Keystone Law Group (AIM:KEYS)

"Show me the incentive, and I'll show you the outcome"

I liked my last bite sized writeup (with a longer version available), so I’m continuing the trend. My full write-up is available here (which has more detailed financial metrics, discussion of the business model in detail, competition analysis, DCF figures, historical capital allocation etc). As always, I welcome any comments or feedback.

Background 

I loved reading Peter Lynch’s ‘One Up on Wall Street’ last year, and I just finished Phil Fisher’s infamous book ‘Common Stocks & Uncommon Profits’. My takeaway is that these guys promote buying a company where you personally see a trend emerging, use a bit of scuttlebutt and most importantly bring your personal background to the table.

So, I’ve been meaning to try and use my ‘edge’ a bit. Unfortunately, a legal background has felt more like a plastic spatula than a knife in terms of ‘edge’. Despite feeling blunt, I decided to take a look at a few law listed law firms and I came across Keystone in a screener. Don your wig, learned friend, and excuse any latin.

Keystone is a UK Top 100 law firm, growing, debt free, profitable and highly cash generative. It is unusually capital light with high operating leverage due to low fixed costs. Importantly, it pays its lawyers commissions rather than flat wages and it only pays its lawyers when the firm receives cash payment from clients. This incentivises higher output from lawyers, and puts a focus from all fee earners on cash collections by the firm rather than WIP figures (which may not be recoverable). In my view, this is an example of Munger’s (also a lawyer) famous saying… ‘Show me the incentive, and I’ll show you the outcome’.

Why does the opportunity exist? 

This has all the hallmarks of a hairy idea:

1. LBO of a co-founder by a PE firm a few years before IPO, clearly with a take public strategy. One of the co-founders exited as part of the LBO. Market no likey (and not without cause - PE involvement turns a lot of investors off).

2. Semi-recent (2017) IPO.

3. PE firm has been selling shares and has virtually exited now, remaining founder has sold down a bit too (still holds >30% of the co). Insiders were selling the top late last year. We’re coming into an earnings print next month.

4. The legal industry has left investors licking wounds before - regulation scares them. But I also suspect Australian readers are currently whispering softly to themselves… ‘Slater and Gordon’, some perhaps rocking back and forth in the fetal position while refreshing their portfolios. Don’t worry, in the full write up, I detail why large law firm blow-ups have actually made Keystone (and its comps) more attractive to fee earners over traditional equity partnerships.

5. This is a small cap, though does carry some analyst coverage. It would be nutty for this company to ever do a cap raise, but who knows. Investor relations were not friendly / open in my attempts to deal with them. My questions around capital allocation and competitive advantages were brushed and I was sent to the IR website which didn’t detail these two (critical) things. 

Why is it compelling?

Some selected data:

• Return on Invested Capital (5Y Avg): 23.8%

• Return on Common Equity (5Y Avg): 30.4%

• Return on Capital Employed: 44.5%

• Return on Invested Capital CAGR (5Y): 7%

• Operating Margin CAGR (5Y): 10.2%

• Diluted EPS CAGR (5Y): 42.9%

• Cash from operations CAGR (5Y): 42%

• FCF Yield: 2.6%

• Debt to Equity: 7.9%

In 2021 it had a 100% operating cash conversion ratio (~80% in 2020). It is exceptionally capital light, and has high operating leverage. It uses a disruptor model which materially decreases risks around receivables as Keystone does not pay its lawyers until Keystone has been paid by clients. On the flip side, lawyers are paid commissions on cash receipts - allowing them to boost their earnings, control their own teams and hours and avoid the risk/pitfalls of traditional equity partnership at a bloated firm. Keystone doesn’t have a legion of fancy offices. Operating margins are expanding and revenue continues to grow, albeit with decreasing velocity on the revenue side. Lawyer churn has been at ~5% since IPO. Lawyer growth has been driven primarily by word-of-mouth referrals and internal recruiting drives rather than gun for hire recruiters (this is a green flag for culture and margins). The valuation has been historically rich, but a recent -22% drawdown has put the price at a more reasonable level. But is it reasonable enough…

Caveat emptor: What are the risks?

The firm faces intense competition. Management has not, through its filings or in response to my questions, been able to clearly articulate whether it believes Keystone has a competitive advantage or pricing power. I think there might be switching costs and potentially a network effect in here, but without the figures I need, its too hard to tell. The company doesn’t disclose the portion of work which it does that is RB (return business) - i.e. recurring revenue stats, nor do they report client churn figures. They weren’t able to tell me whether the model is sticky (either for lawyers, or clients). We also don’t know whether the firm is growing in higher margin practice areas or lower margin practice areas due to low segment reporting info. Also revealing in the filings is that capital allocation is not an obvious focus for management. Other risks include a restriction in the potential hiring pool of lawyers going forward, which would hurt growth (which is slowing in its velocity). The talent pool is wide, but only so deep.

Quantum valebant: what is it worth?

This is priced close to perfection. There is a slight ~15% margin of safety in the price on a DCF (see my full writeup for assumptions, but a multiple contraction is a scary outcome here). Its trading at a P/E of 38.6x and an EV/EBIT of 29.7x. Current price pullback might have further to go. We’re going into an earnings print on 28 April and insiders are selling. While they’re entitled to the presumption of innocence (sorry, I’m trying too hard at this point) - do they know something we don’t?

I will be putting this one on my watchlist, but I don’t hold shares. If I were to buy a listed law firm, this one would probably be it. The receivables and WIP writeoffs are a meaningfully reduced risk, I like the fact that the company is focussed on cash flow in IR material - the thing throws off cash. I also like the margin expansion and low fixed cost base. I also think the TAM/macro strategy makes a lot of sense, as an industry participant.

With that said - I want a greater margin of safety. Alternatively, at this price, I’d consider paying up if IR actually gave me some comfort around a) competitive advantages (if any) b) RB figures, churn on clients and c) some clarification around the CEO’s view on capital allocation. I’d also like a narrative around why insiders are selling, if I could get a cherry on top…

So until the price becomes more attractive, or I get some detail on these other things, it will likely remain on the watchlist. I’ll be reading the earnings print next month with care.