Wendy's (WEN) remains an orphan in today's schizophrenic market. Despite recent improvements with core operations, the addition of a new world-class QSR management, continued leadership from activist Nelson Peltz and the jaw dropping discount to NAV, few investors have bothered to sharpen the pencil. The silence is deafening. Wendy's remains loved by few, and forgotten by most.
In the following three-part analysis, I will demonstrate beyond a reasonable doubt why present institutional apathy is unsustainable. Given the discount to NAV, and the growing list of catalysts, this stock is a goldmine for the patient few.
The first section will include a brief snapshot of WEN, including a recap of recent history and a high level overview of the secular trends in the QSR industry. In the second section (Part II) due later this week, I will analyze the catalysts for unlocking shareholder value. Part III will pull it all together through a nuanced valuation approach that escapes casual cross-comparisons (and most screening tools). Finally, I will conclude with a discussion of "the knocks," risks and challenges facing management and the business in general. In so doing, I hope to illuminate facts from a fresh perspective and provide an alternate framework for evaluating the long-term potential for Wendy's shareholders.
Why Look at Wendy's?
Wendy's is an entrenched toll road business with scale and brand resonance, whose growth is financed with other people's money and is operated by highly incentivized agents. With a current EV of $1.7 billion, patient investors have a triple-digit asymmetric payoff opportunity and a 50% margin of error on NAV. Fortitude and a minimum three-year time horizon are required.
- High quality assets selling at a conservative 50% discount to current NAV
- Underappreciated long-term potential from new management initiatives
- Market apathy nearing an inflection point
PART I: Company Overview
The Wendy's Company is a leading global quick service restaurant business with over 6,594 locations worldwide. Menu offerings include hamburgers, chicken breast sandwiches, salads, chili, fries and frosty frozen desserts. As of January 1, 2012, Wendy's owned and operated 1,417 restaurants and franchised an additional 5,177 locations through long-term agreements.
- Market capitalization of $1.7bn (406m fully diluted shares). EV of $2.7bn.
- 2011 annual sales of $2.4bn. Company owned stores accounted for $2.1bn + $305m '11 franchise revenue.
- Net debt roughly $900m. $1.3bn LT debt maturing 2019 ($400m cash). No significant off-balance sheet obligations.
- Decent operating cash flow of $178m '11 and $316m EBITDA.
- Flat sales growth and GAAP operating margins of 7%.
From inception in 1969, Wendy's established a unique MO for quality food and fresh ingredients. Co-founder Dave Thomas emphasized made-to-order food at a time when the industry relied on heat lamps and pre-made burgers. After Dave Thomas passed in 2002, Wendy's entered a prolonged malaise caused by poorly executed marketing initiatives and ill-conceived acquisitions. Though the core Wendy's brand remained resilient, much of the energy and excitement that propelled the franchise to iconic status began to tarnish. If ever a company was in need of a leadership catalyst, 2007 Wendy's fit the bill.
This catalyst arrived in 2008 when private equity giants Nelson Peltz, Peter May and Edward Garden acquired 20% control through a well-timed merger of their floundering Arby's brand. Peltz quickly initiated a brand revitalization and operational improvement program. However, turnaround efforts were complicated by the financial collapse and a prolonged recession.
Though Wendy's store traffic held up to peers, Arby's horrific sales comps dragged down the conglomerate and distracted management for the core. By late 2011, Peltz took decisive action by selling 81% of Arby's to Roark Capital. A new top-notch CEO was hired from YUM! Brands (YUM) (Taco Bell, KFC, Pizza Hut) and new marketing and HR managers were added to the roster. By mid 2012, Wendy's management and BOD were, for the first time in years, fully aligned and committed on re-igniting the brand through a long overdue investment. By this time, Peltz and Trian accumulated nearly 30% of the stock.
While Wendy's struggled with self-inflicted distractions, the QSR landscape evolved. The prolonged economic malaise brought on by a recession and changing consumer tastes accelerated two major industry trends in U.S. out of home dinning.
- Increased awareness of health/nutrition and food quality. More consumers indicate preferences for healthier options…everyone wants to be a foodie (think TV shows, gourmet food trucks, and foodie pop culture). Consumers have grown more adventurous, demanding quality ingredients and freshly prepared foods. The new breed of fast casual restaurants is recasting incumbent QSR brands by raising the bar on quality/value perception. Panera Bread (PNRA) and Chipotle (CMG), for example, are winning the aspiring, quality conscious consumers with handmade products in an upscale setting. Many customers are happy to pay a 40%+ price premium for this perceived quality.
- Emergence of the new low-end. With the economic downdraft, many consumers are cautious, often trading down in price. To some degree of success, incumbent QSR chains such as McDonald's (MCD) stepped up the low-price offerings in order to retain store traffic. In addition, c-stores and grocery stores have entered the market with competitively priced "to-go" food offerings, often linking meal deals to gasoline purchases and other unique promotions.
Given these secular shifts, many QSR brands remain challenged by market bifurcation. Incumbents lacking the capacity to profitably compete on the low-end or insufficiently capitalized to move "upscale" in value perception will remain under pressure.
Though the above-mentioned secular trends are reconfiguring "competitiveness" in the QSR space, Wendy's retains some key attributes of competitive differentiation. Please note I have defined competition broadly to the entire dinning out of home category.
- Quality. While most QSR mega-chains rely on pre-made, microwaved food assembly, Wendy's has the equipment and process infrastructure to make food fresh to order with real ingredients. This subtle but important kitchen infrastructure attribute plays to Wendy's advantage with market bifurcation mentioned above.
- Brand. The Wendy's brand continues to resonate with consumers on key metrics that matter most. Despite nearly 10 years of sub-par marketing and chronic-under investment, it continues to outrank competitors such as McDonald's.
- Scale. With over 6,500 locations worldwide, it has scale in operations, purchasing and marketing. In such a dynamic industry, incremental benefits of amortizing costs over a large network are amplified overtime - especially during times of commodity inflation and intensifying macro challenges. Larger QSR chains can often rework the supply-chain to their benefit while smaller regional restaurants are stuck with the Sysco (SYY) product catalog.
- Franchisee network. Franchisees are a capitalist's dream. They provide virtually 100% of the capital investment, operation oversight, staffing etc., with contractual 20-year inflation adjusted royalty kickbacks to the franchisor. Franchisees are highly motivated to succeed, and switching costs are enormous given the multi-million, multi-generational sunk cost in building new stores. With 5,177 franchised units, Wendy's owns a considerable asset which provides structural and strategic benefits few restaurant businesses will achieve. This allows for greater financial flexibility and reinvestment opportunities.
Despite years of underinvestment, the core Wendy's brand remains robust as seen in the Zagat data. One can't help but notice the parallels to Roberto Goizueta's New Coke fiasco, albeit on a smaller scale. The New Coke fell at once with one colossal product flop whereas Wendy's gradually tarnished in recent years from self-inflicted cuts. Anytime there is decoupling of this magnitude; where the brand remains active in the hearts and minds of consumers despite company missteps, one can't help but recognize the presence of an irreplaceable intangible asset. Paradoxically, temporary brand mismanagement can sometimes reveal hidden strengths of intangible assets. The continued top Zagat rankings are proof that Wendy's still has the magic.
In the next section (Part II), I will expound on the catalysts and explain the steps being taken to reignite the Wendy's brand.
Disclosure: I am long WEN.