Description

Thesis

Below 10x P/E, acceleration in cash flow near term, strong growth and non-cyclical. The catch: OBL is a complex litigation asset manager, which in recent years has not shown either consistently positive earnings or excess cash flow. This is due to the lags before receiving returns inherent in the business and further lags caused by the waterfall nature of their legacy investment funds. The lack of earnings and cash flow will be fixed as their legacy funds run-off, generating near term earnings/cash, and subsequently as their new funds ramp and the business matures closer to steady state profitability. If the low valuation persists despite the earnings and cash flow improvement, then OBL will use a newly authorized buyback program to help reduce the discount.

Business summary

OBL finances litigation. The core of the business is funding individual cases, where OBL will pay the legal costs of the suit and in return receive a portion of the win. Effectively, they allow lawyers (the main sales channel in litigation finance) to offer clients the option of no-win-no-fee on large cases with no risk to the law firm. The industry has been consistently growing as more lawyers and clients become familiar and comfortable with the arrangement. OBL was written up in June 2020 and peer Burford has been written up four times. Therefore, I will not go into detail on the background and history of litigation finance but will highlight a couple of recent factors which have been a significant drag for OBL but are now improved:

• Covid had a slowing effect on the courts and the progress of cases. This also temporarily hurt the flow of new cases as some potential plaintiffs were put off by the lengthened and costly timelines to progress cases. The overall impact was weaker growth over the past two years in both new commitments (deals) and case completions, hurting profits and cash flow.

• Competition ramped up rapidly pre-Covid with many fund raises across the industry, but now appears to have moderated as less established funders do not yet have recycled capital to deploy or realized returns to show investors. The impact of the previous ramp in competition was primarily on slowing new business growth with less damage to pricing. This is hard to observe from the outside, but is supported by expert and peer commentary.

Management’s track record is good, and they have grown the business while maintaining strong investment returns. They appear well aligned with shareholders, have bought shares in the past, and are thoughtful on capital allocation. They are also notably more modestly paid than Burford executives. Although I have found them to have high integrity and to aim for transparency, the CEO does have a tendency to set guidance and goals as aspirational targets rather than a conservative bar to be met in most circumstances. This has led to an under-delivery on growth, which is the main black mark against an otherwise strong team.

Valuation

While OBL now has 8 funds, the core go-forward business model used by OBL is the large funds 4 and 5, currently US$0.5bn capacity each but likely to be upsized in FY2023 to US$1bn each. These provide (1) a management fee of just under 2% on capital deployed and (2) performance fees of 20-30% based on the level of IRR, which are paid on an ongoing basis (recalculated deal by deal). OBL also co-invests 20% into these funds. While I model the business fund by fund, a simplified approach to estimating earnings power in FY2025 (June end) is to assume a level of deployed capital in funds 4 and 5, an IRR, corporate costs, and a level of ongoing earnings from other smaller specialty funds (including funds 6 and above plus some small long tail earnings from legacy funds). Of these, the most important swing variables are growth (capital deployment) and IRR.

• As mentioned above growth has recently been slowed by Covid and competition, paired with mgmt over-optimism. This resulted in slower growth in FY2022 than guided (new commitments grew 12% in FY2022 and only 1% per employee). This appears to have turned a corner with a strong finish to FY2022 new commitments, also the Covid and competition issues fading. Additionally, since April 2021 OBL have been transitioning their organization to be more US-centric (CEO moved to NYC from Australia and a new CFO was hired) and have made investments in staffing there, and this ramp up should also help growth in FY2023. They guide +25% commitment growth in FY2023 (c.+15% per employee), which I think is broadly reasonable, although their longer term FY2025 guidance is now unlikely to be met without an acquisition. I model a relatively fast fade in growth rate even as they continue to improve productivity with increased employee tenure and increased focus on larger sized deals. A modest sized acquisition (likely cash/debt funded) is likely at some point and would lift growth but leave less room for repurchases. They have a strong track record on integrating acquisitions and this likely nets out for our EPS or is slightly accretive.

