Alaris Royalty: Sandbox Investment Demonstrates The Need For More Due Diligence
- Alaris Royalty surprised investors with a shoe drop just before the annual results.
- The decreased value obtained for Sandbox again raises questions of how in tune the management is with underlying portfolio issues.
- The stock is cheap relative to our benchmark, but the company has been regularly riddled with above-average problems.
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Amounts being referenced could be either USD or CAD and will be indicated within the article.
We have always viewed Alaris Royalty (OTC:ALARF) as a high-risk, high-yield investment. At times, we have noted price points where the risk-reward is appealing and made a buy case for it. Alaris got smacked down as it released some new information on its portfolio on February 28, 2020. We decided to take a fresh look and see if this warranted making another case to purchase the stock.
Alaris redeemed its investment in Sandbox, something it had mentioned that it was pursuing.
CALGARY, Feb. 28, 2020 /CNW/ - Alaris Royalty Corp. ("Alaris" or the "Corporation") [TSX: AD] is announcing today the sale (the "Sandbox Sale") of Sandbox Acquisitions, LLC ("SA LLC") and Sandbox Advertising Limited Partnership ("SA LP" and, together with SA LLC, "Sandbox") to a third-party buyer (the "Buyer"). As a result of the Sandbox Sale, Alaris received total consideration of approximately $32,609,236 (the "Consideration") consisting of: $20,003,644 for the senior debt ("Senior Debt") Alaris held in Sandbox; $1,916,903 for unpaid interest on the Senior Debt; $9,144,448 for a partial repurchase of preferred equity held by Alaris in SA LLC, including $4,115,000 escrowed for working capital adjustments and indemnity obligations (the "Escrowed Cash"); and accrued distributions on the preferred equity of $1,544,241. Alaris may also receive up to an additional $2,000,000 ("Earnout Proceeds") pursuant to an earnout if certain financial performance criteria are satisfied. The Sandbox Sale closed on February 28, 2020. Unless otherwise stated all references to dollars are references to United States dollars.
Source: Alaris Press Release
While the markets themselves have been in a rather tumultuous state, there is no denying that the news was not well received and Alaris has dropped 11% since then.
Data by YCharts
The Key Issue
The sale was at a price far lower than anticipated.
The Sandbox Sale resulted in returns much lower than Alaris had initially anticipated, following a material reduction in the initial offer of the Buyer. Based on the Consideration and the $20,209,774 of distributions paid to Alaris by Sandbox over the course of our partnership, the overall IRR on the investment is between -9% and -16% depending on the amount, if any, of Escrowed Cash and Earnout Proceeds received by the Corporation.
Source: Alaris Press Release
As we read that, we were surprised that Alaris was fine with a materially lower offer by the buyer. There was no additional context presented by the company as to why it was forced to sell. Alaris received a total of about $43.5 million CAD for the transaction. To put that in context, Alaris has investments of close to $80 million CAD in the company. This consisted of $53.17 million CAD in a regular (royalty producing) investment.
Source: Alaris Q3-2019
Additionally, Alaris also held debt of the company in the amount of $26.55 million CAD.
Source: Alaris Q3-2019
On analyzing the press release, it appears that Alaris essentially got the debt paid back at the full value. But the hit to the equity (royalty) investment was incredibly large. Alaris got paid about 25 cents on the dollar and even that number assumes that the company gets the maximum payment that it can. Beyond that, what is even more alarming is that Sandbox did not remotely appear to be a distressed investment. Alaris had it covering its annual distributions moderately well over the last four quarters.
Source: Alaris Presentation
In fact, Sandbox was paying it close to $8 million CAD a year in royalties and Alaris redeemed this for a total maximum payout of $12.77 CAD million.
Source: Author's calculations
That, to us, is a complete and unmitigated disaster. Beyond the obvious hit to earnings, it casts complete doubt on the ability of the company to honestly assess its investments. The "lean and mean" structure (Alaris boasts that it has very few employees) also results in a lack of due diligence at the head office and Alaris is too heavily reliant on third party numbers. Even more worryingly, this has happened a few times before. Providence, another one of Alaris' investments, went from a greater than 2.0X coverage to under 1.0X in one quarter.
Source: Alaris Presentation
Providence was apparently the victim of a Ponzi scheme but the unusual item was that Providence was owed more than its annual revenues by one customer, LuLaRoe. Body Contours Centers has finally begun to show traction, but the investment had got into trouble in the very first quarter.
Based on unaudited statements provided by management for the year ended December 31, 2018, revenue is consistent with the comparable period while EBITDA has decreased due to challenges with sales performance at identified locations as BCC significantly grew their number of clinics. BCC management has addressed the issue through focused recruiting and onboarding efforts with improvements expected in future quarters. The BCC distribution will be adjusted annually (commencing January 1, 2020) based on the change in same clinic sales, subject to a 6% collar.
The Earnings Coverage Ratio has declined since the last period and is now below 1.0x. BCC has no debt and a large amount of cash reserves, the Corporation expects their ECR to improve in the coming quarters.
Source: Alaris Q3-2018
All in all, Alaris needs to invest more in due diligence of its companies as the 10-12% royalty yields have certainly not come pain-free.
Our model for this one was to buy when we get at least 400 basis points of yield premium over the Baa yield.
Data by YCharts
The reason was that we view Alaris as a rather unpredictable investment that lends to companies that it cannot remotely monitor. The royalty payments reduce risk as Alaris is exposed to the top line vs. the operational leverage. But everything we have seen so far makes us wonder if the company would be better off investing more in its due diligence and monitoring process. We are hence using a higher yield spread as our benchmark and we will only buy this if we get 600 basis points of yield over Baa bonds. For now, we rate the company at neutral.
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