Canadian (Non-Energy) Royalty earning entities - Income Oriented Investments

[FFHWatcher]

My goal in this thread is to learn more about Canadian (Non-Energy) Royalty earning entities and to openly discuss the investment pros and cons of such an entity that earns income from an operating business. 

 

Here is a quick history, as I presently understand it.

In Canada we have royalty earning entities that get paid a percentage of top line sales of a group of operating companies.  In most cases, these royalty earning entities are in the restaurant industry.  The royalties collected are in the range of 4-9% of Revenue of the restaurants that are in the 'Royalty Pool'.  Most royalty earning entities are currently structured as Income Trusts that are required to pay out all or almost all of their income to unitholders.  No tax is paid by the entity and it is taxed personally to the unitholders.  Yields are anywhere from 5-15% from these Royalty Trusts. These Income Trust structures will be changing in the very near future, and most will be converted to corporations as of January 2011.  More on that later.

 

In the early part of the decade, income trusts were very popular in Canada and many larger restaurant chains took advantage of this non-corporate, non tax paying entities.  If I understand this correctly, many restaurants separated their trade name, brand, Intellectual Property rights and trademarks, from the primary corporation and monetized that asset through an IPO of an Income Trust.  In most cases, the original corporation maintained a significant ownership in the new high yielding income producing trust.  The restaurant owner would lease an asset, which was the rights associated with the trademarks, brands, etc., into the royalty pool for a period of 99 years, in exchange for cash, while maintaining significant ownership in the Royalty Trust.  Most of the ownership of the Royalty Trust by the original restaurant is approx. 10-30%.  The restaurant receives their share of royalties based on their ownership percentage.  For example, if the restaurants pay 6% of revenue as royalties to the Royalty trust and the restaurants generate $100M of revenue, than the trust would receive $6M.  If the restaurant owns 20% of the trust, they would receive 20% of the $6M in royalties.  The public shareholders would receive the other 80%.  If the Royalty Trust is plain vanilla, than it has virtually no significant costs as they have no operations, just some minor administrative expenses. 

 

When new restaurants are developed, they are generally added to the Royalty Pool after a period of time, usually 1 year.  In return for adding the restaurant to the royalty pool, the operating company/restaurant would receive an allocation of Trust Units based on a formula that ensures the transaction is accretive to public unitholders.  The structure is pretty straightforward except a few of the restaurants have used debt which makes it a little more risky and complex to understand.

 

As I understand it and as the Royalty Funds present it, the success of these entities are almost entirely based on Same Stores Sales Growth (SSSG).  If you want your distributions to grow than you must have SSSG.  If SSSG falls by 5%, it is possible that your distribution will be cut by a similar amount.  In my analysis, that isn't a huge risk if you are invested for income.  Currently, the yields are say, 10% and if they reduce the payout due to a 10% decline in SSSG, than the new payout may be as much as 9% (ie. 10% of a 10% yield = 1%).  Share price would certainly fall 10%, likely more.  I feel the real risk is if the restaurant has steady, long term negative SSSG to the point where they eventually shut down operations as they are no longer profitable.  Therefore, one of the key risk factors is the restaurant's ability to maintain their sales and profitability for restaurant owners (restaurant owners could be corporate owned or franchisees).  If the restaurants are not profitable for them, they will close up shop.  If the restaurants close up shop, 6% of $0 is $0.

 

On Oct 31, 2006 the Canadian Financial Minister Jim Flaherty decided Canada was missing out on revenue due to the Income Trust structure.  He brought in new rules that basically said that all income trusts would have to convert to corporations and start paying tax, or stay in their current structure and pay tax as if they were a corporation.  Corporate tax rate is in the low 30% range (31.5% or so).  January 1, 2011 is the date that trusts need to be converted to corporations and most Royalty Trusts have announced plans to convert to corporations at year end. 

 

Investment Thesis - more and more investors are starved for yield with record low interest rates and the baby boomers aging and retiring.  Next month a glut of high income yielding corporations will hit the market.  Many of these former Royalty trusts will cut their distributions by 30-35% to account for the tax they will have to pay as corporations.  Their share prices may or may not be hit when they cut their distributions.  For the most part, these trusts have made their intentions very public.  While some of the income trusts that have operations (ie. business and energy trusts) are changing their strategies to being growth and income oriented while Royalty Income trusts that have no operations only have one purpose, which is to pay out all royalties/cash flow to shareholders.  With minimal overhead/administration expenses and their health based mostly on SSSG, I only see moderate risks ahead to their entities maintaining their dividends while the possibility of share price increases due to increased demand for demand producing investments.

 

Any input on this subject would be much appreciated.  Additional risk factors that I am not fully comprehending would be great.

