Duke Royalty (DUKE:43.5p) may operate in an area of finance that is under the radar, but it’s a company well worth getting acquainted with given that the directors have made smart progress investing the £79m proceeds from three equity raises (placings at 40p to 44p) to create a portfolio of sound royalty partners since listing its shares on London’s junior market in March 2017.
Moreover, the distributions from these royalty partners and a policy of declaring between 80 and 100 per cent of free cash flow as dividends supports a quarterly payout of 0.7p a share, and one that is predicted to rise to 0.9p a share in the financial year to March 2020. On this basis, the shares offer an 8.3 per cent prospective dividend yield.
Duke Royalty makes its money by providing capital to companies in exchange for rights to a small percentage of their future revenues over a typical term of 25 to 40 years. The company focuses on intellectual property assets and stable, cash-flowing businesses in the underserviced European markets. The benefits to the royalty partners over the alternative of raising equity is that this type of financing arrangement preserves their ownership rights, so is non-dilutive to existing shareholder interests; the owners continue to own and control their company; and Duke Royalty is generally a passive investor.
The arrangement also offers royalty partners access to public investors without the expense, disclosure and dilution of an IPO while at the same time aligning the objectives of the business owners with that of the royalty company to drive profitable growth. As a result, royalty partners retain a greater proportion of the upside from this growth and are not forced to focus on short-term profit maximisation, nor are pressured to seek an exit or liquidity event as would be the case if private equity investment were taken. Furthermore, the royalty partner still retains the ability to issue equity and, in certain circumstances, additional debt. And because the royalty agreement is long-term in nature, the royalty partner is in a prime position to access additional capital from the royalty company at a later date if required.
Under a collaboration agreement with Oliver Wyman, a global management consultancy owned by New York Stock Exchange-listed Marsh & McLennan Companies (US:MMC), Oliver Wyman provides Duke Royalty with deal origination and undertakes due diligence work on potential royalty partners in exchange for a share of the future distributions received once the royalty financing has been completed. The consultancy has more than 1,000 professionals employed in more than 50 cities across 26 countries in the Americas, Europe, the Middle East and Africa (EMEA), Asia and Australia.
The other major differentiating factor in Duke Royalty’s business model is that by creating an operational structure with a low cost base and a tax-efficient domicile, it can deliver high-margin post-tax returns to shareholders. Indeed, the company is registered in and managed from Guernsey, so is subject to a lower rate of corporate tax than its Canadian diversified royalty company peers, thus lowering the cost of capital to its royalty partners. Duke Royalty’s senior management team has extensive experience in royalty management and the UK capital markets, another major bull point given the company’s short operating history. It has some heavyweight backers too, including three of the top 10 largest fund managers in the world.
Importantly, the directors have skin in the game, too. Chief executive Neil Johnson, who has over 25 years of experience in investment banking in both the Canadian and UK capital markets, holds 3.5m shares, or 1.76 per cent of the issued share capital; chairman Nigel Birrell, who works with the directors on deal origination and structuring, owns 800,000 shares; executive director Justin Cochrane holds 740,000 shares and another executive director, Charlie Cannon-Brokkes, topped up his holding a few weeks ago, purchasing 100,000 shares at a price of 43.6p to take his beneficial interest to 5.4m shares. In total, the directors and senior management control around 10 per cent of the issued share capital, thus aligning their interests with outside shareholders.
Understanding the business model
Duke’s Royalty financing structure is not difficult to understand. The company aims to provide royalty partners with long-term financing (typically growth funding but also potentially as part of a refinancing package), which is expected to have a term of between 25 and 40 years (or even, in certain circumstances, a perpetual term).
The terms of the royalty agreements are such that in the first year the royalty partner typically pays Duke Royalty a monthly distribution or royalty equal to 12-15 per cent a year of the financing amount. In the second year, and each year going forward, the monthly distribution would then be linked to the year-on-year growth in the revenue of the royalty partner collared at 6 per cent a year of the total increase or decrease in the royalty partner’s revenue over the prior year. Since the company was formed it has reviewed more than 200 investment prospects worth over £1.5bn in deal value. The targeted deal size is £5m- £20m and to date the company has invested £70.4m across 12 royalty partners and is generating an average cash-on-cash yield north of 13 per cent.
