Slater & Gordon FY14 ahead of forecasts FY14 results Financial services SGH s FY14 results were ahead of expectations driven by a beat in UK revenue. We believe this, and two new Australian acquisitions announced with the results, will see consensus upgrades. Management is guiding to further modest acquisitions in FY15. SGH s own-brand development, tight management of workflow and economies of scale are delivering good growth. The dividend was increased from 6.6c (FY13) to 8c (FY14). Year end Revenue (A$m) PBT* (A$m) EPS* (c) 06/13 298.0 63.4 24.1 6.6 25.6 1.1 06/14 418.5 89.8 31.7 8.0 19.5 1.3 06/15e 515.8 112.8 38.1 9.0 16.2 1.5 06/16e 581.2 129.7 42.8 10.0 14.4 1.6 Note: *PBT and EPS are normalised, excluding intangible amortisation, exceptional items and share-based payments. DPS (c) P/E (x) Yield (%) 26 August 2014 Price A$6.17 Market cap A$1,268m Net debt end June 2014 (A$m) 101 Shares in issue 205.5m Free float 69% Code SGH Primary exchange ASX Secondary exchange N/A Share price performance FY14 key issues Revenue grew 40.4% on FY13 (38% excluding a 7.4m one-off credit, 32% on constant currency). Australian revenue was up 4% with a fall in Queensland revenue post regulatory changes partially offsetting 9% growth in the rest of the country. In the UK both established business and recently acquired businesses delivered c 49m each in revenue with management estimating underling growth of 8%. Personal Injury (PI) cases generated 80% of revenue. Underlying costs rose 37% (ie below revenue growth of 38%). Post-tax profits were up 47% with reported diluted EPS up to 29.8c (from 23.3c). Edison s normalised EPS rose from 24.1c to 31.7c. Operating cash flow as a percentage of net post-tax profit was 89.7% (FY13 78%) aided by a one-off acceleration after an acquisition and tax management. The FY14 dividend was increased to 8c (from 6.6c in FY13). Outlook SGH also announced two acquisitions in Australia. With these adding c A$25.6m to revenue, the management guidance of A$500m looks credible. We have slowed forecast growth in Australia to reflect a further modest impact from the Queensland reforms. Long-term growth of 5% in PI and 8% in General Law appear practical. Our UK revenue has been increased to reflect the FY14 outperformance. We see a range of opportunities for growth once the recent acquisitions have been fully bedded down (March 2015) and the market disruption from major regulatory change moderates. Management guidance remains for group operating cash flow as a percentage of net post-tax profit to be over 70%, which again appears credible. Valuation: Around fair value % 1m 3m 12m Abs 18.3 27.9 75.4 Rel (local) 17.1 24.2 59.3 52-week high/low A$6.2 A$3.3 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 AGM (Melbourne) 20 October 2014 Analysts Mark Thomas +44 (0)20 3077 5700 Martyn King +44 (0)20 3077 5745 financials@edisongroup.com Edison profile page The average of our valuation approaches is A$5.82 (c 15.3x FY15e EPS). This is on the basis of existing business, and further acquisitions may generate upside. Our forecasts are consistent with management guidance, and historically this has proved somewhat conservative. Slater & Gordon is a research client of Edison Investment Research Limited
Australian business update Total revenue growth in Australia was 3.8%. The overall growth in PI (81% Australian revenue in FY14) was 3.3% and held back because of regulatory changes in Queensland (c 20% Australian PI revenue), where the Workers Compensation Rehabilitation & Other Legislation Amendment Bill 2013 was passed on 17 October 2013. The attorney-general said that the purpose of the changes was to strike a better balance between providing appropriate benefits for injured workers and ensuring the costs incurred by employers are reasonable. The key changes to the act that were relevant to SGH include: (i) In order to make a common law claim a worker must now have a 5% degree of permanent impairment (DPI) arising from the injury reducing the number of small claims. (ii) The table of injuries has been removed from the Workers Compensation and Rehabilitation Regulation 2003 and replaced with a new calculation for lump-sum compensation under the relevant DPI. (iii) Allowing employers to seek disclosures