4 October 2019 Royalty investing is a profitable and significant form of alternative finance in North America. However, it is still a nascent industry in Europe and Duke Royalty was set up in 2015 by an experienced team to change this. Its current portfolio is now close to £80m and it aims to add £45–100m in deals a year in the coming years. Duke has just announced a fund-raising of up to £20m, of which £16.1m has already been placed in an institutional offering at 44p per share. This will allow it to invest another £45m in the next 12 months. We estimate a sustainable ROE of 14% for Duke and we see the current fair value range at 50–58p per share. Year end Revenue (£m) PBT* (£m) EPS* (p) P/E (x) Dividend yield (%) Operating cash flow yield (%) 03/18 1.80 0.23 0.4 126.1 4.4 0.8 03/19 6.14 3.13 1.8 25.6 5.7 5.4 03/20e 12.06 6.17 2.8 16.6 6.4 8.0 03/21e 18.70 10.20 3.7 12.8 8.5 11.6 Note: *PBT and EPS are adjusted for unrealised fair value movements, gains on exercise of warrants, share-based payments and adjustments in royalty payment fees. A nascent niche Although royalty finance has grown from its mining and pharmaceutical industry roots to become a US$50bn sector in North America, it is still a new asset class in Europe. Duke is the market leader in the UK in what is an open field for growth. Royalty finance provides flexible, long-term finance while allowing the business owners to retain control and reducing repayment risks by extending amortisations beyond the first three to five years. For investors like Duke, it provides an attractive yield, with potential for growth and a scalable business model. Investment income is reset annually and linked to the percentage change (with a 6% cap and floor) in the partner’s revenue. Terms are typically 30 years with no bullet repayment but a prepayment penalty. Duke positioned to grow After the acquisition of Capital Step, Duke is now more diversified and well positioned to grow. We see the portfolio growing from £80m to £105m by 31 March 2020. We then assume a further £95m of investments by 31 March 2022. It has an experienced origination and underwriting team and we believe there is a large potential market for this product, given sufficient marketing and as familiarisation grows. We expect the operating cash flow yield on Duke’s shares to climb from 5.4% in FY19 to 8.0% in FY20 and then reach 14.9% by FY22. The company has a 65–90% dividend payout policy. Value creation merits premium We value Duke based on its cash flow generation. With yields at inception from 13.5% and the relatively low cost to manage projects, Duke is a cash-generative business. If we assume average gearing of 15%, we estimate the sustainable return on equity (ROE) to be around 14%. Flexing the 9.5% cost of equity (COE) by 50bp, we obtain a current fair value of 50–58p per share. There is further upside to our valuation from greater scaling, gearing or indeed growth assumptions (we use an average 3% annual reset). Duke Royalty Initiation of coverage A new wave of lending Price 47.00p Market cap £111m C$1.64/£ Net debt (£m) at 30 September 2019 7.1 Shares in issue *Includes £16.1m capital placing 236m Free float 90% Code DUKE Primary exchange AIM Secondary exchange N/A Share price performance % 1m 3m 12m Abs 5.2 2.0 1.3 Rel (local) 7.5 8.7 7.4 52-week high/low 48.8p 40.0p Business description Duke Royalty is a financial services company providing royalty-based finance to small and growing businesses in selected sectors and with specific criteria. The royalty payments are either for a fixed term (typically 30 years) or perpetual. Next events H120 results December 2019 Analysts Pedro Fonseca +44 (0)20 3077 5700 Andrew Mitchell +44 (0)20 3681 2500 [email protected]Edison profile page Financial services Duke Royalty is a research client of Edison Investment Research Limited
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Duke Royalty Initiation of coverage...65–90% dividend payout policy. Value creation merits premium We value Duke based on its cash flow generation. With yields at inception from
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4 October 2019 Royalty investing is a profitable and significant form of alternative finance
in North America. However, it is still a nascent industry in Europe and Duke
Royalty was set up in 2015 by an experienced team to change this. Its
current portfolio is now close to £80m and it aims to add £45–100m in
deals a year in the coming years. Duke has just announced a fund-raising
of up to £20m, of which £16.1m has already been placed in an institutional
offering at 44p per share. This will allow it to invest another £45m in the
next 12 months. We estimate a sustainable ROE of 14% for Duke and we
see the current fair value range at 50–58p per share.
