Keystone Law Group - Not Playing by the Traditional Rules

Keystone Law Group PLC (AIM: KEYS) is a full service UK law firm that provides legal services to SMEs and high net worth individuals. Through an unconventional platform business model, the company has managed to establish remarkable organic growth combined with strong returns on invested capital. The stock has declined significantly during 2022 due to, from my point of view, temporary headwinds and valuation normalisation. This has in my opinion created an interesting investment opportunity with decent forward returns and limited downside. The investment case can be summarised in the following points:

• Keystone’s differentiated platform business model offers lawyers more freedom, flexibility and autonomy. This has enabled the company to attract lawyers and increase its market share in the £9B+ UK law firm mid-market. Despite its historic growth, the company is still in its early days with <1% market share while operating in the second largest legal market in the world.

• Keystone is a founder-led business with CEO James Knight still owning 28.6% of the company’s shares. Since FY19, Keystone’s topline and earnings have compounded at a 16% and 17% CAGR respectively. The company boasts strong returns on invested capital, scalable operating expenses and a favourable net working capital structure through its platform model. These factors lead to low capital requirements and high cash flow conversion, substantially improving the quality of the business oppose to peer professional service firms.

• Keystone currently trades at 16x. LTM EV/EBIT, which is at historical lows (avg. ~30x.). While I personally deem its historical valuation to be excessive, I believe its current valuation provides an interesting opportunity for market-outperforming returns because of the company’s capital structure, management team and growth opportunities. Utilising a 10.7% topline CAGR, some operating leverage, 10% discount rate and a 15x. UFCF exit multiple in FY27 (i.e. January 2027), I derive a fair value of £4.95 per share, which implies 15% upside to its current price of £4.31. While this upside seems relatively insignificant, I believe my assumptions are rather conservative. This limits the downside and leaves significant upside in case of stronger growth durability or higher exit multiples.

  ---

Keystone Law’s Business Model

Keystone Law was established in 2002 and operates with an unique business model where it provides a platform to self-employed lawyers. Lawyers can earn up to 75% of the fees invoiced and receive numerous kinds of resources in return, such as IT infrastructure, finance and administrative support, compliance and risk management tools, marketing and business development aid, internal network, office location and junior legal support.

An important aspect of the platform model is that Keystone only pays its lawyers once the client has paid. This improves the resilience of the company and enables higher cash conversion due to lower net working capital requirements. The business model can consequently be seen as a win-win for all parties involved. Keystone is able to collect part of the fees with higher cash conversion and lower risk, whereas lawyers receive a large cut than with conventional partnership models and have more flexibility and freedom in the way they conduct their work. Through the model illustrated below, Keystone has become a “legal disruptor” in its industry and has been recognised as one of the best law firms in the UK by the Times.

Keystone’s lawyers offer a wide range of legal services, including commercial, property, litigation, employment and family law. No client represents >5% of recurring revenues and clients are spread across 50 sectors. Furthermore, the client base constitutes primarily of SMEs and high net worth individuals. In conclusion, Keystone appears to be a well-diversified firm with no client, lawyer, practice or sector dependency.

Keystone’s primary growth lever is organic recruitment of new lawyers that bring their clients with them. The company is structured through so-called pods, which represent service companies owned by principal lawyers, who are the senior lawyers. These pods have service and compliance agreements with Keystone basically turning them into Keystone service entities. Pods can also employ junior lawyers (i.e. other fee earners) who through compliance agreements also become Keystone lawyers. Keystone has since January 2013 grown from 117 principals to 399 principals and 80 other fee earners (479 total). Annual lawyer churn is said to be around 5% of which the majority is due to retirement.

---

UK Legal Services Market

Keystone operates in the UK legal services market, which after the US represents the largest legal service market in the world with £36.8B in annual fee revenues. The UK legal service market is globally recognised as the most international due to the widespread use of English law as the framework for international commercial contracts and dispute resolutions. This market is primarily dominated by the a ‘global elite’ with the top 15 law firms owning approximately 50% of the market.

