slater & gordon

23 September 2015

Slater & Gordon is a research client of Edison Investment Research Limited

Slater & Gordon (SGH) proved it has been listening to investor concerns, has improved its disclosure and promised more in the future. FY15 results were somewhat distorted by accounting changes, but show good progression on a number of fronts. The management team continues to reiterate its cash and EBITDA guidance from the Quindell PSD acquisition. Our analysis indicates the material revenue acceleration and cost control to achieve management guidance is stretching, but not unachievable.

Year end Revenue (A$m)

PBT* (A$m)

EPS* (c)

DPS (c)

P/E (x)

Yield (%)

06/14 443.3 89.6 31.8 8.0 8.4 3.0 06/15 623.3 119.4 35.7 9.0 7.5 3.4 06/16e 1,265.3 274.0 57.9 10.0 4.6 3.7 06/17e 1,315.4 317.8 67.1 11.0 4.0 4.1

Note: *PBT and EPS are normalised, excluding intangible amortisation, exceptional items and share-based payments.

FY15 results The FY15 results have been somewhat obscured by accounting changes, but indicate significant progress on a number of operational fronts. Cash generation was disappointing and reflected higher marketing spend. Debt was also above market expectations, due to acquisitions and the timing of UK billings.

Tackling Quindell and accounting issues head-on There has been deafening noise around the accounting of the Quindell (QPP) acquisition (PSD, now Slater Gordon Solutions, SGS), which we believe has reduced attention on the key question: Can the experienced and focused management team at SGH deliver accelerated revenue and controlled costs to turn a loss-making business into a profitable one? SGH guidance implies an annualised revenue run rate up nearly 50% on June 2015, with costs running slightly below their June level. We have identified eight revenue factors and five cost drivers to achieve the majority of the targets, which would make the deal materially value enhancing if they are delivered.

SGH’s historic reporting meant the market could not reconcile cash receipts with revenue (albeit noting that cash was actually higher than expected). SGH has increased disclosure and has promised more once the Australian Securities and Investments Commission (ASIC) inquiry has concluded in the next few weeks. We believe the inquiry will lead to presentational adjustments. Based on management’s statements of confidence in its approach with the recent results, it appears probable that fundamental changes will have a modest, if any, impact on earnings.

Valuation: Considerable upside with triggers The average of our valuation approaches indicates a fair value of A$7.6/share (down from A$9.1). We now include a dividend discount model (A$6.0), diluting the average. The Gordon’s growth model is A$10.4 (previously A$10.2). The DCF model is A$6.3 (previously A$8.1). Given the cash flow characteristics of the business, cash-based valuations are below the accounting valuation. Delivery of results and more detailed accounting disclosures will be the triggers for a re-rating.

Slater & Gordon FY15 results

Starting the fight back

Price A$2.67 Market cap A$939m

£0.47/A$ Net debt (A$m) at end June 2015 623

Shares in issue 351.6m

Free float 92%

Code SGH

Primary exchange ASX

Secondary exchange N/A

Share price performance

% 1m 3m 12m

Abs (11.1) (57.5) (52.8)

Rel (local) (9.5) (53.6) (50.6)

52-week high/low A$7.9 A$2.6

Business description

Slater & Gordon is the leading consumer law firm in Australia where it has c 25% share of the personal injuries market. It entered the UK in 2012 and following recent acquisitions now has a c 12% share of the PI market. It was the first law firm in the world to list on the stock market (2007).

Next event

Accounting presentation Mid/late October 2015

Analysts

Mark Thomas +44 (0)20 3077 5700

Martyn King +44 (0)20 3077 5745

Moira Daw +44 (0)20 3077 5700

[email protected]

Edison profile page

Financial services

http://www.edisoninvestmentresearch.com/research/company/slater-gordon

Slater & Gordon | 23 September 2015 2

Summary

SGH's FY15 results saw 27% revenue growth across the group, with the company basis organic revenue growth of 11% (8% constant currency). There were improving normalised margins in Australian Personal Injury (PI), and UK General Law operations, the Australian General Law practice saw stable margins, while in the UK PI business margins fell with heavy investment in IT, marketing and office centralisation. Cash generation fell due to a delay in UK billings largely recovered in July/August. Non-cash elements of revenue and profit (such as movement in WIP and gain on bargain purchase) also increased in FY15, but are expected, by management and us, to be a lower proportion of revenue in FY16. Market expectations of debt levels had been built on the December pro forma included in the PSD acquisition presentation and appear not to have taken full account of the cash outflow for acquisitions, the Manchester fit-out costs and the dividend payment. Debt should fall sharply in FY16. We would characterise these results as delivering a strong franchise performance with weakness in cash generation.

SGH’s share price performance in recent months reflects:

concerns about the acquisition of Quindell’s PSD business (now branded SGS). While the strategic rationale for the deal appears eminently sensible, market confidence in the financial impact is less clear. There has been noise created by QPP’s historic accounting, which has led to uncertainty over the nature and risks of what it has actually bought, and whether the price paid was appropriate. We recommend investors look through this noise to answer two simple questions: can SGH management transform a loss-making franchise into one which is profitable and, if so, to what level of profitability? Management’s repeated reiterations make it clear that, with the benefit of inside knowledge and decades of direct experience, it believes it can. To achieve its targets we estimate requires the FY16 revenue run rate to be nearly 50% above the June 2015 level and the cost run rate c 10% lower. We have identified eight revenue factors and five cost drivers, which on balance we believe could deliver the majority of the management guidance. We also highlight how the delivery of the expected cash will lead to the unwind of some the accounting noise including the lower WIP in FY15 accounts compared with the acquisition presentation;

SGH’s own accounting has come under scrutiny. Management has clearly been listening to market concerns about its accounting disclosure and practices and has taken action. It will adopt the harsher standards required by AASB 15 in June 2016 (adoption only required in 2018) and with these results broken-down revenue disclosure so investors can identify the non-cash elements (especially the change in the WIP). It has further introduced a new measure EBITDAW (earnings before interest, tax, depreciation and change in WIP) to give better visibility on the cash generation. Further information is expected in a presentation once the ASIC review is finalised. We believe that the time it has taken for this review to conclude indicates that some changes may be expected. Management’s reassertion of confidence in its approach so close to the review’s conclusion, leads us to believe that revisions will be presentational or of relatively insignificant scale. Our forecasts are based on the existing accounting basis and will be updated for new accounting approaches once we have the appropriate disclosure/historic comparisons; and

cash reconciliation and generation have also been issues: historic disclosure meant that cash receipts could not be exactly reconciled with revenue, with the actual cash flow higher than can be identified from the available information. While SGH has increased its disclosure with the FY15 results, more detail is expected when the accounts are published and the ASIC review is completed. In the section below we highlight the key drivers to reconcile receipts to revenue –


in particular what is in revenue but not receipts and vice versa, the ratios on which we believe investors should focus, and the business model and its cash flow characteristics.