Year end Revenue
(£m) PBT* (£m)
EPS* (p)
P/E (x)
Dividend yield (%)
Operating cash flow yield (%)
03/18 1.80 0.23 0.4 126.1 4.4 0.8
03/19 6.14 3.13 1.8 25.6 5.7 5.4
03/20e 12.06 6.17 2.8 16.6 6.4 8.0
03/21e 18.70 10.20 3.7 12.8 8.5 11.6
Note: *PBT and EPS are adjusted for unrealised fair value movements, gains on exercise of warrants, share-based payments and adjustments in royalty payment fees.
A nascent niche
Although royalty finance has grown from its mining and pharmaceutical industry
roots to become a US$50bn sector in North America, it is still a new asset class in
Europe. Duke is the market leader in the UK in what is an open field for growth.
Royalty finance provides flexible, long-term finance while allowing the business
owners to retain control and reducing repayment risks by extending amortisations
beyond the first three to five years. For investors like Duke, it provides an attractive
yield, with potential for growth and a scalable business model. Investment income
is reset annually and linked to the percentage change (with a 6% cap and floor) in
the partner’s revenue. Terms are typically 30 years with no bullet repayment but a
prepayment penalty.
Duke positioned to grow
After the acquisition of Capital Step, Duke is now more diversified and well
positioned to grow. We see the portfolio growing from £80m to £105m by 31 March
2020. We then assume a further £95m of investments by 31 March 2022. It has an
experienced origination and underwriting team and we believe there is a large
potential market for this product, given sufficient marketing and as familiarisation
grows. We expect the operating cash flow yield on Duke’s shares to climb from
5.4% in FY19 to 8.0% in FY20 and then reach 14.9% by FY22. The company has a
65–90% dividend payout policy.
Value creation merits premium
We value Duke based on its cash flow generation. With yields at inception from
13.5% and the relatively low cost to manage projects, Duke is a cash-generative
business. If we assume average gearing of 15%, we estimate the sustainable
return on equity (ROE) to be around 14%. Flexing the 9.5% cost of equity (COE) by
50bp, we obtain a current fair value of 50–58p per share. There is further upside to
our valuation from greater scaling, gearing or indeed growth assumptions (we use
an average 3% annual reset).
Duke Royalty Initiation of coverage
A new wave of lending
Price 47.00p
Market cap £111m
C$1.64/£
Net debt (£m) at 30 September 2019 7.1
Shares in issue
*Includes £16.1m capital placing
236m
Free float 90%
Code DUKE
Primary exchange AIM
Secondary exchange N/A
Share price performance
% 1m 3m 12m
Abs 5.2 2.0 1.3
Rel (local) 7.5 8.7 7.4
52-week high/low 48.8p 40.0p
Business description
Duke Royalty is a financial services company
providing royalty-based finance to small and
growing businesses in selected sectors and with
specific criteria. The royalty payments are either for
Step Investments Media, hospitality & leisure 3 Capital Step 13.6 Perpetual N
Xtremepush Technology & media 3 Capital Step 13.6 Perpetual Yes (5 years)
Brightwater Recruitment 2 Capital Step 13.6 Perpetual Yes (5 years)
Berkley Recruitment & consulting 2 Capital Step 13.6 Perpetual N
Total investment as of August 2019: c £79m
Source: Duke Royalty data, Edison Investment Research. Note: *Partner Service, Signalhome, Label Express & Day 2 are all controlled by Lynx Group UK, with the annual reset done on a consolidated basis.
Capital Step acquisition in February 2019
After two equity issues in 2017 (£35m), Duke Royalty raised £44m in additional equity (at 44p per
share) in August 2018 with the aim of supporting further growth and diversification of the portfolio.
