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Slater & Gordon's double-down bet

In one fell swoop, Slater & Gordon, the 80-year old personal injury firm has well and truly entered the sharemarket, big time.
The Melbourne-based firm, which in 2007 became the first law business in the world to float on the sharemarket, will pay $1.225 billion to buy the main division of troubled United Kingdom professional services outfit, Quindell.
The deal, which was accompanied by a large $890 million capital raising was trumpeted as an immediate winner for shareholders as it would increase annual earnings by 30 per cent. So, too, would it fast-track Slater's UK ambitions by doubling their market share to 12 per cent and putting them up for promotion to the ASX100.
The dominant emotion over the deal among investors and analyts, which is more than half the size of its current market capitalisation, has been one of unbridled enthusiasm.

The big brokers, UBS and Deutsche, which both recently initiated coverage on the deal-driven, capital hungry law-firm, gave the Quindell deal their wholehearted endorsement.
Shareholders were more than happy to double down on the high flying Slaters, and subscribe to a $890 million equity raising to fund the UK purchase, mindful that its size and share price performance made it a story they cannot afford to ignore.   
But not everyone is buying it the story. There's a small group of analysts who have kept a close watch on the stock and its regulatory filings.  They have grown increasingly wary of the risks associated with managing director Andrew Grech's sharemarket adventure that has led to a sevenfold increase in the stock price through a seemingly never-ending acquisition spree.
The first concern is the target, Quindell, which is the poster-child for an overaggressive acquisition model.


Quindell, described by the Financial Times' journalist Dan McCrum, as "a description-defying collapsed stock promotion acquisition roll-up machine" unravelled in 2014 after short-sellers and independent analysts pointed out concerns about its bookkeeping and governance.
REVIEW IN PROGRESS

In the aftermath, the firm, which is listed on London's alternative stock exchange. appointed big-four accounting firm PwC to review its books, a process that has yet to be formally completed.
Slaters itself has the traits of a roll-up machine, now tallying up an aggregate of $1.7 billion of deals, of which $1.3 billion is accounted for by the Quindell purchase.

The Quindell deal, which is three times larger than the $480 million sum of Slater's previous 40-odd purchases, is more about buying more earnings for a market that has become addicted to growth than the opportunistic swoop for dominance, sceptics believe.
It has also caught the attention of some international short-sellers that seized on Quindelll's weakness with short-selling volumes in Slaters ticking up slightly. They will no doubt run the ruler over Slaters to see if it's an opportunity to bet against Quindell for a second time.  
With regard to the Quindell acquisition, the main question mark surrounds the scale of the deal in absolute and relative terms – which stunned some analysts and Quindell's competitors that had their distressed rival on death-watch.
Slaters tends to pay a multiple of 4 times earnings before interest tax depreciation and amortisation, but has coughed up 7 times for the Quindell deal.

Analysts had expected Slaters to pay a lower multiple given the distressed nature of Quindell's operation but, instead, they've paid what even bullish analysts have branded a full price.
The message from management is that the purchase price reflects the transformational nature of the acquisition. It makes adjustments for Quindell's troubled "noise-induced hearing loss" division, the heart of its problems. Quindell identified hearing loss as a potential source of lucrative claims and pursued them with vigour resulting in over 50,000 cases files being added, of which only a small fraction have been resolved.
Slaters says it knows a good deal when it sees one, having examined hundreds of legal and related firms in the UK and Australia for potential acquisition. It believes it has the best grasp of what constitutes value in a largely uncovered sector.  
So why have they done the deal? Well, ask the management, and most analysts, and you won't get much beyond the earnings accretion and market-share gain – this is a brave and opportunistic swoop by a team that has a near-impeccable record of disciplined and well-integrated acquisitions and should be backed, is what they say.
SHAREMARKET RESPONSE

But is M&A that simple? Can a company dilute the share register by more than 60 per cent to buy a tarnished and opaque business, which hasn't been audited in more than a year, at a premium to deliver windfall gains for shareholders? Yes.
Slaters tracked 6 per cent higher after resuming trading on Thursday, resulting in big profits for the funds that bought into the capital raising at a 15 per cent discount. They expect Slater's management to execute the opportunity successfully and deliver the earnings growth. The strong share-price performance following a discounted 2 for 3 capital raising is a show of faith rarely seen in any market.
But there are still nagging doubts, based on previous experiences in investing in acquisition-hungry professional services firms, that Slaters may have different motivations.
A large part of Slater's earnings story is tied to upward revisions to its "work in progress" – which Morgan's analysts described as "trust me accounting" – because it relies on judgment about the extent of work completed and the expected payment.
"Work in progress" is the accounting terminology for services provided where the revenue hasn't been received or invoiced. There is some discretion to account for this, as Quindell demonstrated, but Slaters uses a percentage of completion method. The more work it does on a case, the more its WIP, and its earnings, increase.
Slater's work in progress has continued to grow since it floated, largely through its acquisitions and after the deal it has now reached a WIP $1 billion.  
In the past, roll-ups including Quindell have had a habit of undervaluing WIP in the firms they buy, and then writing it up over time to boost earnings. How WIP is accounted for in an acquisition can give firms leeway in accounting for future earnings, and auditing sleuths look to make sure it's being matched by real cash intake.  
A steady rise in WIP is often associated with this practice because it points to a firm that's completing more work than its getting paid for. This creates a divergence between accounting profits and cash coming through the door, which pushes the financing capacity of deal-hungry firms to its limits.  
Quindell, for instance, dramatically increased its share count, tripling the number of outstanding shares from 2 billion to over 6 billion over two years.
Slater's WIP balance has risen sharply from $302 million in 2012 to $473 million in 2013 to $563 million in 2014. This UK deal will take its WIP to over $1 billion – an enormous pile of unbilled work.  
The Australian Financial Review has in the past highlighted this and two notable traits of Slater's accounts that at the very least suggest that the company is riskier than its surging share price implies.
One is divergence between its accounting earnings and its cash profits. Since 2007, its cumulative net accounting profit has reached $252 million but $295 million of cash has flowed out since it floated. Without this cash, Slaters has had to expand its share register by 150 per cent and call on debt to finance acquisitions. The risk is that without underlying cash generation, acquisitions can only be financed for so long, before true economic earnings emerge.
The other is Slater's extraordinarily low-tax bill. The Australian Tax Office hasn't shared in the spoils of Slater's great run having received precious little from the law firm despite its large earnings – less than $20 million since it listed in 2007. This is a reflection of acquisition accounting and investors should expect some degree convergence when the deals dry up.
Again, Slaters may have the hallmarks of roll-ups gone wrong, but Grech has done a good job of convincing many investors that the business is growing both organically and through deals, including the mega one he's just closed.   
He's won the trust shareholders by delivering consistently strong accounting earnings, and has successfully married each acquisition to its ever-evolving strategy.
With the Quindell deal, shareholders are not only putting in more money but even more faith in managements' ability to oversee an offshore acquisition full of multi-dimensional risks while ensuring their existing empire pays its way.