Description

Recipe has already shown in Q3 that its system sales and profitability should rebound back to pre-COVID levels. In Q3, Recipe generated $0.59/share in FCF. We think that Recipe can revert back to pre-COVID levels by Q4 of this year, and be generating a run rate of $2.50/share in FCF.  

Recipe has benefited from several structural improvements during the pandemic including starting several “ghost kitchen” concepts, including Ultimate Kitchen and MALGAM La centrale bouffe. Recipe is among the first movers in introducing these “ghost kitchen” concepts in Canada, which take advantage of existing infrastructure and allow customers to order from a number of different brands and mix and match orders under their corporate umbrella. They have already had substantial success in Toronto and will roll it out across Canada offering Recipe healthy new growth opportunities. 

Recipe is planning to have an investor day in May where they will lay out their growth opportunities in the next 12-24 months. We think the investor day and investor realization of Recipe’s 2022 profitability and earnings power will be a significant catalyst for the stock. We believe there is no reason why the company can’t achieve its pre-pandemic profitability target of achieving a 7%-8% operating EBITDA to system sales margin by 2020-2022 (which was suspended during the pandemic, likely from a timing perspective), which would translate into profitability significantly above consensus forecasts could lead to revisions and rating upgrades.

As illustrated in the below table, Recipe is selling at a 39% and 52% discount to the group average EBITDA and P/E multiple of US based restaurant comp’s on FY22 consensus estimates. Investors should think of Recipe in the same context as other restaurant companies that have significant growth opportunities post pandemic. Thus, we believe the current valuation gap allows for a significant share re-rating of Recipe when profitability recovers. As our $250 million FY22 EBITDA estimate (above consensus forecasts) and our 15x multiple both represent a discount to the US restaurant comp average growth and multiple, this estimate may prove conservative. 

Additionally, we think under Frank Hennessy’s stewardship (he became CEO in May 2018), Recipe is likely to take advantage of the reduced competitive environment and target rich M&A opportunities presented by COVID in Canada to accelerate growth, and then eventually sell the business. 

Company Background: Formally called Cara Operations Limited (the name was changed to Recipe Unlimited in May 2018) and with roots dating back to 1883 as a Canadian conglomerate and listed on the TSX between 1968 to 2004, the company was taken private in 2004 and transitioned to a pure-play branded restaurant company. After running into financial problems in late 2012, in 2013 the company was recapitalized by Fairfax Financial Holdings who combined another restaurant organization (Prime Restaurants) into the company’s structure for greater scale. Fairfax appointed a new management team and board which have implemented a financial turnaround and a focus on growing the restaurant brand portfolio. Fairfax spun off the company as an IPO in 2015 and currently maintains a 43% ownership position. Additionally, 22.6% of the shares are owned by the Phelan family (the original owners of Cara Operations) through Cara Holdings.

From its IPO in 2015 RECP’s restaurant brand portfolio has grown from 10 brands and 837 locations to 25 brands and 1,341 locations as of December 2020, of which 84% are franchised. RECP’s growth has been a result of a combination of organic growth in same restaurant sales (SRS), new store expansion within the brands and timely accretive acquisitions. M&A has been and will continue to be a core growth strategy of the company. From the original 10 restaurant brands in the company’s portfolio during the IPO, major acquisitions included: NY Fries in 2015, St-Hubert in 2016 and The Keg (via a royalty pool partnership sharing agreement) in February 2018. Today Recipe is one of the largest restaurant operators in Canada. The brand portfolio as of December 2020 was:

New Leadership: An important addition to the management team of Recipe was the appointment of Frank Hennessey as CEO in May 2018. Mr. Hennessey brings an excellent resume to the company including past positions at Cara and CEO of the Harvey’s brand. Prior to rejoining Recipe, Mr. Hennessey served as the CEO & President of Imvescor Restaurant Group since September 2014. Mr. Hennessey joined Imvescor at a time when the company was facing declining system sales and discord within the franchise owner base at a number of its restaurant brands. Under Mr. Hennessey’s leadership, he took actions to revitalize and update many of the brands and improve relations with its franchisees, which led to a rebound in growth and profitability over the next few years, eventually leading to a sale of the company in February 2018. Under Mr. Hennessey’s tenure at Imvescor, the shares increased by 2.5x. Prior to Imvescor, Mr. Hennessey was CEO at Bento Sushi, a PE owned leading North American sushi brand, from 2011-2014. During his tenure, he accelerated sales, doubled profitability and eventually helped sell the business.