We also review operational leverage (noting the adverse impact of mix from UK acquisitions), growth options (adjusting the 13.8% company long-term trend for FX and post-acquisition new business), third-party disbursements, the impact of terminating the Swinton contract in SGS and acquisition accounting.

Key issue 1: FY15 performance

The accounting noise and acquisition effects have clouded some of the key business messages from the FY15 results. PI units in Australia and the UK each generated c A$211m of revenue and General Law operations A$56m and A$48m respectively. The themes we believe to be most important are:

Australian PI revenue and EBITDAW, both up 12% with a slightly lower EBITDAW margin of 19.5% (FY14: 20.5%). The operation in Queensland has faced challenges from changes in the regulatory environment, but these are now stabilising and other states have seen strong growth;

Australian General Law revenue up 31% and EBITDAW up 23% and a stable normalised EBITDAW margin of 3%. Revenue and profit were helped by acquisitions, but the former still generated double-digit growth on an organic basis. The strategy of broadening the brand from PI is a continuing feature and management expects stronger growth from these units;

UK PI revenue up 48% and EBITDAW up 11%, with a normalised EBITDAW margin of 13.5% (FY14 17.5%). The growth has benefited from positive FX effects of c 7%. Acquisitions have been “performing well”, but the group has invested heavily in its new centralised Manchester office, IT systems and marketing;

UK General Law revenue up 22% and EBITDAW up 67% and with an improving normalised EBITDAW margin of 8% (FY14 6%);

despite rising revenue and profits, the net cash provided by operating activities fell from A$54.4m to A$40.8m. As noted above, greater proportion of revenue and profit being generated from non-cash items such as gain on bargain purchase (EBITDA impact A$17m). Additionally, we understand there was A$7m of WIP acquired from Quindell as part of the advance agreement, one-off lease payments of $1.5m and the AASB payments to owners of $2.8m. Combined with a delay in the UK bill (recovered in July/August) and acquisitions post the SGS deal, net debt (A$623m) was above expectations, with gearing at 43% of equity. If management guidance is achieved, gearing should fall to 34% by June 2016;

acquisitions: management made it clear that bedding down the current integrations will be the key priority and it is not looking for further acquisitions at this stage;

on SGS, the decision not to continue with the c £25m income Swinton contract means the original revenue target of £340m is now a stretch. However, the relationship was low margin and only contributed £1m of EBITDA. Management has reiterated its guidance for £95m of EBITDA in FY16, with an unchanged cash generation forecast; and

for the FY15 accounts management included only A$158m of WIP (against the acquisition pro forma of A$420m) as it eliminated all the WIP associated with noise-induced hearing loss and has given a lower valuation to other legal and complementary services (see Exhibit 2 below). This change increases goodwill and is an accounting issue – management emphasises that cash flows are largely unchanged. The balance sheet at FY15 is still provisional and should SGS deliver as expected, much of this adjustment will be reversed. We recognise that until this


is seen in the FY16 accounts, some investors may perceive the WIP write-down as SGH buying a less valuable business. We discuss this in more detail in the section below.

Key Issue 2: SGS operations (Quindell’s PSD operation)

Summary The strategic rationale for the acquisition of Quindell’s PSD operations appears eminently sensible. Market confidence in the financial impact has been dented by the noise created by QPP’s historic accounting practices, which have led to uncertainty over the nature and risks of what it has actually bought, and whether the price paid (upfront consideration £637m) was appropriate. We believe investors should look through this accounting noise and satisfy themselves that SGH can answer two simple questions: can new management transform a loss-making franchise into one that is profitable and, if so, to what level of profitability on accounting conventions acceptable to the market? Management’s repeated reiterations make it clear that, with the benefit of inside knowledge and decades of direct experience, it believes it can. We estimate that to achieve the targets requires the SGS revenue run rate to be nearly 50% above the June 2015 level and the cost run rate c 10% lower. We have identified eight revenue factors and five cost drivers, which on balance we believe could deliver the majority of the management guidance. We outline the regulatory position and risks later (Appendix 3), but our conclusion is that management has set stretching but not unobtainable targets.

Strategic rationale Although rather overshadowed by subsequent events, SGH gave a presentation on the acquired PSD businesses on 24 June. We will not reiterate all 47 slides here, but the key takeaways were the strategic optionality from a business with much stronger UK portal presence, increased scale in a market where business models need to achieve operational efficiency and a refocus of PSD away from uncertain, long-duration hearing loss and back into its historic core of short-duration, low nominal value, mass-market, road traffic accident (RTA) claims.

Can a loss-making business be turned around and, if so, to what level of profitability? No one disputes that SGS is loss-making. In its one month of ownership, it reported revenue of A$37m and costs of A$43m and a pre-tax loss of A$6m (£3m). The following are key to turning this into a sustainable profit:

Increasing revenue: to hit management guidance we believe the run rate of revenue needs to be c 50% above that delivered in June 2015 (adjusted for loss of Swinton revenue and costs). We note that before and during the initial acquisition process staff will have been distracted about internal matters and concerns for their own job prospects rather than generating external revenue. To a smaller degree, this may also have affected potential customers, especially corporate ones. In practice, during any restructuring process the practical disruption to business can be very significant. SGH claims to have the capability to implement state-of-the-art workflow management systems, the application of which will mean that more cases can be managed by existing staff. Management indicates that PSD’s focus on NIHL meant it turned away RTA cases that will now be undertaken. The speed of RTA settlements is much faster, allowing a faster churn of business. There should be some benefit from focusing more on a single product, allowing greater specialism. Revenue growth has an element of seasonality – there are fewer road traffic accidents in summer, so one may expect June to be below an

https://media.slatergordon.com.au/investor-presentation_0.pdf


annual average run rate. Additionally, the FY16 number will include an element of income from Swinton (contract lasts until October and the existing RTA cases will continue to generate income beyond this), which is not in the adjusted June number. FY16 should include an element of revenue from NIHL cases, where settlement over the next 12 months is likely to be above the level seen in June 2015 given the time it takes these cases to reach completion. Changes in the regulatory environment present both threats and opportunities to revenue. As noted in Appendix 3, significant changes were implemented with the Jackson reforms, the effects of which we believe are now largely in the market. Future changes such as the MedCo proposals (also outlined in Appendix 3) could threaten some of SGS’s revenue streams. However, the potential amendments are likely to have a more adverse effect on smaller players that do not have economies of scale, making their business models less viable and creating the opportunity for SGS to gain profitable share.

Improving efficiency: to hit management guidance we believe the run rate of costs needs to be c 10% below that incurred in June 2015. For cost growth to slow we note that focus should allow even more specialism and operational efficiency. RTAs should incur lower external costs than the more complex NIHL cases. In June 2015 there will have been costs associated with the acquisition transition period, including consultant fees, which should not recur at an annualised rate. Exiting the Swinton contract should free up resources, which can either be devoted to higher-margin business or do not need to be incurred. Integration synergies are relatively minor but provide upside. SGH is not claiming there will be material cost savings, with any benefit from shared IT, central resources (such as compliance) and procurement being relatively minor.

