Description

        I.            LCM: Elevator Pitch

New to VIC and – to the best of knowledge – the first write up on the company anywhere – meet Litigation Capital Management (LCM).  LCM is a litigation finance provider that listed on AIM in late 2018. Muddy Waters’ well publicized short thesis on Burford has brought down not only the price of BUR shares but also the share price of LCM (~20% down). 

LCM is a smaller and more nimble litigation finance player.  LCM has very high return metrics: ROIC of 117% and IRR of 78% with a holding period of ~27 months (FY 2012 – 1H 2019; please note that LCM’s fiscal year ends on June 30).  LCM does not use fair value accounting and instead relies on cost accounting. 

Currently LCM trades at ~15.7x P/E, ~10.8x P/E ex-cash, and ~2.3x P/B (all financial metrics are as of 1H 2019 that ended on December 31, 2019). 

Please note that all financial metrics are in AUD while the share price is in GBp. 

     II.            Why Does This Opportunity Exist?

There are several reasons why this opportunity exists:

(1)   Small company size (~GBp 167M)

(2)   Recent IPO on AIM (December 2018)

(3)   AIM listing

(4)   Muddy Water’s short thesis on Burford

(5)   Litigation finance is a new, evolving industry; many investors are not familiar with. 

  III.            Capital Structure

LCM has ~111.6M shares and no debt. 

    IV.            LCM: Brief History and Key Players

LCM started in Australia in 1998 and spent the next 15 years or so being a small, regional player with little scale.  Things started changing in 2013 when Patrick Moloney took the CEO role. 

Patrick Moloney is an experienced litigator in Australia.  He was a board member at LCM since 2003. According to him, he was the only BoD member from 2003 until 2013 with litigation experience and as a result he was very involved in operations despite his title as a non-executive director.  While being involved with LCM, Patrick Moloney was also running his own litigation practice. Thus, he had two full time jobs. He closed his practice in 2013 and became a full-time CEO of LCM. This appears to be a turning point in LCM history.  As a result, LCM calculates and discloses its return metrics from 2012 onwards. Patrick Moloney owns ~5% of shares of LCM.

LCM did an IPO in Australia in 2016 and then went public on AIM in late 2018.  LCM delisted its shares from the Australian Stock Exchange. 

Another key person at LCM is Nick Rowles-Davis.  Nick Rowles-Davis is a litigation finance industry veteran.  He worked at Vannin Capital and Burford. At Burford he was largely responsible for UK and European origination and investments.  After Nick Rowles-David left Burford, he launched Chancery Capital with backing from Elliott. However, it did not work out. My understanding is that corporate clients did not feel particularly comfortable opening their kimono to a litigation finance provider that is affiliated with one of the best activists in the world.  I will not blame corporate clients for the lack of burning desire to open their kimono under such circumstances. After Chancery, Nick Rowles-Davis joined LCM as Executive Director and Executive Vice Chairman. He also made several hires in the UK. Given his expertise and prior experience, he will be responsible for UK and EMEA originations and investments.  Nick Rowles-Davis received a share grant of 4,347,517 shares (3.85% of share count) in March 2019. These shares will vest if the share price is 175 pence. For context, when the grant was executed, shares were trading ~75 pence. The current share price is 83 pence.

    V.            How to Model LCM and Valuation Sketch

LCM revenue and profitability is next to impossible to model period to period with a reasonable degree of precision.  This is so for at least two reasons: (1) unpredictability of litigation and / or settlement timeline and (2) lack of fair value adjustments.  Hence, one must be prepared that earnings will be volatile.

Thus, the modeling approach below is a proverbial “roughly right” as opposed to “precisely wrong”.  

As of December 31, 2018, LCM had A$20.7 of litigation investments (at cost) and ~A$52.6M of cash.  Thus, its total investable assets were ~A$73.3M. 

I apply an IRR to these investable assets. LCM IRR from 2012 through 1H 2019 was 78%.  I expect that as LCM scales and does more corporate portfolio and law firm portfolio deals, its IRR will compress.  I will use 50% for illustrative purposes. 

With 50% IRR, LCM’s annual profit would be ~A$36.6M.  I expect OpEx of A$11M. Thus, profit before tax = A$25.7M.  Tax rate = 30% (it may end being up slightly lower – 28%). Tax = A$7.7M.  Thus, Net Income = A$18M. EPS = A$0.16. P/E = 9.34x. 

Below I provide sensitivity tables for EPS and P/E multiple based on (1) IRR and (2) OpEx. 

EPS Sensitivity: IRR vs. OpEx

P/E Multiple: IRR vs. OpEx

LCM will reinvest all its earnings and, thus, the future earnings should grow over time at a high rate. 

An extra source of upside is likely to come from asset management business.  LCM currently does not manager other people’s money but management has been very clear that LCM wants to enter the space in 2019 (calendar).  I will not be surprised if it becomes a 2020 (calendar) event but I do think it will happen. 

What is the right multiple for such business given a white space in the industry?  It is anybody guess but 10x looks too low to me. I expect 80% to 100% upside in 3 years driven by (1) earnings growth from reinvestments, (2) asset management fees, (3) multiple expansion.

  VI.            Risks

There is a number of risks here.

1.      Growth and scaling pains.  LCM is a small enterprise with a small team and a small scale.  Growing the book and growing the business will require management to step up their game.  Only time will tell whether management is up to the challenge.

2.      Nick Rowles-Davis’s team integration is another risk.  Management seems to have been very thoughtful and deliberate about integrating the team, but it is a risk.

3.      Lumpiness in earnings may make some investors panic. 

4.      Key man risk: Patrick Moloney and Nick Rowles-Davis are key actors.  Losing any of them will be a significant problem. 

5.      What is in the book?  We do not know exactly which cases are in the book.  Hence, it is a risk. 

6.      To keep growing at a high rate, LCM is likely to raise more capital.  Management has enough skin of the game and is likely to time the capital raising well and reduce dilution.  However, it is a risk.

VII.            Catalysts

1.      Continuous earnings growth.

2.      Entry into asset management business. 

Disclaimer

Presented recommendation and analysis is an opinion of the author.  The author and / or affiliated entities are long LCM shares. Various factors may influence or factor into the analysis or the opinion.  The author does not assume any obligation to update the analysis or recommendation.

Catalyst

1. Continuous earnings growth.

2.      Entry into asset management business.