We believe that Mr. Hennessey brings to Recipe the same knowledge and insights to make strategic improvements and investments in key brands to revitalize growth and divest others that do not fit the company’s long-term strategy. To date, Mr. Hennessey has taken steps to reposition the brands, streamline menus, improve franchisee profitability and build out omni-channel e-commerce business. Moreover, as a long-term industry veteran, Mr. Hennessey knowledge of the industry landscape and major players should prove beneficial in the post pandemic period likely to be marked by a period of consolidation and potential growth M&A opportunities for the strong financial survivors like Recipe.

Pandemic Impact Has Been Minimal On Recipe’s Restaurant Portfolio: In March Recipe closed all its restaurants with its franchisees focusing on maximizing their takeout and delivery business. During the early days of the pandemic the company worked with its franchisees regarding landlord rent deferrals and maximizing their participation in Canadian government wage recovery (CEWS) and rent accommodation programs (CECRA & CERS); both assistance programs will continue to June 2021. In addition, Recipe established a rent assistance program with franchisees to manage/fund rent with its landlords (at a $32-35 million cost to the company) and provided temporary royalty breaks when necessary. The goal of these measures was to help Recipe’s franchisees manage through the pandemic and be positioned for a 2021 recovery. 

Given Recipe’s brand portfolio being primarily a casual dining company with some QSR-like brands, has helped the company weather the pandemic in good shape. With about 10% of overall locations in downtown urban locations, many of the company’s largest brands somewhat QSR in nature (especially St-Hubert as well as Harvey’s and Swiss Chalet) with strong pre-pandemic take-out businesses (St-Hubert & Swiss Chalet had been running ~45% of sales) and minimal mall exposure, the risk profile of the franchise base is not high to permanent closures. Noteworthy, a key differentiator which has helped Recipe whether the pandemic is its significant pre-pandemic e-commerce business which was running close to $500 million on an annual basis. While there has been some near normal franchise turnover from owners who were facing business challenges pre-pandemic and chose to close, all evidence suggests the overwhelming majority of franchisees have to date and will make it through the pandemic. From a beginning pandemic level of 1,363 locations in March 2020, the number of locations has declined to only 1,341 as of December 2020. 

Growing Counter Pandemic Cyclical Retail & Catering Business: A key part of Recipe’s business is a large ~$330 million brand name grocery brand food distribution business that has remained healthy and has proven somewhat counter pandemic cyclical. Recipe sells a broad portfolio of branded food products (ribs, pot pies, sauces, etc.) carrying the St-Hubert’s, Montana & Swiss Chalet labels where the products are #1 or #2 in their respective categories to a growing number of Canadian retailers. With restaurants in Canada mostly closed and stay-in-place orders in many areas, beginning in Q2, consumers increased their purchases of foods to prepare at home. As a result, Recipe recorded a 32% increase in its Retail & Catering sales in FY20. This division accounted for 42% of EBITDA in FY20 (vs 17% in FY19) and helped to offset the impact of the pandemic on its restaurant business. In addition to the profitability of the sales of these branded food grocery items, the increased placement of these items in a growing number of retail stores serves to reinforce and increase the strength of these brands and should help drive more consumers to visit the respective restaurants. 

