September 16, 2012 Comments

I am just reading the annual report for Boston Pizza Royalties Income Fund..

This company (actually entity) is an example of how a share price can increase for reasons not much related to the performance of the company itself. These units have risen 34% this year. We had rated them (higher) Buy at $14.19 for the start of this year and now they are at $19.08.

So why the big rise?

The distributions have risen from $1.104 annually to $1.176 annually. So that’s a 6.5% increase and that does not go very far to explaining a 34% rise in the price.

The mechanics of this fund are such that for the most part new restaurants do not add to the distributions per unit. The owners of the franchise company receive units of this fund when they increase the restaurant count in a year. Roughly speaking the franchise company (which is not the fund) gets 92.5% of the benefit of the increased restaurant count and existing fund unit holders get 7.5% of the benefit. A doubling in the restaurant count, all else equal would only increase the distributions per unit by about 7.5%. So prospects for new restaurants cannot possibly explain much of the 34% increase in price.

A possible risk the fund faces is if the number of restaurants declines. The franchise company only gets new units for net new store openings. Fund unit holders are basically unaffected by closures, EXCEPT if the number closed exceeds the number opened. Fund distributions per unit would decline (all else equal) if the number of operating restaurants ever declines. This has never happened, but in 2010 there were 6 closures and six openings and so it almost happened. But in 2011 there were seven openings and four closures and this risk does not seem to be a serious risk, but it could be at some point.

The distributions will increase roughly in line with same store sales growth over the years. A very good year in same store sales growth is on the order of 6%. In the first half of 2012 same store franchise sales are up 4.9%. And that presumably was the basis for the distribution increase of 6.5%.

And I don’t think the outlook for future all-important same store sales growth has really changed much since January 1, 2012.

So, again we can explain about 6.5% of the increase in price of 34% and some 27.5% remains to be explained.

Part of the increase is possibly related to the fund’s unit buy-back operation. About 5% of this year’s increase came after they announced in late August that they would buy back some units. The fund can borrow money at quite low rates and then use the money to buy back units which saves it the 6.2% yield on those units. This operation can increase the distributions per unit over time. Buy backs are not magic and are not always beneficial. But in this case it does seem like a beneficial operation. It is particularly wise to do this when the units are under-priced, which was probably the case early this year and may arguably still be the case. While the fund wisely bought back units in 2008, 2009 and 2010 at an average price of $10.10. It apparently did not buy any back in the last 18 months or so until it announced a buyback on August 22. It’s not clear why buying back at $18 or $19 is considered wise when apparently they were not willing or able to buy back at much lower prices in 2011. Reports so far do not show any actual buy-backs under the this new program that commenced on September 4. (They may simply have not reported it yet, or maybe they were hoping to buy at the $18 price

Here is the rest of the explanation.

At the start of this year the units had a yield of 7.78%. Today the yield is 6.16%. The yield percent had dropped by 21% even though the distribution went up by 6.5%.

What has happened is that the while the fund distribution has grown about as expected and its outlook for growth has not changed much, the market has “decided” to place a higher value on the units. Previously the market wanted 7.78%, which was a pretty fine yield considering it could be expected to grow at perhaps 2 to 4% per year based on same store sales growth. But there was some risk that same store sales could fall in a recession or even worse that there would be a net reduction in the number of restaurants if closures exceeded openings.

Now the market has determined that even at 6.2% yield this is a reasonable investment given that the yield might be expected to rise at say 2 to 4% per year. And if it did rise at 6.2% and if the yield and P/E ratios remain the same then this would provide a 10.2% return so that does seem attractive.

Part of the reason the price increased was probably related to the general decline in interest rates. At a 7.78% yield and where the distribution could be expected to grow these fund units were increasingly attractive as interest rates fell and so the price was pushed up. Perhaps the market also became more confident that the unit distributions would in fact grow. In particular the risk of the restaurant count declining may be viewed as being lower now.

The thing to remember at this point is that the price of these units would likely fall if there was a major increase in interest rates. And this would happen even if the restaurant same store sales continued to increase.

At a 6.2% yield (and with probably but not guaranteed growth and with some risk of distribution decline, however unlikely) these units still seem attractive. They may well continue to increase in price even faster than the 2 to 4% per year underlying expected increase in distributions. But at some point if interest rates rise they could fall in price for that reason.

I own some and though I trimmed my position recently to take some profits, I have no particular plan to sell any. And I am wondering now why I did back up the truck at much lower prices when they were available.