All values are in CAD, unless noted otherwise.

A&W Revenue Royalties Income Fund (TSX: AW.UN) (OTC:AWRRF) is a top-line Canadian fund. It does not operate any restaurants or pay any expenses directly. The Fund simply earns royalty income from the gross sales of the A&W restaurants, a portion of which flows down to it courtesy its investment in chain of owners of the trademark. The unitholders of this publicly traded Fund are the eventual beneficiaries of the royalty income, which comes in the form of monthly distributions [or did until very recently]. Today, we take a look at this offering from A&W Canada, “The Home of the Burger Family” which was the first of its kind that went beyond meat.

The Structure

The structure of this royalty company is complicated. We will go over it briefly and hopefully the figure at the end will help. A&W Food Services of Canada Inc. [“Services Inc.”] is the franchisor of the A&W restaurant chain in Canada. It pays 3% royalty on the gross sales reported by its franchisees to A&W Trademarks Limited Partnership, the owner of the A&W trademark. Net of expenses and reasonable working capital reserves, the funds are then distributed by the partnership to the sole general partner, A&W Trade Marks Inc. [“Trade Mark”] and from there they make their way to its two shareholders, the majority holder being A&W Revenue Royalties Income Fund [“the Fund”]. The publicly traded Fund holds some of this bounty as a liquidity buffer and distributes the rest to its unitholders.

Source: A&W Revenue Royalties Income Fund

Franchisor and Fund Interests Aligned

Services Inc. is rewarded in the form of partnership units for the gross sales of the NET new restaurants added to the royalty pool annually. These can be converted into the equal number of common shares of Trade Marks and eventually into units of the Fund in the ratio of 2:1. As of March 22, 2020, Services Inc. had the option of converting its Trade Mark shares into 23.6% ownership of the Fund.

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Hence, as you can see, the growth of the A&W chain of restaurants is in the mutual interest of the Fund and the Franchisor.

Covid-19

A&W’s most recent Covid-19 update came alongside its Q1 results on April 29. About 200 of its 995 restaurants in the royalty pool were closed, while the balance were relegated to drive thru, mobile and delivery operations. With the closure of 20% of its restaurants, the overall gross sales fell by 42% which is lower than the decline in the general food services sales in Canada of over 60%.

Services Inc. took action to increase its liquidity to support its franchisees and supply chain during these challenging times. It temporarily withheld the $2.9-million royalty payment owed to the Fund for the last month of Q1 and plans to do so for the entirety of Q2 even. The shareholders injected $10 million of equity into the business. Lastly, they are in talks to increase their credit facility from $6 to $25 million, secured against their indirect interest in the Fund.

The restrictions have eased since the height of the lockdown in March and April. However, the food services business still has its work cut out for it with the reduced traffic, increased expenses and overall uncertainty regarding when things will return to normal or what the new normal will be. What works in the quick-service restaurant or QSR model is that it is relatively inexpensive compared to the fine dining experiences, which will be attractive to the cash-strapped customer during these times. Let’s not forget the government measures to assist businesses with rent, salaries, and other forms of liquidity. A&W Canada believes that the QSR model will recover from the impact of the pandemic. However, as with other businesses, the timing and duration are unclear at this time. Our small-sample-sized observations suggest that there has been a big improvement in the last 1 month in traffic.

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Distributions

The Fund has maintained a steady yield between 4-6% over the last few years before hitting the pandemic roadblock. Investor eyes beheld, very briefly, a 10% Covid-induced yield before the dividends was temporarily suspended due to the prevailing uncertain environment.

The trustees thought it prudent to preserve liquidity as the extent and duration of the financial impact of the pandemic are murky at best during this time. This decision was also cemented by the fact that Services Inc. is withholding the royalty payments effective February 22 until at least the end of Q2 in order to preserve operational liquidity at its end. The unpaid royalties are/will be accrued with an interest rate of 2% per annum over the prime rate and are expected to be paid by December 31, 2021, if not earlier.

As to the timeline for restarting the distributions, the letter to the unitholders in the Q1 results addressed this:

The Trustees are continuing to closely monitor the results of operations and outlook of A&W Food Services and the A&W system with the intention to preserve unitholder value by restarting distributions in a prudent manner based upon A&W restaurant sales that permit distributions to be paid in amounts that are reasonably predictable.

Valuation

On account of the pandemic, we would like a higher compensation for holding this stock. Maybe 7% instead of the 4-6% range that the Fund has consistently maintained over the last few years. Based on the last monthly distribution, the price target to achieve this yield would be $27.26.

Source: Author’s Calculations

In the worst-case scenario, we expect the Fund to reach the annual amount of $1.91 or more by Q4 2022. Let us assume the dividend suspension continues for the balance of this year, and half the old distribution is in effect for 2021. We need to factor this into the calculation.

Source: Author’s Calculations

We get the above buy point for investors expecting the worst-case scenario.

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Conclusion

This is a good top-line fund to hold for diversification in your portfolio, however, there may be some queasiness in the quarters to come. It will be a rewarding play for investors that can look for immediate income elsewhere in their portfolio, giving time for this one to emerge from the pandemic woes. If that is not you, it will be highly prudent to stay away.

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Disclosure: I am/we are long AWRRF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: 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.



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