Stock Analysis: DRI Healthcare Trust

I’m the first to admit I don’t have much experience in the healthcare royalty trust business, for a couple of reasons.

Firstly, I don’t come across many companies operating in the industry. Besides the stock we’re going to talk about today, I don’t think I’ve ever stumbled upon a healthcare royalty stock. Alaris has dabbled a bit in healthcare, but they’ve mostly invested in the clinic side of things. They don’t invest in any drugs.

And secondly, I’ve never really understood the reason for royalty financing in the first place. If a company believes in a drug they’ve just concocted, why bother selling a chunk of future profits for a payout today? Doesn’t that just benefit another company at the expense of your own shareholders?

It turns out there are a few compelling reasons to sell off at least a portion of your ongoing royalty income. If you’re a university or other non-profit research firm, a lump sum often makes more sense than ongoing payments. You can buy a new building or build that new lab. And if you’re the inventor of a drug, it makes sense to take a payout now rather than taking your chances on how well the drug does.

A lump sum also helps take risk off the table. Sure, your MS or HIV drug might be doing well today (and is protected by a patent), but there’s nothing stopping someone else from developing a new drug that treats these diseases. That’s capitalism, baby.

And if you’re a biotech company with just one or two drugs that are actually generating revenue, it makes sense to take a lump sum and pour that cash into the development of new drugs. We all know how the market would value such a name.

From an investment perspective, health care royalties are an interesting asset. Health care spending in general isn’t tied directly to GDP, making it an interesting asset to own when times are uncertain. If you’re sick, you’re going to spend what you need to get better.

Health care royalties aren’t going to be very correlated to the rest of your portfolio, either. Drug royalties keep coming in no matter what the rest of your portfolio does. If anything, an uncertain overall economy is going to be good for royalty companies, since it’ll encourage more drug developers to take their cash today, creating a deal rich environment.

An aging population means our overall healthcare spending versus GDP only has one direction to go. There’s a reason why every investing thesis about the industry mentions this fact.

Put it all together and you have a few interesting reasons to take a closer look at the sector. Let’s go ahead and do that, staring the only healthcare royalty company I’ve ever come across — DRI Healthcare Trust (TSX:DHT.un)(TSX:DHT.u).

The Skinny

DRI Capital has been investing in healthcare royalties for more than 30 years, but the publicly-traded trust on the TSX has only been around for a little over a year. In February 2021, DRI raised some $365 million listing 36.5 million shares on the TSX for $10 each.

(All financials will be in USD for this post, and we’ll compare them to the USD denominated share issue to keep things simple)

DRI Healthcare Trust specifically has 18 different royalty streams from 14 different products. Here’s a list of the main assets, including when the royalty is expected to expire.

You can see some of these assets will start to run dry as soon as 2023, with a few more only lasting 2-3 years after that. No wonder investors are a little nervous about the company.

Management is quite aware of this and has a plan to invest spare cash into longer-term assets. The target is to deploy between $650 and $750 million of cash into new royalty streams over the company’s first five years as a publicly-traded entity. It has been successful so far, putting up to $186 million to work in 2021.

Let’s take a bit of a closer look at one of those transactions to see just how attractive the medical royalty space can be.

The trust acquired the royalty stream for a drug called Vonjo for $60M, which expires in 2034. The royalty structure breaks down like this:

• 9.6% on sales up to $125M

• 4.5% on sales from $125M to $175M

• 0.5% on sales from $175M to $400M

• Zero on sales after $400M

We can look at CTI Biopharma, which is publicly traded, for more info on Vonjo. Here’s what they’re telling investors:

• Launched in March

• Had $2.3M in sales in less than a month, beating expectations

• Total market of $3B in total myelofibrosis drug market by 2026

At the current run rate of about $30M per year in sales (which is ridiculously conservative, but let’s look at it as a worst-case scenario), DRI’s $60M investment would generate $2.9M annually in royalties. Best case scenario is greater than $400M in sales, which would generate $15.5M in annual royalties. I’m no drug royalty analyst, but I’d wager the outcome of this investment would be between $10 and $15M each year in royalties.

Not bad for a $60M investment that expires in 2034.

Ultimately, we don’t know how the investment will do. And CTI isn’t offering much in sales guidance, which makes sense. The last thing they want to do is overpromise and underdeliver. But as you can see, the investment works out pretty well if a few things go right.

