Second Cup Income Fund
TSX : SCU.UN

Second Cup Income Fund

March 18, 2010 08:14 ET

Second Cup Income Fund Announces 2009 Results and Conversion Plans

MISSISSAUGA, ONTARIO--(Marketwire - March 18, 2010) - Second Cup Income Fund (the "Fund") (TSX:SCU.UN) reported today financial results for the fourth quarter and year ended December 31, 2009, and other matters as discussed below. The Fund's units are traded on the Toronto Stock Exchange under the symbol "SCU.UN". All amounts in this news release are presented in thousands of Canadian dollars, unless otherwise indicated.

Highlights

  • A 2.8% increase in net earnings per unit from $0.2973 to $0.3057 for the fourth quarter excluding the future income tax recovery in 2008 and 2009 and the trademark impairment charge in 2008.
  • A 4.4% decrease in net earnings per unit from $1.1284 to $1.0789 for the year excluding the future and current income tax recovery in 2008 and 2009, the transaction costs in 2009 and the trademark impairment charge in 2008.
  • Same Café Sales decline of -1.3% in the fourth quarter and -3.2% for the year.
  • Acquisition of The Second Cup Ltd. on June 27, 2009.
  • Board proposes conversion to a corporation effective January 1, 2011.
  • Continued monthly distributions of $0.07667 per unit in 2010.
  • 2011 dividend policy set at $0.60 per share annually.

The fourth quarter of 2009 witnessed a smaller decline in same café sales of -1.3% compared to the prior year's decline of -1.4% in the fourth quarter and as compared to the declines in the previous three quarters of 2009. The decline is largely due to weakness in western Canada, resulting from among other things, high vacancy rates in office towers in Calgary and the softer economy in Alberta.

"Like most of the retail sector, Second Cup experienced soft same café sales in 2009, with improvements in the trend line in the fourth quarter. Notwithstanding that, we are very confident in the strength of the Second Cup brand", commented Stacey Mowbray, President & CEO of The Second Cup Ltd. ("Second Cup" or "Company"). "We are the largest franchisor of specialty coffee in Canada and we have a unique position with our guests as the trusted coffee experts. We value our unique relationships with our coffee growing estates and partners, our many local food partners and our franchise partners. I want to thank our many franchise partners who everyday provide our guests with high quality, unique offerings with the trust and thoughtfulness only an individual owner can consistently deliver."

Board Proposes Conversion to a Corporation

The Fund announced today that its board of trustees has approved the proposed conversion from an income trust structure to a public corporation (the "Conversion") and its distribution policy for the balance of 2010 and dividends in 2011.

The Conversion is expected to be completed on or about January 1, 2011 and is subject to the approval of the unitholders of the Fund, to be obtained at an annual and special meeting (the "Meeting") of the unitholders to be held on June 2, 2010. Under the proposed Conversion, unitholders will receive, on a tax deferred basis, one common share of the new corporation, on a one-for-one basis for each unit held. All current members of the board of trustees and senior management are expected to continue serving as the directors and officers of the new corporation.

In conjunction with its review of the Conversion, the board of trustees retained Scotia Capital Inc. ("Scotia Capital") to act as its financial advisor. Scotia Capital has provided the board of trustees with an opinion that, as of the date hereof and subject to the particular assumptions and considerations summarized therein, the consideration to be received by unitholders pursuant to the Conversion is fair, from a financial point of view, to such unitholders. The full text of the Scotia Capital fairness opinion will be included in the management information circular to be mailed to unitholders in connection with the Meeting.

The Fund also announced that it will continue to distribute $0.07667 monthly ($0.92 annually) for the balance of the 2010 year. The Fund's board of trustees has approved a dividend policy post Conversion which was developed to continue to pay out a substantial portion of its earnings while retaining a sufficient amount to adequately fund its organic growth initiatives. Commencing in 2011, dividends will be paid quarterly starting on March 31, 2011. The dividend will initially be set at $0.15 per share on a quarterly basis or $0.60 annually. Consistent with past practice, the level of distributions/dividends will be reviewed periodically by the board on the basis of a number of factors including the financial performance, future prospects and capital requirements of the business. The objective of the dividend policy post Conversion will be to reflect a payout ratio of approximately 75% to 85% of net earnings per share, on a normalized basis.

