Globe and Mail - Inside the Market Blog
===== Diversified Royalty Corp. (DIV-T) is at a crossroads, said CIBC World Markets analyst Scott Fromson. It has sold its Franworks restaurant royalty just two years into the investment, the fallout from high Alberta exposure and low oil prices, said Mr. Fromson. This will give it $60-$70 million of cash to deploy (and a 15-per-cent IRR) when the deal closes, expected in late 2016. While DIV currently trades at a high relative yield vs. its brief history and comparable royalty companies, its valuation reflects a higher dividend level than the two remaining royalty investments will cover. We believe DIV will be able to take advantage of its second chance to build a truly diversified portfolio and successfully close an acquisition in H1/17. This is the key near-term potential catalyst. Our view is supported by the following: 1) the large addressable market among North American franchisors; 2) DIV's attractive royalty structure for owners who want liquidity but wish to retain control; and, 3) DIV's strong deal track record and extensive business network. We forecast nominal dividend growth in 2017, increasing to [approximately] 9 per cent. Mr. Fromson initiated coverage of the stock with a sector outperformer rating based on his belief that the company will continue to acquire new royalties. However, he added a speculative label to his rating to acknowledge execution risks. DIV faces a number of challenges, he said. First, and despite its name, the company lacks diversification in its business model. This is largely a function of the companys early stage: DIV is only two years old in its current structure. Still, the portfolio is not yet sufficiently broad to offset a weak Alberta economy, which has hurt its royalty investment in Franworks restaurants. The sale of this interest should bring in $90-million cash plus the cancellation of 9 million shares, which we see as a big win for management. However, it leads to the second, more urgent challenge: finding good opportunities to redeploy the cash. Mr. Lube and Sutton Group are performing well, but expected cash flows may not cover the dividend. Another challenge is concluding an ongoing legal entanglement with John Bennett, the former CEO of the shell company that became DIV. He set a 12-18 month price target of $3 for the stock supported by dividend discount and yield valuations. Consensus is $3.42. To a certain extent, we see our $3.00 price target as a place holder, given the uncertainty over the size and timing of the next royalty acquisition, said Mr. Fromson. To be clear, we are comfortable with DIVs business model, from the perspectives of investor attractiveness, royalty deal structure, management capabilities and benefits to franchisor sellers. Should DIV management announce additional acquisitions with which we and the street are comfortable, and ahead of our expected timeline, we could potentially increase our financial and dividend growth forecasts, as well as lower our yield and cost of capital assumptions. Should the end of Q2/17 pass without DIV having made substantial progress in redeploying capital, we could see our downside case play out. This underpins the speculative component of our rating. =====