Of the four listed groups looking to consolidate the legal sector, only two are worth buying, reckon analysts at Liberum.
The broker began coverage of the listed legal sector on Monday with ‘buy’ recommendations for Gateley Holdings PLC (LON:GTLY) and Knights Group Holdings PLC (LON:KGH), while there were ‘hold’ ratings given to DWF Group PLC (LON:DWF) and Keystone Law Group PLC (LON:KEYS).
After the Legal Services Act (LSA) of England and Wales came into force in 2011, allowing non-legal holding companies to own law firms, among other rule changes.
As of the end of October 2020, there were around 1,130 businesses registered as alternative business structures (ABS), where solicitors are in partnership with non-lawyers, up from 40 in 2012 and 640 in 2016.
As well as allowing IPOs the new structures also can provide extra financial firepower, which has led to the market consolidating and the number of UK law firms beginning to decline, with the Top 100 continuing to take market share at the expense of smaller firms.
By the analysts’ calculations, Keystone and Knights have the highest growth and are trading at higher multiples to the rest of the sector.
Gateley is Liberum’s top pick, having averaged organic growth of 9% over the last four years, “with the second highest margins, the best cash flow, the highest average revenue per fee earner, but is trading on one of the lowest multiples”.
As a result the current market valuation is seen as “unjustified”, and the lack of guidance from management may mean in reality the shares are trading on an even bigger discount. A share price target of 220p was given.
Knights has the highest growth in the sector, with a four year-revenue compound annual revenue growth rate (CAGR) of 38% and average organic growth of 14% over the same period, plus the highest margins, thanks to their regional focus and lower cost base. The target price is 485p.
Keystone, where its lawyers are self-employed and largely work on their own, has an all-organic revenue growth strategy and boasts the highest organic growth in the sector with a four-year revenue CAGR of 24%, plus good free cash flow/sales of a% over the last five years.
It has “an attractive, scalable platform model with a first mover advantage”, with the ‘paid when paid’ working capital model “a differentiator in a sector where working capital is a key risk”, but the group’s quality has already heavily reflected with shares trading at 34 times next year’s earnings. The target price is 485p.DWF, which only floated last year, had a “tough” recent year and has the lowest profit margins, weak cash flow and the lowest fee earner:support staff ratio in the sector but is the largest of the four.
DWF operated under an LLP structure until listing and so the year to end-April 2020 is the first full period that is fully comparable with the rest of the coverage.
“Whilst we expect a quick recovery in financial metrics in FY 21 at DWF, we have reservations about the strategy,” the analysts said, giving a 90p target price.