Evenlode Investment View - May 2011

In Search Of The Great Royalty Streams

“Ideally, to protect against inflation, you want a royalty on someone else’s sales so you don’t have to invest any more capital—you license it to them and you make money as their volume grows.”

Warren Buffett, Berkshire Hathaway AGM, April 30th 2011

Royalties, generally, are fun things to own. They don’t require a lot from you, and they give you a lot back in return. The best royalty businesses generally own some kind of intangible asset (usually brands or intellectual property) with long-lasting appeal. ‘Franchise’ businesses are the purest form of royalty, and probably the most successful franchise business of all time is Coca Cola. Coca Cola owns few tangible assets (production plants etc.) as it outsources much of its  production and distribution to third parties. The things it does own - its brand and the drink's ‘secret recipe’ - are what have made it such a great long-term investment. It is these ‘magic’ factors that have led to consistent growth in sales and earnings, ever since consumers started buying Coca Cola back in the 1880s.

The chief executive of a franchise business said to us recently ‘we don’t make anything here apart from cash’. It was a throw-away comment, but it neatly sums up the economics of royalty businesses. They are the ultimate cash machines – unlike resource companies and other asset-heavy business models, the vast majority of earnings come consistently back to the company’s owners as freely available cash flow, rather than being spent on more ‘stuff’. As Buffett points out in the above quote, this type of business is one of the best ways to protect against inflation. Look back to the 1970s, and it was generally this asset-light group of businesses that were kindest to shareholders in what was a roller-coaster ride for most of the stock market. Asset-intensive businesses such as resources companies were, to many investor's surprise, not so great at protecting the real value of shareholder wealth in this period. Shares of US oil producer Exxon, for instance, only rose from $1 to $1.36 between 1972 and 1982, despite a decade of rampant inflation. After a one-off benefit from the initial rise in oil prices, the business ultimately had to channel increased cash flows into replacing its existing asset base at inflated prices.

Given our focus on cash flow, dividends and high return businesses, we are always interested in identifying the ‘great royalty streams’ of the UK market. A nice example is Nichols, maker of Vimto (a stock we don’t currently own due to valuation, but keep our eye on). Nichols is a mini Coca Cola. While a regular feature on UK supermarket shelves, Vimto - something of a colonial relic - is sold in more than sixty countries internationally, many of which it’s been in for more than ninety years. It’s particularly big in the Middle East and Africa, and in Saudi Arabia it’s the best selling soft drink at Ramadan (Vimto is used as a ‘staging post’, after daytime fasting and before the evening meal - quite a franchise!) All that Nichols provides to the bottlers in these countries is its brand name and some syrup. In return the company gets a royalty on a brand with lasting appeal and a loyal customer base in these regions. Nichols don’t disclose the gross margins on these sales but we suspect eyes would water if they did.

Many other businesses, though not officially franchises, possess these same royalty-like characteristics (i.e. strong brands and intellectual property). An example – again in the drinks sector - is Diageo. As the following quote from a recent presentation makes clear, Diageo’s ‘royalty’ on the consumption of beer in Africa has huge potential:

“Guinness is the only beer brand with pan-African appeal, and many of our consumers consider it their own – a global brand that has effectively been made local. Alongside Guinness, we have a stable of strong local brands that are performing really well. From Serengeti in Tanzania, to Harp in Nigeria, Windhoek in South Africa and Senator and Tusker in Kenya, consumers can access our brands at a range of price points. They have an affinity with these brands and their local meaning and heritage. As the Tusker strap line says – “My country, my beer”.”

Having been to West Africa myself and sat in bars full of Guinness-drinking Ghanaians, this statement rings true. While Diageo do a bit more than ‘provide some syrup’ for their African sales, it is clear from this business’s numbers how strong a franchise they have - the high 20s operating margin in their International subsidiary, for instance, is not the hallmark of a commodity-like business.

