Description

Wendy's/Arby's Group (NYSE: WEN, Price $4.88)

Wendy's/Arby's Group is a franchisor and operator of Wendy's and Arby's restaurants in North America.  Wendy's merged with Triarc Companies, which owned Arby's Restaurant Group, on September 29, 2008.   The combined entity, which is now known as the Wendy's/Arby's Group, has over 10,000 restaurant units in its two restaurant systems and annual combined system-wide sales of over $12 billion, making it one of the leading quick service restaurant companies in the world.  Specifically, Wendy's has 1,400 company-owned restaurants and over 5,200 franchisees; Arby's has over 1,100 company units and more than 2,500 franchisees.

The investment offers the opportunity to participate in a turnaround of an established brand at Wendy's that suffered through years of mismanagement and a disruptive sales process prior to the merger.  Assuming management can successfully achieve its three-year improvement plan while merely maintaining the general performance of the businesses, one can reasonably pencil out a $7+ share price over the next two years, which would provide over 40% upside.  There are additional avenues for upside that could deliver further long-term value.

In late April 2008, Triarc and Wendy's announced the merger after Wendy's had spent over a year evaluating strategic alternatives through a disruptive sales process.  Triarc, which owned Arby's Restaurant Group and some asset management businesses, also conducted its own strategic review throughout 2006 which led to (i) the separation of its asset management group which left Arby's as Triarc's sole operating business, (ii) a corporate restructuring to remove the overhead burden of Trian (Nelson Pelz's New York-based management company) from Arby's, and (iii) a plan to purchase Wendy's.  After the two companies agreed to the merger, they announced that Triarc's executive team would assume the management of the new company, with Roland Smith as CEO.

We like the franchise nature of the business model for its free cash flow characteristics, but there is much more that has drawn us to this opportunity. 

• We believe that Wendy's has been under-managed for years. Even though Wendy's possesses a premium QSR brand, the company has suffered from poor sales performance and weak margins in recent years, particularly as it plodded through its long sale process.
• We have met with the new CEO Roland Smith and spoke to some investors who have worked with him previously, and we are impressed by his credentials, experiences in turning around companies and discrete plans for improving Wendy's. Furthermore, we hear good things about the other members of the executive team that Roland has brought into Wendy's.
• Roland and his team have identified significant cost savings from $60 million of excess G&A in the combined company, as well as $100 million of margin improvement opportunities at Wendy's company-operated restaurants that should provide material upside to earnings in this difficult economic environment. Our own research validates the significant margin gap at Wendy's (for instance, there is a margin gap of approximately 600 bps compared to the franchised stores) and the overhead-savings opportunities at Wendy's/Arby's corporate.
• We believe the valuation is compelling at current prices and offers sizable upside potential if Roland and his team can execute on their plans to improve the Company's operations over the next few years.

To size the potential returns of an investment in the shares of the business, we look to year-end 2011 and employ the following assumptions:

• Baseline 2008 pro forma EBITDA of $367 million (see Q4 earnings release).^[1]
• Management successfully implements the $60 million corporate cost savings and the margin improvement opportunities in the Wendy's company-operated restaurants (worth approximately $100 million at flat same-store sales).
• Modest same store sales performance at Wendy's of 1-1.5% per year increases over the next three years (worth about $15 million).
• Arby's struggles through 2009 with -8% same store sales and is flat thereafter. The sales declines cause commensurate margin compression of ~250 bps at Arby's that does not improve over the period (representing a $30 million deterioration of EBITDA).
• Trian-related overhead costs, which were approximately $36 million in 2008, should also fall away over time in line with management's statements on bringing these costs down to an annualized $8.5 million (providing an additional $25 million in savings for PF EBITDA).
• This totals to approximately $537 million of PF EBITDA in 2011.

Other assumptions:

• Annual capex through 2011 is in line with management's guidance for 2009 of $140 million, and we assume no unit growth. (Note that in the Company's high yield prospectus, they state that non-discretionary maintenance capex is $70 million per year.)
• Through year-end 2011, the Company should generate approximately $400 million of free cash flow. As a result, at year-end 2011, the Company would have about $540 million of net debt, compared to approximately $940 million today. (In this example, we simply assume that interim free cash flow is used to pay down debt.)

Taken together, this scenario implies a share price range of:

The valuation range delivers an upside of approximately 40-65% which could be realized over the next two years.  (At 1.5 cents per quarter, the stock also pays a 1.2% dividend yield.)  Additional upside could result from:

• Improved sales performance at Wendy's and/or Arby's
• Breakfast launches at Wendy's
• International expansion
• Using the idle cash for accretive share repurchases

Of course, the investment has certain risks.  

• We are concerned about consumer spending patterns, and QSR traffic has generally slowed in recent months with industry traffic down 1% in the first quarter.  The new management team has taken immediate steps to address these issues by simplifying Wendy's value menu and reinvigorating the Wendy's product pipeline after a long period of dormancy. 
• Wendy's and Arby's both suffered from increases in commodity costs during 2008.  While commodity costs should provide a near-term tailwind as the industry experiences relief from the soaring food costs of 2008, last year did show the risks of a spike in food prices.   Management has taken steps to improve food procurement, especially at Wendy's, and the CEO has affirmed that his margin improvement goals do not rely on an improvement in commodity costs.
• The QSR environment has also been competitive with value-based menus being emphasized over the past year to drive traffic.
• Arby's is struggling with comp store sales decreasing 4.3% in 2008 and down 8.7% in Q1.  In addition to marketing missteps made during 2008, Arby's has a high average ticket while the recent trends in QSR have tended to more value-based offerings.    Consequently, other sandwich-based chains, notably Subway, have significantly outperformed Arby's over the last year.
• Although Wendy's/Arby's is generally unwinding some of the major entanglements that Triarc had with Nelson Pelz/Trian prior to the merger, the Company did enter into a new services agreement with Trian.  The services fee will fall from $1.75 million per quarter to $250,000 per quarter, but the Company has not totally dissolved this inter-relationship with its largest shareholder. 
• In June, Wendy's/Arby's close a $565 million high yield note offering priced to yield 10.5%.  Considering the Company's consolidated total net debt is ~2.5x trailing EBITDA, this pricing was confounding.  However, the Company demanded the flexibility to employ the cash opportunistically and latitude on covenants.  Furthermore, the Company did not outline its specific use for the cash; it only indicated it raised the funds opportunistically for future debt paydown, share repurchases, investments in the business or acquisitions.  The market was initially concerned about management making an additional acquisition which is a risk that has weighed on the stock.

Note: The information and data above is based on source believed to be accurate but not guaranteed.  Please conduct your own work and analysis, and do not rely on us.  We may change our opinion at any time, and we may purchase or sell such shares at any time without updating this write-up.

[1] While the Company did not provide a pro forma Q1 2008 stub for a clean LTM calculation, PF EBITDA in Q1 was $80 million.   Management suggested this would track to about 20% of full-year 2009 on a run-rate basis.

Catalyst

Progress on turnaround plan

Potential share repurchase