Boston Pizza Royalties Income Fund Stock Report

Boston Pizza Royalties Income Fund

Boston Pizza Royalties Income Fund (BPF.un, Toronto)
RESEARCH SUMMARY
Report Author(s):  InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  The Author(s) do hold shares
Based on financials from: Dec ’16 Y.E. +Q2 ’17
Last updated: 12-Aug-17
Share Price At Date of Last Update: $21.12
Currency: $ Canadian
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): Buy rated at $21.12
SUMMARY AND RATING: We don’t show a graph of earnings per share because accounting and taxability changes over the years distort comparability. Also this entity is almost more like a perpetual  bond or perpetual preferred share than a common equity and the usual notions of revenue really don’t apply.  The value ratios indicate a  Buy rating given a 6.5% cash yield and where that cash yield might be expected to grow at  an average of 1% or 2% per year and is considered relatively low risk. (However the distribution could fall due to recession or deflation or waning popularity of the restaurants or a sharp rise in the interest rate on its relatively modest debt.) The  insider trading signal is positive. It does well on the Buffett criteria. The underlying restaurants which generate the royalty revenue appear to have competitive advantage in terms of scale and brand power. Management quality appears to be strong and trustworthy although disclosure could be improved.  Distributions were cut by 27% in  2011 due to becoming taxable but were since fully restored through growth in revenue per store and through the benefits of share buy-backs and especially the recently completed transaction to buy more of the franchise fee which has resulted in a 6.2% increase to the distribution followed by a second 6.2% increase. Longer term outlook is for the distributions to grow at probably an average 1 to 2% annually but could decline if restaurant closures exceed new openings or if restaurant sales suffer in a recession or due to any menu price decreases. Overall, we rate these Trust Units a Buy.  In particular, these units may be attractive to those that want the yield and are not looking for a very large capital gain over the years. There is certainly some risk that the unit price could decline even if the distribution is stable or continues to slowly grow.
DESCRIPTION OF BUSINESS: This entity is effectively an ownership interest in the cash flows from the franchise fees paid by the individual Boston Pizza restaurant franchisees. This entity is perhaps much more like a higher-yield debt investment than a normal equity investment but there has been some growth in the distributions (excluding a decline in distributions of about 27% when it became taxable in 2011). This Income Trust collects a royalty of 5.5% of the “franchise” restaurant sales (excludes alcohol) reported by the separate operating company which is Boston Pizza International Inc. Royalties are collected indirectly through a partnership, partly owned by Boston Pizza International Inc. The chain has about 383 restaurants. Distributions and earnings grow essentially with same-store sales growth since new restaurants result in more units being issued and are only very (very) modestly accretive. Distributions per unit can also grow modestly with share buy backs. The Fund also derives revenue from a loan made to Boston Pizza International. Closed restaurants are effectively not dilutive to earnings (except during the remainder of the year in which they close) and distributions per unit since BPI is only issued new units for the net amount of revenues added through new openings. Closures would be dilutive to earnings per unit if they exceeded new openings. The valuation is about $1,120,000 per restaurant for the right to collect 5.5% of food revenue (alcohol sales are excluded).
ECONOMICS OF THE BUSINESS: The economics are good in that the fund collects a 5.5% royalty from the food sales revenues at a very popular restaurant chain. The fund does not face any substantial risks of operating costs (there is a small interest rate risk and some modest operating costs)  but only risks of revenue levels. The restaurant chain is popular and is large enough to enjoy considerable economies of scale especially in regards to brand value and advertising but also in restaurant construction and purchasing and menu design. This entity effectively does not benefit from an increase in the number of restaurants since it must effectively buy the 5.5% royalty from each new restaurant (net of closed restaurants) by issuing new units. However it does buy the additional royalty at a 7.5% discount to market value (by issuing 7.5% fewer shares than the market value would suggest). The royalty per unit increases over the years if the same-store sales per restaurant increases which it has tended to do due to inflation. The royalty per unit would decline if there were net closures of restaurants in a year – which has never yet happened.