Rationale and Benefits of the Conversion

On October 31, 2006, the Department of Finance announced the Specified Investment Flow-Through rules ("SIFT Rules") which, through subsequent legislation, changed the manner in which publicly traded income trusts and their distributions are taxed. The SIFT Rules will become applicable to the Fund in 2011 or earlier if it exceeds certain growth restrictions set out under the SIFT Rules. Recent further amendments to the SIFT Rules allow for a trust's conversion to a corporation to be effected on a tax deferred basis if completed in 2012 or sooner.

Having regard to these legislative changes, as well as, the opportunities to advance its long-term strategic plan, the Fund believes that it is in its best interests to proceed with the Conversion at this time. Additional benefits associated with proceeding with the Conversion include:

  • Enhanced access to the Canadian capital markets;
  • A corporate structure that is expected to attract new investors and provide a more liquid trading market, given the diminishing significance of the public business income trust market;
  • It is expected that the Conversion will provide flexibility regarding the retention of capital to fund the future growth of the business;
  • A simplified tax and legal structure, more comparable to the majority of public companies operating in Canada;
  • Following Conversion, distributions to owners will be characterized as dividends, which, for qualifying owners, will provide the benefit of dividend tax credits; and
  • It is expected that the Conversion will be completed on a tax-free rollover basis for unitholders, and no income tax will be payable by the Fund.

Details of the Conversion

The Conversion will be undertaken pursuant to a court approved plan of arrangement and, in addition to court approval, is subject to customary commercial conditions, including the receipt of regulatory approvals including The Toronto Stock Exchange. It is also subject to the approval of not less than 66 2/3% of the votes cast at the Meeting of the Fund's unitholders to be held to consider the Conversion which will be held on June 2, 2010, concurrently with the Fund's annual general meeting. A management information circular and proxy statement outlining the details of the Conversion are expected to be mailed to the Fund's unitholders by the end of April 2010 and will be available on SEDAR (www.sedar.com).

Board Maintains Monthly Distribution of $0.07667 per Unit for February 2010

The Fund has announced that its board of trustees has approved a cash distribution of $0.07667 per unit for the month of February 2010, payable on March 26, 2010 to unitholders of record at the close of business on March 24, 2010.

Year to Date Analysis

Analysis of Revenues

Revenues for the year were $19,504 compared to earnings and interest from equity accounted investment in Second Cup Trade-Marks Limited Partnership ("MarksLP") of $12,567 in 2008. Excluding sales from Company operated cafés, the effective royalty rate was 8.5 %.

Revenues from Company operated cafés were $2,819 for the year. Second Cup ended the year with seven Company operated cafés.

Other income for the year was $3,019. Other income includes: initial franchise fees, which are recognized as income when new cafés are opened; renewal fees, which are recognized when an existing franchisee enters into a new franchise agreement; transfer fees earned on the sale of cafés from one franchisee to another; construction administration fees; purchasing coordination fees earned; and other income earned by Second Cup on the sale of its coffee through alternate channels.

Operating, Administrative and Corporate Café Operating Expenses

Operating and administrative expenses include the general overhead expenses of Second Cup, as well as professional fees, public entity costs and trustee fees relating to the administration of the Fund. Operating costs and administrative expenses increased from $411 in 2008 to $5,415 in 2009, mainly as a result of the acquisition of Second Cup. In addition, the operating costs and expenses of Company operated cafés, amounting to $2,730, are now included. Year to date, the Fund recorded amortization of $126 on property and equipment and amortization of $141 on franchise rights.

