This is an update of the report on Grenville Strategic Royalties prepared in March of 2017.
Report Overview
- GRC has resumed making new cash investments
- Their existing investments have declined in value
- I previously noted GRC could have upside if they were able to earn reasonable IRRs on their money — unfortunately they have not demonstrated the ability to do so
- Business model is fundamentally broken and activism/liquidation is the only realistic avenue to extract value
Update
Grenville management is still promoting the idea of earning 25% IRRs, which I think is thoroughly debunked by now. Additionally, they appear to have lowered their standards for new investments to 3 years of revenue from 5 years of revenue, and still do not require businesses to be profitable to access their cash.
Also:
- GRC is deploying new cash at a relatively significant rate without seeing any improvement in quarterly revenues.
- Management has stopped providing a royalty-by-royalty breakout in their MD&A, which makes the type of cohort analysis I had previously completed impossible.
In the absence of that data, I have compiled a graph of their royalty revenue ex-buyouts, which you can see below.
Putting aside the decline, it is worth noting that the combination of their run-rate G&A and debenture payments, which I estimate at $4.5-million per year now exceeds their run-rate revenues. That is true even if you annualize the last quarter, when the trend is pretty obviously heading downwards.
It is fair to note that I have excluded cash from buyouts from this graph, as they are not traditional revenue but rather the sale of an asset. Grenville has had one material buyout in 2017, receiving $5-million from its investment in Aquam. This was a huge success, as they invested $2-million to purchase the royalty in 2014, and had already received all of their capital back by the end of 2016 in royalty payments. Unfortunately, this success is outweighed by the $7.75-million of royalties written off or extinguished during the first two quarters of the year. There were also various other losses, for example the loss on shares in Lattice Biologics (TSXV:LBL) they took in exchange for reducing a royalty that LBL couldn’t (and didn’t) pay.
This demonstrates what I believe is the biggest flaw in their business model, and it relates to their upside. The biggest potential upside here is that one of their new royalties on a technology company hits, and the company scales. They seem to get cashed in on their successful royalties, which largely eliminates the upside from a business going to scale. After all, if you had had even a very small royalty on a tech unicorn prior to it reaching scale, selling it after a double or triple would likely be the biggest investing mistake of your career.
In the same way, their Aquam royalty provided $1.1 MM in royalty revenue in 2016, and that figure was growing fast, up 19% from 2015. They sold that royalty stream back to Aquam for $5 MM, or 2.5X their initial investment. But that royalty stream was pure free cash flow on a growing business, and if they hadn’t sold it back it was probably worth at least 15X cash flow, or maybe more if Aquam continued to grow. In many ways, they sold an asset worth at least $15 MM back to Aquam for $5MM. I assume they were contractually required to do so (because of the round number and exact multiple in the purchase price). If that’s the case, I think it demonstrates a significant flaw in the design of their business. They cut their winners short, while they have no choice but to ride their losers to zero, because these aren’t liquid investments.
If that is in fact how their investments are structured (guaranteed buy-out price) that makes their move into technology even more strategically ill-advised, as new technology companies are more likely to either scale or fail than nearly any other type of enterprise. Venture capitalists make the vast majority of their returns from the few hits in their portfolio, and if Grenville is truncating their returns on those hits they are likely to never make up their losses on the failures.
Strategic Notes
Activism is the most likely way to realize value here, as the G&A burden of running this public company is simply too high for its asset base and investments. The best course of action is almost certainly to sell the remaining royalties to one of their competitors or back to the portfolio companies, and liquidate. Management is extremely unlikely to do this, and appears set on continuing the business as a going concern until they are forced to do otherwise.
There are two potential ways to take over the company:
- Accumulate enough of the common stock to take over the board: This has the advantage of being possible immediately, but has the material disadvantage of still having the debentures in position as a senior security, which would absorb most if not all of the liquidation proceeds.
- Seek control through the debentures: The principal disadvantage here is that the debentures do not mature until December 31, 2019, so the current management team would have a full two years to run the company into the ground and draw salaries. This is a material disadvantage. There are, however, a number of advantages to this strategy as well. It allows time for a significant stake in the debentures to be accumulated. That would be important, because it is unlikely the company will be able to repay the debentures in 2019, but management could try to offer an extension, which wouldn’t be desirable, so having a big enough stake to block it would be crucial. This assumes the company can’t pay the debentures back. If they can, a large stake in the debentures would have a high IRR just from the discount and interest payments such that the result would likely be satisfactory.
If management cannot get an extension or pay back the debentures, the debentures will need to be repaid in shares. The formula for that is a discount to the weighted average trading price prior to the conversion. That weighted average trading price will almost certainly be low, as the existing shareholders will realize they are about to be massively diluted. An activist who owned a stake in debentures might also choose to sell their equity stake at that time further pressuring the share price. That would make sense to free up capital to buy more debentures as retail holders dumped them, and would also have the incidental effect of lowering the conversion price so that the debentures owned converted into more of the company. I think it is very likely under these circumstances that the debenture holders would get 80–90% ownership in the company after conversion, and anyone with a significant stake in those debentures would now have a control position in GRC, which would now be debt free. $265,000 in face value of the debentures traded in the last month, as compared to approximately $330,000 worth of the stock. So the debentures are slightly less active, but not materially so, and there are likely blocks available from time to time. I do think significant extra supply will come on the market at lower prices if they announce a conversion.
Conclusion
There is still a material discount to book value here, with the company trading at 42% of book value. However, that book value has declined approximately 18% in the two quarters since March, and a 9% quarterly decline in book value will eat up that margin of safety very quickly. It is also worth noting that it gets harder and harder for them to claw their way back to sustainability as their balance sheet shrinks, because their G&A and interest burdens are largely fixed costs. The company appears to be in a death spiral, and only activism and liquidation are likely to change that, unless the hit rate on their new investments is materially better than that on their previous investments. While that is possible, their decision to limit disclosure going forward doesn’t give me confidence that the new investments are performing well, because otherwise management could segregate between new and old and use that for promotional purposes.
Brief thoughts on the Convertible Debentures
The biggest risk to a position in the convertible debentures (and associated activist campaign in ~2 years) is that the ice cube is melting very quickly here. For the debentures to be worth par in 2 years, the company needs to be worth $17 MM or more at that time, and that wouldn’t be true if value is destroyed at a $3 MM per quarter rate as it has been lately. I have sold my convertible debenture position based on this analysis, and would consider the stock uninvestable at this point without the catalyst of an immediate activist campaign.
