DRI Healthcare Trust T.DHT.UN

RBC

[retiredcf]

June 1, 2023

DRI Healthcare Trust

NDR takeaways - NAV discount should improve with continued successful execution; new deals likely

TSX: DHT-U | CAD 9.71 | Outperform | Price Target CAD 17.00

Sentiment: Neutral

Our view: We hosted a NDR with DRI Healthcare management in Vancouver and Toronto this week. The company is seeing increased investor interest, especially after the Tzield royalty transactions. In our view, as the company continues to execute, the discount to NAV should close and the stock could eventually trade at a premium to NAV similar to other royalty peers reflecting the optionality inherent in DRI’s business model. Cash flow generated by existing assets may be redeployed into acquisitions of new royalty assets on an accretive basis, with potential for long-term organic upside from expansion into new therapeutic areas or geographies vs. DRI’s expectation at the time of acquisition. The stock is currently trading at a ~20% discount to our NAV estimate, which we find attractive. We reiterate our Outperform rating with a C$17 PT. Including the special dividend (associated with the Tzield royalty sale) the current dividend yield on DRI units is ~12%. The company will pay the special dividend along with the regular dividend on 20-July to unitholders of record as of 30-June.

Deal pipeline - potential for two royalty transactions this summer. Management noted that the current deal pipeline stands at ~$2B and is growing. At the RBC Global Healthcare conference last month (here), management had noted the deal pipeline is expected to increase to ~$2.5-3B over the next few months; there is currently one deal under exclusivity and another deal is close to exclusivity. We believe the company could close on at least two royalty transactions by the end of summer that are currently on approved or close to approved drugs. Management noted that future royalty transactions could include products awaiting approval with positive Ph3 data (potentially similar to the VONJO royalty transaction that was structured prior to FDA approval and is now performing better than DRI's internal expectations). In the current environment with strong expected IRRs on approved and marketed drugs, the company indicated it would not take risks associated with products that have completed only Ph2 trials and/or are early in their development cycle.

Available liquidity of up to $350MM to fund royalty acquisitions following Tzield and CTI/SOBI deals. Management noted near- term available liquidity of ~$300-350MM (including the loan of $50MM (principal value) extended to CTI BioPharma, that will be returned to DRI following SOBI's acquisition of CTI - VONJO partner). Additionally, management noted that DRI could achieve flat to increasing cash royalties through to 2030E based on the royalty transactions that are expected to close in the current calendar year. We note that with the original Tzield royalty acquisition, the company had addressed the declining cash royalty receipts until 2030E but after the Tzield royalty sale, cash royalties are expected to decline between 2025E and 2030E. However, the ~2.1x return achieved on invested capital within ~45 days in the Tzield royalty transaction was very attractive and should enable the company to redeploy funds to address the declining cash royalties between 2025E-2030E. Management noted that the company would target ~3x leverage (net debt/EBITDA) over the medium term.

Greater opportunities with higher IRRs for DRI in the current macro backdrop. Management highlighted the favourable deal environment for royalty transactions. There is significant interest for royalty financing primarily due to the state of the public markets today. Many biotech companies went public over the last five years are in need for cash. Management noted ~2/3rds of non-profitable biotechs have less than 2 years of cash runway and there is a need for financing but equity markets are currently not conducive to providing that capital. As such, these companies are approaching DRI for non-dilutive funding at relatively attractive terms for DRI. The historical returns on royalty transactions range from high-single digit to mid-to-high teens and in the current environment, DRI is seeing potential returns on the higher side of the historical range.

Competition. Management noted that despite the strong expected IRRs on royalty transactions this year (~14+% vs. ~10-12% IRRs last year), DRI is facing less competition. Some large competitors are raising funds and as such are not active in deal-sourcing and other groups that participate in drug royalty transactions on an ad-hoc basis ("tourists") have likely exited the market in the current high risk-free rate environment. Management did not feel the royalty opportunities have diminished as large pharma companies have embarked upon M&A this year. Additionally, DRI's recent deals have helped to unlock value at some counterparties (Omeros, MacroGenics, CTI BioPharma - all three have outperformed XBI significantly). This creates a feedback loop with more companies wanting to transact with DRI. On competitive advantages vs. peers, management noted that given DRI's long term experience in the drug royalty business (~34 years), the company is flexible and agile to deal with different issues that arise during the deal making process. Additionally, management highlighted DRI's ability to structure deals that meet the demands of counterparties (highlighted a) Vonjo deal structure that involved a secure loan prior to FDA approval and additional deployment on FDA approval of Vonjo and b) Omidria cap structure with lower annual caps in initial years and higher caps in future years).

AI uses in biotech industry. DRI management noted artificial intelligence (AI) could aid the drug discovery process, potentially increasing the number of available drugs and, as such, an associated increase in drug royalty transactions. AI could also help in disease diagnosis and compliance, which should ultimately result in increased drug revenues (along with better health outcomes) that would indirectly benefit DRI with higher cash royalties. Specific to DRI, management noted AI could make the royalty identification process less challenging but unique skills and database would also be critical to optimal outcomes.