Knights numbers mask profit concerns

On the face of it, legal services group Knights (KGH) has bounced back well after its profit warning last year, which sent the shares tumbling by 60 per cent. Revenue has increased by almost a fifth, and underlying profits are up by the same amount. 

However, the figures need closer scrutiny. For starters, revenue growth has been driven purely by new acquisitions. Organic growth was flat in the six months to 31 October, casting doubt over the strength of underlying demand.

Moreover, when it comes to profit, Knights has been making some big adjustments. Underlying profit before tax stands at £9mn, but statutory profit before tax is just £4.1mn. Acquisitions are largely to blame. On the list of non-underlying operating costs is £2.2mn of “contingent consideration”, which relates to extra payments made to certain individuals following an acquisition, and can extend over three years. There is also £584,000 of redundancy and reorganisation costs to take into account. 

The problem for investors is that these aren’t one-off costs. Knights’ growth strategy has so far relied on buying regional law firms. As a result, “non-underlying” operating costs reached £4.8mn this time last year, and £6mn in the six months to 31 October 2020. While this can be adjusted out of the income statement, it has a very real impact on cash flow.

Debt is also worth keeping an eye on. Excluding lease liabilities, net debt was £35.6mn at the end of October, up from £28.9mn in spring 2022. However, lease liabilities are far from insignificant – they total £47.7mn, more than Knights’ total borrowings.

There’s a lot to like about Knights’ business model, and management is confident that its diverse workload will help it to weather a recession. We remain cautious, however. Hold.

Last IC View: Hold, 111p, 12 July 2022