from prospective workers about prior injuries/conditions and obtain their workers compensation claims history. The net effect has been disruption to the market and a lower number of cases. Outside Queensland PI revenue growth was 9%, including a strong bounce back in New South Wales, which changed some of its regulation in 2012 (Workers Compensation Legislation Amendment Act 2012). This recovery gives some comfort that Queensland growth will return in a further 12-18 months. In addition, management has decided to move to a single brand in that state in order to optimise the payback from marketing spend. We note that in its trading update in June 2014, SGH s competitor Shine advised its EBITDA would be at the lower end of the guidance range, noting among other things increased marketing costs. SGH notes its marketing spend in Australia is broadly unchanged (c A$15m, c 6.4% revenue), the number of in-bound client calls stable but the conversion rate of calls has improved. It believes it is getting smarter in targeting marketing and improving brand awareness. It also sees improving client satisfaction (surveys showed satisfied levels up to 67 in FY14 from 54 in FY12) as helping. However, overall client acquisition costs have been increasing reflecting the competitive environment. In general law, SGH is increasing scale in family law and conveyancing. There has been a significant improvement in the client surveys on their likelihood to use SGH for non-pi work (50% in FY14, 30% in FY12) but the business needs more volume to achieve the target EBITDA margin (12-15%). SGH will continue to invest as it sees this market as being 2-3x the scale of PI and with faster growth. It also sees limited competition with economies of scale. The general law EBITDA margin also fell in FY14 due to the non-recurrence of a limited number of class action settlements. The book of this business is being re-built. As other business grows, the sensitivity to lumpy class action settlements should moderate. We note in both New South Wales and Queensland there are potential changes relating to compulsory third party motor vehicle accident insurance. The timing of any legislation is unclear and we do not expect any impact in FY15 and, even if legislated, it is unlikely to impact until FY16 or FY17. Acquisitions SGH also announced two Australian acquisitions. Both are expected to complete in November (subject to final due diligence) and have been completed in line with historic EBITDA acquisition multiples (3.5-4.5x). Management commented that the Nowicki Carbone business has an EBITDA margin above the target range and that Schultz Toomey O Brien is between the group s existing margin and the target. The latter will also add immediate scale to the existing family law operations. Slater & Gordon 26 August 2014 2
Exhibit 1: Summary of acquisitions A$m Nowicki Carbone Schultz Toomey O Brien Annualised revenue 26.0 13.0 FY15 pro-rata revenue 17.0 8.6 Business line Specialist PI c 40% PI, c 40-50% family, c 10% general State Victoria Sunshine Coast, Queensland No staff 100 70 Cash on completion 10.0 12.4 Upfront equity (restraint on sale) 15.0 (5 years) 3.8 (3 years) Deferred and conditional cash FY16 10.0 1.3 Deferred and conditional cash FY16 10.0 1.5 Total consideration 45.0 19.0 Source: SGH, Edison Investment Research UK business update The key objectives for the UK business were to effectively integrate the recent acquisitions and still build core growth from the previously acquired operations. This was delivered in 2014 with the PI EBITDA margin above the high end of the target range (28%). FY14 revenue was flattered by a one-off post-acquisition adjustment to work-in-progress (A$7.4m) partially offset by an onerous lease provision (A$6.1m). Management highlights that the regulatory environment is stabilising, although we note a number of legal developments below. As in Australia, the general law (23% of geographic revenue) EBITDA margin is below target and further scale is being built to deliver on this. The spend on direct marketing appears to be having effect with prompted and unprompted awareness of the brand rising in an independent survey to 11% in July 2014 (up from 5% in December 2013) and well on the way to the