Restaurant trusts can satisfy appetite for steady cash flow

If you are grabbing a bite to eat, it may not make any difference whether you go to Pizza Pizza or Boston Pizza. If you have an appetite for restaurant income trusts, it pays to be picky, analysts say.

"It may be a good restaurant, but not necessarily a good investment," warns National Bank Financial analyst Gareth Tingling.

When Ottawa announced plans last fall to slap a 31.5-per-cent tax on income trusts by 2011, the restaurant sector was among those hit hardest.

That's because most of these trusts get royalty fees from revenue generated by a pool of restaurants. They don't have hard, depreciable assets to offset future taxes. And they are not takeover targets for private equity players who want operating control of businesses.

But the sector still offers stable distributions, while there is potential for unit prices to rise if these trusts restructure into tax-friendlier formats, analysts say.

"[Restaurant royalty trusts]are the most stable, cash flow vehicle that I cover in my income trust universe," said RBC Dominion Securities Inc. analyst Walter Spracklin.

Eight of the nine restaurant trusts on the TSX get royalties from the trademarks (brands) they own, and thus are not exposed to operating costs like rising wages or higher chicken prices, Mr. Spracklin said. "The only important indicator that counts is same-store sales growth."

He expects same-store sales among these trusts to increase at a more moderate average of 3.8 per cent this year compared with 5.3 per cent last year. The historical level is about 3 per cent.

No restaurant royalty trust has cut distributions, he added. "Each of the operating companies that are building the restaurants all own a significant percentage of the fund. They would rather take less distributions to themselves than cut distributions."

Mr. Spracklin's top picks include Boston Pizza Income Fund (target $16) and Keg Royalties Income Fund (target $14). Boston Pizza has the best record for same-store sales over the past three years, and that should continue this year and in 2008, he said. Keg has the strongest steakhouse brand in Canada and offers diversification with outlets in the United States, he added.

Mr. Spracklin prefers the royalty trust model as opposed to Priszm Income Fund, which is a franchisee paying fees for using trademarks such as KFC and Pizza Hut, and is exposed to rising costs. "We have an underperform on Priszm."

Canaccord Adams analyst Chris Rankin also still likes restaurant income trusts, but finds the group to be "fairly priced at the moment." Still, the sector could benefit if it finds an alternative to the trust structure that still offers "trust-like economics," he said. "I think it is inevitable ... the whole asset class will get re-rated when a restructuring occurs."

Restaurant trusts also tend to benefit in rising inflation, Mr. Rankin added, explaining that rising food prices tend to trigger higher menu prices, Mr. Rankin added. "We have pretty clear signs of inflationary pressure, and inflation tends to result in higher restaurant sales."

While he has a "hold" on many trusts, he rates sales leader Boston Pizza a "buy" (target $15.10). And he also likes Second Cup Royalty Income Fund (target $10.50). "Second Cup has repositioned itself as a warmer, friendlier version of Starbucks," he said. "It used to be more or less a Tim Hortons knockoff." While Second Cup trades slightly higher than his target, investors should not lose sight of the 10.3-per-cent distribution yield, he said.

National Bank's Mr. Tingling says the sector should benefit as aging baby boomers extend their restaurant-going habits into retirement. Restaurant chains also can take more market share away from the independents because they can get economies of scale from bulk purchasing, he added.

But the analyst takes a different approach in assessing restaurant trusts, saying he takes more of a "downside risk" or value-oriented approach.

PDM Royalties Income Fund (target $13.70) is his top pick in the full-service restaurant sector. He rates PDM an "outperform" even though its Pizza Delight and Mikes brands are undergoing a needed revamp to be a "trade-up" choice in casual dining.

While he forecasts same-store sales growth of 2.1 per cent this year and next for PDM, he said the trust is trading as if there will never be growth. "Even if PDM doesn't grow at all, it should be worth $11.30," Mr. Tingling said.

His top pick among limited-service restaurants is Second Cup (target $11.80). Despite competition in the specialty coffee sector, Second Cup is attracting consumers who want to trade up to a gourmet coffee experience, Mr. Tingling said.

Your choice of restaurants

The Canadian restaurant trust sector

* Includes special distributions and monthly increases for 2007

SOURCES: GLOBEINVESTOR.COM AND NATIONAL BANK FINANCIAL