CA - Diversified Royalty: Grab An 8.7% Yield On The Debentures

2023-06-12 10:30:00 ET

Summary

• Diversified Royalty owns a bunch of royalties and the exposure to the Mr Lube franchises likely is the best known asset.
• The dividend is fully covered, but I like the debentures more.
• Not only are interest payments and principal repayments senior to the common equity, the YTM on the debentures is higher than the dividend yield.
• Of course, you are foregoing potential capital gains on the common shares up until C$4.05, the conversion price of the debentures.

Introduction

While I currently don’t own any common shares of Diversified Royalty ( DIV:CA ) ( OTCPK:BEVFF ), I think it’s important to keep a finger on the pulse to make sure the company can meet its commitments towards its creditors. I have owned some of the company’s debt for several years now . The first convertible debenture was called on the maturity date and repaid in full, and I participated in the royalty company’s most recent convertible debenture offering. In this article I’d like to have a look at Diversified again, both from an income perspective as well as from a creditor perspective.

The dividend is still fully covered

The company’s first quarter was a bit better than I had expected. As you may know, the owner of the Air Miles program, Loyalty Ventures ( OTCPK:LYLTQ ) entered into bankruptcy procedures and sold the program to the Bank of Montreal ( BMO ). That’s great news for Diversified as the loyalty program continues to exist, but it might take a while before customers find their way back to Air Miles. I used to be an Air Miles user but haven’t used the card since grocery chain Safeway exited the loyalty program. I was glad to see the revenue decrease of the Air Miles program in the first quarter of this year remained limited to just a few hundred thousand Canadian Dollar as I wouldn’t have been surprised to see a steeper drop.

The Air Miles program represented less than 10% of the total revenue in the first quarter, and it becomes very clear the Mr Lube exposure remains extremely important for the company.

As mentioned above, the total reported revenue in the first quarter was C$12.2M from royalty revenues and about C$0.1M from management fees for a total consolidated revenue of C$12.3M .

The operating expenses are pretty low at C$1.2M, of which about a quarter consists of non-cash share-based compensation. This results in an operating income of C$11.1M and a pre-tax income of C$9.2M after deducting the C$2.8M in interest expenses. The net income during the first quarter was C$6.7M, which is approximately C$0.05 per share based on the average share count of 141.5M shares.

Diversified currently pays a monthly dividend of C$0.02 per share (for C$0.24 per share per year ) and based on the Q1 EPS you could argue the dividend is not fully covered. However, there are some non-cash expenses that weigh on the income statement but have no impact on the cash flow results.

Diversified Royalty also publishes a distributable cash per share result . As you can see below, the total amount of distributable cash was just over C$8.8M which is C$0.0624 per share. In this case, the total dividend payments of C$0.06 per quarter would be fully covered.

There’s one caveat though: the total tax expenses came in at C$2.5M but only C$1.1M was deemed ‘current’. This means not the entire amount of taxes is included in the DCF (distributable cash flow) calculation.

I still own a decent-sized position in the debentures

From the perspective of being a creditor, I am positively surprised by the results. I used to own the company’s previous debenture (which has now been repaid in full) and I subscribed to the newest issue of a convertible debenture last year. The company issued C$52.5M of 2027 debentures with a 6% coupon at the end of Q1. These debt securities will mature on June 30, 2027 and are trading in Canada with DIV.DB.A as ticker symbol. The current price is 91 cents on the dollar, resulting in a YTM of approximately 8.7%. That’s appealing.

As the income statement shows, Diversified is generating plenty of free cash flow to cover the interest payments. With an operating income of C$11.1M, the C$2.8M in interest expenses were very well covered in the first quarter. Even if the total interest expenses would double, Diversified would still be able to service the interest payments. The common shareholders wouldn’t be happy, but as an investor in Diversified’s debt, I feel very comfortable seeing those metrics.

Being able to make the interest payments is not the only important metric. Looking at the balance sheet, I also need to be sure the assets are valuable enough to cover the debt. In Diversified’s case, that seems to be fine as well. Diversified has about C$4.4M in cash and C$145.4M in bank loans and about C$52.5M in convertible debentures (the image below shows just C$47.9M in convertible debt), but that’s because the equity component of this specific debt is deducted from the principal. The convertible debentures are convertible in common shares at a fixed price of C$4.05 and considering they are pretty far out of the money, I’ll just assume the debentures will remain out of the money.

As you can see above, the total amount of liabilities versus total assets is approximately 49%, while the total net debt represents a multiple of less than 4 times the distributable cash flow and just about 3.5 times the operating income. So that’s fine with me. I would however like to see a lower payout ratio of the common dividend as that would allow Diversified to slowly reduce its net debt and prepare itself for the next acquisition, but it is clear Diversified is very keen on keeping its dividend high and perhaps continue to increase it (in small increments).

Investment thesis

The dividend is barely covered, but it is covered. I also expect the Air Miles contribution to have bottomed out while Diversified continuously adds new Mr Lube locations to its royalty portfolio. As such, I think the total distributable cash this year could come in closer to C$0.26-0.27 per share and although the payout ratio would come in closer to 90% in that case, the dividend will remain fully covered. So from that point of view, the common shares are getting pretty interesting at the current share price below C$3.

As a potential shareholders, I’m satisfied with the Q1 results. As a creditor, I am very happy with the results. The interest expenses are very well covered thanks to the strong operating income while the balance sheet looks pretty robust as well. Another bonus for me as a non-North American investor is the fact there’s no Canadian withholding tax on the interest payments from the debentures while there is a 15% tax on the dividends (the reduced regime versus the standard dividend tax rate of 25%). This means the current YTM of 8.7% on the debentures is slightly more appealing than the 7.2% dividend yield (the gross yield is 8.5%). Sure, I’m giving up the potential for capital gains between the current share price level and the conversion price of C$4.05. But considering I’m receiving an 8.7% yield on my debentures, I’m more than happy with the risk/reward ratio here and I may even add to my position.

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