According to StatsCan, from October 2019 to December 2021, the retail price of Prime Rib increased from $32.66 to $42.30, an increase of some 30%.  Going forward, it isn’t just protein costs on the rise.  Shipping costs, wages, food packaging, cooking oil, etc., are all moving higher.  

This isn’t great, but as it relates to the KEG ROYALTIES, inflation actually benefits unitholders, as the royalty paid from the operating entity (KRL) to the Royalty Trust is 4% of gross sales.  Like all restaurants, the KEG has been raising prices, and this likely persists.   The risks associated with raising menu prices involve falling traffic due to customer reticence, and no growth in the total restaurant count if individual locations (either corporate or franchise) aren’t generating an adequate return.  But as it stands, Canadians by and large have been returning to the Keg and paying the higher prices.   With perhaps one exception – seniors.  In talking to some KEG managers, this is the one demographic that hasn’t really returned, understandable given the Covid concerns.  Hopefully, this changes thru 2022 and into 2023. 

It is important to ensure that KRL is in reasonable financial shape, given the Trust’s reliance on KRL.   KEG files the statements for the operating company, so how are things going this year?

Year to date, viewing the financial statements, the Keg Operating business (KRL) generated $32.7 million in cash flow from operations, which doesn’t include $15 million in net lease payments and $4.2 million in interest costs.  Sustaining capital expenditures were $2.9 million, So if we look at a conventional definition of free cash flow, tosses back a figure of $10.6 million.   This includes the $11.21 million in royalties paid to the Trust. 

Now recognize that Keg received government assistance.  For the 2021 YTD, KRL received $18.9 million in CEWS (Canadian Emergency Wage Subsidy) and $3.27 million in the Rent Subsidy provided by the government.   So if the government assistance didn’t exist, KRL would have burned thru $11.57 million in cash to sustain its business.  Not great, but not a disaster either, given the circumstances, and management would have likely changed a great many things had govt assistance not been forthcoming.

In the third quarter of 2021, KRL had closures for 8.6% of the available trading days.  Considering that total system sales were $153.5 million for the quarter, we can surmise ($153.5 million /(1-0.914)) that run rate system sales assuming all restaurants open would have been $169 million.   Royalty expense (paid to the Trust) on that run rate figure would be $6.8 million (versus the $6.1 million recognized and paid by KRL in the statements). 

In the two years prior to the onset of the pandemic (2018 and 2019), Keg generated an identical $650 million in system sales (includes gross corporate and franchise sales) and EBITDA levels of $28.6 million (2018) and $25.5 million (2019), inclusive of paying the Trust $25.3 million per annum (~4% of sales).  The number of restaurants in these years was ~105, so average sales per restaurant was $6.2 million.  In the third quarter of 2021, this was $5.7 million in average sales per restaurant, a figure held back by 8.6% of available trading days closed and some capacity restrictions (also more delivery and less in-house means less alcohol sales).

The Keg has weathered the Covid storm, aided by generous (and needed) government subsidy programs, and, positively for unit holders, has not seen its total unit count decrease since Covid began.  KRL will clearly look to nuance its menu to factor in inflationary conditions, but menu price creep can only go in one direction for the foreseeable future. 

From my perspective, KEG ROYALTIES is a reasonable vehicle for this backdrop, as they benefit from the top-line without consequence for the costs.   A loyal customer base, not unreasonable prices (especially when compared to garbage like East Side Marios, Milestones, etc), good locations, no chef risk (is glorified meat and potatoes), and a good dining atmosphere.  BTW, have been a long-term holder of KEG for income stream, so yes, I am bullishly-biased.

Good luck...