duke royalty initiation of coverage...65–90% dividend payout policy. value creation merits premium...

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

https://www.edisongroup.com/company/duke-royalty

Duke Royalty | 4 October 2019 2

Investment summary

Royalty finance is coming to Europe

Duke was set up in 2015 to provide royalty finance, a flexible, revenue-based, long-term form of

finance. Royalty finance originated in Canada in the 1980s in the mining sector and in the 1990s in

the pharmaceutical sector and has since been replicated in other sectors. Duke Royalty estimates

that royalty finance is now worth US$50bn in the US and growing. In the UK and Europe, this is a

nascent sector and Duke is the market leader, with an investment portfolio close to £80m. The team

behind Duke Royalty is an experienced financial services team with a CIO who was a pioneer in

drug royalty finance in the early 1990s in Canada.

Royalty financing involves an upfront, one-off payment in exchange for a revenue stream for a long-

term or sometimes perpetual period. Duke typically receives an initial 13.5% pa (which includes

principal repayment and interest) over a 30-year period. Payments are paid monthly, but reset

annually linked to the change in sales revenue of the invested company or partner. Annual resets

on a cash basis have a ±6% cap and floor, which limits the movement in payment from one year to

another. The royalty partners can prepay the investment, but there is a prepayment penalty

designed to protect Duke from the time lag in reinvesting the money, as well the internal rate of

return (IRR) of the project.

Royalty partners are typically unlisted or privately-owned companies that do not want to issue

expensive equity or loans with significant repayments in the first three to five years. In addition, they

are not usually looking for the exit strategies or additional board influence that private equity and

venture capital partners require. Royalty finance appeals to owners looking to stay in control without

needing to sell their company.

Duke is looking for companies with a long track record and demonstrable strong competitive

positions. A good growth profile is desired, but not start-ups. Duke also eschews particularly volatile

sectors such as biotech, oil and gas and mining. It uses third parties to help with due diligence,

employing consultants such as Oliver Wyman and McKinsey, which it pays on a success-only

basis, typically c 3% of the revenue paid throughout the term of the contract. Although Duke’s focus

is on the UK and Europe, it will also consider deals from North America.

Strong growth expected

Duke had raised £80m in equity and invested a similar amount in 12 different royalty partners prior

to its announced £16.1m placing this week. These investments include the acquisition of competitor

Capital Step in February 2019 for £10m plus £11.6m in debt, which brought on board a portfolio

with six companies, some equity positions and an experienced UK-based team. Management

believes it has a scalable, relatively fixed-cost infrastructure to support £250m in deals comfortably

and its aim is to add five to seven new deals worth about £45–100m a year. The growth will be

largely equity funded. Duke expects to expand its debt facility to lower its cost of capital, and for the

loan to value (LTV) not to exceed 30%. The use of debt helps Duke to better manage its investment

pipeline and avoid cash drag.

Duke has just announced a successful equity offering of £16.1m at a price of 44p per share. This

will give it £45m in capital to deploy by end of FY20 (financial year-end 31 March). This assumes a

net debt to capital ratio (or loan to value) of close to 30%, which is the limit that the company sets

itself for gearing. Assuming £25m in investments would take the portfolio to £105m by end of FY20.

We are then pencilling in £45m in new investments in 2021 and £50m in 2022. To fund this, we

assume that £50m is raised in equity at a price of 59p in FY21 and debt funded during FY22 by

drawing the line of credit to 30% LTV at the end of FY22. The issue price involves rolling forward


our valuation midpoint (53.2p) by one year, ie increasing it by our assumption of Duke’s cost of

equity, 9.5% pa. This will keep the debt to capital ratio close to the 15% range. We see this as a

very cash-generative business. We forecast that the free cash flow yield will be 8.0% in FY20, climb

to 11.6% in FY21 and then reach 14.9% in FY22. The company expects to distribute 65–90% of

earnings as dividends, towards the upper end of the range in the short term (we are modelling close

to 85%).

Current fair value range: 50–58p per share

We value Duke on a cash flow basis and our starting point is the expected average IRR of Duke’s

royalty investments. We estimate this to be 16.1% to 17.1%, assuming a 13.5% average yield at

inception and 3% average growth in the payment. We flex the assumptions regarding the average

investment term (from seven years to 30 years). The early payment penalty clauses mitigate the

impact on the investment IRRs and these are relatively stable across the various terms.

