Is IMF a buy?

In the current investment climate companies with a volatile annual earnings profile are automatically seen as risky businesses, and genuine inherent value is frequently overlooked. Such seems to be the situation with IMF (ASX: IMF) and there is significant long-term upside in this one.

IMF’s business is litigation funding with IMF leading the listed way in this rapidly growing field. A litigation funding agreement is a commercial arrangement under which the funder agrees to pay the legal fees, witness fees and other related costs involved in the undertaking of a court action. In addition, the funder usually indemnifies the plaintiff against any potential adverse costs. In exchange, the litigation funder receives a percentage of the return from a successful settlement – depending on complexity, usually 20%-50% of the payment net of costs. Cases undertaken include commercial litigation, patent infringement and large scale class actions. IMF operates in Australia, Europe, North America and Asia.

The key to commercial success in litigation funding is backing the right cases and IMF’s astute and cautious management has an outstanding record here. Of claims pursued since listing (2001) 85% have been successful, either through settlement or court order.

IMF’s current portfolio of case investments have a claim value of $1.6 billion, which translates into a substantial profit stream in the medium term. Note: no allowance made for possible returns from the potentially hefty Netherlands based action against ratings agency S&P and associates on behalf of some European banks and pension funds.  Ditto the potential Wivenhoe dam case.

IMF’s profit in 2013 is likely to be $12 million, following a $43 million profit in 2012. Such a decline in profits is superficially alarming but this doesn’t tell the underlying story. Unfortunately, legal timetables and judges take no notice of an investor’s desire for comfort in seeing a nice year-by-year profit increase, ideally accompanied by a tasty dividend. On average, IMF’s funded cases take 2-3 years to reach conclusion, and large class actions can take even longer. With IMF, two such cases – Air Cargo (against various airlines re price fixing) and the delightfully named South African National Potato Co-op (against Price Waterhouse re audit issues) are still going after four years!

IMF’s current market capitalization is around $238 million, including $70 million in cash. To assess a company such as this it is best to look at the five-year record – over the past five years the return on equity has averaged 38% and the net profit margin a neat 50%. The thing is how to value a company such as IMF – probably the best way would be to calculate the likely payback period. Allowing for future dividend flows and the conversion of notes, this would conservatively be four to five years. IMF appeals as a solid buy for the medium term.

Foolish takeaway

IMF is essentially an active investment manager, not a relatively predictable provider of goods or services. IMF assesses the merits of potential claims, manages the process, chooses the appropriate jurisdictions to pursue the claims, and selects specialist lawyers to run the action. Litigation is a dynamic business and needs a high level of skill, judgement and patience — IMF has the record to tick all of these attributes.

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Motley Fool contributor Peter Andersen owns shares in IMF.

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