Every now and again I like to revisit a stock I’ve recommended in the past but haven’t covered in recent months or even years. I want to see if the same reasons still hold up.
In December 2016, I recommended Diversified Royalty (TSX:DIV), a company that owns the trademarks of three well-known Canadian brands: Mr. Lube, Air Miles, and Sutton Real Estate. It gets paid a royalty by the operators of those brands to use the trademarks, providing Diversified Royalty shareholders with predictable royalty cash flow.
As dividend investments go, you’re not going to find many stocks that are more reliable than DIV, which is essential if you’re holding it in your TFSA.
Currently yielding 6.8%, DIV’s total return year to date through May 6, including dividends is 17.8%, which is 148 basis points higher than the S&P/TSX Composite Index.
At the time I recommended DIV it was yielding 8.7%, suggesting that it’s appreciated a bit over the past 28 months — 52% to be exact including dividends, an annualized total return of 19.9%.
That’s a solid return by any standard, but doubly so when held in a tax-free TFSA.
The current situation
Back in late 2016, Diversified Royalty had just sold the Original Joe’s trademarks for $90 million and was on the hunt for an acquisition to add to Mr. Lube and Sutton. That third royalty stream turned out to be Air Miles.
The question for investors is: what’s next for DIV?
The company reported preliminary Q1 2019 results on April 25.
Mr. Lube generated $3.7 million in royalty income during the quarter, 10.8% higher than in the same quarter a year earlier. A big reason for the increase was Mr. Lube’s 5.6% same-store sales growth during the quarter, 110 basis points higher than a year earlier.
The more Mr. Lube does in sales, the higher Diversified’s royalty income.
As for Air Miles and Sutton, they had royalty revenue of $1.7 million and $1.0 million respectively during the quarter. Air Miles’ revenues decreased by 2.1% during the quarter, while Sutton’s increased by 2.0%.
Clearly, Mr. Lube is the engine that drives Diversified Royalty’s stock at the moment
As part of the company’s commentary in its April press release, CEO Sean Morrison discussed the future.
“We continue to actively pursue various opportunities to redeploy our cash in accretive and diversified royalty transactions and are targeting 1 to 2 royalty acquisitions in 2019,” Morrison stated.
The company had $78.7 million in cash on hand at the end of the fourth quarter, and likely has more as of the end of March.
The agreement with Mr. Lube currently pays a royalty of 7.45% on non-tire system sales and between 1.25% and 2.50% for tire sales depending on the type of location. With Sutton Group, it’s paid a monthly royalty per agent. Currently, that’s $59.63. As for Air Miles, the company gets 1% of the gross billings from the Air Miles Reward program in Canada.
So, the higher the royalty rate on an annual basis, the higher the acquisition cost to buy the trademarks from potential brands it is interested in partnering.
It currently has $64.9 million in long-term debt and $51.9 million in convertible debentures at 5.25% interest that don’t mature until December 31, 2022 and are convertible into common shares at a conversion price of $4.55.
Therefore, Diversified Royalty’s total outstanding debt is $116.8 million. Subtract the $78.7 million in cash and you have net debt of just $38.1 million or less than 11% of its market cap.
The bottom line
Diversified Royalty has plenty of leverage available to it should the right deal come along. Any acquisition would be immediately accretive to earnings providing the company with ample cash flow to grow the dividend.
Although it hasn’t increased the monthly payout since September 2015, I believe an acquisition will prompt the company to do so.
Until then, why not enjoy its annualized dividend of 22 cents, tax-free in your TFSA?
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Fool contributor Will Ashworth has no position in any stocks mentioned.