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Diversified Royalty Adds A Third Pillar To Its Streaming Model

Summary BEVFF’s recent addition of the Mr. Lube royalty stream has allowed the company to increase its yield to 8.2% at current price levels. Even at conservative growth/contraction rates, the NBV of BEVFF’s royalty streams substantially exceeds its current share price, even with the large share issuance financing the Mr. Lube purchase. At higher growth rates, there is significant upside to 105% based on comparable distributable earnings multiples. BEVFF is not understood by investors even in its home Canadian market, based on its low valuation. Diversified Royalty ( OTC:BEVFF ) is a royalty streaming company deriving its royalties from leading multi-location and franchise operations in North America. I detailed the company’s operations involving Franworks and Sutton Realty in my article from June 2015. However, on July 23, 2015, BEVFF added a third streaming component in the form of Mr. Lube trademarks and intellectual property rights acquisition. This acquisition was significantly larger, leading me to revisit BEVFF’s business case. Mr. Lube was founded in 1976, and is Canada’s leading quick service oil change firm. It was the first North American company to enable oil change service without appointment, and has expanded through the use of the franchise model. It has 170 operations across Canada, with 43% in Western Canada, 43% in Ontario and 14% in Quebec and the Maritimes, giving it a broad exposure to the Canadian economy. Oil changes at a reasonable price are as close to a staple for car owners in North America as there is, making it a relatively recession-proof business. 15 straight years of same-store sales growth have taken Mr. Lube through several downturns, proving this point. This low-volatility business, with its franchise model, makes it a good acquisition for BEVFF, as its cash flows will permit a steady income flow that BEVFF can distribute via its dividend policy. Let’s take a closer look. Mr. Lube Acquisition On July 23, 2015, BEVFF acquired the trademark and other intellectual property rights from Mr. Lube for $111.4m USD . In exchange, BEVFF licensed them back for a 99-year term, with an initial annual royalty of $9.9m USD ($12.4m CAD). This fee is linked to Mr. Lube’s system sales, with BEVFF earning its royalty at a 6.95% rate. Mr. Lube has had positive same-store sales growth for the last 15 years, and through the first 6 months of 2015, has grown at an estimated rate of 1.9% . It will also pay BEVFF an annual management fee of $160,000 , which escalates 2% per year. BEVFF also agreed to acquire land worth $9.8m under 4 Mr. Lube locations that it would finance with debt if it could not find an alternative buyer. The company also increased its tax pools by $84m, giving it over $112m in total tax pools to ensure its future earnings remain tax-free. In order to fund this transaction, BEVFF engaged in the following transactions: Issuance of 40,741,000 subscription receipts convertible to common shares with a deemed value of $2.16 USD ($2.70 CAD), totaling $88m USD. Obtaining a $27.7m USD ($34.6m CAD) 36-month term loan with interest, with 50% at a minimum fixed rate of 3.55% and the remainder variable at Banker’s Acceptance + 2.5%. Obviously, this is very dilutive to existing shareholders, with the share count increasing by 58% . Let’s take a look at whether BEVFF got good value for its purchase. Mr. Lube Royalty Valuation I found the best way to evaluate this transaction was using a Net Present Value analysis of its cash flows. I used the following assumptions: A 99-year term Initial royalty payment of $9.9m, which I then escalated with various same-store sales growth (SSSG) rates ranging from -2% to 2%. The management fee of $0.16m, escalated annually at 2%. Interest on the term loan for the first 3 years at a rate of 3.355%, based on the press release. Discounted at 6.67%, representing an S&P multiple of 15x P/E. I excluded the potential land purchase, as it is not core to BEVFF’s business model. I end up with some very compelling valuations behind this: NPV of Mr. Lube Deal at Various Same-Store Sales Growth Rates SSG Growth Rate Net Present Value 2% $210.7m 1% $175.4m 0% $149.9m -1% $130.8m -2% $116.9m This is obviously very accretive compared the purchase price. With the access to funds that Mr. Lube now has to both open new stores and refresh old ones, a base case of 1% makes the most sense, especially compared to its 15-year track record of growth. In the worst-case scenario at -2%, it still provides some marginal value compared to its purchase price. Obviously, this model is sensitive to the duration (99 years is a long time and of similar duration to Sutton’s). However, using a base case of 1%, if Mr. Lube only goes out 19 years, its NPV will still exceed the purchase price today. Obviously, this deal appears to be very lucrative for BEVFF in terms of acquiring a strong cash flow stream. I now want to roll this up into the rest of BEVFF’s operations, including looking at a worst-case scenario and a best-case scenario. I will also confirm this valuation by comparing its multiple based on its distributable earnings. And finally, I want to confirm that the dividend will be sustainable. BEVFF – Discounted Valuation In order to evaluate BEVFF, I did an NPV on each revenue stream, as well as one for the corporate charges required to sustain the corporate entity. I used the following