At $4.39 per share, we believe Wendy's/Arby's Group (NYSE: WEN) is priced to provide investors with attractive risk-adjusted returns for the next several years.  We think the company's common stock is worth somewhere between $7 and $10 per share, which the market is likely to properly recognize within a reasonable time frame.  Our view of intrinsic value implies a margin of safety of roughly 40% or more, which should provide a significant buffer to both a) protect us from permanent loss and b) provide a high probability of an attractive return on our investment.

Wendy's/Arby's Group is currently trading for 5.9x consensus 2011 EBITDA, which compares to multiples of roughly 9.0x and 6.7x for McDonald's (MCD) and Burger King (BKC), respectively.  The one obvious reason for the company's lower than peer valuation is the fact that the Arby's business is struggling in the face of significant discounting by competitors and its historical higher average check.  However, Wendy's is a healthy, growing business with significantly increasing margins and a significant opportunity to increase average unit volume ("AUV") due to its systemwide 2011 breakfast roll-out.  So what is the Wendy's system worth?  We think the Wendy's system is worth 9.0x EBITDA, which consists of an 8.0x multiple for the company-operated restaurants and a 10.0x multiple for its franchise restaurants.  Based on that assumption, the equity is worth $6.46 per share even ascribing no value to Arby's.  Consequently, at the current market price of $4.39, not only are we getting the entire Arby's system for free, but we are being paid roughly $900 million or over $2.00 per share to take it.  Mr. Market has his mood swings, but rarely do we see him this gloomy.  For additional perspective, we have to reduce the Wendy's multiple from 9.0x to just 6.7x (which could consist of 5.0x and 8.0x, respectively, for the company-operated and franchise restaurants) before we would cease being paid to take Arby's.  Do not misunderstand though - we would still be getting Arby's for free, but Mr. Market wouldn't write us a check too.

This exercise properly conveys the massive undervaluation of Wendy's/Arby's Group and also touches on why the stock is so mispriced.  Many market participants, including sell-side analysts, are valuing the company using consolidated EBITDA and do not differentiate between the respective contributions of the Wendy's and Arby's systems (and certainly not between the respective company-operated versus franchise restaurants).  While Arby's results have been disappointing, we believe the market is ascribing far too much weight to Arby's and thus significantly overreacting to its weak results.  Instead of "waiting for an inflection point in Arby's same-stores sales before getting more constructive on the name," as some analysts appear to be thinking, we believe that the much more appropriate question is: "At this price, am I paying anything for Arby's anyway?"  We think not.

It is worth noting that management does not regularly reveal the respective EBITDA contributions of the Wendy's and Arby's systems, which we believe contributes to to the mispricing of the shares.  In fact, management first revealed actual EBITDA results by brand in the slides accompanying the company's fourth quarter 2009 conference call on March 4, 2010, which showed that Arby's contributed only 18% of consolidated EBITDA in 2009.  We estimate that figure will fall to roughly 10% this year.  To us, Arby's has become almost inconsequential as it has shrunk in size, but also represents an enormous free call option should its results stabilize and eventually recover.  Sales deleveraging has crushed Arby's company-operated restaurant margins from 19.7% in 2007 to only 10.8% in the first quarter of 2010, so a dramatic increase in margins is likely to occur when sales recover.  However, this thesis does not rely on that occurring; rather we assume depressed EBITDA and a very depressed multiple for Arby's, so any upside to that would be incremental to the given intrinsic value range.

Further, EBITDA is highly likely to grow in 2012 versus 2011.  We estimate $508 million of EBITDA in 2012, which translates into only current multiple of only 5.5x.  Importantly, we believe we are being very conservative relating to certain factors, such as same-store sales, breakfast and additional G&A savings.  The current consensus is only $485 million for 2012, implying only 3.5% growth, which does not make sense to us, especially considering the high probability, economy-independent nature of SSG's cost savings.  Even assuming the consensus is correct, the implied multiple would rise to only 5.7x EBITDA, which is still far too low, in our view.  Generally, we think the consensus is both 1) underestimating the ongoing cost savings and margin improvement, and 2) misunderstanding the implied valuation of the Wendy's and Arby's systems.

