MTY Food Group (TSE:MTY), A Canadian company that franchises and operaties quick-service restaurants, announced on the 25th of May that it would acquire US-based Kahala Brands (OTCMKTS:KAHL). The transaction will double the size of MTY Food Group and values Kahala Brands at roughly US$250 million. The market has reacted very favorable to the transaction, that is described by analysts as “transformative” for MTY since it will give the company a big presence in the United States besides the already established position in Canada. Since the announcement the share price of MTY Food Group has increased by more than 25%.
Kahala Brands is presumably a company that few investors knew before this transaction because it is traded on the pink sheets, it doesn’t publish financial information (it’s a so called dark company) and insiders control 93.12% of the outstanding shares. It’s a stock that sometimes didn’t trade for months, and because the Kahala Brands didn’t release financial information investors were pretty clueless to how much it was worth. In April this year it traded as low as $10.75/share, valuing the company at a P/E ratio of just 1x. Now that there is a merger it is suddenly clear how much it is truly worth and the deal valued Kahala at $149/share. Since a part of the merger consideration consists of MTY shares the implied value has increased to $159/share in the past two weeks.
Unfortunately it’s now way too late to acquire Kahala Brands at a 1x PE-ratio, but there is still a very juicy spread between the current market price of $130/share and the merger consideration of $159/share. This is a spread of 22.5% which is huge for a deal that faces no regulatory risks and it should close in two months time (the closing of the transaction is estimated to occur within 75 days after the announcement on May 25). With insiders controlling 93% of the outstanding shares the shareholder vote on July 21 will be a formality. Financing is currently being arranged for the part of the deal that MTY cannot pay using cash on hand and the issuance of shares. Since the market has responded favorably to the announced transaction it is reasonable to expect that obtaining financing will be very easy.
I think the spread is so big because Kahala Brands is a name that is so small and off the beaten path that just a few investors that specialize in merger arbitrage have bothered to take a look. Secondly the value of the merger consideration is not immediately clear. The proxy statement refers to the $149/share value (that is based on a MTY price of CA$35.68/share instead of the current CA$44.86/share). In addition to that we have to continue reading the proxy statement all the way to Appendix C to find out how the merger consideration is calculated exactly. The computation of the estimated closing value is as follows:
To update this computation we simply have to account for the increased value of the stock portion of the deal that is now worth 2,253,930 * CA$44.86 = CA$101,111,300 or $78,017,978. This would bring the total consideration to $261,566,978 or $159.25/share. Shareholders can choose if they want to get the share portion of the deal in MTY shares, or cash based on the 10-day volume weighted average price determined on the day immediately preceding the closing of the transaction.
As visible in the above computation the cash portion of the merger consideration isn’t a fixed amount, but it is subject to various adjustments based on among other things the amount of debt and working capital that Kahala Brands will have at the time of the acquisition. So this introduces an element of uncertainty, and perhaps this is a factor that is contributing to the huge spread. I don’t think we have to be very worried though that the cash portion of the final closing value will be materially less than this estimate because these kinds of estimates are usually conservative. If you overestimate it you might get sued, but if you underestimate it and the final consideration is actually higher everybody will be happy. In addition to that, with insiders owning the fast majority of the company, they will have every incentive to make sure that this equation will have a favorable outcome when the deal closes.
Kahala Brands is I think the juiciest merger arbitrage idea I have come across this year. This is a deal that is almost certain to close, and not only that, it should close fast as well. Because of that I think a reasonable spread would probably something like 2%, maybe a bit more. The current spread of almost 22.5% is simply insane. Of course, there is some uncertainty about the final closing value of the merger. I don’t really believe that this is a good reason for a higher spread though since the current estimate could be just as likely (if not more likely) too low as too high. Since I think the risk/reward ratio of this deal is highly favorable I have made Kahala Brands one of my largest positions.
