1 shows SGH s current market positioning and its target market positioning by 2015. The company sees further room for growth within the PI market (it seeks to grow PI organically by 5% pa), and targets marginal efficiency improvements. Faster growth from a lower base from its non-pi practices (particularly family law and private clients) see revenue growth in general law >10%. It will, however, come at the price of lower margins as the returns on the general law business are generally below those seen in PI. UK operations SGH entered the UK market through the acquisition of RJW in 2012 and has supplemented this with further acquisitions detailed below. In H1 of FY14, the UK generated 35% of group revenue (FY15 Edison estimates 47%) and it has a UK PI market share of around 5% (in all important areas it is number one or two). We believe the market leader is at c 8% market share with the third player at c 1.5%. Australian operations give a competitive advantage in UK expansion We believe that SGH s experience of successful growth in the changing and consolidating Australian consumer legal services market is a competitive advantage as it expands in the UK. Some of the key experiences that should read across markets include: Staff motivation: Moving away from a partnership model to one that incentivises staff in a listed vehicle is critical and, among other things, SGH uses an employee ownership plan. One major problem for a number of acquirers of professional services business is managing their senior members of staff who are close to partnership just ahead of acquisition. Keeping this experience can be critical to an effective integration and SGH has done that in Australia. Business Integration: SGH has direct experience of all aspects of consolidation of the Australian personal injuries litigation market. Strong retail brand for distribution is the key source of referrals from a diverse customer base such that the clients belong to the firm and goodwill accrues to the firm. Brand recognition and attraction is a very important part of the SGH Australian strategy (and will also be in the UK). It is focused on the Slater & Gordon brand, but SGH is pragmatic and retains the Trilby Misso brand in Queensland, where it is the best known PI brand. A significant proportion of client enquiries cite brand reputation as the reason for contacting SGH. Cross-selling the brand: SGH is expanding the range of services provided and has experience in Australia of using its brand to achieve this. Efficient administration: The operational management of higher-value PI claims and in particular segregating services that require legal expertise from those that are better provided through operational centres is important in delivering quality service as well as cost efficiencies. SGH UK is using most of the workflow technology used in Australia. Following the completion of the Pannone acquisition, SGH had 650 employees in Manchester in three offices, allowing scope for premises and operational rationalisation. Access to funding: As we detail in the financials section, new business places a material working capital strain on legal service providers. The scale and stock market listing give SGH Slater & Gordon 13 June 2014 4
access to capital markets, debt and equity, and that has been an essential support to growth in Australia and is already supporting the UK strategy. UK market background SGH estimated that the addressable portion of the UK personal legal services market in the UK, pre Jackson reforms, was four to five times larger than its Australian domestic market (UK population is broadly three times larger). Although the changing legislative environment has yet to be finalised, we believe the pressure it is introducing on fees is likely to reduce the overall size of the market in the short term, but it is likely to still be three to four times larger than Australia. In the key PI segment, distribution in the UK market has traditionally been through: (i) insurance companies/brokers. We estimate nearly half the population, directly, or attached to other insurance policies such as for home or motor, has insurance cover for legal costs. Providers of this insurance typically operated with a panel of solicitors to which claims could be referred; (ii) claims management companies, which advertise for potential claimants, sometimes aggressively, with a view to selling these leads onto solicitors; (iii) unions there are over 50 unions within the TUC, representing c 6.5 million members. The unions are an important source of referrals to solicitors, often working within panels; and (iv) solicitors there are many thousands of law