Early for lunch on the 24th floor of Tower 42 in the City I gazed over the tower blocks of the city. When I started work the City buildings stopped at Liverpool Street Station. The area to the north of the station building was rough land inhabited by a flock of pigeons guaranteed to ensure the recently acquired suit of every new graduate (which had cost the best part of a months’ wages) would be soiled by overhead avians. Now it is Broadgate. Then, the Nat West Tower was the tallest building in the square mile followed by what was then called the Commercial Union building. Of course, these two buildings are now called Tower 42 and St Helens. All the significant buildings were named after the corporate that inhabited them as a prestigious head office offering a symbol of the institution’s achievements and its standing in the City. Now as far as I am aware only the Bank of England is named after the institution that inhabits the building. And some large institutions inhabit We-work offices complete with facilities for dogs and free beer included with rent. The decline of the corporate headquarters reflects a cultural change which is soon reflected in properties.
Retail
Similar forces are at work in the retail sector. Last year there were 7,500 store closures in the UK, an increase of 36% on the prior year and the future of the high street is increasingly uncertain. Yet a visit to Westfield in Stratford shows a very different picture where it is bustling. The Unibail-Rodamco-Westfield (market cap £15bn) investor day on 14th June gave some interesting insights into this cultural change that is happening today. Consumers demand immediacy. They want frictionless products at all times of day and night. Physical and online product have become co- dependent as 56% of online consumers visit stores. The traditional family of 2.4 children has now moved to extended families. 56% of European 20-29 year olds in Europe live with their parents. And so the shopping centre has developed from pure retail to an experience centre. Shops sit alongside casinos, gaming areas, and beauty salons. Cinemas and bowling alleys are part of the centre. Retail has become experience venues.
These changes in retail and office property offering are derived from listening to the customer, something the city is not famed for. Back in the day bank customers felt privileged to be a customer. But customers have changed and now the offering has to adapt to focus on serving the customer rather than selling prestige. Bank buildings have become pubs while Peer 2 Peer, Challenger banks, and Digital banks fight for the customer that was once the territory of incumbents.
Legal Services
Lawyers operate in a traditional industry. The top 15 “magic circle”, “silver circle” and “global elite” law firms account for close to half the £33.4 billion annual market. The fees for the top 15 firms average £388k per fee earner. In the mid market below that fees average £278k per fee earner. This is a very attractive market which is still dominated by the large corporate. And like retail and property this market is bound to evolve from the dominance of these prestigious large firms to one that is rebuilt to serve the customer need.
Changing world
Partnership of law firms was once for life, or until the law firm indicated it was time to pass the privilege on to the next generation. It wasn’t until the 1990’s that law firms were allowed to incorporate by their regulator the Solicitors Regulatory Authority (“SRA”). By 2011 only 2,400 of the 10,973 law firms had incorporated. But the customers have changed. Bruce MacEwen, president of Adam Smith, a legal services consultancy was quoted in the Financial Times recently “People in the industry are oblivious to what’s going on. A profound change is taking place in the nature of the social contract among the lawyer, the law firm and the client”. The article suggests that companies used to entrust an entire transaction to one law firm but have tired of subsidising apprenticeships in legal firms and have taken much of the standard work in house using outside firms for the trickiest and most difficult tasks. This puts the large corporate pyramid under strain.
Where does the innovation come from?
This means the traditional ratio of equity partners to lawyers will have to change. Last year 10 law firms paid their partners an average of £1m or more. Slaughter & May led the way with an average of £2.7m, while Macfarlanes was next at £1.7m. Other Magic Circle firms were Allen & Overy at £1.64m and Clifford Chance at £1.6m. With such high rewards for participants in these firms we can’t expect the change to be led by the firms themselves.
Step forward Keystone Law (share price 520p, mkt cap £163m. Floated in 2017 by Panmure Gordon this firm is affectively a legal platform that lawyers who have a client following plug into to whereby they have no fixed salary but receive 75% of their billings. Keystone provides technology, accounting, risk and compliance services as well as central support to enable the lawyer to conduct their business. Founded by the current CEO James Knight in 2002, a commercial solicitor who set out to create a new type of law firm, the company now has 321 fee earners as at January 2018 – up from 266 a year previously. Over the period since 2016 revenues have grown at 27% pa and the firm is among the top 10 fastest growing law firms in the Top 100.