Exhibit 1 below highlights the composition of both our forecast and management guidance compared with the June 2015 actual reported performance. In essence, it requires an acceleration in the revenue run rate to an annual 16.1-17.5x the June (one-month) level and a deceleration in the cost run rate to an annual between 9.1-10.5x the June level.

Exhibit 1: Comparison between June actual and Edison and management forecasts £m Jun-15 actual* Edison FY16e Edison FY16e vs Jun 15 (x) Mgt guidance* Mgt guidance FY16e vs Jun 15 (x) Revenue 18 290 16.1 315 17.5 Costs -21 -205 9.1 -220 10.5 Source: SGH, Edison Investment Research. Note: *Adjusted for lost revenue on the Swinton contract.

Acquisition accounting The complexity and uncertainty over what has been bought has not been helped by SGH adopting different accounting approaches for its FY15 accounts than it indicated in the acquisition presentation and statements.

Exhibit 2: SGS balance sheet – acquisition pro forma against FY15 accounts A$m Acquisition pro forma FY15 accounts Cash 0 35 Receivables 372 260 WIP 420 158 Intangibles assets 141 59 Other assets 11 76 Total assets 943 688 Payables (239) (360) Borrowings 0 0 Other Liabilities (112) (5) Total Liabilities (351) (365) Net assets 592 323 Source: SGH slide 28, Edison Investment Research

The key variances are: no WIP for NIHL, lower valuation of other legal and complementary services WIP reflecting revised accounting policies and an increase in payables. If the NIHL portfolio were to


deliver the full payout under the sale agreement, it would account for the majority of the WIP reduction.

Bears will highlight that management is now ascribing a much lower value to the work in progress (WIP) and that the business bought was thus less valuable. Management counters this argument by highlighting that the expected cash flows are unchanged and that it is only the current valuation of WIP that has changed. As noted above, the FY15 balance sheet is provisional and the adjustments will be amended to reflect actual performance.

We believe that investors should consider the scenario of what will be presented if management forecasts of an unchanged cash generation on the lower WIP are actually delivered. Cash realisation would be in excess of WIP and would require either a restatement of opening WIP, and intangibles back to the acquisition presentation level, a reserve adjustment possibly taken through comprehensive income, or the gain to be taken as revenue through the P&L. We note management's comment on the year-end presentation (slide 28), which points to the first option.

Risks

Some limited risk to SGH from QPP reviews We believe SGH exposure to the FCA, Serious Fraud Office and Financial Reporting Council reviews currently being conducted on QPP is limited, noting that it is valuing the business on its own assumptions rather than QPP’s, it bought the PSD operations, not the QPP legal entity and any legal/regulatory fallout from the accounting by QPP will be borne by that company, in operational terms management has indicated that relatively few staff are likely to be involved in the inquires, historic records are kept by QPP and it will be for QPP financial control staff to respond to any queries, and the QPP name was not used for branding and the customer impact to date has been limited.

We believe there will be some operational impact as some members of senior management focus on the ongoing enquiries rather than generating growth, but the scale of this problem appears modest. It is early days, but we also believe that the Solicitors Regulatory Authority (SRA) is likely to review its approach to legal firms being too big to fail and, in particular, how litigants can be protected in the event of a failure of major provider. We believe SGH’s control of PSD will give considerable comfort compared with QPP ownership, but the SRA may look to apply incremental regulations in due course.

Accounting noise from Quindell We see little value in considering the historic numbers produced by QPP on its now discredited old accounting policy. Comparing SGH’s assumptions with the revised numbers put out by Quindell on 5 August (slide 15 provides a user-friendly review) should give investors some comfort that the issues identified and correcting adjustments made by SGH were reasonable. We remind investors that Quindell may now be expected to adopt an extremely cautious approach to its accounting. The change in revenue on both approaches is similar and largely accounted for by the effective elimination of NIHL cases in both instances. The net asset value of the business sold on the revised accounting standards as disclosed in QPP’s recent results was £303m. In SGH’s accounts the NAV acquired is £323m: we believe the difference primarily reflects timing differences in cost recognition.

Key Issue 3: Accounting

Management has clearly been listening to market concerns about its accounting disclosure and has taken action. Further information is expected in a presentation once the ASIC review is finalised

http://www.sra.org.uk/home/home.page

http://www.quindell.com/wp-content/downloads/2015/Investor/FRP2014.pdf


(management indicates end September/early October). We believe that the time it has taken for this review to conclude indicates that some changes may be expected. Management’s reassertion of confidence in its approach so close to the review’s conclusion leads us to believe that revisions will be presentational or of relatively insignificant scale. It is unsurprising that management would wish to wait for the review to conclude before providing further incremental accounting detail.

Given the focus on accounting (Appendix 1), we remind investors of the theoretical accounting adopted by SGH and how it feeds through to the profit and loss, balance sheet and cash flow statements. In Appendix 2 we consider the basis for using assumptions (and how SGH is not unusual in this regard), as well as some of the risks in this approach.

Action taken with FY15 results Management has clearly appreciated that investors want more information and with the FY15 results has:

broken fee revenue down into fees and net movement in WIP. The market concern over the use of assumptions in WIP can now be put into context. The net movement of WIP was 12% of revenue in FY15 and 11% in FY14. The vast majority of fee revenue is thus not based on WIP assumptions and investors have visibility on those elements that are; and

announced it will adopt the new accounting standard (AASB 15) early, ie in FY16 (it is only required to be applied annual reporting periods beginning on or after 1 January 2018). While the new standard means revenue can still be estimated using expected value (the sum of probability-weighted amounts), for variable consideration such as SGH’s it can only be included if it is “highly probable” that there will not be a significant revenue reversal. This test is higher than the current approach and so is likely to see a slower recognition of revenue. There is also greater disclosure on things like assumptions than is required at present.

SGH’s historic disclosure made detailed reconciliation between revenue and cash receipts impossible. While the actual cash produced was higher than may have been expected, the lack of reconciliation raised concerns about the prudence of the accounting adopted. We expect this issue to be addressed in detail in the post ASIC presentation.

ASIC review On 29 June SGH announced that it had been advised by its accountants (Pitcher Partners) that ASIC would be raising some questions directly following the routine review of accounting practices. SGH engaged Ernst & Young to assist in this matter. Further, the company had identified the double counting of certain UK disbursement and tax items in the cash flow statement, which in turn led to both higher cash receipts and cash payments. These entries were offsetting, importantly leaving net cash receipts unchanged, but the market was unsettled by the fact that there was a flaw in the internal control processes, which could overstate gross cash receipts by 12% in FY13 and 8% in FY14. Confidence had not been helped by SGH having previously announced on 24 June that neither it nor Pitcher Partners had received any targeted enquires from ASIC. Looking forward, we would expect that all aspects of the accounting principles and processes to have been thoroughly reviewed, markedly reducing the risk of a repetition of this type of embarrassing error.

