Stockwatch: A reliable AIM outperformer for 2017

Is there still upside in Burford Capital? The AIM-listed shares in this litigation finance provider leapt nearly 100p to 570p - i.e. by about £200 million - in response to 14 December news of acquiring a law-focused US investment manager for $160 million or £126.4 million. On such a view it's unsurprising to see the stock consolidate to about 550p, although the deal looks strongly earnings-enhancing.

As a long-term follower I would note Burford's capacity to surprise on the upside due to management's astute investments in litigation cases, a method of funding that's gaining momentum.

Burford is now established as global leader and its invested capital base continues to grow, with an estimated sustainable return on equity over 18%. Capitalised near £1.2 billion, liquidity is better than most - normal market size is 5,000 shares - but there's still volatility within a firm uptrend since early 2015 you can exploit.

M&A boost profit by 16%

Gerchen Keller Capital (GK) has $1.3 billion assets under management and is estimated to have made $9.1 million operating profit for 2016. The deal has come too late for an earnings boost this year, but Burford will benefit in 2017.

Consensus forecasts in the table need updating, I include them merely for context. Sponsored analyst Hardman & Co projects a 16.2% upgrade in 2017 earnings per share (EPS) to 38.8p, which compares with Burford's market value rising about 15% to its present level of 543p. Hardman then looks for 44.4p in 2018. Assuming the 2016 consensus for 28p based on £64.4 million pre-tax profit, this implies 2017 EPS growth near 39%, and 14.4% in 2018.

Dividing the new 2017 price/earnings (PE) of 14 by 39% earnings growth derives a very low PE/growth (PEG) ratio of 0.4 (where sub 1.0 implies value), or more realistically for medium-term growth, a 2018 PE of 12.2 begets a PEG of 0.8, still plenty attractive.

The risk is PEGs are just a snapshot view and so are subject to change quite radically according to forecasts, or in this case an acquisition boost. They do, however, explain why Burford equity has soared from 120p in the last two years - modest PE ratings (see annual average historic multiples of 9.3, 12.2 and 11.3 to 2015) versus earnings growth soaring from 10% through 20%.

The cautious rating is derived from an unconventional business run largely by Americans, listed on AIM and domiciled in Guernsey, with a risk of lumpy earnings. Yet Burford's results since 2014 have affirmed value.

A 123% uplift in 2016 net interim profit to $52.8 million with scant capital expenditure needs meant the deal could be satisfied with only 2% equity dilution - which also hints at a very good second half 2016 with strong cash realisations.

Underlining all this is the operating margin varying only from about 62% to 52% in recent years and jumping near 75% in 2015. So it's possible that expectations for Burford's 2016 results will be beaten when prelims are declared next March.

New angles

Combining these two firms means a very strong service provision with benefits of scale and expanded geographic coverage in the US also globally. Mind that GK is a relatively recent formation in 2013, but has grown revenues from $11.2 million to $15.4 million over 2015-16, and operating profit from $7.3 million to $9.1 million; this achieved with a balance sheet sub-$1 million assets and no debt.

It operates four main funds and some smaller, all closed-end for institutional investors. The funds are mainly "pre-settlement" oriented like Burford's, albeit focused on litigation by large US companies than taking a global approach, and with special expertise in intellectual property which Burford has not had resources to address.

Two GK funds are in "post-settlement", a kind of legal factoring that bridges the time gap between court settlements and actual payments. Such a lower risk business means lower returns but GK's funds are tax-efficient. A new fund will also invest in "complex strategies" e.g. where disclosure requirements may affect the litigation process.

While this sounds like it makes revenues more complex, GK's are fairly transparent, deriving mainly from fees payable on the funds - averaging 1.4% annually on the pre-settlement side, and with a weighted average 23% performance fees above the return on capital. There is said to be additional annual fees potential of over $4 million a year when a new $300 million fund is launched, plus eventual performance fees.

Mind that GK's pre-settlement funds are less mature than Burford's, implying some uncertainty as to performance fees, with the bulk likely post-2017. So there's an aspect of waiting for more proof with this deal, which may bring further consolidation in Burford shares, although scant dilution helps keep the prospective PE modest. The stock would also benefit if the dollar strengthens with further US interest rate increases.

Numis targets 650p

Numis Securities is one of two additional brokers Burford appointed last October in addition to Macquarie Capital, and their fair value target assumes a PE of 14, which seems fair enough in a medium to long-term context.

Burford has demonstrated its growth credentials and is largely insulated from a cyclical downturn given litigation is a distinct process; and its diversification mitigates the risk of bad portfolio outcomes dashing expectations.

The chief risk going forward would be key staff defections to start their own funds, but the team appears stable as yet. While this is a stock I've been bullish on repeatedly since an upbeat trading statement in January 2015, Burford's trait of delivering ahead of expectations make it a solid idea for 2017 onwards.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.