Ultimate Kitchen Concept Launch Leverages Recipe’s Advantages & Offers Attractive Growth Opportunities: Taking advantage from the opportunity that the pandemic has accelerated/created in the growth of off premise, Recipe has launched an initiative based on the “ghost kitchen” concept that the company believes represents a significant opportunity for the future growth and expansion. Labeled Ultimate Kitchen, this is a delivery and takeout concept where a single location is able to offer customers greater choice and the ability to order from multiple brands within the same order at the same time. This model allows customers to order ahead and have delivered or pick up multiple brands on a one-stop shop basis. It also allows Recipe to serve markets where it may otherwise be cost prohibitive to build a traditional restaurant. Recipe can also leverage these Ultimate Kitchen locations to expand its relationships with brands outside its network. For example, Recipe cosigned partnership deals with Blondies Pizza, a successful local pizza company in Toronto and Bento Sushi, a leading national supplier of sushi in Canada, to join the lineup of brands being offered at Ultimate Kitchen. Having a diverse portfolio of brands, gives the company a competitive advantage in that customers will be able to order food from a number of the company’s different brands (from sushi to burgers to pizza to Mexican, for example) all in one order to satisfy the desires of different people.

During FY20, Recipe opened 2 Ultimate Kitchen concept locations in Toronto. In addition, 2 other Ultimate Kitchen locations are planned for opening in Montreal and Hamilton, Ontario by the end of Q2 FY21, with the company expecting to have up to 6 additional locations by the end of the fiscal year. While currently focused on the Ontario market, we believe Ultimate Kitchen can be expanded to other major Canadian (and possibly US) major metropolitan markets. 

Complementing Ultimate Kitchen and inspired by the idea of “ghost kitchens”, Recipe’s St-Hubert brand launched a new concept called MALGAM La centrale bouffe, which combines several restaurant brands at the same location. The first location opened in April with a capital investment of only $2 million (CAD) in a former St-Hubert’s location in Québec. This new concept offers menus from four popular restaurants in Québec; St-Hubert, Sushi Taxi, Harvey's and New York Fries (with additional brands likely to join), for take-out or via a delivery service. We expect this concept will be rolled out further in the province with additional locations opening this year.

With Ultimate Kitchen and MALGAM La centrale bouffe, Recipe appears to be a first mover in Canada in taking advantage of some accelerated trends in the market caused by the pandemic which should add to its growth opportunities.

Balance Sheet Strength A Key Industry Differentiator: Recipe had healthy balance sheet strength going into the pandemic and took steps to maintain its strong footing thru 2020. Early on, the company drew down $300 million on its credit facility in March, amended credit covenants in May for continued flexibility and in the height of the pandemic in Q2 when they were not collecting full royalties had a cash burn of only $25 million in the quarter. In Q3, when reopening’s were growing steadily, Recipe generated $.59/share in free cash flow and paid down $200 million in August on its credit facility. As a result, net total debt and leverage has been reduced from Q2 levels, while the company currently has $300 million on its credit facility. Recipe’s strong balance sheet and liquidity is a key differentiator in what has been a hard hit restaurant industry in Canada. Independent restaurants are finding it tough to get loans, raise capital and get insurance. Recipe’s balance sheet, relationships with banks and access to the financial markets should give the company the financial ammunition to take advantage of what we believe will be a target rich environment for M&A coming out of the pandemic to accelerate future growth prospects.

Q3 Financial Rebound Tied To Reopening’s Illustrates The Resiliency Of The Business & Recipe’s Earnings Power Post Pandemic: Recipe’s system sales trends in FY20 during the pandemic have tracked commensurate with store openings/closing trends associated with local and provincial lock-downs tied to virus infection rates in Canada. The charts below show the trend of infections and deaths in Canada since the beginning of the pandemic in February/March 2020. 

Source: New York Times

Q2 marked the low point for system sales when all store locations were initially closed in the early days of the pandemic when virus cases and deaths surged.

