In our last post, we looked at what Cara will be acquiring
when it closes its acquisition of Keg Restaurants Ltd. (KRL). In this post, we
dig into the Keg’s numbers a little more to try and figure out why Cara is
reportedly paying over $200M for KRL’s shares. Bear in mind that these
observations are based on a somewhat cursory review of the transaction and the limited data that is publicly available; I
certainly would not recommend basing any investment decisions on them.
As we discussed previously, Cara is acquiring three main
assets in this deal:- KRL’s 3.5M units in the partnership that underlies Keg Royalty Income Fund (KRIF), an investment vehicle that receives a royalty equal to 4% of the gross sales from all Keg restaurants. These are assigned a market value of $73.9M on KRIF’s 2017 Q3 financials (the units are recorded as long term liabilities on KRIF’s balance sheet).
- A 2% royalty (i.e. the 6% charged to franchisees, minus the 4% paid to KRIF) on the gross sales of the 56 franchised Keg restaurants.
- The revenue and expenses from the 48 corporate-owned restaurants that do around $300M in annual sales.
Partnership
units
KRIF reports that it has around 11.4M units outstanding,
but that on a fully-diluted basis the number of units would be 14.9M (2017 Q3
report, p. 12). This is because KRL’s 3.5M partnership units are exchangeable
for KRIF units on a 1:1 basis. Given that the 11.4M fund units have a market
cap of around $220M (it was slightly higher at the time the 2017 Q3 balance sheet was prepared), the 3.5M partnership units would therefore now be worth around
$68M ($220M/11.4M x 3.5M = $68M).
Looking a little closer, I am not sure if the math is as
simple as that. It appears that the partnership units get a slightly better distribution
from KRIF than
the regular unit holders; they have received around 27% to 28% of KRL’s total
operating income over the past year, as opposed to 23% (which they would
receive based on 3.5M/14.9M = 23% of the fully diluted units), as shown below:
There also appears to be some reference to this in the
notes to the latest quarterly report; for example, Note 7 to the financial
statements says:
The Class D units were issued to KRL in
return for adding net sales from new Keg restaurants to the Royalty Pool and
are entitled to a preferential proportionate distribution and a residual
distribution based on the incremental royalty paid to the Partnership.
This would imply a somewhat higher valuation for these partnership shares
($220M/73% x 27%) = $81M.
Now, this assumes that the cash flows for both the KRIF units
and the partnership shares will continue to grow at the same rate. This is
likely not reasonable; as we discussed in our previous post, when a new Keg store is added, most of the value of the incremental royalties from that store accrue to KRL in the form of new partnership shares. How do we adjust
for that?
The yield on the KRIF units is around 6%; that is, the annual
distribution is around $1.20 for every unit worth $20. The yield, or
capitalization rate, is a function of:
a) the risk free rate,
b) the equity risk premium,
c) an industry risk factor (this will likely be negative,
since the cash flows of KRIF are very stable, as we’ll discuss below)
d) a projected growth factor.
Without getting into the details of all this, if one assumes
that the income allocated to KRL’s partnership shares will
increase, say, 1% per year faster than the income to the regular KRIF fund
units, then the required yield on the KRL shares would be 5%, and the value of
the shares would be 20% higher than the KRIF units. If we make that adjustment,
our $81M suddenly becomes $97M ($81M
x 6%/5%).
The 2% royalty
The 2% royalty alone would appear to be worth around $6M per year in revenue (based on annualized franchised sales of around $320M. How much of this flows to the bottom line? Looking at Cara's segmented reporting for 2017, it seems like around 85% of royalties flow to the bottom line as pre-tax operating income:
So the $6M in revenue yields around $5.2M in pre-tax
profit, or $3.9M after tax (using a tax rate of around 25%). Assuming a capitalization rate of 5% (based on the
same growth assumptions as above) would give a value of around $77M for the royalty stream to goes directly to KRL.
The
Corporate Stores
This is a bit more tricky to figure out.
We know the existing 48 corporate-owned restaurants do
around $300M in annual sales (2017 Q3 report, p. 13).
Based on Cara's management presentation,
normalized EBITDA for KRL prior to payment of royalties to, and receipt of
interest income from, KRIF, was $41.9M; after considering those amounts, the
EBITDA is $23.5M. I find these figures somewhat puzzling; the corporate stores
only pay around 4% x $300M = $12M in annual royalties to KRIF, and the
partnership shares receive around $10M in annual distributions, so I don’t see
how you get an adjustment to EBITDA of $18.4M.
In any event, the value of the interest paid to the partnership shares is the basis for the value of those shares, so to value the corporate stores on a standalone basis, we need to take their pre-royalty EBITDA (which I’ll assume for purposes of this exercise is $41.9M) and deduct $12M in royalties paid to KRIF. We also need to strip out the $5.2M in royalty operating income, which we’ve treated separately. This suggests that on $300M in annual sales, the corporate stores are generating EBITDA of around $25M, or around 8%.
Interestingly, this is very similar to the EBITDA margin that Cara’s corporate-owned restaurants earned in Q3 of both 2016 and 2017. At first glance, this is somewhat surprising, given that the narrative around this deal is that the management team from the Keg will be coming in to improve operations at some of Cara’s higher end brands. However, don't forget that our 8% margin is after deducting a 4% royalty paid to KRIF; Cara's corporate stores (I assume) do not pay such a royalty, so actually KRL's operations do seem to be more efficient than Cara's.
So that’s EBITDA; how much free cash flow does KRL make on these restaurants? Unfortunately, we don’t have enough information to say. Cara’s financial filings indicate that capex for corporate stores for the past couple years have averaged around 10% of sales. I haven’t researched whether this is a long-term average or just a temporary surge; if the former is the case, then it would suggest that corporate restaurants are not generating much, if anything, in the way of free cash flows or standalone value.
Debt
So far, we've looked at the cash flows to KRL before consideration of debt. To get the share value, you need to deduct the value of the interest bearing debt.
Cara's management presentation shows that KRL has net debt of $25M ($35M in debt less $10M in cash).
KRIF's balance sheet shows that KRL owes it $57M on a note payable, which pays an interest rate of 7.5%. KRIF thus gets around $4M in interest payments from KRL per year.
Conclusion
After all that, things are still pretty murky. However, we
can offer a few tentative conclusions:
- The main source of value in KRL lies in the royalties that are generated from The Keg restaurants. This value is split between a) KRL’s partnership units in the underlying partnership of KRIF and b) the additional 2% royalty stream that franchisees pay to KRL.
- The corporate owned stores, while they generate $300M in annual revenue, do not have as much value, at least on a standalone basis.