Importantly, our intrinsic value range of $7 to $10 reflects 1) no value for the company's real estate holdings, other than that already reflected in operating results, which are conservatively worth over $800 billion or roughly 30% of the current implied enterprise value, and 2) no heroic assumptions relating to same-store sales growth, net restaurant openings, or commodity costs, and 3) no benefit for several attractive long-term strategic initiatives that should create significant value over time, including an aggressive and ongoing share repurchase program.  We believe there is upside to our assumptions over time, but more importantly, we are comfortable that it will be difficult to lose money on this investment at this price.

Company Background

Wendy's/Arby's Group was formed in September, 2008, after Triarc, the owner of Arby's, merged with Wendy's.  Today, the company consists of 6,540 Wendy's restaurants (1,390 company-operated; 5,150 franchise) and 3,699 Arby's restaurants (1,155 company-operated; 2,544 franchise).  Management's initial goal was to generate $60 million of G&A savings and $100 million from improving Wendy's company-operated restaurant margins by 500 basis points, which would only bring them to the level that Wendy's franchisees are already achieving.  In 2009, management achieved $62 million of G&A savings, achieving its three-year goal in one year, and achieved 330 basis points of restaurant margin improvement, all of which was "organic" with no net impact from commodity costs for the full year. 

Management has demonstrated significant progress on its goals and has begun to identify more opportunities for significant, high probability G&A savings, which are incremental to their original target.  For example, the company recently formed the Strategic Sourcing Group ("SSG"), which is a co-op that combines the buying power of all 10,000+ restaurants to achieve cost savings related to non-brand specific restaurant supplies and services, such as disposable gloves, napkins, equipment, kitchen small wares, furnishings, menu boards, utilities and other services.  SSG has already achieved $3.5 million of savings systemwide for the purchase of disposable plastic gloves, which management referred to as only "the tip of the iceberg," at a recent investor conference.  In addition, management is transferring some corporate employees to SSG, which will further reduce G&A expense by "several million dollars on an annualized basis," according to management.  The company recorded a $4.9 million charge during the first quarter to fund SSG's operating expenses for 24 months, but franchisees are likely to pay their pro-rata share of its operating expenses on an ongoing basis, in our view.  A strategic pricing initiative whereby each individual restaurant sets its own prices based on local demographics and price elasticity studies should also show benefits in 2011.  Interestingly, Wendy's is late to the game as competitors have been doing this for some time.  We expect further quantification of projected cost savings from SSG and the pricing initiative on the company's second-quarter conference call in August.

If the company had achieved the cost savings and margin improvement that is has to date, all else equal, the stock price would likely be much higher and this investment opportunity would not exist today.  However, since the merger, the performance of the Arby's business has significantly deteriorated from an estimated $130-$140 million of EBITDA in 2008 to just $78 million in 2009 and our estimate of $40 million in 2010.  Arby's company-operated and franchise restaurants have seen significant declines in same-store sales since 2008, which has resulted in significant operating deleveraging and reduced profits.  However, we think the market is ignoring the massive, underlying, permanent cost savings and structurally higher margins of the whole company because it has been partially masked by the decline at Arby's, which we view as both temporary and fixable.  Arby's continues to be a healthy brand and consistently ranks highly in consumer surveys relating to food quality and taste, however recently ranked last on the question of "worth what you pay for it."  Arby's average check has historically been $7.50 versus a roughly $5.00 average check of peers, many of whom have been aggressively discounting, which caused the declining traffic and sales as consumers have become more price-conscious.  It is worth repeating that consumers enjoy the food at Arby's and that the underlying cause of its present issues appears to be only consumer price sensitivity.  To remedy the situation, Arby's new "Dollar Value Menu" was recently introduced systemwide and began its national advertising on April 11, which may have caused a trend change in transactions (-10.4% in Q4, -1.2% in Q1, +4% in April, including +7% when national advertising was turned on).  While average check fell 12% in April, which was 2% worse than management's expectations, we expect that to moderate over time as the impact of the Dollar Value Menu moderates and traffic increases.