RISKS: This is not a comprehensive list. See annual report for additional risks. Some risk that related entities including Boston Pizza International Inc. and individual franchisees could manipulate figures or otherwise act in a way that disadvantages the Fund. The Fund relies on the continued market success of the individual restaurants and the franchise company. Restaurant success is partly based on continued management competence, aggressiveness of competitors and a healthy economy. The fund is at risk if certain locations close down and there is no net growth of restaurants to replace the closed locations.  The fund relies on related entities to continue to spend on marketing. There is also a risk that new locations can cannibalize the revenue at existing locations. Possibly there could be liquidity risks in the complex structure. Banks could refuse to renew the debt upon maturity. A related company has borrowed $24 million at 7.5% interest and could pay off that loan to avoid the interest. That  would be a modest negative impact. A related entity provides its management staff for a very low cost. There is a risk this could increase. Perhaps the biggest risk to the unit price (as distinct from the earnings and distribution) is a rise in long term interest rates.
INSIDER TRADING / INSIDER HOLDING:  Checking from December 1, 2016 to August 12, 2017. There was just one buyer and no sellers. The Chair of the Board used his full TFSA allowance for 2016 and that of his wife, in early March to buy 240 shares at $22.97 to hold 540 shares in each TFSA. In later March he bought 2000 shares in a joint taxable account at $22.42 to hold 3369 shares. In June he bought 330 shares at $22.94 in an RESP account to hold 6,375 in that RESP account worth about $135,000. This provides a positive insider trading signal. The two founders of Boston Pizza own (directly and indirectly) millions of share units or shares convertible into units.  They have tended to sell units regularly as they receive more units when new restaurants open. But these major insiders have not sold recently. A number of other insiders also own from several thousand to 49 thousand (the chairman) share units. This insider ownership is positive.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand and predict (marginal pass as there are some complex inter-company relationships), has favorable long-term economics due to cost advantages or superior brand power (pass given established top-of-mind brand although the industry is quite competitive), apparently able and trustworthy management (pass), a sensible price – below its intrinsic value (marginal pass, see valuation comments), Other criteria that have been attributed to Buffett include: a low  debt ratio (pass), good recent profit history (pass) little chance of permanent loss of capital (pass) a low level of maintenance type capital spending required to maintain existing operations excluding growth (pass -no  capital spending involved for the Fund itself)
MOST RECENT EARNINGS AND SALES TREND:  Adjusted earnings per share in the past four quarters starting with the most recent (Q2 2017) were down 1%, down 3%, down 3% and up 2.2%. Therefore the very recent earnings trend is below the average level expected (positive 1 to 2%). The lower growth was attributed to weakness in Alberta and Saskatchewan linked to oil prices and a Saskatchewan new sales tax. Adjusted earnings per share for the year 2016 were up 2%. Adjusted earnings per share for the year 2015 were up 10.9%. The growth in 2015 and in Q1 2016 was abnormally high due to an unusual transaction whereby the  entity increased its ownership of the franchise fees on an accretive basis. Adjusted earnings per share for the year 2014 were up 1.8%.
COMPARABLE STORE SALES: Same-store franchise or royalty-eligible sales in the past four quarters starting with the most recent (Q2, 2017) were down 1.6%, unchanged, down 3.1% and down 1.1%. 2016 overall was down 0.3% 2015 overall was up 1.7%. The performance in the past year was weakened by the recession in Alberta and weakness is Saskatchewan related to oil prices and a new sales tax.
Earnings Growth Scenario and Justifiable P/E: This fund which distributes 100% of its earnings justifies a P/E of 15.4 assuming an 6.5% required return (1/0.065) and no growth . In theory it would justify a P/E of 22.2 if it could be expected to grow its distribution at 2% per year indefinitely (1/(.065-.02)). If the required return is lowered to 5.0% due to the lower risk nature of this entity then a P/E of 20 can be justified with no growth and 33 with 2% growth.
