Boston Pizza Income Fund: A Safe 8.2% Yield With Capital Gains Potential

I see a low-risk stock with an 8% total return floor and a 10-11% ceiling

Your author is no fan of the restaurant business. Most of the time, at least.

Many wannabe restaurant operators are sucked into the business, armed with nothing more than a dream, a vague plan, and a few half-baked recipes. If an operator can capture just 1% of all away-from-home meals in their city, they’re one a one-way rocket ship to billionaire status.

After all, everyone needs to eat.

Reality is a cruel mistress, especially in the world of restaurants. That large market attracts competition, and there’s nothing stopping them. The moat in the entire sector is nonexistent. Margins are constantly under attack, and that’s assuming the average operator even keeps track. Anyone who has ever watched an episode of Bar Rescue knows how clueless a lot of restaurant owners are. Staff are out to steal as much as possible, probably because they’re in an industry where they have to depend on the generosity of strangers to make a decent wage.

I can go on, but you get the point. It’s a pretty crummy business, but it keeps enticing people because there’s some serious upside if you do it right.

I prefer to get my restaurant exposure a different way. I’m happy to invest in some of the best brands in the country, the kinds of operations that have already figured out the economics of their businesses. These brands offer an easy-to-follow roadmap for their franchisees, giving them a set of standards that, if followed, lead to success. In exchange, all the parent asks for is a percentage off the top.

It’s an excellent win-win scenario.

A select few Canadian companies have taken this a step further and offered what I think is an even better investment product. These brands give investors the opportunity to invest directly in that top line royalty stream without worrying about all the other headaches of running a restaurant. These investments have been around for years, too, and provide both excellent long-term returns and dependable dividends.

Don’t believe me? Let’s take a look at a few, including A&W (TSX:AW.UN):

Pizza Pizza (TSX:PZA):

Keg Royalties Fund (TSX:KEG.UN)

(The funny thing about these royalty stocks is many investors avoid them because they’re just yield plays and they don’t offer any upside potential. Which might be the case, but they end up doing pretty well if you reinvest the dividends.)

And finally, the topic of today’s post, Boston Pizza Royalties Fund (TSX:BPF.un), which hasn’t performed as well as the others.

Despite underperforming its peers, I’m bullish on Boston Pizza. Let’s take a closer look.

The skinny

Boston Pizza traces its roots back to Edmonton back in 1964 when Greek immigrant Guy Agioritis opened Boston Pizza and Spaghetti House. The concept was an immediate hit and demand was there to start franchising the concept. One of the first franchisees was former RCMP officer Jim Treliving, who purchased his location in 1968.

By 1983, Treliving and his business partner George Melville had purchased Boston Pizza International, which had grown to 44 locations in Western Canada. The concept was expanded to Eastern Canada and into the United States, although the latter hasn’t been terribly successful.

These days there are 377 Boston Pizza restaurants with the majority of locations still located in Western Canada, but there are some 110 restaurants in Ontario, 25 in Quebec, and 18 in Atlantic Canada. It has become the largest fast casual dining spot in Canada with system sales surpassing $1B.

Now’s probably a good time to talk about the stock’s royalty structure. The Boston Pizza Royalties Income Fund doesn’t actually own a single restaurant. It owns all the Boston Pizza trademarks, which are then licensed to Boston Pizza International (the operating company), in exchange for 5.5% of all sales in the underlying restaurants (excluding alcohol), minus the pro-rata ownership stake the operating company has in the royalty company.

If you’re confused, it’s easier to understand the model if we pretend the operating company doesn’t own a portion of the royalty company. Investors are treated to an income stream of 5.5% from every Boston Brute sale, every Perogy Pizza sale and every order of Cactus Cut Potatoes in every restaurant. There are a few corporate expenses like interest and taxes, but pretty much every dollar that flows in flows back out to shareholders in the form of one of the best dividends you’ll find, anywhere. More on that, later.

2022 results were released about a month ago and even though many parts of the country still had COVID-related lockdowns in the first part of the year, sales were still strong. System-wide sales increased to $855M, up substantially from 2021 and 2020 results. Those aren’t the best comps for a restaurant chain, but the company still performed relatively well compared to 2019, when overall sales were $854M. Note 2019’s sales came from about 15 extra stores compared to 2022’s sales. The company closed some non-performing locations during the pandemic.

Even before the pandemic, Boston Pizza had some issues. The first set of problems really came back in 2014 and 2015 when the company’s Alberta and Saskatchewan stores reported weaker than expected sales as an overall slump in the local economy hit the top line. The price of oil was the main culprit, and shares slumped on the weak results.

Oil recovered a few years later, but by then the company was dealing with other issues that impacted sales. Minimum wage hikes in the mid-2010s in key markets like Ontario and Alberta led to the chain being forced to increase menu prices. Combine that with a lackluster menu (which has been revamped more times than this author can count, although he can only count to 10), and more competition, and there were a few lean years in there with flat-to-slightly lower same store sales and eventually a distribution cut at the end of 2019.