assumptions: For Mr. Lube, I used 1% growth as the base, with 0% the worst and 2% the best case. In the Mr. Lube acquisition press release, it denoted that Franworks’ SSSG in Q2 had fallen by -1.8% year-over-year due to a fall off in the Alberta economy, but was offset by gains on the USD sales from its US restaurants. However, it guided to $2.7m USD in revenue, which outpaced the base we used in our model. As a result, I will use 0% growth as our base, -1% worst and 1% best case. Sutton’s results are largely fixed in nature. I assumed corporate costs at $2m USD annually. The last quarter’s was at $0.4m USD, so this seems in line; I will increase it to $2.5m for the worst-case scenario and use a perpetual discounting on it. I assumed litigation costs of $2m USD as a one-time cost related to the legacy John Bennett litigation. I will discount it the entire model at 6.67% , the same as in the Mr. Lube standalone scenario. After all this, we end up with a very compelling case for BEVFF at its current price levels of $2.25 USD and $2.70 for its Canadian listing DIV.TO: From a DCF perspective, the current valuation of DIV gives it a compelling upside, even in the worst-case scenario, with returns ranging from 22% to 68%. BEVFF – Distributable Earnings Methodology With now three defined royalty streams, BEVFF is well on its way to emulating one of the kings in the royalty sphere, Alaris Royalty ( OTC:ALARF ). In order to evaluate BEVFF, I decided to use the same methodology that Baron Investing did in his article on the above company, 24x 2016 earnings as used by Morningstar. This best reflects the steady distributions that shareholders can expect to see from the company going forward. I will utilize year 2’s results, which exclude the one-time litigation costs expected in the coming year, as a more normalized number. Applying the 24x multiple with the outstanding share count of 111,106,901, we end up with a share price of $4.60 USD – an upside of 105% from its current level. Currently, it is trading at less than 12x distributable cash. Dividend Sustainability If we look at the same chart above, we can see that the dividend coverage compared to cash flow is high in year one, largely due to the litigation costs which should be completed by the end of Bennett’s trial in 2016. I forecast BEVFF to have ample cash to cover these one-time costs. After that, the company has good coverage levels going forward, even with the increase to $0.2225 CAD ( $.178 USD )/share. This gives it a dividend yield of 8.2% at current prices. I project BEVFF to have $12.8m in cash after accounting for this deal, giving it some margin of safety in maintaining the dividend. However, the security of its streams make this highly unlikely. Risks The biggest risk I see is how BEVFF intends to satisfy its debt obligations. Both the Sutton and Mr. Lube purchases involved taking on term loans for three-year periods. However, they are non-amortizing, so principal payments are deferred until 2018. At that point, the company may be able to finance at a higher share price or it will be able to renegotiate the loan. The forecasted $12.8m cash on hand would also help to settle these obligation; by delaying the debt payments with a very reasonable interest level, BEVFF should be able to fund almost half of its obligations with cash on hand before it re-finances itself, excluding any further activity. I suspect that the company will continue to acquire further royalty streams in the future, using ALARF as a model. Exposure to the Canadian economy is also a risk, as you have exposure to the Canadian consumer (Mr. Lube), real estate (Sutton) and the Alberta economy (Franworks). The reduced SSSG at Franworks in the Q2 comments show this risk, as it has been impacted by the oil & gas shock in Alberta. However, all are strong brand names which have survived through downturns before. Catalysts I believe the biggest catalyst will be the market’s understanding of this deal. The large share issuance has likely obscured the ability of the market to judge the value of BEVFF, as the share price has drifted right down to the subscription price prior to this deal occurring, making it essentially non-dilutive. Even on Seeking Alpha itself, this company is not well understood. Evidently, it was involved in soil remediation at some point: It is also very much under-followed, as myself and 18 other Basic alert subscribers can attest to: (click to enlarge) I believe management will continue to look for further royalty deals; however, I suspect they will be of smaller scale than the Mr. Lube deal. I forecast BEVFF’s current debt-to-equity ratio to be at just 20% post-deal, with none of it due for 3 years. I think they will want to do further deals with equity issuance going forward, with the only cost being an ongoing dividend payment. This is from Alaris’ playbook as well, as Alaris carries no debt on its books currently. Outperformance by its underlying royalty companies will also help to drive performance of the streams themselves. Mr. Lube now has some large funding to put to use, and an already planned expansion of 15 new stores which could provide some increased growth short term; growth is never in a straight line, though, unless you are Bernie Madoff. This would potentially allow the dividend to continue to rise, as management seems comfortable paying out close to 100% of distributable earnings – which, by year 2, it will clearly have the capacity to do so. The alternative is to settle its debt obligations early; either way, shareholders win. I think it is a great time to take advantage of a short-term market dislocation in valuing BEVFF’s underlying royalty streams. By either valuation metric, there is substantial upside, even if some of its underlying royalties begin to contract. And while you wait, an 8.2% dividend yield doesn’t hurt. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks. Disclosure: I am/we are long THE CANADIAN TICKER DIV.TO. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Due to the low volume of BEVFF, if you are taking a position, it is advisable to do so in the Canadian ticker “DIV” as it is substantially more liquid