Quoted Companies
The disruptors have come to market relatively recently with 6 quoted law firms coming to market since 2015. As a sector some areas are ‘contracyclical’ ie acting in opposition to the economic cycle. In economic downturns litigation and divorce tend to do well while in economic upturns property and corporate transaction work tends to do well. A well-diversified law firm may not be cyclical. The only one of the quoted companies that is highly concentrated is Rosenblatt which would argue it is contracyclical being focused on litigation.
Source: Sharepad, Prospectuses
Descriptions
These companies come with differing business models.
Gateley is a regional law firm based in Birmingham which is still largely owned by the partners (c70%) with three significant income orientated institutional investors (Liontrust, Unicorn, Miton)
Gordon Dadds came to market by the reverse take over of Work Group and aims to consolidate the numerous small legal firms. Institutional shareholders are value orientated (FMT, Ruffer, Janus Henderson, JP Morgan)
Keystone Law is a platform model based around recruiting fee producing lawyers who are self-employed over their legal platform. This is a more organic model and is more highly rated as a platform.
Rosenblatt is a large ticket city litigation practise and has more lumpy revenues as a result. Part of the reason for the IPO was to raise money for a litigation fee funding facility so large litigation cases can be pursued.
Knights Group is a regional law firm which is acquisitive aiming to consolidate the regional mid-market.
DWF is an international law firm with 27 offices across 14 jurisdictions. The firm is head quartered in Manchester and raised money at IPO in part to fund an acquisition strategy.
Strategies
As investors it is important for us not to err from the reason for investing in the sector in the first place. Which is because the structure of the industry is changing. Of the firms listed here it appears to me that Rosenblatt providing litigation funding and DWF consolidating in international markets is less sensitive to changes in industry structure. Also Gateley, with a more traditional practise and the first firm to come to market, it is more traditionary run. Which leaved Gordon Dadds, Keystone Law, and Knights Group as the three direct plays on the changing structure of the industry.
Gordon Dadds
Share Price 147p
Mkt Cap £55m
Source: Sharepad
Acquisitive
Gordon Dadds has made 6 acquisitions since coming to market at prices varying from 0.5X turnover to 1.5X turnover which is earnings accretive when Gordon Dadds trades at 3X turnover. At the smaller end of the market, low acquisition prices are paid and so if the company can achieve scale there may well be a significant arbitrage opportunity to benefit from here. The problem however is that the company continues to need to raise cash to fund acquisitions which is why the share price fall in January on the chart above – as an illiquid stock it was forced to raise £11.5m of new equity at a 25% discount to the share price. So, while the company is small this will remain a risk and is likely to ensure a low valuation.
Estimates
Significant growth is anticipated on the back of recent acquisitions. No further acquisitions are assumed in forecasts so as acquisitions are delivered there could be upside potential.
Source: Sharepad
Valuation
At 11X PER and with a yield of 2.7% the company is the cheapest in its peer group. I suspect that reflects the implied stock overhang from their need for cash for acquisitions as well as the illiquid nature of the shares. Over the medium term this is likely to change as the company grows. Results to September 2018 evidenced £4.5m cash since which time £11.5m new money has been raised, so the company is unlikely to be issuing more equity to raise cash for a while.
Keystone Law
Share Price 520p
Mkt Cap £163m
Source: Sharepad
Recruiting
The company recruits principal lawyers who the bring a team of fee earners and administrators to create a “pod”. At the end of January, the company had 277 principal lawyers and 321 fee earners. The recruitment process is through intermediary channels and the company is developing new social media channels for growing the recruitment numbers. The pipeline is said to be “strong”. Only 28% of the potential recruits join post vetting as the applicants are not always confident in moving to a self-employed model. Of those that join 90% create a sustainable practise while churn is 5% due to retirement
Estimates
Good growth is forecast. Since IPO the company has upgraded estimates more than once and the rating improvement has been assisted by trading updates that include the phrase “comfortably ahead”. Note however that operating margins are low at only 10.4% and as the company grows in scale this margin will also grow.
