Broker Peel Hunt has initiated research on litigation finance provider Burford Capital (LON: BUR) and is broadly positive about the company, which has been under fire from critics over the past two months. The note is not without criticism for the firm, though.

Peel Hunt believes that there are governance and disclosure problems, but that they are exaggerated. Burford will need to deliver on its promises of better governance and accounting information.

Burford is the global leader in litigation finance so it should lead the way in reporting and explaining its figures. By its nature, Burford is an investment company with illiquid assets.

Muddied water

Peel Hunt is critical of some of the Muddy Waters research and the broker is convinced by most of the rebuttals by Burford. The problem is that many of the contentious areas are subjective so there is no firm right or wrong way to value assets and allocate costs.

There will always be arguments about the appropriate valuation for a long running case and the accounts are complicated. There is no real market in these cases on which valuations can be based.

Peel Hunt does agree that Burford’s use of return on invested capital is contentious. It calculates cash IRR as 19%, rather than the 32% reported. Litigation losses are relatively low, but the broker points out that $117m has been spent on cases it committed to more than five years ago.

Petersen

The figures are also distorted by the significance of the Petersen case, where a stake in the litigation related to the nationalisation of assets in Argentina was acquired by Burford for $18m and the liability for all subsequent costs.

Unrealised gains taken on the case have been a large contributor to Burford profit. The note sets out the background to the case and unrealised gains.

In its calculations, Peel Hunt assumes a 54% chance of success and assigns a value of $1bn to this stake. Burford has already sold interests in the case to 40 investors for $388m, but it wants to retain a stake of more than 50%. If this value ends up being accurate then it would be difficult for Burford to repeat the success.

Cash

Generating cash is important for Burford. It is one of those businesses that reports high profits but never seems to generate the cash it should. Fair value adjustments are non-cash and cloud the profit conversion.

Debt is expected to continue to increase as more cash is put into cases than is realised and dividends are paid. The gearing is the thing that helps the company increase its assets, because of the availability of cheap capital.

Target

Peel Hunt has set a target share price of 1164p. This is still well below the level the share price was at its peak last year, but well above the current share price of 791.5p. The estimated 2021 NAV is $11.68/share. The embedded value if Burford went into run off is $1.43bn (521p a share).

Investors will undoubtedly be more cautious about the share price than they were. The old valuation was pricing in significant future gains.

Burford does have a track record of winning cases but there is no guarantee that this will always be so. There is still much for management to do and it appears that competition is increasing. The shares could continue to provide a bumpy ride even with this more positive view from Peel Hunt.