Cube Midcap Report (7 Aug 2019) – Burford unravels #BUR
Today I’m looking at Burford. Later in the week on a quiet day, I may cover these companies:
- Flutter Entertainment – Half year report
- Spirax-Sarco Engineering – Half year report
- PageGroup – Half year report
- Ultra Electronics – Half year report
- Phoenix – Half year report
- Share price: 455p (-60%)
- Market cap: £995 million
There has been an attempted bear raid on Burford by Muddy Waters, which has published a research note (also known as a “short dossier”) here.
Here is a video from Muddy Waters, published today:
1. “Categorising a loss as an investment with significant return”
The first claim by Muddy Waters is all about a case involving Napo Pharmaceuticals.
MW says that Burford booked this as a win, as a “Concluded Investment” in 2013.
However, MW says that Napo actually lost the legal case in court, and was left owing Burford significant sums, which it could not pay.
MW says that an Invesco fund helped to bail out Napo and Burford by investing in a company that acquired Napo. Invesco is Burford’s largest shareholder, thanks to the historic involvement of Neil Woodford (Woodford Investment Management is currently the second largest holder).
This year, Burford finally wrote down the returns generated for it by the Napo case.
Conclusion by MW:
Without the Invesco-led bailout, Napo likely would have been a total loss. We believe BUR investors have been bamboozled by the company and Invesco.
My view: these claims, if true, reflect very badly on the fund manager at Invesco. They would also demonstrate aggressive accounting at Burford. However, I think it’s worth noting that the amounts involved are not so large: profits at the Napo case were alleged to be $14 million, from an investment of $7.4 million.
The Burford market cap has collapsed by £1.4 billion in two days, so let’s read on…
2. “Counting as “recoveries” awards or settlements with uncertain to highly unlikely collections as equivalent to cash returns when calculating IRR”
MW discusses a case that started in 2009 and was claimed by Burford to have concluded in 2013, with an IRR of 51%.
Rather like the example in 1), Burford didn’t receive cash from its client before it presented the case as having concluded. Instead, it received a promissory note where payment depended on a parcel of land being sold. In 2016, Burford sold this note at a discount, and the buyer of the note pushed the issuer (Burford’s former client) into bankruptcy.
Furtherore, MW says that the client’s bankruptcy estate is suing Burford for violating “duties of good faith and fair dealing”, and that Burford has not acknowledged “the significant contingent liability that accompanies this lawsuit”.
MW also discusses a $3 million writedown by Burford which occurred after an individual died: Burford was entitled to value from this individual’s future activities as an inventor!
My view: Again, this suggests that Burford has presented its performance too aggressively. IRR should always be based on cash flows, or the flow of cash equivalents. The receipt of a promissory note should not be treated as a positive cash flow.
However, I would caution bears that even if the original presentation of the 2009 case was far too aggressive, the final and true performance of the case might still be rather good. Burford only ever deployed $7 million to it. As of H1 2019, it claims to have recovered $38 million from the case.
3. “Misleadingly representing an investment that BUR inherited through acquisitions as favourable IRR”
This would not surprise me.
Most listed companies behave similarly: when presenting their results after making acquisitions, they ignore “amortisation of acquired intangibles”. This amortisation is how the purchase price of intangible assets is supposed to be accounted for in financial statements.
If Burford ignores the high purchase price it paid for acquired cases, this would be in line with the type of thing that many other companies do during an acquisition spree.
My view: not surprising, but yet another reason to be cautious about IRRs presented by Burford.
4. “Choosing its own cost denominator when the total cost is much greater”
MW discusses Burford’s position with respect to Tatiana Akhmedova. Burford recorded $5.2 million of partial recoveries against $3.5 million of costs, at 2018 year-end.
However, MW says that Burford made a lump sum payment of “at least $18 million” to Ms Akhmedova, providing this article as a source. I can’t find any evidence that the lump sum is so large – can anyone help me with that?
MW also provides reasons to think that the case is not going particularly well.
My view: the partial recoveries which have been recorded in this case so far are very small, so I doubt that the case is very important in terms of valuing Burford today. But I agree that the value of the case is very unclear and might not be favourable for Burford.
5. “Delaying recognising a trial loss for two years”
MW claims that a $10.4 million case that was lost in 2016 was not recognised as concluded until 2018.
My view: fair criticism.
6. “Keeping trial losses out of the “Concluded Investment” category”
MW provides three examples of instances where negative legal developments have not been reflected in Burford’s valuations of its cases.
