Wendy's: Great Fast Food, Bad Investment

About a month and a half ago, I wrote an article stating that I believe Jack In The Box (JACK) to be overvalued despite the recent positive hype around the company. Lately, I have been researching Wendy's (NASDAQ:WEN) because it has had the opposite problem of JACK -- low expectations -- and I wanted to see if this might turn out to be a potential contrarian value play or a value trap.

I will be referencing and comparing Wendy's to Jack In The Box and the other fast food companies I wrote about in my JACK article, so if you would like to see how Wendy's stacks up against other fast food companies, please reference that article, linked above.

Wendy's Overview

Wendy's is an owner, operator, and franchiser of 6,543 fast food restaurants. Of those, 1,447 of the restaurants are owned directly by Wendy's, with the remainder owned by franchisees. Wendy's offers hamburgers, chicken sandwiches, salads, wraps, fries, and the rest of the typical fast food restaurant offerings, but at a higher quality profile than most of its other fast food competitors. Higher quality also leads to higher prices for its individual product offerings and meals, which greatly affected the company during the recession as customers generally sought cheaper meals. To meet this demand and remain competitive with its peers' lower-cost offerings, Wendy's has introduced its own value and extra value menus with prices generally under $2 per item within the past few years.

Since the recession, Wendy's has streamlined operations by selling off its Arby's subsidiary, enacting cost cutting measures, updating its menu to offer new products (including breakfast at some locations), and has started reimaging some of its restaurants via its Image Activation Program. The program has been put into place to update its restaurants by making them look more modern, offering more amenities to entice customers to stay longer, and increasing the efficiency of the ordering and cooking process so customers can get their meals faster.

Unlike JACK, which has recently finished up its reimaging of its restaurants and should see at least small margin growth due to lower capital expenditures, Wendy's has only just begun this process, and only a few dozen restaurants have been updated thus far. Wendy's hopes that by 2015, about half of its company-owned restaurants will be reimaged, so this process is going to take awhile. As we saw with Jack In The Box, that will lead to generally higher cap ex for the foreseeable future, most likely lower or stagnant margins, possibly more debt, and potential loss of sales due to some of its restaurants being closed for construction periods currently as long as eight weeks.

Valuations

These valuations are done by me and are not a recommendation to buy stock in any of the following companies mentioned. Do your own homework.

All numbers are in millions of U.S. dollars, except per share information, unless otherwise noted. The following valuations were done using its 2011 10K, 3Q 2012 10Q, and its 3Q 2012 investor presentation slides.

Asset Reproduction Valuation

Assets:	Book Value:	Reproduction Value:
Current Assets
Cash And Cash Equivalents	454	454
Accounts Receivable (Net)	65	55
Inventories	12	8
Prepaid Expenses & Other Current Assets	32	16
Deferred Income Tax Benefit	95	48
Advertising Funds Restricted Assets	75	50
Total Current Assets	734	631
Properties	1241	745
Goodwill	877	439
Other Intangible Assets	1315	658
Investments	118	89
Deferred Costs & Other Assets	57	29
Total Assets	4340	2591

Click to enlarge

Number of shares are 390

Reproduction Value:

With goodwill and intangible assets:

• 2591/390=$6.64 per share.

Without goodwill and intangible assets:

• 1494/390=$3.83 per share.

EBIT and Net Cash Valuation

Cash and cash equivalents are 454

Short term investments are 0

Total current liabilities are 344

Number of shares are 390

Cash and cash equivalents + short-term investments - total current liabilities=454-344=110.

• 110/390=$0.28 in net cash per share.

WEN has a trailing twelve month EBIT of 120.

5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments:

• 5X120=600+454=1054/390=$2.70 per share.
• 8X120=960+454=1414/390=$3.63 per share.
• 11X120=1320+454=1774/390=$4.55 per share.
• 14X120=1680+454=2134/390=$5.47 per share.