Importantly, Arby's franchisees have approved a national media rate increase from 1.2% to 2.4% for this year, which should go a long way towards increasing consumer awareness of the brand and the new Dollar Value Menu, and consequently restaurant traffic.  The company is focusing on increasing its share of voice over its share of market, which is a well-known technique to increase market share in the branded consumer business. 

We believe it is important to point out that management is using a "barbell approach" to its menu and is not discounting its premium sandwiches, which is a wise strategic decision because it is not likely to impair the company's brand.  Before the recession, Arby's restaurant margins were among the highest in all of QSR (19-20%) due to its higher average check and quality positioning, so if management were to now slash its premium priced products, we doubt the brand would be able to regain that premium pricing in the future.  Interestingly, Burger King decided to slash its double cheeseburger price to $1, which has caused significant turmoil and dissent among its franchise base, and risks damaging the public's perception of the brand and its quality.

It should be noted that if or when Arby's regains momentum, the margin expansion at Arby's should be dramatic and swift, in our view.  As quickly as margins fell due to sales deleveraging, margins are likely rise due to sales leverage.  An important fact is that only about 0.5% of the roughly 8-9% margin decline at Arby's company-operated restaurants is due to the roll-out of the Dollar Value Menu, while the rest is due to sales deleveraging.  So, we do not expect a lower "new normal" or permanently lower bar for Arby's margins.  The company also recently hired new Arby's President Hala Moddelmog, who was President of Church's Chicken, which is the world's largest chicken chain with more than 1,650 restaurants.  She led the chain for about 10 years, eight of which saw increased same-store sales.  She was also a former market research manager for the Arby's Franchise Marketing Association (AFA) early in her career.  We do not yet have an opinion on her, but expect her to be highly incentivized to achieve improved results at Arby's.

Breakfast

Historically, Wendy's has not participated in the breakfast daypart, which represents a massive opportunity to increase average unit volumes ("AUV") at high incremental margins due to restaurant level fixed-cost leverage.  Prior to the merger, under different management, Wendy's rolled out breakfast despite it scoring poorly in consumer testing.  The resulting results were not surprisingly weak and present management decided, appropriately in our view, to pull breakfast from all restaurants.  Currently, the new and improved breakfast menu that is in test markets, including Pittsburg, Kansas City, and Phoenix, is scoring highly in consumer surveys and appears to be a significantly improved attempt to enter the breakfast daypart.  Management' plan is to roll it out at company-operated restaurants throughout the rest of this year, prove its effectiveness and return on investment to franchisees, and roll it out systemwide in 2011.  The menu includes items, such as a toasted artisan toasted muffin egg sandwich with bacon or sausage, a grilled Panini egg sandwich with freshly cooked thick-cut Applewood smoked bacon, skin-on roasted potatoes, fresh fruit, warm oatmeal, fresh cracked eggs, and a well-known premium coffee brand.

McDonald's and Burger King currently derive approximately 25% and 20%, respectively, of their AUV from breakfast.  Management has suggested that achieving just a 10% mix would be a big success, which certainly seems achievable if the quality of the new breakfast is on par with the quality of Wendy's lunch/dinner fare, which Zagat rated #1 for Top Food among megachains in 2009, among other accolades.  Favorable consumer testing certainly appears to point to a successful launch.  Management has acknowledged that it will be a challenge to win significant share of breakfast from McDonald's, but indicated that there are other many smaller, weaker players who should be easier targets.

International Expansion

Wendy's and Arby's are significantly underpenetrated internationally, having approximately 10% and 4%, respectively, of their systemwide restaurants outside the United States.  This compares to approximately 57% and 39% for McDonald's and Burger King, respectively, and represents another large growth opportunity for the company.

In May, a franchise group opened the first international dual-branded Wendy's and Arby's restaurant, located in Dubai, and has plans to open approximately 80 more dual-branded restaurants, many of which will be in the United Arab Emirates.  Also in May, the company's franchisee in Singapore opened a second Wendy's location as part of the 35 restaurant development agreement.  Franchisees are expected to open 35-45 new restaurants internationally this year and new development agreements for several hundred more restaurants in a few new countries appear to be in the works.  In fact, yesterday (6/3/2010), the company announced a major development agreement with a franchise group in Turkey to open at least 100 Arby's restaurants over the next 10 years, including 50 restaurants during the next five years.  We expect more international franchise agreements to be signed over the coming months and years, including dual-branded restaurants, which can offer franchisees higher AUV and higher returns on capital.

