Alaris Equity Partners... Yield Yield Yield

I was hesitant to write about Alaris because at it's core I couldn't think of a ton to talk about going in. It's a big yield... I think it's sustainable+... what else is there to say?

Introduction 

Alaris is messy to talk about because it's more like a closed end fund of private preferred shares than a company. And I mean when you're telling that story the only thing to gravitate to is 'look, they pay me.' Which is somewhat obvious as everyone's screen quotes them dividend yield. If you had asked me 6 months+ ago about Alaris, I'd have said I own a very small amount but given the ☠️☠️☠️ and chaos in the preferred market, I'm not surprised it's sitting there at that yield. Last year had some one off boosts and a Q1  settlement made this year the opposite.

One aspect that bugged me about Alaris, or rather frequently nullified enthusiasm is how readily they'd use their equity as a currency for capital deployment. It felt like a cap on upside when the price approached something like fair value. 

Yeah, you get the yield, yes you get minor organic growth and some capital deployment but too much of a rerate would be difficult. The second thing that tempers optimism is that I don't love preferred shares and in this case the preferreds weren't in blue chips. Upside capped so no explosive upside on great investments but still lots of downside for mistakes. At least, that's how I think of preferreds and I consider Alaris as preferred equity.

As price declines however, it because easier to look past the potential someday less positives and towards the 'well that's pretty decent for today's.

Bad Company Syndrome

Alaris suffers from what I sometimes refer to as Bad Company Syndrome. No I don't hate it's friends or associate it with a battlefield, I'm referring to stock price. "Everybody knows" good stocks go up and bad stocks go down. Alaris has been declining in share price for a decade. This reinforces the belief that it's not worth people's attention or time. I will say that it probably wasn't worth the multiple that it got at the peak. Despite that it hasn't really lost value since so much as had valuations and expectations crater. Also, in fairness to the company, it's MUCH more difficult to have your share price increase when you're giving back most of your profit to shareholders. It's easy to see progress when every quarter the stock is higher, much harder when your bleed out is trying to be offset by dividends. I don't think this is a bad company but I do think it's important to look at what you're getting in the right way. If this is a 'compounder' most of the compounding will be DIY.

The last thing I wasn't thrilled about was that they did cut and rearrange their dividend on me not too long after I bought it. This was understandable given the uncertainty and the fact that for a while they didn't have access to share capital to grow... but in the end it was both unnecessary and hasn't yet been fully reversed. This is another aspect that contributed to "Bad Company Syndrome." 'Good Companies raise dividends, bad companies cut them'

Also, unlike a telecom or largecap utility, you've never heard of Alaris so the high yield looks more dubious.

Alaris' Structure

Alaris is structured as an income trust which means it yields more because you pay the taxes. Essentially, they're required to pay out much of their taxable net income and in exchange get very favorable tax treatment.

I mentioned before that they're essentially preferred equity. They are but given that they're more custom, private, preferred equity, the terms are often a bit different. That's to say, they're flexible. Given the playing field where they operate (less established perfs) the deal structure can compensate. In addition to higher starting yields, Alaris factors in escalators that grow their payments received along with revenue. Now there are caps, and they're not exactly high but it does allow for some upside participation.

This is the same structure as REITs and those aren't exactly in favor right now either. Obviously, Alaris isn't a reit... but I've heard multiple people call it one. In the end, I don't argue too much because with their old name "Alaris Royalty..." It is a Royalty Equity Income Trust. 

Beyond that, as I mentioned, it must be noted that the giant distribution isn't a dividend anymore. Most of it is treated (and taxed) like income. Depending who you are that could be a negative. You may also get some Return of Capital from time to time. This is much more favourably taxed... In that it isn't... Except that it lowers your cost basis so eventually it may increase your capital gains tax burden.

Beta

One thing I've noticed about Alaris frequently is that it trades like a beta play of the Canadian market. On one hand, that makes sense because of the leverage & the smaller company exposure. On the other hand, most of their exposure is American companies and not directly tied to margins or equity multiples. So if the thinking is that a terrible Canadian economy should be value destructive, well, this isn't what I'd be dumping... Unless the US is also bad... In which case you probably get more rate relief... But that's a whole other can of worms.

Interest Rate Environment

On the positive side, high rates hurt the funding environment and the scarcity of capital mean higher returns on invested capital. This should play through positively for Alaris's position as a funder.