Beginning in the Summer of 2020 when virus cases dropped notably leaving to an easing of lockdowns and government restrictions on indoor dining rooms reopening, Recipe stated that they saw their system sales improve meaningfully week-to-week. The reopening’s of stores and indoor dining in Q3 translated into a significant rebound in system sales, profitability and cash flow. Recipe’s strong rebound in Q3 (ended September) system sales and profitability illustrate the resiliency in the company’s brands and the pent-up desire of consumers to return to restaurants. In Q3 system sales and operating EBITDA rebounded to ~80% of pre-pandemic levels, while FCF before growth cap-ex grew slightly on a year/year basis to $0.59 per share, or ~$2.40/share annualized. We believe the quick and notable financial rebound and results in Q3, which is not normally the strongest quarter of the fiscal year, illustrated the resiliency in Recipe’s business and illustrated the near-term earnings power of the company in a post pandemic environment. The increase in system sales during this period also shows the appetite and pent-up demand that Canadian consumers, similar to what we have seen in the US, have to return to restaurants. So clearly the biggest factor that drove the Q3 rebound in profitability was the ability of Recipe to reopen its restaurant locations and increase its total operating weeks. Thus, Q3 provides investors evidence that Recipe’s overall business and profitability will rebound relatively quickly once lockdowns and restrictions are eased.

Now In The 2/3nd Phase Of Canadian Lockdowns; Recovery Stalled: However, with a spike in infections beginning again in the September/October time frame, Canada began the 2nd wave of government imposed dining restrictions and lockdowns in the Fall, with more strict measures beginning on December 16th and continued thru Q1 FY21. Some provinces eased restriction temporarily in March, only to reinstate them in April. These on/off/on restrictions in Canada contrast with what has been a general easing in most states in the US, with indoor dining opening restrictions being reduced or eliminated in many states. Most US restaurant operators have noted a significant increase in demand when indoor dining restrictions are eased.

With 43% of Q4 operating weeks negatively impacted by either dining room closures or complete closures, Recipe’s quarterly system sales and profitability declined from Q3 levels. With a full quarter of lockdowns in place during Q1, it is possible that Recipe’s Q1 results may take another modest step down from Q4 results, but still be significantly better than Q2 FY20 results.

Increased Vaccinations Will Drive A Recovery: It is unclear when lockdowns and Canadian government imposed dining restrictions will ease, but will likely be influenced by infection and hospitalization levels. Vaccination rates in Canada will be a key driver of reopening’s and as illustrated in the following recent news story and below chart, have trailed the US and Western European vaccination levels.  

https://www.wsj.com/articles/as-the-u-s-vaccinates-millions-for-covid-19-most-canadians-are-still-waiting-11617905495?mod=searchresults_pos1&page=1

The good news is that vaccination rates in Canada have begun to accelerate and recent government expectations are that most people should be able to get a vaccination if they want by the June time frame.

Source: https://health-infobase.canada.ca/covid-19/vaccination-coverage/

FY21 A Transition Year; FY22 The Recovery Year: If the Canadian government's vaccination timetable is realistic, we should see a positive inflection point in Recipe’s business in the 2nd half of FY21, with FY22 being a year that system sales could return close to FY19 levels. For FY21 we suspect that Q1 will likely mark the low point for recipe’s system sales, Q2 will show modest improvement and that beginning in Q3 and accelerating into Q4 they will revert back to traditional seasonal levels. In FY22, while we expect that the number of Recipe locations will decline over the FY19 to FY22 time period due to normal franchise transitions by about 5% to ~1,300 locations from 1,373 in December 2019 (the pandemic has accelerated some normal closures), we believe the company’s system sales (excluding for the moment any M&A growth in acquiring new brands) could come close to approximating FY19 levels due to the continuation of take-out and delivery remaining a new avenue of incremental revenues for many franchisees, higher average sales per location (due to reduced competition) and inflation related price increases. Moreover, Recipe management has stated that when system sales return to FY19 levels, the company will be more profitable. While there will be some modest permanent corporate overhead savings that many other companies will see (greater remote workers, less travel, lower rents, etc.), profitability and cash flow for Recipe will be enhanced by the elimination of a number of underperforming locations which the company had to subsidize with royalty relief and/or rent assistance and the conversion of corporate stores into the franchise base. Thus, for FY22 (again excluding potential growth M&A) we believe system sales will come close to FY19 levels of $3.487 billion, with EBITDA at or slightly exceeding the $216 million recorded in FY19 and free cash flow approximating $2.50 per share.