VALUE RATIOS: (Based on a $21.12 unit price). Price to book value is 1.61, but we place absolutely no relevance on this in this case because the underlying asset is the intangible trade mark value of BP and the associated right to receive a 5.5% royalty on revenues (minus alcohol). The Yield is quite attractive at 6.5% but we must also consider the nature of this yield and that it represents about a 100% payout ratio which limits growth – although historically some growth has been achieved. The adjusted P/E  is moderately attractive at 15.3.  Keep in mind though that with little growth expected, but with (nearly) 100% of earnings received in cash, the justifiable P/E for this entity is about 15.4 assuming no growth and a required return of 5.5% and is 22.2 if we can assume indefinite growth of 2% and a 6.5% required return.  Or 20 assuming no growth and a required return of 5.0% (reflecting the low risk).  Adjusted ROE is good at 10.6%. We calculate the intrinsic value at $22.16 assuming zero growth and assuming a terminal P/E of 15 (6.7% yield) and $27.78 assuming 2% growth in earnings and distributions per units and that the terminal P/E is 18 (5.56% yield). This P/E of 18 relies on a required return of 5.56% reflecting the apparently low risk nature of this entity and reflecting recent record-low market interest rates. Growth is almost entirely driven by same restaurant royalty-eligible sales growth since royalties from new restaurants must be purchased  by this entity by issuing new Trust units and are only very modestly accretive. (A 10% increase in number of restaurants would add only 0.75% to earnings per unit – and that assumes zero cannibalism of existing restaurant sales). In recent years growth has been boosted by borrowing money to buy back units. This seems like a legitimate strategy but it has virtually reached the limit of its credit line for this purpose.  In much of 2015 and in Q1 2016 growth was enhanced by an unusual and accretive transaction whereby the Royalty Trust now gets 5.5% of revenue as a franchise fee up from the previous 4.0%. Additional units were issued but were issued on an accretive basis. Overall the value ratios, in isolation, would point to a Buy rating.
SUPPORTING RESEARCH AND ANALYSIS  
Symbol and Exchange: BPF.un, Toronto
Currency: $ Canadian
Contact: investorrelations@bostonpizza.com
Web-site: www.bpincomefund.com
INCOME AND PRICE / EARNINGS RATIO ANALYSIS  
Latest four quarters annual sales $ millions: $45.9
Latest four quarters annual earnings $ millions: $33.7
P/E ratio based on latest four quarters earnings: 12.7
Latest four quarters annual earnings, adjusted, $ millions: $27.9
BASIS OR SOURCE OF ADJUSTED EARNINGS: In 2007, added back future income tax which was related to multiple years. In 2008 and 2009 also added back any future income taxes.  Starting 2010 used management’s reported distributable cash flow as adjusted net income.
Quality of Earnings Measurement and Persistence: Earnings measurement is very reliable since revenues and expenses are essentially received or paid in cash with no major delays. Unlike most companies there is virtually no amortization expense. The earnings per Trust Unit should also be reasonably persistent as they derive from the revenues of the Boston Pizza locations (as opposed to the profits). These royalty revenues could fall due to competition or recession or deflation in menu prices, including closure of restaurants, but nevertheless seem to be reasonably persistent and reliable at this time. Earnings growth (or decline) is mostly dependent on growth in same-store sales and on any restaurant closures, new restaurant additions have minimal impact on earnings per unit since new units are issued for each new restaurant.
P/E ratio based on latest four quarters earnings, adjusted 15.3
Latest fiscal year annual earnings: $37.8
P/E ratio based on latest fiscal year earnings: 11.3
Fiscal earnings adjusted: $28.2
P/E ratio for fiscal earnings adjusted: 15.2
Latest four quarters profit as percent of sales 60.9%
Dividend Yield: 6.5%
Price / Sales Ratio 9.34
BALANCE SHEET ITEMS  
Price to (diluted) book value ratio:                                         1.61
Balance Sheet: The main asset is the intangible right to collect a 5.5% royalty of restaurant revenues excluding alcohol.  There is a class B and a Class C unit liability that is really more in the nature of additional equity.
Quality of Net Assets and Book Value Measurement: The assets consist mostly of the intangible right to collect the future royalties and to a smaller extent the loan owed by Boston Pizza International. This company is valued for the royalty stream and if the royalty stream became seriously impaired then there are essentially no tangible assets to provide a cushion of safety. Therefore, the book value of the assets is essentially not a relevant figure.
