Alaris Royalty Corp ALARF

Bear $12.00/ Base $17.5/ Bull $20.00 Scotia Targets

[SunsetGrill]

Rating Sector Perform 
1-Yr. Target C$17.50 
AD-T C$16.52 
1-Yr. Return 15.7% 
Div. (NTM) $1.62 Div. (Curr.) $1.62 
Yield (Curr.) 9.8%

Bear Case: $12.00-$12.50

Bear Case Under this scenario, a new challenged file arises resulting in a suspension of the royalty (~5% of total), with new capital deployment turning sluggish averaging $85M/yr, in line with 2011 & 2012, and well below the 7-year average of $130M. We assume similar early redemptions as in our base case, but with an elevated pace for 2019. 25% dividend cut.

Base Case: $17.50
Our Base Case reflects a scenario where royalty streams from existing partners grow at an annual average rate of ~2%, with average net annual new investments of $125M. This is offset by partial redemption of Planet Fitness and early redemption of Labstat in 2018, and assumes $35M in early redemptions for 2019.

Bull Case: $20.00
Our Bull Case builds off our Base Case, but with new investments touching a record level in 2018 and remaining above average for 2019. We assume similar early redemptions as in our base case, albeit at a slightly slower pace for 2019

OUR TAKE: Although Q1/18 normalized EBITDA was in line with expectations, Alaris kicked off the year relatively quietly on the capital deployment front, with a write-down on some outstanding loans, and what appears to be an early, or at least, a redemption of a couple of successful investments on the horizon. Under the right conditions, the model appears attractive for investors seeing yield and dividend growth given strong cash flows and relatively stable and predictable revenue streams. That said, Alaris has fallen out of favour with investors, reflecting (1) an unusual number of challenged files persisting over the past 24 months, and (2) concerns over the ability and time required to re-invest capital from redeemed investments and deploy capital for growth in a competitive environment. Cutting target to $17.50 and downgrading to Sector Perform. Although Alaris has made improvements related to challenged files, and valuation appears discounted, the combination of a highly competitive and uncertain environment for new capital deployment, coupled with the risk of further unexpected early redemptions of successful investments, is likely to constrain multiple expansion over the near-to-mid-term. KEY POINTS With management announcing an unexpected early partial redemption of its successful investment in PF Growth Partners, and what we believe to be the likely redemption of Labstat before the end of the year, totaling a combined $92.5B, we expect these risks to remain on the forefront for investors. Reflecting this activity, combined with the expectation of further redemptions in 2019, we have reduced our estimates. Over recent quarters, management had made progress with a number of challenged files with the sale of one investment garnering a premium, and ultimately generating a solid 25% IRR, and the resumption of royalties from others. The write-down taken against the outstanding debt does not impact our expected cash flows, but is likely to further dampen investor sentiment given management's prior confidence in recovering a significant portion of the loan. On the call, management came across quite bullish surrounding its view on capital deployment for 2018, suggesting it could exceed previous record levels. We have taken a more conservative approach in our forecast, but acknowledge this as a source of upside to our targets and outlook

With progress made on historical challenged files, investor focus turning increasingly to “net capital deployed.” Over the past few quarters, Alaris has made some notable progress related to its challenged investments, and with what appears to be a bit of a “kitchen sink” approach to write-downs in Q1/18, we expect investor focus to increasingly turn to “net capital deployed.” This reflects the level of capital deployed into new investments, offset by early redemption levels. Our scenario analysis suggests a fair degree of risk has been priced into the stock (see Exhibit 1). Our analysis suggests the stock appears to be pricing in below-average capital deployment levels combined with one or two early redemptions per year over the next 24 months. We think a record year of capital deployment in 2018, followed by expectations of another slightly above-average year in 2019, could yield significant upside to our target. That said, if new deployment turns sluggish and further challenges arise, we see downside with risk for a dividend cut with the projected 2019E payout rising to just under 120%. We think demonstrating further momentum in capital deployment, continued growth and maintaining health of the existing portfolio, along with avoiding further disappointment will be key for Alaris’ stock performance over the coming twelve months.

Management expecting another record year for capital deployment in 2018. The private equity environment remains highly competitive but management sees opportunities to grow its capital deployment. This view is likely to come as a surprise and be met with trepidation by investors who are likely to take a “show me” approach. The factors management sees contributing to a constructive environment include (1) increased private equity capital flows that have brought more companies to market, (2) a new tax regime that limits tax deductibility of interest and is likely to create headwinds for mezzanine debt providers and some LBO players, and (3) a rising interest rate environment. Alaris has historically had a solid track record for capital deployment (see Exhibit 2). We estimate that in the past seven years, Alaris has invested, on average, $130 million per year, reaching a record high of $178 million in 2015. 2017 was a near-record year with $172 million in capital deployed, reflecting a very strong second half of the year. Alaris has deployed C$19M so far in 2018, with management expecting another record year. That said, we are forecasting gross new investment of roughly $150M, and $100M for 2019. Portfolio appears to be in good shape, although we are adding a name to our early watch list. The overall portfolio remains in good shape, with about one-third of the revenue contributed from investments remaining greater than 1.5x, with the remainder between 1x to 1.5x covered. That said, there was a bit of movement into the 1x to 1.2x coverage bucket (see Exhibit 3-4). This was the investment in SBI, a management consulting and sales & marketing firm. Management noted that the firm’s backlog remains solid and has confidence the coverage ratio will improve, however, we are adding the name to our watch list.

Attractive 9.8% dividend, but coverage ratio likely to remain a focus. Management's revenue and G&A expense outlook for 2018 was largely intact from last quarter with modest revisions, although a partial redemption of Planet Fitness (~50% of its current FV) could possibly be in the cards (see Exhibit 5). Excluding any new investments or potentially increased contributions from its challenged files, Alaris is entering 2018 with an annualized payout ratio run-rate of just over 90%. Given early redemptions we expect to total $92.5M, we are projecting a coverage ratio of just over 100% for 2018 assuming new investment comes in line with our forecast. We made downward revisions to our forecast. While normalized EBITDA was in line with our expectation, we have made downward revisions to our forecasts, largely reflecting our assumptions related to “net capital deployed.” We have now included two key redemptions this year relating to a partial one from PF Growth Partners, and a full redemption of Labstat, in addition to another $35M of redemption in 2019. See Exhibit 6 for a summary of our estimate revisions. Cutting target to $17.50 and downgrading to Sector Perform. Reflecting a downward revision to our estimates and a reduced target multiple, we have cut our target price to $17.50 (was $22.00). Our target is derived using an 11x multiple of our 2019E NCOA. Alaris currently trades at 10.8x our NTM Net Cash from Operating Activities (NCOA), and a cash flow yield of ~9% (see Exhibits 7-8). This represents a significant discount to its historical three-year average of 12.4x NCOA