We think this 16–17% IRR range (with a midpoint of 16.3%) indicates that a sustainable ROE close

to 14% for Duke Royalty seems reasonable. Translating the investment IRR to the company ROE

requires us to make adjustments for (1) operating costs, (2) forecast average leverage and (3)

taxes.

We have therefore calculated our fair value range for Duke Royalty based on an ROE of 14%

(Exhibit 5) and COE of 9.5%. Duke’s COE reflects its reduced gearing compared to most financial

companies and the risk profile of its lending. We have used a conventional ROE-g/COE-g formula

and have flexed the COE and ROE by 50bp to obtain the current fair value range of 50–58p, with

53.2p as the midpoint.

Company description: Royalty finance leader

Duke Royalty is a Guernsey-domiciled financial services company providing long-term, revenue-

based royalty finance to small and growing businesses, typically private companies. It may

occasionally invest in other alternative asset classes and financing instruments that bear similar

risk. Most of its investments are currently in the UK and Ireland, but the company has a geographic

preference of Europe and North America. Duke Royalty was set up in 2015 and floated on AIM in

2017. It currently has a free float of 90% and its institutional investors include several large asset

managers like BlackRock, AXA and Man GLG. Some of them find it useful that Duke Royalty can

provide exposure to the private lending market, which is otherwise not always easy to access

directly. Management and insiders own 10% of the company.

Royalty-based finance contracts typically involve a one-off, upfront payment from Duke Royalty in

exchange for a specific yield at inception, which is then linked to growth in the revenue of the

company, the royalty partner. The contract may be perpetual or for a fixed period (in Duke’s case,

often 30 years). Unlike a typical loan or bond, there is no bullet repayment at the end of the term, so

it can be viewed like a mortgage in this respect. The borrower is implicitly repaying both the

principal and the interest. For example, in a 30-year contract, we can think of it as the partner

effectively paying back 3.3% of the principal each year as part of the royalty payment. The 13.5%

yield could therefore be envisaged as a 10.2% interest payment plus the 3.3% principal payment.

However, unlike a mortgage, there is no formal amortisation of the loan in the sense that the mix of

principal and interest changes over time.

Duke’s investment yields at inception typically start from 13.5% pa, and usually have a 6% cap and

floor in the annual adjustment factor. This means annual changes in income received from a royalty

investment can go up or down by no more than 6% annually, even if the partner’s sales movements

are greater. These contracts provide Duke with a fairly stable long-term income stream. Although

the contracts are more covenant-light than some lending, Duke Royalty normally secures loans on


a senior basis to available assets. It usually tries to clear existing debt in a partner and roll all the

loans into the royalty contract. Also, while the company does not demand seats on the board, it

usually asks to attend all board meetings to help monitor the investment.

An important feature of Duke’s investment is that typically it wants the royalty payment to be less

than 50% of a partner’s EBITDA. Along with the partner’s normally low or no debt and profitability

track record, this helps control risk.

The royalty agreements have a buyback option, which is especially useful for partners whose sales

revenue has climbed significantly. Early repayments are usually not possible in the first three years,

due to Duke’s upfront costs and the time management puts into making investments. The contracts

have prepayment penalties, typically a 20–30% premium over the initial investment. This not only

protects Duke’s IRR from very early prepayments, but also provides compensation for the delay in

redeploying the money.

Duke Royalty looks for businesses with a good track record of sustainable revenue growth and

strong competitive position. A growth profile is also important for the uplift in yield, but a solid

revenue base is just as important. As such, Duke does not invest in start-ups and also avoids

sectors such as oil and gas, mining and biotech where revenue streams, profits and cash flow tend

to be more volatile. Exhibit 1 details Duke Royalty’s criteria for its royalty partnerships.

