Up until now, most of my analysis on IMF has led me to conclude simply that the stock is relatively cheaply priced, for two principal reasons:
The market cap premium of the stock relative to the intangible balance sheet value of its case investments is currently around 1.65x (i.e. market cap of $312m relative to net assets of $207m gives premium of $105m, versus intangible balance sheet value of $162m, equals $267/$162m). A 1.65x ratio on this metric is the cheapest the stock has been in a decade (using only August average prices) - the last time the stock was this cheap (ignoring the brief blip in late 2015/early 2016, when it got way oversold) was in 2008, when the ratio was around 1.7x.
The NPV of their current litigation book plus net cash on balance sheet, using a 20% discount rate and conservative assumptions on revenue realization that are informed by historical results, is at least $1.20 per share, or around 2/3rds of today’s market cap. Today’s market cap therefore implicitly places little value in the ability of IMF to generate future cash flows beyond the litigation book they currently have.
Knowing a stock is cheap, for me, a very (or perhaps even THE most) important part of any analysis as it helps assure me that the risk of capital loss is minimized (given that the easiest way to suffer capital loss with stocks is simply to overpay in the first place). That said, while knowing something is cheap and therefore downside may be minimized is very helpful, it doesn’t answer the whole question - the other part of the equation is to think about what the upside might be. If something is cheap but the upside is limited, then it’s nothing to get too excited over; however, the situations that are most interesting are those where the stock is both cheap, and there is substantial upside.
I think analyzing IMF’s future potential upside requires a few general comments be said:
Looking at the past is insightful but not necessarily conclusive in IMF’s case, because the business is now in the midst of a 3-year transformation program commenced in late 2015. This transformation program has at its core a few basic goals: 1) To reduce the volatility of IMF’s earnings by investing in more but smaller cases, and diversifying by geography (and therefore reducing reliance on Australia, where IMF dominates the market and so is pushing up against the law of diminishing returns), and 2) To grow the business substantially from where it was 2-3 years ago, by investing substantially more (and more consistently) than was the case up until 2-3 years ago.
Even if IMF is generally successful in its goals, the inherent volatility in the business can’t be totally diversified away or negated. The upshot of this is that any attempt to analyze the future upside of IMF requires looking at a few different scenarios that fall within the bounds of reasonableness based on current business planning, as opposed to simply assuming that one particular outcome is going to come to pass. The latter approach significantly underplays the inherent unpredictability of the business.
The lead time from case investment to results is, in IMF’s case, around 2 years - that is, an increased case investment load won’t show up in the P&L for about 2 years given that cases take around 2 years to go from funding commitment to resolution. Given IMF management commenced the 3-year transformation program in late 2015 and has said that the turnaround program will conclude in FY18, the full P&L impact of the turnaround program won’t be seen until around FY20.
With that said, the way i then think about the upside for IMF is to think about where the business might be in FY20 when the transformation and revised investment program is fully evident in the P&L. Forecasting 3 years hence is extremely difficult for any business and perhaps even more so for IMF, but at its most basic there are two drivers to forecasting IMF’s gross revenue: 1) how much IMF invest, and 2) what the future MOIC is going to be.
Regarding the forecast of point (1), IMF started providing a blueprint of their future investment plans in their FY15 results pack. What i have done below is replicate that table (which has since been provided twice a year in each of their results presentations), and also pulled from their financial report the claim value each period’s worth of funds committed supports:
Column 1
Column 2
Column 3
Column 4
Column 5
Column 6
Column 7
Column 8
1
2014(A)
2015(A)
2016(A)
2017H1(A)
TOTAL TO DATE
2017H2(F)
2018(F)
2
Cases funded
8
21
27
12
42
61
3
Funds committed
$42m
$54m
$81m
$24m
$201m
$83m
$123m
4
Claim value of new cases
$765m
$690m
$1,417m
$390m
$3,262m
???
???
5
$ of CV per $ of funds committed
$18.1
$12.8
$17.5
$16.3
$16.2
???
???
The key number in the above table, as far as forecasting FY20 goes, is how much they plan to commit in FY18: $123m. That represents nearly a 3-fold increase over funds committed in FY14 ($42m), which gives a sense for the scale of growth the business is going through.
The other piece of important information in the above table, aside from dollars committed in a given year, is the claim value each dollar of committed capital supports. While this is definitely not a bulletproof leading indicator of what MOIC might be ~2 years hence, it is an important clue they give. As a general rule, the higher the claim value relative to each dollar of funding committed, the more likely it is that, assuming a settlement at ~15% of claim value, IMF’s MOIC ~2 years hence (when the claim resolves) will be in excess of the targeted 2x. So, looking at the above, one would expect the FY14 ratio of $18.1 to lead to a reasonably profitable FY16, and indeed that was the case (2.9x MOIC pre case losses; 2.1x MOIC post $12.9m loss on appeal); conversely, one could expect the FY15 ratio of $12.8 to lead to a less profitable FY17, and that’s been the case based on 1HFY17 results (1.9x MOIC). What i’m generally looking for going forward, then, is that this ratio stays at or above 15, as that’s a leading indicator of future MOIC; if that ratio dips significantly, that would hint to me that there’s some potentially less profitable growth going on or the law of diminishing returns is applying (i.e. for the same value of dollars committed, they are funding less and less claim value which, all other things assumed equal, would be a leading indicator of reduced MOIC).
