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fabrice taylor

Fabrice Taylor, CFA, publishes the President's Club investment letter. His letter and The Globe and Mail have a distribution agreement.

Royalty firms have been excellent investments over the past decade, so it's not surprising that the Bay Street assembly line churns out more and more of them.

Of the latest batch, the favourite of many analysts is Diversified Royalty Corp., with grand ambitions and a very focused strategy that should deliver solid results for investors (I am a recent owner of the stock).

Typical royalties are payments that come off the top line, right from revenues, which insulates royalty owners from the vagaries of business and the economic cycle. The royalty owner is usually the first to be paid, before employees, creditors, the taxman and shareholders of the target company.

Royalties come in all sorts of varieties. Franco-Nevada, arguably the granddaddy of them all, owns royalties mainly on gold production. PrairieSky Royalty, a recent addition to the growing list of these companies, gets a slice of revenues from oil wells. There are a number of restaurant royalty firms that have done very well for investors. Alaris Royalty Corp. is a multiroyalty firm that earns a stable income stream from a diverse group of industries. It's delivered almost 500 per cent returns for investors over the past five years including dividends.

And now there's Diversified, which I think will combine the stability that comes from strong, growing brands and the diversification that has made Alaris a success.

Diversified recently made its first royalty investment by paying $103-million to acquire 6 per cent of the revenues of Franworks, a private company that owns and operates a number of established and growing restaurant brands including Original Joe's, State & Main and Elephant & Castle.

Franworks started only 12 years ago with two restaurants. Today it has 86 and is still growing. In the past four years, its revenues have more than quadrupled and same-store sales have grown almost 7 per cent a year, about twice the growth rate of the industry.

The Franworks royalty allows Diversified to pay a dividend that equates to a roughly 7 per cent yield today, and given that Diversified's royalty is off the top line, its income from Franworks will grow as the restaurants increase their sales.

The deal with Franworks also allows Diversified to increase its royalty investment if Franworks earnings grow by a certain amount. This is very valuable because it allows Diversified to deploy cash on a business it already knows well, thereby reducing risk and expense.

So Franworks makes a solid anchor royalty that should increase cash flow. But the real secret to success in this industry is to manage the balance sheet to add more royalties in an value-creating way, and I think Diversified has the management horsepower to do that.

CEO Sean Morrison is an accomplished deal-maker with experience in constructing multiroyalty concepts that were later adopted by a number of firms, including A&W and Keg Restaurants.

With $35-million of cash in the bank, he has the dry powder to strike new deals, which I expect will happen soon.

Here's where I see the potential for outstanding long-term returns. Alaris Royalty has grown from a micro-cap to a $1-billion concern in a relatively short period of time. That value creation is partly from a growing dividend, but also from investors accepting a lower yield as the company grew and diversified to lower the risk.

So if Diversified is successful, the dividend should go up and the required yield should fall, meaning investors will pay more to get their hands on that bigger but safer dividend, which will turbo-charge the return for investors.

This is obviously a bet on management's ability to make good decisions. Mr. Morrison strikes me as focused and experienced. He also owns a healthy amount of stock.

I think the odds favour the investor looking for income and a capital gain.