According to the industry's research company Technomic, in 2011, Wendy's (NYSE:WEN) became the second largest burger chain in terms of sales in the United States. While rankings are important, there are three main reasons shares of Wendy's seem more attractive than that of its main competitors in the fast food area: McDonald's (NYSE:MCD), Burger King (BKW), and Yum! Brands (NYSE:YUM). First, Wendy's has a better valuation based on a number of metrics. Second, Wendy's has taken a number of initiatives which should improve its competitive position. And finally, Wendy's appears to have an operational, financial, and marketing edge, which further improves its prospects for success.
Wendy's has about 391 million shares outstanding and a market capitalization of about $1.75 billion. This is relatively small compared to that of McDonald's ($91.4 billion), Yum ($29.2 billion), Burger King ($4.8 billion), and even Chipotle Mexican Grill (NYSE:CMG) ($9.6 billion), which became a national chain relatively recently, in the early 2000s. Wendy's also boasts the second lowest amount of debt compared to its equity, with a debt to equity ratio of 0.7 compared to debt to equity ratios of 1, 1.55, and 2.8 for McDonald's, Yum, and Burger King, respectively. Chipotle Mexican Grill is the only company, which does not have any debt. However, on the basis of an enterprise value to earnings before interest, tax, depreciation, and amortization (EBITDA), a valuation measure many investors use in comparing stock valuations, Wendy's common stock has the cheapest valuation. Its enterprise value to EBITDA ratio is 8.6 compared to 10.4, 11.4, 11.6, and 17.7 for McDonald's, Yum, Burger King, and Chipotle, respectively. With the exception of Chipotle, Wendy's shares offer the best growth opportunity due to its low leverage and also the lowest valuation based on enterprise value to EBITDA. Looking forward, the company expects an EBITDA growth of high single digits to low double digits for 2013.
While profitability measures often change, book value is relatively stable. Based on price to book value ratio, Wendy's shares again have the most attractive valuation with a ratio of less than 1, at 0.88. According to investment textbooks, companies with price to book value ratios of less than one offer exceptionally attractive investment opportunities. Wendy's price to book value ratio compares well to a price to book value ratios of 6.5, 13.7, 4.4, and 7.6 for McDonald's, Yum, Burger King, and Chipotle, respectively.
Wendy's has a cheaper valuation based on enterprise value to EBITDA and price to book value measures. These two ratios look at past margins and balance sheet metrics and sometimes could be poor estimators of the future. Based on price to earnings ratio divided by the future growth rate (PEG), Wendy's common stock is at par with that of Burger King, both having a PEG ratio of 1.1. This is far less expensive than estimated PEGs of 1.7, 1.3, and 1.6 for McDonald's, Yum, and Chipotle, respectively. With a significantly higher leverage level than that of Wendy's, Burger King's margin of safety is much smaller and thus the stock is riskier.
With its smaller size and quality products, Wendy's has been able to grow sales by 14.4% per year on average in the past five years compared to a growth of 5.3% and 5.7% for McDonald's and Yum. It is lagging only Chipotle's growth of 22.5%, which as mentioned above is the new kid on the block (data for Burger King is unavailable as it went public in 2011). On a more recent basis, Wendy's has been able to keep a favorable sales growth by registering a 3.8% growth in the second quarter of 2012, compared to a sales growth of 3.7% for McDonald's, 4.4% rise for Burger King, and an 8% jump for Yum. A major reason that Wendy's lagged behind Yum significantly is that Yum is in the midst of an international expansion and opened 342 new restaurants internationally in the second quarter of 2012. And Burger King's high comparable growth is attributable to a disappointing second quarter in 2011.
There are a number of initiatives, which should keep Wendy's sales growth momentum. First, Wendy's has committed to using fresh ingredients and is the only company among McDonald's, Yum, and Burger King to use fresh (never frozen) beef. Second, from a personal experience, I can say that Wendy's offers the best french fries compared to McDonald's and Burger King. In addition, Consumer Reports rated its new premium Dave's Hot 'N' Juicy burger as very good and a recent article in Time Magazine asserted that the same burger is better (and cheaper) than a similar offering at gourmet burger chain Five Guys. Overall, Wendy's menu is constantly evolving by offering healthier choices such as salads and more unique choices such as chili and baked potatoes as well as limited time products.
Other future initiatives include a goal to remodel 50% of Wendy's company-owned stores by 2015 as well as a number of franchise restaurants. This, according to company's management, increases sales by approximately 25% and also has a positive "halo" effect even on stores that are not renovated. This initiative offers a choice between three tiers of remodeling each costing from $700,000 per store for tier one to $300,000 for tier three.
Lastly, Wendy's is experimenting with offering a breakfast menu and a coffee offering under the Redhead Roasters brand. The coffee is available at 185 New York City restaurants and the economics of breakfast menu are still being evaluated without a specific company-wide launch date. Wendy's is already well established in the late night offerings, and a breakfast and coffee offering should enable it to utilize its restaurants even better.
As mentioned earlier, Wendy's has a relatively low level of leverage. From a financial standpoint, the company is managed conservatively. As a result, it should be able to implement the initiatives discussed above. Also, the company pays a quarterly dividend of $0.02 for an annualized yield of 1.8%. This dividend yield is lower than McDonald's 3.1% yield and at par with Yum's dividend payout rate (Burger King and Chipotle do not pay a dividend). In addition, Wendy's recently refinanced its debt, which is expected to save the company $25 million in interest expense per year.
Beef prices should be lower than expected for the remainder of 2012 for several reasons, which will benefit Wendy's. There is oversupply because of negative media regarding ground beef sold at grocers and farmers are butchering their cattle due to escalating corn prices as a result of the extreme drought in the mid-west. However, food inflation is expected to rise in 2013. Wendy's is counteracting the current and expected commodity price increases by implementing new marketing (it is number two in social media), offering a better customer experience (it is investing in retraining its staff), and by system optimization and better restaurant utilization. All this should provide an edge to Wendy's in 2013 and beyond.
Wendy's has 6,547 company-owned and franchised restaurants (as of July 1, 2012). This is dwarfed by McDonald's, Yum, and Burger King, which have approximately 33,500, 37,000, and 12,500 restaurants, respectively. However, the fast food industry is currently undergoing a big shift. It is becoming healthier and fresher, and customers are expecting a better experience and more choices. With its established focus on quality and freshness and smaller size, Wendy's appears well positioned to meet these new challenges. So far the company has done a good job, and this should show up in its relatively undervalued stock price in the future.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.