Alaris Royalty Corp. (OTC:ALARF) Q3 2022 Earnings Conference Call November 10, 2022 11:00 AM ET
Company Participants
Amanda Frazer – CFO
Steve King – President and CEO
Conference Call Participants
Nik Priebe – CIBC
Gary Ho – Desjardins
Zachary Evershed – National Bank Financial
Operator
Good day, and thank you for standing by. Welcome to the Alaris Third Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded.
I would now like to hand the conference over to your speaker today, Amanda Frazer, Chief Financial Officer. Please go ahead.
Amanda Frazer
Thank you, Liz. We appreciate everyone taking the time to join us this morning. We are excited to present our Q3 results. I’m joined on the call by Steve King, President and Chief Executive Officer of Alaris.
Before we begin, I would like to remind our listeners that all of the amounts given are in Canadian dollars unless otherwise noted. Listeners are cautioned that the comments made today may contain forward-looking information. This forward-looking information is based upon a number of factors and assumptions, and therefore, actual results could differ materially. Additional information concerning the underlying factors, assumptions and risks are available in last night’s press release and our MD&A under the heading Forward-Looking Statements and Risk Factors, copies of which are available on SEDAR at sedar.com, as well as on our website. Non-IFRS data is also presented and may differ from the way other companies present such data. As with the forward-looking statements, please refer to last night’s press release and our MD&A for more clarification regarding non-IFRS measures.
Now for the Q3 highlights. Q3 revenue of CAD42.9 million was consistent with the prior period. The current period benefited from common distributions from both Fleet and Amur of CAD3.1 million and a 4% more favorable exchange rate, while the prior period benefited from the receipt of CAD4.3 million of deferred Kimco distributions.
Cash generated from operations, prior to changes in working capital was CAD44 million with an increase of 1.2% over the prior period, and included in this amount is CAD5.8 million of realized gains relating to a common distribution paid by Fleet.
The increase in the quarter was partially offset by increased G&A expenses of CAD1.5 million. A CAD700,000 decrease in salaries and wages, driven by a change in the mechanics of the bonus accrual, was offset by a CAD400,000 increase related to continued exploration of the AUM strategy and increased insurance costs as well as CAD1.9 million of increased legal spending in regards to the Sandbox matter.
During the quarter, Alaris entered into insurance contracts to mitigate the risks presented by the reassessments of the CRA. The ability of Alaris to obtain insurance contracts show that underwriters are aligned with our views of ultimate success on this matter.
However, the state of the laws influx and by obtaining insurance, we are able to protect against any adverse changes, although there can be no assurance that all the amounts for which Alaris may become liable, will be fully covered. Obtaining insurance provides increased certainty for Alaris and its shareholders. We continue to defend this matter vigorously.
Q3 earnings, as compared to the prior quarter, were impacted by CAD22.5 million change in net realized and unrealized fair value of investments from CAD15.8 million gain in Q3 of 2021 as compared to a current net loss of CAD7.1 million, primarily impacted by the increasing market interest rates effect on discount rates and multiples. Despite these factors, we saw increasing fair values for SCR of CAD1.3 million, BCC of USD900,000, Fleet of USD900,000, Edgewater of USD800,000.
As discussed last quarter, the results of SCR can be impacted by the timing of project related work throughout the year. As expected activity picked up through the summer and have continued increasing our expected cash sweep for the last half of the year as a result, increasing fair value. SCR’s ECR also rebounded and is now back in the range of 1.5 times to 2 times range.
BCC has seen impressive year-over-year growth with record high activity, which has resulted in an upward revision to our reset metric, same clinic sales. In Q2, we realized a USD4.4 million fair value increase on Fleet as a result of significant improvement in their balance sheet and excess assets held in the business.
At the time, it wasn’t anticipated that these assets would be distributed in the near term, but in Q3, Fleet declared a common distribution of USD5.9 million to Alaris and distributed excess cash to common unitholders. This distribution represents a significant portion of the common equity invested in Q4 2021 of USD8 million.
Due to the previous inclusion of these distributed assets in the fair value of Fleet, USD4.4 million of the distribution was included as a realized gain while USD1.5 million was recorded as dividend revenue. The net impact of these realized and unrealized gains was a USD900,000 increase in the fair value of fleet in the quarter.
Edgewater has been able to generate an increase in revenue through growing headcount in both new and existing long-term contracts. With strong spending expected to continue within the US Department of Energy, the outlook for the remainder of 2022 and 2023 continues to be very positive. Offsetting these increases were declines in GWM of USD6.7 million.