firms (SGH estimates 13,000) with a relatively small number of firms and individuals are acknowledged as leaders or experts in their field (eg PI). As we detail below, payments to third parties are now banned and legal firms dependent on these channels need to find new ways of accessing customers. Changes in the UK consumer legal services environment The UK personal legal environment has seen a number of dramatic changes over the past 18 months. We believe that SGH is nearly uniquely positioned to benefit from the pressures these changes will put on a number of providers. Its model is not particularly exposed to the areas worse affected and its streamlined structure administrative process should help. Legal Services Act Early in 2012, this act introduced alternative business structures (ABS) for the first time. An ABS allows non-lawyers to take professional management roles in law firms, as well as ownership stakes. ABSs have greater access to capital markets and are also able to list on the stock market. Companies other than law firms are now in a position to offer legal services. Of the ABSs licensed to date, most are legal partnerships converting or insurance companies creating a wholly new ABS, perhaps in partnership with a legal firm. For the latter s legal partners, the ABS will provide access to customers as an alternative to referrals. Jackson reforms (JR) that were implemented on 1 April 2013 are further encouraging legal firms to adopt these new business and operating structures, and to consolidate. The key changes are summarised at www.justice.gov.uk/civil-justice-reforms/main-changes. A key objective of the JR was to make costs of litigation more proportionate (as noted above the UK PI market is c 4-5x the Australian one for a population c 3x as large). Fewer claims and lower fees seem a likely outcome of these reforms (although the actual impact on the market is yet to be seen as a number of cases taken ahead of 1 April 2013 have yet to work through the system). This is likely to encourage industry consolidation. Those using no win, no fee conditional fee agreements now have a direct interest in controlling the costs that are incurred on their behalf, while the non-recoverability of ATE will discourage claimants from acting with no financial risk to themselves but with significant potential cost to the defendant. Legal firms can no longer pay referral fees to third parties in return for client details. This was not a major distribution channel for SGH (as it often was associated with providing Slater & Gordon 13 June 2014 5
highly-subsidised employment advice), but for those firms that relied heavily on customer referrals it is much more of a problem. The cost of after the event (ATE) insurance will no longer be recoverable as part of a successful claims award and will be borne by the claimant. Success fees, paid to the claimant s solicitor, will no longer be recoverable from the losing party. Success fees will now reduce the value of a claims award, although the guidelines on awards have been increased somewhat to partly compensate. Mitchell Ruling Described in the Law Society Gazette as the most significant decision in civil litigation since 1999, in November 2013 the court of appeal upheld the judgement in Mitchell v News Group that failure to follow correct procedure (in this case JR rules on budget submissions on time) would lead to the claimant being unable to claim back legal fees even if they won the court case. This has led to some negligence litigation against lawyers (for failing to meet the deadline) and some market commentators saying it will lead to even more arbitration. SGH believes that its process-driven workflow systems mean that, relative to the market, it is less at risk of failing to meet such deadlines. There may even be some business opportunity in the negligence cases. RTAC portal was first introduced in 2010. It is an electronic, fixed-fee claims process for road traffic accident (RTA) claims of less than 10,000, where liability is admitted, which covers the majority of claims by number. On 1 July 2013 the scheme will be extended to other types of PI claims up to a value of 25,000, including clinical negligence claims. The fixed RTA fees were originally set at 1,200, but were reduced to 500 on 1 April 2013 and then increased to 800 in July 2013. There has been industry comment that at this level of fees it will be difficult for solicitors to cover costs, and that client service quality may suffer. Portal claims are a relatively small part of SGH s business and, again, the changes are likely to pressure industry revenues and encourage consolidation. Economies of