Description

Wendy’s Company (NASDAQ: WEN)

Recommendation: Buy WEN

Wendy’s Company (WEN) is an unloved company that is in the early stages of improving operating results in line with peers, under the direction of two owner-operators with a track record of success in the food and beverage industries. The market is ascribing little to value to the future prospects and, over time, I believe shares could appreciate to the mid-20’s from the current price of $10.

Wendy’s is the world’s third-largest hamburger-oriented quick serve restaurant, with over 6,500 restaurants. Wendy’s has historically underperformed its larger peers in most areas, especially profit margins. EBITDA margin at Wendy’s in the most recent fiscal year was 14.9% versus 36.8% at McDonald’s and 51.3% at Burger King. Part of this underperformance has historically been due to the mix of Wendy’s restaurants between franchised and company-owned. Only ~85% of Wendy’s stores are franchised compared to ~100% for Burger King. Franchise revenue carries a margin well over 80%. Meanwhile, only ~7% of Wendy’s stores are outside the U.S. versus 69% at McDonald’s and 42% at Burger King, providing a tremendous growth runway for WEN.

This is all well and good, but why will any of this change going forward? First, Nelson Peltz and Peter May, along with their company Trian Fund Management, own 25% of the stock. Peltz acts as non-executive Chairman. Peltz and May have extensive experience in the food and beverage industries, beginning with a 1993 activist investment in Triarc, which owned Arby’s and Royal Crown Cola among other things. Triarc subsequently acquired Snapple in 1997 from Quaker Oats for $300 million. After fixing some of the management and structural problems, Triarc sold Snapple and the rest of its beverage portfolio three years later for $1.4 billion to Cadbury Schweppes. It is estimated that Snapple was worth $900 million to $1 billion at the time of the sale. Triarc merged with Wendy’s in 2008 and the Arby’s brand was sold in 2011. Of the effort to turn around Snapple, Peltz later said, “The only fixed plan we had was to limit the cost of failure. I knew Mike and Ken would make mistakes. So what? The team understood the need to stay away from big risky ideas. All we had to do was to avoid fatal mistakes, to make sure that each time we took a risk, we would be able to come back if the gamble didn’t pay off.”

Second, there is tangible evidence that the turnaround is gaining traction. Management is focused on repositioning the brand within the quick serve restaurant market through the modernization of stores. Tests indicate a 10-20% sales lift for remodeled stores and a 25-35% lift for completely rebuilt stores. The profit flow-through is expected to be 40%. However, the initiative is still in the early stages, so the enhanced profitability will be obscured by the incentives and financing that Wendy’s will offer to induce additional franchises to participate. The company anticipates that 35% of the overall system will be updated by 2017.

Concurrent to this, Wendy’s is in the middle of a “system optimization initiative” during which it is refranchising company-owned stores. As Warren Buffett has said, “The best business is a royalty on the growth of others, requiring little capital itself.” Wendy’s has sold 425 company-owned stores over the past 18 months for $325 million and used $275 million of the proceeds to buy back 7.5% of its shares. The company recently announced plans to sell its 137 Canadian stores within the next 3-4 months.

On the surface, Wendy’s screens poorly on traditional metrics and trades at only a slight discount to peers. However, current earnings are irrelevant and Wendy’s has superior margin and revenue expansion opportunities relative to peers.

Wendy’s restaurants currently do ~$1.5 million in average unit volume (AUV). The refresh initiative yields a 10-35% lift in volumes, so let’s assume a 20% increase. Further, let’s assume that through international expansion, the company can double the number of franchised restaurants. This results in potential revenue of ~$2.9 billion. Through a combination of mix shift and cost initiatives, let’s assume that Wendy’s improves EBITDA margins to 30%, which would be 80% of McDonald’s margin and 60% of Burger King’s margin. Using the current multiple of 11x, Wendy’s shares could be worth somewhere in the mid-20’s, or 130% higher than today’s price.

There does not appear to be any reason why WEN cannot achieve profit margins closer to those of competitors, which would more than double profits. The company is executing a tactical and strategic set of plans to correct its deficiencies, under the direction of two owner-operators, with several levers to pull and sources of earnings expansion. Investors are loathe to look that far into the future, however, and are therefore excessively discounting the probability of success at WEN. As another prominent investor has said, “The market is less efficient in its ability to look around the corners for businesses that are not yet great, but emerging towards Greatness... We are focused on seeking knowledge of the causes that will produce a meaningful inflection point of change on the economics of the business.” Therefore, I believe it is likely that WEN shares will be materially higher 2-3 years down the road as investors begin to appreciate the changes currently taking place at the company.

Catalyst

1. Store refreshes

2. Continued refranchising of company-owned restaurants

3. Passage of time