Diversified Royalty Corp. (DIV) Earnings Call Transcript & Summary

[indiscernible], folks. Welcome to the Business Royalty Panel. I'm Scott Fromson, diversified industries analyst at CIBC. We've got Steve King, CEO of Alaris Royalty; and Sean Morrison, the CEO of Diversified Royalty Corp. So welcome, gentlemen.

Let's start it off with -- let's just start off with a recap of investment highlights over the last year. Steve, do you want to kick it off?

Okay. Yes, we had a busy year. We deployed just a hair under $200 million in capital last year. We had USD 20 million of redemptions in the calendar year, but we had a large one in the first few days of January. One of our partners, SBI -- interestingly enough, we have a 3-year noncall. So the people that we invest our preferred shares into, they can't buy us out for 3 years. And if they do, they have a make-whole provision. They did that, and the reason they did it is there was a bit of an internal situation between their partners. One of the founding partners was stepping away from the business, still collecting the lion's share of the monthly cash. That didn't work so well for his other partners. So they really needed to buy him out. We were not in a position to do that in terms of their own cash flow. So they were kind of forced to sell the business. And unfortunate for them but a very good return for us. So it was a good year, a good year of deployment. And at the end of the day, we're here to make money. And we made $42 million in 2.25-year period, which is not too bad.

Sean, you've been busy as well.

Yes. We have. I think there was about 1.5 years before 2019 started where I think people were wondering if we could actually get another deal done after being quite busy when we started the business. And last year I think just proved the point that with patience, you can get some deals done. And we got 2 deals done last year, which was our goal. And we got an acquisition line set up, and we got some other opportunities that we're pursuing right now. So 2019 was a great year. We got our payout ratio under 100%. We increased our dividend. We got a couple of deals done. We have no more excess cash in the balance sheet. So that was a much better year than 2018 from a capital deployment perspective.

Good. Now what have you learned over the last year with respect to your business model, how to structure and negotiate for new deals?

Go ahead.

Yes. I think, I mean, our structures are fairly unique. So I think just presenting them to potential businesses is a bit of an art, not so much of a science. So the word royalty kind of has some negative connotations to it. So we're -- I think we're getting a little bit better in explaining to people exactly how this -- our structure works. And I think just as we build the portfolio, we build a bit more credibility with other -- with potential companies. And it just creates a bit of momentum, which is good.

Yes. It's the same for us, really. It still boggles my mind. We'll meet with an adviser that I know for a fact we've met with at least 3x, and it's like we're teaching it to them for the very first time. We've been doing it for 16 years, and it's still new to a lot of people. So there's always work to do. There's always little tweaks you can do in terms of how you deliver it and tweaks in terms of what you're delivering as well, which we've tried to do. So it's a battle. But with that being said, I wouldn't want to be somebody that doesn't have that battle because you have to differentiate yourself in this market in order to deploy capital other than by overpaying. So it's well worth it.

That's good. Let's talk a little bit about relationships with prospective investments. Brokers, deal sources, how important are they? And what's your process?

It's everything. We go to probably at least a dozen kind of private equity conferences a year and meet with all the different advisers and sometimes with -- directly with the companies themselves. And you hear a lot of horror stories about other capital providers and large advisory firms saying, "You know what? That firm, I will never ever deal with them again. I will never send them a deal." It's all about building that reputation of delivering on what you say, which is becoming a bigger and bigger problem, I think, in the private equity industry. The higher the multiples have gone, the more inclined private equity firms are to retrade them right before closing because they don't want to pay what they did. They've got it, and they get you 3 quarters pregnant, and then they retrade a week before closing. And it's becoming a real epidemic in the industry. I had an adviser telling me that they estimate it's roughly 70% of the time deals are getting retraded right before closing.

