A&W: 6.2% royalty play grows as valuation

Note: All amounts referenced are in Canadian dollars. The stock prices referenced are prices on the TSX and not USD OTC prices.

You can bid any price. We can ditch rational multiples and move on to “this time is different.” almost It always means that the rate of return at that point in time is lower than in the previous period. A&W Revenue Royalty Income Fund (OTC:AWRRF) (TSX:AW.UN:CA) fell into the same category in 2021, when valuations peaked and jumped to extremely irrational levels. Sure, there was a “restart” ahead, but moving it to a 3% trailing 12-month dividend yield was downright foolish.

Simply put, A&W’s trailing 12-month dividend yield has actually risen faster than its price, and the stock actually peaked near $42 in 2022. If you bought then, you would have lost 21% despite the hefty dividends.

We review the Q4 2023 results and explain why you might now consider this as an investment position and the risks you should consider.

the company

We’ve featured this company more than once, so we won’t go into detail here.

If you’re interested, see my previous article explaining settings and why they’re useful. We’d like to add here that companies typically hold very little cash because they don’t need it to finance expansion. They also tend to pay out the majority of their profits as dividends, literally aiming to pay out 100%. Therefore, investors should not complain about extremely high payout ratios. That’s not a bug, it’s a feature.

4th quarter 2023

The fourth quarter of 2023 was a good end to a good year for A&W. Same-store growth was mediocre at 2.1%, but overall total sales were up more than 5% from the fourth quarter of 2022.

The total number of restaurants in the royalty pool expanded, and distributable cash per unit increased by 3.8%. Despite a slight increase in total distribution in the fourth quarter of 2023 compared to the fourth quarter of 2022, the payout ratio decreased slightly. Those who are confused about the amount should note that there will be one additional distribution in Q4 and one will be skipped in Q1.

Distributions are now clearly above pre-pandemic levels each year and appear well covered.

eyesight

A&W is primarily a loyalty game that benefits from revenue growth (same-restaurant sales) and inflationary changes in the top rankings of these restaurants. What they don’t really benefit from is opening new franchise locations, at least to the same extent. The reason is that new units have to be issued for these restaurants.

The royalty pool is adjusted annually to reflect sales from new A&W restaurants added to the royalty pool and to reflect net sales from permanently closed A&W restaurants. Foodservice will be paid on additional royalty streams associated with net new restaurant sales pursuant to the formula set forth in the Amended and Restated License and Royalty Agreements. This formula provides for payment for food service based on 92.5% of the net new restaurant’s estimated sales volume and the unit’s current production volume, adjusted for any income taxes owed by the brand. Consideration will be paid to Food Service in the form of additional limited partnership units (“LP Units”).

Source: Annual Report

They share these to some extent and of course these sales grow as well over time, but the stock issuance neutralizes this growth angle to some extent. You can see this in this quarter’s results, where cash available for distribution per unit increased 3.8%. This is somewhere between same-store growth (2.1%) and total growth (5.1%).

But this is a pretty good model. If you add a 6.2% yield and get 3.8% distribution growth over the long term, you can earn a 10% total return with minimal capital risk. Even though we might not be able to breathe anything in this ballpark today, they actually performed better than that in the long run.

A&W has barely accessed $15.7 million of its $40 million credit facility, suggesting a lack of risk on the debt side as well.

As of December 31, 2023, Food Services had drawn $15,726,000 in credit facilities (January 1, 2023 – $8,149,000), of which $3,366,000 had been repaid by January 28, 2024, and had issued $198,000 in guarantees ( January 1, 2023 – $8,149,000). $198,000), with $24,076,000 of facilities available (January 1, 2023 – $31,653,000).

Source: Annual Report

Annual pre-tax royalty income was approximately $55 million, leading to negligible debt relative to the EBITDA figure. The risk here comes from the company’s broader macro issues. Fast food has always been expensive, but somehow the pandemic has really turned it into a “luxury item.” We’ve personally seen menu items move from $5 to $7 over four years. A 40% price increase is really hard to accept and there will be backlash if we don’t get pricing reasonable soon. Canadians are also deeply in debt and have given up hope for interest rate cuts. We say this because, as a country, we thought it made more sense to reset our mortgages every five years than to lock them in for 30 years.

We also saw last quarter that customers were being hurt because the CEO refused to admit what everyone with basic math skills knows. So there is a riskier setup, but on the bright side, we finally have a reasonable A&W trade. If you ignore the 2020 COVID-19 price crash (which caused the trailing 12-month dividend yield to move vertically), this is the highest yield you can get from it in the last decade.

Of course, the counterargument is that interest rates are also high. If you express the dividend yield as a spread over the Canadian government’s five-year bond yield, it doesn’t look that cheap today.

So what argument do we rely on?

verdict

The reason we place less weight on spreads compared to GOC-5 yields is because we believe that a high interest rate environment will persist only if inflation remains stubborn. While dramatic price increases between 2020 and 2023 are unlikely to occur, A&W believes it can price its annual price changes closer to the rate of inflation. This company has built-in offsets, and its highest absolute dividend yield in the last decade is enough to get you started. We’ll also note that if we had paid out everything we earned here, the dividend yield would have been 6.77%. All things considered, I think this is a good place to start looking at this a little bit because valuation compression has taken a toll. We’ll be doing just that next week, right where we started.

Please note that this is not financial advice. It may look and sound like it, but surprisingly, it isn’t so. Investors should conduct their own due diligence and consult with professionals who are aware of their objectives and constraints.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.