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The Wendy's Company (NASDAQ:WEN)

Morgan Stanley Retail & Restaurant Conference

April 04, 2013 7:30 am ET

Executives

Stephen E. Hare - Chief Financial Officer and Senior Vice President

Analysts

John S. Glass - Morgan Stanley, Research Division

John S. Glass - Morgan Stanley, Research Division

Everyone, thanks for joining us. My name is John Glass. I'm the restaurant analyst for Morgan Stanley. Welcome to our blank annual field trip and conference. I say blank because I think we've done this now for over 25 years in various locations, far predating me. On behalf of the retail team at Morgan Stanley, I'd like to welcome you. My colleagues here in the audience: Kimberly Greenberger, who does softlines; Mark Wiltamuth, food and drug retail; David Gober, who does hardline retail. There's a number of other Morgan Stanley representatives around for you today and tomorrow to ask questions of. Many of our team members are here.

And just a couple of thoughts about the logistics over the next 36 hours and how this will work. So all the presentations are in this room here. We're going to do chat-show or talk-show formats for all of them. Some are webcast. Some are not. At the end of this session at noon, there's a lunch here with Urban Outfitters. So please stay around for that. There are one-on-ones going on concurrently. So I understand people will be coming in and out. Leave yourself a few minutes. It is across the lobby. I don't know exactly where, but the people out in the hallway will direct you. But leave about 5 minutes to get to those. After that, we're going to get on a bus. We're going to go, I think, just a short distance to a couple of malls, really interesting stuff we're seeing. So please stay with us then. And then we're coming back here after a brief break to kind of -- for people to come back, get organized, come back to this room for a dinner and 2 panel discussions, very interesting, one from Bucks & Associates, one at real estate panel that we've done for years, which I've always found fascinating. And then tomorrow, we'll repeat the process at least in the morning.

Question-and-Answer Session

John S. Glass - Morgan Stanley, Research Division

Okay. So with that out of the way, I'll change hats as an analyst and step over here. It's my pleasure to introduce our first company in the conference and the first restaurant company, The Wendy's Company. Steve Hare is the company's Chief Financial Officer. And, Steve, I wanted to start by asking you, Wendy's is going through a fairly significant transformation, the most significant transformation, I think, I've seen in this brand, it in turn -- it touches the restaurants. It touches the menu. It touches a number of aspects of the strategic plan. So can you -- just for those who maybe haven't followed as closely as I have over the years, what are the big pieces of that structure that you are undertaking now? What are the key milestones you're looking for this year?

Stephen E. Hare

Sure, John, and thanks for having us here. It's good to be with you this morning. I think when you look at the brand transformation that Wendy's is going through today, I think you go back to our CEO. Emil Brolick rejoined Wendy's about 1.5 years ago. I think the advantage that Emil had in coming back to the company is that he was an important part of Wendy's really at the time it was most successful, was a close confidante and partner with Dave Thomas, our founder, and comes in with credibility with the franchisees to really lead the company. Not necessarily back to the good old days, but ahead. And I say -- and ahead, I say a comprehensive, as you mentioned, brand transformation that I think the most visible piece is what we call Image Activation. And that really started with a realization, as we looked at the brand positioning that Emil believes is a natural fit for Wendy's, is A Cut Above. And what do you mean by A Cut Above? We mean a higher quality product offering, consistent innovation in the category and being able to compete not only with the traditional QSRs that are out there, but also with what we call sort of the new QSRs, the Paneras and the Five Guys that present another pull on some of our premium customers. As we looked at it, one of the clear obstacles we had was the age of our facilities. We're a 40-year-old brand. The average age of our facilities then is somewhere in that 20-year category. And so as a result, we felt that we were not presenting a contemporary environment to our customers that was consistent with A Cut Above. So we embarked on a program, and we can talk some more about the details of that. But to really look at, starting in 2011, what kind of designs could we incorporate and reimage a number of our restaurants and really present a consistent customer experience that's very different than a typical QSR experience and one that we think is consistent with the higher quality of our food -- but when we think about transformation, it goes beyond that. I think you've seen some of our new advertising. And frankly, Wendy's is a company that has suffered from an advertising message standpoint really since the glory days when Dave Thomas was such an effective spokesperson for the company. And I think you're seeing us now with really a two-pronged attack on an advertising campaign, using Wendy Thomas, Dave's daughter, to really reinforce the traditional values that Wendy's brings, but also a new character called Red that brings a more come contemporary feel to the brand. And that's been an effective sort of one-two punch in terms of our advertising. Beyond that, if you go into our restaurants today, you'll see new packaging that incorporates the new design, a brand-new logo. We had not touched our logo for a long, long time and, I think, again, all designed to bring a more contemporary feel to the building and all the way down to new uniforms for our restaurant crews. And it's an energizing event when we bring in the new uniforms. And people feel good about working both in a better environment and in a successful restaurant.

