PORTFOLIO POINT: Listed law form Slater & Gordon is on a growth path. Improving cash flow and earnings margins remain its biggest challenges.
Slater & Gordon is best known as the crusading law firm that takes on corporate giants on behalf of everyday Australians.
Although its class actions attract publicity, Slater & Gordon’s real strength is less glamorous: a strong brand, growing scale and excellent systems to process a high number of enquiries.
In some ways, Slater & Gordon is more like a fast-moving consumer services company than a traditional law firm. Any firm that attracts 85,000 client enquiries in a year needs great systems to pick the best cases to pursue and manage, and strong scale to process higher case volumes and boost profits.
The above analogy is not meant to downplay Slater & Gordon’s legal skills, passion for the law, or TO suggest it offers a commoditised service. If anything, the key to its rising valuation in coming years – and something the market may be underestimating – is the power of its brand and its service.
Broker reports devote page after page to Slater & Gordon’s financial metrics, yet fail to identify the source of the improving numbers – its brand and marketing nous, ability to replicate and expand into new markets and then cross-sell services.
Curiously, some analyst reports reveal the lack of business experience of their authors by criticising Slater & Gordon’s marketing spend, which weighs on the firm’s profit margins, even though the advertising campaign, which seems to have been well orchestrated, will probably pay for itself many times over in the long run thanks to inflation.
The key to a sharp rise in Slater & Gordon’s future intrinsic value is its ability to expand beyond personal injury claims into new markets, such as family law and conveyancing. That is as much a test of the power of Slater & Gordon’s brand and economic goodwill as it is of the firm’s strategic and operational capabilities.
An estimated valuation of $1.95 suggests Slater & Gordon is marginally undervalued. An estimated $2.13 of intrinsic value per share suggests there may be a sufficient margin of safety to buy Slater & Gordon at current prices. I predict intrinsic value to rise to $2.37 by mid-2013 and $2.59 a year later (see below).
Slater & Gordon was undervalued for most of FY2012 and especially so earlier this calendar year. Investors who spotted the valuation anomaly when it dipped below $1.50 in March have enjoyed a strong rally. More gains are possible if the firm can improve cash flow and expand its profit margin.
On that front, the company’s scale provides a clear, sustainable competitive advantage over smaller rivals; the law industry has high barriers to entry (for large-volume work) and while Slater & Gordon is working-capital intensive, it does not require huge investments in fixed assets that rapidly depreciate.
Slater & Gordon is more defensive than many small-cap growth stocks because demand for its services is less dependent on the economy’s strength. These so-called “defensive growth” stocks have higher appeal as concerns grow about the economy.
The firm’s share price has doubled since listing in 2007, and the market capitalisation has grown from $107 million to $332 million, mostly during a bear market. Compound annual revenue growth of 29% since listing is impressive for any firm, let alone a legal one.
But the detail is not as flattering as headlines suggest. I rate Slater & Gordon’s performance as a 4 (poor), and it declined from a 2 in 2010. Return on equity has fallen from 19.5% in FY09 to 16.1% in FY12. Total debt has almost quadrupled to $108 million over that period.
Cash flow from operations has fallen from $24.7 million in FY10 to $15.9 million in FY12. Cash flow from the Australian business was 50% of net profit after tax in the FY12 result, and below the company’s guidance of 65-70%, because of the timing of billings. Simply put, Slater & Gordon should be generating a lot more cash relative to its net profit, something the firm is working hard to fix. The issue of course is that expenses flow out early while revenue may not be generated until the end of a project.
The earnings before interest and tax (EBIT) margin is another concern for some investors. It seems to be stuck around 25%, which is odd given the firm’s fast revenue growth. Eagle eyed analysts would note that improving scale should lead to higher profit margins. The issue is the marketing, and a heavy investment in advertising and growing new businesses in recent years has weighed on costs. The good news is that these costs should moderate in coming years while the returns should emerge from the investment. If it doesn’t emerge, you know something is quite wrong.
Acquisition strategy adds another layer of risk. Although the firm has a history of successfully buying smaller law practices, its acquisition of UK law firm Russell Jones & Walker in January for $80 million was a step-change in its strategy. Russell Jones & Walker has a big personal injuries practice, its market is at least four times larger than Australia, and the acquisition is off to a good start.
Prospective investors can view Slater & Gordon in two ways. First, as a company that ran out of growth options in the Australian personal injury claims market, so it had to expand rapidly into new markets to find new growth, lift its waning operating performance and keep the market happy.
Or second, as a top-quality company that has not achieved a sufficiently high shareholders’ equity in recent years because it has invested heavily for the future; and is ideally positioned to capitalise on that investment as improving scale in the personal injuries business lifts profit margins and as new growth engines in family and property law, and the UK business, take hold.
If the second scenario plays out, as seems likely, Slater & Gordon’s debt should peak within two years and start to fall, and fewer mergers should mean less share issuance and dilution. As more cogs in the business turn faster, working capital and EBIT margins should start to improve.