CA - A&W: Close But No Burger

2023-12-21 10:00:00 ET

Summary

• A&W Revenue Royalties Income Fund got a pass for being too expensive at the time of our last coverage.
• The stock has grown into its valuation to some extent.
• We tell you why we came close to buying this 6% yielder, but ultimately took a pass.

All values are in CAD unless noted otherwise.

Prior Coverage

We have covered A&W Revenue Royalties Income Fund (AWRRF)( AW.UN:CA ) a few times on this platform. Each time we have been neutral on this royalty play.

So A&W was always a bridesmaid, never a bride. While we have not found any fault with the numbers of this business, it was trading at a price too expensive for our taste. On our last coverage, the yield, while solid, was insufficient in the era where the 1-year GICs were doling out 5.35%. We preferred to wait before jumping in.

It is hard to find any fault with the company except we can bring up our observation that some of the pricing has gone a little out of whack with reality. Fast food is getting incredibly expensive and A&W has so far been enjoying this price increases via its direct leverage to the top line. But somewhere here with housing costs rising so rapidly and Canadians out on a limb on variable rate mortgages , there will likely be some push back. We would only look to buy this at a far lower multiple today and aim for maybe 13-14X earnings. This would get us to the $28-$30 zone.

Source: A&W Revenue Royalties: Another Dividend Hike Coming For This 5.4% Yielder

The stock currently trades around $31.80.

So while the price is moving in the right direction, the dividend hike that we expected in Q3, did not come to pass. In this piece, we will walk you through the recent numbers and explain why we came close to buying this, but ultimately stayed out. But first, a quick introduction for those unfamiliar with this company.

The Royalty Fund

The 1,048 A&W Restaurants across Canada cater to the burger et al. fast food cravings of its inhabitants.

The Royalty Fund holds close to an 80% interest in the owner of the A&W trademarks, A&W Trade Marks Inc.

The owner of the trademark receives a 3% royalty on the top-line sales of the restaurants in the pool. A proportionate share of these funds (net of expenses and a reasonable reserve) reaches the Income Fund in the form of dividends. As the royalties are based on the gross sales, the fund inflows are not impacted by the variability of the restaurant's bottom lines. The focus of the ownership group is on increasing the size of the pool and the sales in the existing restaurants. Barring 2020, neither of the two metrics has seen a down year since inception.

By the looks of it, 2024 will be no different. The royalty pool is set to increase to 1,047 effective January 5, 2024. The Royalty Fund distributes to its unitholders most of what it receives in dividends, with the aim to have a payout ratio close to 100%.

Q3-2023 Results

In the most recent quarterly results, the same store sales grew (1.1%), but to the lessor extent than the comparable 2022 period (4.0%).

That makes sense, as the 2022 numbers were coming off a lower base due to the pandemic-related restrictions that were in place in 2021. The 2022 increase reflected a higher guest count compared to 2021, as well as menu price increases. The 2023 numbers on the other hand were primarily due to a modest increase in the menu prices in a bid to pass on some of the inflationary pain to the customers. The larger royalty pool of restaurants, and resultant higher gross sales, paved the way for the year-over-year royalty income to increase by 3.8%.

This business continues to benefit from the interest rate swap that was put into place last December. This lucrative deal has cut the effective interest rate on the $60 million term loan from 3.95% to 2.85%. That, along with the interest income on cash, has earned this fund an impressive 45% decline in year-over-year net interest costs.

Q4 is typically the strongest quarter for this restaurant business, which means that despite the solid performance in the first three quarters, the best of 2023 is yet to come.

Outlook and Verdict

While the overall numbers look nice, the 1.1% same store sales growth is a bit disturbing. Canadian inflation has been running rather rampant at over 3%. We have also added close to 2% in total immigrants to Canada over the last 12 months. So same store sales should be powering at least 5% all other things being equal. This makes the 1.1% at least slightly concerning. An analyst did question the slower rate of growth and the fact that it did not keep up with inflation during the earnings call.

Ed Sollbach

Okay. Because with 5%, 6% inflation, I would think transactions are down materially year-over-year?

Susan Senecal

No, I'd say that, we've really been able to keep pricing in a range that said -- that we're not looking at inflation numbers and saying that our prices -- will change by that much. In fact, we've sort of done the opposite. And really, with our Brew Bar items, for example, had lower average checks, more affordable options, things for guests.

And again, it's quite, it's quite sporadic in terms of -- it depends on where you look and what you look at. So, we're still trying to get a read on what that number is and should be. And we think that 2023 will be a good baseline year straight for growth in 2024.

Source: A&W Q3-2023 Conference Call Transcript

This business only works as an inflation hedge to the extent the higher costs are passed on to the customers, and as we have seen in the response above, that cannot always be the case. That sharp analyst was diving deep into this area even before the above exchange.

Ed Sollbach

Hello. I'm wondering if you have any data about the volume year-over-year?

Kelly Blankstein

Our sales for Q3 were up 1.1% and for the year-to-date are up 3% over 2022, which was also a solid sales year.

Ed Sollbach

Okay. But that's that dollar value, right?

Kelly Blankstein

Correct. Yes.

Ed Sollbach

Yes, like I'm talking after inflation, like, I know, prices have gone up. So I would think -- that the same-store sales were actually down after inflation?

Susan Senecal

It's a bit of a mixed bag. We have like shopping center restaurants that are sort of still rebounding, from the post pandemic period, in terms of people shopping habits, and so on. We have urban restaurants where things are growing as people come back in. And of course, things like delivery and mobile ordering has become more of a factor. So it's a little bit hard to tell what the underlying trends are.

Because what we measure in our business is transactions. So, I would say that, that's still settling in -- settling down. And what we what we see going forward would be growing -- our number of visits, and continuing to find those opportunities, like either dayparts, as Tom was mentioning, or products and seeing how all of those do. So right now, it's a little bit hard to kind of pin a number that says, with or without inflation, because the restaurants or the business has changed quite a bit.

Ed Sollbach

But what would the transaction number be?

Susan Senecal

Well, that's what I'm saying. It depends which concepts you're looking at what regions you're looking at, sort of how deep the impact was of the -- pandemic. So, we don't look at -- break it out exactly like…

Ed Sollbach

Are you going to share that data with shareholders like what those transactions are, overall?

Source: A&W Q3-2023 Conference Call Transcript

Investors can read that entire transcript but suffice it to say that Susan Senecal did not come close to answering that actual question. Of course, the math is the math. If we assume there was price inflation in the 2-4% range on the menu, then total transactions were down 1-3%. That is a tough pill to swallow when you have indeed added a massive population growth tailwind. But it does make sense when one considers just how expensive fast food has become since the pandemic. The average price a person has to fork out has increased by roughly 30%-40% since 2020 in our experience. You can only push on that so long before people revolt. On the positive side, A&W has grown into its valuation. Over the last two years, the price has dropped 20% and the earnings have grown steadily to really compress the multiple.

Projecting for 2024, we would expect a 14X multiple on the current price. That would normally be close enough to pull the trigger on this stock. But that transcript exchange was rather unsettling. If management is asked what the volume is, we expect a clear answer. Not a long diatribe that does everything but actually answers the question. If we had long-dated options that could buffer our entry, we might still have taken that LEAP (get it?) of faith. But here we are taking a pass and will wait for a stronger setup on valuation.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

For further details see: