Interactive Investor

Stockwatch: Onwards and upwards for this AIM share

21st March 2017 09:53

Edmond Jackson from interactive investor

Can shares in AIM-listed Burford Capital, the £1.5 billion litigation finance specialist, continue to rise? Its 2016 results have led to substantial upgrades, although historic data in the table looks awry relative to accounts I've studied when drawing attention to this stock from 135p in May 2014.

The 2013 results had then shown a 25% increase in pre-tax profit to $42.5 million (£25.3 million equivalent at the time) amid a 20% increase in litigation investment income. The stock now tests 850p, with the 2016 income statement showing pre-tax profit up 62% to $110 million or £90.2 million, for sterling equivalent earnings per share (EPS) of 42.9p.

The consensus of recent forecasts had anticipated £66.7 million/31.2p, with £88.9 million/38.4p projected for 2017, which Burford has already "beaten". My use of inverted commas reflects an element of subjectivity in Burford's accounting for profit growth, that arose due to a change in the accounting standards, and which appears to bake in profits growth with expansion - assuming management is generally successful in backing litigation cases.

Impressive record since inception in 2009

The investment performance table on page 11 of the 2016 annual report (accessible via the prelims' RNS) shows a total $521.9 million recovered and a 60% return on invested capital.

Furthermore, on 13 March 2017, Burford sold a 10% share of its interest in the "Petersen claims" (relating to foreign investment in an oil company nationalised by Argentina) to net $40 million cash, implying a value of some 20 times invested cost.

The timing was a bit cute as if boosting the results presentation, and is a prime rather than general example of the returns available - in a context where $378 million was committed to litigation finance investments during 2016, an 83% annual increase which compares with $153 million in 2014.

At end-2016, Burford had $549 million outstanding litigation investments and a further $290 million in undrawn commitments made to existing investments, across 64 different litigation plays. It's this ramp-up of investment exposure, in context of an enviable performance record, that explains the big rise in share price over the last two years.

IFRS 9 means profit growth with expansion

Be careful of assuming much about profits and how they are rated as a guide to valuation. Page 10 of the 2012 annual report explains how Burford adopted IFRS 9, effectively requiring a board of directors to take a view on the outcome of litigation investments which goes against a conservative sense to book profit only when realised.

Before IFRS 9, Burford applied any positive change in valuation it deemed below the profits level on the income statement. When an investment concluded successfully, such "below-the-line" fair value change was reversed to book a profit on the income statement. Yet, coinciding with rapid expansion of the business, IFRS 9 requires judgments about value - be they an increase or decrease - to go through the income statement with an immediate effect on profits, even if the case is continuing and the result is not yet known.

This helps explain the massive beat in market expectations for 2016 profit; analysts probably did not factor in the effect of IFRS 9 sufficiently. From the outside it's very hard to make such value judgments about litigation cases. Moreover, IFRS 9 goes against an investment analyst's conservative instinct on profitability.

The 2016 income statement shows the main profit driver is litigation investment income, up 60% to $140.2 million, while insurance income was virtually flat at $12.9 million, although new initiatives income jumped from $2.5 million to $8.8 million. Note 7 to the accounts then shows contrasts within the profile of litigation investment income, with net realised gains down 21% to $47.5 million but fair value movements on litigation investments rose 299% to $87.8 million.

Cash flow statement is a mixed profile

After various adjustments, cash flow before working capital changes fell from a negative $13.5 million to negative $76.5 million. Proceeds of $203 million from litigation investments, plus $127.8 million disposals of cash management investments, radically improved the balance enabling $275.7 million funding of litigation investments, such that the net cash outflow from operations has reduced from $20.1 million to $6.7 million.

The financing side of the statement then shows $189.6 million raised in loan capital notes, in support of expansion. In one sense, therefore, the business is nearly balanced in cash terms regarding its organic growth objective. On the financing side, a loan note issue brought in $189.6 million and $17.1 million went out as dividends, such that balance sheet cash rose from $45.4 million at end-2015 to $158.4 million at end-2017.

So the business is well-balanced as regards funding continued growth, although the profile of cash flow statement helps explain the relatively modest dividend. Burford's business model weighs more towards capital gains from litigation investments, where the results are potentially lumpy, than predictable cash flows favouring payouts. But if Burford's seven-year record is at all sustainable, arguably profits are better retained.

Demand for litigation finance is increasing

Trends in legal funding favour Burford's operation. The Litigation Finance Journal cites the US market as particularly robust with over a quarter of private attorneys using litigation finance in 2016, a record high, following double-digit growth in such usage for the last four years.

This journal describes Burford as "the growing powerhouse which is redefining litigation finance" and, while its investment record is bound to encourage rivals, it has a dominant position. Exposure to US dollar earnings/reporting is also useful for UK-based investors as sterling remains pressured by Brexit and tightening US monetary policy.

The Bank of England is starting to signal sense for an interest rate rise, but seems unlikely to get hawkish given its governor has taken a medium-term negative view of the effect of Brexit on the UK economy. So US dollar exposure remains useful, and Burford is a fast-growing means to get it.

The factors I describe make it tricky to define intrinsic value and set price targets, but you can see from Burford's underlying momentum it is capitalising on remarkable change within the legal sector that looks to have a good many years to run; it's why I felt it justified to cite Burford as a stock-of-the-year around 540p just before Christmas (similarly as at 215p in January 2016).

It has paid to use volatility as a means to accumulate than trade stock, and that approach remains intact. A stockmarket plunge, or questions posed about reported profits and their valuation, may unsettle earnings-driven holders, causing a drop. But, for the longer run, it looks "onwards and upwards" for Burford.

For more information see the website.

Burford Capital - financial summary       Consensus Estimates
year ended 31 Dec  2012201320142015201620172018
          
Turnover (£ million)  34.239.049.967.4121  
IFRS3 pre-tax profit (£m)  10.71.428.844.477.1  
Normalised pre-tax profit (£m)  21.520.128.844.481.5107126
Operating margin (%)  62.951.762.074.675.7  
IFRS3 earnings/share (p)  6.10.813.520.639.2  
Normalised earnings/share (p)  12.010.013.520.641.342.646.2
Earnings per share growth (%)   -17.135.552.61003.28.4
Price/earnings multiple (x)      19.118.517.1
Annual average historic P/E (x)   9.312.211.315.815.7 
Cash flow/share (p)  17.112.4-29.3-9.7-7.0  
Capex/share (p)  0.010.070.030.130.6  
Dividend per share (p)  2.42.94.24.96.18.79.7
Yield (%)      0.81.11.2
Covered by earnings (x)  5.33.22.93.96.54.94.8
Net tangible assets per share (p)  93.5101120144164  
          
Source: Company REFS         

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