With these results management indicated that the review has taken longer than expected (but should conclude shortly) and re-emphasised the board’s confidence in the existing approach. We interpret these comments to mean that there may be presentational changes but that any fundamental revisions are likely to have only a minor impact.


Key issue 4: Cash conversion

Historic disclosure meant cash receipts could not be reconciled exactly with revenue, with the actual cash flow higher than can be identified from the available information. While SGH has increased its disclosure with the FY15 results, more detail is expected when the accounts are published and the ASIC review is complete, probably in late September/early October. In the section below we highlight the key drivers to reconcile receipts to revenue, the ratios on which we believe investors should focus and comments on the fundamental business model and its cash flow characteristics.

Key drivers to reconciliation When we have the detail with the report and accounts, we will provide investors with a more detailed quantification of the issues below. In the meantime, we believe investors should consider the factors that result in revenue and receipts not reconciling.

Items in revenue, but not in receipts WIP: the statutory revenue numbers include the change in the value of the WIP, although the

cash is only realised after the successful completion of the case. SGH’s new disclosure is helpful in breaking out this effect from revenue.

Interest income: interest income is in the other income line and separately reported in the cash flow statement below customer receipts. It also includes a notional interest on VCR loans, which again is not in receipts.

Items in receipts, but not revenue Receivables: changes in timing of when SGH invoices are paid will affect the receivables in the

balance sheet and cash receipts, but do not show in revenue.

Bad debts: bad debts are shown as a cost in the profit and loss, but reduce cash receipts.

Sales taxes: sales taxes are not included in WIP or revenue, but are included in debtors and cash receipts. For net cash this effect is offset in creditors and cash paid to suppliers, but means the cash receipts are above the revenue reported. The precise impact is not quantifiable from published information as it is complicated by the treatment of non-recoverable against recoverable VAT payments, on which we have limited disclosure.

Forex movements: when sterling appreciates against the Australian dollar and an invoice raised by the UK subsidiary is paid after a period end, the Australian dollar value of the receipt will be higher than reported in the last set of accounts. The difference on the settlement of the invoice will be reflected in “other comprehensive income” as foreign currency translation differences, not in revenue.

The lack of disclosure to enable detailed reconciliation has led to speculation in various quarters over other issues. The uplift when a case concludes against previous assumptions (which can be up to 25%) is in both revenue and receipts and is not a distortion between the two.

Ratios to consider In the exhibit below, we highlight some of the cash conversion ratios investors may want to consider and a number of important business trends:

The higher cash receipts to WIP (2016e on 2015) reflect the shorter-duration SGS cases together with a catch-up effect re the delayed billing in FY15 carrying cash collected into 2016.


The increase in cash receipts to total revenue reflects our forecasts assumption of zero gains from bargain purchases in 2016-17e. Fees become a greater proportion of total revenue and so the non-cash items are a smaller percentage.

We have given credit for the company nearly achieving its target of c 100% cash conversion of EBITDAW. This is a marked improvement on FY15 performance and is due to non-recurrence of non-cash bargain gains, non-repeat of one-offs noted on page 3 above, timing of billing and inclusion of higher-margin SGS businesses with faster time to settlement.

The operational efficiency issue is also shown by the improvement in trend of payments to suppliers against cash receipts.

Exhibit 3: Some key cash conversion ratios 2014 2015 2016e 2017e Cash receipts as % opening current WIP n/a 183% 220% 214% Cash receipts as % total fee revenue 112% 103% 103% 107% Cash receipts as % total revenue 93% 84% 96% 99% Cash payments as % expenses 105% 95% 103% 107% Gross operating cash as % EBITDA 58% 43% 75% 76% Gross operating cash as % EBITDAW 96% 85% 97% 99% Gross operating cash as % NPAT 86% 68% 113% 111% Payments to suppliers as % receipts -84% -89% -82% -81% Source: SGH, Edison Investment Research

Business model cash flow characteristics We are expecting a significant improvement in cash generation in FY16, but note investor concern that to date cash generation has not followed franchise growth. We regard low free cash generation compared with accounting profit on a short-term basis as inevitable in a business in this market where growing case files require cash funding. It is not unlike other businesses where cash receipts trail costs materially (eg the whole life industry) and where investing in work in progress will have a working capital drag. Strategically, investors wanting an immediate cash generative option should not be investing in a growing legal firm.

The critical issues are as follows:

Firstly, does the company generate the expected cash over time, even if it does not do so in the current period? While reconciling revenue to cash is not exact, our analysis indicates that over time the variance is relatively modest and should give considerable comfort in this area.

Secondly, investors need to have confidence that the total return by the business not only covers its upfront costs, but also compensates them for the later delivery of returns (at cost of equity not cash costs). SGH has consistently delivered mid-teens returns on equity (a credible number if one accepts that the variances to cash over time are modest).

Thirdly, will the company run out of working capital? The pricing of the facility to fund the PSD acquisition would suggest financers are very comfortable with SGH’s creditworthiness. Our forecasts indicate a falling net debt position though to June 2017, a trend in line with management guidance.

Fourthly, access to funding is a key SGH competitive advantage. Financing no-win, no-fee portfolios is an industry issue and SGH’s scale and access to capital markets means its carry cost is lower than smaller legal practices.

Lastly, SGH could become free cash flow generative by stopping new business. It is the relative growth of new business against maturing cases in the portfolio that requires funding.


Other issues

Lack of operational leverage In Exhibits 4 and 5 below, we detail the 2007-14 trends in revenue, operating costs and EBITDA (all on a consistent accounting basis). Over the long term, revenue and operating costs have broadly tracked each other. We note that the largest negative gap between revenue and costs occurred in 2012 when the consolidation of the initial UK acquisition brought in a less efficient business. This structural change saw costs rise materially faster than revenue (29% vs 19%). We also note the growth in marketing expenses as SGH builds its brand.

Exhibit 4: Revenue, operating costs and EBITDA indexed to 2007 (100)

Exhibit 5: Revenue less growth in costs (%)

Source: SGH, Edison Investment Research. Note: On previous accounting basis for long-term trends.

Source: SGH, Edison Investment Research. Note: On previous accounting basis for long-term trends.

It is nonetheless disappointing that operational leverage has not been more visible from a model driven by the industrialisation of many legal processes. Looking forward, there should be a positive mix effect from consolidating the PSD business, which is at margins above the group average. Brand recognition has improved markedly (eg UK unprompted brand awareness 24% in FY15 vs 11% in FY14) and the need for incremental increases in marketing should moderate. Management has outlined a number of operational improvements and efficiency programmes that may be expected to show some leverage.

Lack of growth options Management highlighted that organic growth since 2008 has shown a CAGR of 13.8%. This is flattered by exchange rate differences, although the effect is likely to be moderate. The FX effect (c 24% FY15 on FY13), assuming the UK was around a third of organic revenue, would be less than £14m, reducing the exchange rate-adjusted CAGR to 12.6%.

