Slater & Gordon’s dramatic fall this year has cast a shadow over listed professional-service firms and created an opportunity for contrarians to pounce on undervalued stocks, such as Queensland-based law firm Shine Corporate.
A fall from glory
Slater & Gordon could seemingly do no wrong when it soared from $4.50 at the start of 2014 to a 52-week peak of $8.07 in April this year. The market applauded its acquisition of Quindell’s Professional Services Division (PSD) for $1.25 billion in March 2015 – a deal that would make it the United Kingdom’s largest personal-injury law firm.
Then hedge funds struck. They queried its audit relationship with Pitcher Partners and upped their bets against Slater & Gordon through short selling.
Investment bank reports that questioned the price Slater & Gordon paid for Quindell’s were picked up in financial newspapers and negative sentiment towards the law firm escalated.
A selling frenzy followed when Britain’s Financial Conduct Authority announced in June an investigation into Quindell Plc’s financial accounts, and when Slater & Gordon said it had contacted the Australian Securities and Investments Commission (ASIC) about an accounting error that related to differences between UK and Australian accounting standards and had no effect on its profitability and cash flow.
Slater & Gordon tanked to $2.65 in September, wiping $1.8 billion off its valuation in a few months. The former market darling was being death-ridden by hedge funds that believed it had paid too much for PSD, conducted insufficient due diligence and that there were flaws in PSD’s accounting process to book revenue from work-in-progress for cases.
Chart 1: Slater & Gordon
Source: Yahoo!7 Finance, 8 October 2015
Late last month, Slater & Gordon released its audited 2014-15 financial accounts, after appointing Ernst & Young to audit its UK business. The review identified a range of minor accounting adjustments that had a modest effect on earnings. The review eased some concerns about Slater & Gordon’s financial accounts, and confirmation of the value of the firm’s work-in-progress was a good sign. But the share price has barely moved as the market awaits ASIC’s impending review of the firm’s accounts.
The company’s sceptics still outweigh the true believers, judging by the steady state of short-selling interest: Slater & Gordon remains the market’s third-most shorted stock. Some hedge funds believe the PSD transaction has destroyed rather than created value in Slater & Gordon and have valued its stock at $1, according to recent newspaper reports. ASIC’s review, taking longer than expected, has made the market nervous, but not everybody expects a damning review from the corporate regulator.
Macquarie Equities Research wrote in late September: “The release of the audited accounts with significantly more disclosure should go a long way to settle any lingering concerns in Slater & Gordon’s financial accounts. For us, the auditor’s confirmation of the value of work in progress indicates the business remains well supplied with cases – a very good indicator of future revenues. We are still awaiting formal conclusion to the ASIC review, albeit remaining confident there will be no adverse findings.”
Those hoping for a quick recovery will be disappointed. Slater & Gordon had some justification when it argued it was the subject of rumourtage, market manipulation and false stories being leaked to the media about the extent of its problems. Still, the accounting errors, the ASIC problem, and scandals this year at Quindell Plc, the crisis-ridden UK insurance firm and PSD’s former parent, have dented confidence.
Value territory
But every stock has it price. Slater & Gordon is trading at a two-year low and its valuation is back to the level before the transformative Quindell’s PSD acquisition. Effectively, the market is giving no value to a $1.25 billion acquisition that gives Slater & Gordon the top position in the fast-growing, lucrative UK personal-injury law market. At $3.04, Slater & Gordon is capitalised at $1.08 billion.
Using consensus analyst forecasts, Slater & Gordon trades on a forecast Price Earnings (PE) multiple of less than 6 times 2015-16 earnings and is expected to yield 3.9%, partially franked. The stock had an average PE of 13 in 2014-15. The market must believe the company’s earnings are heading sharply lower, but there was no sign of that in the UK audit.
Seven of 11 broking firm that cover Slater & Gordon have a buy recommendation, two have a hold and two have a sell. Broker estimates ranging from $2.94 to $8.73 reflect the uncertainty in its outlook. The lowest valuation estimate is in line with the current price and a median price target of $5 suggests significant upside. Much could still go wrong. However, Slater & Gordon’s valuation offers a reasonable margin of safety for prospective long-term investors who can withstand short-term volatility, provided no nasty gremlins emerge in the financial accounts or ASIC review.
Slater & Gordon was one of Australia’s great professional service companies and can be again once the market is assured the UK problems are behind it. It has the management and board strength to get back on track quickly. Amid all the controversy, it’s easy to forget why Slater & Gordon bought PSD in the first place, and paid a higher-than-usual valuation multiple for it. The UK legal market is ripe for consolidation – it has more than 10,000 law firms, with almost two-thirds of them owned by one or two partners. Regulatory change in the UK is expected to drive greater industry consolidation, and by paying up for PSD, Slater & Gordon has done most of its acquisitions in the UK in one transaction.
Shine Corporate
Shine Corporate was affected by sentiment towards Slater & Gordon and it too may have been the target of short selling, given it has a similar business model. The Brisbane-based personal-injury firm dropped from $3.36 in March – just as Slater & Gordon’s problems emerged – to $1.93.
Shine listed on ASX in May 2013 after raising $45 million at $1 a share, in a weak market for initial public offerings (IPOs). It earns most revenue from personal-injury litigation services, in areas such as workers’ compensation, motor accidents, medical negligence and public liability claims. It also has an emerging practice in product liability, professional negligence, class actions and other areas. Shine’s market capitalisation of $345 million is about a third that of Slater & Gordon.
After soaring in 2014, Shine was a candidate for profit taking during the share market correction in August and September this year. A tougher year for the personal injury market, more aggressive competition, and changes to Queensland WorkCover rules weighed on Shine’s full year earnings. But its after-tax net profit still grew 37.8% in 2014-15.
Chart 2: Shine Corporate
Source: Yahoo!7 Finance, 8 October 2015
Shine has good long-term growth prospects, is well run, and unlike the much larger Slater & Gordon, is focused on the Australian market – its strategy relies mostly on growing outside Queensland. Shine’s acquisitions are modest by comparison, and there is less risk – although less upside – compared with Slater & Gordon’s UK business. All five broking firms that cover Shine have a buy or strong buy recommendation, according to Thomson/First Call consensus analyst forecasts. Price targets range from $2.77 to $3.65 and the mean forecast is $3.50 – a 57% premium to the current share price. The leading share valuation tool, Skaffold, values Shine at $2.90 over one year.
On balance
Of the two stocks, Shine is the lower-risk play to capitalise on ongoing consolidation in Australia’s legal industry and growth in personal-injury claims. Like Slater & Gordon, it looks undervalued and suits experienced long-term investors comfortable with small-caps.
Slater & Gordon offers a lot more upside – and risk. My sense is the market has over-reacted at the current price, and that Slater & Gordon’s due-diligence processes on the PSD acquisition and management strength will see it recover. It’s not every day that a dominant firm in the Australian and UK personal-injury legal market trades on a PE below 6, with a near 4% yield. Plenty of crappy industrial companies that are constrained to this market trade on higher multiples.
While we’re on legal-related stocks, litigation funder IMF Bentham also looks interesting after recent share-price falls. More on that in a later column.
– Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at Oct 6, 2015.
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