Introducing IPH Limited IPH

  • Moat Rating: None
  • Share Price on 24/09/2024: $6.01
  • Fair Value: $5.50
  • Price to Fair Value: ~1.1
  • Uncertainty Rating: High

IPH Limited (“IPH”) holds a strong position within the intellectual property (IP) industry offering a wide range of services through its subsidiaries. These include patent filing, prosecution, trademarks and various others. Their work is largely transactional which encourages stable cash generation in comparison to other legal services firms. However, the company lacks fundamental competitive advantages that risk client retention rates. Further, IPH is highly acquisitive which has significantly increased market share – with its latest purchase being Bereskin & Parr, an IP firm in Canada.

In addition, the company adopts a high dividend payout ratio with a mixed track record of extracting synergies from acquisitions. This leads our analysts to initiate coverage of IPH Limited with a three star rating and high fair value uncertainty.

With the share price down ~35% over the last three years, IPH Limited (“IPH”) continues to grapple with issues stemming from a lack of moat and poor capital allocation strategies.

IPH

Figure: IPH weekly share price from 24 September 2021 to 24 September 2024. Source: Morningstar

Financial pressure

Our fair value estimate for IPH is currently $5.50 per share translating to a FY25 price/adjusted earnings ratio of 11.0x with a dividend yield of ~7%.

Whilst there has been growth in earnings before interest, tax, depreciate and amortization (“EBITDA”), profitability metric earnings before interest and tax (“EBIT”) margin has remained stagnant. Moreover, the asset turnover ratio and the return on invested capital have been on a seven year (to fiscal 2024) downward trajectory despite revenue growth.

This could indicate persistent cost pressures, limited revenue synergies or potential integration issues. The firm continues to pursue large acquisitions despite a lack of free cash leading to frequent debt facility drawdowns and capital raisings.

While IPH intends to continue pursuing operational efficiency, Morningstar expects fee compression amid ongoing inflationary costs (wages, acquisition costs, agency fees) to dampen profitability. Over the next five years we have forecasted a ~6.0% net profit after tax margin, compared to the previous 12.5% per year over the last five years.

No moat in sight

We do not assign a moat to IPH given potential business shortcomings dulling confidence in the company’s temporary advantages (e.g. switching costs and traces of intangible assets). Furthermore, the firm lacks pricing power and long standing client relationships that are required to negate the low barrier to entry.

IPH’s revenue is mostly derived from transactional work, meaning lower client engagement is threatened by the presence of larger legal firms offering a wider range of services. IPH’s group market share has also declined over the past three years in key geographies such as Australia and Singapore.

75% of revenue is derived from “secondary” market patent filing, which is relatively transactional and electronic. This large revenue segment is prone to competition due to the lower client touch points and lack of switching costs. There is also more optionality for clients to select providers at this stage as most of the critical work is done in the “primary” market filing. In addition, there is no contractual obligation for clients, and they can switch providers at their free will.

The existing customer base is considerable, however this cannot be solely attributed to client goodwill or switching costs. Instead, it points towards the lengthy patent application process (approximately two to six years), which Morningstar does not deem as inherently moatworthy.

Given the inability to monetize client relationships, IPH has been forced to undercut competitors to win new business as they’ve suffered client defection after passing on the costs of mergers and acquisitions. Self-proclaimed strengths of efficiency, advanced technology and service quality are not unique to the firm and can be replicated by competitors.

IPH is also at risk of regulatory changes in the various demographics it operates in. For example, its recent announcement to acquire ROBIC and Bereskin & Parr (both Canadian IP firms) has raised conflict of interest concerns due to an Australian company owning one-third of Canada’s patent law market.

Capital allocation woes

IPH has been assigned a Poor Capital Allocation Rating due to a string of underperforming acquisitions and excessively high dividend payouts in the context of its acquisition-growth strategy. The firm recently completed a $100 million placement in August to fund the cash consideration of their latest acquisitions, as well as reduce outstanding debt.

The company’s leverage has increased over the last five years with net debt/earnings before interest tax, depreciation and amortisation (“EBITDA”) pushing 1.9x in FY24 compared to the five-year average of 1.0x. This number is at the upper end of management’s target range of 1.5 – 2.0x. We do expect it to decrease over the next year through proceeds of the recent equity raising. The high leverage reflects the frequent debt drawdowns for less-than-synergistic acquisitions and the considerable one=off restructuring and compensation expenses.

We believe the current dividend payout ratio of ~80% net profit after tax is unsuitable for the acquisition-focused business strategy. Especially considering their weak free cash position. The balance sheet currently remains manageable, however staying the current course could further weaken financial health.

It is important to note that the firm does not have fundamental cash flow problems, simply poor capital allocation and excessive dividend payouts. Despite this, IPH’s states that acquisitions remain a part of the FY25 growth strategy, and low capital requirements reinforce their ability to service dividends at a high payout ratio. The value accretion to shareholders from the acquisitive-growth strategy has been elusive to say the least.

What we think

Continued debt facility drawdowns and equity raises to fund expansion risk IPH’s financial leverage and further dilute shareholder value. Morningstar believes a more conservative dividend payout would allow IPH to reinvest its earnings for growth and reduce its reliance on external funding. Achieving cost efficiencies and reducing its debt balance should be key before pursuing new acquisition opportunities.

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Terms used in this article

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued. 

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica. 

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.