For shareholders, the franchise business is a very attractive, high margin revenue stream with no incremental overhead, no store employees, no commodity cost risk, no inventory and limited, if any, capital requirements.  To the extent the company can increase its percentage of franchise restaurants compared to company-operated, the more valuable the overall business becomes, in our view.  Wendy's and Arby's systems are made up of approximately 79% and 69% franchise restaurants, while McDonald's and Burger King are approximately 81% and 88%, respectively, so the opportunity to re-franchise many company-operated restaurants certainly exists.  After achieving the targeted margin expansion at Wendy's company-operated restaurants, management could likely sell them off to franchisees for roughly $300,000-$400,000 each, plus the associated real estate in some cases, and use the cash to repurchase additional shares while transforming into an increasingly franchised, higher margin, higher return on capital business.

Real Estate Assets

As of January 3, 2010, of Wendy's/Arby's Group's 1,391 company-operated Wendy's restaurants, the company owns the associated land and building for 634 restaurants and owns only the building for another 471 restaurants.  Based on our sampling of 7 recent sale data points and 24 for-sale listings of Wendy's properties (land and building), the average Wendy's is asking $1.42 million.  Based on that, we estimate that the 634 land and building locations alone could be worth somewhere between $700 million and $800 million, assuming a 10-20% discount from list prices.

Additionally, there are 471 owned Wendy's buildings, which if worth $300k-$500k each, would add another $140-$240 million of value, bringing the combined total value to $840 million to $1.04 billion.  Further, the company owns an undisclosed number of the 220 land and buildings that it leases to franchisees and owns 131 land and/or buildings related to company-operated Arby's restaurants.  We will exclude those out of conservatism and conclude that the company's real estate assets are likely worth somewhere between $840 million and $1 billion, which represents approximately 30%-37% of the current enterprise value.  We do not directly include these assets in our valuation, other than that which already gets reflected in operating results, but it is clearly another opportunity for value creation should management monetize some of these assets.

Remodeling

The company is currently undergoing a significant remodeling program at both its Wendy's and Arby's company-operated restaurants.  Management plans to remodel 100 company-operated Wendy's restaurants into the "Curve" or "Tower" design during 2010, after having remodeled about 90 during 2009.  Management has seen an increase in sales from remodeled stores and indicated they are targeting a 10% sales lift at remodeled store.  Management also plans to remodel 100 company-operated Arby's restaurants into its "Pinnacle" design during 2010, which is included in a $75-$100 million investment over the next three years.  Currently, about 56% of company-operated Arby's have this new design and the goal is to bring that to 75% by the end of 2012.  While the returns from a large remodeling initiative are always uncertain and difficult to quantify for minority owners, even after the fact, we believe Chairman Nelson Peltz and Vice Chairman Peter May, who collectively control approximately 23% of the company, have a strong track record in business and capital allocation, so we are comfortable with this investment.

Share Repurchase Program

Since the inception of the company's share repurchase program in 2009, and as of May 25, the company has repurchased 47 million shares for $223.1 million at an average price of $4.74.  The original program was announced in August, 2009 with second-quarter earnings and authorized a $50 million repurchase program. Since then, in less than 10 months, the company has increased the authorization four times to the current $325 million program, of which $101.9 million remains outstanding.  The 47 million shares repurchased represent about 10% of the original outstanding shares, which has significantly increased the per-share intrinsic value of the business.  The ongoing margin improvement at Wendy's, the ongoing G&A savings, the breakfast and international growth opportunities, and longer-term opportunities to monetize real estate holdings and re-franchise restaurants is highly likely to create significant value in the future, so to the extent the company can aggressively repurchase shares before these value-enhancing events unfold, it should should create significant value for shareholders.

Valuation

Note: This analysis assumes a cash balance equal to the first-quarter balance sheet figure less $32.9 million for approximately 7 million shares repurchased between May 7 and May 25, 2010.  The diluted share count reflects the approximate 430 million shares outstanding as of May 7, less approximately 7 million shares repurchased since.