On the negative side, being levered at 3x net debt to EBITDA into a more business stressed environment isn't the ideal position to put a lot more funding to work.

Overall I think I'd still side with my past comment that we're in a higher ROI environment and that should more than offset leverage costs. This is almost like the whole "higher interest rates are good for banks," fallacy that we're working past. It is but it devalues old investments and is offset by higher cost of capital. How long that environment lasts is anyone's guess.

Distribution Sustainability

I'm always hesitant to suggest a high yield distribution is 'obviously' sustainable. If it were obvious or risk free the price would probably be different. So, of course there are scenarios where the distribution gets reduced. That said, I think there's a decent buffer here.

2022 probably wasn't the cleanest data point due to a large capital return event but even rewinding to before that the revenue trend was up and the payout ratio wasn't stretched. If business(es) were running normally, the payout ratio should be in the low-mid 60%s excluding recent investments. It really should be more than sustainable. It should be gradually growable. If I had to bet, I'd think that in the next 6 months we get a small distribution hike. (0.01 or 0.02 per quarter)

It interests me more at this time to know what the point is where they decide enough is enough and restart the buyback.

Diversification

Alaris has a reasonable portfolio of active investments. Plenty more have been concluded at various levels of success/failure. I think the amount of positions is reasonable and solid enough but for something like this, would prefer a bit more size balance... Something to grow into I think.

Growth

Reset growth hasn't been excessive, but it has been steady. This is essentially what I'd call organic growth... But again, this is without additional capital. 2-3% growth with a company spending all of their capital to achieve it would be pitiful but without capital it's closer to an inflation hedge... Most years at least.

Alaris has since invested another US$60 into a new partner "The Shipyard" at what should generate a 14% pre tax yield. That's probably a decent idea for a starting point of what AD is looking at on their fresh investments. That's not bad at all as a starting point (although it has no consideration for risk or effects of the collar + or -). That should spit out CAD$11M (before interest and carrying costs).

IRR

Overall, you can see how a decent return can come together even just factoring the distribution plus minor growth from existing contract escalators.

You then get a bunch of capital available for redeployment that looks to have minimal expectations attached to it. I think this gets you into the teens IRRs. How far into the teens starts to depend on economic and ROI forecasting.

Expected returns with most companies converge on earnings yields. Maybe the company can do slightly better with retained cashflow, maybe it's slightly worse... Either way most things mean revert.  Getting a mostly stable teens cashflow yield is probably a decent prospect for above average long term returns.

Cheap 

Generally, I'm of the opinion that "cheap" isn't a thesis. That's why I layer on some skepticism earlier. It was cheap but I didn't see it getting to be anything else. It's still cheap and there isn't a reason why it needs to get uncheap. At this point however, I think we're significantly closer to the point where the yield becomes enough of an argument... And we're far enough away from a point where their currency starts working against your risk/reward. The thesis I guess rhymes with cheap in that... "I don't think they'll have to cut the distribution and eventually the market will appreciate that... And if not, that's fine too."

What's it worth?

Alaris is a very ok company. For a seemingly volatile stock, it's financial performance has been rather consistent. Not amazing, not bad just steady. This along with their return metrics & type of business make me think that the most reasonable target is book value. So almost $20. That's probably where your expectations should be about average. 

The interesting thing about getting beyond that is cheaper capital would make it look like an intrinsically better company deserving of cheaper capital. In that sense it could be argued that fair value is what you make of it. Half price capital earning 10% delivers a ROE and book value growth beyond something that should trade at book. I call this the Realty Income Syndrome. It traded at +2.5x book a decade ago. As I mentioned before I'm not convinced it should have.

...I hate digressing into reflexivity discussions, they make so much seem pointless.

Conclusion

I think it's a solid idea at the moment. What it would take to be especially good is both continued solid capital allocation and probably a higher hurdle rate for when equity is used for acquisitions. Don't get me wrong, I don't think they'd issue equity at this price, not do I think they're negligent with equity uses. I'm only saying that a slightly accretive acquisition may look like minimal help... But it also makes it MUCH less likely to get a more favourable cost of capital.

Overall with the amount of capital returned to shareholders it's easier to not stress about smaller things where there may be room for improvement.

Disclosure: I own units in Alaris Equity Partners $AD-UN.TO.

Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.