scale from the segregation of legal and non-legal processes, and efficiently delivering the latter, are a major advantage. SGH s UK model was different from the market as a whole. It had a limited presence with some of third parties above (eg unions) but also built an independent brand-led platform. RJW included Claims Direct, a claims management brand that was initially operating as a marketing co-operative for around 16 law firms including RJW. Post takeover, the business has been increasingly brought in-house and the Claims Direct brand remains one of the most recognised (unprompted) brand names in the PI and claims management market. More recently, SGH has introduced a direct marketing campaign, with the company describing the early signs from this initiative as positive. Being brand-led and direct to customer are key differentiating factors. SGH is targeting 8% organic growth for SGH UK. We note SGH s existing position has been acquisition-led and see scope for growth from the acquisition of teams and key personnel, and the acquisition of books of work-in-progress as weaker players are forced out of the market by the regulatory changes above. Integration update Acquisitions have formed part of the strategy in order to: Increase scale, expanding SGH UK s revenue and earnings base. Greater volumes allow increased economies of scale in the administration of non-legal services through operational centres. Increase the UK geographical diversification. SGH s presence is now strongest in the North West (especially Manchester and Liverpool) and London. Increase its depth of competence while adding specialist practice area. Broaden brand value both by a higher visible presence but also allowing marketing spend to be spread over a larger revenue stream. Slater & Gordon 13 June 2014 6
We believe SGH is looking for firms with a strong cultural fit with its existing business and that it will in due course complete further deals. Consolidation in the UK market is driven by a range of regulatory developments, the need to access funding for work in progress and economies of scale in non-legal administration. SGH believes that a number of existing practices understand these market drivers and have both the cultural and geographic fit to add value. Exhibit 2: UK acquisitions Date Region Annualised revenue Pro-rata revenue FY14 acquired m A$m m A$m Russell Jones Walker April 2012 National 47.4 83.1 47.4 83.1 Taylor Vintners Aug 2013 Cambridge 3.9 6.8 3.4 6.0 Goodman Aug 2013 Liverpool 3.4 6.0 2.8 4.9 Fentons Sept 2013 London/Manchester 27.7 48.6 20.7 36.3 Pickering Oct 2013 North West and Yorkshire 3.0 5.3 1.8 3.2 Pannone Feb 2014 Manchester and London 34.5 60.5 11.5 20.2 Source: Company data, Edison Investment Research. Note: 0.57/A$. Taylor Vintners, Goodman and Pickering have all been fully integrated, branded S&G, and operate on a common practice management system. The larger Fentons is for now trading as Fentons, a part of the S&G Group, but will be full rebranded shortly. Its administrative integration is scheduled to take place in March 2015, following the implementation of a new group-wide practice management system. Similarly, a phased approach to the integration of Pannone is planned on completion, mitigating the integration risks, with it also planned to join the new practice management system in March 2015. The acquisitions bring some changes in business mix: PI in RJW accounted for 58% of revenue. Including the deals completed in CY13 this rose to 76% but post Pannone it drops somewhat to 69% of total revenue. We note that the Pickering acquisition brought in particular expertise in asbestos. The mix of PI is changing with a higher share of higher margin, more complicated, serious injury PI cases. Management says that, including Pannone, the split between simpler, lowermargin claims portal business and serious PI cases should move from c 70:30 to c 45:55. Because they are more complicated, serious PI cases take longer to settle, and alongside a higher margin will also consume more working capital. This effect, as well as the phased implementation of the new practice management system, leads us to believe that cash conversion from the UK business may slow somewhat. Geographically there is now a greater presence in the Northwest and London. Once the existing deals have been bedded down, we expect SGH to be an active consolidator in the market. Its listing gives it access to capital markets if required, there are economies of scale and geographic coverage is far from complete. We believe that targets would not only have to add value in these areas but also be a strong cultural fit. Management The divorcing