by David Sterman
For much of the past 18 months, it's been fair to question whether the economy is truly on the mend. Not anymore. The recent employment trends have started to cement a new reality: companies are starting to rebuild their workforces and consumer spending may finally turn up to a higher plane later this year. Trouble is, many consumer stocks have already anticipated that brightening outlook. So it pays for investors to find companies that are still being viewed as victims of the lousy economy, getting no credit for an eventual upturn in demand.
For fast-food operator Wendy's (NYSE: WEN), expectations are quite low, as shares trade at a hefty discount to the peer group. Yet a recently articulated turnaround plan, coupled with the benefits that will come from rising employment, could help the company to generate better financial results. When that happens, the shares' major discount to the peer group could narrow, pushing shares up 50% -- or more.
In the past few years, Wendy's has lost ground to rivals such as McDonald's (NYSE: MCD). Mickey D's wisely sought to modernize its stores and upgrade menu offerings, which helped deliver solid increases in foot traffic. Over at Wendy's, the struggling Arby's chain has gotten much of management's attention, which led the core Wendy's stores to suffer from benign neglect. As a consequence, financial results have looked pretty lousy when compared to McDonald's.
There is a key takeaway from these numbers: Investors value every dollar of McDonalds' sales much higher than every dollar of Wendy's sales (3.72 vs. 0.84). And for good reason: McDonald's knows how to really squeeze profits out of sales, so its operating margin is vastly higher than Wendy's. The key for Wendy's is to boost those margins, and when that happens, the price/sales valuation gap between these two firms is likely to narrow.
As a first step, management announced plans in early March to sell the underperforming Arby's chain. Merrill Lynch thinks the chain will fetch at least $200 million, while UBS suspects the chain will sell for $300 million. Yet this is addition by subtraction. With the proceeds of the sale, Wendy's will follow the McDonald's playbook by remodeling stores and rolling out new food offerings.
Store remodeling has shown to have a tangible effect on sales, as consumers' perceive a higher quality offering. (And that is surely required for Wendy's, which already charges slightly more for its food and needs to retain a solid brand image.)
The menu revamp is taking place in several steps. First, Wendy's will again make a big push into breakfast (with the twist that it will offer burgers and other lunch fare as well during morning hours). Wendy's has had a hard time cracking the breakfast market in the past, yet there is little risk, as the fixed costs such as utilities, rent and taxes are already covered.
More importantly, Wendy's will roll out a new "hot 'n juicy cheeseburger" this fall, with an emphasis on a more loosely packed burger that has scored very well with consumers in test trials. The burger's launch will coincide with "Wendy" as a spokesperson, the daughter of founder Dave Thomas and inspiration for the chain's name. This will mark the most serious image re-branding for Wendy's since before the recession took its toll.
Lastly, Wendy's, which currently has about 800 international stores, hopes to follow in the footsteps of McDonald's and steadily expand into countries such as Brazil and China, pushing the international store base past 5,000 within five years. Wendy's is unlikely to ever catch up and surpass McDonald's. Instead, the goal is simply to close the gap between the two.
We looked at Wendy's numbers before. Now let's look at them with the assumption that Wendy's can boost operating margins to 15% -- still half of McDonald's. (I've kept all other metrics constant for the sake of simplicity).
Even if Wendy's margins rise (thanks to the leverage associated with increased foot traffic and the international expansion) to just half of McDonalds' margin levels, shares would end up being far cheaper than shares of Mickey D's on an enterprise value (EV)-to-EBITDA basis.
This isn't just idle speculation. It's actually the roadmap Wendy's management is pursuing. Investors remain in watch-and-wait mode and shares won't appreciate until progress begins. That is likely to play out through 2011, as breakfast, the new burger, the new ad campaign and the international expansion all begin.
Optimism over plans to sell the Arby's chain in early March pushed shares above the $5 mark. That euphoria has faded and shares are now back to where they were before the Arby's announcement was made. Investors have already moved on to other ideas, but I'm betting they'll cycle right back to Wendy's, as turnaround plans start to take shape in coming quarters. The fact that another 200,000 consumers are finding work every month is just icing on the cake for this turnaround plan, as I see shares having at least 50% upside from current levels.