Diversified Royalty (OTCPK: BEVFF) is a Canadian royalty company. The business model is quite simple: in exchange for an upfront cash payment, Diversified receives revenue-based royalties from the issuing companies. For these companies, it’s an easy way to finance themselves without having to issue debt and without having to give up voting rights while Diversified generates strong cash flow based on revenue and not on the profitability of a business.
Diversified’s primary listing is on the Toronto Stock Exchange where it trades with DIV as its ticker symbol. The average daily volume in Toronto is nearly 400,000 shares per day, clearly making it a much more liquid listing than its US listing.
Diversified royalty: Lots of cash flow, but almost everything goes to the dividend
Of course, a royalty company is only as good as its royalty portfolio, and although it’s a revenue-based system, you still need to make sure that the companies you hold royalties on are in good condition. If the operator goes bankrupt, your fee will be worthless.
Diversified’s royalty portfolio includes only a handful of royalties and, as you can see below, nearly 50% of its revenue is generated from Mr. Lube’s royalty.
Mr. Lube is a well-known name in Canada in the vehicle maintenance industry (think tire changes or oil and other fluid changes). It was no surprise that Mr. Lube performed poorly in 2020 due to the COVID pandemic, but we see revenue growing well in 2021.
AIR MILES is the second largest component of the wallet. It’s a loyalty program that really has nothing to do with the aviation industry. In Canada, grocery chain Safeway is probably the most well-known user of the program, which is owned by Loyalty Ventures (LYLT). The concept is very simple: Safeway buys the “miles” from the program provider and gives them to its customers as a promotional tool (“spend $100 and get X miles”). Customers can then use these miles for cash back on their next grocery purchase. Personally, I think maybe the owner of AIR MILES should consider changing the name because it has nothing to do with the aviation industry, but it’s a tough decision to choose between making your offer of clear products and get rid of a well-known brand name.
For a complete list of the royalties held by Diversified Royalty, including the business models and specific details of each royalty, I would like to refer you to the company’s annual information form which provides a nice and detailed overview.
In 2021, total reported revenue was approximately C$37.3 million, a nice increase of more than 20% over the previous year, as operators of the underlying businesses recovered from the pandemic . Operating profit increased significantly to nearly C$35 million, primarily due to Diversified taking a large impairment charge in 2020 and being able to reverse some of that impairment charge in 2021. But in Excluding these non-recurring items, cash overheads represent approximately 8% of revenue.
Reported net income was approximately C$23.5 million, or approximately C$0.19 per share, but reported net income was boosted by the fair value adjustment of C$6.9 million on financial instruments and the aforementioned C$1.7 million reversal of the impairment charge.
There are also non-cash expenses and part of the taxes are deferred. Diversified reported operating cash flow of C$27.8 million and adjusted operating cash flow of C$29.1 million while capital expenditures were only a few hundred thousand dollars. That’s the beauty of a royalty company: there’s only one initial sunk cost, but no additional follow-on investment is required.
If I deducted normalized taxes of approximately C$5.6 million, the free cash flow result would be C$23.6 million or C$0.192 per share. This is less than the current dividend which now stands at CA$0.22 per year (payable in monthly installments), but keep in mind that Diversified’s cash result improved in the second half and I expect the dividend to be covered by normalized free cash flow starting next year.
Although the dividend is attractive, I own the debentures
As I expect the dividend to be fully covered, I sold my entire position in Diversified Royalty, after investing in history in the C$1.30-1.40 range when the COVID pandemic was accelerating. I also bought the 5.25% debentures maturing at the end of this year, but earlier this week I also initiated a long position in the recently issued 6% debentures maturing in 2027 Diversified Royalty will use the proceeds from the 6% debenture to redeem a portion. 2022 bonds before maturity.
The 6% debentures mature on June 30, 2027 but can be called from 2025. Since the current price of the bonds is only 98.35 cents on the dollar, this results in a yield to maturity of about 6.3%. I like these debentures because debt obviously takes priority over equity, which means the debentures are lower than bank debt, but ahead of the almost C$200 million of equity.
Although a total net debt of approximately C$157 million is not low, this leverage is fine with me, given that a royalty company is a cash flow vehicle and the cash flow of operating is generally equal to free cash flow. This means that if ever there are repayment issues, Diversified can reduce the dividend and make more cash available to strengthen the balance sheet. The dividend is currently costing the company around C$27 million per year, so it would be fairly easy to reduce cash outflows quickly by cutting the dividend – should it ever become necessary. Second, in order to avoid a debt default, Diversified can always issue more shares to quickly reduce its net debt.
There is an additional interesting feature that makes bonds more appealing to me. While I understand that each jurisdiction treats withholding taxes differently and my situation may not be the same as yours, in my case my cash inflow from bonds is actually higher than those from the dividend.
Under the Canadian withholding tax system, there is a standard 15% withholding tax on Canadian dividends after you complete certain documentation confirming that you are not a Canadian resident. This is a reduction from the “normal” rate of 25%. However, on bonds and debentures, there is no withholding tax. This means that after deducting applicable withholding taxes, the dividend yield is around 5.8% while the bond yield is around 6.3%.
So for investors living in a jurisdiction where A) the 15% Canadian dividend tax cannot be easily recouped and B) the domestic interest income tax is not punitive, it is in makes more sense to buy debt because your return including Canadian withholding tax but before domestic taxes is higher for bonds. This strategy will not work in all countries of the world because the requirements [A] and [B] must be fulfilled simultaneously.
The dividend should be fully covered again from this year, but income-oriented investors should take a close look at the recently issued 2027 debentures. There is very little potential for capital appreciation, but I like that debt is prioritized over equity and operating cash flow before paying interest is over $30 million Canadian dollars per year, so Diversified generates a lot of cash flow to cover interest costs.
Of course, a royalty vehicle could also be considered an inflation hedge. If the underlying companies increased their prices by 5%, Diversified’s cash flow would increase by a similar percentage, which would further improve the dividend coverage ratio and pave the way for additional capital appreciation.
Diversified Royalty could attract income investors interested in both dividends and interest. In my personal case, owning the debentures makes more sense than the stocks in my income portfolio. But that’s just a personal preference.