John S. Glass - Morgan Stanley, Research Division

Can you talk about, I guess, the crux of the turnaround. I want to -- do you want to talk about the menu innovation because I think there's a lot going on there as well. But I think the heart of it is the reimaging and the active -- Image Activation program that you're undertaking. There is a significant amount of capital to be deployed there. There is a significant amount of return you're expecting given the increase in sales. I think there is investor skepticism around, can you sustain those kind of gains? So can you outline what you're expecting and maybe what your experience has been to-date on those reimages?

Stephen E. Hare

Right. So in the Image Activation, as I mentioned, we started in 2011 with 10, what we call, prototype restaurants that used 4 different designs. We really used those as a test to see what would resonate with customers. Those, from a cost standpoint, were very expensive, $1 million-plus from a reimage standpoint. But it was meant to go out and say, "What do we need -- what features do we need in our restaurants that would help differentiate us in the marketplace and also be consistent with A Cut Above?" We then went in 2012 and reimaged 48 of our company restaurants, brought the average cost of what we call Tier 1, which is our sort of flagship design, brought the cost down to $750,000, which is a significant reduction, but we still recognize is a higher cost than most of our franchisees would like to have to reinvest in the business. The good news though is 4 of those 48 restaurants, and 4 of the prototypes before that, were seeing an average sales lift of about 25%, which is really remarkable when you think about an industry that's relatively flat from a traffic standpoint. That 25% sales lift is mostly driven by traffic. So we're not raising prices as part of that. So what's very encouraging is both the fact that we see an average check lift because more people are dining in our restaurants where our average check is higher, but certainly a strong response, a favorable response, that we're doing something remarkable at that Tier 1 level, but still recognizing that, that's a significant financial investment, we're now trying to use tiers to look at what we call a Tier 2 and a Tier 3 to look at different cost points to see if we can keep that strong customer response and the financial returns that we're seeing. And we're excited to say we just opened up our first Tier 2 this month in Columbus and our first Tier 3 in Orem, Utah, which will be really the starting point for showing to our franchisees what kind of a return can we see, what kind of customer response at points we think will be more affordable to our franchisees at a whole.

John S. Glass - Morgan Stanley, Research Division

And what were the costs -- do you think you, first of all, hit your cost targets in the Tier 2 and 3 that you opened up? And what are -- what were the goals and the cost of those?

Stephen E. Hare

So Tier 2, what we're targeting is an investment that would be more of a $550,000 investment compared to the $750,000 on Tier 1. And then at Tier 3, we're trying to get below $400,000 in cost to present a more affordable option. Frankly, John, seeing the 2s and 3s now up and running, we've captured a lot of the features that we think excite our customers in the Tier 1. So I'm very encouraged that we're going to see a good financial response as well at lower cost points, and I think that's critical to getting franchisee support behind that.

