IMF has been on and off my radar for a long time - i’ve always thought of it as a relatively well-managed business with a very interesting niche. In fact, i once owned the IMFG notes (perhaps up until 3-4 years, when they were redeemed). That said, as anyone who’s at all familiar with the business knows, it has always had two key challenges (amongst the day-to-day challenge of ensuring it gets adequate return from the cases it funds):
Lumpy outcomes of cases, which are often binary in nature; and
As a result of (1), IMF has always mandatorily been ‘capital inefficient’, in the sense that the volatility of the business’ cash flow and the requirement that IMF be well-funded to have counterparty credibility in the cases it funds, has forced them to be heavily net cash.
So, not only is the business very hard to accurately value as a result of the inherently lumpy and unpredictable nature of its cash flows (both in terms of timing and quantum), but the rate at which cash is returned to shareholders is uncertain as a result of (2) above. Further, the business has always been at risk of a seriously negative yet somewhat unquantifiable capital event (i.e. dilutive equity raise) as a result of its capital intensity. These two factors have prevented me from ever being willing to buy the equity of the business, even when it appeared obviously cheap in late 2015 / early 2016 (after the stock was sold almost down to $1).
However, something important occurred a few weeks ago on February 13, when IMF announced its US venture with Fortress. All of a sudden, the business had gone from being a capital pig with the constant risk of a seriously negative capital event for IMF shareholders, to having the luxury of investing up to $200m to underwrite its expansion into the US, but with IMF shareholders only being on the hook for $1 in every $4 investment, without IMF’s investment discretion being cruelled (as it obviously was under the Euro JV structure, which broke down in 2016 - that’s the price of learning). Great result for IMF as it significantly solves what, for me, is the primal problem that has always beset the business (its capital intensity). Not only that, but the venture brings with it two other significant benefits:
The potential for IMF to earn a large performance fee once the venture matures. This is impossible to quantify, but it’s a valuable option even today.
The “lemming effect” - with the greatest of respect, institutional investors (like Fortress) are lemmings - the first thing they usually want to know before investing into a product (especially a new one, like litigation funding) is “who else has done it?”. Having now raised its first fund, i expect IMF is well-placed to raise other funds with respect to its other geographies, to further reduce the “capital pig” nature of its enterprise.
So, as a result of this development, IMF became of interest to me. I then took a first sweep look at the company’s valuation - given earnings multiples are basically useless in valuing this business (because earnings are so volatile), i think you have to use a balance sheet metric and see where the company is trading relative to the balance sheet value of its intangibles. The purest way i think you do this is assume everything else on IMF’s balance sheet is dollar-for-dollar, compare market cap to net asset value, and apply the entire market cap to NAV premium to the balance sheet value of the company’s intangible investment in its cases. Here were the results:
The key ratio here is the last line of the table. On this admittedly very crude and simple metric, IMF is trading cheaply relative to its last 10 years of trading history. So, this got me digging and, while on a scenic walk near Byron Bay, the bright idea of attempting to do what i previously thought of as very difficult with respect to IMF - namely, a DCF to spit out what the very rough value of the company’s existing (not future) litigation book is - struck me.
As with all DCFs, this is very much garbage in / garbage out exercise, so i wanted to put some meat around what the key assumptions on the existing litigation book are. Here’s broadly how i conceived of the exercise:
Valuing any future cases (that aren't yet on the books) is a waste of time. The object of the exercise is to put a reasonable value on what the existing litigation book might return over the next 3 or so years as the cases are realized, discount that back at a reasonable rate, and calculate the NPV of the existing litigation book relative to the company’s existing market cap.
The key assumptions to value the existing litigation book actually aren’t that hard, and we have 10 years of observable and reported data on which to base them (i've used the last 7, as that's as far back as when the annual reports stated all of claim value resolved, income, and investment by IMF). They are:
What portion of claim value IMF is likely to see as income. This is reported in their annual reports every year. This metric is volatile year to year - for example, in 2010 they earned 32% of claim value on cases resolved, whereas in the terrible year of 2015, they earned only 15%. That said, the cumulative average over the last 6 years is 19% (they’ve earned $534m on $2,825m claim value). I have picked a relatively conservative 17% for the base case DCF (only 1 year in the last 7 has IMF realized less than 18% on that ratio, namely 2015).