Exhibit 1: Criteria for royalty partnerships

Criteria Description

Established track record 10 years of operating history

Royalty coverage >2.0x EBITDA (ie minority of cash flow)

Payback 6–7 years

Management continuity Not looking for companies for sale. Will back management with a track record of delivering

Defensible business model Sustainable competitive advantage

Security Senior security sought on available assets

Low debt If other debt exists, seeks inter-creditor agreements

Use of proceeds Growth capital, shareholder restructuring, or acquisition capital

Deal size £5–20m

Preferred sectors Hospitality & leisure, industrials, healthcare, technology & media, business services

Avoid Start-ups, oil and gas, mining biotech

Source: Duke Royalty

Further expansion

The company now believes it has capacity to scale up investments from the current £80m to £250m

in the next few years. Duke divides the ability to scale into four operational objectives: (1)

origination capabilities; (2) deal execution; (3) portfolio monitoring; and (4) plc investor activities. In

addition, Duke has eliminated its sole current UK competitor. The ability to scale up is one of the

attractions of royalty financing. An extreme example of this is the market leader in the US, Franco-

Nevada, with a market cap of C$21bn and only 29 employees.

Exhibit 2 below shows some details of the current portfolio. Duke is currently aiming to add c £50–

100m pa with roughly five to seven deals a year (this includes increasing the size of the deals). It is

now reasonably well diversified, but the aim is to take the current number of clients from 12 to least

20 companies to hit its diversification target.

Although the portfolio is still quite new, we note that investments are typically achieving 6% resets,

including Temarca, Lynx and United Glass Group (UGG). Although we model Duke on an average

3% annual reset on investments, we think it is likely that in the first years, many investments will be

hitting the 6% cap and, conceivably, this should be a good source of newsflow.

Sometimes the money raised from Duke is for management or shareholder buyout purposes (eg

with Berkeley, Brightwater, BHPC and Trimite), but often it is used as growth capital, which of

course directly benefits Duke by generating more revenue. Examples of growth capital funding by

royalty partners include InterHealth, UGG and Temarca. In the case of Temarca, Duke helped it


fund a third vessel (Temarca runs river boat cruises on the Danube). The Lynx and Welltel deals are

examples of acquisition capital. Typically, these companies have been competitive and in business

for some time, as this is one of Duke’s investment criteria. For example, Duke’s last major single

company investment, Miriad, has been operating for more than 40 years as a spares and

accessories specialist for the caravans and motor homes market and is now the market leader.

Exhibit 2: Royalty partners as of August 2019

Portfolio

% Aug 2019

Initial investment

date

Current yield

%

Term Loan as

well (Y/N)

Trimite Coatings/powder 14 2018 13.5 30 N

InterHealth Hospital management 14 2018 13.5 30 N

Miriad RV parts wholesaler 14 2019 13.2 30 N

Temarca River cruise operators 12 2017 13.5 25 N

United Glass Company Glass processing 10 2017 13.5/14 30 N

Lynx Group UK Diversified holding company, there are revenue agreements with four Lynx subsidiaries

Partner Service* Commercial cleaning 6 2018 12.5 Perpetual N

Signalhome* Construction services 3 2017 12.5 Perpetual N

Label Express* Industrial label manufacturer 3 2017 12.5 Perpetual N

Day 2* Office renovations 1 2018 12.5 Perpetual N

Welltel Telecom services 6 Capital Step 14.1 Perpetual Yes (5 years)

BHP Insurance 6 Capital Step 13.6 Perpetual N

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.


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.


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

Control Passive Passive Loss of control

Covenants Significant Covenant-light Covenant-light

Security Typically senior Typically senior None

Free cash flow impact (years 1–5) Significant Light Light

Source: Edison Investment Research, Duke Royalty

Investment process

The process of origination at Duke Royalty includes business contacts, professional services

companies (accountants, lawyers, etc), as well as the use of third parties. In the case of third

parties, finder’s fees are usually applicable. Typically, Duke will pay 0.5% if a deal is more than

£20m and 1% if less than £20m (which has been the case of all the deals so far). Duke also

expects follow-on business opportunities from existing clients.

Duke’s investment committee currently consists of five executives: Neil Johnson (CEO), Jim

Webster (CIO), Justin Cochrane (president of Cobalt 27), Andrew Carragher, (a founder and

managing partner of DW Healthcare Partners, a private equity firm founded in 2002 with over

$1.25bn under management) and John Romeo (Oliver Wyman global executive committee

member).

