We began buying the stock in April 2005, mostly in the form of long-dated call options (LEAPs), with the stock around $18 (all prices in this letter are adjusted for the spin-off of Tim Hortons). Here’s a chart of the stock’s performance since then, with key events discussed below highlighted:
Given the underperforming stock and business, what did we find attractive about Wendy’s when we began buying it in April 2005? In short, the combination of Tim Hortons plus a smart, determined activist with the right plan to unlock Wendy’s hidden value.
Tim Hortons (NYSE:THI) is a magnificent business that today franchises nearly 3,000 units, 90% of them in Canada, selling coffee and baked goods – sort of a cross between Starbucks and Dunkin Donuts. It dominates its niche in Canada to a remarkable degree and, thanks to the beauty of a strong franchising model, has mouth-watering economic characteristics.
Wendy’s had purchased Tims in 1995 and, as we examined it 10 years later, the business was thriving, with robust new unit expansion and high growth in sales, same-store sales and earnings. Yet this success was being masked by the poor performance of the Wendy’s restaurant business. To be specific, in the first quarter of 2005, the Wendy’s brand accounted for 65.9% of the company’s revenues, yet only 42.7% of operating income, whereas Tims was 28.5% of revenues and 60.7% of operating income! Making the disparity even greater, Wendy’s sucked up 59.5% of the company’s cap ex vs. 36.0% for Tims.
When we conservatively estimated the value of Tim Hortons as a standalone business, it was worth nearly the value that the stock market was placing on the entire company – in other words, buyers of Wendy’s stock were paying for Tims and getting 6,699 Wendy’s restaurants (1,491 company-owned and 5,208 franchised) almost for free!
The decision to invest was not so easy, however, because our experience is that the decision-makers at companies that have two divisions, one firing on all cylinders and one underperforming, are highly reluctant to separate them, especially if they might be stuck running the inferior business. Thus, the main risk to this investment was that the status quo might have continued indefinitely, with the value of Tims remaining hidden within the larger company and Wendy’s-branded restaurants continuing to struggle under weak management.
This risk was diminished by the appearance of an activist investor, Pershing Square, a highly successful hedge fund that we know well, which made public a large stake in the company in late April 2005. It had acquired a 9.3% stake and was calling on Wendy’s to refranchise units, use the proceeds to buy back stock and, most importantly, spin off Tim Hortons. Pershing Square hired Blackstone Group to back up its analysis and, on June 9th, released an open letter to the company, outlining its proposal and an analysis showing the stock to be worth nearly 50% above the current level in the low $20s.
Wendy’s did nothing for nearly two months until, in late July, it announced “Comprehensive Strategic Initiatives to Enhance Shareholder Value” that exactly mirrored what Pershing Square had proposed. The stock popped to around $25 on this news (indicated by the 2nd red circle).
With the stock up around 40% (and our LEAPs up far more), we had no intention of adding to our position at that price, but then the stock trickled back down to nearly $20 (see 3rd red circle) due to temporary closures of Wendy’s units in the aftermath of Hurricanes Katrina and Rita. This was clearly a temporary effect and certainly had no impact on Tims’ value, and by then we knew with certainty that the Tims’ spin-off was happening, so we enthusiastically added to our position.
The stock rose about 50% over the next six months as the Tim Hortons’ spin-off approached (it look place in late March 2006, indicated by the 4th red circle). Consistent with the cliché, “buy on the rumor and sell on the news,” many investors sold their Wendy’s stock and, until recently, this appeared to have been the smart thing to do, as the stock went nowhere for the next year.
We hung on, however, because another activist, Nelson Peltz of Trian Partners, had also accumulated stock and pressured Wendy’s into adding three of his colleagues onto the company’s board, which took place in early 2006. We are very familiar with Peltz and, in particular, the remarkable turnaround he engineered with a far inferior restaurant business, Arby’s, so we decided to hold on, figuring that one of two things would happen: Peltz would help Wendy’s improve its business or, failing that, put the company into play. In either case, we saw the stock hitting $40 this year.
The latter scenario appears to be playing out, as the company put itself into play last week (see the final red circle). We continue to hold our position in the belief that there is little downside risk and the company will likely be sold at a modest premium to today’s price.
Full disclosure: Long WEN