As part of this strategy, Duke acquired Capital Step in February 2019 for £10m in cash plus
£11.65m in debt. Capital Step added £16.5m in investments, plus equity positions estimated at
£1.2m and increased the number of royalty partners from five to 11 (we include the various Lynx
group of companies as one client in this respect).
It is worth noting that the Capital Step royalty model had some differences from Duke’s. The royalty
adjustments are carried out on a monthly basis and fixed as a percentage of revenue with a floor
and cap ranging from 14% to 30%. Capital Step also has some senior conventional loans (on three-
to five-year terms) as part of a ‘unitranche’ product to three of its six royalty partners. Duke’s
existing practices should be the most common in new deals, but management expects to keep an
open mind in terms of royalty finance formats. We note that soon after the acquisition, Duke made
some changes to the investment. For example, Pearl & Dean changed to a perpetual investment
from one amortising by 50% over a three-year term, and the terms of the loan components in the
Welltel and Xtremepush investments were extended by two years (to 2024). The Pearl & Dean
investment was subsequently moved to its parent investment company (Step Investments), which
has several investments in the media and hospitality & leisure sectors (Pearl & Dean is focused on
cinema advertising). The Capital Step debt is in the form of an £11.65m revolving credit, which
costs Libor + 9.5% with Honeycomb Investment Trust. On 10 September 2019, Duke announced it
had refinanced this with a lower rate (Libor + 7.25%) and increased the credit facility from £15m to
£30m. The new terms also include an accordion facility that could provide a further £20m if certain
LTV thresholds are maintained.
Duke Royalty | 4 October 2019 6
Gearing restraint
Duke has high yielding assets and expects to pay a generous dividend. It targets a 65–90%
earnings payout ratio (likely to be closer to the upper end of the range in the near term). The
forecast yield for FY20 is 6.4%, the company has delivered three dividend increases in the last two
years and we are assuming a further increase from 0.75p to 0.80p in the last quarter of FY20.
Management expects to continue to use a limited amount of gearing as working capital. However, it
does not expect the net debt to capital (or LTV) to exceed 30%. In our forecasts, we assume an
average LTV of 15%, although in the short to medium term we are forecasting it to reach 30.1% by
31 March 2022 (FY22).
We are factoring in the £16.1m just announced in fresh equity capital. We forecast that Duke will
deploy £22m in the second half of FY20 and the net debt to capital ratio will be 14% in FY20. These
investments are expected to be one new partner and some follow-on from existing clients. The
increase in gearing to 30.1% assumes investments of £95m over 2021 and 2022 and the
assumption of a £50m equity raise in FY21, as we detail later.
Duke does not hedge its FX position because it is relatively small (essentially it is just the Temarca
investment, a European river boat cruise company) and because its high operating margins make
tight FX control unnecessary. However, it may review the situation if its FX positions grow
considerably.
The case for royalty financing
Royalty financing started in the mining sector in North America in the 1980s as a useful alternative
to equity and bond funding. It began with smaller players, then large mining companies such as
Vale, BHP and Glencore started to use it and it has also now spread to other players in that sector,
notably with Franco-Nevada. Pharmaceutical royalties became an asset class in the 1990s and this
is now a multibillion-dollar sector.
Flexible, long-term finance
Royalty finance is an attractive option for borrowers that want to avoid expensive equity dilution, but
also do not want covenant-heavy debt, often with bullet payments in the first three to five years that
can bring refinancing risk. Some business owners prefer venture capital/private equity money, and
the expertise, or even exit strategies it brings. However, if a business owner is not interested in
these features, royalty finance is less disruptive. It is likely to appeal to business owners who want
to grow the company while retaining control and also to those who do not want to be tempted to
make overly ambitious promises of future growth to investors, which might bring problems later on.
We also note that, like debt, royalty funding is more tax efficient than equity.
There is some benefit in reducing interest payments when sales go down, but we would regard this
as of relatively minor importance in terms of helping the company cope with business downturn.
Royalty funding should also be quicker to arrange on average. Covenants tend to be more
straightforward and it is usually easier to price the investment than equity finance, for example.