My view: these all sound fair. Committed capital in the three cases adds up to c. $57 million.
7. “Failing to deduct various costs against recoveries, including the very operating expenses associated with the investments themselves”
MW says that return metrics don’t include expenses needed to fund the business and the cases being measured.
My view: the business does have very high operating costs, and it’s reasonable to think that many of these costs will relate to specific cases.
“Net realised gains”
This section of the short dossier, beginning on page 15, is the most important part for me. If what it says is true, then the portion of Burford’s returns which are derived from fair value movements are much higher than what the numbers appear to suggest at first glance.
I will explain it as simply as I can.
Suppose we invest $100 in a case. We then mark it up to $120, recording a fair value movement of $20 for the period.
Now suppose that in a later period, we sell the case for $150. How should we account for what has happened in this later period?
Investment income includes net realised gains on investments and fair value movement on investments.
Intuitively, most people would think that in the later period, we record a $30 net realised gain on investments, since we sold the case for $30 more than its carrying value. That’s not how Burford does it, according to MW.
Instead, if we are Burford, we record a $50 net realised gain on investments, and record minus $20 in fair value movements.
As you can see, by doing it this way, we get a much higher net realised gain, and a much lower fair value movement.
Do this with a big portfolio of cases and the net realised gain every period will be much larger, and the fair value movement much lower, than what would make sense intuitively to the ordinary person.
Burford has always been a complicated story, and I have always found it difficult to come to any firm conclusions on it. For several years I was extremely sceptical of it, since its financial statements (especially the balance sheet) were so bizarre. In the last year or so, I gradually began to accept the possibility that its profitability was real and that litigation finance, in the right vehicle, might offer extraordinary returns for shareholders.
This short dossier, for me, has cast serious doubt on Burford’s claims with respect to its ROIC and IRR. It is an impressive research note with plenty of sources provided to back up its claims (though in the space of a few hours, I have only been able to verify a few of its assertions).
The section on “net realised gains” is the most damaging part of the dossier for me, since it blows up my trust in the company’s mix of realised gains and fair value movements. As the dossier says, the mix has traditionally been reported around 50:50. But because of the way Burford defines “net realised gains” (which it is entitled to do, under accounting rules), the mix is going to be something else. MW says that in H1 2019, between 72% and 90% of investment income was from fair value gains.
To the extent we are correct that most investors misunderstand Net Realized Gains, it is almost certainly because BUR deliberately misled them.
Indeed, if you look at the 2018 annual report (page 3), Burford uses language such as:
Unrealised gains remained generally consistent with prior year levels at 55% of income (2017: 53%; 2016: 54%)
To honest, I am annoyed with myself for accepting this 55% number at face value – if I had studied the annual report in more detail, I hope that I would have figured out the less impressive truth on my own. After all, Burford itself described its fair value movements as being “net of realisations” and it reported that 39% of its entire investment portfolio consisted of fair value gains, with this percentage increasing year-on-year. In hindsight, it does not seem so difficult to figure out that the 55% number was misleading. But well done to Muddy Waters for highlighting it.
“Arguably insolvent” – Muddy Waters stretches credibility in the final section, subtracting Burford’s debt balance and litigation commitments from its “adjusted capital base” to arrive at a negative number, and claiming that this makes the company “arguably insolvent”. This section doesn’t take into account the likely returns on Burford’s capital base and the timing of future cash outflows, and also doesn’t seem to bother mentioning Burford’s cash balance. I view this section of the report as the only section which fails to make a strong case.
So what’s Burford worth? I previously balked at Burford’s valuation, thinking that a price-to-book multiple of 5x was too aggressive for what was fundamentally an investment vehicle. Over time, as I began to accept that Burford’s profitability might be real, I began to warm to the idea that paying a significant premium or even a multiple of book might be justified.
Given the extreme uncertainty which hangs over the value of the company’s balance sheet, and the poor quality of its earnings, as explained brilliantly by Muddy Waters today, I once again think that investors should anchor themselves to book value when it comes to valuing this company. And for those of us who have lost trust in management, we might reasonably think in terms of a discount to book as representing fair value.
Net assets at 30 June 2019 were $1,567 billion ($7.17 per share). If 40% of the investment portfolio are unrealised gains, and we don’t want to pay anything for them, that knocks the value down to $860 million ($3.93 per share). The latest share price is 568p, representing $6.90 at the latest exchange rates.
In other words, normality has been restored to the Burford valuation.
Thanks everyone – I will be back again with more midcap news here tomorrow.