Alaris Equity Partners: Too Cheap After Multiple Dividend Cuts
Why I think this 7.8% yield could grow 5%+ per year
A dividend policy is a funny thing.
Let’s talk for a minute about stocks like REITs, telcos, or other lower growth companies that pledge to pay out virtually all their earnings back to shareholders.
This policy works out great, assuming the underlying earnings continue to march slowly forward over time. But oftentimes things come up, and throws the whole plan for a loop. A small decline in earnings can be a very big deal if you’ve committed to paying out 80 or 90% of earnings.
Such stocks always get whacked when that happens, as investors hit the sell button and ask questions later. And hey, I totally get it. I recently wrote about how a dividend growth strategy with a quick trigger during bad news is likely one that outperforms over time.
Today, I’m going to talk about a stock that I believe is suffering from just that, a too aggressive dividend payout policy that was exposed during 2020. This stock has paid the price for its sins and is currently putting up excellent numbers, but short-term oriented investors are too worried about prior issues to see the opportunity right in front of them.
That stock is Alaris Equity Partners (TSX:AD), and I think it’s an excellent opportunity for long-term investors. Let’s take a closer look.
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Alaris is, essentially, in the private equity business. The company provides capital to mid-market companies in boring industries to use on things like funding expansion programs, pay off debt, or buy out other partners. Rather than take an equity position like so many other similar firms would do, Alaris opts for a preferred share structure with rewards based on sales increases or early repayment.
Let’s take a look at a recent deal as an example. In November 2022, Alaris invested a total of US$24M in a company called Sagamore Plumbing and Heating. The deal consisted of US$20M in preferred shares and US$4M in common shares. The $20M in preferred shares will pay a dividend of 15%, or US$3M per year, increasing or decreasing at the same rate as sales, up to a maximum of 6% annually.
Sagamore has no debt and earns approximately US$5-6M per year. The funds will be used to fund certain growth projects and liquidity.
The rest of Alaris’s portfolio is filled with companies like Sagamore. It has a total of 18 investments in boring industries like construction, technical services to nuclear power companies, rebar fabrication and installation, IT consulting, health and fitness clubs (Planet Fitness, likely the only company you may have heard of), cosmetic surgery, and fleet management. These are not home run venture capital-esqe investments. They’re intentionally boring.
It has worked out quite well over time. Since Alaris’s 2008 IPO, it has generated a return on assets of approximately 16% per year.
Here’s a list of investments and the amount they’re projected to bring in during 2023.
This type of financing is a surprisingly lucrative growth area. Most middle market companies have no interest in public markets, which don’t really offer them much benefit. A listing on the stock exchange costs at least six figures per year (more likely closer to seven), comes with far greater disclosure requirements, and is just generally a pain in the ass. Why deal with a bunch of small retail investors when you can just find one partner like Alaris and keep them updated once a quarter?
It works from an investor’s perspective, too. Small caps are an interesting spot in the market most investors don’t bother with. Alaris gives you the opportunity to own a bunch of them. The way these deals are structured is they offer equity-like return profiles with better security, since Alaris is putting its capital into preferred shares.
And, most importantly, the model is working to deliver excellent returns. This is where I’d normally post a long-term price chart, but online calculators got messed up when Alaris converted from a corporation to an income trust in 2020. So I’ll give you this instead. From a recent investor presentation:
In other words, a $100k initial investment made 15 years ago would be worth more than $300k if dividends were reinvested in more Alaris shares. And if you didn’t choose to reinvest your dividends, the original stake of 8,333 shares would offer $11,333 per year in dividends.
What has fueled these long-term returns? It has been primarily increases in deals funded, even including a certain amount of dilution as shares were issued to help goose the top line. Revenue increased from just over $50M in 2013 to $198M in 2022, or growth of approximately 15% per year. The bottom line did even better, increasing from $30M to $130M. Even after accounting for dilution, Alaris increased its bottom line from $1.09 per share in 2013 to $2.79 in 2022.
Most of Alaris’s earnings come from the underlying cash flow generated by its investments, but every now and again the company gets surprised by having its interest bought out. This generates a nice one-time earnings bump as the preferred equity gets repurchased at a premium, but at the expense of forward returns. That capital must then get reinvested.
So far, it has worked. Alaris hasn’t had many problems spending its cash on new investments. But 2022 was a bit of an odd year. It saw redemptions from two large partners, and cash on the balance sheet ballooned to more than $60M at the end of last year. The market has officially entered wait and see mode, cautiously hanging out to make sure Alaris doesn’t do anything stupid with this windfall. Higher interest rates may have also curtailed Alaris’s growth, but as I’m typing this government bond yields are collapsing in both Canada and the United States.
Why am I bullish on Alaris? Why buy today, compared to a year or two ago?
First, let’s talk about valuation. As mentioned above, Alaris is unlikely to repeat last year’s numbers, which saw it earn $2.79 per share. We’ll be conservative and assume Alaris doesn’t put another nickel to work in 2023 and it’ll generate $150M in revenue. That’s a 20% haircut compared to 2022, so we’ll discount earnings the same amount. That works out to $2.23 per share.