Other Income and Expenses

The Fund incurred interest expense of $708 (2008 - $727) related to its term loan and $150 (2008 - $50) in amortization of the term loan's financing charges. The Fund also recorded a non-cash credit of $114 (2008 – charge of $269) for the movement in the fair value of the derivative interest rate swap, which fixes the interest rate on the Fund's term loan. The Fund incurred other interest expense of $5 and earned bank interest income of $6 year to date (2008 - $44). The Fund recorded a loss of $76 on the writedown and disposal of Company operated cafés. In 2008, the Fund recorded a non-cash impairment charge related to the carrying value of its investment in MarksLP of $24,349.

Income Taxes

A future income tax recovery of $1,144 was recorded in 2009 related to changes in future tax rates. In addition, an income tax recovery related to prior years of $150 was recorded, including $103 included in the equity accounted income of MarksLP (2008 - $nil). In 2008, the Fund recorded a non-cash future income tax recovery of $3,664, primarily related to the impairment charge.

Net Earnings

The Fund's net earnings for the year were $11,464, or $1.1614 per unit, compared to a loss of $9,531, or ($0.9642) per unit in 2008. Excluding the transaction costs of $480 (2008 - $nil), the current income tax recovery of $150 (2008 - $nil) related to prior years, and the future income tax recovery of $1,144, net earnings were $10,650 or $1.0789 per unit. In 2008, excluding the non-cash impairment charge of $24,349 and the non-cash future income tax recovery of $3,664, net earnings were $11,154 or $1.1284 per unit, a decrease of 4.4%.

Café Development

In terms of 2009 network development, Second Cup opened 13 cafés and closed 30 cafés, the majority of which had sales below the average performance of its cafés. In terms of renovations, 25 cafés were renovated. As previously reported, management's decision to close unprofitable Company operated cafés is designed to improve the overall earnings of Second Cup.

Distributable Cash

Distributable cash is not an earnings measure recognized by generally accepted accounting principles ("GAAP") and therefore may not be comparable to similar measures presented by other issuers. Distributable cash year to date was $9,680, or $0.9806 per unit compared to $11,377, or $1.1510 per unit in 2008. This decrease is primarily due to the changes in non-cash working capital, which on a year to date basis increased by $910 for the Fund, and decreased by $76 for MarksLP up to the acquisition date, compared to an increase of $96 for the Fund and MarksLP in the comparable period in 2008. Changes in non-cash working capital are primarily due to the timing of payments. Excluding the impact of changes in non-cash working capital, distributable cash would have been $10,514, or $1.0651 per unit, compared to $11,473, or $1.1607 per unit for 2008, a decrease of 8.2%. This change is partly due to transaction costs of $480 ($0.0486 per unit) relating to the acquisition of Second Cup.

Fourth Quarter Analysis

Analysis of Revenues

Revenues for the quarter were $7,300. Excluding sales from Company operated cafés, the effective royalty rate was 8.5%.

Revenues from Company operated cafés were $1,217 for the quarter. Second Cup ended the period with seven Company operated cafés.

Other income for the quarter was $1,687. Other income includes: initial franchise fees, which are recognized as income when the new cafés are opened; renewal fees, which are recognized when an existing franchisee enters into a new franchise agreement; transfer fees earned on the sale of cafés from one franchisee to another; purchasing coordination fees earned; and other income earned by Second Cup on the sale of its coffee through alternate channels.

Operating, Administrative and Corporate Café Operating Expenses

Operating and administrative expenses include the general overhead expenses of Second Cup, as well as professional fees, public entity costs and trustee fees relating to the administration of the Fund. Operating costs and administrative expenses increased from $148 in the fourth quarter of 2008 to $2,834 in the current quarter mainly as a result of the acquisition of Second Cup. In addition, the operating costs and expenses of Company operated cafés, amounting to $1,061 in the quarter, are now included. The Fund also recorded amortization of $75 on property and equipment in the quarter and amortization of $85 on franchise rights.

