John Heinzl is the dividend investor for Globe Investor's Strategy Lab. Follow his contributions here. You can see his model portfolio here.
I've dropped a lot of dough at Pizza Pizza over the years.
As a university student, I dialled its familiar phone number too many times to count. Now that I have kids, the chain's party-size pizzas have become a staple of birthdays, hockey tournaments and school-fundraising events. The food is affordable, fun and filling, which is why people keep coming back for more.
Now, I'm also getting a slice of the profits.
As a shareholder of Pizza Pizza Royalty Corp. (PZA) – one of several restaurant-royalty stocks traded on the TSX – I receive a monthly dividend of 6.97 cents a share, or 83.64 cents annually. That may not sound like much, but based on Pizza Pizza's closing price of $12.94 on Tuesday, it works out to a tasty yield of 6.5 per cent.
What's more, thanks to Pizza Pizza's growing sales, its dividend has been climbing steadily: Since 2011, the company has hiked its payment six times – at a compound annual rate of 3.6 per cent – including two increases in 2015. Unless people suddenly lose their appetite for pizza, the dividend will almost certainly continue to grow.
"We are forecasting another 5.8-per-cent and 5.4-per-cent boost in 2016 and 2017, respectively," analyst Derek Lessard of TD Securities said in a note.
Pizza Pizza isn't the only royalty stock to raise its distribution recently. A&W Revenue Royalties Income Fund (AW.UN) and Boston Pizza Royalties Income Fund (BPF.UN) both hiked their payments twice in the past year and now yield 5.3 per cent and 7.5 per cent, respectively. Keg Royalties Income Fund (KEG.UN), meanwhile, announced three distribution increases in 2015 – plus a special distribution – and yields 5.7 per cent.
More increases could be on the way. Michael Glen, who was until recently an analyst with Laurentian Bank Securities, estimated in a February note that A&W will raise its distribution by 4 per cent in each of 2016 and 2017, while Keg could hike its payment by 2.5 per cent in both years.
If you're tempted by the juicy yields of royalty stocks, it's important to understand what you're getting into. When you invest in royalty shares you're not buying a piece of the restaurant business itself as you would if you bought, say, McDonald's Corp. (MCD). Rather, you're investing in an entity that owns the restaurant's trademarks. These trademarks are licensed to the operating company in exchange for a royalty that is based on a percentage – usually from 4 per cent to 9 per cent – of sales by restaurants in the "royalty pool."
Because of the way royalty agreements are structured, growth in same-store sales – that is, sales at restaurants open for at least a year – is the main driver of distribution growth. Same-store sales are affected by myriad factors including the economy, weather, new menu items, competition and advertising, so investors need to be mindful of risks.
For example, even as distributions rose in the past year, share prices of some royalty stocks fell sharply. Pizza Pizza's stock, for example, has dropped about 13 per cent in the past 12 months, excluding distributions, reflecting concerns about weak results at its Pizza 73 chain in oil-ravaged Alberta.
On Monday, Pizza Pizza reported that Pizza 73's same-store sales fell 5.3 per cent in the fourth quarter. However, the drop was more than offset by same-store sales growth of 5.3 per cent at Pizza Pizza's much larger namesake chain in Ontario and Quebec. Over all, fourth-quarter same-store sales rose 3.4 per cent.
Even with the drag from Alberta, the company's same-store sales growth of 4.5 per cent for all of 2015 was its best showing in eight years, Mr. Lessard said. Another thing to keep in mind is that royalty shares typically have low trading volumes, which can lead to wide spreads between bid and ask prices. When buying thinly traded stocks, you may want to use a limit order to specify your maximum price. Otherwise, you could end up paying more than you had intended. You can still use a market order, but to avoid nasty surprises, it's wise to examine the stock quote to see how many shares are on offer and at what price. Similar prudence is also advised when selling.
One other point that's worth mentioning: Because royalty companies have minimal operating costs, they can afford to pay out most of their after-tax earnings as distributions. Pizza Pizza's payout ratio, for example, was 91 per cent in the fourth quarter. That would be a red flag for most operating companies, but for a royalty stock it's actually conservative. The low payout ratio is one reason Mr. Lessard expects Pizza Pizza's dividend to continue to grow. (Note: Because Pizza Pizza is a corporation, its dividend is eligible for the dividend tax credit; tax treatment varies for other restaurant-royalty distributions.) Even when the economy struggles, people still have to eat. By including restaurant-royalty shares as part of a well-balanced portfolio, you can grab a piece of the pie and satisfy your appetite for growing income. Just be aware that the rewards also come with risks.
Disclosure: The author personally owns shares of PZA and AW.UN.
John Heinzl