John Heinzl is the dividend investor for Globe Investor's Strategy Lab. Follow his contributions here. You can see his model portfolio here.
Craving dividends? Restaurant royalty stocks could hit the spot.
Whether you prefer pizza (Pizza Pizza Royalty Corp.; Boston Pizza Royalties Income Fund), burgers (A&W Revenue Royalties Income Fund) or casual dining (Keg Royalties Income Fund; SIR Royalty Income Fund), there's plenty of choice on the menu.
As a class, royalty stocks have several things going for them: They offer above-average yields; their share prices tend to hold up relatively well in market slumps; and in many cases, their distributions have been climbing gradually. "For some time, we have promoted the restaurant royalty stocks as a defensive alternative within more volatile equity markets," Michael Glen, an analyst with Laurentian Bank Securities, said in a note earlier this year. "This defensive attribute is primarily related to their dividend yields and the sustainability of these yields through periods of economic uncertainty."
Before you indulge, though, it's important to understand how these securities work.
When you invest in royalty shares, you're not buying a piece of the restaurant business itself. Rather, you're investing in an entity that owns the restaurant's trademarks, which are licensed to the operating chain in exchange for a royalty. The royalty is based on a percentage – usually 4 to 9 per cent – of sales by stores in the "royalty pool."
Royalty agreements can be complex, but the key thing for investors to know is that the restaurant chain's same-store sales – that is, sales at locations open for at least a year – are the main driver of distribution growth. New restaurants added to the royalty pool also contribute to distributions, but not to the same extent.
Royalty stocks aren't risk free. Same-store sales are influenced by myriad factors, including the weather, the economy, competition, price increases, advertising and new menu items. But generally speaking, restaurant royalty shares are less volatile than traditional restaurant stocks because royalties are based on top-line sales and are not affected by the earnings and expenses of the operating company.
In recent months, many royalty stocks have been serving up distribution increases after posting solid sales gains.
In early November, for instance, Pizza Pizza Royalty (PZA) hiked its dividend by 2.5 per cent – its second increase this year – to 6.97 cents per month, or 83.64 cents annually. Based on Tuesday's closing price of $14.15, the shares yield 5.9 per cent.
For the third quarter ended Sept. 30, the company reported same-store sales growth of 6.3 per cent, with Pizza Pizza stores up 7.5 per cent and its smaller Pizza 73 chain – located primarily in the struggling Alberta market – ahead 0.8 per cent. "Given what has been traditionally a conservative board, the move, in our view, signals confidence in the company's outlook despite showing some early signs of consumer capitulation in Alberta," TD Securities analyst Derek Lessard said in a note.
Based on Mr. Lessard's expectations of continued same-store sales growth at Pizza Pizza and "flat to only modest" growth at Pizza 73, he projects that the company will boost its dividend by 5.8 per cent in 2016 and 5.4 per cent in 2017.
Because royalty companies have minimal expenses, they can afford to distribute most of their cash flow to investors. Mr. Lessard estimates Pizza Pizza's 2015 payout ratio at 94 per cent, rising to 99 per cent in 2016, assuming the company increases its dividend as expected.
A&W's sales and distributions have also been on the rise. Fuelled by same-store sales growth of 8.3 per cent for the third quarter ended Sept. 6, the fund (AW.UN) in October raised its distribution by 3.3 per cent – the second increase this year – to 12.5 cents per month, or $1.50 annually. Based on Tuesday's closing price of $27.75, A&W's units yield 5.4 per cent.
"A&W continues to significantly outperform its peers in terms of [same-store sales growth] … with results clearly indicative of market-share gains," Laurentian Bank's Mr. Glen said in a note. He attributed the sales growth to A&W's emphasis on better ingredients along with other menu innovations and limited-time offers.
Given A&W's payout ratio of about 97.6 per cent of distributable cash and expectations for continued growth in same-store sales – despite softness in the Alberta market – Mr. Glen said that "A&W can afford additional distribution increases, and we have factored an incremental 6-per-cent increase into our 2016 estimates."
Keg has also raised its distribution twice this year and Boston Pizza – whose shares rose Tuesday after it announced better-than-expected results – has increased its distribution once in 2015. SIR – whose brands include Jack Astor's and Alice Fazooli's – last raised its distribution in 2013.
If you're considering restaurant royalty stocks, keep a couple of things in mind. First, the units tend to be thinly traded, so it's important to use a limit order specifying your buy or sell price. Second, the tax treatment of distributions varies. For example, Pizza Pizza Royalty's distributions are eligible dividends for tax purposes, whereas A&W's distributions are classified as non-eligible dividends and taxed at a higher rate.
Finally, don't let the juicy yields of restaurant royalty stocks cause you to overindulge. Invest in moderation as part of a well-balanced portfolio.
Disclosure: The author personally owns shares of PZA and AW.UN.