The Post-Pandemic Industry Environment; Less Competition & A Target Rich M&A Landscape: The overall industry landscape for strong survivors like Recipe should be more favorable than the past few years. One major outcome is that the overall restaurant industry is likely to get less competitive. Various industry sources speculate that the pandemic could result in the elimination of roughly 10,000 restaurants or 15%-25% of the industry (mostly independents) in Canada. Information from Canadian food wholesalers suggest the true final number when all is said and done could even be higher. Additionally, we understand that many independent restaurants still operationally are struggling financially and are having challenges in the current environment getting financing and insurance. This is significant as in recent years there has been a growing oversaturation of restaurants in the country and the pandemic may have accelerated in a brief period what was likely to be a natural consolidation in the market. We have heard from sources that in the 4 years prior to the pandemic the number of new full service restaurants in Canada had been growing at about +15% annually with restaurants per capita in Canada well above US levels. Noteworthy, this oversaturation in Canada has been weighing heavily on same store sales and was a major reason for the challenges that Recipe had faced in FY19 with organic growth. 

A side note benefit to the closing of many restaurants in Canada due to the pandemic is related to real estate. With many new vacancies due to restaurant closures, Recipe has some leverage with landlords to garner more favorable leases and now has the ability to gain access to key locations that were previously unavailable.

The second important factor relative to the post pandemic industry environment which will benefit Recipe is with a number of restaurant brands impacted by the financial toll of the pandemic it is likely that many will be forced to merge or sell themselves to financially stronger organizations like Recipe to continue to operate and prosper. With its balance sheet strength, including a healthy amount of liquidity as well as access to the debt and capital markets, Recipe is in a prime position to take advantage of the opportunity. M&A has been, and will likely continue to be a key part of the company’s growth strategy. Recipe has a history of making accretive growth-oriented acquisitions since its IPO, growing the portfolio from 10 brands to 25 since 2015. Also, we sense that the company may also use the post pandemic environment to divest some poorly performing or not well positioned brands to increase the overall profitability of its portfolio and growth prospects. It is likely that Recipe will move closer to having a few large high cash flow generating brands with more moderate growth prospects combined with some younger brands with healthy organic growth prospects.

A Strong Track Record Of Growing Profitability Aided By An Accretive M&A Strategy: Since Recipe’s IPO, the company has delivered a strong track record of growing profitability pre-pandemic.  Over the pre-pandemic period from FY13 to FY19, Recipe grew its operating EBITDA at a 28.5% CAGR. 

A major element of the company growth over this time period was a number of accretive acquisitions, with the most significant being: NY Fries in October 2115, St-Hubert in September 2016, Burger’s Priest in June 2017 and The Keg in February 2018. In FY19 the company’s EBITDA growth slowed due to a couple of factors. The acquisition of The Keg included the integration of a number of lower margin corporate restaurants into Recipe’s financials as well as franchisees who were grandfathered in under lower than corporate average royalties until their renewals became effective at a higher rate. Also, new CEO, Frank Hennessey, slowed down the pace of company acquisitions in order to reassess and redesign Recipe’s acquisition strategy. Finally, the growing competitive environment in Canada marked by an oversaturation of restaurants per capita began to have a negative impact on organic same restaurant sales (SRS) growth. 

We believe these factors that pressured FY19 growth and EBITDA profitability will prove temporary and Recipe will reaccelerate its post pandemic EBITDA growth to a CAGR in the 15%-20% range aided by improved SRS growth, accretive M&A and possible divestitures of non-strategic lower profitability locations/brands. Outlined above were our thoughts on how the pandemic has improved the competitive landscape in Canada and would likely create M&A opportunities. In addition, CEO Frank Hennessey had made a number of internal changes with a number of brands to freshen the banners and improve SRS that were beginning to take hold pre-pandemic that should play out when restaurants reopen post pandemic.  

Vaccine Roll Out Gap Creates Mis-Pricing Opportunity, With Significant Upside Share Potential: We believe that some Canadian restaurant stocks like Recipe are mispriced relative to US traded comp’s due to the relative lag in Canadian vaccination levels compared with those in the US, which has resulted in longer provincial and regional lockdowns and government restrictions on dining rooms being opened. Thus, delaying the reopening story trade for many Canadian consumer stocks and creating the current investment opportunity.

