BUR - Burford Capital: A Cheap Moat With A Cherry On Top

2023-12-11 10:18:33 ET

Summary

• Burford is the global leader in litigation financing with over $7 billion in available funds, offering a strong business model and track record.
• The recent favorable ruling on the YPF case, awarding $16 billion in damages, adds a significant opportunity for Burford.
• The new president of Argentina, Javier Milei, may help increase the likelihood of a faster payment for the damages.

Burford (BUR) is the global leader (by AUM) in the litigation financing space. We are very positive about the business model, given its track record and future opportunities. We also believe this asset comes with a “cherry on top”, the recent favorable ruling on the YPF case awarding $16 billion in damages. There has been also another important development, that we think will be a key variable in the enforcement of the judgment: the new president of Argentina Javier Milei. We believe his comments and his behavior can offer interesting insights and increase the odds - still considered very low by the market - of a faster-than-expected payment.

The business model: an undisputed leader in a niche market

With a total portfolio that surpasses $7 billion available to fund any kind of legal claim and a very successful track record, they consolidated their position on top of the rankings for this niche sector. Their closest competitor by balance sheet size is Omni Bridgeway with less than $2 billion.

Burford clearly built enough expertise and infrastructure to be able to scale faster and more efficiently, and today it serves as a precedent for other ambitious players. Today the company is actually focused on two different “segments”: the direct (1) litigation funding business, and a (2) pure asset management business. In the former, the company funds legal actions with its own balance sheet, benefiting from profits and suffering losses directly. In the latter, they manage funds under a standard 2/20 (2% fixed, 20% performance fees) structure. The introduction of the asset management business aimed at stabilizing earnings and revenues, as the litigation financing business generates much volatility through unrealized and realized gains/losses.

Also, Burford provides a very special fund through which a sovereign wealth fund is able to access peculiar investment strategies in legal finance. The partner is not disclosed, but the business is bringing in consistent and generous fees for Burford.

This helps compensate for the volatility of the on-balance sheet business, and the slowdown in new AUM from the other funds. The company announced an extension of the arrangement just this October.

Last but not least, we feel comfortable using the past track record for the risk-taking business as a guideline for future performance. The company has been doing this for decades, accumulating an expertise that is very hard to replicate. While in a normal asset management business scaling is relatively easy for most investment strategies, replicating what Burford did would be tremendously difficult for new entrants. We think the company has a moat for this reason.

If you add their ability to print an ROIC of 87% and an IRR of 27% on deployed capital - computed on realizations - it is already a strong case for a compelling opportunity. But let’s discuss two important things: (1) what’s the case with YPF, and (2) how much we are paying for this peculiar company.

The YPF case and the Javier Milei variable

Other than the strong moat and successful business model, we are also receiving a little bonus for buying Burford. Some years ago, in 2015, it funded the action of Petersen and Eton Park vs Argentina, for the nationalization of YPF by the government. They claimed that they had been unlawfully expropriated and the government should have gone through a formal tender offer process that never occurred. After 8 years of intense litigation, the parties, backed by Burford, prevailed against Argentina in the court of the Southern District of New York (SDNY). The judge ordered the sovereign country to pay the two former shareholders of YPF a staggering $16 billion in damages. As a litigation funder, Burford is now entitled to receive a percentage of the proceeds from the parties, but only once Argentina actually pays the damages. Let’s compute how much the company would collect:

The funder would stand to benefit from an incredible $6.3 billion - more than two times its current market cap. However, there are several obstacles on the way, and these are the reasons why even the company is reporting a fair value of just $1.3 billion related to the YPF case.

First of all, a judgment against a sovereign country is hard to enforce. In the case Elliott v. Argentina, on the default of their bonds, which included seizures of hard assets (such as navy vessels and satellite launch pads) around the world. They even tried to seize their pension fund assets and central bank reserves but with limited success. That was a $2.4 billion judgment, which falls many billions short of this one.

But there is one possible bright (and fast) outcome to this story. Yet uncovered here on Seeking Alpha, the recent comments on the newly elected president Javier Milei are spurring hopes that YPF might be privatized again. On top of this, Milei also traveled to the US to meet top officials in Washington to reshape the country’s image . This attempt to regain the favor of the US and IMF may start by showing efforts to respect the YPF judgment. While the enforcement of the judgment is stayed for now as Argentina appeals, the court ordered to post equity in YPF as a bond. This means that there is a good chance that in case of privatization, this will mainly benefit the two parties of the litigation, Petersen and Eton Park.

YPF is one of the few gems left in Argentina’s state-owned portfolio, generating a staggering $18.7 billion in revenues in 2022.

This suggests that a privatization, and the release of substantial equity to the damaged parties, would likely result in a substantial recovery. While we do not feel like assigning numbers, it makes sense to look at the current odds given by the market and Burford itself. The company estimates a fair value of $1.3 billion out of potential proceeds of $6.3 billion, implying a success probability (or potential recovery) of around 20%. Also, the market is quite conservative, given that it’s offering a company that generated $300 million of (ex-Burford) operating income in 9 months at only $2.9 billion. If we stick a P/E of 10 on the (ex-Covid) average net income in the last 8 years, we find that we’re basically getting the YPF case for "free".

Bottom line: weighting risks and the upside

To conclude, we will offer an overview of what we believe is a fair price range for this peculiar company, along with possible risks associated with it. Indeed, Burford has been a target of a very serious short-selling report back in 2019, that claimed that the company was allegedly engaging in misleading accounting. This tanked the stock by more than 50% and left it trading at depressed valuation multiples for years. Then Covid hit and this dramatically slowed the work of courts and thus Burford’s profits, indirectly (but wrongfully) potentially invigorating the short seller’s claims.

The complex accounting is necessarily incorporated in Burford as a result of its peculiar activities. There are a handful of companies performing these kinds of operations, and existing accounting standards are not always suited for properly reflecting their earnings and cash flows. This creates some uncertainty that adds to the already volatile nature of their revenues and income. Investors should be aware of possibly painful earnings misses, or negative updates in important cases that are very large in size. Also, while the YPF case has been dramatically de-risked, it still accounts for a disproportionate amount of the balance sheet, exposing the company to potential harsh non-cash losses.

But let’s now turn to the bright side. We are paying very little for a moat, steady income, and the cherry on top that is a potential multi-billion dollar payout. We feel that given the current P/E ratio of around 5x is not properly evaluating the company. If we exclude the COVID-19 impact that dramatically impacted income and gains, we can see that the company is perfectly able to generate income in excess of $200 million per year. If we also include an even mild 30% recovery rate on the YPF case (around $1.8 billion), it means we are only paying $1.2 billion in EV. We would feel comfortable assigning a P/E ratio of 10x on a (conservative) long-term net income of $200 million, meaning an equity value of $2 billion. After adding the cash payout expected from Argentina we can compute a fair value per share of around $17.5. This means there is an upside potential of around 30% from the current price.

Conclusion

Burford is an impressive company that has been able to conquer the leadership position in that niche sector which is litigation financing. They have a diversified business with both on-balance sheet activities and an asset management arm generating fees. On top of this, the company has recently capitalized a multi-billion dollar in-court win of $16 billion that could be worth many times the current capitalization in case of full recovery. We feel the market is understating Burford’s potential and the stock is undervalued by around 30%.

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