Other Income and Expenses

The Fund incurred interest expense of $178 (2008 - $183) related to its term loan and $54 (2008 - $12) in amortization of financing charges also relating to the term loan. The Fund also recorded a non-cash credit of $57 (2008 - charge of $176) for the movement in the fair value of the derivative interest rate swap which fixes the interest rate on the Fund's term loan. The Fund incurred other interest expense of $1 in the quarter, and earned bank interest income of $1 (2008 - $10). During the quarter, the Fund recorded a loss of $62 on the writedown and disposal of Company operated cafés. In the fourth quarter of 2008, the Fund recorded a non-cash impairment charge related to the carrying value of its investment in MarksLP of $24,349.

Income Taxes

The Fund recorded a non-cash future income tax recovery in the quarter of $1,111, mainly due to a decrease in future tax rates. In the fourth quarter of 2008, the Fund recorded a non-cash future income tax recovery of $3,735, primarily related to the impairment charge. No current income taxes were recorded in the quarter or in the comparable 2008 quarter.

Net Earnings

The Fund's net earnings for the quarter were $4,119 or $0.4186 per unit, compared to a loss of $17,675 or $1.7881 per unit in 2008. Excluding the non-cash future income tax recovery of $1,111, net earnings for the quarter would have been $3,008 or $0.3057 per unit. Excluding the non-cash impairment charge of $24,349 and the non-cash future income tax recovery of $3,735, net earnings for the comparable 2008 quarter were $2,939 or $0.2973 per unit, an increase of 2.8%.

Distributable Cash

Distributable cash for the quarter was $2,706, or $0.2750 per unit compared to $2,551, or $0.2581 per unit in the fourth quarter of 2008. This increase is primarily due to the changes in non-cash working capital, which for the quarter increased by $390 compared to an increase of $576 for the Fund and MarksLP in the comparable 2008 quarter. Changes in non-cash working capital are primarily due to the timing of payments. Excluding the impact of changes in non-cash working capital, distributable cash would have been $3,096, or $0.3147 per unit, compared to $3,127, or $0.3163 per unit for the third quarter of 2008, a decrease of 0.5%.

FINANCIAL HIGHLIGHTS

The following table sets out selected pro forma and non-GAAP financial information and other data of the Fund and its wholly owned subsidiaries, and should be read in conjunction with the audited consolidated financial statements of the Fund.

(in thousands of dollars, except number of cafés and per unit amounts) Three months ended
December 31
Year ended
December 31
2009 2008 2009 2008
         
System sales of cafés(1)(4) $53,234 $53,562 $190,406 $197,340
         
Number of cafés – end of period(1) 344 341 344 341
         
Same café sales growth(1)(4) (1.3%) (1.4%) (3.2%) 0.2%
         
Total revenue(3) $7,300 $3,448 $19,504 $12,567
         
Earnings before items noted below(2) $3,008 $2,939 $10,650 $11,154
         
  Non-cash impairment charge(3) - $24,349 - $24,349
         
  Transaction costs(3) - - $480 -
         
  Current income tax recovery re prior years(3) - - ($150) -
         
  Non-cash future income tax recovery(3) ($1,111) ($3,735) ($1,144) ($3,664)
         
Net earnings (loss) for the period $4,119 ($17,675) $11,464 ($9,531)
         
Earnings per unit before non-cash impairment charge, transaction costs, current income tax recovery re prior years and non-cash future income tax recovery(4) $0.3057 $0.2973 $1.0789 $1.1284
         
Basic and diluted earnings (loss) per unit $0.4186 ($1.7881) $1.1614 ($0.9642)
         
Distributable cash per unit excluding changes in non-cash working capital(4) $0.3147 $0.3163 $1.0651 $1.1607
         
Distributable cash per unit(4) $0.2750 $0.2581 $0.9806 $1.1510
         
Distributions declared per unit $0.2300 $0.2820 $0.9547 $1.1250
         
Payout ratio excluding changes in non-cash working capital(4)(5) 73.1% 89.2% 89.6% 96.9%
         
