BUR - A Normalized View On Burford's Core Portfolio Performance

2023-09-20 09:06:43 ET

Summary

• Burford's recent quarterly reporting shows impressive YoY growth, but this is not meaningful due to the very easy 2022 comp.
• We review whether recent tangible book value growth of the core portfolio is living up to management's 20% ROE targets.
• We adjust for the effects of YPF and certain accruals and find that adjusted tangible book value growth in H1 was close to management's target.

We previously covered Burford's liquidation valuation twice, both before and after winning a large award against Argentina. We concluded the stock continues to trade below its liquidation value and remain bullish. Following Burford's quarterly earnings, we dive deeper in this article into the core portfolio performance (excluding the YPF case). We compare and contrast the recent performance with management's targets. This article focuses on the company H1 performance as opposed to Burford's valuation (see my previous articles).

We want to measure Burford's (BUR) recent quarterly reporting against a fair yardstick to see if the core portfolio is doing well again. Burford reported 'impressive growth', but this is not really meaningful to look at as the 2022 comp was a year of CV-19 delays with little realizations and hence earnings.

Burford's CIO and co-founder John Molot mentioned on the Q1 call that Burford conducts underwriting to get to 20% net ROE as a target (after employee carry and all other costs). Burford has indeed compounded at this target excluding YPF in the past. Covid-19 saw a large (temporary) decline in income as case realizations (driving revenue and income) were delayed. After the long wait, shareholders want see if Burford is on track to compounding at 20% ROE again. This post is focused on doing exactly that, i.e. normalizing H1 ROE for the ex-YPF portfolio.

Overall tangible book has increased 12.3% in the last 6 months (see picture below), which would suggest a 26% ROE when extrapolating over another 6 months. We'll now have to look closer to see if this performance is not merely attributable to YPF or other one-offs.

The tangible book value of course includes the YPF case. Stripping this case from both the numerator and denominator, we get a tangible book value at the 2022 year end of $786 million and at the end of H1 2023 of $800 million. We can see Burford's tangible book value only increased a modest 1.8% in H1 ($17 million or 2.2% on a pre-tax basis). We have to adjust this number for both noisy items on the cost side, and changes to valuation side.

Starting off with adjustments on the cost side:

1. Revenue - expense time mismatch: H1 saw a large increase in commitments. We could allocate a portion of the H1 opex to the future. I propose to exclude 15% of H1 cash opex, i.e. $8 million

2. The following two images are slides on Burford's operating expenses in Q1 and Q2 ($54 and $44 million). However, Burford noted in Q1 that YPF fair value gain accounted for a $13.4 million expense accrual). In both quarters, Burford suffered from an accrual from incentive compensation cost which increases when the share price increases, while Burford noted it is actually fully backed by an employee share trust. In Q2, Burford didn't separately break this out, but inferring from the relative share price increase from YE22 (respectively 13% and 30.5%), we deduce this was $4.6 million in Q2. We get a total adjustment of $13.4 + $2 + $4.6 = $20 million

There is one significant adjustment remaining: the accrual headwind from higher rates.

Since the SEC - Burford discussions on GAAP valuation of its litigation book have successfully concluded, Burford is re-valuing its open cases using a time value component and an associated discount rate. In Q2, the discount rate rose 70 bps. On an isolated basis this had a $94 million impact on book value. However, in the Q1 call, Jon Molot noted a "beneficial effect" of a 28 bp decline in rates. We assume linearity between the quarters, meaning a net headwind of $56 million on a H1 basis. We'll have to back-out the YPF asset. We allocate this headwind to the core portfolio ($25) and YPF ($31 M) pro rata to their respective book values.

Conclusion

In this post, we backed out a few non-core effects to get a normalized ROE of Burford's core business in H1 2023. Notably, we stripped out YPF from book values and costs. We excluded the valuation headwind on the book value of the core portfolio from higher rates. We excluded the fictional employee incentive costs from a higher share price, given Burford is fully backed with an employee share trust doing buybacks in the open market, but this is invisible in the accounting.

Wrapping it all up, we found a very modest $14 million gain on the core tangible equity book (ex. YPF) in H1 on an unadjusted basis, from a starting tangible book value of $786 million at YE22. This represents a paltry headline 1.8% return, or a 3.6% ROE.

Adjusting these headlines we find a pre-tax adjusted gain of $17 plus:

1. an add-back of $8 million opex to account for the large revenue-expense mismatch from Burford's growth in commitments (these bring costs that only bear fruits in the future)

2. an add-back of $20 million opex to account for YPF related costs, unfair accruals for share price gains with the employee trust being fully backed with Burford's stock

3. an estimated $25 million headwind from a net rise in rates of 42 bp in the valuation methodology

The normalized gain which accrued to the core balance sheet ex-YPF in H1 was hence $67 million, or a more respectable 8.5% return. On an annualized basis, this represents a 17.7% ROE. We can conclude Burford's H1 still fell somewhat short of management's 20% ROE goal net of all costs.

We will have to wait even longer after CV-19 to see if Burford's normalized ROE recovers to its historical one. As a shareholder, I hope to see this in H2 2023.

Remark on asset management

As you may have noticed, we looked at the compounding of tangible book value per share (TBVPS), while the asset management franchise is capital-light (but carries some goodwill). Burford TBVPS should compound faster than 20% given the comment by John Molot on 20% ROE being the target for balance sheet investing, and on the other hand asset management income being capital light (as far as tangible book value is concerned). But in the last quarters (and even years), asset management income has been a disappointing waiting game. In H2, Burford booked a total gross asset management income of $25 million. If you allocate a portion of Burford's total expenses to asset management pro rata to the AUM managed (52% is third party capital), you will conclude that H1 asset management performance actually penalized the tangible book value in the first half with a segment loss of around $10 million.

Asset management income is a waiting game because Burford's funds (excluding BOF-C) use the European waterfall structure, where its LP's get paid the first fund returns, and Burford gets paid last as a GP. As such, Burford will only recognize profits once its LP's have earned their money back from fund realizations, and then some preferred profits. Investors have been waiting for a long time already to get paid GP profits, so the YoY decline is not a good sign in my opinion and somewhat surprising after the long wait.

Backing out asset management performance (around a $10 million loss in H1) would however get you to 20% ROE for Burford's balance-sheet only activities.

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