Update No. 152 – 01/03/14

I mentioned in last week’s post a business we own (Dicker Data) that has good operating leverage characteristics (the result announced this week [.pdf] bore that out with a modest 5.6% rise in revenues generating a 12.8% rise in NPAT half on half). This week I will look at one we don’t own that has extremely poor operating leverage.

I have mentioned Slater & Gordon (SGH) on these pages before here, here & here. My concerns with this business remain basically the same as they’ve always been. A business that is trying to build scale should show characteristics of operating leverage, or in simple terms, a 10% increase in revenue should lead to more than a 10% increase in profits for the business.

Three years is a reasonable time across which to compare a business’s performance, particularly an inherently stable business such as a legal practise (more specifically a group of legal practises). The table comparing revenues, costs and profits for the respective half years is set out below:

In the 3 years to December 31 2013, revenues (half year on half year) have more than doubled, rising 110.2%. For a business with good scalability characteristics, this would lead to more than a 110.2% increase in profits. As you can see from the table above, the Profit before Tax (PBT) has risen by only 63.4%, primarily because expenses rose much faster at 124.4%.

The three largest expense lines above are salaries, advertising and administration. In a business with scalability, these three lines should all grow meaningfully more slowly than the revenue line. Advertising might be forgiven as they try to grow ‘brand awareness’ (though I’m sceptical how much this works in a legal practice). Salaries should not grow faster than revenues, but can be hard to manage in a business where your revenue generation capacity walks out the door every night. The most inexcusable one of these three is administration. If you are not making savings in administration, then aggregating businesses doesn’t make much sense (unless the acquired businesses have the inherent capacity to grow earnings at a suitable rate for the price paid).

All said though, EPS has grown 22.3% (or about 6.9% annually); though per share PBT has only increased by 16.5% (about 5.2% annually) as they had a lower tax rate in the 2013 half.

All these things do not indicate a business in decline, but the only real winners in this process of aggregation seem to be the board and senior executives. In 3 years the per share profit before tax may have only grown by 5.2% per annum, but the managing directors salary has managed to grow at an impressive 21.6% annualised rate…

One area where shareholders might raise a legitimate concern about the conservatism (or lack thereof) of management’s accounting is in the area of “Work in Progress” (WIP). In the report for December 31 2011 SGH carried WIP of $191,222,000 their revenues for the half were

$99,464,000. If we double the revenues to roughly annualise ($198,928,000), we establish that 2 years ago, SGH were carrying roughly 350 days’ worth of WIP on the balance sheet. At the December 31 2013 date just passed, $392,628,000 of WIP is recorded on the balance sheet, annualised revenue at the same date is $356,642,000 or about 402 days. On a like-for-like basis, had the 350 day figure from 2 years ago been held constant, the WIP balance would be a little over $50m lower. If I held SGH shares, I would watch this metric very carefully to see how it is managed in future reports! For if the value of the WIP is for some reason found to be $50m lower than the carrying value, well…

The only reason SGH are growing their EPS is because they are paying less for the businesses they acquire than the multiple their own business is operating at when they issue equity (which they do regularly). In simple terms, if they stop acquiring businesses, their EPS will most likely start to decline, unless they can figure out how to make expenses grow more slowly than revenues.

This is not a troubled business, and EGP have no dog in the fight, we currently hold no position in relation to SGH and I don’t want to see anyone take any specific action based on this post. It is more for the purpose of education in how to look at an average business. Charlie Munger say ‘Invert, always invert’, so I figure when you learn how to spot a crappy business, you will be better positioned to spot a really good one.

Despite what would appear to be a pretty mediocre business, the price of SGH stock has risen strongly over the examined period, from $1.79 on December 31 2010 to $4.84 on December 31 2013. Add back in the dividends and the owner of SGH has nearly tripled their original investment (efficient markets eh?). The simple difference can be attributed substantially to ‘multiple expansion’, SGH on December 31 2010 were trading on a multiple of about 9.7x earnings, the multiple 3 years later was about 19.8x. What information exists in these reports three years apart to warrant that multiple expansion, I am at an absolute loss to explain…

In my view a mediocre business such as SGH, which has only muted prospects for EPS growth (without constant acquisitions & WIP shenanigans) is perhaps fairly valued at 10 or 12x earnings. Top end of fair value for SGH in my view, is perhaps between $2.50 and $3.00.

Next week I will present our 6-monthly portfolio metrics post, where I will pull apart the portfolio and try to explain how we intend to trounce the market over the coming 6 months… – Tony Hansen 01/03/2014

P.S. the Berkshire Hathaway shareholder letter was released today, and as usual makes for an excellent read.

EGP Fund No. 1 Pty Ltd. Down by 0.25%, trailing the benchmark by 2.01% since January 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 63.89%, leading the benchmark by 36.38% all-time (April 1^st 2011).

^{*1 after 31May 2013 dividend of 2.333 cents per share plus 1 cent per share Franking Credit}

^{*2 calculated based on dividends reinvested}