Okay. So in terms of -- in our business model, our approach has been more trying to build relationships with potential target companies as opposed to dealing with the advisers. We -- Greg and I used to be advisers, and you can't really rely on them because they're basically, just whatever is coming in the door, they're focused on that particular thing. And then like Stephen said, you might have to pitch them 2 or 3, 4x the same pitch, and they just -- they've already forgot it because it wasn't relevant into them when you pitched it to them. So like I said, the 2 deals we did this year were both deals that were -- we reached out to the owners of these businesses 5 years ago and kept in contact with them and explained to them how the royalty model worked. And when the time was right, that we'd be one of the options they can -- would consider. So that hard work does eventually pay off, but it is frustrating sometimes because you never know when that's going to happen.

Okay. [Operator Instructions] There's a question here. You started buying back stock. Is this a temporary program?

We didn't buy back stock.

Me neither.

Okay. We'll move on.

We actually have a DRIP in place.

But it was a bit of a surprise to me, too. It might have been from the previous session. So we'll let it go. So let's go back to the deal pipeline. How is it looking for both you guys? What -- how does it compare to a year ago?

For us, it's -- I think it's pretty similar, maybe a little bit better. I think the better companies in the world, and we talked about this earlier, they're not going public anymore. So the choice of good kind of small- to medium-sized companies is better than it's ever been probably because with the amount of capital that's in the private equity industry, it's bringing out more good companies that are choosing staying private compared to going public. The downside of that is, with all that capital, and one of the reasons they're staying private is because multiples are as good, if not better, in the private markets now as they are in the publics. And so it's a double-edged sword. But for us, because we're so unique, I'd rather have this kind of frothy environment because it just brings out more good companies. And if the fit is right, we'll win it.

Go ahead.

Yes. So right, what was the question again?

How's the deal pipeline?

Deal pipeline, yes. No, I think deal pipeline has kind of been the same in the last 2 or 3 years for us. In 2018, we got no deals done. Last year, we got 2 deals done. So sometimes you get to the finish line, and we were competing against some private equity funds that did exactly what Stephen was saying before, where they win with an outlandish bid, we tell the adviser, we tell the owner, I said, "Listen, our -- what we are pitching here will be precisely what we can deliver because we got a cushion in the way we structure our royalties deals." I said the way private equity guys do it is they bait and switch. And sure enough, this guy had a back-ended loaded forecast that Greg already knew was not going to be hit. And a week before closing, there was a big kerfuffle, and no deal got done. So yes, just got to be patient.

Has the market loosened up in terms of valuation, Sean?

I guess every deal is different. It feels like it's a little bit easier because we got a couple of deals done last year and obviously a very small select group of data points. But we were able to get traction with a couple of deals last year. Whereas the year before, we were kind of finished second place a couple of times. But I think that's maybe more specific to each of those particular deals than what's happening out there. I mean, there is a lot of capital out there. And it really -- it's reverse engineering. It's how much debt you can put on these businesses is what's driving the private equity multiples. And I think that's what they use as the grind factors. They said, "Well, it looks like your normalizations aren't what they are. And because the bank won't give us enough money, we're good guys, but we can't give you that enough money." So they're going to do their homework upfront, I think, before they make their bids. But that's the market today.

Yes. Multiples have not come down. We got one of our partners -- most of our companies in our portfolio get pitched all the time from private equity, trying to get them to sell. And one of our companies last week got a quote of 15 to 17x next year's EBITDA. So yes, multiples have not come down. He's not selling, by the way.

So maybe in the context, maybe this isn't a relevant question. Are you seeing an increase in the number of inbounds? Or are you revisiting a lot of warm files?

Some of both. We've had situations, because we've been doing it for so long, where maybe there was a deal we lost 5, 6 years ago, and now the PE firm that then ended up buying it is now in a recycling mode. And it comes back on the market. And the entrepreneur remembers us. Maybe the experience with private equity wasn't so great. And so they give us a call. But for the most part, it's new companies.

Yes. For us, it's actually the deals we did last year were all kind of legacy deals. So I'd say, because we're getting a little bit more traction with getting deals done and announced, that pulls more lead and flow from the investment banking community. Those tend to be not as good of a deals because they're usually massively marketed and the normalizations are pretty awesome. And the forecasts are pretty awesome. But basically, we spent a lot of time maintaining relationships so that when the time is right, that we've built that credibility.

