The rewards – and risks – of restaurant royalty funds

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Based on the questions I get from readers, there is a growing appetite for restaurant royalty funds. Today, I'll provide an overview of these high-yielding securities. Then, I'll answer a couple of reader questions.

Royalty funds span the menu, from fast food (A&W Revenue Royalties Income Fund, Pizza Pizza Royalty Corp.), to casual dining (Boston Pizza Royalties Income Fund) to higher-end establishments (Keg Royalties Income Fund, SIR Royalty Income Fund).

When you invest in a royalty fund, you aren't buying into the restaurant chain itself. You're acquiring a stake in an entity that owns the restaurant's trademarks. These trademarks are licensed to the operating company in exchange for a royalty based on a percentage – usually 4 per cent to 9 per cent – of sales by stores in the "royalty pool."

The stream of royalties, in turn, funds the monthly cash distributions to unitholders. If a chain's same-store sales are growing steadily, the distribution will also likely increase over time. The annual addition of new restaurants to the royalty pool also contributes to distribution growth, although not to the same extent. (I explained how these restaurant royalty pool "vend-ins" work in a previous column: tgam.ca/2sDkJ4u).

For most royalty funds, distribution growth is modest – typically in the low single-digits annually. What really makes investors salivate are the above-average yields, which range from about 5 per cent (A&W) to 8 per cent (SIR). Because royalty companies have minimal expenses, they can afford to distribute most of their cash flow to investors. Because royalties are tied to top-line sales and are not affected by the fluctuating operating costs of the restaurant business itself, the cash flows tend to be relatively stable.

That's a double-edged sword, though. Because of the slow-growing nature of their cash flows, these securities have bond-like characteristics that make them vulnerable when interest rates rise. All five of the royalty funds mentioned here have seen their unit prices (excluding dividends) decline over the past year, with A&W (AW.UN), Pizza Pizza (PZA) and Keg (KEG.UN) falling by double digits and SIR (SRV.UN) and Boston Pizza (BPF.UN) off by single digits. (Disclosure: I own AW.UN and PZA both personally and in my model Yield Hog Dividend Growth Portfolio).

Another point worth mentioning is that restaurant royalty funds tend to be thinly traded and often have wide spreads between the "bid" (what buyers are willing to pay) and "ask" price (what sellers are willing accept). For instance, when I checked on Friday morning the bid-ask spread for AW.UN was a hefty 21 cents, compared with a penny for most liquid stocks. For this reason, you should check the bid and ask prices carefully before entering a "market order" so that you aren't surprised by the price you get. Alternatively, you could use a "limit order" specifying your price, although this creates a risk that your order won'get filled.

Finally, the tax treatment of distributions varies depending on the company. You can usually find tax information on the fund's website or by contacting its investor relations department.

Now, to your questions.

In January, A&W Food Services of Canada Inc. filed an "early warning report." Should this concern me?

No. Because A&W Food Services (the operating company) owns more than 10 per cent of the royalty fund (24.7 per cent, to be exact), it is required to disclose when its ownership changes by 2 per cent or more. This typically happens when restaurants are added to the royalty pool annually, which results in A&W Food Services receiving units that effectively increase its stake in the fund.

What's your opinion of Keg Royalties?

I don't own it, but the units have tumbled about 8 per cent in the past month, which may appeal to bargain hunters. In a report this week, analyst Elizabeth Johnston of Laurentian Bank Securities noted that Keg Restaurants Ltd., the operating company, posted strong same-store sales growth of 4.8 per cent for the quarter ended Dec. 31. Ms. Johnston has a "buy" rating on Keg units and expects distribution increases of about 2 per cent in each of 2018 and 2019.