Despite rebounding from oversold March pandemic lows during the panic selling period, the shares of Recipe are still selling at levels about 35% below 2019 levels.

This chart illustrates the significant penalty that RECP was given by investors relative to what appeared to be near bankruptcy levels in the early days of the pandemic relative to the overall market and other restaurant shares. While the shares have rebounded significantly off these levels, the shares still have not closed the underperformance gap relative to other restaurant comp’s and have underperformed the overall market.

RECP vs the S&P 500 Restaurant Index (February 2020 to Present)

Additionally, as illustrated previously, on a valuation basis RECP’s valuation trails that of many US restaurant stocks 

The Roadmap To A $60+ Stock: We believe the shares of Recipe are mis-priced on both a near-term and longer term basis. In Q3, Recipe generated $.59/share in FCF. We think that Recipe can revert back to pre-covid levels by Q4 of this year, and be generating a run rate of $2.50/share in FCF. As illustrated in the below chart, the shares of Recipe are currently trading well below its pre-pandemic trailing 12-month P/FCF trading range multiple average of 20x. 

The company’s FCF multiple also trails its US comp average of ~15x FCF. If we use the group average P/FCF multiple of 15x on Q4 FY20 run rate FCF, the stock should trade at $37.50/share or 80% upside from current levels. 

In FY 22, we believe Recipe’s business will return back to more traditional levels and that with pent-up demand, additional off-premise take-out/delivery revenues and contribution from ghost kitchens, system sales and revenues (excluding an M&A growth) at least equal or exceed FY19 pre-pandemic levels. With some permanent cost reduction and efficiency savings in the business, we believe EBITDA profitability could reach ~$250 million, at least on a run rate basis, which would exceed FY19 EBITDA by ~15%. Such a post-pandemic increase in profitability for RECP would be consistent with what we are seeing for US based QSR/casual dining restaurants (illustrated earlier in the report). As our $250 million FY22 EBITDA estimate (above consensus forecasts) and our 15x multiple both represent a discount to the US restaurant comp average growth and multiple, this estimate may prove conservative. The average EBITDA growth for FY22 vs FY19 for US based casual dining restaurant companies is ~21%. If we apply that metric to Recipe’s 2019 $216 million pre-pandemic EBITDA we get $ 263 million in EBITDA. We use $250 million to be conservative as well as 15x 2022E EBITDA when the comp group is trading at 16x FY22 EBITDA. 

Moreover, our $250 million EBITDA estimate would be within the range of management's pre-pandemic target. Prior to FY20, management had stated in the MD&A the following: “Management’s focus will continue to be on improving the earnings efficiency of our assets and our increased sales base to grow Operating EBITDA as a percentage of System Sales back to within our 7% to 8% target range by 2020-2022”. While the pandemic has changed the timeframe to achieve this target, we believe it is still realistic. Noteworthy, using FY19 systems sales, the 7% to 8% target would translate into $244-$279 million in EBITDA, which is consistent with our FY22 estimate.

Assuming an industry average 15x multiple on our FY22 EBITDA estimate of $250 million translates into a $55-60 share price in 12-18 months.

Additionally, we think under Frank Hennessy’s stewardship, Recipe is likely to take advantage of the reduced competitive environment and target rich M&A opportunities presented by COVID in Canada to accelerate growth, and then eventually sell the business. We think that with beneficial M&A in ~3 years Recipe could be earning ~$300 million in EBITDA and could be sold for 12-15x EBITDA, which would lead to a share price of around $60-$80/share or 200-300% upside from today’s levels. 

Catalyst

• An easing of government imposed lockdowns & restrictions throughout Canada.
• Growing system sales and profitability post pandemic to/above FY19 pre-pandemic levels.
• A possible investor day event in May where management will highlight its growth opportunities in the next 12-24 months.
• Management re-establishing its future EBITDA/system sales targets.
• An increase in future profitability forecasts.
• Sell-side analyst upgrades.