Description

Summary:

Priszm Income Fund (Canada: QSR.UN) is the world’s largest KFC franchisee (from Yum Brands) with 483 quick serve restaurants (mostly KFC; some taco Bell) located in Canada.  Since April, shares have sold off steadily from $11 to $5.29 on weak same store sales/quarterly results and expectations that the dividend would be cut.  With the company trading at 21.4% yield on 2008’s $1.20 dividend, however, shares are now oversold and represent an attractive investment.  Even making conservative assumptions about the long run, the company should at least be able to support a $.95 distribution (assuming no improvement in the business), which represents a 17% yield at the current stock price.  Furthermore, a restructuring and the rollout of chicken bowls (which were a huge success in the U.S.) in Q1/2008 should be the catalyst that provides a lift to comps and improved profitability.

Note:  All dollars in Canadian dollars

Recent Results:

Over the period 2004-2007, Priszm’s comps have been flattish (2006 was the company’s best year with a +3.1% comp, while 2007 has been the weakest with a -3.7% comp YTD). The most recent two quarters were especially weak with comps of- 5.0% in Q2 and -4.7% Q3. 

It is difficult to directly compare these results to that of YUM’s KFC restaurants since YUM does not break out comps by brand.  However, we can interpolate from YUM’s recent comments that Priszm’s performance is not inconsistent with that of its U.S. counterparts.

From our discussions with industry participants, the weak comps are due to the fact that KFC’s most recent promotions have been unsuccessful (in particular, KFC’s transfat-free message has not resonated with the consumer).

Two keys to the story:

1) Restructuring Plan/Dividend Change

Priszm recently announced a restructuring plan to refocus on high volume and high profit restaurants. Quoting from the 3Q press release:

“It plans to sell up to 120 locations and close approximately 25 unprofitable restaurants over the next twenty-four months. Priszm expects it will receive $20 to $30 million in proceeds from the sale of these restaurants over the next two years and generate savings of approximately $4 million in 2008.”

Importantly, while these 120 locations represent ~25% of the store base, they only represent $3.5m in ebitda (the consensus ebitda estimate for ’07 is just shy of $35m).  Thus, the sale of these restaurants should have minimal impact to cash flow and will hopefully be offset by cost savings.

As a result of the restructuring plan, the company expects to take a one time $5m charge in Q4.  In order to finance this expected charge, the fund temporarily cut the distribution to 3 cents per month (from $.1067) for the remaining 3 months of the year.  In addition, the company agreed to withhold distributions on the subordinated units until 3Q 2008.

Beginning in January 2008, the dividend will be re-instated at $1.20 (down from $1.28 if you assume the $.1067 had continued throughout 2007).

In short, these actions, will improve the balance sheet, eliminate costs, improve the comps (by eliminating the weaker stores in the base), and improve the company’s payout ratio.

2) Expected Turn in Comps

On top of the restructuring actions, it appears that KFC’s comps should begin to improve in the near-term.  The first evidence we have of this is from YUM: YUM now seems more determined about improving their US business.  On their most recent earnings call, management indicated the comps recently turned positive for Taco Bell (a slight positive for QSR.UN).  And for 2008, US franchisees have agreed to allocate half a point of local ad spend to KFC’s national campaign due to enthusiasm over YUM’s upcoming new advertising/marketing plan.  In short, these two minor positives and YUM’s overall new-found determination to improve its U.S. comps (perhaps neglected in the past year as YUM has been focused on growing China) should help boost QSR.UN’s comps and overall profitability.

But the larger catalyst is likely to be the introduction of the chicken bowl.  The rollout of KFC’s famous chicken bowl in Canada should be significant.  Amid the negative comp trend, the company delivered a 7.4% comp in the Manitoba region, where it tested the chicken bowls during Q2. 

This product was also extremely successful in the US.  When it was first introduced in the States, KFC’s posted a 5% comp on top of a 12% comp the prior year.  Margins are great since the bowls use mashed potatoes, which are cheap.  While the chicken bowls are being launched across Priszm’s restaurants late Q4, the impact will likely be seen in it’s full significance in Q1/2008.

Our projections

We anticipate a modestly negative comp in Q4 given that the YUM advertising and re-focus as well as the QSR restructuring and chicken bowl rollout will largely begin to impact in Q1.  Even if all these catalysts only produce a flat comp, we believe QSR can support a 95 cent distribution.  If, as we expect, comps turn positive, especially as we get into q2 and q3 of 2008 (which are easier comps compared with 2007 than q1 is), QSR could support a higher payout, closer to the 1.20 they are expecting.  A 12% yield using the conservative 95 cent distribution would put the unit price closer to 8, for a 50% plus gain, in addition to the 17% yield.

To summarize, in QSR.UN, you have a decent business with a high yield with several upcoming catalysts which should result in a stabilization or outright turnaround in the company’s comps.  Once this becomes evident, the units should attract closer a 12% yield (I believe a 12% yield is achievable with a turn in fundamentals given that it had previously traded in a range of 9-12% during prior periods of decent/good performance), resulting in over 50% upside from it’s current price, along with the aforementioned yield.

Catalyst