Smaller Canadian Stocks Worth a Closer Look: Diversified Royalty

By Will Ashworth

• Diversified Royalty (TSE:DIV) is ideally suited for a TFSA (tax-free savings account) 

• While it was born out of controversy, the company that exists today is anything but.

• It continues to diversify into new and attractive industries.

Today’s article is the second in a series covering three smaller Canadian stocks I’m putting on my watchlist for possible inclusion in my Canadian Investor portfolio. 

These stocks trade on the TSX or TSX Venture and have market caps between $100 million and $400 million. On Monday, I covered Yerbaé Brands (TSXV:YERB.U), an Arizona-based company that makes a healthy caffeine-infused sparkling water product. I’ll continue to watch its progress. 

Today’s idea: Diversified Royalty (TSE:DIV, OTCMKTS:BEVFF), a Vancouver-based company with a $350 million market cap. 

The TSX index today, as reflected in the iShares S&P/TSX 60 Index ETF (TSE:XIU), is down 3.3% for the year. And while DIV stock is down more than 18% through the end of October, the shares are trading at a price-to-earnings multiple of 19.6.

Who Is Diversified Royalty?

As the company name implies, Diversified makes money from royalties generated from its royalty partners. It owns the trademarks of Mr. Lube, Air Miles, Sutton, Mr. Mikes, Nurse Next Door, Oxford Learning Centres, and Stratus Building Solutions.

The business strategy is simple: it acquires royalty streams from companies like the ones above. It buys the trademarks of these companies, which get cash up front for those trademarks, and DIV gets a diversified stream of cash from its royalty to use the trademarks in the future.

Vancouver-based Diversified’s history dates back to July 1992. It started as Bennett Environmental Inc. until June 2012, when shareholders voted to change its name to Benev Capital Inc. 

John Bennett, the founder of the contaminated soil cleanup business, was sentenced to 63 months of jail time in November 2016 after a New Jersey jury found him guilty of corruption and bid-rigging.

Strong Management

In September 2014, the company announced that its $102 million royalty deal with Franworks Franchise Corp. had been approved by its shareholders. The company’s name was changed to Diversified Royalty, with the acquisition providing $12 million in annual royalty revenue. 

Sean Morrison was the relatively new CEO who made the deal. He remains Diversified’s CEO today. CFO Greg Gutmanis has been with the company since September 2015, although he did  previously serve as interim CFO from March 2014 to January 2015. 

The two have grown the business through several acquisitions in the eight years since. Its strong leadership is a big plus. 

Their pitch to franchisors is that the long road to a liquidity event doesn’t need to be that way. 

Burrito Buy

The company’s latest transaction is a textbook liquidity event: On Oct. 4, Diversified announced that it had acquired the trademarks and other intellectual property of BarBurrito Restaurants, a fast-growing, quick-service Mexican restaurant in Canada. It has over 260 locations across the country, with system-wide sales of $135 million in the latest fiscal year. 

BarBurrito is the company’s eighth royalty stream. It paid $72 million in cash for these assets. In addition, it has a $36 million promissory note to BarBurrito that is paid down as new locations open. 

Diversified leased back the trademarks, etc., for 99 years. In return, it gets an initial royalty payment of $8.3 million, growing at 4% a year over the next seven years, and then in 2031, the royalty will be based on the gross sales of 225 locations in the royalty pool.

Serving Up 10% Dividend

The company reported Q2 2023 results in August. They included $15.4 million in adjusted revenue, 25.1% higher than a year earlier, with distributable cash of $9.8 million, 23.7% higher than Q2 2022.  

“Q2 was DIV’s best second quarter, in terms of adjusted revenue and distributable cash, in its history as a royalty company. Mr. Lube, our largest royalty partner, continues to produce strong double-digit growth, generating SSSG (same-store sales growth) of 21.1% for the three-month period ended June 30, 2023,” Morrison stated in the company’s Q2 2023 press release.

Consistent Cash Flow

The beauty of Diversified’s business model is that franchisors and operators get to take cash off the table without giving up control by partnering with the company. 

Diversified obtains consistent cash flow generation. That consistency enables it to pay out an annual dividend of 24.5 cents. It currently yields 9.9%. 

Four analysts cover the stock, including Canaccord’s Matthew Lee and CIBC’s John Zamparo. Both have a ‘buy’ rating on the shares, with a CAD 4.25 target and CAD 3.00 target, respectively. DIV stock closed Tuesday at CAD 2.43.

The consensus of all analysts is for Q3 is earnings per share of 3 cents on revenue of $11.05 million, according to S&P Capital IQ.

Buying DIV shares isn't a bad idea if you’re looking for a stable income investment. Just don’t expect a lot of capital appreciation from your shares. Putting them in a tax-advantaged account is wise for this holding.

On the date of publication, Will Ashworth did not have (either directly or indirectly) any positions in the securities mentioned in this article. None of the above should be construed as investment or financial advice. Investing is inherently risky. Please perform your own due diligence.

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