Description

CERTAIN STATEMENTS CONTAINED HEREIN REFLECT THE OPINION OF THE AUTHOR AS OF THE DATE WRITTEN. NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT. YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. Please see additional Important Disclaimers at the end of this analysis.

Knights Group is a publicly traded law firm with over 1k fee earners that service over 10k clients across the UK. 37% of revenue is from the real estate sector, 21% dispute resolution, 19% private client, 16% corporate, and 6% employment.

However, from an investment perspective, one might describe Knights as follows: a busted growth stock now sitting squarely in the deep value camp. The company IPO’d in 2018 and enjoyed a spectacular four-year period of rapid double-digit top-line growth with high-teens operating margins. The stock price roughly doubled over that period to about 4 GBP per share.[1] Times were good.

Then, in March 2022, the share price collapsed. From 3.65 on March 21^st to 1.45 on March 25^th, Knights’ share price declined a remarkable 60% in two days, then continued to bleed to a low of about 0.60 per share in October 2022. At the low, this represented a stunning ~85% price decline compared to one year prior.[2]

Without knowing anything else, one might assume an 85% decline resulted from something along the lines of bankruptcy, fraud, massive equity dilution, core business disaster, etc. But when one zooms in on Knights to investigate what’s going on, none of those crisis-level issues are really present at all. What one finds is a business whose revenue is basically flat (+0.4% organic YoY as of its 10/31/22 earnings report), with positive earnings and an OK balance sheet. In fact, we believe the company’s economic profile is semi-decent. Its gross margin is almost 50% and the adjusted operating margin is in the mid-teens, which contributes to incremental returns on capital north of 20% and reasonable free cash conversion. There is some debt on the balance sheet, but it doesn’t look aggressive relative to earnings power. For reference, as of October 2022 Knights had about GBP40m of gross debt with about GBP4m of cash, so a net debt position of approximately GBP35m. That compares to FYE April 2022 underlying operating profit of around GBP20m and run rate underlying EBITDA of about GBP30m. In fact, the financial position supports a nearly 4% dividend yield as of 5/15/2023.

So, what gives? Well, the air has come out of the balloon, basically. If one rewinds the clock just a year or two, Knights was a high-flying compounder with an M&A roll up story. Then, out of nowhere, management unexpectedly reported the growth engine was sputtering and perhaps soon to stall out. With growth prospects in question, the company’s high-flying valuation multiples compressed sharply, which then led to negative share price reflexivity in the George Soros sense. Negative reflexivity resulted from the fact that Knights was (and sort of still is) pursuing an M&A roll-up strategy, where management was using the company’s premium-priced shares at high multiples to issue equity as consideration to acquire smaller firms at low multiples. Thus, Knights generated earnings accretion with its deal activity, which capital markets rewarded with a high multiple for the stock, which allowed it to finance more deals with equity, and so on. But with the share price now under significant pressure, the ability to continue financing M&A was called into question.

Investors recoiled. No longer was this a hot recent IPO. No longer was this a growth stock. No longer was this an M&A roll up. No longer was this an EPS accretion story. So, whose model would it fit into? Well, that question is currently underway since it hasn’t been that long since the stock’s precipitous decline, and price discovery takes time. What’s more, consider that Knights’ market cap fell from over US$400m in early 2022 to about US$75m in October, moving it from an institutional small-to-mid-cap box into an awkward microcap territory below many investors’ cutoff. So, in the world of style boxes, Knights has suddenly found itself out of place.

Who would be buying? Well, for one, it seems the founder and CEO himself. Andrew Beech has significant skin in the game, even after the IPO and an exit of about half his position in 2021 where he reduced his ownership at an attractive valuation. It’s interesting – if not telling – that he’s re-upped his position a bit after the massive share price decline. In late 2022, Andrew took around GBP1m cash out of his pocket to buy more shares. And with a 22% stake, his interest is quite aligned.

To be clear, we do think risk is above average here. In our minds, the equity is a bit option-like and should be position-sized to reflect high uncertainty. There are a couple of reasons for this. One is that M&A roll ups often go wrong, and it’s hard – if not impossible – to really see this from the outside. Sometimes roll ups are just houses of cards that only exist when there’s ability to issue shares at high multiples to finance acquisitions at low multiples and engineer earnings accretion. But underneath the accretion there may be serious issues: acquired executives may depart; synergies may not exist; redundant costs may build; customer churn may accelerate; margins may prove elusive; system integrations may cause execution problems, etc.

And then there’s particular concern with regard to rolling up law firms. It’s one thing to acquire a manufacturing plant, but it’s another thing entirely to buy the practice of one or two lawyers who could leave and take their relationships (and thus Knights’ earnings) with them. Churn and client retention is a serious question here. There’s also a classic agency problem of why a law firm should be publicly traded at all, with the tension of who captures surplus economics when the firm creates economic value – does it go to the lawyers or the public shareholders? If the lawyers feel they aren’t capturing their fair share, nothing really prevents them from walking away and taking relationships with them. Or put into finance parlance, how sustainable are the earnings?

Without wading too deep into all the specific issues surrounding Knights - partner retention, staff churn, lock up days, working capital trends, etc. – it’s important to acknowledge that they are serious concerns. This is deep value, and the question is what’s in the price, and at current levels we think the odds are in one’s favor.  

Perhaps it’s worth thinking about a couple scenarios. A reasonable upside scenario could be that Knights generates GBP20m of sustainable operating profit, and since it’s a professional service business we might use 10x to value the enterprise at GBP200m. Back out GBP35m of net debt and one derives an equity value of approximately GBP165m, over 2x the current market cap. A reasonable downside scenario could be normalized EBIT of GBP12m with an 8x multiple. The implied EV would be about GBP100m with an equity value of GBP65m, about 15% below the current price. There are obviously ranges outside of these, good and bad. But sticking with the exercise, if one calls it a coin flip either way, the expected value would be GBP115m against a GBP77m market cap.

Or to say it differently: we believe this stock just looks pretty dang cheap at close to 4x earnings. Risk is above average, so proper sizing is warranted.

Important Disclaimers

The provision of this report does not constitute (and should not be construed as) a recommendation, financial promotion, investment advice, encouragement or solicitation to buy, sell, or hold the security of the subject issuer (the “Security”), or any other securities, discussed herein. This report is for informational purposes only. All of the information contained herein is based on publicly available information with respect to the security and the author’s analysis of such information. Past performance is no guarantee, nor is it indicative, of future results.

Certain statements reflect the opinions of the author as of the date written, may be forward-looking and/or based on current expectations, projections, and/or information currently available. The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term. The views are those of the author acting in his individual capacity and not as a representative of the firm.  The author’s opinions on this Security may change at any time in the future and the author will not, and disclaims any obligation to, update this report to reflect any change in opinion. The author further disclaims any obligation to respond to any comments or questions posted regarding the Security discussed herein.

NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT.  YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. AN INVESTMENT IN THE SECURITY DOES NOT GUARANTEE A POSITIVE RETURN AS STOCKS ARE SUBJECT TO MARKET RISKS, INCLUDING THE POTENTIAL LOSS OF PRINCIPAL.

The author or his or her respective employer or employer’s clients, affiliates, officers, managers, directors, and other associated parties, may or may not hold positions in the Security noted in this article. These parties may trade at any time, without notification to this community, and will not disclose this information to this community. The author and his employer disclaim any liability for investment losses that you may incur under any circumstances.

Catalyst

None.