Duke’s royal credentials

Having raised £44m of new equity capital and trebled the number of royalty partners to 12 in the 12 months to 31 March 2019, the business has subsequently posted record quarterly cash revenue in the first quarter of the 2019/20 financial year. This added credence to the forecasts of analysts at house broker Cenkos Securities that point towards Duke doubling adjusted pre-tax profit from around £4.4m to £8.9m in the 12 months to end March 2020, based on forecast revenues rising from £6.1m to £10.9m. On this basis, expect fully diluted earnings per share (EPS) to increase by from 2.2p to 3.9p and support an annual dividend of 3.4p a share, up from 2.8p a share paid in the 2018/19 financial year. This means that Duke’s shares trade on a forward price/earnings (PE) ratio of 12, offer a prospective dividend yield of 7.5 per cent, one of the highest on London’s junior market. They are also rated on a modest 1.2 times price-to-book value.

A key take for me is the ongoing strong operational performance of Duke’s royalty partners. 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 is then 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.

Duke has invested a total of £75m in its 12 royalty partners, so it's reassuring that all four of the annual adjustment resets from the existing royalty partners were revised upwards during the 2018/19 financial year and in the first quarter of the 2019/20 financial year. This is important, as the ability of Duke to maintain a strong cash-flow performance from its existing portfolio, and deploy free capital on additional future investments, is key to delivering the step change in profitability that analysts predict. Moreover, if these royalty partners continue to perform well then there will be a compounding effect on the company’s royalty stream in the future.

I would flag up, too, that the business has high operational leverage so a high proportion of incremental royalty investment drops through to operating profit, another reason why analysts expect pre-tax profits to ratchet up in the current financial year. To put this into perspective, Duke’s estimated operating costs of £1.7m in the 2018/19 financial year are only forecast to rise to £2.1m in the 2019/20 financial year even though annual revenue is set to increase by £4.8m to £10.9m. The large increase in revenue also reflects a full 12-month contribution from the Capital Steps acquisition and its six royalty partners.

The directors are in on-going discussions regarding several follow-on investments in the existing portfolio in order to provide both acquisition and expansion capital, so improving the balance of the portfolio weighting following the acquisition of smaller rival Capital Steps in February. The board is also in the late stage of assessing investments in new royalty partners.

There is good news on Duke’s finance facilities, too. That’s because the £21.65m consideration Duke paid for Capital Steps included £11.65m of Capital Steps borrowings under a £20m debt facility with Honeycomb Investment Trust, a credit fund run by Pollen Street Capital, spin out of Royal Bank of Scotland. Duke has just agreed improved terms in principal on a much larger facility, and shareholders can expect news on the refinancing within weeks. That’s important because the loan facility enables Duke to fund future investments through debt before having to raise additional equity, thus avoiding dilution to shareholders as well as minimising holding excess cash on its balance sheet. The point being that with debt service costs set to be cut, then future planned royalties will be even more accretive to shareholders given the operational leverage of the business and the higher level of profitability on the existing portfolio as annual royalty adjustments are made.

I first advised buying the shares at 41.6p in my February Alpha Report ('Duke Royalty: A royal high-yielding investment', 18 February 2019), since then the board has paid out two quarterly dividends of 0.7p a share to give a total return of 11.5 per cent, during which time the FTSE Aim All-Share Total Return index has declined by 5 per cent. I expect the ongoing outperformance to continue and maintain my target price of 55p ahead of next month’s annual results. Buy.

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