Alaris trades at just over $17 per share, currently. That puts shares at approximately 7.5x what I think are conservative earnings. At its peak, when shares were above $35 each, Alaris traded for approximately 20x earnings. I’m not saying we’ll get there again, but 7.5x forward earnings — and just over 6x trailing earnings — is too cheap.
A 20x multiple on 2023’s projected weaker earnings still gives us a target price of $44+. Again, I’m not saying Alaris shares get there. All I’m saying is there’s a big disconnect between the valuation of shares today and the valuation of shares in the past.
One reason Alaris shares are cheap is the dividend. The dividend has been slashed twice now, once shortly after its 2008 IPO and once again in 2020. But the dividend was raised steadily in between those cuts, going from a low of $0.84 per share annually to a high of $1.65 per share. The payout has been raised three times after being cut to $1.16 per share in 2020, and is currently sitting at $1.34 per share. That works out to a yield of 7.8%.
No investor likes to see dividend cuts. Certainly not me. But I think the days of dividend cuts are behind Alaris. The new payout is less than half 2022’s earnings, and only at 60% of 2023’s conservative earnings projection. There’s plenty of wiggle room here.
To look at it another way, the current portfolio is invested at a yield of 13%. The distribution is 7.8%. That leaves us plenty of wiggle room if some bad things happen.
I also think there’s loads of potential for Alaris to put some (or all) of that $60M to work, plus it has available liquidity of an additional $300M. Say it puts $200M to work at a 12% return, which gives us an additional $24M in pre-tax earnings. Call it $20M after tax. Multiply that by 45M shares outstanding and it gives us additional earnings of $0.44, or enough to return earnings to 2022’s levels. And there’s still dry powder there to do the next deal.
I’ve gone most of this post without mentioning Alaris’s most recent deal because it could potentially be a game changer.
Alaris recently restructured its deal with Body Contour to bring in Brookfield as a partner. Alaris will own US$145M worth of a new series of preferred share paying 8.5% per year, plus the ability to convert to common shares at previously agreed upon valuations. Essentially, this is a preferred share deal that pays 8.5% plus a free option to convert to common shares. There’s also a 1% per year escalator on the distribution after five years.
This is a little unlike deals Alaris normally does. For the most part, they’re not interested in conversion rights. They want to own straight preferred shares. The reason they did this is a portion of Brookfield is in on this deal, putting in US$400M to Alaris’s US$145M.
At 8.5%, this is Alaris’s lowest yielding partner. This will hurt earnings compared to the deal negotiated with Body Contour years ago. But, Alaris was essentially forced to do this deal. Body Contour wanted more growth capital than Alaris was able to provide.
The reason Alaris participated in the deal (at arguably crummy terms) is this transaction gives it an in with Brookfield. Alaris took a portion of the deal, found someone willing to do the rest and, perhaps most importantly, will collect an annual transaction fee for its troubles.
Yes, Alaris has entered the asset management business. And it entered the space with a bang, putting together a deal with one of the biggest investors in North America.
The company is cautious when talking about growth potential for this business. And, as Dream Asset Management and Morguard have proven, investors aren’t super jazzed about asset managers hiding amongst other businesses. If you wanted an asset management business for free, both of those companies are offering it. But this is certainly a step in the right direction, and it meshes real well with Alaris’s scalable business model. It can take a piece of these deals and bring in partners for the larger portion.
The bottom line
I think Alaris is one of those stocks that will be chronically misunderstood by the market. It doesn’t screen particularly well, people assume it has a lot of leverage, and a recession probably won’t be good for at least a few of its partners. Plus, as mentioned, the dividend cuts alienated the income crowd.
In other words, this is exactly what I’m looking for. I want overlooked dividend payers that offer good payouts and capital gains opportunities. Alaris checks off both boxes.
I think the company can pretty easily return to $2.50 per share in earnings by 2024, and then grow the bottom line by 5-10% per year after that, on average. The earnings will likely be lumpy, but I never mind that.
At 10x earnings, that translates into $25+ per share. And it still puts the dividend at a 5%+ yield. I think it’s a very reasonable target over the next 2-3 years, representing close to 50% upside on the share price alone.
If it works out this is the kind of dividend I really want. Shares yield more than 7% today. Add in an annual distribution hike in the 5% range and this is the kind of stock that can help pay for a lot of rounds of golf.
Disclosure: Author owns Alaris Royalty shares
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Alaris has been around for years, so this concern may be unfounded, but it seems like the business model has a flaw.
If a business performs well, Alaris will get bought out since success provides the opportunity to access cheaper capital. That leaves underperforming businesses in the portfolio. If we’re headed for a recession, could Alaris end up involuntarily pulling the flowers out of the portfolio while getting stuck with weeds? I am wondering if that concern is why Alaris transitioned to pref shares from royalties.
The analysis of reviewing stocks for high dividend yields cannot be done without considering that investors can now get attractive and safe returns through high interest savings accounts.
This would imply investors expecting an even higher return on stocks or simply leaving this asset class for the time being.