While the ratio of (claim value:funds committed) provides a hint as to future direction of MOIC, i think it’s also instructive to look at what the business has done over the last 10.5 years:
Column 1
Column 2
Column 3
Column 4
Column 5
Column 6
Column 7
Column 8
Column 9
Column 10
Column 11
Column 12
Column 13
1
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017H1
TOTAL
2
Settlements
$31.30
$55.20
$63.20
$46.10
$57.90
$117.80
$43.90
$75.90
$92.30
$99.80
$66.65
$750.05
3
Contracts in progress expense
-$16.20
-$17.60
-$21.90
-$22.70
-$18.70
-$44.00
-$18.80
-$33.50
-$48.50
-$22.50
-$34.42
-$298.82
4
Written down expenses
-$1.10
-$4.10
-$6.20
-$4.70
-$1.20
-$3.20
-$1.40
-$16.50
-$0.60
-$11.40
-$1.15
-$51.55
5
MOIC pre-losses
1.81
2.54
2.25
1.68
2.91
2.50
2.17
1.52
1.88
2.94
1.87
2.14
6
Losses on appeal
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
-$28.60
-$12.90
0
-$41.50
7
MOIC post losses
1.81
2.54
2.25
1.68
2.91
2.50
2.17
1.52
1.19
2.13
1.87
1.91
This helps isolate the drag that the 2015-2016 lost appeals had on the overall performance of the business - MOIC is 2.14x over 10.5 years pre those losses, but goes down to 1.9x post those losses.
Forecasting 2020
So, rolling all this through, we can start to come up with some rough scenarios for where the business might be in FY20. Below i have constructed 3 scenarios based on the above data, each of which i consider to be within the bounds of reasonableness (albeit each produce very different scenarios for shareholders).
Column 1
Column 2
Column 3
Column 4
1
BAD
OK
GOOD
2
Investment realised in FY20 (investment made in FY18)
$100.00
$110.00
$120.00
3
MOIC assumed
1.75
2.00
2.25
4
Gross revenue
$175.00
$220.00
$270.00
5
Less: case investment
-$100.00
-$110.00
-$120.00
6
Net revenue
$75.00
$110.00
$150.00
7
Overhead
-$35.00
-$35.00
-$35.00
8
EBT
$40.00
$75.00
$115.00
9
Multiple
6
7
8
10
EV
$240.00
$525.00
$920.00
11
Net cash (assumed)
50
50
50
12
Implied market cap
$290.00
$575.00
$970.00
13
SOI
190
190
190
14
Price per share
$1.53
$3.03
$5.11
Below is an explanation of each scenario:
BAD: Management here, frankly, have done a poor job on two fronts: 1) they have significantly under-committed funds relative to their FY18 stated target of $123m (i.e. they committed $100m instead of targeted $123m); 2) not only have management not got enough money out the door, they have also consistently selected bad cases in which to invest, which leads to a 1.8x MOIC (well below the stated 2x MOIC target). Under this scenario, management gets a “C-” grading, particularly in the context of a business which has more than doubled its corporate overhead from $15m in FY15 to a forecast $35m in FY20. In this scenario, the market assigns a very modest 6x pre-tax multiple to the business’ earnings.
OK: Management here have done an OK but not great job; they have under-committed relative to stated $123m target but have managed to get $110m out the door in FY18. Case selection / management is solid but not great, resulting in a 2x MOIC. Overall, management here probably get a “B-” or thereabouts for their performance. The market assigns a marginally more aggressive 7x pre-tax multiple to the business’ earnings.
GOOD: Management have done a good job - they have more or less hit their $123m FY18 funds commitment target, and they have marginally exceeded the 2x MOIC target. Overall, management here scores a “B+” or better. The market gives the business an 8x multiple for pre-tax earnings.
Below is an explanation of some specific assumptions:
Investment realized: I’ve simply assumed the funds committed in FY18 (target: $123m) is what comes back in FY20. The “good” case, therefore, is the one in which management hits its committed investment target.
MOIC: While this has been as high as ~3x in FY11, and as low as 1.2x in FY15 (due to losses) based on IMF’s historical results which have been overwhelmingly driven by Australian cases, my expectation is that the MOIC will be less volatile going forward as the US funding agreements have two key advantages: 1) no adverse costs orders, 2) IMF’s return is stipulated as being the higher of a prescribed MOIC or % of funds received by claimant. Additionally, having more invested across a greater number of cases should iron out some volatility. The leading indicator to watch here, as mentioned above, is the (claim value:funds committed ratio) in FY18 - the higher, the better, all other things being equal.
Overhead: The business currently has a run-rate overhead of $30m p.a. but i’m expecting this to grow a little between now and FY20, particularly as they are looking into reopening in Europe and expanding somewhat in Asia.
