I am a unitholder of A&W Revenue Royalties Income Fund (AW-UN-T), and I would like to get your take on its proposed combination with A&W Food Services of Canada Inc. Do you recommend that investors tender their units for the $37 in cash being offered, or exchange their units for shares in the merged company?
Let’s clarify something off the top: There is no guarantee that you will be able exchange all of your AW-UN units for cash even if you wanted to. That’s because the cash available for redemptions is being capped at $175.6-million, which is enough to purchase up to 4,746,582 royalty fund units, or 32.5 per cent of the outstanding float (excluding units held by A&W Food Services).
If cash requests exceed $175.6-million, which is quite possible, the number of units redeemed for $37 will be prorated for each investor, with the balance exchanged for shares of the new company on a one-for-one basis. So, whether you want to become a shareholder of the new company or not, there’s a good chance you will end up with some shares.
Now, if you have no interest in becoming a shareholder of the merged company – temporarily named A&W Food Services NewCo – you could always sell your units on the open market now and pocket the cash. But you probably won’t get $37 for them, as the units closed Friday at $34.55 on the Toronto Stock Exchange, up from the prior week’s close of $28.54 before the deal was announced.
Before you sell, however, let’s look at the pros and cons of investing in the merged company.
Two presentations available on the royalty fund’s website outline the deal’s potential positives. One benefit is that NewCo expects to maintain AW.UN’s annualized distribution of $1.92 per unit, with the added bonus that NewCo’s payments – to be made quarterly instead of monthly – will be considered eligible dividends for tax purposes, as opposed to non-eligible dividends that the royalty fund currently pays. That will provide some tax relief for investors who hold the shares in a non-registered account.
A bigger change, however, is in the nature of the investment itself. Instead of receiving distributions funded by a 3-per-cent royalty on sales of A&W restaurants in the “royalty pool,” shareholders of NewCo will become direct investors in the restaurant operating company. That means their returns will be driven largely by the profitability of the entire restaurant business – in other words, the performance of its bottom line, not just the top line.
All of this is great for anyone who believes A&W has a bright future. As the presentations explain, investors in NewCo will benefit from sales growth for all A&W locations (not just those in the royalty pool), new restaurant openings, franchise fees, sales of root beer by retailers and new concepts such as Pret A Manger (Europe) Ltd., the British sandwich chain for which A&W Food Services owns master franchisor rights in Canada.
Another potential benefit is that, because NewCo will adopt a traditional corporate structure, the company could attract more interest from institutional investors and Bay Street brokerage analysts. Currently, AW-UN is not covered by any analysts.
“A&W has tremendous growth opportunities, and this new combined entity structure allows us to fully take advantage of these opportunities for the benefit of unitholders, franchisees, employees and our guests, enabling everyone to win and grow, together,” Susan Senecal, president and chief executive officer of A&W Food Services, said in a statement.
Now, for the potential downsides. If the restaurant business hits a pothole – labour and ingredients costs rise sharply, for example, or a price war erupts in the fast-food business – NewCo’s profitability and, hence, its share price would be expected to suffer.
With the current top-line royalty structure of AW-UN, investors are largely insulated from such earnings volatility. That’s one reason restaurant royalty funds appeal to risk-averse investors who are primarily seeking stable income. On the other hand, NewCo’s shares will likely be less sensitive to interest rates than A&W’s royalty units which, because of their bond-like cash flows, typically stumble when rates rise.
Many publicly traded restaurant chains have delivered solid results for investors. For the 10 years through June 30, Domino’s Pizza Inc. (DPZ) posted an annualized total return of 22.8 per cent, Chipotle Mexican Grill Inc. (CMG) returned 18 per cent, McDonald’s Corp. (MCD) 12.5 per cent and Restaurant Brands International Inc. (QSR; parent of Tim Hortons, Burger King and Popeyes) 10.5 per cent. All of these returns include dividends.
Whether NewCo will also produce such strong returns remains to be seen. To be sure, A&W has proved itself to be a worthy competitor in fast-food business. Total system sales have more than doubled to $1.85-billion in 2023 from about $890-million in 2013, making it the second-largest burger chain in Canada behind McDonald’s. And A&W still sees plenty of room for growth, with the potential to add 400 locations to the 1,062 restaurants operating as of mid-June.
Similarly, combined adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) for the royalty fund and operating company have also been on a steady incline, rising to $91.1-million in 2023, up from $86.5-million in 2022, $77.9-million in 2021 and $65.7-million in 2020.
Still, more recent results have been underwhelming. Year to date through June 16 (the end of AW-UN’s second quarter), same-store sales of restaurants in the royalty pool rose just 0.5 per cent, as an increase in the average cheque size driven by higher menu prices was offset by a decline in customer traffic. A&W Food Services attributed the softer traffic to “increased interest rates and inflation, along with market uncertainty, which have impacted consumer discretionary spending.” A&W makes great burgers, in my opinion, but its prices are not cheap.
Before you decide what to do with your units, I strongly recommend that you read the management information circular, which will likely contain additional details about A&W Food Services’ historical financial performance and outlook. The fund plans to mail the circular to unitholders in September in advance of a special meeting where investors will vote on the transaction. The circular will also be posted on Sedar.com.
Assuming the merger is approved, it is expected to close in October, after which Canada will have a new publicly traded player in the fast-food wars.
E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.