- Grenville Strategic Royalty (TSXV: GRC) provides funding to small and medium enterprises in exchange for a top line royalty on future sales
- Potential downside from G&A cash burn and portfolio underperformance, but the assumptions required for Grenville to be worth multiples of the current share price aren’t onerous
- With no controlling shareholder and poor investment performance, an activist looking to liquidate the company could eliminate the cash burn and realize the asset value very quickly
Grenville’s business model has been borrowed from the commodity space, where it is a very common funding mechanism for mining and energy projects. Grenville has a unique twist on that, as they are playing in the small business end of the sandbox. This has both advantages and disadvantages.
Advantages
There is little to no competition trying to sign up businesses for revenue-based royalties, and there is very little competition to fund these businesses in general. The comparisons a business owner would make are likely to be expensive debt financing or equity financing at a very low valuation. Because the original payment for the royalty never has to be paid back, and you don’t have to issue shares, it may be attractive to control minded entrepreneurs. Grenville takes advantage of these factors by charging a high price for its capital, with its deals underwritten to a 25% initial return. So when they pay a business $1-million for a royalty, they will take a percentage of revenue to equate to $250k in annual payments.
The Downsides
These are small businesses. The company does not require profitability to take one of its royalty investments, although it does require the business have been operating for 5 years. They have indicated that they believe this reduces their total write-offs, as the number of businesses that fail begins to drop off dramatically after the five year mark. Of course, any business that will take capital that costs 25% is either desperate for money or run by someone who isn’t very financially literate, neither of which are promising for its future success. Maybe some of their customers have multiple investment opportunities with better than a 25% IRR that they will be funding using the money, but that doesn’t seem especially likely on a portfolio basis, as generally speaking a business with a 25% ROE should be able to grow using internally generated capital, or secure cheaper funding sources.
They do require businesses to have gross margins of more than 30%. This makes quite a bit of sense, as anything lower than that and a royalty based on revenues would be much too onerous to ever be repaid.
Current Situation
The company’s shares have been significantly punished, for a number of reasons, many of them important. The company was pitched to retail investors as a yield play, and has cut its dividend. That alone is enough to crush a stock. Unfortunately, they cut their dividend for very real sustainability reasons, and had to write off some investments.
Investment Quality
The key to analyzing this business is determining the quality of their investments. I have completed a cohort analysis on their investments, dividing all the investments since the inception of the company into 6 month intervals.
The very first semi-annual period has produced by far the best results. In the second half of 2013, the company completed four investments. The results of those investments can be nearly completely determined, as two of the companies have bought out the contracts, and one was a loan that was repaid. The third has not been a success, paying less than 2% of the amount invested in 2016, so it is unlikely to move the needle. Even including the one failure, the IRR of those investments is approximately 51% (I assumed all cashflow received in the middle of the period, so this isn’t perfect but is close). To me, this strong performance right off the bat suggests that there is in fact a real business buried underneath the write-downs and G&A expenses here, or at least there is the potential for there to be one. Investing capital at anything close to 50% can support material G&A, and would easily be able to attract outside investors.
That being said, the excellent performance on their first $2.7-million of investments is more than overshadowed by the terrible performance on the investments made in the second half of 2014. The company made 9 investments for a total of $17.4-million. They have had three buyouts, and that combined with other payments meant that this cohort returned over $12-million in 2015. That being said, I still believe it to be a failure, as the three winners are outweighed by the rest of the investments which have been unsuccessful. They were owed $1.3-million in revenue from this cohort in 2016, but over $1.1 MM of it is notated as being unrecorded as it has not yet been received. Another $125k is from a company that has been paying a flat $125k, which is probably the minimum payment associated with the contract, which doesn’t bode well for its future. Assuming they receive the $1.1 MM the IRR of this cohort is -19% at present, and given the outlook getting back to zero is probably unlikely. Given this cohort was a huge amount of capital, this is a big part of the reason why the company is doing poorly.
The hit rate is extremely important here, but so are the terms of the buyout deals, as that seems to be where most of the capital returns come from. One of the deals in the second half of 2014 actually had a loss on the contract buyout, and the best one was gross receipts of exactly twice the invested amount, which suggests to me that the contract had a capped buyout amount at that price. My biggest concern here is that if you can’t cut your losers, and the upside from the winners is capped, you will be at a big disadvantage in a high dispersion situation like small business investing.