TEV/EBIT and EV/EBIT Valuation

Total enterprise value is market cap+all debt equivalents (including the capitalized value of operating leases, unfunded pension liability, etc) -cash-long term investments-net deferred tax assets.

• TEV/EBIT=3310/120=27.58
• TEV/EBIT without accumulated deficit counted=2833/120=23.61
• Regular EV/EBIT=2946/120=24.55

The average EV/EBIT in the fast food industry that I found when analyzing JACK was 15.68, and the only company to have a higher EV/EBIT than Wendy's is Chipotle Mexican Grill (CMG), which had an EV/EBIT of 26.53.

I usually like to buy companies that have an EV/EBIT multiple under 8, so the fast food industry as a whole appears to be massively overvalued to me. Not only that, but Wendy's current EV/EBIT multiple is comparable to Chipotle's, which generally has very high margins -- exactly the opposite of Wendy's. As we will see later, Wendy's margins do not even come close to Chipotle's, and are generally much worse than even the rest of the fast food companies' margins, so its extraordinarily high EV/EBIT multiple is astounding. I will explain later why it is so high.

I also did my other normal valuations, but they did not work because after you take out the company's debt and or goodwill and intangibles from the other valuations, you get negative estimates of intrinsic value for Wendy's equity.

Margin Comparison

Please reference my JACK linked article above to see my thoughts on the other companies' margins, as I will only be commenting on Wendy's margins in this article. The below chart has been updated to include Wendy's margins for comparison to the other fast food companies. The industry averages are still only including the previous five companies I talked about: Jack In The Box, Sonic Corp (SONC), McDonald's (MCD), Yum Brands (YUM), and Chipotle Mexican Grill.

All numbers in the table were compiled using either Morningstar or Yahoo Finance:

	Jack in the Box (JACK)	Sonic Corp (SONC)	McDonald's (MCD)	Yum Brands (YUM)	Chipolte Mexican Grill (CMG)	Company Averages	Wendy's (WEN)
Gross Margin 5 Year Average	16.28%	34.30%	37.94%	26.20%	24.28%	27.80%	25.70%
Gross Margin 10 Year Average	17.08%	43.38%	40.42%	35.59%	11.73%	29.04%	39.86%
Op Margin 5 Year Average	7.46%	16.24%	27.42%	14.22%	12.76%	15.62%	-1.70%
Op Margin 10 Year Average	7.07%	18.05%	22.62%	13.50%	6.64%	13.57%	0.21%
ROE 5 Year Average	20.16%	66.33%	30.26%	131.56%	18.55%	53.37%	-6%
ROE 10 Year Average	18.77%	43.71%	23.19%	105.85%	10.27%	40.36%	-4.68%
ROIC 5 Year Average	11.17%	3.38%	17.38%	24.97%	18.49%	15.08%	-3.77%
ROIC 10 Year Average	10.91%	8.97%	13.37%	23.54%	10.22%	13.40%	-2.45%
FCF/Sales 5 Year Average	-0.26%	6.48%	15.90%	7.70%	6.92%	7.35%	1.07%
FCF/Sales 10 Year Average	0.80%	7.10%	12.86%	6.70%	2.26%	5.94%	-3.74%
Cash Conversion Cycle 5 Year Average	0.78	1.23	0.91	-36.35	-5.24	-7.92	-4.18
Cash Conversion Cycle 10 Year Average	0.27	1.14	-1.22	-49.02	-5.21	-10.81	-4.53
P/B Current	2.9	12.4	6.7	14.3	8.2	8.9	0.9
Insider Ownership Current	0.38%	6.12%	0.07%	0.50%	1.64%	1.74%	6.83%
EV/EBIT Current	14.25	9.65	12.16	15.81	26.53	15.68	24.55
Debt Comparisons:
Total Debt as a % of Balance Sheet 5 year Average	30.78%	80.91%	35.28%	45.24%	0	38.44%	34.03%
Total debt as a % of Balance Sheet 10 year Average	26.84%	50.77%	35.22%	40.72%	0.14%	30.74%	38.58%
Current Assets to Current Liabilities	1.02	1.38	1.24	0.97	4.13	1.75	2.13
Total Debt to Equity	1.03	9.69	0.97	1.6	0	2.66	0.81
Total Debt to Total Assets	30.50%	71.20%	41%	37.21%	0	35.98%	36.87%
Total Contractual Obligations and Commitments, Including Debt	$2.6 Billion	$1 Billion	$27.20 Billion	$11.42 Billion	$2.20 Billion	$8.88 Billion	$1.9 Billion
Total Obligations and Debt/EBIT	21.67	8.85	3.15	5.4	5.82	8.98	13.33

