As Yogi Berra once said, it’s like deja vu all over again. That is, anyone who remembers the collapse of ABC Learning Centres will be having nightmares if they invested in embattled ASX-listed law firm Slater & Gordon.
The similarities between the fallen angels are so extraordinary that, by comparison, Star Wars: The Force Awakens feels like an original screenplay. Both ABC and Slaters were among the first of their kind to list. ABC at one point was the world’s largest listed childcare centre (by market value) while Slater & Gordon was briefly the largest listed law firm globally. Both were led by charismatic CEOs (Eddie Groves and Andrew Grech) who made substantial fortunes as their respective share prices appreciated (ABC would at one point be 1600% higher than its IPO price, while SGH showed 800% share price growth).
The two businesses also shared some less favourable traits. Both appear to have had difficulty understanding accounting principles and preparing financial reports. As Stephen Mayne pointed out back in July last year (when Slaters were trading at $3.40) both ABC Learning and Slater & Gordon were audited by embattled mid-tier firm Pitcher Partners.
ABC and SGH used similar acquisitive business models, initially using equity and later debt to mop up smaller firms before moving onto bigger targets. The roll-up model works well when smaller businesses are able to be bolted on and the acquirer effectively gets a free kick due to its higher earnings multiple — this means each acquisition is EPS accretive (increases the acquiring company’s earnings per share). The problem with this model is eventually, the music stops, usually because the acquirer becomes faster and looser with its acquisition practices and runs out of profitable targets.
This happened with ABC Learning Centres (which I detailed in Pigs at the Trough: Lessons from Australia’s Decade of Corporate Greed). Eddie Groves undertook a series of acquisitions — first in Australia and later in the US and UK. To undertake these purchases, ABC needed to borrow around $1.8 billion — its balance sheet became mired in dubiously valued intangibles (largely goodwill and childcare licences) of $2.9 billion. The following year, ABC would announce a shock profit result that had been inflated by highly dubious accounting practices — ABC also announced that its operating cash flows were negative. ABC’s financial statements had been seriously inflated by payments it had been receiving from developers (which it had been booking as ordinary revenue). ABC’s claimed $37 million profit in for the six months ending December 31, 2007, was really a loss of at least $80 million. Within a year, ABC would collapse, costing lenders, investors and taxpayers billions.
The similarities between ABC and SGH extend to their respective relationships between profit and operating cash flow. For most businesses, the two measures should be roughly the equal (profit should be similar to cash, but for some timing differences). When profit being materially higher than cash flow (for a sustained period) it is usually a sign that a business is not collecting cash from its customers (or worse, it’s inflating sales). SGH reported earnings before interest, tax, depreciation and amortisation of $102 million in 2014 and $124 million in 2015 — however, it had operating cash flow of only $54 million and $41 million respectively. Even worse, Grech told shareholders at the company’s AGM this year that while it was on track to generate earnings (before “work in progress”) of $200 million, it would record negative cash flow of $40 million for the first half of the year. This was allegedly due to a “slower than expected start to the year” Slaters’ UK business.
This has been a continuing theme — The Australian Financial Review noted back in 2014 that despite reporting profits of $200 million since 2007, Slaters had bled $160 million in cash.
Those who question Slaters’ earnings point to the fact that its earnings are a mirage — as the legal giant continued to acquire competitors, it increased its “work in progress” amount and therefore, its alleged profits. But like ABC, the profitability wasn’t real — it was like a high-finance version of “pass the parcel”. (ASIC announced an investigation into SGH and Pitcher Partners back in June, but the regulator has not yet announced its findings. Meanwhile, Slaters has started reporting EBITDA before “work in progress” changes).
As with most companies that rely on acquisitions to drive earnings growth, the music eventually stopped when Slaters paid $1.3 billion for controversial UK litigator Quindell. Possibly because it ran out of other firms to acquire, or possibly because the SGH management team started believing its own press, Quindell was a disaster in every sense of the word. Not only was it a patchwork quilt of acquisitions itself (with its own serious accounting issues, generously described by PwC as “aggressive”) but, even worse, Quindell was heavily reliant on fast-track motor accident minor claims, which would soon be restricted by the UK government.
Former Bank of America analyst Nadya Nilova, who was one of the first to question Slaters’ performance, claimed that Quindell was only worth around $550 million, far less than the $1.3 billion SGH paid. Given Quindell would later announce substantial losses in 2013 and 2014, it’s possible that the firm is actually worth nothing at all.
Like ABC Learning, SGH experienced an explosion of intangibles on its balance sheet — from a comfortable $108 million in 2013 to $1.2 billion in 2015 (most of which relates to Quindell). Between 2013 and 2015, Slaters balance sheet expanded from $598 million in total assets to more than $3 billion in assets, meanwhile operating cash flow barely moved.
As with ABC’s beleaguered executive suite, Slater & Gordon’s chairman and CEO spent much of 2015 not taking responsibility for the firm’s rapid downfall, instead blaming short sellers for the their predicament. Short sellers, of course, played no part in Slaters’ dubious accounting practices, nor its ham-fisted expansion into the UK, nor its abject failure to keep the market adequately informed of its continued performance. A CEO blaming short sellers is akin to an obese man blaming his doctor for telling him he needs to change his diet.
If the ABC experience is any guide, it would appear that Slater & Gordon probably won’t see out the year as a listed entity. It will almost certainly need to massively write down the value of intangibles on its balance sheet, while the debt and payables load of $1.3 billion will loom ever so large (compounded by the business’ terrible cash flow). In December, Slaters downgraded earnings — indicating not only is the company performing terribly, but management has no idea as to the extent of the problem and the profitability (or lack thereof) of their business. Just a few weeks earlier, Grech reaffirmed guidance at the Slater & Gordon AGM, claiming that the UK business would have a “strong recovery in the second half [of FY2016]”.
Slater & Gordon shares have continued to slide, closing yesterday at only 71 cents — 92% lower than its all-time high reached in April 2015.
Rest assured, if a company looks as rotten on the outside as Slaters, it’s likely the inside looks a lot worse.
*Correction: An earlier version of this article misreported Slater and Gordon’s 2014 and 2015 EBITDA. It also omitted that the negative $40 million cash flow mentioned at the AGM was for the first half of the year. It also misstated how much money Slaters has bled between 2007 and 2014 — it is $160 million, not billion.