None of the other cohorts are at a place where they can reasonably be said to have the results be known (although the 2015 cohorts look better so far than 2014). That being said, I have included my spreadsheet I used to run the cohort analysis. They were not making new investments during most of 2016, so the two capital deployments at the end of the year were not included in a cohort.
Joint Venture
The company has signed up to joint venture partners to co-invest with them in their new royalty deals. The structure of the new deals is that each JV partner will contribute 25% of the funding for each new deal, and receive 25% of the upside, less fees to Grenville. The fees are described below. Essentially one of the partners will be paying based on the returns of capital, and one will be paying based on the capital managed (with an upside kicker).
Assuming Grenville is able to invest $1 MM per month with 250k coming from each JV partner, that will produce $3 MM in investments by each JV per year. That would have FGII paying $30k in fees on the first year’s investments, and if they get 20% of their cash back in the first year, $36k in fees from Darwin. Foregrowth also pays 1% on the invested balance, so these revenues have the potential to scale with time. This is a high margin revenue stream, and if they are able to effectively grow the business it has huge potential. I especially like it as an offset to G&A. Presumably they are doing these deals anyway, so having the JVs adds only a bit of extra legal work, but potentially significant extra cash flow. I will model this as a $66k offset to the G&A. Granting that they are very unlikely to earn $66k in 2017 from the JVs, but it should be possible to do so in 2018 if things go well. It also has the potential to end up as a material income stream, as they could continue to put capital to work in future years.
Run Rate G&A
The business has both upsides and downsides as I’ve mentioned. The biggest downside to me appears to be the rather significant G&A. The company is run from the financial district in Toronto, and employs finance professionals at what appear to be high compensation levels. Conference calls have mentioned the effect of “a new managing director” on G&A going forward, as well as the CEO expressing concern that they may not have enough options authorized to keep their team properly incented. He gave up 1 MM of his options for that purpose, which is admirable, but the high comp still concerns me going forward.
My estimate of run rate G&A is $3.2 MM. I took the salaries and benefits line and removed the $675,000 payment to the previous CEO, as that should be a one-time expense. I also reduced professional fees to their 2015 values, as that increase is probably legal fees relating to the transition and potential JV negotiations, both of which are complete. I also removed share based compensation, and will add the dilution separately. Subtracting my estimate of near term JV income leaves a $3.1 MM G&A run rate. This squares reasonably well with the $250k monthly run rate the CEO mentioned on their most recent conference call, which can be found here.
Now, given the company has no plans whatsoever to liquidate itself, the G&A is a highly certain cash outflow. That would suggest a low discount rate is appropriate. At 5%, that would imply the G&A deducts $62 MM from the valuation. That isn’t realistic, as the G&A probably doesn’t give the company a negative value, so I am going to use a return on assets model instead of a sum of the parts model here.
The bigger issue here is simply that the company is subscale. With $33 MM of shareholders’ equity trying to support a $3.1 MM G&A run rate, the company needs to earn a 9% return on its capital just to keep the lights on. Although they have indicated they are targeting a 25% initial yield on their investments, it is probably not realistic to expect the company to have IRRs of that amount, which will make it tough for there to be significant return to equity holders.
As an example, for the company to be worth book value, they probably need to have an ROE of 10%, which means they need to earn 19% on their equity after G&A. Of course, book value would be a 2.5X gain from here, so there may be a happy medium…
Balance Sheet
The company’s most recent balance sheet had $6.2 MM in cash, which they expect to be able to deploy into new royalties. The company also has an outstanding convertible debenture with $17.25 MM of face value outstanding. The debentures bear interest at 8% and are convertible into shares at $0.92. Given how far out of the money the conversion price is at present, deducting these at full face value and not accounting for dilution seems like the reasonable thing to do. The maturity of these debentures (December 31, 2019) provides the company a bit of a hard deadline, as forcing conversion would dilute the equity holders nearly to irrelevance, and it’s doubtful they could refinance at present on comparable terms.
Debentures
The market is also suggesting the debentures might not be fully covered, as they currently trade at $78 per $100 of par value. That is over an 18% yield to maturity, suggesting some doubt about prompt payment at maturity. I actually think the debentures are a reasonable way to express a positive thesis here, as they do have the 18% YTM, and if they aren’t paid back at maturity they will convert into common stock at a discount to the prevailing price, and the prevailing price would almost certain decline at that time as a result of the pending dilution.
Potential Catalysts
There are a number of potential catalysts that could materially improve the stock price.
