Keystone can justify its premium valuation

“No targets, no politics, no pressure.” That’s what solicitors enjoy when they join Keystone Law (KEYS) – at least according to the firm’s advertising campaign. Seasoned practitioners, reared on a diet of billable hours and six-minute recorded time slots, may well raise an eyebrow. It’s also an alarming proposition for investors. Can a laid-back approach really yield results in a notoriously high-pressure industry?

Bull points

  • Capital-light operating model
  • Consistent growth in headcount and fees
  • Attractive alternative to Big Law
  • Strong return on equity

Bear points

  • Tight labor market
  • Expensive shares

It seems so. In many ways, Keystone’s business model pre-empted the pandemic and cushioned it from the worst of the last two years’ turbulence. Unlike traditional law firms – which are typically structured as limited liability partnerships – Aim-traded Keystone is a platform. Its lawyers are self-employed and take a direct chunk of what they bill: 60 per cent for doing the work and 15 per cent for introducing a client. In return, the company provides infrastructure and support, including a small pool of junior lawyers, via a central office.

Homeworking is crucial to this model. The company has a small set of premises on Chancery Lane as well as other meeting rooms, but nothing compared with the glassy monoliths found elsewhere in the City. This means overheads are modest and hiring new lawyers can be done quite cheaply, as capital commitments are low. Keystone splashed out just £ 50,000 on capital expenditure in the year to 31 January 2021, which it described as the “normal run rate”.

All of this is good news for shareholders. The law firm has reported strong sales growth since listing in 2017, and its return on equity has been consistently impressive, averaging more than 30 per cent over the past three years. The group is also debt-free and has dodged the liquidity issues that have plagued the sector since the onset of the pandemic. While trade receivables are predictably high – totalling £ 19m at the end of July 2021, against total assets of £ 33.6m – cash conversion hovers at around 100 per cent. Meanwhile, debtor days are significantly lower than those reported by many of its competitors, at just 34 days.

Law of (rising) averages

Repeated lockdowns have done little to unsettle Keystone’s smart business model. Indeed, pre-tax margins have expanded because the firm has been hosting fewer in-person events, while analysts at Liberum estimate revenue per principal has increased to around ,000 180,000 in the 12 months to January 2022, compared with £ 163,000 in both FY2019 and FY2020. This is partly due to an abundance of work: M&A lawyers have been run off their feet during the pandemic, while Covid has generated a heady volume of litigation. The usual pre-Christmas slowdown and summer lull also failed to materialize in 2021.

All of this has translated into sustained momentum. In a trading update published this month, the group said “unique market conditions” had continued unabated through the second half of its financial year. Consequently, management informed investors that full-year pre-tax profits would be “materially ahead” of market expectations, leading broker Peel Hunt to lift its forecasts from £ 8m to £ 9.1m. This, it should be noted, was not the first time analysts have booked major upgrades; just 18 months ago, consensus had FY2022 profits at £ 4.5m.

The trading update prompted Peel Hunt to upgrade its profit predictions for 2023 and 2024, on the assumption that legal work will remain stronger than previously thought. But investors should be guarded in their hopes that a frantic period of trading can continue, and remember that the upgrade was fueled by unusual Covid-linked market conditions that may soon subside. Going forward, investors will need to focus more on structural growth opportunities.

Unlike listed rivals such as Gateley (GTLY), RBG Holdings (RBGP) and DWF (DWF), Keystone has not branched out into litigation funding, or into other types of professional services. Instead, it has stuck to what it knows: providing legal services for SMEs and high-net-worth individuals. Unlikely Knights (KGH), which embarked on a buying spree as soon as it floated, Keystone has also steered clear of acquisitions. It has a small presence in the Middle East and a minority shareholding in an Australian law firm, but the lion’s share of its income comes from lawyers in the UK.

At the moment, therefore, the only realistic way for the company to grow is by hiring more fee earners. Keystone’s lawyer base has expanded steadily since listing, and there were 21 new joiners in the six months to July, taking the total number of ‘principals’ to 386. This compares with 170 at the start of 2016. Recruitment slowed slightly during the worst of the pandemic, but Keystone attributed this to pervasive uncertainty at the time, and expects things to pick up in the coming months.

