At the time of my last update in early May, the board confirmed that trading was in line with analyst expectations which pointed towards pre-tax profits rising from £10.46m to £11.1m in the 12 months to end December 2016, according to analysts Roger Leboff and Hannah Crowe at equity research firm Equity Development. The latest guidance is that adjusted pre-tax profits for the first half will match the outcome in the same six month period last year when Fairpoint reported profits of £4.06m, albeit it has taken a 20 per cent hike in revenues to do so.
The key driver of the top-line growth is the company's growing legal service business which now accounts for three quarters of Fairpoint's turnover, buoyed by the contribution from last summer's acquisition of Colemans-CTTS and Holiday Travel Watch, a provider of consumer-focused legal services specialising in volume personal injury, volume conveyancing and travel law. The Colemans trading brand has been retired and all legal activity is harmonised under the Simpson Millar brand, a consumer legal services business acquired by Fairpoint a couple of years ago.
Debt solutions under pressure
The move into the high-growth, low-margin legal service markets has been well timed given the ongoing pressures on the higher margin, low growth debt solutions operations encompassing debt management plans (DMP), claims management and IVA services. And it has been pressures on the debt solutions side that has led to the board's decision, announced in a pre-close update earlier this month, to wind down both the DMP and claims management operations.
The problem being that the Financial Conduct Authority (FCA) is driving a tighter and far more stringent regulatory agenda in the DMP sector and one that will impact the commerciality of the whole industry, in effect transferring the competitive advantage to the charitable DMP sector from commercial operators like Fairpoint. The model is in effect unsustainable, prompting Fairpoint to take the decision to wind down its DMP business in the second half this year during which time the unit will make no profit contribution at all for the company. This will also have an impact on Fairpoint's claims management business which is dependent on selling services to its DMP clients.
Admittedly, this move has come sooner than I was anticipating and it will result in Fairpoint taking a £2m exceptional charge in the second half, of which £1m is non-cash, as well as booking a £5m non-cash write-down of the intangible assets attributed to the DMP business in its accounts. On a proforma basis, this reduces the company's net asset value to £32.6m, a sum worth 71p a share, before accounting for post-tax earnings accrued in the first half this year. Net debt was £13.6m at the start of 2016, implying £11.4m headroom on the company's £25m long-term debt facility, so balance sheet gearing is around 41 per cent of pro-forma shareholder funds, still a comfortable level.
More importantly, the effect of winding down the DMP and claims management operations reduces Equity Development's full-year profit estimate from £11.1m to £8.8m of which £300,000 of the shortfall represents one-off transaction costs incurred in acquiring a practise specialising in child abuse actions in order to expand the legal services offering. The new forecast represents a 14 per cent decline on pre-tax profits of £10.46m reported in 2015.
On a more positive note, EPS estimates of 15.6p covers last year's payout per share of 6.8p more than two times over and analysts at Equity Development still expect the payout to be raised to 7.2p a share this year. This means at the current price Fairpoint's shares are being rated on 7 times forecast earnings, offer a prospective dividend yield of 6.7 per cent and are valued on a price-to-book value of around 1.5 times.
Lowly rated
In my view, that's a low rating for what is now essentially a legal services operation set to generate north of £7m operating profit this year with a small IVA services business which made £1.26m operating profit in 2015. To put the rating of Fairpoint into some perspective, the only other listed legal services provider is Aim-traded Gateley (GTLY) and its' shares are priced on 12 times earnings estimates for the 12 months to end April 2017, or a 70 per cent premium to Fairpoint's own rating.
It's worth flagging up that Fairpoint's board remains on the look-out for further debt-funded bolt-on acquisitions to grow the legal services side further. There are 10,000 providers in the fragmented legal services market employing less than 10 people, so offering the potential for Fairpoint to act as a consolidator.
I would also point out that the company has a new finance director from the start of August, David Broadbent, following the decision of 56-year old John Gittins to step down from the board to pursue a portfolio career of non-executive positions. He was appointed a non-executive at soft drinks maker Nichols last year, so has already been taking on such roles. Mr Broadbent previously served as finance director and chief commercial officer at overseas sub-prime money lender International Personal Finance (IPF), so has valuable industry experience.
The bottom line is that I feel that the de-rating of Fairpoint has gone too far especially as analysts believe there is scope for pre-tax profits to bounce back next year to £9.8m, reflecting an increasing contribution in the mix from legal services. I also feel that the negative publicity surrounding the previously reported government changes in whiplash claims is overdone especially as only 9 per cent of Fairpoint's first-half revenues came from this segment, any changes made will not be implemented before autumn 2017 and are likely to follow prior precedent, so are unlikely to be retrospective. Based on current case volumes Fairpoint's revenues from whiplash claims, and road traffic accidents in particular, look underpinned through to the summer of 2018. Moreover, Fairpoint has a competitive advantage over rivals looking to process volume legal work on low-cost claims.
In the circumstances, if you followed my earlier advice I would continue to hold the high-yielding shares for their recovery potential ahead of interim results on 15 September. Hold.