The most obvious one would be liquidation. The company has a 33 MM book value, and while they probably wouldn’t realize the deferred tax asset in a liquidation, it would probably still result in a double from here if they reduced G&A dramatically right away. I suspect most of the G&A is related to the “deal team” for sourcing new deals, so in a liquidation scenario those employees and their expensive office space could be let go immediately. I don’t see a significant likelihood of this happening, although it is possible as management and the board don’t own a stake significant enough to block a determined activist. That being said, the company has recently had significant insider buying. The most interesting insider purchases have come from Rob McLarty, the company’s new California based managing director. He started buying shares in December, right around the time the most recent tech deals were announced. It seems likely that he was significantly involved in those deals, so his purchasing shares on the open market seems to be a positive sign. You can see his LinkedIn profile here. The open market purchases in December of 2016 were broad based (CEO, CFO, directors, senior staff), although even in aggregate were not a significant amount of money.
The company has suggested in the past that the IPO of an investee could be a potential catalyst, but given all of their portfolio companies have buyout options, I would imagine they would get bought out as part of any IPO process. That being said, cash coming in from buyouts would also be a potential catalyst, as it would help to validate the model for the market, as well as providing them cash to invest in new royalties with their JV partners. Given the front end heavy nature of these investments and their G&A burden, the company is always on a cash flow treadmill, so if they’re not going to liquidate they do need to continue making new investments.
Another potential catalyst would be the company raising additional capital. There is the potential for real reflexivity here; as if the share price increases they will almost certainly use that as an opportunity to raise additional capital. If they can effectively invest that, it would disperse their G&A over a larger capital base, making the entire business more sustainable. Thus, this is an investment which has the potential for success to be self-perpetuating.
Value of Investments
The most important factor in valuing the company is the performance of their existing and future investments. For the purposes of conservatism, and because of the current share price, I am going to assume the company’s capital base stays the same. I will assume the company invests their remaining cash, and then reinvests the proceeds from buyouts as the come in, so the invested capital base will be roughly constant. The sensitivity table below shows the valuation of the shares at a variety of different IRRs on the invested capital. I have assumed all $40 MM is invested, and that cash inflows in excess of the IRR are required for reinvestment. This would effectively allow the company to return to being a sustainable dividend paying company, which would definitely cause a re-rate.
A 10% IRR should be attainable for the company, which suggests a price target of $0.17, which is 26% in excess of the current share price of $0.135. However, even small variations to this IRR make a big difference to the value of the company, and if they can sustainably return 15% on their current portfolio the shares should be worth $0.51, which is in excess of their book value of approximately $0.31 per share. With a conservative price target of $0.17 and a potential upside from here, there is a reasonable case for an investment in the common shares.
Competitors and Potential Acquirers
I am a very big fan of royalty businesses. The characteristics I especially like are the lack of capital spending required to grow earnings. If the assets are of high quality, the operator of the business should have an incentive to provide capital for the operation to increase revenue. Generally speaking, this grows revenue and earnings for the owner of the royalty without them having to put up any cash. Thus, the free cash flow conversion of a royalty company can be very high, as they are able to return money to shareholders or reinvest for new royalties essentially all of their after tax earnings. This is in stark contrast to most companies, which require maintenance capital spending to stay even. I have included a list of competitors. Generally these are all trading at or above book value, and at high multiples of earnings.
- Alaris — Royalties on bigger businesses
- Diversified Royalty Corp — Royalties on franchise businesses
- Royalty North — A startup playing in the same space as Grenville. Interestingly, Royalty North has a similar market cap to Grenville on a much smaller equity base, and with only one royalty investment so far.
- Crown Capital Partners — A capital provider to the same space, focused more on loans than royalty investments.
I believe any of Crown, Royalty North, Diversified, or Alaris could consider a purchase of Grenville, and it would likely be accretive on both a book value and earnings basis to any of them. Royalty North would either need to raise capital or pay in equity, but the others could likely pay for Grenville in cash if they desired to do so.
Conclusion
The company is trading at an extremely low valuation. A reasonable price target based on 10% IRRs is $0.17 per share, materially in excess of its $0.135 current share price, and prices as high as $0.51 are not out of the question. That being said, there are significant possible downsides here. The G&A is high, and if the investment performance does not improve there is the potential for G&A to burn the cash flow, and in that case the company will end up in the hands of the convert holders in 2019. I think the convertible is also a reasonable way to play this undervaluation. It doesn’t have the potential for a triple, but I think the loss potential is much more muted as well. There is also acquisition or activist potential here, both of which would make a common position more rewarding than a position in the convertible.
