As an investor in Pizza Pizza Royalty Corp. (PZA), I have noticed the privately held operating company, Pizza Pizza Ltd., receives additional securities exchangeable into shares of PZA whenever new restaurants are added to the royalty pool. Pizza Pizza Ltd. now effectively owns 21.1 per cent of PZA, up from 20.4 per cent in 2016 and 19.9 per cent in 2015. If this trend continues, is it of long-term concern for PZA shareholders?
No. PZA and other restaurant royalty stocks – such as A&W Revenue Royalties Income Fund (AW.UN) and Keg Royalties Income Fund (KEG.UN) – employ a similar structure and use a nearly identical formula when new restaurants are added to their royalty pool.
Essentially, every year, the royalty company must pay the operating company for the future stream of royalties tied to sales of new restaurants added to the royalty pool. (For PZA, the royalty is 6 per cent of Pizza Pizza's annual system sales and 9 per cent of Pizza 73's system sales.)
However, PZA does not pay cash to Pizza Pizza Ltd. for the rights to the new royalty stream. Rather, it gives Pizza Pizza Ltd. additional shares exchangeable into PZA shares. That's why Pizza Pizza Ltd.'s effective ownership interest in PZA has been rising (and will likely continue to rise, barring a sale by Pizza Pizza Ltd. of a portion of its stake in PZA, such as happened in 2015).
Far from being detrimental, however, the formula used to calculate the number of exchangeable shares payable to Pizza Pizza Ltd. is actually beneficial to PZA shareholders.
Essentially, Pizza Pizza Ltd. agrees to pay a royalty, forever, on new restaurants added to the royalty pool. In exchange for receiving these royalties, PZA awards Pizza Pizza Ltd. shares exchangeable into PZA stock, using a formula agreed to at the company's initial public offering. The formula is complex – it takes into account factors including sales of the new restaurants, the royalty rate, taxes and the yield on PZA shares – but the upshot is that PZA effectively purchases the new royalty stream at a 7.5-per-cent discount.
Because of that discount, these annual restaurant "vend-ins" to the royalty pool increase cash flow for each PZA share, even as Pizza Pizza Ltd.'s effective ownership in PZA also increases. If sales of the new restaurants grow in future years – as expected – PZA shareholders would benefit even more as its royalty income increases. Furthermore, Pizza Pizza Ltd. has an incentive to grow royalty pool sales by opening new restaurants and increasing same-store sales of restaurants already in the royalty pool.
I was going through the annual report for Telus Corp. (T) and noticed its payout ratio has climbed to a whopping 89 per cent as of the fourth quarter of 2016, up from 73 per cent in 2015 and 66 per cent in 2014. Should I be worried about the dividend's sustainability?
I'm not worried. If you read further in the management's discussion and analysis section of the annual report, you'll see that Telus's guideline is to pay out 65 per cent to 75 per cent of "sustainable earnings per share on a prospective basis." In other words, it sets the dividend based on expected earnings for the following year, excluding any one-time items that might cause earnings to fluctuate in the short term. In 2016, Telus's net earnings were depressed by an unusually large restructuring charge and other costs recorded in the fourth quarter, which caused the payout ratio to soar. Using adjusted net earnings per common share, however, Telus's payout ratio was a more reasonable 77 per cent in 2016. That was still slightly above the target range on a trailing basis, but the company said it expects "that we will be within our target guideline on a prospective basis." It's also worth mentioning that Telus has indicated its intention to raise its dividend twice a year – at an annual rate of 7 per cent to 10 per cent – from 2017 through the end of 2019. Dividend hikes aren't official until the board approves them, but Telus probably wouldn't be signalling dividend hikes if it was uncomfortable with its current payout ratio.
Enbridge Inc. (ENB) raised its dividend by 10 per cent in January and said it would announce another increase following its merger with Spectra Energy Corp. That deal closed on Feb. 27, but there has been no increase. Do you anticipate that it will still take place?
Yes. On Enbridge's fourth-quarter conference call in February, president and chief executive officer Al Monaco said the company expects to "formalize the dividend top-up announcement" when it releases first-quarter results on May 11. Enbridge has said the top-up would bring the total dividend increase in 2017 to about 15 per cent.
Disclosure: The author owns shares of PZA, AW.UN, T and ENB personally, and holds T and ENB in his Strategy Lab model dividend portfolio (view it online at tgam.ca/divportfolio).