Making minimum wage (TSE:SRV.UN)

The province of Ontario has passed a law to increase the minimum wage in 2018 and 2019.  The minimum wage which was $11.60 in 2017 has increased to $14 this year and will increase to $15 next year.  This is an astonishing 20.7% and 7.1% consecutive increase.  I don’t usually take marco-economics into account when I evaluate investments, but this is too big to ignore and regardless of your political opinion on the matter is a reality.

As an investor the best way I can see to take advantage of this is an investment in SIR Royalty Income Fund (SRV.UN).  SRV.UN is a trust fund which owns the trademarks of SIR Corp. which include the restaurants Jack Astor’s Bar, Scaddabush Italian Kitchen (formerly Alice Fazooli’s), Canyon Creek Chop House and several others.  This entitle’s the fund to receive a 6% sales royalty on the restaurants listed above as well as interest payments on a loan to SIR Corp.  You can read more details about the fund here.  The main message though is that the greater the sales at the restaurants that SIR Corp. owns, the more money flows to SIR Royalty Income Fund.  The fund is committed to pay out 100% of it’s earnings after taxes to it’s unit holders in the form of dividends making SRV.UN more or less a pass-through entity.

Now, what does the minimum wage have to do with this? Well the reality of the restaurant business is that it is hyper competitive and low margin.  That means that any increases in costs will be passed onto consumers in the form of price increases and the restaurant industry is one of the biggest employers to people earning minimum wage.  The unique features of SRV.UN is that it derives earnings from the total revenue of the restaurants and it unaffected by their costs.  So menu price increases are good for the fund while labour cost increases have no effect.  Also almost all of SIR Corp’s restaurants are located in Ontario.

Looking deeper we can view the latest yearly result for SIR Corp. posted Nov. 22 on sedar.  We can see that for the year ending on August 27, 2017 the total operating costs of the restaurants were $270 million with labour costs making up $108 million for a ratio of 40% of operating costs.  I am going to assume that about half of the wages were paid employees making close to minimum wage.  There is also likely an effect on pay to restaurant managers though who would expect a small pay bump as well, but I will leave that out of the calculation. That would mean that a minimum wage increase of 20.7% and 7.1% would likely result in total cost increases of 4.14% and 1.42% and given that restaurants are small margin businesses they would need to increase prices by about the same amount.  These increases would be on top of general inflation of around 2% that you would expect every year regardless.

For a royalty stock I consider anything paying more than 8% to be a good investment.  An investment SRV.UN generated distributable cash of $1.18 per unit in 2017.  Given it’s unit price of $14.52 as of this post that gives a cash yield of 8.1% which I would consider a good investment by itself.  But given that we can expect menu price increases of 4.14% and 1.42% due to minimum wage plus 2% each year for inflation I expect the distributable cash to increase to $1.295 in two years time which would give a yield on cost of 8.9%.  I believe that SRV.UN is a good investment at the current price and that $16.20 would be a good exit price.

Disclosure: I own shares of SRV.UN