Shooting the messenger at Slater & Gordon

Since I last wrote about Slater & Gordon (ASX: SGH) in July, its shares have plunged a further 82% (no, I didn't short it).

At last week's AGM, however, instead of criticising management and the board and questioning them over the company's accounting policies, strategy, and outlook, shareholders concentrated on blaming short sellers for their predicament.

I think they're wasting their time.

With things having only got worse since the AGM – the UK has proposed regulatory changes that may drastically reduce the profitability of Slater Gordon Solutions (the rebranded Quindell Professional Services Division) – there are some good, albeit painful, lessons here for individual investors.

1. Cheap for a reason?

Many investors think the price falls have been too severe and that SGH may be good value at current prices.

All thing equal, a company is better value the more its share price declines but you also need to determine whether in fact all things aren't equal. In other words, is the stock cheap for a reason?

My main concern is the company's $620m in net debt. With a current market capitalisation of $240m, the entire company is priced at $860m so looking just at its $0.69 share price and ostensibly low PER is incorrect.

To my knowledge, Slater & Gordon hasn't released details of its covenants but merely noted that they aren't based on market capitalisation. As this information is vital to any informed analysis, the fact that they haven't is reason enough to steer clear.

Despite expecting negative cash flow in the first half of 2016, management still expects at least $205m in earnings before interest, tax, depreciation and amortisation and changes in work in progress (EBITDAW) for 2016.

This implies significant positive cash flow in the second half of 2016. If this occurs – and it's a big if – then its debt may be manageable whatever its covenants (presumably net debt / EBITDA and / or interest cover).

However, most of the debt is floating rather than fixed – meaning rising interest rates are a risk – and it has 375m pounds (or $760m using exchange rates at 30 Jun 15) in debt that isn't hedged against foreign exchange movements.

Instead, Slater & Gordon is using the earnings of the company's British-based businesses as a 'natural hedge' to this debt. Unfortunately, however, the proposed regulatory changes in the UK may significantly reduce these businesses' future profitability, a reason why analysts have subsequently slashed their estimates.

Any capital raising to reduce debt would be highly dilutionary at current share prices.

2. Its real assets

Of the $1.43bn in net assets at 30 Jun 15, a cool $1.24bn is intangibles and most of that is goodwill. So even at these low prices and (perhaps generously) assuming the $826m in Work in progress will ultimately be converted to cash, the company is still selling above tangible book value.

In any case, Slater & Gordon's main asset is its lawyers but they aren't locked in on long-term contracts and so are free to move to a competitor or set up their own shop.

If they leave, they take their knowledge, experience and contacts with them, meaning the company doesn't have any long-term competitive advantages (management would argue that the company's brand is valuable, however).

With the company's falling share price decimating the value of any shares they hold and its reputation taking a beating, more employees may opt to leave and take much of the company's value with them. This will also force Slater & Gordon to increase compensation to attract and keep valuable employees.

3. Accounting flexibility

By their nature, accounting principles involve a great degree of estimation and judgment, meaning companies don't need to breach accounting principles or the law to paint their performance in the best possible light. (And I'm not suggesting Slater & Gordon has committed anything untoward or illegal here.)

The flexibility in accounting principles means that when a short seller raises questions about a company's accounting (or its business model or capital structure), it's always wise to assume they may be on to something.

If you short sell a share intending to buy it back at a lower price, but it rises instead, your losses are potentially unlimited (at least in theory).

So despite the (mostly unjustified) criticism they receive, short sellers are usually some of the most skilled investors in the market. As such, unless you're just as sophisticated as them, you take them on at your peril.

4. Cockroaches aren't loners

Slater & Gordon has already admitted to some accounting errors and a good rule of thumb is that such errors are rarely one-offs. Once an accounting error is revealed, it's probably time to cut your losses before others appear.

This is especially the case when a company's CFO departs, as has occurred with Slater & Gordon recently. In isolation, the departure of a long-standing CFO isn't a major concern but combined with questions over its accounting and already-revealed accounting errors, this is just another red flag suggesting investors look elsewhere.

So while I can understand shareholders' anger at their losses, I think blaming others is counter-productive. Instead, investors should use Slater & Gordon as a good but rather expensive lesson.