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Update: DRI Healthcare Trust is Still Insanely Cheap
The company has delivered on promises but still trades at 3x trailing cash flow
I last wrote about DRI Healthcare Trust (TSX:DHT.un)(TSX:DHT.u) back in May of last year.
I liked its cheap valuation, its generous dividend and its exposure to the healthcare industry, an area lacking in my portfolio. I disliked the large management fee and the impending royalty cliff, but they weren’t enough to scare me off. I entered into a small-ish position, confident management would put freshly raised capital to work effectively.
I recently took another look at the company to see if the thesis had changed and discovered I think I like the stock even more than I did last year. The story has gotten significantly better, yet the stock price has barely moved.
Let’s take a closer look.
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(DRI reports in U.S. Dollars and has a U.S. Dollar listing on the TSX. All figures are in USD unless stated otherwise)
Since I had approximately 14 subscribers back when I wrote about this company originally, let’s start over from the beginning. I’m sure even the people who read this in the first place could still benefit from a review.
DRI Healthcare Trust invests in global pharmaceutical royalties, allowing inventors, academic institutions, or even cash-strapped biotech companies to exchange an ongoing royalty in exchange for a lump-sum payment. Drug creators tend to like these deals because it allows them to cash out immediately, rather than wait for sales that may take years to fully ramp up. The lump sum can then be used to buy a house, expand a lab, or fund new drugs, depending on an inventor’s motivation.
The trust is managed by DRI Capital, one of the oldest and largest drug royalty companies. DRI Capital has been around since the 1980s, slowly growing its portfolio into a multi-billion dollar enterprise, acquiring 70 royalties on 40-plus drugs. I’m comfortable with management of this fund, even if the management fee is high.
As you can see, DRI has a pretty solid track record.
As it stands today, the trust’s portfolio consists of 23 royalty assets spread among 20 different products.
Despite DRI’s long history in the business, the royalty trust hasn’t been around for very long, only debuting on the TSX in 2021. It was listed for close to $10 per share before collapsing to today’s level of $5.50.
One reason for the crummy performance since the IPO is the company didn’t exactly put its best assets into the public offering. It had a portfolio stuffed with drugs with upcoming royalty expirations, creating a situation where investors rightfully questioned the medium-term health of the company. The average length of royalty was eight years at the time of the IPO, but a few of the big earners were out before that.
Part of the reason for the IPO was to raise cash to put to work in new royalty streams. Management vowed to do so, but investors were skeptical. Reinvestment risk is huge in a situation like this. What happens if there are no good royalties?
Management set a target to invest $650-$750 million by 2026, or five years after the IPO. The company has deployed nearly $500M so far, plus signed deals for an additional $176M in options and milestones, essentially second chances to invest in drugs that exceed expectations. The target has been upped to deployment of $850-$900M by 2025.
As it stands today, DRI has acquired enough new revenue to ensure earnings roughly stay flat through 2030, with earnings upside potential if the deals perform a little better than expected. Add in the goal of deploying an additional $200-$300M by 2025 and that should translate into some earnings growth starting either next year or the year after that.
It has also been busy acquiring more capital to put to work, as evidenced by a recent preferred share issue. The deal was worth $115M for series A and B preferred shares at an interest rate of just over 7%. Series A (about $95M worth) is a 50-year preferred share, expiring in 2073. Series B (about $20M worth) comes up for renewal in 2027. Note the Series A preferred share resets at a 10% interest rate after December, 2027. The preferred share deal also included approximately 6M warrants, which can be exercised for US$11.62 per share at any time before February 8th, 2028.
The proceeds of this issue plus cash on hand increases cash available for acquisitions to approximately $150M today.
I’ll be honest and say I don’t particularly like the terms of this preferred share issue, but I’ve come to realize smaller companies must pay much more dearly for their financing.
The nice thing about investing in a royalty company is there isn’t much in the way of overhead. The entire company can fit on one floor in a moderately large office tower. This translates into high margins and lots of cash available to reinvest in new deals, pay to shareholders via dividends, and buyback undervalued shares. DRI is doing all three.
As I type this, DRI trades at just US$5.50 per share, putting the stock at just 3x trailing cash flow. That’s especially cheap considering we can now reasonably expect earnings to stay flat or grow slightly through 2030.
In the meantime, investors get to collect a solid US$0.075 quarterly dividend, good enough for a 5.5% yield. The company also paid a US$0.1655 special dividend at the end of 2022 (after an even larger special dividend in 2021), giving the stock a trailing yield of 8.5%. It also repurchased US$7.3M worth of shares in 2022 and continues to repurchase shares in 2023.
I’ll come right out and say I don’t like the management fee, which is 6.5% of all cash receipts. I’m willing to pay it because I like DRI’s long-term track record, but I’d much prefer to invest in something where I got that expertise at a much more reasonable rate.
DRI does own a little over 4% of all units outstanding, which is a decent start. But it’s easy to see why investors might see such a small ownership stake by the manager and come to a conclusion that management’s interests aren’t aligned with shareholders.
The market is also very clearly in a wait and see mode with DRI. Investors want evidence the earnings aren’t about to fall off a cliff and so far all they have is management’s assurance. As mentioned, I like what management is doing, but investors are treating it with at least a little bit of skepticism. If the earnings don’t come I see downside potential.
But at the same time this stock passes the cheapness test, and I think DRI’s long-term track record means it passes the quality test. Put those two together and I think we have a somewhat reasonable margin of safety there.
The bottom line
I’ll admit this one has a few more warts than I’d like. It reminds me a lot of Polaris Renewable Energy, which is also cheap because of some pretty obvious risks.
I like to minimize the downside potential in situations like this by limiting my exposure to the name. I intentionally keep my position to under 1% of my total assets as a just in case hedge. I think there’s virtually zero chance Telus or Fortis blows up, but there’s a non-zero chance DHT.un blows up. I’m not saying it’s a big chance, it’s just a bigger chance compared to the blue chips of my portfolio.
But I like it as a smaller speculative position, and I just added a little bit more.
Author is long DRI Healthcare Trust. None of what was written above constitutes investment advice. Consult a qualified financial advisor before making any investment decisions.