Company Analysis: Evaluating Growth and Risks
Diversified Royalty Corp (TSX: DIV) has recently made headlines with a 10% dividend hike and the acquisition of Cheba Hut Franchising’s intellectual property. This move reflects management’s confidence in the company’s cash flow generation but also raises concerns about the sustainability of its elevated payout ratio and leveraged growth amidst rising macroeconomic headwinds. This analysis will delve into the risks and opportunities associated with DIV’s strategy.
Introduction to the Dividend Increase
The dividend per share has increased to CAD 27.5 cents annually, marking a 10% rise from 2024. However, the pro-forma payout ratio, which stands at 94.9% before the DRIP and 83.0% after, is considerably high. Typically, royalty-based REITs and income-focused equities maintain a payout ratio between 70-80%. A ratio exceeding 90% often signals vulnerability to unexpected downturns, making it crucial for investors to assess whether this dividend increase is a testament to DIV’s robustness or a precarious bet on flawless execution.
The Cheba Hut Acquisition: Growth Potential and Operational Risks
The $36 million acquisition of Cheba Hut’s trademarks adds a ninth royalty stream to DIV’s portfolio, with an initial annual royalty of $4 million. This represents 7% of pro-forma revenue and includes a growth mechanism where royalties will annually increase by the greater of 3.5% or U.S. CPI +1.5%, plus potential escalations based on Cheba Hut’s financial performance. While this could enhance cash flows over time, it introduces operational risks. For instance, if Cheba Hut’s same-store sales growth slows, the company might struggle to justify additional royalty hikes, potentially exposing DIV’s payout ratio.
Leverage and Debt Management
Funding the acquisition required $36 million in new debt and reserves, with a significant reliance on floating-rate facilities. The exposure to rising interest costs, should the Federal Reserve continue tightening, poses a risk. Although management has the option to swap 75% of the Cheeb Facility’s rate within 90 days, the remaining 25% remains unhedged. The Acquisition Facility offers a 12-month interest-only period but requires successful cash flow generation and refinancing to facilitate repayment. If EBITDA growth stalls, debt servicing couldsqueeze distributable cash, thereby pressuring the dividend.
Macroeconomic Risks and Their Impact
Cheba Hut’s success is closely tied to consumer spending on fast casual dining, a sector sensitive to inflation, recession, or shifts in consumer preferences. Achieving the 2025 sales target of $187 million necessitates flawless execution in a potentially weakening economy. Furthermore, the royalty’s CPI-linked escalator could backfire if inflation surges, as higher royalties might strain Cheba Hut’s profitability and lead to operational challenges.
Strategic Strengths and Tax Benefits
The acquisition brings $51 million in tax pools, increasing total tax assets to $424 million. This serves as a significant shield against future liabilities. Notably, the deal avoids equity dilution, thereby preserving shareholder value. Management’s decision to maintain a hands-off approach to Cheba Hut’s operations, allowing the founder to retain control, minimizes integration risks and aligns with DIV’s passive royalty model.
Investment Thesis and Recommendation
DIV’s dividend hike is compelling for income investors, but the high payout ratio and leveraged growth strategy introduce considerable risks. In the bull case scenario, where Cheba Hut meets or exceeds its 2025 targets and interest rates stabilize, the dividend could remain intact, rewarding income seekers. Conversely, in the bear case, where a macro downturn stifles Cheba Hut’s sales and debt costs rise, the payout ratio could strain cash reserves.
Conclusion
In conclusion, Diversified Royalty Corp’s strategy is aggressive but not without merit. For now, the high yield is sustainable if all factors align favorably. However, given the risks associated with leveraged growth and macroeconomic uncertainties, investors should proceed with caution. Overweighting the dividend yield while hedging against leverage risks could be a prudent approach. Monitoring the company’s debt repayment progress and Cheba Hut’s sales performance will be crucial. Considering a long position in DIV paired with short-dated puts could help mitigate downside risk, making this a viable strategy for those seeking to balance potential rewards with risk management.