Source: Sharepad
Valuation
The shares are the most expensive in the sub sector at a PER of 37.7 and yielding 1.7%. Platform models are generally more expensive because as a service which is not dependent on a number of rainmakers the scalable business has the potential to make high operating margins. Hargreaves Lansdown is an example of a platform that makes a 68% operating margin. The margins at this stage are a lowly 10.4% so the valuation is somewhat forward looking.
Knights Group
Share Price 265p
Mkt Cap £194m
Source: Sharepad
Acquisitions
Since IPO the company has made 3 acquisitions for a combined value of £20m which represents turnover multiple of 1.2X. This is 2.0 times more expensive than Gordon Dadds has been acquiring at as the business are larger. This is still significantly less than the 4.7X turnover that Knight Group trades at indicating a significant arbitrage opportunity for Knights Group.
Estimates
On 21 May the pre close update indicated a strong H2 accompanied by those deeply appreciated words “ahead of profit expectations”. Results are due on 9 July. Estimates anticipate 44% profit growth followed by 57% in the year just started fading to 19% the following year which is largely driven by acquisitions since IPO.
Source: Sharepad
Valuation
16.3X May 2020 earnings is close the rating of the market with the FTSE index trading on a PE of 17.5X.
Personal View
I really like the disruptive model of Keystone Law but many years of bitter experiences has meant I am now unable to deal with the emotional distress of paying 37X for a company when there are so many external factors that could change the environment before the company has grown into its valuation. While Gordon Dadds undoubtedly has the most upside, I don’t underestimate the risks of acquiring small companies when your shares are illiquid. So, I could well be tempted by the young pretender that is Knights Group threatening the gilded pillars of the magic circle.
Summary
Offices have been disrupted from having executive suites in corporate HQ to Wework offices where facilities are shared and beer is included with the rent. The same has happened in retail; where shops are now experience centres. Disruption begins with the customer. As the focus turns from customers using services because they need them the choices are increasing. In banking we had the challenger banks and the peer2Peer lenders. Next up is the lawyers. And as people love to knock lawyers I find myself wondering how large a fan club these companies could build and how highly rated they could become.
Forthcoming Events
We can expect results from five out of six of these new companies in July. The disruptors are on the pitch and are set to perform this month.
Weekly Commentary: 01/07/19
Disruption in the Courts
Early for lunch on the 24th floor of Tower 42 in the City I gazed over the tower blocks of the city. When I started work the City buildings stopped at Liverpool Street Station. The area to the north of the station building was rough land inhabited by a flock of pigeons guaranteed to ensure the recently acquired suit of every new graduate (which had cost the best part of a months’ wages) would be soiled by overhead avians. Now it is Broadgate. Then, the Nat West Tower was the tallest building in the square mile followed by what was then called the Commercial Union building. Of course, these two buildings are now called Tower 42 and St Helens. All the significant buildings were named after the corporate that inhabited them as a prestigious head office offering a symbol of the institution’s achievements and its standing in the City. Now as far as I am aware only the Bank of England is named after the institution that inhabits the building. And some large institutions inhabit We-work offices complete with facilities for dogs and free beer included with rent. The decline of the corporate headquarters reflects a cultural change which is soon reflected in properties.
Retail
Similar forces are at work in the retail sector. Last year there were 7,500 store closures in the UK, an increase of 36% on the prior year and the future of the high street is increasingly uncertain. Yet a visit to Westfield in Stratford shows a very different picture where it is bustling. The Unibail-Rodamco-Westfield (market cap £15bn) investor day on 14th June gave some interesting insights into this cultural change that is happening today. Consumers demand immediacy. They want frictionless products at all times of day and night. Physical and online product have become co- dependent as 56% of online consumers visit stores. The traditional family of 2.4 children has now moved to extended families. 56% of European 20-29 year olds in Europe live with their parents. And so the shopping centre has developed from pure retail to an experience centre. Shops sit alongside casinos, gaming areas, and beauty salons. Cinemas and bowling alleys are part of the centre. Retail has become experience venues.
These changes in retail and office property offering are derived from listening to the customer, something the city is not famed for. Back in the day bank customers felt privileged to be a customer. But customers have changed and now the offering has to adapt to focus on serving the customer rather than selling prestige. Bank buildings have become pubs while Peer 2 Peer, Challenger banks, and Digital banks fight for the customer that was once the territory of incumbents.
