Duke Royalty is a unique company that is looking to bring the royalty model to Europe. The shares were hit hard during lockdown, but they have performed well of late on the back of a strong trading update. James Faulkner believes there’s more to play for.
I like companies that carve out a niche for themselves, and Duke Royalty* (LON:DUKE) is doing just that.
You may not have come across the royalty model, but it was popularised in the North American mining sector and then the pharmaceuticals sector. It is relatively rare in Europe, but it has many attractions, for both the lender and the borrower.
For example, equity finance might entail loss of control whilst debt often comes with refinancing risk and/or restrictive covenants. As the typical Duke royalty partner is a European SME, often where management has a significant ownership stake in the business, retaining control over the business whilst financing growth can be a key issue.
Meanwhile, Duke typically sees its initial investment repaid in 6-7 years and royalties are paid over a 25-40 year period, leaving another 18+ years of royalties to come. The yield on investment is reset annually on a +/-6% range, which reflects the movement in the SME’s revenue, thereby giving Duke a stake in the performance of the investee business.
The cash generative nature of the business model means that shareholder returns can be generous, with the company having a dividend payout ratio of 65-90%.
One of the real beauties of this business is that the model requires little expansion capital in terms of fixed overheads, whilst deals are funded by a mix of debt and equity. The ability to scale up without incurring a significant increase in the cost base is crucial to understanding the attractions of royalty companies. At the extreme end of the scale, Franco Nevada is a multi-billion-dollar mining royalty business operating in North America which still only has 29 employees.
When it comes to royalty partners, Duke looks for established businesses with a strong track record of trading and high barriers to entry. It tends to avoid cyclical businesses and industries that exhibit a high degree of volatility such as oil & gas and biotech. (A full list of Duke’s royalty partners can be found here: https://www.dukeroyalty.com/partners.)
The scaling of Duke’s royalty portfolio was progressing as expected up until March, when Covid-19 hit. March saw record cash receipts, but this fell to £600,000 in April as lockdown began to bite. However, the company stressed that “it should be noted that the reduction has not been waived or lost by Duke, rather… the shortfall will be made up in subsequent periods as the pandemic stabilises and trading improves.”
With its operating cost base at just £1.8 million per annum, Duke was able to put in place forbearance measures where its partners required them, whilst simultaneously continuing to deploy capital into new deals.
In order to prioritise the liquidity position to support the aforementioned measures, a scrip dividend was declared. Whilst this may have come as a disappointment to some shareholders given the emphasis Duke management has placed in the dividend in the past, it looks reasonable given the unusual nature of the situation and the heightened level of uncertainty prevailing at that time.
Nevertheless, Duke said that it “intends to revert to the payment of cash dividends when a more normalised trading environment returns.”
A return to cash dividends?
Judging by Duke’s latest update, that time could come sooner than some had anticipated. On 6th August Duke revealed that “most of its Royalty Partners have experienced a significant upturn in trading during May and June” and that the upturn “has continued into Q2 FY2021”.
What’s more, the forbearance arrangements that Duke put in place to help some of its partners are due to end in September, and based on current trading, Duke does not expect that these agreements will need to be extended.
As a result, Duke is “cautiously optimistic that it will be able to announce a positive trend of increasing quarterly cash revenues over the coming quarters and that quarterly cash revenue growth will accelerate further into Q3 FY2021.”
To my mind, this sets the scene for a return to a cash dividend in the latter part of calendar 2020, which, even at an annualised rate equivalent to the scrip dividend (0.5p) would result in an annualised dividend of 2p and a yield of 7.4% at the current share price of 27p.
Indeed, house broker Cenkos seems to concur, stating that “cash receipts should step up from Q3/21 back towards the record monthly cash receipt of £1m (seen in March 20), which bodes well for future earnings and dividend payments returning to a cash paid basis in the future.”
The shares have bounced quite nicely off of lows, but they could have further to run in anticipation of a continued improvement in royalty income and a potential return to cash dividend payments to shareholders.
* James owns shares in Duke Royalty.