Diversified Royalty: Finally, It Is Diversified

Summary Diversified Royalty transitioned from a capital pool to a royalty stream vehicle in June 2014. BEVFF took steps to prepare its capital structure to add additional royalty streams in the most cost-effective manner. Following a delay after the initial fundraising, BEVFF added a second lucrative royalty stream in early June 2015, truly diversifying itself. Diversified Royalty ( OTC:BEVFF ) (or DIV on the TSX Exchange) came into being on June 30, 2014 when a former capital pool, Benev Capital Inc., put together a transaction to acquire $12m in annual topline revenue for the purchase price of $103m ( $82m USD ) in the form of a royalty stream of income from Calgary-based Franworks Franchise Corp., the owner of the Original Joe’s, State and Main, and Elephant and Castle restaurant chains. Streaming transactions have been common in the basic materials sector for some time, utilizing with great success by Franco Nevada (NYSE: FNV ) and Silver Wheaton (NYSE: SLW ), to name a few. They serve to provide funding for business initiatives without utilizing formal debt instruments. In fact, they partially tie the vendor to the sustainability of the enterprise going forward. Due to their success in the materials sector, these transactions have gained some traction in other sectors as well, as diverse as restaurants and farming. The Franworks transaction was structured as follows: $64m ( $51m USD ) cash on hand Franworks was issued approximately 9m shares worth $14.9m ($12m USD) Maxam Opportunities LP, a venture fund, subscribed for 5.2m shares or $8.7m ($7m USD) in a private placement $15m ($12m USD) coming from borrowings Franworks’ position in DIV amounted to 16.9% of the company at the time of the deal (now 15.4% after some other transactions) so they are very vested in the success of DIV as well. Franworks has the funds from the royalty sale to accelerate growth of its brands by adding new locations, as well as by renewing older locations. Both these help to drive revenue and should provide growing royalties to DIV down the road. Franworks’ restaurants are in the “upscale, casual” dining space. This is where you pay close to upscale dining prices, but without the dress code required. Go in to any of these restaurants and you will see people dressed up for a nice night out sitting next people just off the beach in tank tops and flipflops. The margins are much better than most mass eateries while still having a broad appeal. Maxam Capital Management, the manager of the Maxam Opportunities Fund, uses an “active, opportunistic and flexible” approach to capital management. DIV’s CEO, Sean Morrisson, is also a Managing Partner at Maxam and has a very strong background in capital management, advising the Keg Restaurants, a restaurant royalty income fund in Canada (KEG.UN), among other activities in his venture capital career. Maxam is a good partner for DIV to have in expanding its business, both to generate leads as well as to help evaluate transactions initially and on an ongoing basis. The restaurant-based royalty stream transactions are quite common in Canada with several others utilizing the income fund structure, such as the A&W Revenue Royalties Income Fund (AW-UN.TO), the Boston Pizza Royalties Income Fund (BPF-UN.TO) and the Keg Royalties Income Fund (KEG-UN.TO). DIV is not setup as an income fund, which makes it more flexible to acquire new streams of income down the road, as there are some limitations with the tax structure for income funds. As well, they can simulate the tax-free structure by utilizing its $35m CAD ($28m USD) in tax losses. Like these other royalty funds, the Franworks royalty is a gross revenue royalty, earning 6% of the top-line revenue from the restaurants included in the pool. These can change over time as locations are added or subtracted. Some royalty streams are based on net revenues, where some deductions are taken prior to payment, but DIV will receive its royalty regardless of how profitably the locations are operated. That said, it is clearly to their advantage to have successful restaurants available in the future. DIV’s future is clear: The royalty acquisition from Franworks is a platform transaction for BCI and the first step in our recently announced strategy to purchase top-line royalty streams from a number of growing multi-location businesses and franchisors. Franworks is a fast growing chain with strong unit-level economics and a superb management team – key success factors for a top-line royalty acquisition. With the successful completion of this transformational transaction, BCI intends to focus its efforts on acquiring additional royalties from growing multi-location businesses and franchisors. In October 2014, DIV received final approval for the transaction