the ownership of a law firm from its legal practitioners has the potential to create conflicts of interest between the interests of shareholders and the legal duty to represent the best interests of clients. To address this, the company s constitution makes clear that the directors must always give primacy to the duties that a lawyer owes to the court first, secondly to clients and then to shareholders. We are not aware this has caused any difficulties for SGH in the six years since flotation nor had any negative impact on SGH as an investment. The board consists of six directors, four of whom are independent NEDs and two are executive directors who are also legal practitioners (Andrew Grech, managing director, and Ken Fowlie, head of Australia). The group has an independent chair, John Skippen, who took over from Anna Booth in Slater & Gordon 13 June 2014 7
March 2012. Managing Director Andrew Grech joined SGH in 1994 and has been MD since 2000. He has more than 20 years legal experience. Ken Fowlie has been a litigator for more than 16 years and has been with SGH since 1995. We provide senior management biographies on page 12. Sensitivities Future acquisition activity (most likely in the UK, of firms, books of business, or key individuals) is a key sensitivity for our earnings expectations. We would highlight the following additional key sensitivities to our forecasts and valuation: Regulation. In Australia, each state and territory has its own legislation, regulations, and conduct of practice rules. Expected harmonisation over time is likely to have a number of positive and negative impacts on SGH. Moves to regulate personal injury fees, as is occurring in the UK, would clearly have an impact. Historically, regulatory change has encouraged the consolidation from which SGH has benefited in Australia and seeks to benefit from in the UK. Brand: Strong brand recognition in the Australian market has been a competitive advantage for SGH, driving enquiries into call centres, contributing to revenue growth and helping to limit key man risks. Building and maintaining a strong and positive brand image in the UK market is important to SGH s UK strategy. Acquisition risk: Acquisition remains central to SGH s strategy, particularly in the UK where it may need to move quickly to build a leading position in a consolidating market. It has much experience of acquisitions, but in general these pose more risk than wholly organic growth. Case funding: We note that cash is typically only received upon completion of a case and that funding work in progress is a critical business issue. There are a range of options available to group and competitors. We note that specialist litigation funders in Australia are relatively advanced (eg Bentham IMF, Burford), but that such companies have yet to establish a material presence in the UK PI market. Over the long term, this may be expected to develop, thereby reducing somewhat the current advantage that SGH has in raising funding. FX: With earnings generated in sterling but reported in Australian dollars, there is sensitivity to FX movements. Management has indicated that the cost of hedging is excessive relative to the benefits gained bearing in mind the natural hedge from sterling debt in issue. Valuation The average of our valuation approaches indicates a fair value of A$5.0. Peers Shine Lawyers (ASX code: SHJ) is also a quoted law firm and trades at 15.9x. The UK support services sector trades on a trailing P/E multiple of 20.5x with a yield of 2.17%. There are a range of litigation funders but their earnings streams are highly volatile and unpredictable and we do not consider them good comparators. DCF value (A$4.71) We have generated a discounted cash-flow valuation (DCF) for SGH of A$4.71 per share. We have taken our actual forecasts for FY14 and FY15 and have grown cash flow by 10% a year, for a further 10 years, through FY24. The terminal value is calculated on a multiple of 15x cash flow (a rating reflecting this is free cash flow not an EBITDA measure) and cash flows are discounted at a rate of 10%. The growth rate that we have used should be viewed in the context of the significant Slater & Gordon 13 June 2014 8
