Diversified Royalty Corp's High-Yield Dividend: Sustainable Growth or Leveraged Risk?

Diversified Royalty Corp (TSX: DIV) has reignited investor interest with a 10% dividend hike and its acquisition of Cheba Hut Franchising's intellectual property. While the move underscores management's confidence in cash flow generation, the question remains: Can the company sustain its elevated payout ratio and manage leveraged growth amid rising macroeconomic headwinds? This analysis dissects the risks and opportunities embedded in DIV's strategy.

The Dividend Increase: A High-Water Mark for Payouts

DIV's dividend per share has climbed to CAD 27.5 cents annually, marking a 10% increase from 2024. However, the pro-forma payout ratio—94.9% before the DRIP and 83.0% after—raises eyebrows. Such a high ratio leaves minimal margin for error in cash flow generation. For context, the average payout ratio for royalty-based REITs and income-focused equities typically hovers around 70-80%, with 90%+ ratios often signaling vulnerability to unexpected downturns.

Investors should scrutinize whether this dividend is a testament to DIV's robustness or a precarious bet on flawless execution.

The Cheba Hut Acquisition: Fueling Growth or Overextension?

The $36 million acquisition of Cheba Hut's trademarks adds a ninth royalty stream to DIV's portfolio, with an initial annual royalty of $4 million (7% of pro-forma revenue). The structure includes a growth mechanism: royalties will rise annually by the greater of 3.5% or U.S. CPI +1.5%, plus potential escalations if Cheba Hut meets financial targets. While this could boost cash flows over time, it also introduces operational risk. For example, if Cheba Hut's same-store sales growth (SSSG) slows, the company might struggle to justify additional royalty hikes, leaving DIV's payout ratio exposed.

The 25% revenue jump projected for 2025 is ambitious. A shortfall here could crimp royalty income, testing DIV's ability to maintain dividends.

Leverage: Balancing Growth with Debt Costs

Funding the acquisition required $36 million in new debt and reserves, with significant reliance on floating-rate facilities. The Cheeb Credit Facility (SOFR +2.5%) and Additional Term Facility (SOFR-based) expose DIV to rising interest costs if the Federal Reserve continues tightening. Management has 90 days to swap 75% of the Cheeb Facility's rate, but the remaining 25% remains unhedged. Meanwhile, the Acquisition Facility's 12-month interest-only period offers breathing room, but repayment hinges on cash flow and refinancing success.

If EBITDA growth stalls, debt servicing could squeeze distributable cash, pressuring the dividend.

Macroeconomic Risks: A Double-Edged Sword

Cheba Hut's success is tied to consumer spending on fast casual dining—a sector vulnerable to inflation, recession, or shifting preferences. The 5% SSSG in 2024 is encouraging, but achieving the $187 million 2025 sales target requires flawless execution in a potentially weakening economy. Additionally, the royalty's CPI-linked escalator could backfire if inflation spikes: higher royalties might strain Cheba Hut's profitability, leading to operational stress.

Strategic Strengths: Tax Benefits and Operational Control

DIV's acquisition also delivers $51 million in tax pools, boosting total tax assets to $424 million—a significant shield against future liabilities. Crucially, the deal avoids equity dilution, preserving shareholder value. Management's hands-off approach to Cheba Hut's operations, allowing founder Scott Jennings to retain control, reduces integration risks and aligns with DIV's passive royalty model.

Investment Thesis: Proceed with Caution

DIV's dividend hike is compelling for income investors, but the high payout ratio and leveraged growth create risks. Bull Case: Cheba Hut meets or exceeds its 2025 targets, interest rates stabilize, and DIV's existing royalty streams remain robust. The dividend could stay intact, rewarding income seekers. Bear Case: A macro downturn stifles Cheba Hut's sales, debt costs rise, and the payout ratio strains cash reserves.

Recommendation: Investors should overweight the dividend yield (currently ~6.5% based on the new payout) but hedge against leverage risks. Monitor DIV's debt repayment progress (aiming to pay down the Acquisition Facility within 12 months) and Cheba Hut's 2025 sales performance. Consider pairing a long position in DIV with short-dated puts to mitigate downside risk.

In conclusion, DIV's strategy is aggressive but not without merit. For now, the high yield is sustainable—if the stars align.