However, Keystone specifically targets the £9B+ mid-market segment. Comparing the market size to its current revenues, Keystone appears to have 0.8% market share in this segment. Besides having a large addressable market, Keystone also appears to still be in its early days where it can continue to grow and capture market share through the onboarding of new lawyers. Moreover, the total market itself is also estimated to continue to grow around 4% per annum. Hence, the combination of increased market share and industry growth provides Keystone the opportunity to grow organically at high single digit or double digit rates. Lastly, it is worth noting that new model law firms, such as Keystone, have been growing at three times the rate as those of traditional mid-market law firms.

Keystone competes against both the aforementioned traditional mid-market law firms and newly established law firms that operate through similar models as Keystone. The Legal Services Act 2007 allowed for the creation of the platform model, challenging the long standing models of the traditional law firms. Prior to the Legal Services Act, equity partnership was the only basis on which a lawyer could access the highest level of remuneration within a law firm. While I do not believe Keystone has a significant competitive edge (most professional service companies don’t) it does have a first-mover advantage and leverage over traditional firms through higher compensation structures and more personal freedom via the platform model. It is also worth highlighting that although similar platform model companies exist, Keystone is the only one included in the UK top 100 law firms, giving it a brand reputation advantage.

All in all, Keystone operates in a large addressable and growing market. The company is still in its early days with plenty of market share left to capture, especially from traditional mid-market law firms. All of this ensures growth durability for many years to come. The question remains whether Keystone’s business model, brand and first-mover advantage are sufficient to successfully capture and realise the growth opportunities ahead.

---

Keystone Law Management

As mentioned earlier, Keystone Law Group was established in 2002 by current CEO James Knight and his partner Charles Stinger. In 2014, PE firm Root Capital acquired a 35% stake in the company through which Charles Stinger retired, meaning Knight is the only founder currently involved. The PE firm has partly through the IPO in 2017 exited its position in Keystone. Knight is currently the largest shareholder owning 28.58% of the company, indicating significant skin in the game and alignment with other shareholders. Ashley Miller, the company’s finance director, is the second largest insider owning 0.66%.

Looking at Keystone’s management team, it becomes apparent that many within senior management have been with the company either since or before the PE investment in 2014. This to me is a good sign, as it signals a positive company and working culture. All members also possess several years of relevant working experience. Rather than listing all the names plus CV’s, I recommend reading the resources provided by the company if you are interested in this topic. Keystone has a long-term incentive plan for its executives granting share awards that cannot exceed 100% of the individual’s base salary. The plan includes a three year vesting and a two year holding period during which the shares cannot be sold. Performance criteria is 70% based on EPS growth and 30% based on comparative total shareholder return. I personally believe the incentive plan aligns well enough with shareholder value creation.

---

Keystone Law Financials

Keystone has experienced robust growth over the recent years with a 16% revenue CAGR between FY19-LTM23. Gross profit margins have remained relatively stable around 26%-27%, which vary based on utilisation rates and type of business demand. EBIT margins have slightly expanded to 11.5% in the LTM period after a dip and rise during covid. Keystone experiences some forms of operating leverage as the incremental costs for onboarding new lawyers are not that high. This leads to enhanced profitability margins as Keystone grows.

Two key KPIs for Keystone that every investor should follow are the total amount of fee earning lawyers and earnings per lawyer, as these two KPIs determine the topline development of the company. As can be seen from the graph below, both the amount of fee earners (12% CAGR) and revenue per fee earner (4% CAGR) have increased gradually over the years, with a pricing dip during covid and recruitment issues during FY22 and FY23. The latter has explicitly been mentioned in the company’s latest reports, as it faces strong recruitment headwinds in “the biggest war for talent seen in over a decade”.

Interestingly, from the revenue bridge below it becomes observable that the company is facing for the first time a decline in revenues due to recruitment issues (in my historic dataset). In the previous years, onboarding of new lawyers has been the main source of topline growth, only being outpaced by pricing impacts in FY22 and H1 2023. Once again, both pricing and onboarding of more fee earners are the two growth levers that Keystone can pull. Inflation will help drive price increases going forward, however these increases are commonly made redundant through pressure on wages (i.e. salaries must go up). Hence, recruitment is perhaps a more valuable growth pillar that also enables the operating leverage to kick in more effectively. In summary, the current recruitment headwind is a major point of concern and important to the investment thesis.