Legal Services
Lawyers operate in a traditional industry. The top 15 “magic circle”, “silver circle” and “global elite” law firms account for close to half the £33.4 billion annual market. The fees for the top 15 firms average £388k per fee earner. In the mid market below that fees average £278k per fee earner. This is a very attractive market which is still dominated by the large corporate. And like retail and property this market is bound to evolve from the dominance of these prestigious large firms to one that is rebuilt to serve the customer need.
Changing world
Partnership of law firms was once for life, or until the law firm indicated it was time to pass the privilege on to the next generation. It wasn’t until the 1990’s that law firms were allowed to incorporate by their regulator the Solicitors Regulatory Authority (“SRA”). By 2011 only 2,400 of the 10,973 law firms had incorporated. But the customers have changed. Bruce MacEwen, president of Adam Smith, a legal services consultancy was quoted in the Financial Times recently “People in the industry are oblivious to what’s going on. A profound change is taking place in the nature of the social contract among the lawyer, the law firm and the client”. The article suggests that companies used to entrust an entire transaction to one law firm but have tired of subsidising apprenticeships in legal firms and have taken much of the standard work in house using outside firms for the trickiest and most difficult tasks. This puts the large corporate pyramid under strain.
Where does the innovation come from?
This means the traditional ratio of equity partners to lawyers will have to change. Last year 10 law firms paid their partners an average of £1m or more. Slaughter & May led the way with an average of £2.7m, while Macfarlanes was next at £1.7m. Other Magic Circle firms were Allen & Overy at £1.64m and Clifford Chance at £1.6m. With such high rewards for participants in these firms we can’t expect the change to be led by the firms themselves.
Step forward Keystone Law (share price 520p, mkt cap £163m. Floated in 2017 by Panmure Gordon this firm is affectively a legal platform that lawyers who have a client following plug into to whereby they have no fixed salary but receive 75% of their billings. Keystone provides technology, accounting, risk and compliance services as well as central support to enable the lawyer to conduct their business. Founded by the current CEO James Knight in 2002, a commercial solicitor who set out to create a new type of law firm, the company now has 321 fee earners as at January 2018 – up from 266 a year previously. Over the period since 2016 revenues have grown at 27% pa and the firm is among the top 10 fastest growing law firms in the Top 100.
Quoted Companies
The disruptors have come to market relatively recently with 6 quoted law firms coming to market since 2015. As a sector some areas are ‘contracyclical’ ie acting in opposition to the economic cycle. In economic downturns litigation and divorce tend to do well while in economic upturns property and corporate transaction work tends to do well. A well-diversified law firm may not be cyclical. The only one of the quoted companies that is highly concentrated is Rosenblatt which would argue it is contracyclical being focused on litigation.
Descriptions
These companies come with differing business models.
Gateley is a regional law firm based in Birmingham which is still largely owned by the partners (c70%) with three significant income orientated institutional investors (Liontrust, Unicorn, Miton)
Gordon Dadds came to market by the reverse take over of Work Group and aims to consolidate the numerous small legal firms. Institutional shareholders are value orientated (FMT, Ruffer, Janus Henderson, JP Morgan)
Keystone Law is a platform model based around recruiting fee producing lawyers who are self-employed over their legal platform. This is a more organic model and is more highly rated as a platform.
Rosenblatt is a large ticket city litigation practise and has more lumpy revenues as a result. Part of the reason for the IPO was to raise money for a litigation fee funding facility so large litigation cases can be pursued.
Knights Group is a regional law firm which is acquisitive aiming to consolidate the regional mid-market.
DWF is an international law firm with 27 offices across 14 jurisdictions. The firm is head quartered in Manchester and raised money at IPO in part to fund an acquisition strategy.
Strategies
As investors it is important for us not to err from the reason for investing in the sector in the first place. Which is because the structure of the industry is changing. Of the firms listed here it appears to me that Rosenblatt providing litigation funding and DWF consolidating in international markets is less sensitive to changes in industry structure. Also Gateley, with a more traditional practise and the first firm to come to market, it is more traditionary run. Which leaved Gordon Dadds, Keystone Law, and Knights Group as the three direct plays on the changing structure of the industry.