John S. Glass - Morgan Stanley, Research Division

And what was -- when, in fact, you did these, were you able to hit those cost targets? Are you still working on a prototype as you build it out to realize that.

Stephen E. Hare

Yes. Well, the first 2 that we've built have come in slightly above that from a cost standpoint. But I think that's sort of the typical early bidding process that you go through when you're breaking new ground. We would expect over time that we will be able to come down to this target level.

John S. Glass - Morgan Stanley, Research Division

And just for the benefit of everyone, can you talk about what is the schedule then as you roll out these 3 tiers? Obviously, you've got to make sure the 2, Tier 2 and 3, work the way you want them to. But what is your plan for 2013? What is your plan for 2014 as it stands now for each of these tiers?

Stephen E. Hare

So for 2013, on the company side, we'll go and we've got a firm pipeline now of 100 company restaurants that we will open during this calendar year. That will be a spread of about half that will be Tier 1s, including some scrape and rebuilds. And then we'll do half of those 100 in Tier 2s and 3s so that we can start to develop a good base of restaurants in different locations, different AUVs, that our franchisees can then look at and hopefully get them working alongside of us. We have put in an incentive program this year in 2013 for early adopters. Because we recognize we're early in the process. There is more risk to the process until we have more of a track record around the returns on these reimages. So we've encouraged our franchisees to join with us. And we've put a $10 million incentive program together. And we hope that's going to be enough to generate interest in about 100 franchise units as well. So that would get us to 200 units done this year across the system. And then our longer-term goal, John, would be 50% of the company restaurants to be reimaged by the end of 2015.

John S. Glass - Morgan Stanley, Research Division

And have you seen, has there been an uptake in that offer for franchisees, has that all been spoken for at this point?

Stephen E. Hare

We're just about fully subscribed at that point. That program initially started late last year when we had just the Tier 1 designs available. So we started at a Tier 1 level. But now that the 2 and 3 designs are available, we've extended it across the spectrum. And now we have about 100 units spoken for at this point in time.

John S. Glass - Morgan Stanley, Research Division

Got it. And before we go further, I wanted to make sure -- this is fully interactive. I've got lots of questions, but please don't be bashful. Raise your hand if we're on a topic and I haven't fully explored it. I wanted to move for a moment, though, Steve, to the notion of refranchising. It's an important piece. It's been a popular, to say the least, strategy employed in fast food today. One of your competitors, Burger King, is literally going to be entirely franchised within 60 days. McDonald's, over time, has winnowed down its U.S. ownership. So you've been left actually with some of the higher U.S. ownership percentage relative to your peers. You've talked recently about maybe changing that. Can you maybe just elaborate on what you're thinking about from a refranchising standpoint, what your targets are, your goals are? It would seem attractive to do at this time given rates, given the capital intensity of the remodels, et cetera.

Stephen E. Hare

Well, and I do think our views around refranchising are tied in some ways to the Image Activation process that we're under because I do think with the magnitude of the investment that we think is critical for our system to really transform the brand, we recognize that some of our franchisees are going to be faced with a decision to either invest to stay competitive or maybe exit the system. At the same time, we're being approached by a number of people that see the power of Image Activation, want to come in and become new investors in the Wendy's system and want to buy some of our restaurants and embark on an Image Activation program with us. And we'd like to cultivate that interest. So we're in the process now of looking -- our ownership percentage today is about 22% of the system. We did buy 2 markets last year, Albuquerque and Austin. And so I think you will see us involved from time to time in transactions similar to that. But I would say the overall direction, if we look at our footprint of company restaurants, we're a little bit scattered. I think we're in too many markets. So I think there's an opportunity for us, from an efficiency standpoint, to actually focus our company restaurants on fewer, more consolidated DMAs and, in that process, maybe free up some restaurants that could be used either to building with current franchisees who are also interested in Image Activation or some of these new franchisees that I've talked about, where there would be a commitment to immediately go into an Image Activation program with those restaurants. I think as a result of that process, John, I would think that our ownership percentage over time will gradually come down. But I'm talking probably more in the high teens, mid-teens as an endpoint, certainly nothing as drastic as going to an all-franchise model. The reason, if you look at that, I don't think there's one business model that works and doesn't work. But I think in our case, with strong AUVs in the North America market, our beginning point is $1.5 million for a lunch-and-dinner business. Our profitability of running company restaurants is different than some of the other restaurant chains that are taking alternative strategies.