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As you can see from the margin comparison above, Wendy's margins are almost all quite a bit worse or, at best, about even with industry averages compared to its fast food competitors. Even if we were to exclude Wendy's absolutely horrible 2008 from its numbers, its margins are still quite a bit lower than its competitors'.

Especially of note are its ROIC, ROE, FCF/Sales, EV/EBIT, and Total obligations and debt/EBIT ratios, which are all a lot worse than its competitors' ratios. Wendy's EV/EBIT is especially inflated due to its high amount of debt in comparison to its profitability, which is why it has a comparable EV/EBIT to the much higher-margin Chipotle. My calculations of ROIC are a bit different than Morningstar's numbers and help Wendy's out a bit, but even at 5.4% without goodwill and 3.85% with goodwill, those numbers are still generally quite inferior to its competitors.

About the only thing that Wendy's has in its favor compared to its competitors is its P/B ratio of 0.9, which is quite a bit lower than its competitors' and could mean undervaluation. In this case, that P/B ratio is a bit of a farce because goodwill and other intangible assets make up the vast majority of current book value, as just those two combine for an estimated $2.2 billion in value. After subtracting goodwill and intangible assets, tangible book value is actually negative. The $2.2 billion is actually more than the current market cap, so I think that it is fair to say that those values are probably massively overstated and may soon have to be restated or written down to a more reasonable level, thus eliminating some further perceived value and bringing the P/B value closer to its competitors'.

I also think that Wendy's debt levels and costs are too high in comparison to its profitability, as 83% of operating profit (EBIT) goes to interest expenses. Costs and other expenses, not including interest expense and loss on extinguishment of debt, take up 95% of total sales. Other expenses include general and administrative, depreciation and amortization, etc. If you include interest expenses and loss on extinguishment of debt, that takes total costs and expenses over 100% of sales, which is why Wendy's recent earnings have been negative.

Pros

• Pays a dividend and recently increased it 100%.
• After a lot of the stores are reimaged, margins should improve due to lower cap ex and higher same store sales. Of the stores that have been reimaged so far, Wendy's says it has seen 25% increases in sales.
• Has positive net cash.
• Has a good amount of cash on hand.
• Same store sales have risen for six straight quarters and a total of 2.3% in the past nine months.
• Wendy's has recently paid off some of its 10% coupon debt by taking out lower interest debt, which should lead to lower interest expenses going forward.
• Wendy's recently overtook Burger King as the second biggest fast food burger chain.
• Owns a lot of its restaurants and the property underneath the buildings, so Wendy's does hold some valuable assets in case it runs into problems.
• Just fewer than 80% of its restaurants are owned by franchisees that pay a 4% royalty to Wendy's. Collecting franchise royalty fees is a very high margin business.
• The company produces positive FCF, excluding cap ex.