Gordon Dadds
Share Price 147p
Mkt Cap £55m
Source: Sharepad
Acquisitive
Gordon Dadds has made 6 acquisitions since coming to market at prices varying from 0.5X turnover to 1.5X turnover which is earnings accretive when Gordon Dadds trades at 3X turnover. At the smaller end of the market, low acquisition prices are paid and so if the company can achieve scale there may well be a significant arbitrage opportunity to benefit from here. The problem however is that the company continues to need to raise cash to fund acquisitions which is why the share price fall in January on the chart above – as an illiquid stock it was forced to raise £11.5m of new equity at a 25% discount to the share price. So, while the company is small this will remain a risk and is likely to ensure a low valuation.
Estimates
Significant growth is anticipated on the back of recent acquisitions. No further acquisitions are assumed in forecasts so as acquisitions are delivered there could be upside potential.
Source: Sharepad
Valuation
At 11X PER and with a yield of 2.7% the company is the cheapest in its peer group. I suspect that reflects the implied stock overhang from their need for cash for acquisitions as well as the illiquid nature of the shares. Over the medium term this is likely to change as the company grows. Results to September 2018 evidenced £4.5m cash since which time £11.5m new money has been raised, so the company is unlikely to be issuing more equity to raise cash for a while.
Keystone Law
Share Price 520p
Mkt Cap £163m
Source: Sharepad
Recruiting
The company recruits principal lawyers who the bring a team of fee earners and administrators to create a “pod”. At the end of January, the company had 277 principal lawyers and 321 fee earners. The recruitment process is through intermediary channels and the company is developing new social media channels for growing the recruitment numbers. The pipeline is said to be “strong”. Only 28% of the potential recruits join post vetting as the applicants are not always confident in moving to a self-employed model. Of those that join 90% create a sustainable practise while churn is 5% due to retirement
Estimates
Good growth is forecast. Since IPO the company has upgraded estimates more than once and the rating improvement has been assisted by trading updates that include the phrase “comfortably ahead”. Note however that operating margins are low at only 10.4% and as the company grows in scale this margin will also grow.
Source: Sharepad
Valuation
The shares are the most expensive in the sub sector at a PER of 37.7 and yielding 1.7%. Platform models are generally more expensive because as a service which is not dependent on a number of rainmakers the scalable business has the potential to make high operating margins. Hargreaves Lansdown is an example of a platform that makes a 68% operating margin. The margins at this stage are a lowly 10.4% so the valuation is somewhat forward looking.
Knights Group
Share Price 265p
Mkt Cap £194m
Source: Sharepad
Acquisitions
Since IPO the company has made 3 acquisitions for a combined value of £20m which represents turnover multiple of 1.2X. This is 2.0 times more expensive than Gordon Dadds has been acquiring at as the business are larger. This is still significantly less than the 4.7X turnover that Knight Group trades at indicating a significant arbitrage opportunity for Knights Group.
Estimates
On 21 May the pre close update indicated a strong H2 accompanied by those deeply appreciated words “ahead of profit expectations”. Results are due on 9 July. Estimates anticipate 44% profit growth followed by 57% in the year just started fading to 19% the following year which is largely driven by acquisitions since IPO.
Source: Sharepad
Valuation
16.3X May 2020 earnings is close the rating of the market with the FTSE index trading on a PE of 17.5X.
Personal View
I really like the disruptive model of Keystone Law but many years of bitter experiences has meant I am now unable to deal with the emotional distress of paying 37X for a company when there are so many external factors that could change the environment before the company has grown into its valuation. While Gordon Dadds undoubtedly has the most upside, I don’t underestimate the risks of acquiring small companies when your shares are illiquid. So, I could well be tempted by the young pretender that is Knights Group threatening the gilded pillars of the magic circle.
Summary
Offices have been disrupted from having executive suites in corporate HQ to Wework offices where facilities are shared and beer is included with the rent. The same has happened in retail; where shops are now experience centres. Disruption begins with the customer. As the focus turns from customers using services because they need them the choices are increasing. In banking we had the challenger banks and the peer2Peer lenders. Next up is the lawyers. And as people love to knock lawyers I find myself wondering how large a fan club these companies could build and how highly rated they could become.
Forthcoming Events
We can expect results from five out of six of these new companies in July. The disruptors are on the pitch and are set to perform this month.