Perhaps you could both go through kind of the archetype deal that you've done, whether it's been in the last year or over the last couple of years, sort of what you did to get the deal, what you got -- did to win it and what attracted the vendor to your particular model.

Sure. Go ahead.

Okay. And ours, as I said, Nurse Next Door, the last deal we did was probably a unique situation where the entrepreneur was massively bullish on his business. He owned about 45% of the equity in the business. He had a longtime partner and -- longtime partners that own the other 55%. And our model, because we're not buying equity, and he believed in the business so much, it was a way that he could use our capital as a vehicle to buy out 100% of his partners, own basically 90-plus percent of this business and really reap the benefits of the growth in the business because he believed in the growth. So because we don't grab the equity, if you believe in your business especially to that extent, it's pretty much a no-brainer. So that worked out well for us.

Yes. We have similar situations that we look for and similar situations that we're good for with companies, and it is entrepreneurs that believe in their business and have a high-growth trajectory. So we just had the first year anniversary of a company, GlobalWide Media, out of Los Angeles. And it was the company that just got that ridiculous bid. They've gone from $20 million to $40 million to $60 million of EBITDA in 3 years and are expecting over $100 million next year. And so it's a special company and a really good business with great people. And that's what every investor looks for. But because our preferred shares have a cap on the annual growth, there's no bid from private equity, including 15 to 17x. They can knock us out. And so a lot of people mistakenly think that we're an investor of last resort for bad companies. It's actually the exact opposite. We're very inexpensive equity for very good companies. And so yes, that's kind of a good example. So we actually took out private equity in that case. They were private equity-owned, and the management team just had a huge belief in their abilities and negotiated a takeout of that private equity firm and used our capital to buy those common shares and retire them. And so they went from 40% owners to 100% owners and are feeling pretty good about their decision.

Are you seeing any industries that are -- either you're interested in or not interested in, that things have changed to -- to change your outlook?

We've always had a bit of a focus on health care services. So we acquire health care services. We've got some deals that we're looking at in that space right now. But just in general, I also think right now, there is -- I think the market has gone too far on some industries in terms of the multiples they pay. And there's some other industries that have not had the benefit of riding that wave. And so I think there's an anomaly there that we can take advantage of with some businesses that are old economy but not heavily cyclical and are not trading at the super high multiples. So I think you'll see from us -- in that case, we may look for a little bit of common equity in addition to our prefs. And we think that will allow us to stay in them longer. We think the cash yield on the common can very quickly become much more than the cash yield on the prefs. And in a lot of these cases, the owners want to have a shoulder-to-shoulder partner with the same class of shares. So we think that will help us actually deploy more capital. And we're not going to be paying 15 to 17x for any common. But in situations where we can get it at the right price and it helps us deploy more prefs, then we're going to do that. So I think you'll see some more kind of old economy-type, service-y businesses that we think are undervalued in the current market.

Yes. I think the one -- the space we're looking at is franchisor businesses that are maybe a bit more in the services area, and like the Nurse Next Door would be a great example of that. And we've got our eyes on a couple of other businesses in those types of areas where we think those are just really good, well-protected. Technology is not going to be really an issue to affect those types of businesses. It's services that people need and will always need. So those -- that's our focus right now.

So maybe more of a demographic play than a sort of a technology play?

Yes. Definitely not technology. Yes, it's more just services that people need for themselves and their family.

Yes. I think some people were a bit surprised at the Mr. Mikes investment after the...

Franworks?

Thank you. I was going to say Original Joe's after the Franworks acquisition, which reality, you made apple pie out of apple peelings.

I heard that. It sounds good, though.

Well -- sorry, apples to apple peelings to apple pie.

Okay. That's much clearer. Yes, I mean, I think I'll just answer the question quickly because when we announced that deal, obviously, we addressed those -- that particular question and we tried to address in great detail. It's a franchise model versus a quasi-corporate model, which the risk profile of the business is dramatically different. The management team was much more seasoned. They had a much bigger G&A, no debt on the balance sheet postclosing, no debt allowed to put on the business postclosing. So we structured a different deal with a different type of business with a better management team. So a much smaller deal, too. The first one was 100% of our revenues. This Mr. Mikes deal is now less than 10% of our business. So we think it adds diversification to our portfolio and is not really representative of, let's say, the Franworks transaction, which was basically a better whole company on it. And it helped create us. So that was great, and it created a bunch of shareholder value for us. But it was a bit of a wild ride.