As discussed last quarter GWM has not achieved the growth expected at the time of our investment. While they continue to see improving top line growth and a diversification of their customer base, we have further decreased our reset expectations to the full 8% collar.
We continue to believe in the long-term trajectory of the business, but given the slower-than-expected start, have pushed out the forecast to achieving this level of growth. This shifted expectations, coupled with the continued discount rate increases and declining multiples, have resulted in a decrease in fair value.
Planet Fitness and D&M, each had declines of USD3.5 million and USD3.4 million respectively, again due mainly to the impact of rising interest rates that have had on the respective discount rates used to value these companies’ equity investments.
In addition to the follow-on investment of USD26 million into our existing partner Accscient, including USD16 million of preferred and USD10 million of common earlier this quarter, this week we closed an investment into new partner Sagamore for USD24 million, including USD20 million of preferred at a pretax yield of 15% and USD4 million of common. These two investments bring our year-to-date deployment up to USD152.8 million.
Subsequent to the quarter, FNC fully redeemed their investments, marking the first common equity crystallization for Alaris. Proceeds of USD58.3 million consists of USD51.7 million for the redemption of the preferred and common equity and USD5.2 million of make-whole distributions to the third-year anniversary of the deal.
Those revenues will be recorded in Q4. The total return on our USD40 million investment, including preferred and common equity distributions, will be USD29.9 million, or 75% upon the collection of the USD1.4 million of escrowed amounts, which represents an approximate 43% IRR for our preferred equity investment and 38% IRR for our common equity investment in FNC.
In Q3, we also completed an amendment to the credit facility increasing the facility from CAD400 million to CAD450 million with an additional CAD50 million accordion. The amendment also extended the facility maturity date from November 2023 to September 2026.
Subsequent to the quarter, we decreased our senior debt outstanding by USD47 million as a result of the FNC redemption as well as cash flow, partially offset by the investment in Sagamore. We currently have CAD231 million of senior debt outstanding resulting in CAD290 million of available capacity and are at approximately 1.6 times senior leverage ratio.
In regards to our partners, our portfolio continues to have a weighted average ECR over 1.75 times with 13 of 17 continuing to have an ECR above 1.5 times. We now have eight months of financial results for all of our partners and are anticipating total aggregate resets of 3% in 2023, an increase of approximately CAD4.5 million or CAD0.10 per unit. Top of the collar resets are expected from 10 partners.
Our current outlook calls for CAD47 million of revenue in Q4, inclusive of CAD7.1 million in make-whole distributions received on the redemption of FNC and a 12-month run rate of CAD161.5 million, up from CAD159.3 million last quarter or CAD168.6 million, including the FNC make-whole.
Our G&A expectations have increased from CAD16 million to CAD17 million. This is to reflect the amortization of the additional insurance contracts entered into in Q3. Although, it should be considered that those are non-cash in nature as all of those contracts were paid in cash.
I will now turn it over to Steve for his comments.
Steve King
Great. Thanks, Amanda, and thanks, everybody for tuning in.
We’re in an environment where other companies are seeing increased costs and volatility. Alaris, on the other hand has been able to stay incredibly stable. Our third quarter, again, highlights the strength and diversity of our portfolio and a record high earnings coverage ratio reported by our partners. And while some – there were some negative adjustments in the quarterly valuations, as Amanda said, those were simply just changes in the discount rate used by KPMG and did not reflect any long-term impairment in the company’s future prospects.
All that said, our book value per share did go up by around CAD1 per share in the quarter. So that’s significant. And the best thing for me is that 17 out of our 18 companies in our portfolio are reporting stable to nicely improved results compared to last year, which is a really incredible performance. A significant number, in fact, they’re showing more than 25% year-over-year growth in 2021, which was itself a good year.
We have a number of embedded factors in our company that explains this unusually strong performance. First is, our portfolio is constructed with required service-type businesses that have either no or very low levels of debt, low CapEx, which can be negatively impacted by inflation or supply chain issues, we don’t have to really deal with a lot of that, and also customer demand that is not highly sensitive to the economy.
We’re also very pleased to announce the closing of another new partnership yesterday with the addition of Sagamore to our family. Sagamore is a highly profitable commercial plumbing and HVAC company with customers in many sectors of the economy in the Boston area. Sagamore displays all the characteristics we look for in a company, including highly motivated owner management group, 30-year plus track record of profitability, no debt and a coverage ratio above 1.5.
Our G&A was a little higher than expected. I guess, the good news is, a large part of that is a very positive sign for the future. And our travel and transaction expenses were higher than usual, due to the fact that our deployment activity is very strong. We’ve also continued to progress on our third-party asset management initiative, so a significant start-up costs are required for that concept, but we feel very strongly about the future success of it for Alaris shareholders.