Author is long KAHL
How did you come across this idea? Too bad the price has moved up to $148 from your writeup at $130 :/
A friend alerted me to this opportunity. But don’t be too sad about the big price increase, even at $148 and higher it’s very attractive. I also wasn’t able to enter my position that low.
I think it’s fairly disingenuous to post a write up where you claim the price is 130 but it is really 148. I want my 5 minutes back.
The price was $130 when I published my post…
Are you kidding? AlphaVulture writes this blog free of charge providing great opportunities to invest and learn and you are complaining?
Thanks Pete! ♥
You briefly mentioned low financing risk…
MTY’s balance sheet for 2/29/16:
Cash: CA$40mm or $31mm.
Equity: CA$175mm or $137mm.
Tangible SE: CA$17mm or $13.3
Net of cash, MYT is going to need $152mm to close merger. Thoughts?
Looks like MYT has available credit lines for a total of $26.4mm. Also this is MYT’s largest acquisition (http://www.theglobeandmail.com/globe-investor/investment-ideas/mty-food-shares-soar-on-kahala-brands-acquisition/article30169274/) by a material amount. Not sure how I feel about them securing financing… Not trying to scare you, I am just borderline paranoid. Sorry!
Being paranoid is fine, as long as it doesn’t paralyze you. Sure, it’s their biggest transaction, but 1. MTY and KAHL both have a low amount of debt so after the transaction leverage will still be low and 2. A merger that received such a positive reaction on the equity market should receive a similar reception in the debt market. Getting financing here should be really really easy.
Combined entity estimated to have $90MM in EBITDA. MTY/KAHL are franchising businesses (few of their QSRs are operated), so relatively little in the way of capex requirements. EBITDA, while not my favorite metric, roughly approximates funds available to paydown interest.
Canadian leveraged loan market is mostly a Term Loan A business (i.e. banks take the loans on books / not traded) so more conservative. However, I would think MTY is at least a BBB credit, which warrants a drawn spread over ~+300 bps over 3-month bankers’ acceptance of 0.84%. Lets overround at 5%, so on the ~$200M deficit they need financed (assuming they don’t touch credit line), that’s $10MM annual interest costs. You’ve got 2-2.5x Debt/EBITDA and over 8x interest coverage. Financing isn’t even a risk in my view.
Did you hedge the non-cash part by shorting MTY Food Group?
I have currently not hedged my position by shorting MTY, but it’s a decent option, and I might still do it.
At current prices, you’d only start losing money on this trade once MTY drops 20%. At the price of your article, you would need a ca 60% share price drop before you’d lose money. I guess this margin is safety made you feel that hedging would be a bit of a overkill ( ?)
Another question, where are you able to check what are the borrowing costs of MTY?
loanconnector is best bet, but see sedar.com for their Annual Info Form filed by all Canadian cos. If not that try the proxy statement. You should find the revolving credit facility there
Sorry for not being clear: I meant the borrowing costs to borrow MTY shares in order to short sell them. In the meanwhile I found that IB has a tool (Short Stock Availability) to check this.
Nice catch, and for the right price i might set up a tiny position.
I don’t like the situation as much as you do given the way above normal tail-risk. If for some reason this deal falls through (always a small % chance), you might be stuck with this company for a long time. Looking at Google/Yahoo, it looks like 2000 shares were traded over the last 2 years. 8500 shares have been traded since the announcement (probably some traded between arbs themselves). These new shareholders are in for the deal spread. In case the deal falls through, the question is not what the right price might be, but who will buy your shares.
Fair point, but guess I’m not as worried about that as you. Since the company also released annual reports to their shareholders in combination with the proxy statement people now know what it’s worth, and it’s in my opinion very unlikely that it will trade as inefficient (/at such a low price) as previously. We not only know how much it is worth now, but in addition to that we know that the company is controlled by a managementteam that is willing to sell. So I don’t think downside will be worse than with a normal merger arb deal where you also could see a -50% move if it fails or something like that.
Pingback: Dark stock Questar turns into special situation | ValueInvestingBlog.net