You could argue the same issues are plaguing Boston Pizza today, but I really think they’ve turned a corner.

Boston Pizza today

Let’s first talk about what COVID did to the restaurant business in Canada. According to Restaurants Canada, folks are still struggling. From a September, 2022 report:

Please don’t make fun of my terrible highlighting skillz

Independent restaurants were hit especially hard by the pandemic, with most taking on new debt to get through the pandemic.

85% of all independent restaurants took on new debt to make it through the pandemic. And half aren’t making money even though we all think restaurants have recovered. Yikes.

If that wasn’t bad enough for independent restaurants, some 200,000 workers left the industry for good during COVID after getting their hours cut or their job temporarily eliminated. Labour shortages continue to be a problem for the entire industry.

Restaurants are also having problems passing on input cost increases. Restaurant prices are up approximately 7-8% on a year-over-year basis, but food inflation is over 10%. These restaurants also have to deal with other forms of inflation, like increased wages and higher fixed costs.

Put it all together and we have:

• Sales that have just recovered to 2019 levels

• Three years of pouring cash into businesses, additional debt, and the emotional burden of dealing with the pandemic

• Cost pressures from every direction

• Labour shortages

• Some pricing power, but not enough to make up for higher ingredient costs

That translates into a pretty bleak outlook for the industry, but an especially poor outlook for the independent restaurants that compete with your local Boston Pizza franchise.

There’s a reason why chains have come out of the pandemic in much better shape than independents. They’re better equipped to deal with every issue on the list.

The beauty of royalty companies is you don’t need to need to worry about all that stuff. Remember, our earnings stream comes right off the top line. All we need to worry about is the restaurant being able to raise prices and grow same-store sales over time. The first is pretty much a given. The second is a little more complicated.

As mentioned, Boston Pizza struggled with increasing same-store sales from 2015 to 2019. I think the company is past these struggles for a few different reasons, including shuttering some of its worst-performing locations in the pandemic and my bearish outlook for independent restaurants. The same Alberta-centric portfolio that was an issue in 2015 should be an asset over the next few years as the energy sector remains solid. And travel should continue to be strong in 2023-24, a good thing for generic restaurants that won’t offend grandma or the grandkids.

Valuation and dividend

Why I like the restaurant royalty stocks is I view them as a high-quality bond with a little bit of upside potential.

In other words, I view Boston Pizza as a pretty much guaranteed 8.2% return (its current dividend yield), plus it should have 1-3% annual upside potential from increasing same-store sales. Any additional restaurants adding to the royalty pool are just gravy.

My hurdle rate is 10%, and I think there’s a pretty good chance BPF.un does 10-11% annually going forward. And if not, my worst case return is the dividend. I’ll take that risk/reward tradeoff all day long. I like stocks with high floors.

Boston Pizza isn’t your typical dividend growth stock. Since it pays out virtually all of its earnings to shareholders, investors may have to endure periodic dividend cuts as the payout ratio surpasses 100%. This happened in 2019 and again in 2020, although the latter cut wasn’t the company’s fault. There was apparently a pandemic happening or something.

It hasn’t been all dividend cuts and sadness for Boston Pizza shareholders. The company regularly increased dividends between 2002 and 2017, barring one dividend cut as it converted from an income trust to a corporation. It has also increased the dividend three times in the last year, including increasing the current payment to 10.7 cents per share each month. That’s still down a little bit from 2019’s 11.5 cent monthly dividend, but there should be room to hike the payout again in 2023 as higher menu prices translate into increased sales.

Besides, Boston Pizza is quick to point out it has paid more than $25 per share in dividends since its IPO. It is proud of that record, and it should be.

The current payout is 8.2%, or $1.284 per share annually. This should end up being approximately a 95% payout ratio, a concerning number for the rest of the dividend universe but pretty okay for a top line royalty company.

The bottom line

I’m the first to admit Boston Pizza Royalties Income Fund doesn’t offer much upside. I think 11% annually is as good as this stock will ever perform. But it comes with very limited downside, which I especially like. I’ll gladly take a floor of 8.2% if it comes with a little upside potential.

This isn’t a stock that’s going to make anyone rich. But it does offer plenty of predictable income that you can use to create a really nice compounding effect if you’re still in the accumulation stage of your investing journey. Or you can simply withdraw the distribution, knowing the share price should stay relatively consistent.

There’s also upside if interest rates go down again. Shares trade hands at $15.31 currently. They spent much of the mid-2010s above $20 each. I’m not optimistic about the stock getting back to that level anytime soon, but I can also envision a world where a distribution growing 1-2% per year is worthy of a 5-6% yield, not an 8.2% yield. A 6% yield on today’s distribution would be worth $21.40 per share, or approximately 40% upside from here.

Disclosure: Author owns shares in each restaurant royalty company included in this article, including Boston Pizza. Nothing written above constitutes financial advice. Consult a qualified financial advisor before making any investment decisions.