Cons

• Wendy's is overvalued by every one of my valuations -- sometimes in extreme cases -- except when including the massive amount of goodwill and intangible assets.
• Wendy's margins overall are generally much worse than its fast food competitors.
• Book value is only positive because of goodwill and other intangible assets.
• The company has had recent negative earnings.
• 83% of operating profit went to interest expenses.
• The company's equity has negative value after subtracting goodwill and intangible assets on various valuations.
• The company has been buying back a lot of stock at what I think are overvalued prices.
• The company's debt levels and costs are too high, in my opinion, compared to its profitability levels.
• Wendy's will have higher cap ex for the foreseeable future due to the reimagining of its stores.
• The reimaging of Wendy's stores could be going on for at least a decade, if not more, as it hopes to have around 750 stores reimaged by 2015. That leaves around 5,750 stores to be reimaged after that, not including new stores that are opened by Wendy's itself or its franchisees.
• Cap ex this year has been around $225 million and will likely stay close to that elevated level for many years due to the reimagining of its stores, which should either lead to lowering or stagnating margins for the foreseeable future.
• The company has negative FCF when including cap ex.
• This year, Wendy's spent $126 million in cash on cap ex, with the remaining $99 million coming from other sources. To me, that means Wendy's will have to either increase its margins and FCF to pay the remaining cap ex costs, or more likely, it will continue to have to issue debt to fund the reimaging of its stores.
• While sales have been rising within Wendy's, costs have also been rising at about the same rate, which is why margins have not been increasing much as sales have improved.
• The company has quite a few related-party transactions that make me a bit uneasy, including with Mr. Peltz (former Wendy's executive and current chairman) and Trian Partners, the investment fund Mr. Peltz has formed with a couple of other Wendy's board members.
• Just one example of the questionable transactions is that Wendy's paid just under $640,000 in security costs for Mr. Peltz, who is a billionaire and could easily pay these costs himself.
• Trian Partners currently owns just under 25% of Wendy's and has three members on Wendy's board of directors, so Trian could exert a lot of pressure on Wendy's if it saw fit to do so.
• Due to some of the transactions that make me a bit uneasy; I do not trust management to do what is right for shareholders and increase shareholder value.

Potential Catalysts

• The reimaging of its stores will most likely eventually lead to margin and sales growth.
• If Wendy's can get its costs under control, which it is trying to do now, it could achieve some margin growth.
• In my opinion, Wendy's has overstated its goodwill and other intangible assets and may have to restate or write down some of the value of those. Wendy's warns it may have to do this in its most recent annual report, which would lead to less perceived value in the company, and would probably drop the stock price further.

Conclusion

Wendy's has recently overtaken Burger King as the number two fast food hamburger chain in the United States. In this case, growth appears to be bad for shareholders, as its costs have been rising about in line with sales, which are why margins have not seen much growth. Wendy's margins are also generally quite a bit worse than its other fast food competitors', in my opinion, its debt levels and costs are too high, and I do not trust management to do what is right for shareholders.

Wendy's appears to be destroying shareholder value with its high costs and debt levels, buying back its stock at overvalued prices, and continuing to grow its restaurant count and sales, but not improving its margins. Because Wendy's margins have not improved as sales have been rising, it looks like the company is growing at less than its cost of capital, which in my opinion, has led to value destruction for shareholders. The destruction of shareholder value will not reverse unless Wendy's can cut its costs and debt levels, and/or improve profitability, which probably will not happen for awhile due to some of the reasons stated above. Unless something drastic happens, in my opinion shareholders of Wendy's stock can only look forward to further value destruction of their shares in the future.

Having stated all of the above, I would estimate Wendy's intrinsic value to be my 5X EBIT and cash valuation of $2.70 per share. As a result, I do not think that Wendy's is even worth its reproduction value, and I would not even be a buyer of the company at my $2.70 per share estimate of value.

Even if Wendy's margins and sales do rise following the reimaging of its stores, which should happen, that will not take place for many years, as Wendy's has only recently started the lengthy reimaging process.

I hope I am wrong about Wendy's because food-wise, it is by far my favorite fast food restaurant. I hope it can fix its problems, and that it begins to thrive as a company. However, as an investment, I think Wendy's is the proverbial value trap, and I plan to keep my investment funds far away from the company.

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. I have no business relationship with any company whose stock is mentioned in this article.