John S. Glass - Morgan Stanley, Research Division

Okay, interesting. I'm going to turn now to the menu. And there's been a number of changes that have gone on the menu. We've -- you've launched a value -- a new value platform this spring or this, excuse me, over the winter. You've -- you're in the process of exiting a breakfast business that I think you felt -- and maybe you can explain what the strategy is behind there. And then you've also launched, most recently, a new sort of product, flatbreads, which is new to the category. Can you first just talk about what -- value has been important to Wendy's for years and perhaps though you felt like you were stuck at $1 price point? So what did you -- what were you trying to do with the new Right Price, Right Size? And I might get it wrong but -- so correct me, menu and then maybe transition into talk a little bit more broadly about the menu.

Stephen E. Hare

Yes, clearly, value is an important ingredient, I think, for every QSR player out there. And for us, we were probably one of the early people to recognize that with our Super Value Menu many years ago. But I think to be fair, if you look at our performance in 2012, we lost traffic in the value part of our business. And I think we attribute that mostly to an inconsistent execution of our value strategy. You could go into a franchised Wendy's and see a very different approach to pricing, which items would be on a value menu, if on a menu at all. And so as a result, I think we confused our customers with inconsistent execution across the system. So the Right Price, Right Size was in some way designed to say, "What could a menu be that deals with the value part of our menu, an audience that in this economic environment clearly wants a value message and a value alternative?" And what we looked at was, let's come up with a menu that does preserve some choices at the $0.99 price point, which is still an important threshold in our industry, but also extend the definition of value to include prices for us up to $1.79 today. And in doing that, we think we're balancing both a compelling value message to our customers but also something that's sustainable on a consistent approach across all our system, so something that recognizes for our franchisees that there's a profit motive in everything we do and being able to sell products in the face of pretty significant commodity inflation around our beef products, in particular. Then it's where, we think, we can have a profitable business, but also one that's still compelling to our customers from a choice standpoint.

John S. Glass - Morgan Stanley, Research Division

And McDonald's did try this same sort of transition last winter and they now admit that it didn't work for them because it took the focus off of value. And value in this industry, in the customers' eyes, is still $1. How did you avoid -- or do you think you're avoiding that trap?

Stephen E. Hare

Yes, we saw -- at least in our test markets last year that supported the launch in January, of Right Price, Right Size, we saw an ability to sort of maintain traffic, but at better margins, and one that we think we've gotten a favorable response from our system in being able to consistently support. We think it's a long-term battle. We think we need to continue to be able to advertise and raise awareness that there is this choice of value. And I think that -- I think we're pleased with the results we've seen to date, but recognize it's going to be a very competitive category. You're seeing a tremendous amount of advertising being driven to value. And I think that reflects the economic environment we're in, where discretionary income is being pushed down by a lot of outside factors. And so as a result, we think there is going to be a very competitive race on the competitive edge of -- around value. But we think Right Price, Right Size, for us, is a good balance.

John S. Glass - Morgan Stanley, Research Division

Breakfast has been, by I think everyone in the category's admission, really the key driver to traffic, right. In the category of quick service, breakfast has been the real bright spot for many years. Wendy's has entered it and exited it a number of times. You're in the process, I think, of exiting it now. What do you -- why is that the case? I thought the food -- I think, generally, the food offerings were good, unique and it's differentiated vis-à-vis the brand. So what -- is it that you need to renovate restaurants before you reintroduce the breakfast idea? Was it -- is it simply just too crowded a category and there's no point in being the last into that?