opportunity that SGH has for expansion in the UK market. A 1% increase in the assumed long-term growth rate increases the valuation by c 8%, while a 1% increase in the discount rate decreases the valuation by c 9%. We have subtracted debt as well as deferred acquisition liabilities from the equity value. Gordon s growth model (A$5.35) To capture the value added by the business, we introduce a new Gordon s growth model, which measures long-term returns on equity against cost of equity and growth. Overall we assume a longrun ROE of 15%, which is broadly in line with medium-term experience and forecast levels. The cost of equity should be relatively low given the low volatility of earnings (near-term high predictability as generated from a stock of WIP see below) and we assume 10%. We have assumed long-term equity growth of 5%, somewhat above nominal GDP, reflecting material UK market share opportunities for several years. While the forecast ROE is below our long-run average, the near-term growth is above and we build in a premium for this growth. The sensitivity to these assumptions is given in the exhibit below. Exhibit 3: Gordon s growth model and sensitivity Central ROE +1% COE -1% G+1% Return on equity (%) 15 16 15 15 Cost of equity (%) 10 10 9 10 Growth (%) 5 5 5 6 Implied P/BV 2.00 2.20 2.50 2.25 NAV 2015e (A$) 2.3 2.3 2.3 2.3 Implied price (A$) 4.65 5.12 5.81 5.23 Discount/premium re ST growth performance (%) 15% 15% 15% 15% Implied price (A$) 5.35 5.88 6.68 6.02 Source: Edison Investment Research Financials We detailed the assumptions behind our forecast in our February report and these are unchanged. In summary, we forecast FY14 revenue of A$394m, normalised EBITDA of A$97.3m (24.8% margin) and operating cash flow at 71.2% of net profit after tax. Net debt ends the year at A$115.7m. The absence of UK tax was an H1 FY14 event and we expect normal tax rates to apply going forward. Looking to FY15, including acquisitions we forecast UK revenues (in sterling) to increase 43.4% in aggregate and for the average UK EBITDA margin to increase to 21.7%, reflecting the improvement in the existing business as well as the higher and increasing margin in new business. In Australian dollar terms, UK revenues are forecast to increase c 51%, with domestic revenues increasing c 8%. Cash flow from operations is forecast at just above 70%, and with lower acquisition spend, net debt is forecast to decline to A$108.9m. 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 progress of the work in progress (which is recorded in the balance sheet). The key business messages are that (i) 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); (ii) most earnings evolve from existing WIP so there is a good predictability for the near term; and (iii) earnings are not cash, although the historic conversion has been strong at 70-80%. In the exhibit below we have taken a case where the expected remuneration to SGH is 35,000, disbursements 4,500, and it is expected to take three years to settle, with the expenses for the case Slater & Gordon 13 June 2014 9
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 4 below) by taking the expected remuneration (35,000) x the stage of completion (line 1) x the probability of success (line 2). The change in WIP (line 8) 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 7). However, cash is leaving the business to pay expenses (line 21) and disbursements (line 20), resulting in a worsening cash position (line 3) until completion. On completion the cash is received from the client. The financial position is thus critically dependent on assumptions on 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. We note that in H1 FY14 the Australian WIP days (ie balance sheet WIP/total revenue annualised) was 414 (vs 412 for FY13). The effect of the UK acquisitions saw WIP days rise to 326 against 233 respectively. Exhibit 4: 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 20,790 0 0 0 Debtors 5 1,500 3,000 39,500 35,000 0 Creditors 6 0 0 0 0 0 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 6,043 0 10,500 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 on sensitivity if this deal completed in two years not three, the end year one cash position would be -14,500, and net assets 2,625. Slater & Gordon 13 June 2014 10
Exhibit 5: Financial summary (A$000s) Year ended June 2012 2013e 2014e 2015e PROFIT & LOSS Revenue 217,704 297,576 394,346 492,484 Cost of Sales 0 0 0 0 Gross Profit 217,704 297,576 394,346 492,484 Normalised EBITDA 58,615 74,263 97,342 119,497 Operating Profit (before amort. and except.) 