The investment committee reviews the pipelines and proposals, gives advice on royalty terms,

manages conflicts of interest, assesses capital requirements, and reviews the performance and

outlook of the portfolio. It also makes investment recommendations to the board, but these are non-

binding. All final investment decisions are made by the board. If the board favours an opportunity, a

non-binding terms of trade or letter is sent and due diligence is completed before the final contract

is agreed. Duke Royalty had an exclusive agreement with Oliver Wyman, but works with a variety of

third-party experts, including global management consultant McKinsey, to obtain expertise. These

often obtain a percentage of revenue (typically 2–3%) if the deal goes ahead. However, there is no

payment if the deal is rejected. The guiding investment criteria are as described on page 4 and

shown in Exhibit 1. As mentioned above, sustainability of revenue is of paramount importance due

to the nature of the investment. We also note that Duke requires the operating cash flow of a royalty

partner to be at least twice the royalty payment where practicable.

Management incentives

Duke has two management incentive schemes. These are divided into short-term (STIP) and long-

term (LTIP) incentive plans. The STIP is limited up to 100% salary, annual, based on performance

and limited to 15% of each year’s increase in free cash flow versus the previous year. There are

also share option schemes. The LTIP is limited up to 200% of salary and is 50% based on total

shareholder return and 50% based on total cash flow per share available for distribution. Both

metrics have to be positive for shareholders.


Management

Nigel Norman Birrell – non-executive chairman: works with the executive directors on deal

origination and structuring and has 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.

Neil Allan Johnson, CFA – chief executive officer: responsible for Duke’s overall strategic

direction and performance, he leads all deal origination, due diligence and structuring. Mr Johnson

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 Canadian publicly listed 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.

Charles (Charlie) Cannon Brookes – executive director: 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.

Justin Cochrane – non-executive director: works with the executive directors on deal origination

and structuring, and is a member of the investment committee. He is president and COO of Cobalt

27 Capital Corp. Mr Cochrane was executive VP of Duke Royalty from 2015 to 2018 as he

transitioned into the executive role at Cobalt 27. He was previously executive VP of corporate

development for Sandstorm Gold, where was a key part Sandstorm’s team as it grew into one of

the largest royalty and stream financing companies in Canada. Prior to Sandstorm, he was a VP at

National Bank Financial.

Matthew Wrigley – non-executive director: works with the executive directors on structuring and

all legal matters. Mr Wrigley is a partner at asset management advisory firm MJ Hudson. In his 15

years in alternative assets, he has gained experience through a mix of legal and commercial roles,

including serving as general counsel for a listed Australian fund management company, COO of a

Singapore-listed investment trust and with a global law firm, Baker McKenzie. He also sits on

several fund and general partner boards, with strategies spanning private equity, infrastructure and

real estate.

Mark Le Tissier – non-executive director: responsible for the oversight of the company’s

corporate obligations in Guernsey. He is the European regional director of Trident Trust, overseeing

five offices, as well as the managing director of Trident Trust Company (Guernsey), having worked

for Trident for over 20 years. He has extensive board-level experience and has in-depth knowledge

of Guernsey and corporate and investment regulation in other jurisdictions.

James (Jim) Webster – chief investment officer: 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.

Sensitivities

We believe the key risks to Duke’s income and earnings are as follows:

Duke Royalty’s income is exposed to the economic cycle, not only in terms of revenue, but also

credit risk, much like banks.

Duke Royalty is now the market leader in the UK and has first-mover advantage in a niche that

has much space to be explored. Nevertheless, competition in the coming years could increase

as more companies enter this attractive market.

The royalty funding market is relatively illiquid so it may become more difficult to sell the

investments, should the company want to do so.

Prepayment risk exists, although it is significantly mitigated by penalty clauses (typically at a

20–30% premium to the initial investment, not the amortised value).

The company may not be able to source the appropriate royalty transactions to deploy the

money that it is raising or that is prepaid.

Some aspects of due diligence are outsourced to third parties, which are paid on the basis of

whether the investment goes ahead.

Accounting rules can make changes to the accounting fair value of the investments based on

changes to growth and discount rate assumptions. These are recorded as unrealised changes

in the fair value of investments and are a non-cash item (unlike royalties received). There is

relatively low visibility of these unrealised changes and in fact they may sometimes be negative

in the future. However, we note that although these unrealised changes accounted for 39% of

revenue in 2018, we have assumed them to be net zero in our forecasts.