Exhibit 6: Organic revenue (A$m) since FY08 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 CAGR Organic revenue 70 85.7 98.5 110.4 108 114.6 154.9 172.6 13.8% Growth on prior year 22% 15% 12% -2% 6% 35% 11% 13.8% Source: SGH, Edison Investment Research. Note: SGH definition of organic growth includes revenue generated from businesses after they have been acquired.

The table clearly shows how volatile particular periods can be. FY14 saw 35% organic growth after just 6% in FY13. There will be periods when the regulatory environment is not favourable and so organic growth is under pressure. However, the average double-digit growth is very encouraging.

The growth figures do include organic growth delivered once an acquisition has been made (ie new files opened after the deal has concluded) and so have the benefit of the larger franchise post acquisitions. We note that the 35% growth in FY14 will only have had a minimal benefit from this

0100200300400500600700800

2007 2008 2009 2010 2011 2012 2013 2014

Index

ed to

2007

Total revenue Total operating costs EBITDA

-12%-10%-8%-6%-4%-2%0%2%4%6%8%

2008 2009 2010 2011 2012 2013 2014


factor given the absence of deals in FY13. Management guidance has for some years been c 5% for PI business and 8% for General Law.

Third-party disbursement funders – economics to SGH’s benefit We note the adverse press commentary on SGH's relationship with Equal Access Funding (EAF), a third-party funder of legal case disbursement. In Australia, law firms can fund these costs, to be repaid at settlement, but cannot charge the client interest, and financing the disbursements can prove expensive. EAF provides such funding direct to the client under a consumer credit contract. The group’s use of third-party funding is modest when compared with its WIP and the level of disbursements, although historically a more significant element of net debt. Following the PSD acquisition, and A$375m facility to fund it, pro forma third-party funding will fall to less than 5% of net debt.

Exhibit 7: Third-party funding 2010 2011 2012 2013 2014 Gross amount (A$) 306,326 9,289,925 6,700,697 8,759,653 19,048,164 As % WIP 0.3% 5.0% 2.7% 2.9% 4.0% As % disbursements 0.8% 18.2% 10.6% 13.3% 14.2% As % net debt 6.0% 21.3% 6.4% 27.3% 18.8% Maximum exposure (A$) 306,326 9,289,925 6,700,697 8,759,653 12,881,278 As % WIP 0.3% 5.0% 2.7% 2.9% 2.7% As % disbursements 0.8% 18.2% 10.6% 13.3% 9.6% As % net debt 6.0% 21.3% 6.4% 27.3% 12.7% Source: SGH Report & Accounts (other commitments and contingencies note), Edison Investment Research

The concerns raised about this relationship are:

the debt is generally repaid from proceeds of the settlement or a court outcome. However, SGH guarantees the repayment of the funding debt (excluding accrued interest and fees, which are written off by EAF). In practical terms the guarantee is only called on when a client fails in their claim. Concerns about this guarantee miss the economics of the situation. SGH would have incurred the same loss in the event of an unsuccessful claim and is no more at risk than if it funded disbursement directly. It is arguable whether disclosing this liability on the balance sheet or in the notes to accounts is material to understanding the risk;

the scheme is technically legal (SGH is not arranging the financing), but may be seen as going against the spirit of the law and could thus lead to the law being changed in due course; and

Mr Henderson, who worked for SGH for 29 years until March this year, is a director at EAF and a significant shareholder. This close relationship has raised some concerns about corporate governance (eg in the FT on 24 July), but we note that it is all in the public domain and it would be unusual for EAF not to have someone with industry experience on its board.

End of Swinton relationship SGH announced on 27 July 2015 that the first notification of loss services contract with Swinton would end on 31 October. This deal is one of the larger contracts for revenue, accounting for c £25m of SGS’s income. The margin was slim with the contract generating just £1m of its £95m company estimated EBITDA. Management clearly believes that the resources currently devoted to the this contract can be better deployed elsewhere in the business.

The unit was a source of referrals for legal services (we understand c 8% of total introductions), but management indicated that pre-acquisition PSD was turning away significant numbers of referrals to focus resources on NIHL cases. Assuming this is correct, the loss is unlikely to affect the outlook for the legal services unit.

Quindell has previously made much of this relationship with a high-profile introducer of business, but the profitability was limited. SGH will now focus on margin in a way not followed by previous


ownership. Management has indicated that counterparties are generally happy with the change of control and we do not expect further material announcements on contract losses.

Acquisition accounting including goodwill assumptions

Acquisition accounting to manage profitability The bears have argued that a company making regular acquisitions never has truly comparable accounts and acquisition accounting can be used to manage reported earnings with, for example, taking a larger than required goodwill hit and then having correspondingly higher earnings. For a company such as SGH this would be achieved by having a low WIP on acquisition, but then increasing the WIP/seeing cash generated once the deal has concluded.

Acquisitions have been a feature of the business but need to considered in context. Acquired WIP (company basis) has from 2007-15 annually averaged 17% of opening WIP and 14% of revenue (see Exhibit 8). Excluding the UK deals in 2012 and 2014, both numbers drop below 10%. For there to be a major distortion to earnings, the understatement of WIP would need to be huge relative to the WIP reported, which makes avoiding a goodwill write-down after the first year nearly impossible.

Exhibit 8: Impact of acquired WIP (2007-14) 2007 2008 2009 2010 2011 2012 2013 2014 2015 Average As % opening WIP 4% 19% 5% 7% 39% 19% 4% 40% 21% 17% As % revenue 4% 16% 4% 5% 26% 17% 4% 29% 18% 14% Source: SGH, Edison Investment Research

Goodwill Some bears have noted changed assumptions on goodwill and concluded that SGH has been more aggressive. In particular, the discount rate applied in the calculation was reduced from 10.2% in Australia and 9.4% in the UK in 2013 to 9.1% and 8.8% in FY14 respectively (FY15 numbers will be available when the report and accounts are released). A lower discount rate means that future cash flows have a higher net present value and so a goodwill impairment is less likely. The fall in the UK discount rate used was despite a rise in long-term government yields over this period. We note that:

the discount rate is country specific and reflects the WACC in each area. There has been a steady reduction in discount over several years (eg Australia 2011: 11.1%, 2012: 10.5%, 2013: 10.2%, 2014: 9.1%), primarily driven by the fall in Australian government bond rates (from over 5% at the start of 2011 to less than 3% now). Additionally, as credit spreads have improved in the years following the credit crisis, all other things being equal, the WACC may be expected to fall;

the discount rates have risen as well as fallen (eg 2010: 11.0% to 2011: 11.1%); and

historically, SGH used a relatively high equity risk premium of 6% (2012 last disclosure).

Fee growth expectations has also increased from 5% real in 2013 to 5-8% real in FY14. We note that in 2014 the key acquisitions were all in the UK, a market SGH has consistently stated that it expected to show greater growth than Australia. While the company’s 13.8% organic growth benefits from FX and post-acquisition new business, the assumptions used do not appear unduly unrealistic.