47,025 73,990 95,382 119,506 Intangible Amortisation (500) (431) (940) 0 Exceptionals 10,539 0 0 0 Share based payments (987) (1,377) (1,377) (1,377) Operating Profit 56,077 72,182 93,065 118,129 Net Interest (5,485) (5,877) (6,882) (8,500) Other 12 390 390 390 Profit Before Tax (norm) 49,934 63,454 84,772 106,355 Profit Before Tax (FRS 3) 36,494 61,364 80,486 104,978 Tax (11,502) (19,454) (23,319) (30,444) Minority interests (1,035) (35) (86) (100) Profit After Tax (norm) 33,161 43,302 60,125 75,412 Profit After Tax (FRS 3) 24,992 41,910 57,167 74,535 Average Number of Shares Outstanding (m) 159.0 177.4 204.6 207.6 EPS - normalised (c) 21.53 25.06 29.90 36.59 EPS - normalised and fully diluted (c) 20.86 24.41 29.39 36.32 EPS - (IFRS) (c) 15.07 23.61 27.90 35.85 Dividend per share (c) 6.00 6.60 7.50 8.50 Gross Margin (%) 100% 100% 100% 100% EBITDA Margin (%) 27% 25% 25% 24% Operating Margin (before GW and except.) (%) 22% 25% 24% 24% BALANCE SHEET Fixed Assets 134,650 138,960 172,884 173,736 Intangible Assets 102,691 108,296 145,445 146,199 Tangible Assets 14,596 12,219 10,018 8,984 WIP 1,937 2,337 2,266 3,398 Other 15,426 16,108 15,155 15,155 Current Assets 385,049 459,962 680,347 740,336 WIP 244,898 299,859 412,259 461,731 Debtors 127,948 130,499 210,355 220,873 Cash 4,373 20,056 5,000 5,000 Other 7,830 9,548 52,733 52,733 Current Liabilities (106,500) (129,931) (206,967) (185,527) Creditors & other (94,016) (109,829) (204,265) (182,825) Short term borrowings (12,484) (20,102) (2,702) (2,702) Long Term Liabilities (169,893) (119,790) (226,122) (243,751) Long term borrowings (96,092) (32,032) (117,982) (111,234) Other (73,801) (87,758) (108,141) (132,518) Net Assets 243,306 349,201 420,141 484,794 CASH FLOW Operating Cash Flow 20,819 39,095 50,911 65,940 Net Interest (5,017) (5,877) (6,882) (8,500) Tax 157 (537) (3,498) (4,567) Capex (4,273) (2,311) (3,355) (3,972) Acquisitions/disposals (66,110) (16,467) (113,383) (32,000) Financing 2,694 67,803 4,744 6,395 Dividends (8,786) (9,580) (12,144) (16,548) Net Cash Flow (60,516) 72,126 (83,606) 6,748 Opening net debt/(cash) (43,687) (104,203) (32,078) (115,684) Closing net debt/(cash) (104,203) (32,078) (115,684) (108,936) Source: SGH accounts, Edison Investment Research Slater & Gordon 13 June 2014 11
Contact details Registered Office, 485 La Trobe Street, Melbourne VIC 3000 + 61 3 9602 6888 www.slatergordon.com.au/investors/ Revenue by geography CAGR metrics Profitability metrics 2014 e Balance sheet metrics 2014 e Sensitivities evaluation Norm EPS 2013-15e 22% Rev growth 2013-15e 29% Admin costs 2013-15e 29% WIP 2013-2015e 24% Equity 2013-2015e 18% Operating cash 2013-2015e 27% Management team Managing director: Andrew Grech Operating profit margin 24% Pre-tax margin 20% Adjusted ROE 16% WIP days 384 % WIP < 1 yr 99% Andrew joined SGH in 1994 and became MD in 2000, leading the group through a period of substantial growth, incorporation and flotation. He has more than 20 years experience as a legal practitioner and has experience as a litigator in most areas of SGH s practice. Chief financial officer and joint co secretary: Wayne Brown Wayne joined SGH in 2004 as chief financial officer and company secretary. Previously he was financial controller at Grand Hotel Group, which followed 10 years at Arthur Anderson where he specialised in corporate recovery and corporate restructuring. Net debt A$m 115.7 Current asset/liab 3.3 Debt/equity 28% Net / total assets 49% Receivables days 194.7 Payables days 168.7 Litigation/regulatory Pensions Currency Stock overhang Interest rates Oil/commodity prices Executive director & head of Australia: Ken Fowlie Ken has been a litigator for more than 16 years and has been with SGH since 1995. He was one of SGH s two original employees in NSW and has taken a leading role in its growth. More recently Ken has led the commercial and project litigation practice as general manager. Non-executive chairman: John Skippen John has been chairman since March 2012. He has more than 30 years experience as a chartered accountant, and brings extensive public company and retail experience, including skills in financial management, general management and strategy. He has served on a number of company boards and is currently also and NED of Flexigroup Ltd, Super Retai Group Ltd, Briscoe Group Ltd (NZ), and Emerging Leaders Investment Ltd. Principal shareholders (last reported: 28 August 2013) (%) NAB 11.1 Perpetual 10.1 Mawer 10.0 % 54% 11% 35% Australian PI Australian General UK Companies named in this report Shine (ASX SHJ), Burford (LSE BUR), Bentham IMF (ASX IMF) Edison, the investment intelligence firm, is the future of investor interaction with corporates. Our team of over 100 analysts and investment professionals work with leading companies, fund managers and investment banks worldwide to support their capital markets activity. We provide services to more than 400 retained corporate and investor clients from our offices in London, New York, Frankfurt, Sydney and Wellington. Edison is authorised and regulated by the Financial Conduct Authority (www.fsa.gov.uk/register/firmbasicdetails.do?sid=181584). 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