Booming jobs market

The labor market is getting ever tighter, however. A new study conducted by Harbor, a litigation funder, found that recruitment and rising salaries are becoming a major issue for law firms. Almost half of the 203 partners Harbor surveyed said attracting and retaining talent is their biggest challenge, against a backdrop of rising cost pressures. Meanwhile, data from legal recruiter BCL Legal and labor market data company Vacancysoft shows that there were more than 2,300 legal private practice vacancies in London between January and November 2021. This is a record, and represents a 37 per cent increase on 2019.

On the surface, a booming jobs market has worrying implications for Keystone’s growth prospects. However, the group is better protected than many of its competitors. For starters, it is not targeting junior lawyers, who are increasingly expensive and who bill less than experienced hires. Top City firms now pay well over £ 100,000 for a newly-qualified associate, so the fact Keystone’s lawyers have an average of 22 years post-qualifying experience will work in its favor.

The company also does not have to worry about salaries: principals simply get a chunk of what they bill. This mutually beneficial arrangement should protect profit margins from the worst of wage inflation. However, it is important to monitor the other ways that Keystone incentivises its workforce. One of the risks of investing in law firms – where people are the main asset – is that extra stock will be issued in order to attract new talent, thus diluting existing shares.

Keystone operates a long-term incentive plan (LTIP) that offers discretionary benefits to “selected key employees” in the form of nil-cost options or performance share awards. According to management, the plan is designed “to increase the alignment of the interest of the employees with the long-term goals and performance of the business and its shareholders”. So far, the dilution effect from the scheme has been very small; after including grants made under the LTIP, the share count rose by just 0.5 per cent in the year to July. However, share-based payments are increasing and more than doubled to £ 169,000 in the first half of the current financial year.

For solicitors, however, the opportunity to make barrels of money is not Keystone’s main selling point. Lots of mid-market players – not to mention the elite magic and silver circle firms – promise this. Instead, Keystone allows experienced solicitors to have greater control over how they work, without taking on the risk of branching out on their own. Following multiple lockdowns away from the office, this might be more attractive than ever for some lawyers, be they partners nearing retirement or younger associates keen to abandon their office sleep pod for good.

The money isn’t bad, though. Mainstream commercial law firms typically have profit margins of around 30 per cent. At Keystone, lawyers get to keep up to 75 per cent of their earnings – albeit without such a strong life support system around them. And if they want to earn more, they can always work longer hours.

Is there room for outside shareholders in this set-up? There’s no getting around the fact that Keystone’s shares are expensive on 40 times forward earnings, which represents a significant premium to peers and well above the stock’s own historic trading average multiple of 34. However, this also rests on the consensus view that earnings will go sideways in FY2023, which seems somewhat conservative given the growing recognition within the profession of Keystone’s lean operating model.

Just over four years after its initial public offering, Keystone’s growth as a plc looks to be just getting started.

Company Details Name Mkt Cap Price 52-Wk Hi / Lo
Keystone Law (KEYS) £ 274m 875p 910p / 560p
Size / Debt NAV per share * Net Cash / Debt (-) Net Debt / Ebitda Op Cash / Ebitda
53p £ 5.9m 98%
Valuation Fwd PE (+ 12mths) Fwd DY (+ 12mths) FCF yld (+ 12mths) P / BV
40 1.7% 2.3% 16.3
Quality / Growth EBIT Margin ROCE 5yr Sales CAGR 5yr EPS CAGR
12.2% 31.9% 21.4% 51.1%
Forecasts / Momentum Fwd EPS grth NTM Fwd EPS grth STM 3-mth Mom 3-mth Fwd EPS change%
-5.7% 6% 8.0% 1.9%
Year End 31 Jan Sales (£ m) Profit before tax (£ m) EPS (p) DPS (p)
2019 42.7 5.10 13.4 9.0
2020 49.6 5.74 15.0 10.8
2021 55.0 5.90 15.6 16.4
f’cst 2022 69.0 9.02 23.2 15.0
f’cst 2023 72.4 8.55 21.7 14.5
chg (%) +5 -5 -6 -3
source: FactSet, adjusted PTP and EPS figures
NTM = Next Twelve Months
STM = Second Twelve Months (ie one year from now)
* includes intangibles of £ 31m or 20p per share

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