Richard Hemming article in the Australian, page-3

Don’t tar legal stocks with Slater & Gordon brush


Investors know the cliche “one bad apple spoils the barrel” all too well.
Just think of those invested in the education sector, which has collectively plunged since the high-profile fail of training provider Vocation in 2014.
Then there was the even higher profile demise of Slater & Gordon, the negative sentiment from which has infected all the stocks on the domestic legal landscape.
When misfortune does happen in a sector, there can be opportunities to make money.
Here are some crucial differences between Slater & Gordon and three other firms in the legal services sector — the intellectual property specialists IPH, legal services group Xenith IP, and the litigation funding group Bentham IMF.
Slater & Gordon’s business model is to employ large numbers of staff to run personal injury cases, while IPH and Xenith also employ large numbers to provide services such as commercialisation and enforcement of IP rights. A key difference is that Slater & Gordon’s profitability is heavily based on success in legal cases where the result could go either way, while IPH and Xenith generate profits based solely on billable hours.
Bentham IMF’s business model is based on winning or successfully settling cases, but it employs a very small number of staff, who run an investment portfolio of legal cases.
In this way, its business model is much more leveraged, and not reliant upon continually merging with other businesses to lower costs.
On the management competence front it doesn’t look good for Slater & Gordon.
In buying the professional services arm of the British insurance claims company Quindell, did Slater & Gordon take a good business and make it bad, or was it so obsessed with growth at any cost that if it wasn’t Quindell, it would have been something else?
In a similar vein to when the US insurance group AIG blew up, helping to precipitate the global financial crisis, the banks and the regulators had no idea how to manage the assets and were forced to either rehire or keep hiring the management responsible.
Bentham IMF has had its managerial problems and is now moving from funding a small number of high value cases to a large number of smaller cases. Separately, the company has big cash reserves and has had a couple of big wins this year. Arguably you would give management the benefit of the doubt on this new strategy.
On the accounting front, the litigation funder’s profits are incredibly lumpy.
In the final quarter of the 2015-16 financial year it made more money than the rest of the year combined.
But its profitability should be smoother if the new strategy works out, plus its accounting policies are conservative. It doesn’t account for revenue until the final cash is received.
Similarly, the accounting policy for IPH and Xenith IP is straightforward, being based simply on billable hours.
You couldn’t get a bigger contrast when it comes to Slater & Gordon. In 2014-15 the firm’s reported profits were up 23 per cent at $83.8 million, while net operating cash flow fell 25 per cent to $40.7m.
The group’s profit was climbing because it was bringing forward revenue receipts in its “work in progress” account. In hindsight it was overly optimistic in anticipating expected cash won through successful cases.
One of the big red flags for any company is when there is a big change in accruals. Companies can record revenues, but not actually receive cash. Fortunately for shareholders in Bentham IMF, IPH or Xenith IP, this is something they don’t have to worry about.