Australian Family Lawyers (AF Legal) is the largest specialist Family Law business in the country, having annualised revenues of ~$20m or close to 2% market share of the Family Law market. The business was founded by Edward Finn back in 2015, who has since moved on from the business, leaving the operations to Executive directors Grant Dearlove, Glen Dobbie and Stace Boardman. Family Law is a subset of the Personal Legal market that has no national presence despite having a substantial $1.1B market, furthermore it is very stable in nature with a stable ~50 thousand divorces per year, rising household wealth and increasing defacto relationships.
The AF Legal business model is highly optimised in it’s operating structure, leveraging technology to improve client attraction and operational efficiency. This ‘NewLaw’ model compares favourably to an industry plagued by traditional partner reliant businesses with excess firm leverage, low contribution margins and bloated operating costs / lockup.
Originally, I had emphasised using data to generate client leads however, I believe that with the step change in scale that has come with recent acquisitions, the business has skewed towards more of a balance between traditional norms and digital influence for better or worse. It remains to be seen how scalable the AFL 2.0 digital model can be and how integration occurs in these larger deals. Nonetheless, AFL has had a 5-step system for converting clients including:
Free Consultation via. Phone appointment
Strategy Session ($350) to discuss the situation & provide an estimate of future costs
Dispute resolution where property/children are involved.
Assisted negotiation/mediation to avoid courts where possible
Final settlement by consent (preferable) or court hearing.
One of the most common criticisms I received from others when first sharing this investment was the downfall of other listed businesses including Slater & Gordon etc. First of all, this business operates in Big Law and bills often on a “no win no fee” basis. This as a result requires a huge amount of subjectivity when reporting results due to the revenue being based on Work in progress (Dollar value of unbilled work). The subjectivity is mainly on management’s best estimates. As such I would recommend focussing on cash flow as a result. AF Legal compares favourably on this front as for working capital purposes, they encourage upfront payment and bill at most on a monthly basis as opposed to a no-win-no-fee structure where WIP is accrued often for as much as 2 years. This is a huge differentiator and should not be understated by shareholders.
From an investment standpoint here and from what private business valuations imply, there is a significant amount of intangible value in firms that is subject to key-man risk, otherwise these businesses should not trade on cents in the dollar that they do, reflecting a much higher discount or hurdle rate to carry forward with actually buying a firm. If the profit margins of Australian Family Lawyers is 15-20% on a post-tax per firm basis, the businesses that sell for just half a turn of sales/fees, implies entry multiples in the ~3x PE range, assuming zero volume growth here that is implying a discount rate of 33%, or 3.3x the long-run public market returns.
So what’s going on here, and does it really deserve such a ridiculously high hurdle rate? To explore this further, it’s in my belief that I needed to look at client loyalty and lawyer loyalty. On clients I can simply say that what is worth noting is that Family Law is non-recurring work and that once a file is closed, it’s unlikely for better or worse that there will be much additional work for clients, perhaps a prenup on a new marriage, perhaps asset protection services, but for the most part I don’t see clients being ‘recurring’ in nature, and that is made up for with the stability of volumes in the industry. As for the lawyers, there is no mistaking that a something like Kelly+Partners Partner-Owner-Driver model incentivises partners through a partnership based model with significant equity ownership and the existence of a cross-guarantee where partners are liable for each other's obligations. Grant, the executive chairman of AF Legal gives an interesting answer to this which can be quoted as below:
“On the partnership side it's an interesting question because in a lot of respects it sort of centres back to the nature of family law and diversity or gender balance. So 90% of our lawyers are women. They've never really had the desire to own businesses, their focus is more on having careers, having children, having families and having balance. So, that's sort of you know male historical dominated “i want to own, i want to make millions” doesn't sort of permeate through the culture of family law so we don't get people leave us because they want to own their own business, they're actually coming to us because we can accommodate all of their needs but it's very much driven by the fact that predominantly they're women. Women tend to be better at family law because they're more empathetic and considerate”
~ Grant Dearlove, Coffee Microcaps Morning Meeting 2 September 2021
Lastly, what I wanted to cover was some reasoning behind why I think AF Legal is an extremely compelling investment thesis which is the optically expensive valuation, which in my belief is largely smoke and mirrors to the underlying earnings power of the business which i will detail in several points below
On listing, AF Legal did so through what is called a reverse merger, which is effectively an existing listed company with no business, raising cash through a capital raising to buy an unlisted business. Upon doing so they treated the IP of the AF Legal business as an intangible asset to amortisation, effectively as formation costs to be amortised over a 5 year period, this is $180k per year after tax on a straight line basis.
Given the size of the business, and the substantial costs associated with being a listed company, these largely fixed costs in nature are expected to decline as a % of sales as they grow. These fees amount to ~$1m in head office costs and $125k in ASX fees. I will go ahead and argue that these are largely variably in nature, but they certainly won’t grow to the pace of the underlying business. 3
Acquiring Watts McCray, upon consolidation there were a lot of private business costs that have since been eliminated post-merger, resulting in a messy FY2021 contribution and the group estimates these costs are substantial in nature, to the tune of ~$1.9m before tax
Stock based compensation. This is a hugely controversial topic amongst investors, but I will go ahead and say right now that I lie firmly in the camp of the current treatment of SBC is incorrect in that it treats it as both a non-cash expense, and dilution of the company's shares. In my view, this is non-cash as such does not represent an expense. The important thing here is that the outflow of intrinsic value is represented already in the increased share count, as such not requiring an expense line. For AF Legal this amounted to $738k for FY21.
Other realised cost savings on the integration of recently acquired businesses are expected to contribute $600k to the bottom line in FY22.
Adding back these costs (besides the head office costs) takes the FY21 profitability from a loss of 0.7c per share to a profit of ~2.7c per share for FY21, a margin of ~12% on the business. There has also been organic growth in the business in the year to date which annualised represents $19.2m or 25c per share. At similar margins, this would represent 3c in per share earnings on an enterprise value of just 35c, a valuation multiple of just 11-12x earnings for a business growing as quickly as this one.
In conclusion, I view AF Legal as heavily asymmetric in nature, with largely stable volumes, an increasingly diverse lawyer base reducing key man risk, focus on operating efficiency and lockup along with a cheap entry multiple leading to a “heads I win, tails i don’t lose much” scenario. Of note is that performance rights for the CEO are tied to a hurdle of 30% EBITDA growth (EXCLUDING M&A) and other executives are tied to a 2024 EBITDA per share of 9c, with a maximum of $200k in ‘growth related cost adjustments’, which would translate to a NPATA of ~$4.5m on a mostly statutory basis assuming a similar level of lease expenditure for the group. This would put the group at a EV/NPATA of just 6x in FY24.