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When you think of royalty companies, stocks in the mining industry may instantly come to mind. But there is a lesser known multi-royalty company called Diversified Royalty Corp. DIV-T that may be of interest to investors, particularly those seeking income given its yield of roughly 7 per cent.

In addition to income, analysts believe the share price may be headed significantly higher. According to Refinitiv, the average target price is $4.13 and the stock has a unanimous buy recommendation from four analysts.

While you may not have heard of this small-cap stock, you likely are familiar with one or more of its six royalty partners: Mr. Lube, Air Miles, Sutton Group Realty, Oxford Learning Centres, Mr. Mikes Restaurants, and Nurse Next Door. Diversified Royalty’s business model is to acquire trademarks from franchisors in return for royalties based on their top line sales.

In a recent interview with The Globe and Mail, Sean Morrison, president and chief executive officer of Diversified Royalty, discussed management’s key objectives for this year and in the years to come.

Why is this royalty structure attractive to business owners?

Let’s say I am a business that’s making $10-million of cash flow, you go to the bank and they give you $30-million to $40-million and you’d have to pay it back.

If you have a $10-million cash flow income stream from a franchisor business, we might give you $100-million and we will agree to give you more money if you grow your business so it’s more money up front by a large margin, you don’t have to pay the capital back, you are not giving up equity in your business, and you are paying us a royalty based on sales in perpetuity.

How did your career path lead you to your current position as the CEO of Diversified Royalty?

My background is a chartered accountant. Then, I became an investment banker at a boutique firm in Vancouver for 12 years. I ended up being the investment banker for Chip Wilson at Lululemon, Brian Hill at Aritzia and I helped David Aisenstat buy the Keg restaurant chain. I also worked with A&W Food Services, Slocan Forest Products and got exposure to all of these spectacular businesses. They were all private companies in Vancouver.

In the late 1990s, I invented the idea of a top-line royalty for franchisor businesses. Using that top-line royalty model for franchisors, I have built Diversified Royalty Corp. over the last seven years.

I believe you have a very lean management team with five employees. Is that correct?

For most of DIV’s history we only had three employees. I’m responsible for business development, managing the markets and promoting DIV. Then I have a very capable CFO whose focus is on the nuts and bolts of running a public company. When we find a deal, he has that investment banking, private-equity expertise to dive into the business to understand it and due-diligence it. Those are the two main roles. If you think about it, we have six royalty partners that each sends us one payment per month. That part of the business, from an accounting perspective, is not overly complicated. We have two accountants who work with us to consolidate financials. I am also on the board of five of those companies as an observer. I go to the board meetings and am more of a strategic partner and involved in their high-level conversations.

Which company’s meetings do you not join?

Air Miles. Our relationship with the other companies is more as a long-term partner. For Air Miles, we bought the trademarks from a third party who already owned them. Air Miles just sends us royalty payments and audited financial statements.

I think of you and CFO Greg Gutmanis as the engine driving the company’s growth. Isn’t there a potential risk if one of you were to leave the company?

We both have a huge, vested interest in DIV. We are vested in a number of different perspectives. I’m vested because I invented the royalty concept for DIV. It’s not like I just joined as an employee. Everybody in Vancouver who knows of Diversified would know that Sean and Greg put this thing together, so we have a huge personal interest in the performance of the business. As well, this is our primary source of income and we both have a vested interest as shareholders. I own approximately 1.8 million shares of the company, which is meaningful. We feel that we are in the early innings of creating something much bigger and better.

Many of DIV’s shareholders appreciate the high dividend yield. Last quarter, the payout ratio was a conservative 84 per cent and 90 per cent for 2021. What payout ratio level are you comfortable with?

When COVID hit, we reduced our annual dividend by 15 per cent. The payout ratio was 90 per cent in 2021, which I think was the right place to be as we worked our way through COVID.

Looking ahead, I think a payout ratio in the mid-90s is probably the right place to be as this is not a business where you need to retain capital. … Investors are buying the stock for the dividend and we are prepared to give them as much cash flow as we think is sustainable.

We completed two acquisitions in the six months before COVID; each time we were able to increase our annual dividend.

During COVID, our share price was so low, it was hard to make acquisitions, so we didn’t. When the share price falls from $3.20 to $1.80, you are not going to issue equity at $1.80, it’s too dilutive. Now that our share price has recovered, pairing a dividend increase with an acquisition is probably the smart thing to do.

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In May, 2021, you filed a short form base shelf prospectus valid for 25 months, allowing you to quickly raise up to $200-million. What size and timing are you thinking in terms of acquisitions and new partnerships?

