Litigation Capital Management (LIT:74p), an Aim-traded Sydney-based provider of litigation financing to enable third-parties to pursue and recover funds from legal claims, has reported far better annual results than analysts had anticipated when I included the shares in my market beating 2019 Bargain Shares Portfolio.
Strip out one-off costs, including fees for last December’s IPO when the company raised $35m (£19.4m) of new equity, and underlying pre-tax profits of A$12.3m (£6.7m) delivered on 17 per cent higher revenue of A$34.7m were only slightly below the record level (A$12.9m) in the 2017/18 financial year, even though management has invested heavily in new offices in London and Singapore. Cash receipts from litigation investments were maintained at A$26.8m. It’s worth noting that analysts at broker Arden Partners had been predicting pre-tax profits of A$9.5m.
Retained profits and the capital raise helped to treble net assets to A$76.2m (£42.3m) in the 12 months to end-June 2019, of which Litigation Capital holds net cash of A$49m and A$27.4m of litigation investments, which are conservatively valued at their cash cost. The litigation portfolio comprises 29 projects, up from 20 projects in June 2018, of which 23 are conditionally funded.
Litigation Capital’s shrewd team of lawyers received a total of 419 applications for litigation funding during the 12-month trading period, and converted 3 per cent of them into investments. This highlights strict financial discipline, the key reason why the company has generated a cumulative return on invested capital (ROIC) of 135 per cent in the past seven financial years. The internal rate or return (IRR) on these investments is high, too, at 80 per cent (including losses), reflecting a short 25-month average payback period on funded litigation cases.
Significant portfolio developments
A significant portfolio development has been Litigation Capital’s entry into the corporate portfolio market, a key growth area and one that is presently largely underserviced. The company managed to originate more than 15 applications for corporate portfolio funding, of which two have so far been funded. The benefit for corporate entities to use external sources of litigation funding is that they can take litigation risk off the balance sheet, thus not exposing their own shareholders, while at the same time financially benefiting from any upside when the disputes are resolved in the courts.
Changes to the relevant insolvency laws in both Australia and the United Kingdom, which allow insolvency practitioners to assign statutory causes of action, has provided another new business line. Prior to the insolvency law changes, an insolvency practitioner could not assign statutory rights and was restricted to traditional funding techniques. Litigation Capital initiated a pilot programme to provide a funding solution for the insolvency market in both countries and has realised new opportunities for referral relationships that previously did not exist. In Australia, the company has so far considered 30 applications and entered into three agreements for the funding and/or assignment of smaller insolvency-based claims. In the UK, a total of 56 applications have been received and are subject to due diligence.
Smaller claims arising out of insolvency typically require a less significant funding commitment and have a shorter duration period of 12 to 18 months, so will see potential returns being realised at a faster and more consistent rate. It’s an interesting move because the revenue earned by providing funding for smaller insolvency claims should supplement the revenue Litigation Capital generates from funding projects outside of insolvency that have a larger funding size and a longer duration.
In total, the company currently has 64 projects in its pre-qualified pipeline with an estimated invested value of A$$394m (£219m). There are also a healthy number of litigation cases going through the court process, thus offering scope for Litigation Capital to deliver on Arden Partner’s maintained pre-tax profit estimate of A$14.8m for the 12 months to 30 June 2020, a result that would boost earnings per share by 29 per cent to 10.4¢ (5.8p). Shareholders are rightly being rewarded with a final dividend of 0.828¢ (0.46p) in addition to the interim of 0.506¢ (0.28p) paid in June. Analayst Michael White at Arden forecasts a sharp increase in the total dividend per share to 3.1¢ (1.7p) in the current financial year.
Low price-to-book value ratio unwarranted
True, Litigation Capital’s shares have pulled back from their June highs around 112p to slightly below my 77.5p entry price in my 2019 Bargain Shares Portfolio after market leader Burford Capital (BUR:785p) was subject to a bear raid by US hedge fund Muddy Waters. The hedge fund produced a scathing report, which made a number of unsubstantiated claims about Burford’s accounting practises and has dented sector sentiment. However, as I have noted previously, there is absolutely no read across to Litigation Capital’s own accounting policy, as the company carries all its litigation investments on the balance sheet at cash cost and continues to reap hefty returns for shareholders even after allowing for losses on cases.
Trading on 1.9 times forecast June 2020 net asset value estimates, and nearer to 1.4 times if you mark the litigation portfolio to a more realistic value, the potential for Litigation Capital to continue producing an IRR of 80 per cent is simply not priced into the valuation. Buy.
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