What is Diversified Royalty Corp. Worth?

Diversified Royalty Corp. got their start in late 2014 by buying a royalty on the sales of Franworks restaurants, with the goal of acquiring a diverse portfolio of royalties from multi-location businesses across North America. Diversified was a misnomer until June of 2015, when the company acquired a royalty from Sutton Group Realty. And then in August of that year, the royalty for Mr. Lube Canada was acquired.

At that time the story seemed to be on track.

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That chart is relevant because the majority of Franworks restaurants are in Alberta. Just like every other stock at all related to Alberta, investors punished Diversified. The same stores sales growth of Franworks plummeted, as did Diversified’s stock price.

That all changed this past September when Diversified struck a deal to sell the rights to the Franworks royalties to Cara for $93 million. This dramatically reduced the Alberta cloud hanging over Diversiified, as well as gave the company a lot of cash with which to work. And the deal was done on good terms for Diversified (the company achieved an internal rate of return of almost 15% in the time it owned the royalty).

Since selling the Franworks royalty stream, Diversified has been paying out an unsustainable dividend while burning through the giant pile of cash Cara paid. The idea was to reinvest the money into more streams until the dividend was once again covered by cash flow; that is still possible but every month that goes by the cash pile is lower and the company is worth less.

Valuation

I believe there are two ways to value the company right now: a liquidation value and an intrinsic value assuming the dividend is cut. Management has proven to be adept allocators of capital, but looking at the lack of new deals from any of the diversified (ie. not restaurant) royalty companies (the main peer being Alaris) shows that it likely isn’t prudent to believe Diversified can find a new stream any time soon.

Dividend Cut

The thought behind this method is that, if Diversified is unable to ever find another royalty partner and cut the dividend down to a 100% payout ratio, what would the stock be worth?

In Q1, Diversified made $4,148,000 in royalties and management fees from just Mr. Lube and Sutton. In all of 2016 those two royalties equaled $16,845,000.

Sutton is a fixed royalty per month based on the number of agents in the royalty pool, with contractual 2% increases every July 1st. So it is known that for the rest of 2017, Sutton will contribute $2,825,604. Sutton has the right to add agents to the pool as of July 1st, so this number could also be marginally higher. In 2016, Sutton added 215 agents, but I won’t consider any possible new agents in this valuation.

Mr. Lube has had fantastic same store sales growth (SSSG) since Diversified acquired the royalty, including SSSG of 2.7% in the first quarter of 2017. For the purposes of this valuation I will assume royalty income increases just 1.5%. This would make royalty income from Mr. Lube $10,291,085 for the rest of the year.

So royalty income for 2017 will be $17,264,689. Operating expenses will come in around $2,856,000. Interest expense will be around $1,452,000. Diversified has consistently had an income tax rate of 27%, so income tax should come out to approximately $3.5 million, leaving net income of $9,456,689. Add back $648,000 of share based compensation, and we get “distributable cash” of just over $10 million, or 9.51 cents per share (fully diluted).

If Diversified cut the dividend to 9.5 cents, and traded at a 6 yield, the stock would trade at just $1.58. But considering that there would be about 25 cents of net cash on the balance sheet, I would estimate a fair value of $1.83.

If you consider some tax pools that Diversified has, the dividend could be ~13 cents, and this would lead to a fair value of about $2.42.

There’s a lot of problems with this valuation though so I’m not too happy with it (6% yield too high for the stable revenue, expenses could be cut, cash should be paid out, I didn’t account for Diversified’s ability to defer taxes, etc). Any premium to the fair value here would be the premium for trusting management to invest the cash well. I have full faith that Diversified management could do that, with the caveat that thee has to be a company out there looking for this financing. That is the question. It’s possible that in thee prosperous times of easy credit, every company can get loans that needs them, and none need Diversified’s relatively expensive form of financing.

Liquidation

For this method I’ll assume that Diversified sells the Mr. Lube and Sutton royalties, distributes all the cash and shuts down the company. I don’t think there is much chance this happens any time soon, so the fair value will go down every month as the company burns through cash, but there is a value to the components of the company.

As described above, there is 25 cents of net cash.

Sutton is very stable, and luckily there is a company out there that competes in the same sector which should be very interested in purchasing the Sutton royalty if it were made available: Brookfield Real Estate Services (BRE). In January, BRE acquired royalty income of approximately $1.2 million for $8.2 million. Based on that valuation, Sutton would be worth $26.2 million to Brookfield. However, I believe Diversified would not sell for less than their initial purchase price ($30.5 million), and that there would be other interested suitors that would bid the price up to that. So I’ll estimate that Diversified could recover approximately 29 cents for Sutton.

Mr. Lube is the jewel in the Diversified crown. Outstanding SSSG, a household brand name, I think the Mr. Lube royalty would fetch a lot if put up for sale.

Diversified acquired the royalty for 11.2x the first year’s royalty ($138.8 million for a royalty of $12.4 million). If Diversified can only sell the royalty for the same multiple, it would now be worth over $150 million, and $1.42 per share.

Assuming closing costs of ~$10 million, this would leave shareholders with $1.86 in the event the company was liquidated.

I think that the Mr. Lube and Sutton royalties could be sold for slightly more than this (and every $1 million more is worth ~1 cent per share), seeing as the Franworks royalty was sold for more than Diversified paid for it, while the royalty income had gone down. But at most I think a purchaser would pay 10% more than my estimates above, which would make liquidation value still just $2.13

Conclusion

I still believe that this company has a good management team that I would trust to invest my money. That’s why I bought shares in the first place, they’ve proven to me to be good at allocating capital. But their skill is entirely dependent on finding companies that need financing. I’m not sure there are enough opportunities out there to be found. And if there are opportunities out there, will Diversified be able to achieve similar returns as they have with their previous royalties?

I no longer believe that burning cash while looking for a new royalty is prudent, and I am not confident there are quality businesses out there looking to sell 7% of their top line to Diversified Royalty Corp. I love letting good capital allocators allocate my capital, but I think there are better opportunities in the market right now, including two that I need to write new posts on. Diversified could announce a new royalty any day now, and that would dramatically change my thesis, but for now I am happy to reduce my position slowly until it is a much smaller part of my portfolio.

Disclosure: In the process of selling most of my position in DIV.

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