Valuation

In our view, the best way to appreciate Duke’s value creation is, first of all, to look at the expected

average internal rate of return (IRR) of its royalty investments. We estimate this to be 16.1% to

17.1% assuming a 13.5% average yield at inception and 3% average growth in the payment. We

flex the assumptions regarding the average investment term (from seven years to 30 years). The

early payment penalty clauses mitigate the impact on the investment IRRs and these are relatively

stable across the various terms. In Exhibit 4, we also show the IRRs with other levels of annual

revenue growth (-3% to 6%) with different investment terms.

Exhibit 4: IRR at 13.5% net coupon at inception, pre-tax

Investment life (years)

Revenue growth 7 10 15 30

-3% 15.2% 13.8% 12.5% 10.2%

0% 16.1% 15.0% 14.2% 13.2%

3% 17.1% 16.3% 16.1% 16.1%

6% 18.0% 17.8% 18.1% 19.1%

Source: Edison Investment Research

We think this 16.1–17.1% IRR range (with a mid-point of 16.3%) indicates that a sustainable ROE

close to 14% for Duke Royalty seems reasonable. Translating the investment IRR to the company

ROE requires us to make adjustments for (1) operating costs, (2) forecast average leverage and (3)

taxes.


Based on the view that with a £2.5–3.0m operating cost structure Duke could grow investments to

more than £250m, we believe it is realistic to assume 100–150bp operating costs (with bonuses).

Further scaling benefits are possible. If we assume a 700bp spread on financing and 15% gearing

to capital, this should add 105bp to the total return on equity before taxes. The beneficial impact of

leverage greatly offsets Duke’s relatively low costs. The effective tax rate of 10% brings down the

ROE to around 14% with these assumptions.

We have therefore calculated our fair value range for Duke Royalty based on an ROE of 14%

(Exhibit 5) and COE of 9.5%. Duke’s COE reflects its reduced gearing compared to most financial

companies and the risk profile of its lending. We have used a conventional ROE-g/COE-g formula

and have flexed the COE and ROE by 50bp to obtain the valuation range of 50–58p, with 53.2p as

the midpoint.

Exhibit 5: Duke fair value estimate

ROE (13.5%) ROE (14.0%) ROE (14.5%)

Cost of equity Fair value: Price to book (x) 2019

9.0% 1.50 1.56 1.61

9.5% 1.42 1.47 1.53

10.0% 1.39 1.40 1.45

Cost of equity Fair value: Pence per share

9.0% 54.1 56.1 58.1

9.5% 51.3 53.2 55.1

10.0% 50.1 50.5 52.3


As a check and for completeness, Exhibit 6 shows Duke’s market multiples compared with some

royalty company peers. As noted above, we do not believe this is the best way to value the

company, given the different profiles/exposures of these companies and the relatively low visibility

of the non-cash fair value adjustments.

Exhibit 6: Peer comparison market multiples

Company Segment Price* Market cap* P/E (x) ROE (%) PBV (x) Dividend yield (%)

(C$) (C$m) 2018 2019 2020e 2018 2019 2020e 2018 2018 2019

Duke Royalty Diversified 47.0 111 N/M 25.6 16.6 N/M 3.4 7.7 1.4 4.4 5.7

Franco-Nevada Mining 123.1 23,047 79 65.6 63.4 4.7 5.8 6.5 4.9 0.8 0.8

Alaris Diversified 19.0 697 11 10.0 N/A 9.6 9.5 10.6 1.1 8.5 8.7

Diversified Royalty Diversified 2.7 299 18 13.9 N/A 5.3 8.2 10.9 1.5 8.1 8.2

Boston Pizza Restaurants 17.0 371 13 12.5 N/A N/A N/A N/A 1.4 8.1 7.7

Source: Refinitiv, Edison Investment Research. Note: *Duke Royalty price is in pence, market cap is £m. C$1.65/£. Prices at 2 October 2019.

Financials

Big expansion expected

We expect Duke Royalty to grow its business significantly over the coming years. Management has

indicated that it would like to add £45–100m pa in the next few years. The £16.1m in equity that

Duke has raised will enable it to increase its investment portfolio from the current estimated £80m

to about £105m by end FY20 and a forecast net debt to capital (or LTV) of 14%.

The company has indicated that it expects to pay dividends of 65–90% of earnings and we have

modelled this at close to 85% on average. Although we forecast that Duke will remain a very cash-

generative company, we expect it to keep raising equity to fund this growth.