Valuation

The average of our valuation approaches indicates a fair value of A$7.6 per share (down from A$9.1) and equivalent to 13x FY16e earnings). The decrease is due to the inclusion of a lower-valuation dividend discount model (A$6.0), reflecting an increased investor focus on cash. The


Gordon’s growth model is A$10.4 (previously A$10.2). The DCF model is A$6.3 (previously A$8.1) and reflects a lower cash receipts adjustment (see section on financials), partially offset by rolling forward the valuation by a year. It is unsurprising that a model based on accounting equity would show a higher valuation than cash-based models given the cash flow characteristics of the business. Over the long term, we would expect the two to be more closely aligned.

Peers Shine Corporate (ASX.SHJ) is a quoted Australian law firm and trades at c 12.5x 2015e earnings. In November 2014, IPH (an Australian intellectual property services company and patent lawyer) floated on the ASX and now trades at a prospective P/E of c 35.0x. We note that Fairpoint (AIM.FRP, December 2015e P/E 9x) has been moving into the PI legal services space through acquisition and post its 3 August 2015 deal, legal services will now be the majority of earnings. Gateley (AIM.GTLY) listed on 8 June 2015 and provides UK legal services across five core groups to more than 4,000 corporate and 1,500 private clients. There is a range of litigation funders (eg Bentham IMF [ASX.IMF] and Burford Capital [AIM.BUR]), but their earnings streams are more dependent on specific cases than the mass market and we do not consider them good comparators. National Accident Helpline (AIM.NAHL), while focused on the UK personal injury market, may be considered more of a consumer marketing business than a legal services business.

DCF value (A$6.29 from A$8.05) We have generated a discounted cash flow valuation (DCF) for SGH of A$6.29 per share. Our model uses two years of forecasts and 10 years’ growth at 5%, with the terminal value calculated on a multiple of 15x cash flow (a rating reflecting that this is free cash flow not an EBITDA measure) and all cash flows discounted at a rate of 10%. The drop from our last valuation reflects the reduction in cash receipts adjustments partially offset by rolling forward the valuation by a year.

Dividend discount model value (A$5.96) We have introduced a dividend discount model to reflect the market’s increased focus on cash and direct investor returns. Our model uses two years of dividend forecasts, beyond which we assume a two-thirds payout ratio (derived from 15% ROE to fund 5% growth). The third year earnings on which we base this are our 2017e inflated by our growth assumption of 5%. The dividend is then growth for 10 years at 5%, with the terminal value calculated on a multiple of 15x. All dividends are discounted at a rate of 10%.

Gordon’s growth model (A$10.43 from A$10.18) To capture the value added by the business, we believe it appropriate to use an accounting equity-based Gordon’s growth model, which measures long-term returns on equity against cost of equity and growth. Overall, we assume a long-run ROE of 15%, which is broadly in line with medium-term experience and forecast levels. For the cost of equity we assume 10%. We have assumed long-term equity growth of 5%, somewhat above nominal GDP, reflecting further material UK market share opportunities for several years. The forecast ROE is around our long-run average, but the near-term growth is well above and we have built in a premium of 2015 to reflect this growth. The sensitivity to these assumptions is given in Exhibit 9 below. The accounting changes introduced by SGH have resulted in an uplift in statutory equity increasing our valuation since the last report.


Exhibit 9: Gordon’s growth model and sensitivity Central ROE +1% COE -1% G+1% Return on equity (%) 15 16 15 15 Cost of equity (%) 10 10 9 10 Growth (%) 5 5 5 6 Implied P/BV 2.00 2.20 2.50 2.25 NAV 2016e (A$) 4.53 4.53 4.53 4.53 Implied price (A$) 9.07 9.98 11.34 10.20 Discount/premium re ST growth performance (%) 15% 15% 15% 15% Implied price (A$) 10.43 11.47 13.04 11.73 Source: Edison Investment Research

Financials

With the changes in accounting, the statutory numbers cannot really be compared with our previous forecasts. The change in accounting for deferred consideration increased FY15 profits but will reduce them in FY16. Noting this caveat in our FY16 estimates we have:

increased Australian revenue from A$318m to A$328m, but reduced the EBITDA margin from 24% to 18%;

taken UK non-SGS revenue from A$312m to A$323m significantly affected by updating the exchange rate from A$1:£0.52 to A$1 £0.47. This is a slightly better rate than assumed in management guidance and our overall fees are slightly above the management level; and

cut SGS revenue from £340m to £290m and EBITDA from £95m to £85m. The main driver has been the lost Swinton contract (£25m revenue and £1m EBITDA). In A$ the revenue cut is from A$654m to A$622m with the business trend partially offset by the exchange rate effect.

In addition:

our normalisation process for pre-tax profits and earnings has seen some more material changes with the net benefit increasing in FY16 from A$7m to A$20m. This is primarily related to excluding payments to former owners A$14m. In FY15 the normalisation adjustments are now A$9m (from A$5m);

our WIP assumption has gone from A$1,265m to A$908m primarily due to the change in accounting for the SGS acquisition; and

our net operating cash generation has been reduced from A$232m to A$163m In the past we had made an allowance for cash receipts exceeding the level expected from revenue. To be conservative we have largely eliminated this adjustment.

Exhibit 10: Changes to forecasts* Revenue (A$m) Adj pre-tax profit (A$m) EPS (c) DPS (c)

Old New Change (%)

Old New Change (%)

Old New Change (%)

Old New Change (%)

FY15 623.0 623.3 0% 150.3 119.4 -21% 49.5 35.7 -28% 9.0 9.0 0% FY16e 1,277.9 1,265.3 -1% 296.1 274.0 -7% 64.8 57.9 -11% 10.0 10.0 0% FY17e N/A 1,315.4 N/A N/A 317.8 N/A N/A 67.1 N/A N/A 11.0 N/A Source: Edison Investment Research. Note: *Old estimates were on old accounting basis, new estimates on new accounting base making comparisons less clear.