Royalty funding typically has buyback clauses (always the case for Duke) and this flexibility further
adds appeal to this type of long-term funding.
There are some drawbacks, including a higher cost of borrowing than straight debt and the
administrative cost of the payments (especially on monthly resets), while royalty financing is not
suitable for lower-margin or lower-revenue businesses. In addition, there may be inter-creditor
issues if the company already has senior debt.
Duke Royalty | 4 October 2019 7
Good yields, plus upside
The attraction for royalty investors such as Duke is that borrowers are willing to pay a higher return
for flexibility, the long-term nature and other features of royalty finance. Furthermore, royalty
investments provide some room for income growth, but with less work than would typically be
involved in a venture capital investment, for example. The procyclic pricing helps asset quality,
without having to formally restructure loans. A portfolio can be diversified and is relatively easy to
manage. Finally, there is a stronger bias/incentive to choose winners compared with some other
types of debt finance such as distressed lending.
Exhibit 3: Royalty finance vs debt and private equity
Debt Royalty Private equity
Term 3–7 years 25–40 years Permanent dilution
Refinancing risk Significant None Pressure to exit
Interest and finance expenses paid 0 (172) (1,808) (3,707) (3,797)
Borrowings 0 (5,609) 8,000 (3,000) 48,000
Net cash inflow from financing activities 18,149 31,807 15,283 29,639 27,642
Net change in cash and cash equivalents (11,282) 2,749 (506) (139) 93
Source: Company accounts, Edison Investment Research
Duke Royalty | 4 October 2019 14
Contact details Revenue by geography
Trafalgar Court 4th Floor West Wing St Peter Port GY1 2JA Guernsey 44 (0) 1481 741 240 www.dukeroyalty.com
Management team
Non-executive chairman: Nigel Birrell CEO: Neil Johnson
Mr Birrell works with the executive directors on deal origination and structuring, with extensive public company experience and expertise in the gaming, media and financial services sectors. He is the CEO of Lottoland, Gibraltar, a regulated gaming group, and was previously an executive director at bwin.party, a global online gaming business, where he was responsible for mergers and acquisitions, business development and management of its portfolio of investments. Before that he was a director of HIT Entertainment (formerly a FTSE 250 company). He was also an investment banker at Donaldson, Lufkin & Jenrette and Dresdner Kleinwort Benson. He is a qualified solicitor of the Supreme Court.
Mr Johnson is responsible for Duke’s overall strategic direction and performance, leading all deal origination, due diligence and structuring. He has over 25 years’ experience in investment banking, merchant banking and research analysis in both the Canadian and UK capital markets. In 2012, he co-founded and became CEO of Difference Capital Financial, a publicly listed Canadian alternative financing company, which raised c £100m in its first two years of operations from institutional investors. Previously, he held various senior positions at Canaccord, spearheaded the firm’s diversification into the technology industry and led Canaccord’s initiative to encourage North American firms to list in London, which resulted in Canaccord becoming AIM’s largest broker by its clients’ market capitalisation and raising more than £3bn in aggregate for North America-based, UK-listed companies.
Executive director: Charles Cannon Brookes CIO: Jim Webster
Mr Cannon Brookes works alongside the CEO on deal origination, due diligence and structuring. In addition, he is responsible for Duke’s liaison with UK institutions and advisors, and has oversight of the company’s corporate governance and compliance with AIM rules. Mr Cannon Brookes has over 20 years’ investment experience, working for Arlington, Jupiter Asset Management, ABN Amro and Barclays de Zoete Wedd. He has advised and sat on the board of a number of different funds, trusts and other operating public companies.
Mr Webster has a long experience in royalty finance dating back to 1993 when he started Drug Royalty Corporation in Canada. He was the company’s president and CEO from 1999 to 2002 and held the positions of chair of the corporation’s investment committee and CFO. He was the managing partner of Capital Royalty Partners, a private equity investment firm in Houston, Texas, for six years from 2003 to 2009, and conducted independent advisory work for pharmaceutical and biotech clients before joining Duke Royalty.
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