Stephen E. Hare

Well, John, I think we got to the point last year. And what our decision was as we looked at breakfast -- and to your point, we really charged into breakfast, saying, "Look, we're the only major hamburger chain in QSR that's not a participant in the breakfast category." We see 25% of the traffic in QSR coming in that morning day part. And the feeling was if we can consistently deliver A Cut Above menu in the breakfast day part that we ought to be able to carve out a reasonable market share. So we pushed hard in that direction, but got to the point where we were looking at sort of inconsistent market performance. In some of our markets, that differentiated menu made a difference and we were seeing very profitable operations. But in other markets, we were not seeing traction and we were seeing sales stay below a breakeven level. So we had both company stores and franchisees losing money at breakfast. And I think we came to the realization that there was no short-term event that was going to drive that because we were not seeing traction. So we made the decision to pull out of those restaurants across the system where we were losing money in the morning day part. We will stay in breakfast. We will have about 400 restaurants that are profitable in the morning day part continue to serve this differentiated breakfast. And we think, over time, while we're not ready to charge back in, in the short term, I do think you'll see us approach the business from a standpoint of establishing our coffee program, I think one of the weaknesses and maybe the lack of traction related to not having a strong branded product offering on the coffee side. And so we're developing our own internal brand, Redhead Roasters, that does well in taste tests. And we think we'll establish that as an all-day-long part of Wendy's and maybe leverage that over time to be able to expand hours and begin to work back into morning day part participation.

John S. Glass - Morgan Stanley, Research Division

One sort of series of questions left, but before I do that, any questions from the audience? Let me maybe finish, Steve, by talking about just the balance sheet and how you think about capital deployment. Right now, you're using your cash flow from the business to reinvest in it because you think the returns are strong. There's also a buyback program going on. There's a healthy dividend. The company's levered but -- on a gross basis at least, but there is still an opportunity. I mean, the rates are the lowest we've seen. We've seen a number of companies, in your sector specifically, take on significantly more debt, very recently some private, like CKR, for example. What's your thought on that? Is there an opportunity to be more -- even more aggressive in the capital markets and the debt markets to fund now, for example? Or alternatively, are you rethinking the way the amount of capital you put back into your business and maybe redeploy some of it back to shareholders? Is there a change in thought in any of those?

Stephen E. Hare

So if you look at our balance sheet today, we have about $1.5 billion of debt on the balance sheet. But we have over $400 million of cash on the balance sheet as well. So from a net debt standpoint, we're leveraged about 3x. We're very comfortable with that level of leverage in terms of having a financial flexibility to fund a capital-intensive Image Activation program. What we've said, from an Image Activation program, we want to be able to move as quickly as possible to reach our 50% goal of company restaurants reimaged. That's an investment that's between $440 million and $500 million over the next 3 years. And the gating there is really operationally driven. So we said we've got full financial capability using existing cash flow, backstopped with the excess cash we've got on the balance sheet, to fully fund capital investments that -- for this year, for example, we'll have a capital budget of $245 million, which is an increase of about $50 million over last year. With that, we looked at our available cash over the next couple of years and felt very comfortable doubling the dividend to shareholders, as a way of saying, "We're confident in the future. We've got that flexibility. And we also want to give you an investment return now while this Image Activation program is developing." We authorized a stock buyback program of $100 million. But from a priority standpoint, I would list those clearly: number one, priority cash back into the restaurants; two, sustaining the dividend at an attractive level; and then three, the stock buyback, really on a opportunistic basis based on what happens in the marketplace.

John S. Glass - Morgan Stanley, Research Division

Terrific. Steve, we're out of time. Thank you so much for coming today. Many of you will be meeting with Wendy's later on today, and so I appreciate that. And everyone, stay tuned here for Darden as we transition in the next couple of minutes.

Stephen E. Hare

Very good. Thank you, everyone.

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