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Pizza Pizza has shown consistent increases in same-store sales in recent years, and distributions continue to grow. (Left: Kevin Van Paassen/The Globe and Mail)
Pizza Pizza has shown consistent increases in same-store sales in recent years, and distributions continue to grow. (Left: Kevin Van Paassen/The Globe and Mail)

YIELD HOG

Yields: Don't be greedy with restaurant stocks Add to ...

Pizza and burgers have long been staples of the North American diet. Should they be part of your investment portfolio, too?

Mike Henderson thinks so.

The retired political science professor owns four restaurant royalty companies and has been “delighted” with the results.

For the three years ended Oct. 31, Pizza Pizza Royalty Corp. (PZA-T) delivered an annualized total return – including reinvested dividends – of 28.3 per cent, followed by Boston Pizza Royalties Income Fund (BPF.UN-T) at 25.2 per cent, Keg Royalties Income Fund (KEG.UN-T) at 17.4 per cent and A&W Revenue Royalties Income Fund (AW.UN-T) at 9.6 per cent.

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Mr. Henderson likes these stocks for a few reasons. They pay attractive yields of around 6 per cent, the business model is “a genuine money spinner” for the franchisor and most sell moderately-priced meals that consumers can afford even when times are tough. Still, these stocks tend to fly under the radar of investors because few analysts cover them.

But before you stuff yourself with restaurant royalty companies, here are some things to keep in mind.

Watch same-store sales

When you buy these stocks, you’re not investing in the restaurants directly. Rather, you’re buying into a royalty stream based on a percentage of the restaurants’ sales. The royalty agreements are complex, but the important thing for investors to know is that same-store sales – that is, sales at locations operating for at least a year, excluding the effects of store openings and closings – are the key driver of distribution growth.

For example, in recent years Pizza Pizza (known as Pizza 73 in Western Canada) has consistently grown same-store sales in the low single-digits. As its sales have climbed, Pizza Pizza has hiked its distribution three times since May, 2012, and there could be more distribution increases coming.

Derek Lessard, an analyst with TD Securities, predicts Pizza Pizza’s distribution will grow about 5.5 per cent in 2014 and 3.4 per cent in 2015, assuming continued same-store sales gains. Still, while investors stand to benefit from “consistent and predictable earnings, growing market share, and an attractive (and sustainable) dividend going forward,” he believes the shares – which closed Tuesday at $13.24 – are now “fully valued.” He rates them a “hold,” with a 12-month target price of $14.

Pay attention to payout ratios

At A&W, sales haven’t been nearly as steady. Same-store sales were flat in 2011, fell 0.7 per cent in 2012 and got off to a rocky start in 2013 before rebounding slightly over the past two quarters. Perhaps not surprisingly, A&W hasn’t raised its distribution since February, 2011.

Another concern is A&W’s elevated payout ratio. Unlike most corporations, restaurant royalty stocks don’t need to retain a lot of cash for reinvestment, so they can pay out close to 100 per cent of their “distributable cash” to unitholders. Pizza Pizza, for instance, has an estimated payout ratio of 97 per cent, according to Mr. Lessard.

But A&W’s payout ratio over the past 12 months was an uncomfortably high 106.5 per cent, according to analyst Michael Glen at Laurentian Bank Securities. To get the payout ratio down, “we see an increasing need for [same-store sales growth] to be at or above 0 per cent through 2013/2014,” Mr. Glen said in a note. He rates A&W a “hold.”

In a bid to boost customer traffic, A&W is rolling out new menu items and promoting its beef “without any added hormones or steroids,” but the chain faces intense competition from the likes of McDonald’s, Tim Hortons and Subway, as well as from premium burger chains.

Mr. Glen also rates Keg a “hold,” citing falling same-store sales and stiff competition in the more expensive casual dining segment.

Look for growing distributions

Mr. Glen is more upbeat on Boston Pizza, whose trailing 12-month payout ratio is slightly under 100 per cent and whose franchise same-store sales have been consistently positive for the past few years. What’s more, the chain has an opportunity to boost sales by promoting its delivery business, particularly in Eastern Canada, he said.

Boston Pizza’s stronger fundamentals are reflected in its rising distribution. The company announced a 4-per-cent hike in March and Mr. Glen expects a similar increase in early 2014.

Digesting the numbers

Restaurant royalty stocks have posted impressive gains in recent years as investors snapped up anything with a solid yield, but future returns will almost certainly be more muted. Also keep in mind that these stocks are thinly traded, so bid-ask spreads can be wide. Investors should order carefully, and not overindulge.

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