Recipe Corp Merger Arb: Is This 20% Annualized Return Too Good to Be True?

I didn’t mince words when I first heard about Fairfax Financial’s (TSX:FFH) offer to purchase the portion of Recipe Corp (TSX:RECP) it doesn’t already own.

I’ve owned a small position in Recipe since slightly before COVID started. I was attracted to the company’s strong brands, robust free cash flow, and low price-to-free cash flow ratio. It also paid a reasonable dividend until that dried up in 2020.

It also had some significant warts. It has a history of overpaying for acquisitions, including when it acquired Quebec-based St. Hubert. Most restaurant folks aren’t in love with Recipe’s brands, either. They’re viewed as being slightly lackluster compared to some of the competition’s. And Recipe has this bizarre setup where a good portion (15%+) of its restaurants are operated by the company. The franchise business works a lot better when somebody else takes the risk of running the restaurant.

Fairfax has owned a pretty big chunk of the company for a while, sharing ownership of a multiple voting share class with the founding family. Fairfax head Prem Watsa has made it clear in the past they’re long-term owners of Recipe, mentioning they like the company and the industry its in.

The reason why your author was so against Fairfax’s offer to acquire the portion of Recipe it doesn’t already own (proposed purchase price is $20.73) is I think Fairfax is taking advantage of recent weakness in the stock to buy at a really good price. Despite offering something like a 40% premium to the market price, I still think Prem and the boys are still underpaying.

My metric is simple. Here’s a snapshot of Recipe’s free cash flow over the last number of years:

2018 - $158M2019 - $178M2020 - $85M2021 - $163M

The deal values Recipe at approximately $1.2B, or about 7.5x trailing FCF. You can see why I think Fairfax is getting a deal, although I’m mostly upset I wasn’t buying when the stock cratered to $12 per share.

The deal skinny

At first glance, the deal seems like an absolute slam dunk to close. The company has approximately 58 million shares outstanding. Fairfax and the Phelan family own some 34 million multiple voting shares that have 25 votes each. The rest of us plebs own 24 million shares that get a meager one vote each.

The math is pretty simple. The guys acquiring the company have a combined 850 million votes, give or take a few thou. The rest of us have… not that many. So why is the current share price a full $1 per share under the offer?

I think I found why. From Recipe’s most recent annual information form:

This sure looks to me like a takeover bid. Even if it’s from a current majority shareholder.

Fairfax’s votes don’t matter. The founding family’s votes don’t matter. It comes down to investors like me and you, folks who can take a quick look at the financials and see a company that generates tons of free cash flow.

There’s a reason why the spread between the current price and the offer price keeps getting bigger and bigger.

As I type this, the spread between the current and the deal price $1.09 per share. The deal is projected to close in the fourth quarter. Let’s take a look at a couple scenarios:

1. Deal closes Dec 31 (four months from now). $1.09 per share spread x 4 months = 16.6% annualized return

2. Deal closes Nov 30th (three months from now). $1.09 per share spread x 3 months = 22.2% annualized return

The market is sending a pretty obvious message. This deal has some serious warts.

How I play merger arbs

I’ve dabbled in merger arbitrage situations over the years and think I’ve figured a few things out. When I look at any deal — including this one — I’m mostly concerned with two things:

1. What’s the chance the deal falls apart? (This is obviously just a guess and usually it has more to do with instinct than anything scientific)

2. Am I happy to buy today if the deal wasn’t happening?

We’ll ignore the first point for now. I think I’ve already explained the risks here. The second point is the more interesting one.

I’d be happy to buy all of Recipe for 7.5x free cash flow. It’s really that simple.

I also think there’s the possibility Fairfax raises its offer. Prem and the boys can see the action on the stock just as well as I can, and an extra $0.50 or $1 per share isn’t huge in the scheme of things.

The bottom line

I think there’s a fairly good chance this deal happens. It’s not 100%, but I’d put it around 80-90%. There are a lot of long-suffering RECP shareholders who will be tempted to take their money and go away forever.

I don’t think downside is huge here either. Obviously Fairfax thinks the price is fairly valued. Who would know better than those guys?

I like this deal and will likely add to my position in the coming days.