The current portfolio is also delivering gobs and gobs of cash each quarter, showing that the folks at DRI have figured out a thing or two over their years of investing in the space.

In 2021, the total portfolio delivered $1.85 per share in adjusted earnings, which is essentially earnings before the trust amortizes the assets on its balance sheet. In its most recent quarter it did $0.49 per share in adjusted earnings.

These are massive earnings numbers for a stock that trades hands at US$5.50 per share.

It’s pretty obvious why this thing is so cheap. Investors are worried earnings are about to fall off a cliff and management won’t be able to acquire new assets fast enough to make up for the earnings decline. Analysts are equally uncertain; just about every question during quarterly earnings calls has something to do with the pipeline of potential deals.

Analyst estimates on TIKR tell a similar story. Adjusted earnings are expected to fall to $1.13 per share in 2022, increasing a bit to $1.21 per share in 2023. The big growth will come in 2024, with adjusted earnings increasing to over $2 per share.

However, I can’t find anything in recent quarterly or annual reports why analysts would think earnings will skyrocket in 2024. I’m also not convinced $1.13 is a reasonable target in 2022, considering the stock just posted $0.49 in adjusted earnings in just one quarter.

So, like a lot of analyst expectations, we’ll ignore those.

Management continues to reassure the market and say there will be plenty of deals to invest in. The company has also recently renegotiated their line of credit from US$150M to US$350M, which is bullish for the future, and something you wouldn’t do unless you were looking to put cash to work.

Another reason this stock is so cheap is it doesn’t screen particularly well. There’s huge differences in net income and cash flow, thanks to the aforementioned amortization expenses. Net income was $0.59 last year, a far cry from the $1.85 per share in cash flow.

Management fees

A quick note on management fees. DRI Capital manages this fund. They charge a management fee of 6.5% of all royalty payments. That is… a lot. And it’s probably a big reason why the stock is so damn cheap.

However, there are ways to spin this a little more positively. Management fees are essentially the fund’s only operating expenses outside of what it costs to be a publicly-traded company. And DRI is clearly good at what they do. They should be able to charge a premium for it.

DRI also owns approximately 1.3 million units, or a little more than 3% of the total float. That’s something, but not nearly enough to assure nervous investors.

Returning cash to shareholders

As it stands today, DRI pays a $0.075 per quarter dividend, which is good enough for a 5.5% yield. That’s not a bad start.

The company also paid a special dividend at the end of 2021, returning an additional US$0.22 per share to its shareholders. That puts the trailing dividend at a close to 10% yield.

There are no guarantees of additional special dividends, of course. But with a stock that generates this much cash flow, I like the message they’re trying to send to the market. They can return more cash than expected while still hitting their acquisition targets.

The company also has been buying back shares. It ended the 3rd quarter at 40.11 million shares outstanding. That number dropped to 39.8 million at the end of the 4th quarter and 38.74 million at the end of the 1st quarter. That’s a little less than 4% of the company bought back in just two quarters.

Management expects to continue buying back shares, and has recently gotten approval to repurchase 2.5 million shares versus the 1.5 million share approval originally given.

The share repurchase will also increase earnings per share. Adjusted earnings were $1.85 per share in 2021. If total earnings stay the same in 2022 and shares outstanding fall by 5%, we’re looking at $1.94 per share in earnings in 2022. And that doesn’t count any additional cash flow from the cash put to work in the latter part of 2021.

In other words, I expect approximately $2 per share in adjusted earnings/cash flow in 2022. Again, this stock trades at $5.50 per share. It is ridiculously cheap.

The bottom line

I like a lot of things about this stock. I think the macro trend on healthcare spending will bode well for the entire sector. I think DRI is uniquely positioned to benefit as well. They shouldn’t have any problem putting cash to work and I can easily see a future where they’ve grown the bottom line significantly in 3-5 years as they execute on that plan.

But the 6.5% management fee on all royalties (plus performance fees on acquisitions) really makes me nervous. DRI is clearly taking care of DRI before they take care of DRI Trust shareholders, and that should give anyone pause.

Is the cheapness enough to make up for that major wart? I’m on the fence. I’m going to think a little more on this one before making a decision.