Yesterday, Cara Operations Ltd. – owner of such iconic
brands as Harvey’s, Swiss Chalet and East Side Mario’s – announced the purchase
of Keg Restaurants Ltd. (KRL) in exchange for $105M in cash and around 3.8M new
shares of Cara with a current value of $94M. In the next few days, I'll be doing a series of posts on the transaction. Today's post gives an introduction into just who KRL is.
Prior to the acquisition, KRL was 51% owned by Fairfax
Financial. Fairfax is a large company, and does not disclose KRL’s results –
either its balance sheet or income statement - separately.
This raises the question: What is Cara buying?
While information on KRL is not so easy to come by, around 15
years ago KRL spun off its intellectual property (mainly its brands) into a separate, publicly
traded entity called the Keg Royalties Income Fund in exchange for around $113M. (The publicly traded KRIF units are not part of the Cara transaction, although the ones owned by KRL are.) The public filings of KRIF
contain some interesting information on KRL and give us some picture of what
Cara is getting in the deal. To wit:
- As of October 1, 2017, KRL owned and operates 48 “Keg” restaurants in Canada and the USA. There are an additional 56 franchised restaurants, all of which are located in Canada (KRIF 2017 Q3 Report, p. 3). The total number of stores has actually declined somewhat in the past couple of years (ibid, p. 6), but has hovered between 100 and 105 in the past couple of years.
- Interestingly, in the quarter ended October 1, 2017, the 56 franchised stores did $80.6M in sales (or $1.4M per store), while the 48 corporate stores did $73.8M in sales (or $1.5M per store) (ibid., p. 13), so at least on a sales basis there is not much difference between the franchised and corporate stores.
- According to the Keg’s website, franchisees pay a royalty equal to 6% of gross sales. In addition, they pay a marketing fee equal to 1.5% of gross sales.
- KRIF receives a royalty equal to 4% of gross sales from (essentially) all of the Keg restaurants (both franchised and corporate-owned). Annual sales from these restaurants are around $600M (which means the average Keg restaurant does around $6M in annual revenue), so royalties paid to KRIF are around $24M per year.
- KRIF has around 11M units that are publicly traded, with a market price per unit of around $20 (although this dropped by almost 4% yesterday), and thus a total market cap of around $220M. KRL owns around 3.5M shares in The Keg Rights Limited Partnership (the legal entity that actually owns the Keg brands and which issues the payouts to the KRIF) that are exchangeable for KRIF units on a 1:1 basis; effectively, KRL’s shares in KRIF are the equivalent to around 1/3 of the market cap of KRIF, or $74M. At least, that is the value assigned to the KRIF partnership units in Cara’s management presentation yesterday and which appears on KRIF's balance sheet, although I wonder at this valuation, given that historically the distributions of “interest” payments to the KRL units have represented a higher proportional allocation (closer to 1/3 of KRIF’s operating income than the 1/4 they would be entitled to if they converted to KRIF units). I'll talk a bit more about this in my next post.
- Moreover, while existing unitholders of KRIF benefit from growth in same-store sales of existing Keg units, whenever a new Keg store is added almost all of the benefit accrues to KRL in the form of additional partnership units being issued.
So what is Cara buying? It is getting:
- A 2% royalty (i.e. 6% minus the 4% paid to KRIF) and 1.5% marketing fee on the gross sales of the 56 franchised restaurants.
- 3.5M Partnership units in the underlying partnership of KRIF.
- The revenue and expenses from the existing 48 corporate-owned restaurants.
- The potential for growth in either corporate stores (and their associated profits) or franchised stores (which generate initial franchise fees of $75,000 and incremental royalties).
- Based on yesterday’s management presentation, KRL has $25M in net debt ($35M of debt, less $10M in cash).
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