• While the 3y trailing IRR is 39% and historically has been higher, I assume c.30% going forward, with slightly higher returns in the non-US funds and lower in the US funds where there is more competition. Management targets 30% minimum when underwriting deals. c.30% IRR is also consistent with Burford, who on average have a greater share of lower return and lower risk portfolio deals. It is worth noting that while these IRRs appear unsustainably high relative to asset management, private equity or most specialty finance, the IRR is far less generous when accounting for the high operating costs as a percentage of invested capital needed to evaluate deals successfully (likely to remain above 5% for the foreseeable future despite scale improvements and in prior years has been above 10%).

I estimate an FY2025 EPS of A$0.39 and a net cash position after modest buybacks. At 15x (in line with good quality specialty finance/asset management) this would be A$5.85 and a 58% return in two years (when investors look to FY2025). 15x may be conservative given I expect underlying growth in new commitments to be 10%+ and invested capital to be growing 20%+ (given growth lags). Additionally, while most speciality financials and asset managers struggle to trade above 15x, they are generally highly cyclical, while litigation finance is more or less non-cyclical (potential minor defendant ability to pay issues in a downturn balanced by the new business benefits of more insolvency related claims and greater desire to use OBL’s capital provision by plaintiffs). In a reasonable upside case of 37% IRRs (45% ex-US and 30% US, closer to their historical track record and targets), and 17.5x P/E, the shares would return +130% to A$8.5.

In the meantime, over the next two years, OBL will see most of the lucrative tail end of their legacy Funds 1-3 and some more minor returns from corporate balance sheet investments. Funds 1-3 were structured as ‘European waterfalls’ with the result being that until this year the vast majority of cash flows and profits have accrued to the investors. Now, with these almost paid back, the dynamic will likely switch to over 80% paid to OBL likely at some point in FY2023. 

Management provides specific estimates of the cash realizations they expect from their committed business, which, although clearly subject to high uncertainty, have in the past been accurate about quantity on average, with some over-optimism on speed of resolution. These estimates point to c.A$430m of cash to OBL (pre-tax) over the next two years from these legacy investments after minorities. In the context of the other funds and corporate expenses this should drive bumper EPS (I estimate A$0.40/0.50 across FY2023/24). Even considering the high uncertainty and lumpiness inherent to the business, these years are very likely to provide strong cash flows, which can be used for buybacks and/or acquisitions. In other words, investors do not have to wait for the core business to ramp up to see strong earnings and cash flows. I think this helps de-risk the investment case and potentially pulls forward realization of the valuation upside.

Risks

• Increased industry competition and lower returns either through pricing or taking on worse cases is the key risk for OBL in my opinion. Currently, this risk appears to be receding with less money raised in the past year to focus on litigation finance and the returns are far less egregious than they seem once fully costed with opex. The proportion of cases they fund vs. deals they see has also not risen, which is encouraging.

• Increased competition from law firms taking more risk on themselves is another area to watch as they take learnings from the litigation finance industry and develop their ability to fund. So far it appears that increased focus on law firms self-funding has come hand in hand with increased awareness of the benefits of litigation finance, which is logical given they are two sides of the same coin and large law firms will often use both.

• Regulatory risks. Generally regulation has been on an improving or neutral trend with regards to litigation finance but there is a persistent risk of tightening either the percentage of a case that can be earned or the type of cases it can be used in. OBL’s geographical diversification mitigates this to an extent.

Catalyst

• If the valuation discount remains, I expect management to execute on their recently announced A$50m buyback program over the next year, and will increase the authorisation in FY2024 (alongside strong cash flows).

• Achieving the transition from the legacy funds to the ramped up funds 4 & 5 should improve visibility of the growth and allow for a more steady base of earnings from FY2025. This should steadily become more clear in the coming two years.

• There is upside to our and consensus numbers for FY2024 if management’s surprisingly bullish expectations for current Fund 4 and 5 investments play out over CY2024. I only assume 30% IRR, while their estimates imply far higher returns (50%+) on their current book of investments, with much of this expected to be realized in FY2024.

• Only a small slice of the equity market is truly non-cyclical, and a weak macro backdrop should help focus attention on OBL.