Despite unprecedented operational and strategic upgrades to Wendy's (WEN) ecosystem, investor sentiment could not be worse. Valuations have moved from amusing into the realm of absurd. Given today's EV of $2.6 billion, patient investors have the opportunity to own a high-quality franchise royalty annuity backstopped by considerable real estate assets while getting 1,400 company-owned stores for free. Management initiatives, new executive leadership, Image Activation, and international expansion efforts are thrown in for good measure.
In Part III of this series, I will examine the valuation anomaly with Wendy's and develop a foundation for further analysis of recent growth initiatives.
A brief cross-comparison provides a useful starting point. When Wendy's is mentioned, the most frequent valuation objections relate to P/E and PEG ratios as seen below.
Although Wendy's appears unexciting from a P/E and PEG perspective, we can see this reflected in P/S and P/B ratios. These ratios likely reflect the widely held belief that Wendy's can't or won't manage to grow the bottom line. Clearly, the market is not expecting much if anything over the next five years.
However, the table below adds another dimension to this analysis:
Top Global QSR Brands
Wendy's is significantly under-indexed to international growth markets. Furthermore, the company-owned store asset mix is noticeably high at 79%. From both tables shown above, one might conclude that mega-QSR chains with higher franchised assets and international exposure tend to command a valuation premium (P/S, EV/EBTIDA).
So Why Should Investors Care?
Although a quick cross-comparative view may be a sufficient proxy of "value" during times of market equilibrium, these metrics are far less meaningful during times of punctuated equilibrium (i.e., rapid or unexpected transformation in business fundamentals). As discussed in Part II, Wendy's is clearly in the midst of a multi-year punctuated equilibrium phase. An alternative valuation approach therefore seems appropriate.
Building the SOTP Model
To quote from Belen Villalonga in the Harvard case study "Note on Some-Of-The Parts Valuation":
This [SOTP] method of valuating a company by parts and then adding them up … is commonly used in practice by stock market analysts and companies themselves. However, it is rarely taught in MBA programs or broached in valuation textbooks.
Though used often by business owners and Private Equity, this tool is underutilized -- especially in the case of Wendy's, as we shall see.
Inventory of Assets
As mentioned in Part II, Wendy's owns a treasure trove of assets and resource conversion opportunities. The following is a list of the major value drivers going forward. Through critical examination of these components, we can identify the latent value hidden below the surface of simple P/E and EV/EBITDA ratios.
Click to enlarge images.
Step 1: Valuing the Franchise Toll Road
Wendy's enjoys an all-expenses paid royalty stream on 454 long-term franchise agreements. Once the franchisee buys into the system (paid upfront franchise fees, acquired land, signed 20-year franchise contracts, negotiated leases), they are essentially locked into the Wendy's "toll road" for years -- decades and, in some cases, generations. Day or night, rain or shine, the franchisee pays a monthly royalty over the lifetime of their business. Given the high franchisee switching costs and the recurring revenue, Wendy's franchise asset is more akin to a royalty trust or real estate annuity than a traditional restaurant operator.
The 5,177 franchised WEN restaurants each yield an average of $58,240 per year on a per unit basis (assuming a $1.46 million AUV found in North America company-owned stores). This amounts to a normalized full-year run-rate of $301 million on franchise royalty revenue. Please note this does not include real estate income, franchising fees, and other franchise revenues as seen in the 10-K.
Estimating the EBITDA margin on Wendy's franchise royalty business presents a challenge. Few comparable QSRs provide this level of detail in public documents, presentations or conference calls. However, on Feb. 28, 2012, the CFO for Jack In The Box (JACK) provided some color. JACK references adjusted EBITDA margins of roughly 90% on franchise royalty payments.
Additionally, the 2011 McDonald's (MCD) 10-K reveals the franchised revenue margin in the neighborhood of 82%. Pure-play franchise businesses such as Dunkin' Brands (DNKN) are less relevant due to other businesses (sub-leasing and ice cream sales) as broken out in the recent 10-K. However, Burger King (BKW) reports an 85% margin on "franchise and property revenues" in its recent 10-Q.
Though difficult to pinpoint, we have to start somewhere for Wendy's. I have applied a highly conservative assumption of 65% margin on Wendy's royalty income (the actual number is likely closer to BKW). Taking the normalized royalty run-rate of roughly $300 million less $105 million for expenses, we might expect recurring cash flow of $195 million.
Taking the $195 million in recurring cash flow as our baseline, and assuming a conservative 10-year time-horizon with a 12% discount rate, we can estimate the PV for Wendy's franchise business. Royalties are paid monthly and PV calculations should be adjusted accordingly (not to be confused with annual cash flow). This results in a PV of $1.86 billion. Please note that this estimate does not include a terminal value and or cash flows from continued operations after 10 years. Considerable residual value is omitted as we aim for conservative estimates.
NPV Estimate: $1.86 Billion
Comparative EV/EBITDA Analysis
For recent QSR comparable transactions, we can look the Duff & Phelps report titled "Restaurant Industry Insights" from Q1 2012. This provides additional color on the Wendy's franchise annuity valuation.
The Krystal Company
Arby's Restaurant Group
(Surprisingly, the EBITDA multiple on Arby's is higher than the current multiple for Wendy's today. I'll discuss this later in the follow up article due to space constraints.)
Since we are attempting to value Wendy's stand-alone franchise annuity, we may look at publicly traded peers with higher franchise to company-operated mixes as seen in the 10-K reports or recent IR presentations.
