Description

Share count of 18.4 mm includes Food Service’s’ 23.6% minority stake (see below for details). All dollar amounts are Canadian dollars. 

Canada has crushed the curve

Daily new cases and deaths have declined to <200 and <10 respectively. Meanwhile, the daily hustle and bustle have returned to life. Inspired by Rearden’s excellent write-up on MTY Foods, I think at current prices A&W Revenue Royalties Income Fund (the "Fund") offers an opportunity to get long a pure-play Canadian QSR royalty stream at an attractive entry point.

Resilient business 

A&W is the second-largest burger chain in Canada with $1.5 bn of system sales (behind MCD’s $5 bn) and 1,000 units. A&W is known for its root beer and better ingredients - the chain uses beef raised without hormones and chicken without antibiotics. The price points are similar/slightly more expensive than MCD. The chain has a successful history of increasing comparable store sales and unit count. 

Same store sales growth:

2019: 4.1%

2018: 9.8%

2017: 2.0%

2016: 3.4%

2015: 7.6%

2014: 6.3%

2013: 0.4%

2012: -0.7%

2011: 0.0%

2010: 2.2%

2009: 1.5%

2008: 7.3%

Advantageous locations

Of A&W’s 1,000 locations, 550 are freestanding restaurants offering self-service counters and drive-through service. 150 locations are co-located with gas/convenience retailers. 80 locations are urban street-front locations. 

The remaining 200 locations are in food courts located in shopping centres, airports, and universities. It’s these 200 locations that are more problematic in today’s environment. However, only 90 of these indoor locations are in Ontario and Quebec, the hardest hit provinces which account for 90% of Canada’s total covid-19 cases. Encouragingly, data from ON and QC have got a lot better. ON is reporting <150 daily cases with ~0.5% positivity rate, and just reported 0 death yesterday. QC is reporting <100 daily cases and deaths have also dropped to low single digits.

Lean cost structure

Investors are already familiar with publicly traded franchisors which are involved in the day-to-day management of the system - they generate revenues from royalties, food and equipment sales to franchisees, and corporate-owned stores. They collect ad funds and manage marketing campaigns. They also sign leases on behalf of franchisees. 

In contrast, Canadian QSR royalty income funds represent a pure royalty stream with minimal opex, while the operations (food processing and distribution, equipment sales, marketing etc) remain at a separate company (“OpCo”). The Fund owns 76.4% interest in A&W Trade Marks Inc, which receives a royalty stream equal to 3% of system sales from A&W Food Services (“Food Services”, the OpCo). Food Services passes the royalties it collects from franchisees to the Fund, but makes money from margins on food/equipment sales and mark-ups on leases it signs on behalf of franchisees. As a result, Food Services bears almost all the expenses associated with managing the franchise. The Fund, on the other hand, only incurred $0.8 mm of G&A on $45 mm of royalty revenues in 2019. 

As an income vehicle with no capital requirements, the Fund typically targets almost 100% payout ratio. 

Aligned interest

A&W Food Services owns 23.6% of the Fund, and receives Fund units for new franchisees it signs into the system. Since Food Services passes its more valuable revenue source (the royalties) to the Fund and only makes money on lower margin sources, its minority stake in the Fund is arguably its most important asset. 

Strong balance sheets at Fund and OpCo

The Fund has a $60 mm term loan maturing in December 2022, and $9 mm of cash. Net debt is 1.1x 2019 EBITDA. 

Food Services does not have outstanding debt. It had $7 mm of cash as of March 22. In April, shareholders of Food Services injected $10 mm capital into the company. In May, Food Services expanded its credit facility from $6 mm to $25 mm. This credit facility is currently unused. 

These strong balance sheets should afford the Fund and OpCo the staying power to a better world. 

Canada’s covid-19 stimulus programs

Canada has established the following programs to help small businesses: 

Canada Emergency Wages Subsidy (CEWS): CEWS pays 75% of employees’ earnings up to $1,129 per week (~$58k/year) for businesses whose revenues declined more than 30% either year over year or from the average of Jan and Feb 2020. The program was enacted in April but can be used retroactively from March 15. In May the program was extended to August 29. 

Canada Emergency Commercial Rent Assistance (CECRA): businesses whose revenues declined more than 70% could have their April, May, June and July rents reduced by 75%. The tenant would still pay 25% of the rent, the landlord would take a 25% haircut, and the government would offer landlords a forgivable loan equal to 50% of the rent. 

Canada Emergency Business Account (CEBA): This is a $55 bn program offering small businesses up to $40,000 of interest-free loans. Repaying the balance by 12/31/2022 would result in 25% loan forgiveness. Small businesses whose annual payroll is between $20k and $1.5 mm are eligible. 

Temporary Wage Subsidy: The temporary wage subsidy is a 3-month measure that allows eligible employers to reduce the amount of payroll deductions required to be remitted to the CRA. The subsidy is equal to 10% of remuneration paid from March 18th to June 19th, up to a maximum of $1,375 per employee and $25,000 per employer.

Tax deferral: Businesses may defer income tax payments until August 31, 2020. In addition, the deadline to remit sales tax owing on or after March 27 was extended to June 30, 2020.                                                                              

A&W Covid-19 update

From March 13 to March 22 (end of the Fund’s first fiscal quarter), sales declined 42%, inclusive of 200 restaurants (20% of units) that were closed during the period. 

Food Service has delayed the payment of $2.9 mm of royalties on system sales from Feb 24 to March 22, and expects to defer the payment of Q2 royalties. Late payments accrue interest at 2% over prime rate. To preserve liquidity, the Fund has suspended monthly distributions. 

While the Fund has not provided further updates, some US QSR concepts have disclosed encouraging sales trends, and I believe A&W is on a similar recovery path. 

JACK: Jack in the Box® system same-store sales have accelerated into the third quarter, with same-store sales through the first eight weeks ended June 7, 2020, increasing approximately 5 percent.

WEN: Global same-restaurant sales have improved each week throughout the fiscal month of May after being impacted by the previously disclosed disruption in beef supply at the beginning of the month. Global same-restaurant sales for the last week of May turned positive in the low single digit range.

MCD: U.S.: Comparable sales results steadily improved throughout the months of April and May; however comparable sales and guest counts remained negative, particularly the breakfast daypart. Comparable sales continue to benefit from strong average check growth.

Valuation 

Before covid-19, A&W traded at 18x EBITDA and 5% dividend yield (on annualized distribution of $1.908/share). Currently, it trades at 11.6x 2019 EBITDA. As fast food consumption in Canada normalizes, I expect Food Services to catch up with its deferred royalty payments and the Fund to reinstate the monthly distributions. YTD, Canada’s 10-year yield has dropped from 1.5% to 0.5%, and A&W’s monthly distributions will be chased by investors looking for a consistent income stream.  

Risks

Failure of Food Services - I view this as unlikely given the government's strong support for small businesses and Food Services' strong balance sheet/liquidity.

While A&W is available on various delivery services, it traditionally did not emphasize this segment given its mostly drive-through locations. So its performance couldn't match Dominos during lockdown. However as restrictions are eased, A&W's convenient locations should serve the chain well. 

Appendix A

A&W’s app is ranked #7 on the Canadian app store, behind Skip the Dishes (delivery app), Uber Eats, Tim Hortons, DoorDash, McDonald’s, and Starbucks. 

Appendix B: Sample A&W menu and order pickup screen

Catalyst

System sales recovery

Reopening & survival of franchisees

Reinstatement of monthly dividend