Our three-year DCF, which incorporates the $70 million of maintenance capital expenditures indicated in the company's 2009 debt offering prospectus, results in an $8.80 per share valuation using a 9.0% discount rate and 2.5% terminal growth rate.  We give virtually no top-line credit for growth capital expenditures in the DCF, so we believe using maintenance capital expenditures is consistent and appropriate.

Wendy's/Arby's balance sheet has a current net debt-to-EBITDA of about 2.1x and recently renegotiated its credit agreement, which lowered its interest expense and extended its maturities.  The nearest term maturity is now its 6.2% Senior Notes, which are due in 2014.  The company's sizable cash balance should continue to provide flexibility to repurchase shares and reinvest in the business.

Conclusion

As we have articulated, we believe the current market price of $4.39 per share implies a valuation of about 6.7x EBITDA for the Wendy's system - a nonsensical multiple for a healthy, growing business with several attractive strategic opportunities - and the entire Arby's system is free.  We believe it will be extraordinarily difficult to lose money on this investment given a) a popular, healthy brand is selling at a massive discount, b) a popular, but struggling brand is free and we are being paid to take it, c) significant real estate assets that are likely to be worth over $800 million represents at least roughly 30% of the current enterprise value and can be partially monetized over time, d) attractive growth opportunities relating to breakfast and international franchise growth, e) management can re-franchise company-operated restaurants, generating immediate cash and gradually transforming the business into an increasingly franchise-driven model.  In addition, we consider the current aggressive share repurchase program being executed at depressed prices, before many of these initiatives occur, to be the icing on the cake.  We have difficulty imagining a scenario where we would lose money on this investment at this price, and to us, all the other alternatives are good.

Risks

While we believe we are being fairly compensated for assuming the following risks, these risks do exist and could cause the results of this investment to be less favorable than we expect.

-High unemployment and low consumer confidence serves as a headwind to traffic and sales at both Wendy's and Arby's.  These and other macroeconomic factors could worsen.

-Wendy's and Arby's company-operated restaurants are vulnerable to rising commodity costs, including beef and chicken.  To the extent the company cannot or does not pass along rising costs to consumers, margins would be negatively impacted.

-While we believe the Arby's system is entirely free at this price, part of this investment thesis relies on the cost savings initiatives that are contingent on utilizing the purchasing power of over 10,000 restaurants, of which Arby's is roughly 3,700.  To the extent Arby's restaurants close, it could be detrimental to these initiatives.

-Approximately 10% of Arby's franchisees are struggling, mostly due to recent declining sales and franchisee leverage.  The company is working with these franchisees and their lenders, however there is no guarantee these restaurants remain open or are not taken over by the company.

Appendix

To update humkae848's EBITDA bridge for what actually occured in 2009, we roughly think about it as follows:

PF 2008 Adjusted EBITDA: $367 MM

G&A Savings: $62 MM

Wendy's Margins: $39 MM (our estimate)

53rd Week in Fiscal 2009: $14 MM

Arby's Decline: -$57 MM (our estimate)

2009 Adjusted EBITDA: $425 MM

Finally, we recently did some due diligence at Wendy's, which included a quarter-pound Baconator and a Honey BBQ Boneless Wings.  There was a noticeable improvement in the bun and the bacon, which management has cited, and which was crispier and firmer than I recall and was unlike the floppy and somewhat transparent kind.  The burger had slightly too much mayo for my taste, but was still quite good.  The boneless wings were all-white meat and looked and tasted like "real chicken."  My guest had an Asian chicken salad that had mandarins, crispy Asian noodles, walnuts, and dressing, which was described as "very good" and "surprisingly good."  Neither of us had eaten at a Wendy's, McDonald's, or Burger King in at least a year and we were both pleasantly surprised by the food quality.  Service, store cleanliness, and other factors were non-issues, which is always good.  Also, the general consensus among my peers is that Wendy's food quality is far superior to both McDonald's and Burger King.

*We are long shares of WEN, but may change our position at anytime without updating this board.  This is not a recommendation to buy or sell any security.  Do your own work.