The selection methodology is significantly different from the traditional forward-looking venture capital model, with a key focus on the age, historical track record and stability of potential royalty partners. Given that the company will generally be exposed to risks principally related to a potential royalty partner’s top-line revenue and free cash flow generation, the due diligence process is focused on the overall sustainability and growth prospects of the potential royalty partners’ revenue stream and free cash flow.
A good example of the type of business Duke Royalty looks for is royalty partner Temarca, a Netherlands-based river cruise provider that offers luxury four-star riverboat cruises on Europe's main rivers, the Rhine and Danube. The company’s initial €8m (£6.9m) investment enabled Temarca to purchase two of the three boats that had previously been leased, refurbish a portion of its fleet and repay existing creditors. The international river cruise industry growth is supported by better health of older individuals, growing demand for land-based exploration and the increasing popularity of riverboats with younger generations.
The royalty financing arrangement has gone well. Temarca exceeded the 6 per cent revenue target in its first year’s trading, which meant the distribution to Duke Royalty was reset at €1.06m from July 2018, implying a cash-on-cash yield of 13.3 per cent of its original €8m investment. In fact, the arrangement has worked so well that Duke Royalty subsequently invested a further €1m in Temarca.
Incentivising royalty partners and mitigating risk
In order to incentivise the royalty partner to grow revenue strongly, which de-risks the investment risk to Duke Royalty, there is a cap in place on the maximum increase in distribution. Royalty agreements also include a buyback clause that is a pre-determined fixed amount and/or a multiple of the annualised royalty payment from the royalty partner to Duke Royalty on the date of exercise of the buyback option.
Equally, to make sure Duke Royalty is protected in the event of revenues falling, there is a collar on the percentage (6 per cent in a typical example) that the distribution can decline by. Duke Royalty also takes senior security on the royalty partners’ available assets, so ranks above equity shareholders in the enterprises it lends to. This means that even if the royalty partner’s trading deteriorates, Duke Royalty’s investment has some degree of protection. Also, the company only lends to lowly geared royalty partners, and where other debts exist it seeks inter-credit agreements to protect its capital investment.
Typically, Duke Royalty’s funding has fewer negative covenants relative to debt, although the company does mitigate risk by targeting companies that have an established track record, and have been in business for 10 or more years; backs management with a track record of delivering; and focuses on businesses with a defensible business model. The cash pay-back term is typically six to seven years, and royalty coverage is at least two times earnings, before interest, taxation and depreciation (Ebitda), so the royalty distribution made to Duke Royalty represents a minority of the royalty partners’ cash flow.
Portfolio growth supports progressive dividend policy
Duke Royalty’s latest deal is a £10m investment in Miriad, the largest privately owned recreational vehicle parts wholesale company in the UK and one that supplies more than 15,000 individual products and accessories in the motor home, caravan and converter market to 1,700 business customers. Miriad services customers through two distinct sales divisions, the first of which supplies parts to original equipment manufacturers (OEMs) by targeting manufacturers of motorhomes, caravans and specialised vehicles such as horseboxes and trailers. The second division supplies parts to the retail market and targets motorhome and caravan dealerships in the secondary aftermarket.
Miriad’s owner-directors are all longserving employees with a combined total of more than 80 years' experience. The company has increased sales 25-fold to £23m between 1999 and 2018 and Duke Royalty’s investment will be used to accelerate the company’s growth.
Factoring in the contribution from Miriad, and a full 12-month contribution from its other 11 royalty partners, analysts at house broker Cenkos Securities predict that Duke Royalty can lift pre-tax profit from £4.7m to £8.5m in the 12 months to end March 2020 to boost earnings per share (EPS) by more than half to 3.8p and support an annual payout of 3.6p a share, up from 2.8p a share in the 2018-19 financial year. On this basis, Duke Royalty’s shares trade on a forward price/earnings (PE) ratio of 11.5, offer a prospective dividend yield of 8.3 per cent and are rated on a modest 1.2 price-to-book value.
The bottom line is that as more investors become aware of the solid progress Duke Royalty is making, the shares are likely to rerate towards the 55p target price I outlined in my February Alpha Report when I suggested buying at 41.6p, since when the board has paid out a quarterly dividend of 0.7p a share ('Duke Royalty: A royal high yielding investment', 18 February 2019). Buy.
■ Simon Thompson's new book Successful Stock Picking Strategies and his second book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 to place an order. The books are being sold through no other source and are priced at £16.95 each plus postage and packaging of £2.95, or £3.75 if you purchase both books. Details of the content of both books can be viewed on www.ypdbooks.com.