Slater & Gordon Outlook Hinges On ASIC

This story features SLATER & GORDON LIMITED. For more info SHARE ANALYSIS: SGH

-Addressing accounting concerns
-ASIC clearance a re-rating chance
-Weak cash flow conversion in H1
 

By Eva Brocklehurst

Brokers have welcomed the enhanced disclosure by lawyers Slater & Gordon ((SGH)) in the FY15 results. The report was complex as the company elected to change its accounting policies regarding revenue recognition, work in progress and acquisition accounting.

The company is being proactive in addressing transparency concerns and cash flow, which Deutsche Bank finds encouraging. Queensland continues to be adversely affected by regulatory changes and increased competition, while Victoria and NSW were strong. In the UK, the results were better than Deutsche Bank anticipated.

Management highlighted increased brand awareness and a strong increase in new cases, with a shift in mix towards higher value, significant injury work. Deutsche Bank switches its valuation methodology to a cash earnings multiple from a discounted cash flow basis. The broker considers this a prudent decision, given market concerns around cash conversion. As a result the broker’s price target is reduced to $5.00 from $8.00. Deutsche Bank finds the valuation attractive and retains a Buy rating.

Morgans was pleased with the extra disclosure. While there has been no actual conclusion to the Australian Securities and Investment Commission (ASIC) investigation, the regulator has said it welcomes the decision to reclassify certain items as non-current, noting the company’s early adoption of AASB15 – revenue from contracts with customers.

The broker acknowledges the sustainability of earnings is the biggest risk ahead but believes there are a number of catalysts which could support a re-rating such as ASIC signing off on the accounts, an update on accounts at the October briefing and AGM commentary. Moreover, with the stock trading on a FY16 enterprise value/earnings ratio of 5.5x, Morgans believes the risks are well priced in at current levels.

UBS remains an outsider, suspecting the ASIC investigation poses the risk of further, more material, accounting policy changes. Upon conclusion of this review the broker believes the company will need to demonstrate strong cash conversion to justify its accounting policy. There are a number of issues with respect to the accounts UBS has an issue with, such as reconciling management’s income statement to the unaudited statutory accounts.

As management has suggested the first half will be weak in terms of cash flow the broker anticipates evaluating a regular flow will take 12-18 months. UBS assumes 50% conversion of reported earnings to free cash flow, down from 60% previously. The broker has a Neutral rating.

Macquarie was pleasantly surprised by the changes in accounting and the results broadly met expectations. The three changes are not expected to affect performance, rather they are considered cosmetic. The broker observes the stock has been heavily sold over recent months, as the market took on board the sizeable PSD acquisition and the ASIC inquiry.

Macquarie believes increased disclosure will go a long way to soothe concerns. Moreover, near-term multiples are not considered demanding. The broker expects cash flow conversion will improve over time, with greater UK exposure and changes in business mix as well as operational improvements. Still, Macquarie flags the fact that cash flow in FY16 is expected to be weighted to the second half.

FNArena’s database has three Buy ratings and one Hold. The consensus target is $5.73, suggesting 66.3% upside to the last share price. Targets cover a wide range, from $3.10 (UBS) to $7.52 (Morgans).
 

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