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What do you think of SIR Royalty Income Fund (SRV.UN)? Is the 8-per-cent yield sustainable?

First, a little background.

SIR Royalty is one of about half a dozen restaurant royalty funds in Canada. I don’t own SIR units, but I do hold Pizza Pizza Royalty Corp. (PZA) and A&W Revenue Royalties Income Fund (AW.UN), which are structured in much the same way. The key thing to understand is that these royalty funds don’t own any restaurants; rather, they indirectly own trademarks that they license to the restaurant operating company in exchange for a royalty based on sales.

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In SIR’s case, the fund is entitled to a 6-per-cent royalty on sales of the 57 restaurants in the “royalty pool,” which consists largely of 40 Jack Astor’s casual dining establishments, most of which are located in Ontario. Other restaurants in the royalty pool include Canyon Creek, Scaddabush Italian Kitchen & Bar, and Alice Fazooli’s.

Potential investors should note that SIR lacks the size or geographic diversification of some other restaurant royalty funds. Pizza Pizza, for example, has 758 restaurants in its royalty pool and A&W has 896, generating sales of about $551-million and $1.19-billion, respectively. That compares with royalty pool sales of $283-million for SIR. On a positive note, SIR’s royalty revenue has grown about 20 per cent since 2013, driven by additions of restaurants to the royalty pool and rising same-store sales.

Another encouraging sign: After holding its distribution steady since June, 2013, SIR has recently boosted the amount of cash it pays to unitholders. In December, the fund served up a special distribution of 2 cents a unit, and on April 10, it raised its regular monthly distribution to 10 cents from 9.5 cents – an increase of 5.3 per cent. SIR units, which closed Friday at $14.77, now yield 8.1 per cent based on the annualized distribution of $1.20.

Is the yield sustainable? Well, since SIR (which stands for Service Inspired Restaurants) went public in 2004, the fund has cut its distribution once, but that was in 2011 when the new income-trust tax kicked in. If recent positive sales trends are any indication, the distribution appears secure – barring a change in the company’s fortunes.

In the fourth quarter, same-store sales at Jack Astor’s jumped 5.5 per cent, lifted by a combination of renovations, price increases, marketing programs and the launch of new craft beers. Scaddabush’s same-store sales growth was even stronger, up 10.6 per cent. Growing same-store sales are the key driver of distribution growth, so this is good news for unitholders. (In addition to receiving royalty income, SIR collects interest from a $40-million loan to SIR Corp., the operating company).

However, as SIR points out in its 2017 annual information form, investing in the units carries numerous risks.

“The restaurant industry generally, and in particular, the casual and fine dining segment of this industry, is intensely competitive with respect to price, service, location, food quality and qualified staff. There are many well-established competitors with greater financial and other resources than SIR,” the annual information form says, referring to SIR Corp., the operating company.

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“Recently, competition has increased in the mid-price, full-service, casual and fine dining sectors in which many of the SIR restaurants operate. Some of SIR’s competitors have been in existence for a substantially longer period than SIR and may be better established in the markets where SIR restaurants are or may be located.”

The restaurant business is also affected by changes in demographic trends, food and labour costs, customer preferences, the economy and consumer spending. All of these factors could affect sales and the company’s ability to pay royalties or interest.

Elizabeth Johnston of Laurentian Bank Securities is the only analyst who follows SIR, and she rates the units a hold with a 12-month target price of $14 – below the current market price. The target price equates to a yield of more than 8.5 per cent, which is higher than other restaurant royalty funds.

The elevated target yield reflects “the capital intensity of the underlying operating company” – which bears the cost of opening restaurants because it uses a corporate, as opposed to a franchised, model – and “the limited outlook for new store openings,” Ms. Johnston said.

One other thing to keep in mind if you are considering an investment in the fund: The units are very thinly traded, which creates wide spreads between bid prices (what buyers are willing to pay) and ask prices (what sellers are willing to accept). When I checked on Friday, for example, the bid-ask spread was 28 cents. (For liquid stocks, the spread is usually a penny.) So, it might be prudent to use a limit order specifying your price. If you enter a market order, you could end paying more than you expected.

Bottom line: Although SIR’s distribution appears to be safe, there’s no such thing as a free lunch with restaurant royalty funds. In exchange for that high yield, investors have to accept some risk.

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