Why now might be the time to start nibbling on A&W

What is your outlook for A&W Revenue Royalties Income Fund (AW.UN)? Why has the unit price fallen so much?

Before I answer your questions, I’ll briefly explain the structure of the fund. This will provide some context for understanding why the units have been struggling, and why they might be at or near a bottom.

When you invest in A&W Revenue Royalties Income Fund, you aren’t buying into the burger chain itself. Rather, you are acquiring a stake in the entity that owns the trademarks used by the operating company, A&W Food Services of Canada Inc. In exchange for licensing the trademarks to the chain, the income fund earns a royalty equal to 3 per cent of gross sales by A&W restaurants included in the “royalty pool.”

The stream of royalty pool income, in turn, funds the monthly distributions paid to unitholders of A&W Revenue Royalties. Currently, the fund distributes 16 cents per unit each month, or $1.92 annually, which works out to a yield of about 6.7 per cent based on Friday’s closing unit price of $28.65.

One advantage of restaurant royalty funds is that, because their revenues are tied to top-line sales and are not affected by costs for labour, ingredients and other operating expenses, their royalties – and, hence, distributions – tend to be relatively stable. The COVID-19 pandemic was a rare exception, when many royalty funds, A&W included, slashed their distributions as sales dried up and some restaurants closed temporarily. (I sold my A&W units at the time, both personally and in my model Yield Hog Dividend Growth Portfolio. View the portfolio online at tgam.ca/dividend-portfolio).

But as the pandemic faded and people went back to dining out, A&W has since boosted its payout several times. Its distribution is now slightly above prepandemic levels, yet the unit price has sunk to its lowest since late 2020, when COVID-19 fears were still rampant.

Why have the units lost their sizzle?

There are a couple of reasons. One is that sales at A&W’s restaurants have cooled off recently. In the first quarter ended March 24, same-store sales for the more than 1,000 restaurants in the royalty pool rose just 0.6 per cent on a year-over-year basis – down from growth of 2.1 per cent in the fourth quarter – marking the weakest showing since same-store sales fell 5.6 per cent in the first three months of 2021. Same-store sales are the biggest driver of distribution growth for royalty funds, so investors may have interpreted the results as a sign that A&W’s monthly payout, which was last raised in October, 2022, won’t be increasing again any time soon.

On its first-quarter conference call on May 9, the company attributed the meagre same-store sales increase to a higher average check size, reflecting inflation-induced price increases, offset by a decline in customer traffic. Consumers’ disposable income is “under a lot of pressure, given things like interest rates and rentals and food inflation,” Susan Senecal, president and chief executive officer of A&W Food Services, said on the call. “And that’s why we’re really focused right now on offerings that give great value, and in particular, great value for families.”

A second reason the unit price has dropped is that bond yields have remained stubbornly high. Because of the relatively stable nature of their distributions, royalty fund units trade somewhat like bonds, whose prices decline when interest rates rise. Since the start of 2022, Canada’s five-year government bond yield has more than doubled to about 3.7 per cent. Over the same period, A&W Revenue Royalties’ unit price has tumbled about 28 per cent, pushing its yield up by about 2 full percentage points.

What will it take to get the unit price moving higher? Clear signs that inflation is under control and that the Bank of Canada plans to cut interest rates would certainly help. So would an improvement in A&W’s same-store sales growth, which the chain is trying to reignite with new menu offerings such as its Brew Bar and old classics like its Whistle Dog. The company also recently signed a long-term development plan with British sandwich chain Pret A Manger (Europe) Ltd., which will include the introduction of Pret coffee to A&W restaurants nationally this fall.

Absent falling interest rates or rising sames-store sales, I would expect the units to continue muddling along.

Still, there’s a case to be made that the units offer good value at their current price and that further downside may be limited. The current dividend yield represents a spread of about three percentage points over the yield of five-year government bonds. That compares with a spread of about 1.9 percentage points two years ago. In other words, A&W investors today are earning a significantly fatter yield premium over government bonds, which may indicate that the unit price is close to a bottom, assuming bond yields don’t suddenly surge higher again.

If you decide to invest, keep in mind that the fund is thinly traded, with an average daily volume of less than 20,000 units. The lack of liquidity can lead to wide spreads between bid and ask prices, contributing to volatility. As such, you may want to use a limit order specifying the maximum price you’re willing to pay.

A&W Revenue Royalties isn’t the sort of stock that will generate huge returns. But with much of the bad news already baked into the unit price, investors can likely look forward to a stable distribution and the potential for modest capital gains over the long run.

E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.