So Steve, I've asked Sean a question about an investment that didn't...

Come at me.

That was easy for you. What have you learned in the past a little while about managing investments that haven't gone according to plan? What have you changed in your approach that...

Yes. Yes. I mean, you'd be a pretty poor manager if you didn't try and learn from everything, good and bad. And in a couple of the cases where we've had companies go bad, and just to maybe backtrack, there's really nothing you can structure that's going to 100% prevent bad investments. I don't care who you are and how good you are. But with that being said, 2 of the companies that we took some losses on, we identified the problem very early. We were not able to act because we had senior lenders in front of us that would not act, and we had a standstill agreement that prevented us from doing so. And there were some other factors in with the banks as well. It would take too long to tell you. But because of those situations -- and so it ended up taking a couple of years to sort out. During that period of time, a distressed asset that you have to wait 2 years to liquidate, you're not going to get what you want out of it. We could have -- when we identified the problem, we could have gotten everything out. So in all the deals we've done over the last 2 or 3 years, we have negotiated the right with every senior lender that's in front of us to be able to take them out with no negotiation. They can't block that. We've also negotiated the right to -- in a lot of cases, our distributions have been binary. The bank just has the right to just shut them off no matter how small the default was by the company. That's no longer the case. So we've got a kind of a ratchet provision where if they can still pay us 95% of our distribution and stay on the side, they are allowed to do that. So that materially lessens our risk profile on our cash flows. And then the other part of it is the vast majority of the companies that we've transacted with over the last 3 years actually have no debt. So that just makes it a lot less risky and a lot easier where you've just got you and the entrepreneur, and you'll figure out how to deal with things if and when they come.

Good. Any questions from the audience? You are quiet ones. What are your thoughts on the current capital structure and access to capital?

Because of the SBI redemption, we've got about $260 million of dry powder on our balance sheet. So we're in good shape. We're working on a couple of pretty large transactions that could kind of change that dynamic fairly quickly. But the nice thing is, if we ever come back to the market, it will be with a lot of good news in between now and then. But we've got a $380 million facility. I would want to keep probably at least $125 million of dry powder at all times because that's -- deals that we bid on can get that big. And so they need to see that I've got that on my balance sheet without financing risks. So we've got some money to spend to get to that spot, and we're going to have fun doing it.

Yes. And capital flexibility has been a big issue with you, Sean. And you've made some pretty significant changes.

Yes. Exactly. So we sold one of our businesses. And that created a situation where we had basically a bunch of cash sitting on our balance sheet, which is a great resource and an asset to have. But at the end of the day, it's dilutive to your shareholders and your distributable cash per share and your payout ratios and all that stuff. So last year, we deployed all our capital. When we announced the Nurse Next Door transaction, our fifth royalty, we graduated to a royalty company that could actually get a proper acquisition facility. So that gives us the flexibility that Steve's had for a long time now, where you can point to your target businesses and say, "I have the cash. I can write the check. There's no financing risk." And we're not -- we don't have a ton of leverage on our business. So we can use that acquisition facility to fund an acquisition with 100% debt, put some permanent debt into that business and then finance the rest of it with equity with hopefully an increase in the dividend and a reduction in our payout ratio. So right now, we've -- it's been a lot better positioned today than it was for the last 2 or 3 years, where we've been paying out way more than we're making because we have a big pile of cash in our balance sheet, which is not the best place to be to optimize your capital structure.

We'll take a bit of a turn here and talk about ESG. Has the topic of ESG come up in investor discussions recently? And I imagine it has. If so, what's your messaging? Let's start with Sean.

