One of Canada’s best-known fast-food chains – and the country’s strongest brand – has a new recipe for a major corporate restructuring.
A&W Food Services of Canada Inc., a successful and growing company based in North Vancouver, plans to consolidate its operations, purchase the A&W Revenue Royalties Income Fund (TSX:AW.UNP) and conduct an initial public offering.
The timeline for that process is not yet available, but is expected to be released soon, according to executives at A&W, which independent brand valuation firm Brand Finance ranked earlier this year as Canada’s strongest brand for the second year in a row.
Susan Senecal, CEO of A&W Food Services, said voting instructions will be mailed to unitholders and filed on Sedar in a management information circular, likely in September. Regulatory approval could follow this fall.
A&W has a complex corporate structure
While many, if not most, Canadians are familiar with A&W’s hamburgers, its famous root beer and its mascot Root Bear, the company’s somewhat convoluted organizational structure is less well known.
Since 2002, its trademarks and intellectual property have been owned by the A&W Revenue Royalties Income Fund, listed on the Toronto Stock Exchange.
Investors in this company own a vehicle that earns its income from royalty payments.
More than 98% of A&W Food Services’ restaurants are part of a business segment the company calls a “royalty pool.” The income fund receives 3% of the gross sales generated by the restaurants in the royalty pool, and substantially all of that money is distributed to unitholders.
In exchange, A&W Food Services restaurants and franchisees may use A&W trademarks, such as branding, menu item names and mascots.
A&W Food Services, on the other hand, operates largely as a franchisor: 1,052 of A&W’s 1,062 restaurants in Canada are franchised. Its only company-owned restaurants are 10 in Ottawa, which were launched in the 1990s and were intended to show potential franchisees in Eastern Canada that the company had a market share in the operation. These locations are also used to test new products.
A&W Food Services charges franchisees a one-time fee of $55,000 for each 20-year agreement to operate an individual A&W-branded restaurant, plus a recurring royalty of 6%, split into a 3.5% service fee and a 2.5% marketing fee.
The company requires all franchisees to dedicate one percent of their gross sales to community initiatives and marketing.
A&W Food Services derives a portion of its revenue (a single-digit percentage) from selling A&W brand root beer in cans and bottles to various suppliers, such as restaurants and grocers, Senecal told BIV.
It also recently became the master franchisor for Canada for London, England-based takeaway sandwich giant Pret A Manger.
A Pret A Manger test store is operating in Toronto, and A&W Food Services is “active in determining what the next locations will be and how we want to expand,” Senecal said.
The result of this split corporate structure is that the only public option to invest in A&W is to purchase shares of the income fund.
This has become a problem because investments in income funds behave more like bonds than stocks.
Prior to the announcement of the proposed repurchase, unitholders received monthly distributions of $1.92 per unit, for an annualized yield of 6.7%.
The Bank of Canada’s rapid interest rate hikes, starting in March 2022, have led to a parallel rise in bond yields. As a result, income-seeking investors now have more options for high yields, Senecal told BIV.
That dampened interest in buying shares of the income fund, and the income fund’s performance was below what the combined adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) of the new company would have been, according to an A&W presentation.
The income fund’s directors realized this and “began having conversations” with A&W Food Services shareholders about combining their fund with A&W Food Services’ operations, Senecal said.
The latter has four major shareholders, she added. They include private equity firm TorQuest, income fund chairman and former A&W Food Services CEO Paul Hollands, A&W Food Services chairman emeritus and former CEO Jeff Mooney and a shareholder Senecal declined to name. Together, those four investors hold a majority stake and have agreed that merging the two A&W entities is desirable, Senecal said.
“It all came together pretty quickly, in my opinion,” she said.
If the merger goes through, it would attract more institutional investors, analysts and stock market liquidity, she said, adding that the company could then likely trade at a valuation similar to other large fast-food chains.
What the future might hold
If the merger and IPO go through, shareholders in what is now dubbed Newco would own a stake in the entire company and, instead of just being exposed to the amount of gross sales generated by the royalty-bearing restaurants, would also be exposed to the company’s overall profits or losses.
If operating costs of servicing franchisees increase faster than fees collected from franchisees and other sources of revenue, the company as a whole could record a net loss and the company’s stock price would likely come under downward pressure.
Senecal, however, said she expected investors would fare much better under an A&W merger.
This is because they would be exposed to new restaurant openings, she explained. They would also benefit from business synergies and higher profit margins through a larger franchisor.
An investor presentation describes A&W Food Services as a “high-margin, capital-light franchise business” that exhibits “high free cash flow conversion.”
All this before the Pret A Manger brand franchise took off.
If the transaction is completed, unitholders of the income fund will have the option to sell their units, convert them into shares of A&W Food Services or a combination of both.
The $37 per unit value represents a premium of approximately 30% over the value of the units prior to the announcement of the proposed merger.
A&W Food Services is only willing to pay $175.6 million to buy the units. So if there is greater demand from unitholders to cash out, they could be forced to convert some units into A&W Food Services stock, which they could then sell.
The units purchased by A&W Food Services will be prorated so that all unit holders who wish to sell certain units may do so.
The $175.6 million is enough to buy nearly 4.75 million units, or 32.5% of the units not already owned by A&W Food Services.
Management stressed that the planned structural change would not impact operations. That means there will be no management shakeup and a new publicly traded company will be based in North Vancouver.
(protected email)