Payout ratio(4)(6) 83.6% 109.3% 97.4% 97.7%
         
(1) "System sales of cafés", "Number of cafés – end of period" and "Same café sales growth" refer to active cafés in the Royalty Pool for periods prior to June 28, 2009, and refer to all Canadian cafés for all subsequent periods. As at the acquisition date of Second Cup, there were 351 cafés in the café network that now makes up system sales. There were 10 café openings and 17 closures in the period from the acquisition date to December 31, 2009. Year to date, there have been 13 café openings and 30 closures.
(2) "Earnings before items noted below" is a non-GAAP measure and represents the earnings, before non-cash impairment charge, transaction costs, current income tax recovery re prior years and non-cash future income tax recovery of the consolidated Fund and its wholly owned subsidiaries, including Second Cup since June 27, 2009, which are consolidated with the statements of Second Cup for reporting purposes in accordance with GAAP.
(3) "Total revenue", "Non-cash impairment charge", "Transaction costs", "Current income tax recovery re prior years" and "Non-cash future income tax recovery" represent the combined amounts of the consolidated Fund and its wholly owned subsidiary, MarksLP, which was, prior to June 28, 2009, consolidated with the statements of Second Cup for reporting purposes in accordance with GAAP. Prior to June 28, 2009, the Fund had accounted for the earnings of MarksLP on an equity accounted basis in its consolidated financial statements, in accordance with AcG-15 relating to variable interest entities ("VIEs").
(4) "System sales of cafés", "Same café sales growth", "Earnings per unit before non-cash impairment charge, transaction costs, current income tax recovery re prior years and non-cash future income tax expense recovery", "Distributable cash per unit excluding changes in non-cash working capital", "Distributable cash per unit", "Payout ratio excluding changes in non-cash working capital" and "Payout ratio" are non-GAAP measures.
(5) "Payout ratio excluding changes in non-cash working capital" is calculated as "Distributions declared per unit" as a percentage of "Distributable cash per unit excluding changes in non-cash working capital.
(6) "Payout ratio" is calculated as "Distributions declared per unit" as a percentage of "Distributable cash per unit".

The audited consolidated financial statements of the Fund, together with its Management's Discussion and Analysis, are expected to be available at www.sedar.com and on the Fund's website at www.secondcupincomefund.com on or before March 19, 2010.

Tax Treatment of Distributions

The tax treatment of the 2009 distributions is approximately 6.35% return of capital, and 93.65% other taxable income (equivalent to interest income).

Outlook

The information contained in this "Outlook" is forward-looking information. Please see "Forward-Looking Information" below for a discussion of the risks and uncertainties in connection with forward-looking information.

Second Cup expects to regain growth with positive same café sales, and the addition of net new cafés. The focus will be on driving traffic into cafés through external messaging, sampling and product news. In café, the focus will be on operating excellence, training and promotion of the brand's quality credentials.

In terms of 2010 network expansion, Second Cup expects: (1) to open 18 to 24 new cafés in Canada; (2) to close approximately 15 cafés during 2010, the majority of which have sales below the average performance of its cafés; and (3) approximately 30 cafés will be renovated.

Forward Looking Information

Certain statements in this news release may constitute forward-looking statements. Forward-looking statements include words such as "may", "will", "should", "expect", "anticipate", "believe", "plan", "intend" and other similar words. These statements reflect current expectations regarding future events and operating performance and speak only as of the date of this release. These forward-looking statements should not be read as guarantees of future performance or results and will not necessarily be accurate indications of whether or not those results will be achieved. Forward-looking statements are subject to known and unknown risks, uncertainties and other factors that may cause the Fund's actual results, performance or achievements, or those of Second Cup cafés, or industry results to be materially different from any future results, performance or achievements expressed or implied by those forward-looking statements.

About the Fund

The Fund is an open-ended trust established under the laws of the Province of Ontario. It holds, through a direct wholly-owned limited partnership, the Canadian trade-marks and other intellectual property and associated rights used by Second Cup in connection with the operation of Second Cup cafés in Canada. The Fund also owns, indirectly, Second Cup. For more information on the Second Cup Income Fund please visit www.secondcupincomefund.com.

About Second Cup

Second Cup is Canada's largest specialty coffee café franchisor and second largest retailer of specialty coffee, as measured by number of cafés. For the ultimate on-line coffee experience, visit www.secondcup.com.

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