% Franchised Units
Given comparable private market deals to the EBITDA multiples of publicly traded QSR brands, Wendy's stand-alone franchise annuity could trade in the 10 times to 12 times range under reasonable growth estimates. Under financial duress and weak SSS, a more conservative 8 times to 9 times multiple seems appropriate.
Net-net, Wendy's crowned jewel should be worth anywhere from $1.5 billion to $2.3 billion with conservative assumptions. I have applied an estimate of $1.8 billion (DCF valuation result, or 9.5 times EBITDA) to maintain conservative approximations.
Franchise Annuity: + $1,800,000,000
Step 2: Valuing the Real Estate Assets
Wendy's real estate assets are significant. As found in the 2011 10-K, they own the following:
- 643 commercial lots with buildings
- 486 Wendy's restaurant buildings
- 56 commercial lots with buildings leased to franchisees
- 205,000 square foot bakery in Zainsville
- 250,000 square foot corporate office complex in Dublin
A conservative orderly liquidation value is derived from a combination of comparative asset sales and the guidance in regulatory UFDD filings. The estimated average land, buildings and construction cost is $1.27 million per restaurant (given the average price of $900,000 to $1.6 million from the 2011 UFDD). For the building only assets, a conservative value of $125,000 per unit is assessed for construction costs. For the company-owned bakery and corporate office building in Ohio, comparable list prices and recent transactions are applied from LoopNet data.
The 2011 accumulated depreciation on land, buildings and equipment is $294 million. This figure is subtracted for the real estate assets listed below.
Real Estate: + $700,000,000
Step 3: Valuing Company-Owned Restaurants
The company currently owns and operates 1,417 stores with an AUV of $1.46 million. Restaurant margins were 14% for calendar 2011. Note that restaurant margin is derived from stores sales less COGS, occupancy expense, labor, advertising and other corporate operating costs. This restaurant margin is used as a proxy for normalized company-owned store operating cash flow.
Conservative comparable values are used from recent distressed private market sales (seriously underperforming stores with weak restaurant margin and subpar sales). The recent P/S is roughly 0.6 and an OCF (operating cash flow) multiples average 4.5 times. Relevant comps for WEN and other QSR brands may be found on bizbuysell.com. Applying these distressed comps to the Wendy's 1,417 unit asset results in a valuation of $900 million to $1.3 billion. A mid-range estimate of $1.1 billion seems reasonable.
Company-Owned Stores: + $1,100,000,000
Step 4: Valuing Other Forgotten Assets
Wendy's continues to own 18.5% of Arby's. This investment is worth around $65 million given the Roark valuation of $350 million EV. Additionally, they own 50% equity in a Canadian JV (TimWen) with C$75 million in property and C$84 million in equity. The total 2011 TimWen income of C$27 with a conservative 5 times multiple results in a C$135 million valuation ($136 million USD/2). No value was assessed for a new 49% equity in a Japan JV.
Other Assets: + $130,000,000
Step 5: Don't Forget the Cash
Q2 2012 total current assets of $730 million less $348 million current liabilities results in net current assets of $382 million.
Net Current Assets: + $380,000,000
Step 6: Long-Term Liabilities
As of Q1 2012, Wendy's long-term debt was $1.34 billion. Balance sheet flexibility has improved measurably in the past year. On April 3, 2012, the company secured a new $1.3 billion senior secured credit facility comprised of a $1.12 billion term loan maturing 2019 and a $200 million revolver maturing 2017. Moody's upgraded the company's rating to B2 positive (from neutral) due to the refinancing.
This refinancing deal saves $25 million per year in interest payments, improves covenant flexibility, and reduces balance sheet risk. Though $1.3 billion in long-term debt is a significant encumbrance, the balance sheet is adequate given the trailing 12-month debt/EBITDA of 4.4 and backstopped by considerable asset conversion opportunities. Annual interest payments of $80-$90 are significant. However, this seems manageable given the financial engineering opportunities inherent in a vertically integrated QSR franchisor.
Debt: - $1,400,000,000
Adding It All Up
Summing up the assets, Wendy's total NAV is $2.71 billion vs. $1.6 billion market cap today. Keep in mind, these estimates are highly conservative and do not include any of the strategic or leadership initiatives discussed in Part II.
With approximately 390 million shares outstanding, we have a conservative NAV per share of roughly $6.95. Assuming the Oct. 24, 2012, close price of $4.14, the current discount to NAV is 68%. This estimate is for Wendy's as is and does not include any benefits from recent management initiatives, and zero assumption for margin improvement. This will be discussed in a follow-up article.
Weighing the Strengths and Weaknesses of this Analysis
Although the SOTP framework offers a glimpse into a portfolio of assets that might otherwise escape casual analysis, this method has limited short-term predictive value. In the absence of a clear catalyst, real estate or other operating assets can remain undervalued far longer than the frenetic pace of modern portfolio management will tolerate.
However, when the crowd has given up and investors have mentally checked out, catalysts often emerge quietly and with little fanfare from the investment community. As discussed in Part II, Wendy's certainly fits the bill. We have the following recipe for mean-reversion:
- Quality assets that are mispriced
- Significant market apathy (15 sell-side holds, three buys, and two sells)
- Emergence of catalysts as discussed in Part II
We will never know the precise timing or trigger point for mean-reversion. However, with a conservative and well-reasoned valuation model such as the SOTP framework outlined above, we can evaluate the margin of safety to further growth assumptions.