As well as being a huge player in African beer, Diageo is also market leader in premium spirits with nearly a 50% share (outside South Africa, Diageo’s spirits volume is roughly four times that of its nearest competitor). By the middle of this century, Africa’s working population of 500 million is forecast to increase to 1.1 billion – more than India or China. To own a royalty on this workforce’s favourite after-hour drinks is a powerful investment proposition. Diageo’s African business has roughly doubled in size in the past 5 years, and we wouldn’t be surprised if it continued to grow at a similar rate for some time to come.

Moving away from the beverage sector (in which there are no shortage of great franchises!) a less appealing area from the perspective of royalties are pharmaceutical companies. These businesses have some royalty-like characteristics – as owners of intellectual property and brands they generate high returns relative to invested capital. However, they have a problem with their royalty streams that the market is acutely aware of – products don’t last for long as drug patents constantly expire. To be fair, companies such as Glaxosmithkline are making big steps towards elongating their ‘royalty streams’ as business areas with longer life-cycles (such as vaccines, biologics and consumer healthcare) become a greater part of their business mix. However, the reason we have exposure to this sector is not the enduring potential of their royalties. It is because even the prospective cash-flows from their existing product portfolios should provide a decent return.

Elsewhere in the healthcare sector, medical devices have a longer-lasting royalty stream than their pharmaceutical peers. Orthopaedic products such as hip joints clearly do change over time, but at a slower pace than pharmaceutical drugs. The requirements for medical device companies are more about continual product evolution than revolution - the longevity of their royalty streams sit somewhere between Coca Cola and Glaxosmithkline. I view Smith & Nephew as a royalty on the wealth of technical knowledge and intellectual property that has built up over its 150 year history (research spend now runs at c£150m per annum). This is S&Ns ‘magic’. Its history means that only a handful of businesses in the world can now compete with S & N. As a testament to the value of S & N’s long-term royalty stream, one of its few competitors – Synthes - has just received a takeover offer from Johnson & Johnson. This c$21bn takeover offer values the Synthes business at about 4.4x its sales, not out of line with other acquisitions in the industry over the years. Applying this multiple to a Smith & Nephew share today would give a value of over £12.50 – more than 80% above the current share price. And as chief executive David Illingworth said at a recent results presentation (reassuringly for the investor if not for the consumer!) - ‘if you had osteo-arthritis before the recession, you’ve probably still got it now’.

So far we’ve only touched on more defensive areas of the market as potential sources of royalty. However, we’d also class our media and technology holdings as some of the great royalty streams in the market. Take for instance, the royalties that Experian or Reed Elsevier make from their huge propriety databases each time a loan is made or someone buys a product online with a credit card. Another great royalty is the $60 Microsoft makes each time a Windows PC is shipped to a customer anywhere in the world.

Even deeply cyclical industries can be great sources of royalty streams. We view the recruitment sector as a royalty business of sorts. Hays, for instance, is paid a small percentage of the salary of each employee they place in a job. Referring back to Buffett’s quote this business model – providing a way to participate in wage streams, without needing to deploy much capital - should be an effective inflation hedge. When you combine this basic idea with Hays’ ability to move its business into new geographic locations, a powerful argument for long-term value creation builds (Hays grew its business by 300% from 2002-2007 – peak-to-peak of the last economic cycle).

Currently however, as regular readers are probably tired of hearing, it is the steadiest, most consistent royalty streams that stand out to us as most compelling (Peter Lynch used to call this group of businesses the ‘Stalwarts’). While the long term potential for their royalties is clear, we’re also being paid up front for owning them today. If prospective valuations change significantly, we’ll shift the portfolio to reflect this. But in the meantime, we’ll keep sipping our Guinness and remind ourselves of the power of a great royalty stream!

Hugh Yarrow
May 2011

Please note, this investment view contains the personal opinions of Hugh Yarrow as at 10th May 2011 and does not constitute investment advice.

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