Industry
· Within restaurants (and consumer discretionary in general), Quick-Service burger stocks are best positioned for 2018. The three largest: MCD, BK (owned by QSR) and WEN are all among the top 5 restaurants for reported SSS growth YTD and have a clear runway to repeat this outperformance in 2018. Drivers of outperformance include:
1. Strong pipeline of value focused products
2. Accelerating wage growth among low income consumers + improving confidence
3. A narrowing of the gap between restaurant inflation and grocery inflation, encouraging more restaurant visits
4. A fleet of domestic units that have received significant capital spend and remodels over the past five years, creating a more appealing customer experience than offered by competitors in casual dining, fast casual and smaller QSR burger chains.
WEN’s sales
· WEN has sold off on fears that MCD’s accelerating domestic sales must be coming at the expense of market share loss by WEN. This view is misplaced. WEN’s comps have historically been positively correlated to MCD comps due to both being impact far more by swings in the economic cycle (namely strength of the low income consumer which is currently improving), than share swap between the chains.
· WEN’s comp sales are also among the most resilient in the entire restaurant industry. 3Q17 marked its 17th consecutive quarter of positive comp store sales – the second longest positive streak in the industry (DPZ 1st).
· While WEN’s comps are safe, it’s also worth highlighting that following its refranchising, its sensitivity to comp has been significantly reduced. Each 1ppt move in comps impacts EPS by 1ppt. To reinforce this immateriality for earnings, the widest range of comps WEN has experienced since 2013 is only 440bps (+0.4% in 2Q16 and +4.8% in 4Q15).
Earnings and cash flow
· 2018 is set to be a year of significant earnings and cash flow growth for WEN. The company has guided to 20%+ EPS growth driven by:
o Comp store sales growth
o Unit expansion
o G&A reductions
o Net working capital improvements (aiding FCF).
· WEN’s guidance calls for 30% growth in 2018 FCF, with four of the top five variables entirely under the company’s control.
· Beyond 2018, WEN’s best-in-class business model derives an ongoing EPS CAGR of 20% through continued unit expansion (including internationally), comp growth, high-margin buy-and-flip real estate transactions and ongoing share repurchases.
Tax reform
· WEN’s current position as almost entirely domestic makes it one of the biggest beneficiaries in the restaurant industry of coming tax reform.
· It’s historic tax rate of ~36% should be reduced to 20-25%. That sees EPS upside of 12-20% on top of a business model already built to deliver high growth. The cash flow this generates could then be used to create further accretion by allowing for greater share repurchases.
Arby’s stake
· Often forgotten by investors, WEN owns an 18% stake in Arby’s. This is often forgotten because the income it generates doesn’t hit WEN’s P&L.
· WEN provides a fair market valuation each quarter and the latest update showed $1 per share in value (post tax).
· The recent Arby’s acquisition of BWLD makes it seem more likely that WEN is closer to having an opportunity to monetize this stake. If not, it will share in the upside from synergies generated by the acquisition.
Valuation
· WEN’s valuation looks expensive but is misleading. It currently trades at 29x EPS however this includes neither the benefit of tax reform or the Arby’s stake. Stripping out the value of the Arby’s stake but not including tax reform it trades at 27x.
· Including both tax reform and adjusting for the Arby’s stake, WEN trades at 24x 18 EPS. This is for a valuation that continues to offer 20%+ EPS growth.
· WEN looks even better on FCF. It currently trades at a 6.6% 2018 FCF yield and a 7.1% yield after adjusting for Arby’s. The benefit of tax reform should see that yield improve to 7.1%, which unlike comparable FCF yields will deliver consistent growth.