We filed the shelf prospectus knowing that we were going to be refinancing our existing converts, so that’s like $60-million of it, so it was really only $140-million available for acquisitions.

In a dream scenario, if I could pick the next royalty partner it would probably be a $100-million deal with a $10-million income stream. But when you go out there looking for royalty partners, they range in size from Oxford that’s paying around $4-million in royalties yearly to a Mr. Lube that’s paying around $20-million. Whether it’s a smaller royalty or a larger royalty, we are looking for high-quality franchisor partners. Obviously, bigger is a little bit better because you are doing the same work and you get more bang for your buck. But we don’t get to pick the size of our royalty partners.

How do you find these partnerships and how many businesses are you looking at?

For the first five years, I’d say 90 per cent of the traction with potential royalty partners was me instigating, reaching out, and maybe a couple of investment bankers coming with some ideas. I don’t remember a single company calling us.

I’d say in the last three or four years, we’ve had a few more investment bankers approach us. We’ve had a few companies call us.

It is a slow process. It’s like planting seeds and two or five years later, you may get a deal done. With Mr. Lube, we did a deal almost two years to the day after the first reach-out to them. When I reached out to Mr. Mikes, I talked to them five years before making a deal.

I was just down at the International Franchise Association conference in San Diego. We had a booth there looking for royalty partners. I’ve got probably a dozen names of companies that I have some level of traction with and another 20 that I touch base with over time. There are probably 20 to 50 companies that are at various stages.

What key attributes are important to you when considering a potential new royalty partnership?

There are basically two main criteria: strong store-level economics and scale.

Strong store-level economics is the most important for us. So if you open up 1,000 stores and 400 of them close then the franchisees are probably barely making a living – that’s not a good business model. If they add 100 stores and have had three stores close in the last five years, that’s probably a pretty good business model.

And the second is scale. There may be a business where they have good store economics but it’s only been around for a few years, they may only be break-even at the franchisor level and therefore are too small for us.

Originally, management’s strategy was to focus on buying royalties from Canadian companies. But with the acquisition of Nurse Next Door, a company with many of its locations in the U.S., has this focus shifted to include potential royalty partnerships from companies outside of Canada?

The business plan since the beginning was to focus on Canada, where the royalty model is known, build a sizable business and then go to the States.

In San Diego, we were actively looking for a U.S. royalty partner. So we are open to North American royalty opportunities right now.

How do you envision a diversified portfolio for DIV as you bolt on additional acquisitions?

Right now, Mr. Lube is around 45 per cent of DIV’s total revenue. Ultimately, I think Mr. Lube at around 20 per cent of total revenue would be great, but that would mean we would be 2½ times bigger than we are today, which I think in the next five years would be a reasonable goal.

What do you hope to accomplish in 2022 and five years from now?

The 11 months before COVID hit, we completed three royalty transactions, we bumped our dividend twice, we were on a roll. We got the acquisition facility in place, our payout ratio was below 100 per cent. When COVID hit, that put a stop to everything.

If we can get a couple of deals done this year, I think that’s a realistic goal. And if we do that, we are probably bumping our dividend.

Re: the five-year plan, we are at six royalty partnerships right now, and if we get to 12 to 15 royalty partners, that would be great.

So around one or two partnerships a year?

Two would be the target, some years you may do zero, some years you may do three. I like to have goals that are realistic.

These deals are a bit complicated; they do take a bit of time. Unfortunately, I am not in control of the number of deals we can complete each year. I can’t just go make three deals this year. I have to find three owners who want to do a liquidity event this year and then get a royalty deal done.

We did three deals before COVID, the year before we did zero but we finished in second place on three deals.

On average, how long does it take to make a deal once parties have agreed to explore a potential royalty deal?

It might take us a few weeks to put together a letter of intent. Let’s say we sign that agreement, then it usually takes probably two months to 2½ months to get to the finish line.

What other industries would you love to add to your portfolio of royalty partners?

We have six industries that we are in. It’s not like we say we want to be in a particular industry, we don’t target it that way.

I like the franchisor business model. We are looking for good franchisor businesses. There are a lot of opportunities that we think will add diversification to our business.

How does the Russian invasion of Ukraine affect DIV?

When there is massive uncertainty in the world, there is not a lot of capital being raised. When there’s no access to capital, then we won’t be able to grow because we won’t be able to go to the equity markets.

What motto do you live by?

Carpe diem is my favourite saying, “Seize the day!”

This interview has been edited and condensed. An extended version is available online at tgam.ca/inside-the-market.

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