All of those factors were key elements in our decision to increase our dividend to CAD1.36 per share annually. For the majority of our time, as a public company, we have established a track record of consistent dividend increases. And this is our third dividend increase since the start of the pandemic in 2020. And in keeping with our objectives, we are maintaining our payout ratio between 65% and 70% after giving effect of the dividend increase.
So there’s roughly CAD220 million of capital available. We expect to keep driving down that payout ratio with accretive new transactions like we’ve just done with Sagamore. The current environment really is ideal for Alaris and we have a very robust deployment pipeline. We’ve essentially been competing against free money for the better part of a decade, so having the cost of both debt and equity increase over the last few months makes our offering to entrepreneurs even stronger than it has been.
While it’s still highly competitive out there with a massive amount of capital chasing few quality deals, traditional private equity is facing a challenge since the type of investment – that type of investment is typically predicated on high leverage levels within their portfolio companies. Not only is that now very difficult to find, it’s also considerably more expensive than it has been in many years. So private equity firm needs to adjust the multiple that they pay for an asset or they have to accept lower economic returns.
Alaris’ model does not rely on any leverage in our deal. So our returns can stay consistent or move up slightly. In this environment, we were able to strike deals slightly higher as seen in the Sagamore transaction with a starting dividend yield of 15% compared to 14% in most deals done over the last several years.
We also have the advantage of resetting our dividend from our partners based on their top line performance, which is a very nice feature in an inflationary environment given that top line should grow faster, but we’re insulated from the increase in costs. So putting it all together, with 90% of our revenue in US dollars, low debt, top line orientation and non-cyclical investments, we feel like we’re really ideally suited for the uncertain world we’re in today.
So, Liz, I’ll turn it back to you and open the floor up for questions.
Question-and-Answer Session
Operator
[Operator Instructions] Our first question comes from the line of Nik Priebe with CIBC.
Steve King
You there, Nik?
Operator
Just one moment.
Nik Priebe
Yes. Can you hear me?
Steve King
Yes, now we can.
Nik Priebe
Okay. Wanted to start with a question on the dividend or the distribution. In the past, you’ve talked about a comfort level for a dividend raise being a payout ratio below 60%, whereas it seems now you’re anchoring on a range of 65% to 75%. I’m just wondering what prompted the change in thinking there, like is that partly a product of the deployment pipeline you see in front of you?
Steve King
It is – yes, it’s always a balance between our payout ratio and the amount of capital that we have available for deployment and the prospects for deployment of that capital. So, yes, we felt very comfortable. We’ve targeted the 65% to 70% to stay within that range. We did that, and yes, we see some good activity coming in the near term.
Nik Priebe
Okay, fair enough. And then with borrowing costs rising, does that impact pricing at all on new investments in preferred equity? Historically, your entry yield has been in a relatively tight range. The latest one was kind of towards the high-end of that range. Does that start to move upwards at all? Or do you feel that that pricing is probably going to be pretty static?
Steve King
I think it’s moved up a little bit Nik, as evidenced. But it will never be – like we’re never going to be able to get to 20% or anything like that. So it’s always been in a pretty tight range for our full 19 years. So in early days, in a different interest rate environment, I was able to do some deals at 16%. Obviously, over the last several years, it’s been an extremely low interest rate environment.
So for follow-on deals, we went to 13% to be competitive. So now we’re seeing some senior debt yields on certain companies approaching double-digits. So for us, having an equity option for a company where you’re eliminating refinance risk and you’re only paying 14%, 15% compared to 10% on senior debt with a large amortization schedule, it now becomes very, very competitive.
And as I mentioned, like we don’t compete against debt. We do compete against private equity, but they – all those people are facing the same issues with that expensive debt and the higher amortization rate. So it’s – it is a really tremendous environment for us.
Nik Priebe
Yes. Okay. All right. That’s it from me. Thank you.
Steve King
Thanks, Nik.
Operator
Our next question comes from the line of Gary Ho with Desjardins. Your line is now open.
Gary Ho
Great, thanks and good morning. Hi, Steve. Just great to see another investment announced. Just wondering if you can provide a bit more color and update on the capital deployment environment activity in the pipeline and maybe elaborate on kind of – I think you touched on in your prepared remarks, but how the higher rate has really benefited the Alaris royalty structure there?