Our positive outlook in terms of share price is predicated by the potential for the company to finance

growth with equity issuance at rising prices as portfolio returns and scale benefits generate higher

EPS and hence dividend growth. In the table below, we show the impact of any future potential

capital raising and growth in scale of the company on both EPS and DPS, together with the


attractive yields on the prices assumed. In our model we assume that £50m in equity will be raised

at FY21. This will help fund our forecast £45m investment in FY21 and £50m in FY22. These

assumptions mean that the number of shares would increase from the current 236m (with 36.6m

new shares from the £16.1m issue) to 321m by the end of FY22.

This will allow the company to continue to grow and keep its gearing at no more than 30% (it will hit

this level, as discussed above, at end of FY22. As previously mentioned, Duke has capped its

gearing at 30% and uses it to manage its investment pipeline without having a cash drag, rather

than to leverage results.

Exhibit 7: Assumed equity issue and forecast

FY21e

Capital raised (£m) 50

Price of issue (p) 59

EPS (p) 5.07

DPS (p) 4.20

Payout ratio (%) 83%

Dividend yield (%) 7.1%


Exhibits 8 and 9 show the impact of greater scale on Duke’s profitability. We forecast that the

royalty income as a percentage of average investments will reach almost 15% by FY21. As Duke

gains scale, we expect the cost to income ratio to decline significantly and by FY22 to be close to

12%, including unreimbursed transaction costs. The pre-tax margin mirrors this and under our

assumptions rises from an estimated 31% in FY19 to 71% in FY22.

Exhibit 8: Investment flow, royalties received as % of average investment at fair value

Exhibit 9: Cost to income ratio and pre-tax margin forecasts

Source: Duke Royalty data, Edison Investment Research Source: Duke Royalty data, Edison Investment Research

Operating cash yield 8.0% by FY20

We expect Duke Royalty to generate an ROE of 7.7% in FY20, and for this to rise to 9.1% in FY21

and to 12.3% by FY22. Further increases in scale and gearing could increase this ROE. Although

most of Duke’s revenue is royalty revenue received, there is also a non-cash component driven by

changes in the fair value assessment of the investment portfolio. In the income statement, this is

classified as ‘unrealised changes’ in the net change in the fair value of financial assets and

liabilities. This is driven by changes in assumptions regarding the annual reset of the revenue

(capped at 6%) as well as the discount rates used (15.4–17.3% in the last annual report). In our

model, we have assumed a sharp decline in this non-cash component from as high as 39% of total

revenue in 2018 to 0% from FY20. It is possible that the ROE forecasts may be understated as a

result, but at any rate we believe the operating cash flow yield is more important. We see this rising

from 8.0% in FY20 to 11.6% in FY21 and to 14.9% in FY22.

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

0

50

100

150

200

2018 2019 2020e 2221e 2022e

£ m

New royalties advanced (£ m)Investments (avg fair value) (£m)Royalties income % avg. investments, RHS

62

2820 15

31

57 61

71

0

20

40

60

80

100

2019 2020e 2221e 2022e

Cost to income ratio (%) Pre-tax margin (%)


On the cost side, we expect the company’s structural costs to climb to about £2.5m in 2020 and

reach £3.0m in 2022. This figure excludes transaction costs that are not reimbursed (currently

running at c 2.2% of new deals, which the company expects to drop to 1.0–1.5%), as well as royalty

partnership fees. Regarding the latter, Duke employs third-party companies like McKinsey to help

with the due diligence and pays them on a success-only basis if the investment goes ahead.

Typically, these are 3% of revenue and capitalised upfront, but in terms of cash flow are paid

throughout the length of the contract.