Yes. So if you asked me that question 2 days ago, I would have likely looked at you and had no idea what you're talking about. So luckily, no investor has asked me about it yet. Ignorance is bliss. Greg and I were just literally talking about that yesterday. The Head of our Governance Committee came to the management team and said, "I want to put something like this in place this year." So we're working through that. In terms of our business being fairly progressive, we did have half of our Board of Directors being female and half male. One of them got elected to government. So now it's down to a 5-person Board, but I think we've been progressive in that area. But ESG is another area that we're going to basically put together something that makes sense for us and for the capital markets very soon.

Yes. For us, it hasn't been a topic, quite honestly. And on the Board front, we've had -- we've been public for 11 years. And so I think it's healthy at this point to have some changeover. So we've kind of started doing that about 2 years ago. And we only have 1 female director. And so we've been working very hard on identifying others. And the 1 director that is telling us not to worry about that is our female director. She's saying, "Look, it should be only merit-based. It does not matter what sex the person is. If it's the right candidate, it's the right candidate." So you have to mix in. I think almost everybody agrees with that sentiment, but it's a different world today. And you have to respond to that.

We've got about 4 minutes left. Just a couple of quick questions. How do you see your portfolio in terms of recession resistance? And as we heard from Avery Shenfeld, we're not looking for a recession. But it will come at some point in time.

Well, something we think about a lot and always have really, we went through the '09 recession. We only had 4 companies in '09. Thankfully, only one of them got hit. But that was enough for us. So it's something we think about a lot. But it doesn't mean you can't do some investing in companies that have some cyclicality. Obviously, you can't go into deep cyclicals that are going to be losing a bunch of money in the downtime. But if you build in enough of a buffer, right now, our average buffer is about 55%. So company's cash flow would have to decrease by 55% before they can -- they're getting in trouble in terms of paying our distributions. Most of our companies have no debt. These, again, are very asset-light, kind of mostly service-type industries that typically can be pretty nimble in terms of reducing their cost base. So those are the things that we look at. But the biggest thing is diversification. You just need to be well diversified, and that's been our biggest focus.

Yes.

Our portfolio is bullet proof.

Like Stephen said earlier that you can't structure your way around businesses that get impacted by things you can't see coming, so obviously, every deal you do, you're doing your best to try to come up with something that mitigates risk and gives you good risk-adjusted return. But it does -- diversification that really creates value and gives your -- protects your dividends and stuff like that. So that's why last year was an important year to go from 3 to 5. It doesn't sound like much, but it's 67% growth in terms of number of income streams. And we're going to try to do the same thing this year. And you can get kind of get ahead of it a bit by adding in diversification in terms of industries and number of deals. That will protect you as best as possible. But at the end of the day, there's going to be businesses that are hit by things you can't foresee and some you can. And you have to manage through those. But if they're 80% of your revenues, it's a bigger problem than if they're 5% of your revenue. So...

Okay. We're down to the last minute. So I'll give you each 30 seconds to sum up.

I think that's you.

Okay. Yes. So I mean, like I said, 2019 was a great year for us. We got our payout ratio under 100%. We increased our dividend. We used up all the cash in our balance sheet. We got a proper acquisition facility. We've been busy this year so far, and we're hoping to use that acquisition facility to create value for our shareholders, increase the dividend, again, reduce the payout ratio and try to build the diversification for our business. So if we can do that, I think we're going to be well on our way to creating value for shareholders.

Good. Steve?

Yes. We had a big year as well. We got our payout ratio down. And for a brief period, we're under 80%. We're at 78% before SBI was sold. So we're at about 83% today, and that's a good place for us. I think if we have the same kind of year of deployment that we had last year, I would expect to have some dividend growth in addition to continuing to bring that payout ratio down. I think getting it down to around the 70% range is something that I'd like to have. But it was nice to see the market when we sold SBI actually reacted positively. That's a first. People actually believe we can redeploy it profitably. And I remember when we had a sale of a really good company 4 or 5 years ago, our stock went down 12% on a 26% IRR investment. I thought we were in the business of making money, but I guess not. So I think it's been good. We're just going to keep on doing the same, adding good companies. And if the opportunity is there to take a profit on another one, we'll do so because we can deploy it.

That's great. Thanks very much, Sean and Steve. Thanks very much to all of you in the audience.

Thanks a lot.

Great. Thank you.

Appreciate your time.