Very nice questions Kyn. All are very interesting to discuss. But I will skip over some assumptions when explaining because otherwise post runs too long. If you don't understand something just ask again.
1. Yes.
2. Typical for all companies is not as important as what should Shine's typical conversion should be based on their business model. What is their business model and cash cycle? Let's look at this. Below is an example of a case and how law firms accounts for it as accrues on their books.
WIP is estimated by hours worked and probability of success.
If you look at the graph, see how it is sloping upwards. This is because I am trying to illustrate the effect of settlement probability. As time goes on, not only did you complete more of the work, but also your probability of success increases, since the ones that cannot be settled, are culled early on. However, the curve I drew is perhaps too curvy upwards, and hence it might not be the best portray of a typical case, but it should give you an example of how individual cases are accounted for.
PI industry in Australia usually have a 24 months settlement timeframe.
If we assume cases are evenly distributed across time and also WIP is weighted towards the older age cases, then we can come up with another example of how total WIP carried on their balance sheet looks like:
6 months WIP: 10 mil
12 months WIP: 15 mil
18months WIP: 20 mil
24months WIP: 25 mil
Accounts Receivable: 5 mil
Accounts Rec. plus WIP = 75 mil
Only the bolded ones can convert to cash in the next financial year for obvious reason of time = 50 mil
Conversion should be 55/80 = 67%
The ratio above is based on my example numbers, it will change obviously if you assume different numbers. If shine provided more data, specifically WIP with intervals of 6 months periods, then we can have a more accurate number of a typical conversion ratio for Shine.
However, I will tell you there is a couple of main things that will affect the ratio. Firstly, if the business is growing organically, then young WIP will increase versus old WIP, and hence lower the ratio. Secondly, if the business acquires a lot, then old WIP and accounts receivable will increase versus young WIP, and increase the conversion ratio. Finally, if there are changes to the type of cases a law firm takes on it will affect the ratio too, since different cases have different settlement timeframe, and shorter the period, the higher the conversion ratio.
Shine has an average of 71% over the last 6 year's of reporting. Slater has an average of 80%. Then you might think well this proves Shine is cheating, since Slater is already in all sorts of issues and Shine is lower. This would be a very superficial judgement. The reason being, Slater has businesses in the UK that has settlement periods materially shorter than Shine. Also, although Shine acquired some companies during that period to boost the ratio, Slater acquired significantly more WIP and accounts receivable to move the ratio up even more than Shine.
My analysis cannot prove or disprove whether Shine or Slater is cheating the WIP, but it does illustrate to you how complicated it is. We cannot use a benchmark comparison to say Woolworths, like the previous poster did to illustrate how Shine is cheating. All we can tell from this is that if there are no other evidence to suggest Shine is cheating, then their ratio is within the ball park and should be taken as approximately correct.
3. As I mentioned above, acquisitions actually should increase conversion, since acquisition cash outflow is accounted for in investments and not in operation, and what you are buying essentially is mature WIP and accounts receivable that is not accounted for in the previous year's balance sheet, which boost conversion ratio for this year. There could be various reasons culminating in why 2012 had only 59%, but that isn't exactly very far off from the average, and nothing to be alarmed about.
4/5. Both questions are very similar right? Well, my valuation is based on the most likely normalised earnings for the foreseeable future divide it by market cap. If this ratio is lower than another company, then it's cheaper. However, you do have to adjust for the risk as well. Slater and Shine are very close in terms of value at the moment according to my analysis, but no where close in terms of risk. Slater is a ticking bomb with their leverage and recent developments.
I don't like valuing a company on growth, since that's very unpredictable and rosy. You try to predict the most likely earnings in the foreseeable future such as 1-3 years from now, and use that as your basis for earnings. A company has to be cheap without growth for me to make a serious investment in. Growth is an add on benefit that I will pay only a tiny premium for, since it's so hard to predict correctly. Shine and Slater both is extremely cheap if you normalise earnings for the next year or two. Both would have P/E of around 2 or 3 without needing any growth in your estimations.
So the question is will Shine and Slater normalised. I thought Slater would normalise before. But so many cards were turned, and especially the card of no cash update, that was the final straw for me. Seeing that you know Slater has a high probability of a major issue such as bankruptcy brewing in the short term. Of course things could still turn good for Slater with more news. But currently based on what I am looking at, it just doesn't look as good as Shine.
Shine looked mediocre before. It's share price was nothing to be drooling about. It had normalised P/E of around 10 at $2 plus. Now Shine is 1/4 of the price as before and don't have debt and other issues as dangerous as Slater, so it's a no brainer switch.
Anyways I hope this can help you. If you don't understand something I said just ask.
SHJ Price at posting:
58.5¢ Sentiment: Buy Disclosure: Held
(20min delay)