 

Here is a list of a few of the trusts.

 

Boston Pizza Income Fund

Keg Royalties Income Fund

Pizza Pizza Royalties Income Fund*

SIR Royalties Income Fund*

Second Cup Royalties I.F.

A&W Royalties I.F.

Second Cup Royalties I.F.

 

** I have not researched all of these companies so they may not all follow the above structure that I discussed.

* I have ownership in these.

[beerbaron]

You can add Imvescor Restaurant Group Inc on your list. It's a crappy business in my opinion but trades at a very low valuation.

 

BeerBaron

[oec2000]

I bought some PZA.UN when it was yielding north of 14% for my RESP account for the reason you gave.

 

Imo, there is going to be a tug of war between:

 

1) Those who hold these trusts in their registered accounts (like me) who should, in theory, sell these positions. (When the distributions were fully taxable, it made sense to shelter the income in registered accounts but with the dividend tax credit now applicable to the distributions, it makes more sense now to hold them in non-registered accounts, and

 

2) Non-registered accounts hungry for yield who will be tempted to buy these for yield.

 

I suspect the balance will favour group 2 especially since those in group 1 may simply switch their positions from reg to non-reg accounts (although some might not have as much funds in their non-reg accounts to do the switch).

 

The other reason I bought the units was because they offered protection from food inflation. If restaurants raise prices in response to rising food commodity prices, these royalty trusts get a direct boost to their revenues. Of course, this could be offset by declines in sales. (This is why I bought only PZA because it sells a low price product that I thought would be more resilient to an economic downturn. As it turns out their SSSG have suffered slightly in the recession.)

[FFHWatcher]

You can add Imvescor Restaurant Group Inc on your list. It's a crappy business in my opinion but trades at a very low valuation.

 

BeerBaron

 

I did look at Imvescor, formerly called PDM Royalties Income Fund.  Crappy business is an understatement.  I noticed that PDM did a lot more than just collect Royalties from Pizza Delight, Scores, Mikes, Baton Rouge, etc.  They also sold advertising to the franchisees and owned corporate stores.  They broke the basic rules by having operations and overhead.  This is not an investment that I would want to be in as the risk profile is much greater than a plain vanilla entity that receives a percentage of revenue and turns around the pays it all out to shareholders.  There were quarters for Imvescor/PDM that they generated $11M in gross profit but had $8M in expenses.  In this thread, I am trying to keep the discussion around companies that collect $11.2M in Royalties, have $0.2 in admin. costs and pay out $11M in distributions.  In the future, I expect $11.2 in revenue, $0.3M in admin. $3.5M in taxes and a $7.4M dividend. 

 

I am trying to determine if these Royalty Trusts that have 12% yields are going to survive or perhaps thrive as corporations.  Going fwd., many will convert to corporations, pay approx. 31.5% in tax and reduce their yields (dividends for 2011 and in the future) to about 8%.  If sustainable over the longer term, and perhaps even with a tiny bit of growth, these entities may represent good value.  Very few corporations generate 8% or more cash returns to investors without eventually squandering that excess cash on overpriced acquisitions and inflated executive compensation.  These corps generally do not really allocate capital other than pay it all out to shareholders and have no executive compensation issues as they are paid mainly by the operating company.

 

I am particularly interested in getting a better understanding of the trusts that carry debt, especially if it is related to the operating company.  In particular, SIR Royalty and, to a lesser extent Pizza Pizza Royalty.  What is the likely scenario if the wheels fall off the top line growth for an extended period of time?  It has to turn out better than PDM Royalty/Imvescor because they had true operating expenses, overhead, etc, while SIR and Pizza Pizza do not.

[beerbaron]

Parsad, you mentionned buying Buying Boston Pizza if I remember correctly, am I right?

 

BeerBaron

[StubbleJumper]

Second Cup is not just a top-line trust anymore as it acquired the operational side of the cafes earlier this year for a nominal price.  Essentially all of their profit was being distributed to unit holders and the losers who held the cafes were making next to nothing.  Unfortunately the majority owner of the units was also the owner of the actual cafes, and he made the decision to merge them back together.  So now it's a mix of raisins and turds.

 

SJ

[FFHWatcher]

In general, is the feeling with the Royalty Trusts the same as high paying dividend entities?  15% yields plus 50% capital losses still equals as shitty investment?  That is my concern.  Chasing yield is generally idiotic and ends in major losses.  Is it the same here or is it a free ride and undervalued? 

[capitalistcollective]

Chasing yield when it is not being paid out of free cash flow is foolish but many of these trusts (or former trusts) are being disciplined about their dividends.  There is very little growth but the dividends seem quite sustainable and are therefore tempting.