Shares on issue: The DRP will see that today’s shares on issue will rise from their current 171m, to around 190m, given current rate of dilution. I find it annoying that the business is paying dividends but then has a DRP in place which leads to dilution - i’d much rather they just reduced the dividend - but that is what it is.
The multiple
Aside from MOIC, this is the biggest driver of potential future value. I’ve said before that this business is tough to ascribe a multiple to given inherent volatility in earnings and the need for IMF to constantly reinvest its earnings to stay alive (a little like a property developer who is constantly buying, building, selling, and then buying again), but inevitably i think market participants are going to revert to pricing IMF using familiar metrics, and market participants will be increasingly comfortable giving IMF a reasonable multiple (in the order of 8x) if IMF can: 1) smooth out its earnings profile over the next few years via its diversification and growth strategy, and 2) demonstrate that it’s on a sustainable growth path. I think 6x pre-tax earnings on the low side would be a pretty harsh number, but i do think something even higher than 8x by FY20 is possible, particularly if the case book at that point in time shows more growth and/or they have further developed their funds strategy (i.e. earning recurring fees from investing other people’s money, similar to Fortress deal) - there is plenty of precedent over the last decade or two in the Aus REIT space of real estate developers that have converted themselves into funds managers, and subsequently garnered much higher earnings multiples than a real estate developer might typically attract (which may be the 6-8x EBIT range i’ve used).
On multiples, below is how IMF has traded, using August data, over the last ten years (August being selected as it’s the month in which they report annual results). The numbers in brackets are adjusted for IMF’s losses on appeal ($28.6m in FY15, and $12.9m in FY16). While the multiples fluctuate wildly from year to year (because these are trailing multiples and the market is valuing the future), i think the below broadly lends support to my selected 6-8x range in a more stabilized state (although i reiterate that i think an 8x could be a slightly low number in the “good” scenario). What i also found somewhat interesting is that the market broadly “looked through” the appeal loss impacted years of FY15 & FY16, in terms of still ascribing the business a decent multiple ex the losses and appeals. If i take a simple average (rather than weighted average) of the appeal-adjusted multiple over the last 8 years, i get 7.8x.
Column 1
Column 2
Column 3
Column 4
Column 5
1
Market cap (August avg.)
EV
NPBT
EV/NPBT
2
Aug 09
174
113
30.4
3.7x
3
Aug 10
182
139
16.8
8.3x
4
Aug 11
200
178
32.8
5.4x
5
Aug 12
225
197
61.4
3.2x
6
Aug 13
285
255
20.1
12.7x
7
Aug 14
308
250
15.6
16.0x
8
Aug 15
277
195
8.6 (37.2)
22.7x (5.2x)
9
Aug 16
337
274
20.8 (33.7)
13.2x (8.1x)
10
WTD. AVG.
1,988
1,601
206.5 (248)
7.7x (6.5x)
11
SIMPLE AVG.
10.7x (7.8x)
Interpretation / conclusion Based on my workings, it seems that IMF is both relatively cheap at current levels, and offers significant upside under even a mildly successful implementation of management’s 3-year growth plan (i.e. the “OK” scenario). If management are successful in getting the targeted $123m out the door in FY18 and do a reasonable job of investing it (2x MOIC or higher), the upside appears large (refer “good” scenario”). My interpretation of where the stock is trading currently is that market participants are thinking one (or more) of a few different things:
Don’t quite understand the dynamics of this business, and the 2-year lag between investment and P&L impact - effectively, the revenue side of the business today represents the structure of the business 2-3 years ago, whereas the cost side of the business (the $30m overhead...which has doubled in the last 2 years) represents the investment to get the business to be able to deliver on its growth plans.
Don’t believe management will get their $123m investment target. Some skepticism here is perhaps warranted because the FY16 funds commitment target of $86m (stated on 1 October 2015) was undershot by $5m (they actually committed $81m in FY16). That said, given the growth in overhead (hiring of new personnel) and the opening of new offices etc., there’s little doubt in my mind they have the people and platform necessary to commit $120m. In simple terms, i look at the business and say that, on average, they were committing about $35-40m p.a. from 2010-2016 (total litigation expense of $248m over that period of 7 years) with an overhead that was $8m in 2014, i.e. they were committing $4-5m of case spend per $1m of overhead. The current $30-$35m overhead only has to commit $3.5-$4 per dollar of overhead to get to $120m committed, so even if they are substantially less efficient in writing new business than they were before the expansion started, they should still have enough people on the ground to ensure the funds are committed (and managed) as communicated to the market.
Are assuming that MOICs across the industry are heading down. Again, this could be true - IMF has been mentioning in its reporting for a number of years that money and competition is entering the industry, which could push returns on cases down over time. I think the offset to this for IMF is a few different things: 1) the US should generate higher and more stable MOICs over time given the agreements there are structured more favorably (no adverse costs, floor on prescribed multiple), 2) IMF is already likely to be earning some small recurring fees on funds managed on behalf of Fortress, and it appears as though management are thinking about implementing this structure elsewhere.
This isn’t the sort of situation i’d mortgage my financial future on because there are scenarios where things don’t work out (“bad” scenario), and the upside isn’t a 10x, but it does appear to me to be a well-calculated bet.