Analysing the balance sheet, it quickly becomes evident that Keystone operates an asset-light business model. As mentioned before, this is partly due to Keystone not paying its lawyers until they have been paid by the client first. Net working capital (NWC) remains consequently only slightly positive, ranging historically between 5%-8%. Its main components include receivables, accrued income and payables. NWC has decreased as percentage of revenues because of a substantial decrease in DSO

Other major balance sheet components include IFRS leases, intangible assets (lawyer relationships), cash and deferred taxes. The company has a net cash position of £5.4m (including deferred CIT and IFRS leases). Due to the company’s asset-light business model and strong profitability, Keystone boasts extremely high capital efficiency ratios which can be seen in the graph below.

Lastly, due to its asset-light business model Keystone also exhibits strong cash flow generation with minimal capital expenditure and NWC needs. Keystone has historically managed to convert 93% of EBIT into free cash flow and around 100% in both FY21 and FY22. Therefore, for quick and dirty valuation practices it is not unreasonable to utilise EBIT multiples as it can be regarded as a close proxy for free cash flows.

---

Keystone Law Valuation

At the current share price of £4.3 and 31.4m shares outstanding, Keystone Law trades at a market capitalization of £135m. Looking at the enterprise value by factoring in net cash, the company currently trades at an EV/S of 1.8x, EV/EBIT of 16.3x and a EV/UFCF of 15.5x. As can be seen from the graph below, the company is trading at historically low multiples. I believe this is a double-edged sword. On the one hand I believe historical multiples have been pretty elevated, hovering between 25x-35x EBIT. On the other hand I think current valuation is pretty fair/cheap for this kind of business based on all the factors mentioned throughout this write-up. I reckon the truth lies somewhere in the middle, but as with all valuation exercises it remains a subjective game, including different assumptions and perceptions of the same company.

Having said that, below you can find the output of my short-term forecast model. The main assumptions include a modest increase in total fee earners followed by an acceleration as the labour market loosens. However, the growth in the forecasted period remains well behind that of the historical period because I want to use a conservative approach. Price per fee earner is expected to compound slightly above inflation but below the historic average as it recently experienced a significant bump due to inflationary pressures. My result is a revenue estimate £114.8m in FY27, which represents a market share increase from 0.77% to 1.11%, assuming the earlier mentioned 4% market CAGR.

Gross margin, share based payments and other operating income are held stable in relation to revenues. Administrative expenses are expected to scale slightly because of the operating leverage mentioned earlier, leading to 11.8% EBIT margin at the end of the period. Furthermore, capex remains limited and I expect slightly negative effects from NWC as the company grows and DSO normalises. Effective tax rate is held constant at 20% of EBIT (UK CIT is 19% on PBT) and share dilution through share based payments is appropriately accounted for. I utilise a 10% discount rate (my minimum IRR requirement) together with 15x UFCF exit multiple. I believe this exit multiple might also be a bit conservative given the quality of the company, but it leaves room for further upside. Using the aforementioned assumptions I derive a fair value of £4.95 per share, implying 15% upside to the price at time of writing. The sensitivity table illustrates the potential up- and downsides. Overall, I believe the potential upside outweighs the downside as I could easily see the company beating my growth expectations and/or potentially trade at a higher multiple at the end of the period. Therefore, I regard the current price of Keystone as fair and potentially cheap.

---

Conclusion

I believe the recent drawdown has provided an attractive investment opportunity in Keystone Law Group. The company displays many high quality characteristics through its differentiated and asset-light business model, solid financials, growth durability, large addressable market, capital efficiency, high cash flow generation, net cash position and aligned management team with skin in the game. Nevertheless, while the company enjoys some form of competitive edge through its brand and first-mover advantage, I definitely do not believe Keystone to possess a strong economic moat.

Given all of the mentioned characteristics and the utilisation of what in my opinion are relatively conservative assumptions, I find the current share price more than fair for this type of business and see substantial potential upside through both organic growth and multiple expansion. By continuing to not play by the traditional rules, I expect Keystone to become a much larger entity than it is today.

---

Disclaimer: I’m long Keystone Law Group PLC at the time of writing this report. The information contained in this report shall not be understood or construed as financial advice. I am not a financial advisor, nor am I holding myself out to be, and the information contained in this report is not a substitute for financial advice from a professional. I shall not be held liable or responsible for any errors or omissions from this report or for any damage you may suffer as a result of failing to seek competent financial advice from a professional.