The unloved legal eagles chalking up bumper returns
In a year in which ‘quality growth’ stocks stretched their outperformance over ‘value’ stocks, notwithstanding a late bounce-back in the latter on the announcement of a Covid vaccine, it seems odd that UK investors should have overlooked the legal sector.
As it is, most legal services and related stocks registered double-digit percentage losses last year with many underperforming the FTSE All-Share index by a wide margin.
The recent negative response to an underwhelming update (26 Jan) from litigation finance firm Manolete Partners (MANO:AIM) won’t have helped sentiment.
However, considering a good portion of these stocks generate significantly higher returns on capital employed (ROCE) than the rest of the market thanks to their high-margin, high-quality cash flows, the pressure on valuations looks like an anomaly with two outstanding opportunities to buy for the long term.
And with many firms employing a ‘buy and build’ strategy and having had to put their expansion plans on hold during the pandemic, 2021 is likely to see a sharp rise in merger and acquisition (M&A) activity providing a potential catalyst for the sector.
A ‘GOOD’ CRISIS
Most quoted legal services firms have come through the pandemic in a strong position financially and in terms of their market position.
Stepping up their investment in technology was a pre-requisite for most firms before they became publicly-listed, so a move to remote working was less of an ordeal than it might have been.
Also, the move from an old-fashioned partnership arrangement to a corporate structure has led to a quicker decision-making process and made it easier to identify cost efficiencies.
Below we present a profile of the leading companies in the legal services sector and the litigation funding sector.
Following a spate of flotations on the AIM market in the last couple of years, there are now six quoted law firms offering legal services to consumers, businesses or a combination of the two.
The largest by market value is Knights Group (KGH:AIM), the first company of its type to adopt a corporate business model back in 2012 and the fastest-growing firm over the last four years in terms of revenues following a series of acquisitions.
Knights distinguishes itself as the leading legal and professional services business outside London, with a strong focus on the North, the Midlands and the South West, and a list of 18,000 corporate customers including several FTSE 250 companies.
The largest firm by revenue, by some distance, is Main Market-listed DWF (DWF), which has expanded rapidly both domestically and internationally thanks to a string of acquisitions.
It focuses on the insurance market, financial services, the commercial property market and commercial litigation. After a period of expansion, the firm has been consolidating its operations in Europe, the Middle East and Australia.
Curiously, one of the bigger firm by revenue, Ince Group (INCE:AIM), is actually the smallest in terms of market value. Like Knights it has grown largely by acquiring other law firms, which it then leverages through its proprietary platform and infrastructure, yet it hasn’t enjoyed anything like as much market favour.
John Llewellyn-Lloyd, director of corporate finance and head of professional services at Arden Partners, believes investors have been put off by the size and complexity of the most recent deal, but he points to the valuation.
‘Valuing law firms on earnings is problematic as the majority of long-term equity value is removed each year by the equity partners’, says Llewellyn-Lloyd. ‘A benchmark valuation for private legal practices is one times revenues. For corporatised firms it is higher than traditional partnerships, often more than two times revenues. Ince trades on about 0.3 times revenues.’
One of the great success stories in the sector is Keystone Law (KEYS:AIM), which not only broke away from the old partnership structure but from the beginning operated on a decentralized basis with ‘pods’ of lawyers using its platform in exchange for a cut of their fees.
Unlike most of its rivals, it has grown organically rather than by acquisition, recruiting high-quality teams from traditional firms thanks to the attractions of its modern working practices, which came into their own during lockdown.
Having been considered distinctly esoteric a decade ago, litigation funding has begun to move into the mainstream. The largest and best-known company in the sector is Burford Capital (BUR:AIM), which over the last decade has amassed a portfolio of more than a thousand cases working both with corporate clients and major law firms.
Having been a stock market darling for many years, Burford shares suffered a sharp fall in mid-2019 after an attack by a US short-seller, from which they have yet to recover.
Notwithstanding, the company has continued to generate significant returns both from its own case realisations and from cases it manages in private funds.
Burford is joined by Litigation Capital Management (LIT:AIM) and Manolete, although they are very different beasts.
Litigation Capital is an international dispute financing firm with its own asset management division, while Manolete is purely focused on the UK and is unique in actually buying disputes in order to manage the entire process and retain all of the proceeds, rather than paying the bulk of its returns to the case holders like its rivals.
It’s recent profit warning was linked to the economic support measures in the UK which are supressing the corporate insolvency disputes it would normally invest in.
OUTLOOK FOR 2021 AND BEYOND
Having proved its resilience during the pandemic, despite a generally poor performance in stock market terms, the legal sector is poised for a year of expansion in 2021.
Legal disputes and insolvencies should eventually rise as a result of the pressures on businesses over the last 12 months.
And legal firms which have bided their time during the crisis and accrued cash will want to re-start their growth strategies with targeted acquisitions, which is likely to fuel a rise in valuations.
Added to this, more privately-owned law firms, in particular those in the arena of personal law, will come to market this year after having to shelve their plans to float last year, says Llewellyn-Lloyd.
‘External capital will be a key competitive tool for acquisitions, IT upgrades and lateral hires. Moreover, there is a clear arbitrage between unquoted valuations and quoted ones’, he adds.
TWO LEGAL SECTOR STOCKS TO BUY
Ince Group (INCE:AIM)
Buy at 47p. Market cap: £32 million
Buy at 171p. Market cap: £202 million
The most obvious valuation anomaly in the legal services sector is Ince Group (INCE:AIM), with the firm having lost two thirds of its market value last year despite posting strong revenue in the face of the pandemic and generating an enviable return on capital employed.
Turnover in the six months to September rose 6%, driven equally by organic growth and acquisitions. The international business saw revenues increase across the board while the core UK business saw income almost recover its pre-Covid level by the end of the half.
Having digested the Ince acquisition, the firm is increasing lateral hires and reducing its debt and expects to generate enough cash-flow to declare an interim dividend with its final results.
Whether using a price to earnings multiple of less than six times, or price to sales of less than a half, there is no question the shares are extremely cheap. Even if it isn’t a target for other legal firms or private equity investors, a resurgence in deal activity will lift valuations across the sector, which is no less than the stock deserves.
Gateley (GTLY:AIM) is a consolidator with the professional legal services sector, a factor which has helped it grow its revenues every year since it was founded in 1986.
High margins and strong free cash flow have enabled the firm to make nine acquisitions in the last five years, for a total of £25 million, half of which has been paid on cash and half in shares.
In the six months to October the firm posted a 16% increase in operating profits despite a slight dip in revenues, which is testament to the resilience of its business model.
Encouragingly, turnover in November and December was well ahead of last year and spring comparables look favourable as the firm laps the onset of the pandemic and the shutdown of the economy.
Given the firm’s strong returns on capital employed (ROCE), the current multiple of 14 times earnings for the year to April 2022 looks undemanding, especially compared with 20 times for Knights and more than 30 times for Keystone, according to data from broker Liberum.
With a net cash position of over £9 million at the end of October, Gateley has plenty of options to expand organically, by taking on more fee earners – without having to increase office space, thanks to flexible working – or by acquisition, where it is looking to add to its consulting businesses and where it says it has a good pipeline of opportunities.
Disclaimer: The author owns shares in Burford Capital and Manolete Partners