Exhibit 10: Financial summary

Year end 31 March £000s FY18 FY19 FY20e FY21e FY22e

INCOME STATEMENT

Royalties received 987 5,024 11,015 17,697 25,673

Change in unrealised 636 652 0 0 0

Net change in FV on financial assets & liabilities 1,555 5,676 11,015 17,697 25,673

Interest income 0 257 943 936 950

Other income 242 208 100 70 30

Total income 1,797 6,140 12,058 18,703 26,653

General administrative costs (1,318) (1,845) (2,550) (2,800) (3,080)

Transaction costs (488) (808) (360) (585) (600)

Other operating costs 0 (42) (6) (8) (9)

Operating expenses ex-royalty participation fees (1,806) (3,395) (2,916) (3,393) (3,689)

Royalty participation fees (849) (432) (480) (270) (300)

EBIT (858) 2,314 8,662 15,040 22,664

Interest and finance costs (0) (397) (1,808) (3,707) (3,797)

Profit before tax (858) 1,916 6,854 11,333 18,867

Taxation expense 0 (119) (685) (1,133) (1,887)

Minorities 0 0 0 0 0

Attributable net income (858) 1,797 6,169 10,200 16,980

Adjusted Profit Before Tax 232 3,133 6,169 10,200 16,980

Adjusted net income 232 2,992 6,169 10,200 16,980

Ratios and per share

Weighted number of shares (diluted) mn 62 165 218 279 321

End of period number of shares (diluted) 97 200 236 321 321

EPS (reported), pence (1.38) 1.09 2.83 3.66 5.29

EPS (adjusted), pence 0.37 1.81 2.83 3.66 5.29

EPS (diluted, adjusted), pence 0.37 1.81 2.83 3.66 5.29

DPS (pence) 1.50 2.70 3.00 4.00 5.00

Operating cash flow per share 0.40 2.49 3.76 5.46 6.99

Book value per share 0.33 0.36 0.37 0.43 0.43

P/E (x) N/M 25.4 16.6 12.8 8.9

P/BV (x) 1.38 1.28 1.26 1.10 1.09

Cost to income ratio (%) 147.8 62.3 28.2 19.6 15.0

Pre-tax margin (%) (47.8) 31.2 56.8 60.6 70.8

ROE (%) N/M 3.4 7.7 9.1 12.3

Operating cash flow yield (%) 0.9 5.4 8.0 11.6 14.9

Net debt to capital ratio (net cash) % (7.5) 9.0 14.0 7.7 30.1

BALANCE SHEET

Financial assets at fair value through profit or loss 23,569 71,232 95,232 140,232 190,232

Trade and other receivables 6,687 178 200 220 242

Loans to royalty partners 0 9,626 9,900 11,000 11,000

Cash and cash equivalents 3,165 5,894 5,622 5,388 5,248

Other 0 203 (1,057) (525) (916)

Total assets 33,421 87,132 109,897 156,314 205,806

Equity 32,244 72,108 88,028 137,074 137,994

Trade and other payables 260 714 708 929 1,431

Financial liabilities and borrowings 917 13,058 19,691 16,691 64,691

Other 0 1,252 1,470 1,620 1,690

Total liabilities 1,177 15,024 21,870 19,240 67,813

CASH FLOW

Receipts from royalty investments 987 5,097 11,015 18,633 26,623

Interest on loans to royalty partners 0 257 943 936 950

Payments for royalty participation fees 0 (161) (480) (270) (300)

Operating expenses paid (786) (1,392) (3,267) (4,078) (4,822)

Other 45 309 0 0 0

Net cash inflow/(outflow) from operating activities 246 4,110 8,211 15,221 22,451

Royalty investments advanced (22,932) (25,033) (24,000) (45,000) (50,000)

Capital step cash payment 0 (4,274) 0 0 0

Other (6,745) (3,861) 0 0 0

Net cash outflow from investing activities (29,678) (33,167) (24,000) (45,000) (50,000)

Proceeds from share issue 19,840 44,010 16,100 50,000 0

Share issue costs (766) (2,398) (800) (2,500) (500)

Dividends paid (925) (4,023) (6,209) (11,153) (16,060)

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


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.

Principal shareholders (%)

Hargreave Hale 15.30%

Blackrock 10.04%

Axa Investment Managers 9.13%

Downing 6.37%

GLG Partners 5.11%

Janus Henderson 4.50%

Partners Value 4.38%

Capital Group 4.27%

Companies named in this report

Franco-Nevada (FNV.TO), Diversified Royalty (DIV.TO), Boston Pizza (BPF_u.TO), Alaris (AD.TO), Vale (Vale3.BZ), Glencore (GLEN.LN), BHP (BHP.AU)

56% 19% 14% 11%%

UK Ireland Offshore EU


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duke royalty initiation of coverage...65–90% dividend payout policy. value creation merits premium...

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