Number of Diluted common shares in millions:                                  20.3
Controlling Shareholder: As of Spring 2017, the two owners of Boston Pizza International Inc. control (indirectly) about 16% of the units and all of the special voting rights..
Market Equity Capitalization (Value) $ millions: $428.4
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 58.4%
Interest-bearing debt as a percentage of common equity 33%
Current assets / current liabilities: 14.6
Liquidity and capital structure: Liquidity is difficult to understand. The Fund itself has little debt but also has very little cash as earnings are paid out as received. Therefore liquidity is not that strong.
RETURN ON EQUITY AND ON MARKET VALUE  
Latest four quarters adjusted (if applicable) net income return on average equity: 10.6%
Latest fiscal year adjusted (if applicable) net income return on average equity: 11.0%
Adjusted (if applicable) latest four quarters return on market capitalization: 6.5%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE  
5 years compounded growth in sales/share 1.1%
Volatility of sales growth per share:  Modest growth
5 Years compounded growth in earnings/share 11.7%
5 years compounded growth in adjusted earnings per share 4.7%
Volatility of earnings growth:  Modest growth
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? Modest growth due to its nature
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 0.0%
More conservative estimate of compounded growth in earnings per share over the forecast period: 0.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 2.0%
OUTLOOK FOR BUSINESS:  Distributable cash (adjusted earnings) per unit should grow modestly in the next year as it laps the weak quarters of the previous year. Interest on its relatively modest debt is rising with higher rates and could prevent growth in the next year. While the number of restaurants will likely grow slowly , the fund benefits only very modestly as it must buy the royalty stream from each new restaurant albeit at a small (7.5% discount) to the market value of the royalties on a price/ royalties basis. A 10% increase in the number of restaurants increases earnings per unit by only 0.75% and that assumes no cannibalism of existing restaurants. And recent net store count growth is closer to 3% per year. Growth per unit  (or possible decline) comes mostly  from increases (or decreases) in same-store sales. (Technically from the change in same store sales to which the royalty applies which excludes liquor.)  The fund is essentially not at risk for closures since new units are issued to BPI representing 92.5% of net added revenues after accounting for closures. The fund would be at risk for closures if closures exceeded additions, which could happen at some point in the future. Share-buy backs can also have a material benefit to earnings per unit.  Longer term the distributions should grow with restaurant menu price inflation but may not grow much beyond that as the restaurants are already reasonably busy.
LONG TERM PREDICTABILITY: Due to the structure of the trust with its earnings based on 5.5% of sales (excludes alcohol), the earnings do seem highly predictable. Barring a major recession and/or deflation the earnings and distributions per unit should continue to slowly grow and this future seems quite predictable.
Estimated present value per share: We calculate  $22.16 if earnings and distributions per share grow for 5 years at the more conservative rate of 0% and the shares can then be sold at a P/E of 15 (6.7% yield) and $27.78 if earnings and distributions per share grow at the more optimistic rate of 2% for 5 years and the shares can then be sold at a P/E of 18 (5.56% yield). Both estimates use a 5.0% required rate of return (lower than our usual 6.5% because of the apparently safer nature of this investment).
ADDITIONAL COMMENTS  
INDUSTRY ATTRACTIVENESS: (These comments reflect the BP restaurants as a successful established incumbent in this industry) Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition.  No barriers to entry except for scale (fail, although scale is a significant benefit). No issues with powerful suppliers (pass). No issues with dependence on powerful customers (pass), No real potential for substitute products for the industry overall (pass) Probably limited tendency to compete ruinously on price (pass). Overall this industry appears to be moderately attractive for BP as an established incumbent.
COMPETITIVE ADVANTAGE: The Restaurants, on which the fund relies for royalties, have strong economies of scale for advertising purposes. They appear to be well managed, well located and well positioned in the casual dining market. The requirement for restaurants to renovate every seven years probably increases sales but could be problematic if it is too expensive for the franchisees. Ultimately they do not have any truly sustainable competitive advantage in this very competitive industry except their brand power and established menu and business practices. Their brand is powerful and is top-of-mind especially in small cities.