What portion of claim value is typically invested by IMF to realize any income. Similar to the above, this is highly volatile - for example, in 2010 IMF invested $27m on $142m claim value (5.2 ratio), but in 2011 they invested $20m for $270m claim value (13.6 ratio). The average over the last 7 years across all cases resolved is 9.8 (IMF has cumulatively invested $289m in litigation expense, on $2,825m claim value cases resolved). This informs how much more money IMF needs to invest in litigation expenses to see their existing litigation book through to its maturity. At the moment, IMF has invested $162m for a claim value of $3,370m, so the (claim value / invested litigation expense) is ~21; however, as noted, i know the 7-year average is ~10x**. Therefore, i estimate IMF need to invest an additional ~$175m in their existing loan book to support the $3,370m claim value (i.e. a total of $337m invested to support $3,370m claim value). I then pro-rate this expenditure based on when claims resolve (i.e. if 10% of existing claims are resolving in a given period, then i assume 10% of that $175m additional required investment falls in the corresponding period).
When the cases are going to resolve. IMF provide a broad outline of this in their 1HFY17 results ($238.5m in 2HFY17, $1,623m in FY18, and $1,508m in FY18 or beyond). I assume the FY18 cases resolve evenly each quarter (for simplicity), and then assume the remaining $1,508m resolves evenly over 8 quarters.
Set out below is the summary table of the last 7 years of data as per IMF's annual reports:
3. Overlay the corporate expenses on top of the litigation book income
Corporate and office expenses is running at ~$4m per half
Employee recurring expenses is running at ~$4.5m per half
Other expenses is running at ~$0.5m per half
4.Pick an appropriate required rate of return. For me, i’ve picked a round 20%, because i’d want at least a 20% p.a. return to invest in a business as volatile as this.
5. 30% tax rate assumed,
Plugging that all into a DCF yields the following:
As can be seen, on these broad-brush assumptions, i value the existing litigation book at about $1.60 per share. The two big assumptions which drive valuation are, of course, what % of claim value is assumed as income to IMF, and what the investment:claim value ratio is. If i run a more conservative 15% claim value:income ratio (instead of 17%), and a more conservative 9 claim value:investment ratio (instead of 10), that value drops to $1.30, so there’s obviously significant sensitivity to those assumptions.
** While i have picked a 10 investment:claim value ratio (based on average over last 7 years), i think this is actually a somewhat conservative assumption. The reason is that what really drives this ratio lower than it otherwise would be is the bank fees case, where IMF admitted they invested far too much relative to claim value against an extremely well-funded counterparty (i.e. the big banks) that was always going to appeal all the way to the high court - this was a big gamble with shareholders money, and it failed. Stripping out the bank fees case, this ratio would be more in the region 11.
Translating the above
So, i think on reasonably conservative (albeit admittedly rough) assumptions, IMF’s existing litigation book is worth about 60-75% of current share price. If i use more aggressive albeit not crazy unrealistic assumptions (say, 18% income:CV ratio and 11 CV:lit investment ratio), i can get almost 90% of today’s share price in NPV of the existing litigation book.
I would say there aren’t too many businesses on the ASX where the cash-adjusted NPV of the business’ next 3 years of free cash flows approximate ~60%+ of existing market cap (in fact, probably very few). However, the trick with IMF is, of course, that this cash doesn’t land in shareholders’ pockets; instead, the majority of it will be reinvested by management into future cases, so it is a bit of a ‘trust me’ exercise. But, with the business in the best position it has ever been in regard to capital funding (following the US JV), with an increasingly smooth cash flow profile (due to increased number of smaller cases), and a shot at earning a potentially material performance fee from the US JV 4-5 years from now, i think the odds of shareholders generating favorable 3-5 year returns on today’s <$2 per share price are good.
For me, this business still has (and probably always will have) too many inherent vicissitudes and uncertainties to make it a large part of a sensibly allocated portfolio, but i think it’s a sensible and calculated bet at today’s prices.
I welcome any comments, and particularly critiques, of any of the above. I'd especially be interested in hearing any comments regarding the two key ratios that drive valuation (income as % of claim value, and investment as % of claim value).
IMF Price at posting:
$1.99 Sentiment: Buy Disclosure: Not Held