company target of 20%. We note that the full brand transition will only be complete in March 2015. The new practice management system should be fully implemented by then, as will the integration of 700 staff into a single site in Manchester (the latter requiring capital spend of 6-7m). The Manchester site will then hold nearly half the UK staff. Management has commented that the UK deal pipeline is strong with good prospects of further acquisitions being completed in FY15. The scale is likely to be modest with the objective of filling geographic or specialist practice gaps. The type of most likely deal was described as 100-150 people and the consideration around 10m. Justice ministry proposals August 2013 On 3 August the justice secretary announced that from October the new rules will mean medical professionals can only charge 180 for an initial whiplash report, against current prices of up to 700. Proposals will also stop experts who produce medical reports from also offering treatment to the injured claimant, to ensure there is no incentive for them to encourage unnecessary treatment. The Association of British Insurers (ABI) estimates that more than 1,500 whiplash claims are made in the UK every day, costing the insurance industry more than 2bn a year. These proposals appear targeted more at the cost per claim rather than intending to materially reduce the number of claims. As a result, the direct effect on SGH is likely to be limited, but it is part of the government s overall drive to reduce insurance fraud and turn the tide on the growing compensation culture. Proposals also discourage insurers from settling whiplash claims without a medical report confirming the claimant s injury. In the past insurers have settled claims without evidence in order to deal with them quickly, meaning some questionable claims are not challenged. This may provide some upside in that cases that were previously settled may now come to court. Any development which creates more certainty and stability should help the long term sustainability of the market. Slater & Gordon 26 August 2014 3
Relevant legal developments 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. As these developments increase risk and complexity it is likely to accelerate consolidation of PI practices and S&G expects to be a beneficiary from this. Proctor/Raley case In Leeds Combined Court, county court, the judge ruled a law firm was in breach of duty after it assessed a client s case for compensation without a face-to-face meeting and misjudged the extent of their case. In essence, a system with the extensive use of questionnaires and standardised letters with very little personal contact was heavily reliant on the client carefully reading all the correspondence and filling the questionnaires in accurately, and not all claimants had that capacity. SGH expects this further evidence of a shift in judicial attitude to encourage consolidation which is likely to be beneficial to SGH. In the summer 2014 the government introduced a new clause into the Criminal Justice and Court Bill that banned PI lawyers from offering inducements to potential new claimants (claims management companies had previously been banned from offering inducements). This was not SGH s standard practice and the effect is not likely to be material and SGH is strong supporter of these reforms. Valuation The average of our valuation approaches indicates a fair value of A$5.8 (15.3x FY15e earnings). Peers Shine Corporate (ASX: SHJ) is a quoted Australian law firm and trades at 14.4x 2015e earnings. We note that Fairpoint (LSE AIM: FRP) has been moving into the PI legal services space through acquisition, but it remains predominantly a debt advice and solutions business. There are a range of litigation funders (eg Bentham IMF [ASX: IMF], Burford Capital [LSE AIM: BUR]), but their earnings streams are highly volatile and unpredictable and we do not consider them good comparators. We also believe that the business model of Quindell (LSE AIM: QPP) means it is not a meaningful comparator either. National Accident Helpline (LSE AIM: NAH), while focused on the personal injury market, is more of a UK consumer marketing business than a legal services business. DCF value (A$6.19) We have generated a discounted cash-flow valuation (DCF) for SGH of A$6.19 per share. We have taken our actual forecasts for FY15 and FY16 and have grown free cash flow by 10% a year, for a further 10 years, through FY26. 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%. 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 10%. We have subtracted debt as well as deferred acquisition liabilities from the equity value. Slater & Gordon 26 August 2014 4