COMPETITIVE POSITION: Boston Pizza indicates that it is the number 1 causal dining brand in Canada.
RECENT EVENTS: A big event in 2015 was that the fund purchased an additional 1.5 percentage points of the franchise fee. It previously had 4%. New units were issued to finance this but the purchase was about 9% accretive per unit and the distribution was raised 6.2%. And then was raised another 6.2% in February 2016. Continues to open new restaurants. A few restaurants have closed. However, new restaurants generate an automatic addition to the number of fund units and thus do almost nothing to increase earnings per fund unit in any case. Two restaurants closed in 2016 and 13 new ones were opened. Six restaurants closed in 2015 and 12 new ones opened. Six restaurants closed in 2014 and 14 new ones opened.  Two restaurants closed in 2013 and 12 new ones opened. Two restaurants closed in 2012. Three restaurants closed in 2011. Four restaurants closed in each of 2011 and 2010 while  1 restaurant closed in 2009 and two restaurants closed during 2008 while only 1 closed in the five years prior to that.   Selling gift cards through Petro Canada and other retail partners and through Air miles. Have promoted more take-out and delivery business.
ACCOUNTING AND DISCLOSURE ISSUES: There are some complex accounting issues raised by the Trust structure and its relationships with an associated Partnership, the managing General partner, the franchise company, Boston Pizza International and the ultimate sales at the individual restaurant level. Accounting for the purchase of royalty rights from new restaurants has been complex. The impact of potential dilution in Trust Units seems complex. Overall, we are not aware of any reason to be concerned by these complexities, but we note that they do exist and might be of concern in future. Offsetting this complexity is the fact that the cash earnings of the Trust are very transparent and are received by Unit holders in cash. As an illustration of the complexity the accounting was changed in 2005 to no longer consolidate the associated Partnership. Then with the adoption of IFRS in 2011 the partnership was once again consolidated. The impact of share buy-backs is also a complicating factor. The Trust sometimes borrows permanently at short-term money rates to buy back units and avoid a distribution that is much higher than the cost of borrowing. But this may be risky. The treatment of actual and potential units owned by Boston Pizza International is complex. There is a deferred income tax liability but there was no explanation of whether this could be expected to reverse and become payable.
COMMON SHARE STRUCTURE USED: One vote per unit except that Boston Pizza International Inc. controls certain special voting rights.
MANAGEMENT QUALITY: The Fund itself is a non-active business and has delegated day-today administration and management to an “external manager” which is Boston Pizza GP Inc. which is 20% owned by the Fund and 80% owned by Boston Pizza International Inc. We have little basis on which to judge management quality but we do note that the restaurants seem to be doing well. We are concerned though that earnings often report headline the total revenue growth and do a poor job of high-lighting the results on a per unit basis. This causes us to be concerned about how candid the management is. Share buy backs in 2009 at around $10.00 were a very astute move. More recent buy backs in the range of $17 also seem to have been astute. Overall the management disclosure seems to lack plain language and does not do the best job of explaining some of the complexities. Still, the quality of management seems good.
Capital Allocation Skills: By its nature management is limited in its capital investment decisions. By prior agreement it is required to invest in the royalty of new restaurants by issuing new units to founders of Boston Pizza. It has however displayed great capital allocation skills by borrowing money at attractive rates to repurchase units at attractive prices and more recently in issuing new units to the public in order to increase its royalty share from 4.0% of eligible revenue to 5.5% and did so at a price that was about 9% accretive to existing EPS.
EXECUTIVE COMPENSATION: There are no executives and no employees. The three Trustees are compensated at about $66,000 per year. This compensation seems quite modest. Effectively a related company provides the management and charges a modest fee for doing so. This could rise in future. In 2016 the total administrative expenses were $1.174 million which amounted to 3.54% of revenue and only 0.27% of the market value of and 4.17% of distributable cash.
BOARD OF DIRECTORS: There are just three trustees, all of who appear to be independent of the owners of Boston Pizza International Inc. Two of the three own a moderate amount of Trust Units (5000 and 6250) while the third owns 49,000 units. In addition there are 5 directors of the General Partnership.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, earnings growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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