Exhibit 11: Financial summary Year ended June A$000s 2014 2015 2016e 2017e PROFIT & LOSS Total fees (co guidance level) 366,415 506,739 1,174,477 1,216,361 Other revenue 76,896 116,609 90,822 99,081 Revenue 443,311 623,348 1,265,299 1,315,442 Cost of Sales 0 (16,662) (184,500) (193,725) Gross Profit 443,311 606,686 1,080,799 1,121,717 Adminsitration expenses (327,679) (475,048) (789,144) (791,209) Statutory EBITDA 115,632 131,638 291,655 330,508 EBITDAW (co guidance level) 75,606 84,743 221,629 252,223 Operating Profit (before amort. and except.) 115,632 131,638 291,655 330,508 Depreciation and amortisation (6,955) (9,945) (13,500) (14,500) Operating Profit 108,677 121,693 278,155 316,008 Net Interest (8,156) (11,468) (24,000) (18,000) Profit Before Tax (FRS 3) 100,521 110,225 254,155 298,008 Profit Before Tax (normalised) 89,640 119,353 273,988 317,841 Tax (22,523) (27,884) (64,242) (72,609) Minority interests (159) (271) (100) (100) Profit After Tax (FRS 3) 77,839 82,070 189,813 225,299 Profit After Tax (normalised) 65,111 84,518 205,679 241,165 Average Number of Shares Outstanding (m) 204.7 236.5 355.4 359.3 EPS - normalised (c) 32.34 35.99 58.15 67.43 EPS - normalised and fully diluted (c) 31.80 35.73 57.87 67.12 EPS - (IFRS) (c) 38.02 34.70 53.41 62.70 Dividend per share (c) 8.00 9.00 10.00 11.00 Gross Margin (%) 100.0% 97.3% 85.4% 85.3% EBITDA Margin (%) 26.1% 21.1% 23.1% 25.1% Operating Margin (before GW and except.) (%) 26.1% 21.1% 23.1% 25.1% BALANCE SHEET Fixed Assets 409,313 1,710,643 1,753,859 1,797,271 Intangible Assets 122,574 1,229,398 1,229,398 1,229,398 Tangible Assets 12,964 31,657 40,157 48,657 WIP 189,262 272,721 299,993 329,992 Other 84,513 176,867 184,311 189,224 Current Assets 505,434 1,311,440 1,348,523 1,476,668 WIP 284,077 553,177 608,495 669,344 Debtors 183,684 616,396 678,036 745,839 Cash 25,270 96,985 31,971 31,463 Other 12,403 44,882 30,022 30,022 Current Liabilities (219,550) (654,111) (689,933) (727,905) Creditors & other (210,473) (650,060) (685,882) (723,854) Short term borrowings (9,077) (4,051) (4,051) (4,051) Long Term Liabilities (266,825) (918,426) (786,890) (705,163) Long term borrowings (117,254) (716,302) (540,000) (400,000) Other (149,571) (202,124) (246,890) (305,163) Net Assets 428,372 1,449,546 1,625,559 1,840,872 CASH FLOW Operating cash flow 67,384 55,974 215,000 250,000 Net Interest (4,943) (6,571) (21,719) (21,719) Tax (8,006) (6,049) (13,936) (15,751) Other 0 (2,592) (16,694) (16,694) Net operating cashflow 54,435 40,762 162,651 195,836 Capex (4,769) (22,308) (24,000) (25,000) Acquisitions/disposals (120,827) (1,310,708) 0 0 Equity Financing 5,247 863,364 4,500 4,500 Net debt financing 81,075 528,051 (176,302) (140,000) Other (120) (18,907) 0 0 Dividends (9,907) (15,924) (31,863) (35,843) Net Cash Flow 5,134 64,330 (65,014) (508) Opening cash 20,056 25,270 96,985 31,971 FX 80 7,385 0 0 Closing cash 25,270 96,985 31,971 31,463 Opening net debt/(cash) 32,078 101,061 623,368 512,080 Closing net debt/(cash) 101,061 623,368 512,080 372,588 Source: SGH, Edison Investment Research


Appendix 1: Understanding the accounting

We believe it is important that clients understand the accounting for a legal services firm where part of the revenue is derived from assumptions on the work in progress (which is recorded in the balance sheet). The key business messages are that there is material cash flow strain from growing work in progress (and access to funding is an advantage for SGH, as is a workflow management that accelerates claim settlement).

Exhibit 12: Illustrative example of the accounting for legal services A$ Line Period 1 Period 2 Period 3 Period 4 Total Stage of completion 1 33% 66% 100% Probability of success 2 85% 90% 100% Balance sheet Cash 3 (9,667) (19,333) (29,000) 10,500 10,500 WIP 4 9,818 20,790 0 0 0 Debtors 5 1,500 3,000 39,500 35,000 0 Creditors 6 0 0 0 0 0 Net assets 7 1,651 4,457 10,500 45,500 10,500 Change in balance sheet WIP 8 9,818 10,973 (20,790) 0 Dr debtors 9 35,000 (35,000) 0 GST debtor 10 3,500 (3,500) GST creditor 11 (3,500) 3,5000 Cash 12 (9,667) (9,667) (9,667) 39,500 10,500 Paid disbursements 13 1,500 1,500 1,500 (4,500) 0 Legal creditors 14 (2,000) (2,000) Dr anticipated disbursements 15 2,000 2,000 Profit & loss Movement in WIP 16 9,818 10,973 (20,790) 0 0 Fees 17 35,000 35,000 Total revenue 18 9,818 10,973 14,210 35,000 Expenses 19 (8,167) (8,167) (8,167) (24,500) Net profit 20 1,651 2,806 6,043 0 10,500 Cash flow Receipts from customers 21 35,000 35,000 GST receipt from customer 22 3,500 GST paid to tax authority 23 (3,500) Disbursements 24 (1,500) (1,500) (1,500) 4,500 0 Profit & loss (expenses) 25 (8,167) (8,167) (8,167) (24,500) Net cash-flow 26 (9,667) (9,667) (9,667) 39,500 10,500 Source: Edison Investment Research. Note: By way of sensitivity if this illustrative deal completed in two years and not three, the end year one cash position would be -14,500, and net assets 2,625.

In Exhibit 12 we have taken a case where the expected remuneration to SGH is A$35,000, expenses A$24,500 and disbursements A$4,500, and it is expected to take three years to settle, with the expenses for the case evenly spread over the period. As time progresses, the probability of success increases from 85% to 100% at settlement. The accounting recognises the value of the case in the balance sheet work in progress (WIP) (line four) by taking the expected remuneration (A$35,000) x the stage of completion (line one) x the probability of success (line two). The change in WIP (line eight) is recognised as revenue in the P&L (line 16) where, in this example, it more than offsets the expenses incurred (line 19), thus generating a profit (line 20) and retained earnings in the balance sheet (line seven). However, cash is leaving the business to pay expenses (line 25) and disbursements (line 24), resulting in a worsening cash position (line three) until completion. On completion, the cash is received from the client including payments for disbursements. The financial position is thus critically dependent on assumptions of how long cases take to complete and success rates. New business incurs a cash flow strain, which has to be financed.


Appendix 2: Use of assumptions in generating revenue

We believe that the best test of accounting assumptions is to follow the cash. The new disclosure, breaking down revenue into fees and movements in the WIP, together with targeting cash generation against EBITDAW, is helpful. However, we appreciate why management believes this does not reflect the real value created in the franchise and so continues to use assumptions in its statutory accounts.

Many financial sectors see WIP assumptions feeding through to equity and profit and loss The use of assumptions in valuing WIP in the balance sheet is endemic across sectors. Manufacturers assume inventory has value (Ford Q215 inventories other than finished goods at $4.3bn are 16% of equity). Contractors typically also use stage completion methodologies. Indirectly, this impacts on earnings in that write-downs to inventory through changed WIP assumptions could see an impairment, but for most sectors the valuation of the WIP is not the key driver to earnings.

However, there are a range of industries in the financial sector where this is not the case:

Life company use of embedded value: the life industry in many countries addressed the problem of large up-front costs generating multi-year (often multi-decade) cash flows by using embedded value accounting. This has evolved over a number of years and disclosure is more advanced than at legal practices, in that it includes detailed analyses of variances against forecast assumptions. However, the principle of matching revenue and costs is the same.