Gordon s growth model (A$5.45) To capture the value added by the business, we introduce a new Gordon s growth model, which measures long-term returns on equity against cost of equity and growth. Overall we assume a longrun ROE of 15%, which is broadly in line with medium-term experience and forecast levels. The cost of equity should be relatively low given the low volatility of earnings (near-term high predictability as generated from a stock of WIP see below) and we assume 10%. We have assumed long-term equity growth of 5%, somewhat above nominal GDP, reflecting material UK market share opportunities for several years. While the forecast ROE is below our long-run average, the near-term growth is above and we build in a premium for this growth. The sensitivity to these assumptions is given in the exhibit below. Exhibit 2: Gordon s growth model and sensitivity Central ROE +1% COE -1% G+1% Return on equity (%) 15 16 15 15 Cost of equity (%) 10 10 9 10 Growth (%) 5 5 5 6 Implied P/BV 2.00 2.20 2.50 2.25 NAV 2015e (A$) 2.37 2.37 2.37 2.37 Implied price (A$) 4.74 5.22 5.93 5.33 Discount/premium re ST growth performance (%) 15% 15% 15% 15% Implied price (A$) 5.45 6.00 6.82 6.13 Source: Edison Investment Research Financials The accounting revenue recognition for legal firms requires a number of assumptions on factors affecting their likely success see Understanding the accounting on pages 9 and 10 of our June report. In summary, we forecast FY15 revenue of A$516m, Edison normalised EBITDA of A$122.7m (23.8% margin) and operating cash flow after interest and tax at 69% of net profit after tax. Net debt ends FY15 at A$113m. Key changes to FY15 estimates are: Revenue (A$516m vs A$492m): In H214, Australia missed our forecast revenue by A$4m and we have carried this slower growth forward in FY15. We have added the company estimated revenue from new acquisitions (A$26.5m) meaning that total Australian revenue is now forecast at A$276m (previously A$260m). In FY14 the UK beat revenue forecasts by A$29m (helped by a one-off A$7m WIP adjustment and A$6m forex). We have carried half the underlying beat through to FY15 noting that the tone of government comments and their actions has become increasingly anti-compensation culture. In the long term, we expect SGH to benefit as weaker competitors are even more challenged by these developments, but for 2015 we have not carried forward the full gain seen in 2014. We now forecast UK revenue at A$240m (previously A$232m).The group revenue of A$516m is c 3% ahead of the company s own revenue target, but we note it has been conservative in the past. Operating costs were some A$7m ahead of forecasts largely due to the onerous lease provision. Including acquisitions we now forecast 2015 operating expenses at A$393m (previously A$388m). The forecast statutory EBITDA is thus A$123m (previously A$120m). Finance, depreciation and amortisation charges remain unchanged at A$15m. The normalisation adjustments (see table below) result in a slightly higher level for our normalised profits. We have also introduced 2016 forecasts. These are based on the same underlying business growth (Australia 8%, UK 12%). We have assumed the whole UK business will achieve a 23.9% EBITDA margin with some further moderate economies of scale. Slater & Gordon 26 August 2014 5