and completed its name changed to Diversified Royalty Corp. This followed quickly with a promotion of the company on to the TSX big board , providing it a better avenue to raise equity funds than they would have had with a Venture Exchange listing. They quickly utilized this, closing a $34.5m bought deal financing in November 2014 ($27.6m USD). Now all they needed was another royalty stream. So shareholders waited. And waited. And waited. Message boards on stock forums complained about DIV’s lack of action. Analysts on business TV poked fun at its name “how can it be Diversified with just one royalty stream.” On April 1, 2015, DIV added 5 new restaurants to its Franworks deal, increasing annual royalties by $0.6m ($0.5m USD) annually, at a consideration of $6.2m ($5.0m) , $4.8m ($3.9m USD) payable upfront in DIV shares, valued at $2.69 CAD ($2.15 USD), with the remainder due in a year depending on performance of these locations. However, this didn’t move the needle for most shareholders. However, patience was rewarded as on June 9, 2015, DIV announced it had purchased its second royalty stream from real estate company Sutton Realty. (click to enlarge) Sutton is a very strong realtor brand in Canada and has had a relatively stable level of agents throughout the past decade, despite not having the funding available to acquire smaller brokerages or to grow organically. This transaction with DIV will allow it to jumpstart its growth, which will be a positive for both Sutton and DIV. DIV receives, in exchange for $30.6m ($24.5m USD), a fixed royalty payment for licensing the Sutton brand back to Sutton of $3.5m ($2.8m USD) annually plus a $100,000 CAD ($80,000 USD) annual management fee. The royalty payment escalates 2% each year, the management fee 10% every four years and the entire deal is for 99 years. This fee has 40% coverage by Sutton based on EBITDA so there is a good margin of safety to ensure DIV receives their fees each year. Sutton can increase the rate by 10% on four occasions during the life of the deal or choose to add additional agents to the pool in exchange for further investment by DIV based on a pre-set formula. DIV will fund this transaction using $24.3m ($19.4m USD) in cash and an additional $6.3m in debt. This will leave DIV with a roughly $10m ($8m USD) cash on its balance sheet with debt of $21m ($16.8m USD) , a small portion compared to its equity valuation and covered by its future cashflows. Going Forward In its presentation to shareholders, DIV provided the following competitor analysis and forecasted cashflow coverage: (click to enlarge) The first 5 royalty companies all are strictly food-based royalty companies, while Alaris is significantly more diversified than the others. DIV is more hedged with its two current streams than the restaurant only funds, though not as much as Alaris. Its 6.9% dividend yield is significantly higher than the mean of 5.5%. These payouts are made monthly rather than quarterly like most dividends so they are in your hands sooner. The high payout rate is common with these types of corporate structures, as shown above. In some cases, high dividends can be a sign of trouble at the company as the market doesn’t believe they are sustainable; however, in this case it is due to a lack of market awareness. DIV has only one quarter as a royalty company, and this is only with the Franworks royalty stream. However, I wanted to see if they were roughly on track. From the first quarter 2015 MD&A: While they clearly paid out more than planned in this quarter, several extra events impacted the result: $700K CAD ($560K USD) in costs associated with litigation from a former CEO (who left the company in 2004, long before the business model change) $300K ($240K USD) in financing related costs $400K ($320K USD) in taxes; the company has losses that will be applied going forward to minimize these costs. I don’t believe the 2015 first quarter excess distribution over distributable cash is a concern. DIV has undergone a very drastic transformation and will have some costs associated with this, which should normalize in the next couple of quarters. The fact that revenue delivered as expected, despite economic headwinds in the Alberta oil patch, is positive. DIV should also see some economies of scale when the Sutton royalty starts to show up in its results. DIV is not without some risk. Most of the Franworks locations are in Western Canada, which makes it somewhat susceptible to the fortunes of the oil patch; that said, Q1 gives a pretty good indication that they should not be significantly affected by this as this was when the oil price drop was most severe. The frothiness of Canadian real estate is also well known . If there were a downturn in housing, eventually you would likely see some agents take down their shingles. That said, Sutton has maintained its levels of realtors consistently over the past decade so they likely wouldn’t need to retrench much in a downturn. The coverage provided by the EBITDA levels also will ensure Sutton makes its minimum payments to DIV. DIV gives an investor diversified exposure to the Canadian consumer with steady, growing businesses that hit two of the necessities of life — food and shelter, all while receiving an above-average yield ( 6.9% ). Well worth the wait. All figures in CAD, except where indicated. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks. Disclosure: I am/we are long BEVFF. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.