Playing Offensive in a Defensive Business

Summary

• AFL is a ‘New Law’ firm growing in the realm of 50% p.a. looking to rival and disrupt the incumbent ‘Big Law’ firms.
• AFL is a stock is potentially overlooked; its financial performance is obscured by the nature of its historical data.
• It is trading at a P/E of 65x based on statutory earnings but it’s P/E based on normalized earnings are in the range of 16 – 20x.
• Management have demonstrated an ability to allocate capital via acquisitions.

Business Summary

AFL, also known as Australian Family Legal, is a firm that provides specific advice to clients in respect to divorce, separation, property, child custody and ancillary services such as litigation and estate planning. AFL has become the largest specialized family law firm and is seeking to become the most dominant player in the fragmented market of family law. Currently, there are neither national competitors nor leaders in this market.

The company has an insurgent mission to disrupt the business models of traditional law firms which are often called ‘Big Law.’ The profitability of ‘Big Law’ firms are often associated with non-targeted referrals with most of the revenue generated by key senior lawyers. In large firms, hierarchies and bureaucracies often lead to friction costs and operating inefficiencies. Scalability also proves to be an issue as the growth engine of the firm, backed by the referral business, is limited by human capital.

On the contrary, AFL is considered to be ‘New Law’ firm. These firms have an alternative business model whereby the operating model has been redesigned to involve the use of technology. Instead of generating leads via referrals, AFL employs a client acquisition model which it refers to as DSAS (Data, Strategy, Acquisition and Sales Conversion), leveraging multiple digital marketing techniques to gain insight on customers and generate leads. The benefits associated with this model is associated with operating efficiencies and boundless scalability. These benefits are unhindered by a key lawyer or geographic borders. Some of the benefits are outlined in the comparison below (taken from the AF Legal Group Prospectus).

Figure 1: % of revenue

Additionally, AFL has only captured a mere $7 million of the $1.1 billion in potential market opportunity. AFL represents less than 1% of market share. The industry is also relatively stable and the business possesses a defensive type of revenue given the natural occurrences of domestic issues and divorces.

Misunderstood Investment Proposition

The market is currently mispricing the business due to several factors:

• Market cap is currently $26 million as of writing. Institutional and fund managers would ignore such a stock due to minimum market cap and liquidity requirements.
• AFL was involved in a reverse takeover with the then publicly-listed Navigation Resources (NAV:ASX). The financial data is irrelevant for the years prior to the Navigation Resources acquisition of AFL. Companies such as Morningstar and IRESS would report historical figures that seem terrible. This is further complicated by AFL’s backdoor listing in May 2019. 30 June 2019 only shows 1-month worth of data when compared to 30 June 2020 data.
• The financial statements may not show strength but the growth strategy and discipline in acquisition has proven worthy. This will be touched upon further below.

Statutory vs Normalized Earnings

AFL is currently trading at a P/E of 65x on statutory earnings. Although this seems rather expensive, acquisitions and new offices opened during this time have rightfully depressed the bottom line; the current NPM is a mere 6%. New offices, or greenfield sites, have larger outlay costs relative to other types of expansion and also take longer to realize ROIs. Doing so is necessary in building out the “train tracks” of the national network.

The normalized P/E would therefore be dependent on the normalized NPAT. My guesstimate is that the normalized NPAT margin is realistically between the range of 20 – 25% (by doing a deduction from AFL’s ‘Profit before tax’ margin); the normalized PE would therefore be between 16 – 20x. The forward P/E, given the company’s growth, would be in the low teens range.

Management

To capture the significant upside that the market presents, management must efficiently allocate to grow whilst building brand equity that signifies expertise and trust. This is reflected in the company’s execution of the growth strategy presented below.

Figure 2: AFL's growth strategy

Management have demonstrated an ability to allocate capital whilst making strategic decisions about firm locations. Executive Chairman, Grant Dearlove, said that AFL collects and utilizes ‘the patterns of digital search’ to understand where to place firms to best cater for the people’s needs and to ultimately maximize the firm's ROI. AFL has also publicly announced that they are targeting Queensland, whose state has the highest divorce rate in Australia and significant opportunity for the company.

When AFL does acquire in these targeted areas, AFL transacts at a “small business” multiple. The most recent transaction shows that AFL acquired Strong Law Pty Ltd for 0.35x sales with the WIP attached. Once the business integrates into AFL’s ‘New Law’ model, WIP would eventually be reduced in half as shown by the Lock-Up days comparison in Figure 1. The cash freed up would be returned to AFL to further reduce the cost base of its acquisition. The acquiree also receives a margin uplift has a result of integration into AFL’s decentralized operating model.

Other examples include AFL’s purchase of Walls Bridge Lawyers in early 2019 at a multiple of 0.23x earnings and Nita Stratton Funk & Associates Solicitors in the middle 2019 at 1.7x normalized EBITDA.

The acquisitions AFL have to date have demonstrated discipline and great insight by management to inorganically scale and consolidate in a market with no national players. The longer-term goal of leveraging brand to expand into adjacent sectors also presents optionality for the company as well to address a larger TAM.

In terms of incentives, management have significant insider ownership at 22% with the founder holding the largest stake at 17%. The Founder, Edward Finn, transitioned from the Managing Director into the Marketing Advisory Board to focus on the new client acquisition model called AFL 2.0. This change in management structure best utilizes Finn’s skills since he studied a double degree at the University of Melbourne in Law and Arts (Media and Communications). 

Risk

Other law firms which adopt a similar strategy to AFL will heighten competition and pose a risk to AFL's plans to consolidate the fragmented market. The large generalist law firms such as Shine will most likely find difficulty in adapting its business model to compete due to size. Other smaller and nimble firms with greater management would pose a greater threat. Constant monitoring of the industry and the business itself, as always, is necessary.

Management have option packages and performance rights which are not tied to any publicly declared KPIs. Although it is not a significant amount, relative to revenue or otherwise, it may unwind down the track to favour executives as opposed to shareholders. Signifcant management shareholdership and large opportunities within the business would incentivize management to increase per share value. Nonetheless, constant monitoring is also necessary under in this situation. 

All in all, this investment opportunity presents an offensive play on a defensive business. Given the long-run way potential, the stable nature of the business and managements ability to allocate capital, a low-teen forward P/E represents good value.