Steve King
Yes. So I think I mentioned in previous calls this year that the – it wasn’t so much. The number of deals was an issue earlier in the year. It was the quality of those deals and we have seen a rebound in that where some of the higher quality companies are kind of coming back to the market and looking to raise capital. But I also think that it’s been a change and we’re expecting to see even more of this change, and that fewer companies will be looking for complete sale transactions. Because multiples are coming down, it’s not a great environment to be selling your company.
So people are going to want to keep more skin in the game, live to see a better day again in terms of multiples and access to capital and cost of capital. So I think we’re going to see more kind of partial liquidity events, dividend recaps and those are all things that we really do well with our structure. So we expect a very robust 2023 in terms of capital deployment, both from the access to capital being constrained in other cases, and also just the cost of capital.
As I mentioned when you’re seeing senior debt at 10%, you’re seeing mezz debt in the mid-teens, seeing equity multiples come down, that is really a perfect environment for us. And with the lack of downside in terms of debt within our portfolio, we’re really not getting hit by the other edge of that sort. So we’re pretty excited. I think an average – I think there still will be some 14% deals out there for some larger ones that are very hotly contested. But I think for smaller deals, 15% would be kind of a new normal.
Gary Ho
Okay, great. And then maybe on the flip side, we saw the FNC redemption, great returns there. Any other partners potentially indicating they may look to redeem over the next 12 months?
Steve King
Nothing. Nothing that’s evident right now. But as I’ve always said, we always expect kind at least one or two a year. So I don’t think that will change. That is one slight advantage of a bad market as well as that it’s not as you can do so for someone wanting to sell. So I think we’ll probably see people kind of stay with us for longer on average.
But it’s different in every case. There’s – a lot of the time, it’s exterior forces that cause the sale, whether it’s a medical issue or just age related issue, whatever it is, there’s always just kind of different circumstances on every deal. But in general, I would still expect another one or two redemptions and there could be someone that have excess cash, where they can even just pay down our preferred investment a little bit as opposed to taking this right out. So I think you could see some of those as well.
Gary Ho
Okay. And then while I have you, Steve, can you give us an update on the managing third-party capital strategy discussions you’ve had, and perhaps maybe some timeline, guidepost you’re targeting?
Steve King
Yes. We’ve made some very good progress since we talked to you last quarter. So we’re certainly more confident in our ability to announce something relatively near future compared to what we were three months ago. So I can’t give any timeframe on it, but yes, it’s gone very well and that’s evidenced in our actual costs that we’ve had that we wouldn’t have had those costs if there wasn’t a concrete transaction on the table.
Gary Ho
Okay, great. If I can just sneak one more in, maybe for Amanda. Just given the higher FX, we have benefited quite a bit, and I think, Steve, you also mentioned the 6% increase in book value per share. Any thoughts on hedging more of your distribution at these levels? I know you have a rolling 12 and 24 months hedge in place. Just wondering if at all you consider more.
Amanda Frazer
We actually don’t bring a lot of cash back to Canada. So while we do benefit from the FX in our financial reporting, as far as converting US dollars into Canadian on a regular basis, we are fairly well hedged on that standpoint. So to hedge any further, we would be bringing Canadian dollars back to Canada kind of unnecessarily or most of our debt is also been held in US dollars, so we don’t have as much of an advantage to that conversion.
Gary Ho
Okay, great. Thanks for the color. That’s it from me.
Steve King
Thanks, Gary.
Operator
[Operator Instructions] Our next question comes from the line of Zachary Evershed with National Bank Financial. Your line is now open.
Zachary Evershed
Good morning, everyone. Congrats on the quarter.
Steve King
Thanks, Zach.
Zachary Evershed
Most of my questions have been tackled. So maybe just a quick one on the insurance for the negative outcome on the tax issue. With that in place, what’s your potential net exposure now?
Amanda Frazer
It really depends on the circumstances. I mean, we continue to believe that there is no exposure and we will be successful in the case. This is currently a number of cases going through the courts, and those decisions can always impact the view on our case, and because we are uncertain on what those other cases may hold for ours, we just thought it’s prudent to protect ourselves as much as possible. But we continue to believe that we’d be successful.
Zachary Evershed
Sounds good. I’ll leave it there.
Steve King
Okay. Thanks, Zach.
Operator
I’m showing no further questions in queue at this time. I’d like to turn the call back to Steve King for closing remarks.
Steve King
Great. Thank you, Liz, and thanks everybody for tuning in and asking questions. And as always, if there’s any follow-up questions, both Amanda and I are always available to take those anytime. So thanks very much again. And we look forward to reporting back to you with our year-end results. Thanks very much.
Operator
This concludes today’s conference call. Thank you for participating. You may now disconnect.
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