The banking industry’s work in progress is its loan book: bad debt impairments, especially for mass-market customer portfolios, are significantly driven by assumptions on expected cash flows, often over several years. The accounting approach is not to say you should only value a loan when repayment is received, but rather to assess the likely repayment of loans.

Stage of completion revenue recognition: The concept The accounting adopted by SGH is termed “stage of completion revenue recognition” and reflects AASB 118 (Revenue), which requires that “Revenue is recognised when it is probable that future economic benefits will flow to the entity and these benefits can be measured reliably”. It adopts the logical approach of asking 'What will be the fees be if I win?', 'What is the probability that I will win?' and 'How much of the case have I completed?' A detailed worked example is given in Appendix 1.

The underlying principle is to generate a fair view of the company at the reporting date. There is an important distinction here between certain and probable transfer of economic benefit. A realistic view does not require absolute certainty. Those arguing for a cash-received basis for recognising income are adopting a level approximating certainty of the transfer, which is in our view unduly conservative and does not reflect the realistic value of the business.

Application is key and the portfolio approach on proven cases should moderate inaccuracy SGH has based its assumptions on experience over many years, across tens of thousands of cases and overlaid with a level of caution so that, on the successful completion of a case, there is a typical uplift of up to 25%. SGH does not adopt one set of assumptions across the whole portfolio, but rather has completion milestones driven by the type of business and follows different measurement assumptions in the UK to Australia.


We note that SGH is not relying on a small number of cases that may be non-representative of the existing portfolio in new markets where case law is unproven and so historic experience may not be the ongoing result.

Risk in assumptions approach Using assumptions is not risk free. In particular there is the danger that:

Management may manipulate assumptions: the increased disclosure now provided and long-term trends would suggest this has not been the case to date at SGH, giving some comfort on management attitudes. In purely practical terms, with both regulatory review and market enquiry likely to challenge any anomalies rapidly, we believe the potential for future manipulation is also limited. We expect concerns about this to moderate with the increased disclosure post the ASIC review and with the adoption of AASB 15 (Revenue from Contracts with Customers).

The financial crisis has proved that modelling based on historic experience fails where behaviour changes. For SGH, investors should thus consider what will drive such a major change in portfolio success rates or fees earned in the event of success. We believe that the most likely scenario would be major legislative change but, given the time to enact such a change, it is unlikely to impact on current business. Investors should obviously be aware of any such potential changes but the major impact will be on future business not the accounting of current WIP.


Appendix 3: UK political/regulatory environment

Summary We believe investors should consider regulatory risk business line by business line. It is unlikely to be a material factor in high-value, material injury cases. In the low-value, mass-market we have seen significant changes, the effect of which is already visible. While it presents SGH with challenges, it also creates opportunities as many competitor business models are less well suited to the new environment.

Background We believe the UK political and, in turn, the regulatory environment is being driven by a number of conflicting factors. Concerns driving more regulation include the perception that insurance premiums are unfairly high because of false claims, a distaste for ambulance chasing, the high failure rate of certain classes of case and a perception of excessive legal fees. The Association of British Insurers' (ABI) paper Tackling the Compensation Culture illustrates these issues with regard to hearing loss. It notes that the number of claims industrywide that did not result in payment to the claimant was 65% in 2013 (and that this rate is now on the increase, with one insurer reporting a claims failure rate of 85% in 2014). In 2013 the average compensation payment for an NIHL claim was £3,100, while average claimant legal costs were £10,4006.

By contrast, there is a desire to see innocent victims compensated, ensure a safer overall environment and help those who have been injured and are less capable of promoting their own interests.

We believe that the net result will be that different parts of the personal injury market have faced, and will face, different pressures. In particular mass-market, relatively low claim amounts have seen and are more likely to result in regulatory changes than serious injury cases.

Historic reforms to UK personal injury Lord Justice Jackson carried out a review of the cost of civil litigation in 2009 and a number of his proposals were implemented as an interlocking package of reforms through the Legal Aid, Sentencing and Punishment of Offenders (LASPO) Act 2012. Part 2 of LASPO came into force on 1 April 2013 and had the effect of:

removing the recoverability of success fees;

removing the recoverability of After the Event (ATE) insurance premiums; and

introducing damages-based agreements (DBAs).

In addition, there were amendments to the Civil Procedure Rules (CPR) and Pre-Action Protocols including:

introduction of qualified one-way costs shifting (QOCS) in Civil Procedure Rule 44.13 in cases where no ATE premium can be recovered;

horizontal and vertical extension of the Claims Portal and accompanying extension and reduction in fixed recoverable costs; and

introduction of fixed costs outside the Claims Portal for single defendant RTA/EL/PL claims up to £25k.

Effect and outlook The objective of these reforms was to reduce the numbers of spurious claims and the legal cost of low-value claims, and the desired effect has been achieved. The ABI noted that as a result of these

https://www.abi.org.uk/~/media/Files/Documents/Consumer%20Guides/Tackling%20the%20Compensation%20Culture.pdf


reforms, low-value RTA claims legal fees were reduced by around 60% and that total claims costs were down 8% in 2014 alone. The ABI notes that on 19 June 2015 the average comprehensive private motor insurance premium was £360, 13% lower than at the start of 2012. Around 1,400 claim management companies focused on PI law have ceased trading. The effects on SGH are mixed. Clearly, a trend to fewer cases and lower fees makes the market more challenging. However, the commoditisation of the low-value claims plays to SGH's business model, where the process of claims has been streamlined relative to traditional legal practices. The new fee structure may be uneconomic for some players, forcing them to leave the industry, outsource their business or consolidate – all factors that are likely to see volumes concentrated in SGH.

MedCo reforms A further area being reformed is the medical cost associated with personal injuries and this will impact on PSD’s health business. Again, the preliminary effects are visible and we believe the most probable outcome will have been included in SGH budgets. The government is aiming for greater independence in the way that medical evidence is obtained through the establishment of MedCo Registration Solutions (MedCo) and its IT portal. The first phase of the reform programme was implemented on 1 October 2014 via changes to the CPR and the Pre-Action Protocol for Low Value Personal Injury Claims in Road Traffic Accidents. The key Phase 1 reforms were fixed costs for medical reports, an expectation that there will usually be only one such report, prohibiting the reporting expert from also treating the claimant, discouraging pre-medical offers to settle and allowing defendants to give their account of the accident to the medical expert.

The second phase of reforms is being implemented throughout 2015-16. The MedCo Portal became operational on 6 April 2015 for sourcing all medical reports in support of low-value, road traffic accident-related whiplash cases. From 1 January 2016 all medical experts who provide initial medico-legal reports for road traffic accident soft tissue injury claims must be accredited otherwise they will be removed from the MedCo Portal. The success of the portal changes are subject to a government review, with evidence to be submitted by 4 September.

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