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Has Alaris Royalty Corp. (TSX:AD) Finally Turned the Corner?

If you took a flyer in May on Fool contributor Kay Ng’s suggestion to buy a small position in Calgary-based alternative lender Alaris Royalty (TSX:AD), you’d be up almost 28% over the past five months.

“Alaris is not an investment for the faint of heart,” Ng wrote May 10. “However, those who seek high income might consider a small position in the stock for a 10.6% yield and as a potential turnaround investment.”

Well, kudos to Kay for correctly identifying Alaris as a stock ready to take off.

The question investors now face is whether it’s turned the corner and is ready to move back into the $20s and $30s where it routinely traded between 2012 and 2016 before issues cropped up with a few of its partners.

It’s a tricky business

I first covered Alaris in March 2016, calling it the best private equity firm in Canada.

“[Alaris] isn’t really a private equity firm but rather a lender of growth capital that happens to take non-control equity positions as part of its payment,” I wrote at time. “This model allows entrepreneurs to hang on to their businesses while obtaining the funds necessary in order to grow. It’s a win/win proposition.”

The problem with Alaris’s business model is that its valuation is totally dependent on the cash flow distributions from its partners. There’s very little capital appreciation built into its preferred share investment agreements, so it doesn’t gain much when a company becomes uber successful beyond getting repaid on the funds contributed.

On the one hand, it’s a great arrangement for both parties: Alaris gets stable, high-yielding distributions, while the partners maintain control of their businesses.

However, when Alaris steps up to the plate and invests in a middle-market business providing millions of dollars in capital when other financial institutions wouldn’t, it doesn’t seem fair that a double-digit interest rate is enough of a trade-off for the risk taken.

That’s especially true when you consider that Alaris has a collar on the annual distributions it receives.

A recent contribution

Take the company’s September 14th announcement that it was lending an initial US$46 million to Body Contour Centers LLC (BCC), the largest private plastic surgery practice in the U.S. with over 50 locations spread across nearly 30 states.

Alaris will receive a 14% yield on the US$46 million in contributions for first-year distribution of US$6.44 million. That’s how much it will receive in 2019. In 2020, the amount of distribution will go up or down by a maximum of 6% based on the growth of its same clinic sales.

That means if it has a great year, Alaris could get as much as US$6.83 million in 2020 distributions. However, if BCC has a bad year, it could get as little as US$6.05 million in 2020 distributions.

It’s done this way to ensure BCC has enough cash flow to keep its business running in good times and bad. So, while technically Alaris would gain from its success through higher contributions in the good years, it loses in the bad years, balancing things out.

As a result, Alaris is considering situations where common equity is taken on top of annual distributions, although it’s still a tiny fraction of its overall business.

Has it turned the corner?

If you look at the company’s July presentation, one number jumps out at me.

The organic revenue growth of its partners in 2018 has been 6% year to date, the highest level of growth in the past nine years. As a result, all nine of its partners with an annual reset reset positively in 2018, resulting in an additional $2.8 million in revenue from those partners.

More importantly, with the U.S. economy going strong, much stronger than here in Canada, the fact that 90% of its investments are south of the border means any slowdown domestically will do little to slow Alaris down.

The initial September contribution by Alaris in BCC and a commitment for another US$45 million in two future tranches suggests that CEO Steve King continues to make the investments necessary to get its stock into the mid-$20s and beyond.

If it’s not all the way around the corner, it’s pretty darn close.

Below $20, I think Alaris is a buy.

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Fool contributor Will Ashworth has no position in any stocks mentioned. Alaris is a recommendation of Dividend Investor Canada.

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