Exhibit 3: Changes to forecasts Revenue (A$m) % Adj pre-tax profit (A$m) % EPS (c) % Dividend (c) % Old New Change Old New Change Old New Change Old New Change FY14 394.3 418.5 6% 84.8 89.8 6% 29.4 31.7 8% 7.5 8.0 7% FY15e 492.5 515.8 5% 106.4 112.8 6% 36.3 38.1 5% 8.5 9.0 6% FY16e N/A 581.2 N/A N/A 129.7 N/A N/A 42.8 N/A N/A 10.0 N/A Source: Edison Investment Research Exhibit 4: Normalisation adjustments 2012 2013 2014 2015e 2016e Statutory PBT 36,494 61,341 84,449 108,640 125,242 VIOX write down 10539.0 0.0 0.0 0.0 0.0 Share based payments 987.0 1377.0 1,180.0 1,180.0 1,180.0 Other amortisation 500.0 431.0 1,462.0 500.0 500.0 WIP adjustment Re Fentons 0.0 0.0 (7,400.0) 0.0 0.0 Acquisition costs 1414.0 282.0 4,054.0 2,500.0 2,792.3 Onerous lease costs 0.0 0.0 6,100.0 0.0 0.0 Adjusted PBT (Edison basis) 49,934 63,431 89,845 112,820 129,714 Tax (at same rate) (15,738) (20,495) (24,836) (32,718) (37,617) Post tax 34,196 42,936 65,009 80,103 92,097 Minority Interests (unchanged) 1,035 35 159 100 100 Adjusted post tax profit 33,161 42,901 64,850 80,003 91,997 Source: SGH, Edison Investment Research Slater & Gordon 26 August 2014 6
Exhibit 5: Financial summary (A$000s) Year ended June 2012 2013 2014 2015e 2016e PROFIT & LOSS Revenue 217,704 297,963 418,466 515,781 581,244 Cost of Sales 0 0 0 0 0 Gross Profit 217,704 297,963 418,466 515,781 581,244 Normalised EBITDA 46,662 74,277 101,980 122,680 140,180 Operating Profit (before amort. and except.) 47,025 73,967 99,816 123,274 140,728 Intangible Amortisation (500) (431) (1,462) (500) (500) Exceptionals 10,539 0 0 0 0 Share based payments (987) (1,377) (1,180) (1,180) (1,180) Operating Profit 56,077 72,159 97,174 121,594 139,048 Net Interest (5,485) (5,877) (4,943) (4,962) (5,652) Other 12 390 1,640 1,640 1,640 Profit Before Tax (norm) 49,934 63,431 89,845 112,820 129,714 Profit Before Tax (FRS 3) 36,494 61,341 84,449 108,640 125,242 Tax (11,502) (19,820) (23,344) (31,506) (36,320) Minority interests (1,035) (35) (159) (100) (100) Profit After Tax (norm) 33,161 42,901 64,850 80,003 91,997 Profit After Tax (FRS 3) 24,992 41,521 61,105 77,135 88,922 Average Number of Shares Outstanding (m) 159.0 177.9 204.7 210.2 215.0 EPS - normalised (c) 21.53 24.76 32.21 38.52 43.29 EPS - normalised and fully diluted (c) 20.86 24.12 31.67 38.06 42.78 EPS - (IFRS) (c) 15.07 23.33 29.77 36.65 41.31 Dividend per share (c) 6.00 6.60 8.00 9.00 10.00 Gross Margin (%) 100% 100% 100% 100% 100% EBITDA Margin (%) 21.4% 24.9% 24.4% 23.8% 24.1% Operating Margin (before GW and except.) (%) 21.6% 24.8% 23.9% 23.9% 24.2% BALANCE SHEET Fixed Assets 134,650 138,960 157,728 174,737 175,737 Intangible Assets 102,691 108,296 130,190 146,199 146,199 Tangible Assets 14,596 12,219 12,964 13,964 14,964 WIP 1,937 2,337 2,730 2,730 2,730 Other 15,426 16,108 11,844 11,844 11,844 Current Assets 385,049 459,962 737,650 866,807 967,090 WIP 244,898 299,859 470,609 588,261 676,500 Debtors 127,948 130,499 229,368 240,873 252,916 Cash 4,373 20,056 25,270 25,270 25,270 Other 7,830 9,548 12,403 12,403 12,403 Current Liabilities (106,500) (129,931) (232,848) (263,039) (263,039) Creditors & other (94,016) (109,829) (223,381) (253,039) (253,039) Short term borrowings (12,484) (20,102) (9,467) (10,000) (10,000) Long Term Liabilities (169,893) (119,790) (239,450) (272,183) (300,056) Long term borrowings (96,092) (32,032) (116,864) (127,843) (131,853) Other (73,801) (87,758) (122,586) (144,340) (168,203) Net Assets 243,306 349,201 423,080 506,322 579,731 CASH FLOW Operating Cash Flow 20,819 39,131 67,791 72,500 87,500 Net Interest (5,017) (5,877) (4,943) (8,500) (8,500) Tax 157 (537) (8,006) (10,805) (12,456) Capex (4,273) (2,311) (5,176) (6,357) (6,357) Acquisitions/disposals (66,110) (16,467) (120,827) (72,500) (57,792) Equity Financing 5,992 69,001 5,127 24,047 5,247 Other (3,298) (809) 6,958 (13,847) (4,282) Dividends (8,786) (9,580) (9,907) (16,550) (19,221) Net Cash Flow (60,516) 72,551 (68,983) (32,012) (15,861) Opening net debt (43,687) (104,203) (32,078) (101,061) (112,573) Closing net debt/(cash) (104,203) (32,078) (101,061) (112,573) (116,583) Source: Slater & Gordon, Edison Investment Research Slater & Gordon 26 August 2014 7
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Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE s express written consent. Frankfurt +49 (0)69 78 8076 960 Slater Schumannstrasse & Gordon 34b 26 August 280 High 2014 Holborn 245 Park Avenue, 39th Floor Level 25, Aurora Place Level 15, 171 Featherston St 8 60325 Frankfurt Germany London +44 (0)20 3077 5700 London, WC1V 7EE United Kingdom New York +1 646 653 7026 10167, New York US Sydney +61 (0)2 9258 1161 88 Phillip St, Sydney NSW 2000, Australia Wellington +64 (0)48 948 555 Wellington 6011 New Zealand