Hungry for Returns? Try Wendy's/Arby's Group

by: Brian Zen, CFA
Wendy’s/Arby’s Group (NYSE:WEN) is one of the largest quick service restaurant (QSR) chains in North America, 2/3 Wendy’s and 1/3 Arby’s. WEN is in a fundamentally good business with a premium brand. The company’s financial performance and margin suffered after the founder’s death in 2002 and years of bickering with its current largest shareholder Nelson Beltz. After some initial digging, we believe there hidden value in international expansion, breakfast offering and cost savings. The turnaround could work out well in the next two to three years. Wendy’s was recently rated number one in hamburgers and number one in service speed.

The investment offers the opportunity to participate in a turnaround of an established brand at Wendy's that suffered through years of mismanagement and a disruptive sales process prior to the merger. Assuming management can successfully achieve its three-year improvement plan while merely maintaining the general performance of the businesses, one can reasonably pencil out a $7+ share price over the next two years, which would provide over 40% upside. There are additional avenues for upside that could deliver further long-term value.


Nelson Peltz may be the man we could bet with.
After limited research on Nelson Peltz, we are starting to develop an admiration for him. Nelson Peltz’s Triarc Companies Inc. (TRY) acquired Dublin-based Wendy’s in 2008 for $2.34 billion and combined it with the chain of Arby’s roast beef sandwich shops to form Wendy’s/Arby’s Group Inc. Peltz is the largest shareholder of Wendy’s.

Peltz, a native of Brooklyn, New York, was enrolled at the undergraduate program at the Wharton School of the University of Pennsylvania, but never completed his degree. He dropped out to work for his family's business selling food to restaurants in New York. He has a life time of experience in the food and beverage business. Some analysts are thrilled to have Peltz there watching management to make sure they do the positive things.

Forbes magazine ranks Peltz 366 on its list of 400 richest Americans, with an estimated net worth of about $1 billion. He is on the board of directors at Wendy's/Arby's Group fast-food chain and at ketchup giant H.J. Heinz (HNZ). Peltz's most famous deal involves Snapple, the beverage company he purchased for $300 million in 1997 and sold three years later to Cadbury Schweppes (NYSE:CSG) for $1.5 billion.

Peltz has the right strategy for WEN.
Nelson Peltz spoke at Harvard Business School and CNBC about his business thinking. (See here.) He has a solid track record. If he can deliver, WEN could be a hit.

Selling Hamburgers and Roast Beef Sandwiches in North America
Wendy's/Arby's Group mainly operates in the United States and Canada. Wendy’s is the restaurant franchising system specializing in the hamburger sandwich segment of the quick service restaurant industry; and Arby’s is the restaurant franchising system specializing in the roast beef sandwich segment of the quick service restaurant industry. As of March 29, 2009, the Wendy’s restaurant system comprised 6,623 restaurants, of which 1,399 were owned and operated by the company; and the Arby’s restaurant system consisted of 3,741 restaurants, of which 1,171 were owned and operated by the company. The company is headquartered in Atlanta, Georgia. Tim Hortons (THI), the coffee and doughnut chain once operated by Wendy’s, was spun off in 2006.

Target price could be $8 at one times sales.
Of the three major fast-food chains, Wendy’s is the cheapest in terms price over sales. Wendy’s P/S is 0.61 compared to McDonald's (NYSE:MCD) P/S of 3.04 and Berger King’s P/S of 1.03. We think WEN could be trading at Berger King’s multiple and potentially closing in on McDonald’s if Nelson Peltz can work the miracle he delivered with Snapple.

International expansion could be huge upside.
Franchisee agreements (in addition to the recently announced (35 units in Singapore and 135 in the Middle East) show management’s ambition for global growth. Wendy’s/Arby’s has only 8% of total units outside the U.S., while competitors have 30% to 50% of their store base overseas.

Sales growth could come from new breakfast offerings.
There’s room for sales growth in Wendy’s/Arby’s breakfast offerings. They are pulling back unsuccessful breakfast launches and trying to start anew. Other potential uses for the newly issued debt include a broadened breakfast program and international expansion. Management will likely attempt to introduce breakfast items at the Wendy’s brand. Breakfast accounted for a minuscule 2% of total sales at the chain. This number hovers around 20%-25% at many peers.

Cost savings promised by the turnaround team may work out.
The turnaround at Wendy’s could work out quite well. Ever since the death of its founder Dave Thomas on January 8, 2002, Wendy’s has struggled. Then its financial performance suffered more during the years of bickering with billionaire investor Nelson Peltz, who eventually bought the franchise. However, the fast-food business is fundamentally good because people have to eat.

We are hearing some good things about Roland Smith.
CEO Roland Smith was a well regarded turnaround executive. They have identified cost savings from $60 million of excess G&A in the combined company, as well as $100 million of margin improvement opportunities at Wendy's company-operated restaurants that should provide upside to earnings. Some analysts do see a margin gap of approximately 600 bps compared to the franchised stores and overhead-savings opportunities at Wendy's/Arby's corporate. If the promised $160 million cost savings can 100% flow through to net income, assuming revenue remains the flat, at 13 times $160 million of additional earnings, the cost savings could translate into an additional $2 billion of market capitalization. That’s would indicate a $10 stock. We think serious cost savings and volume discounts could be attained at the combined purchasing for Wendy’s and Arby’s.

WEN’s numbers are pointing towards the right direction.
After the Peltz’s purchase, the numbers are moving in the right direction at WEN. In spite of the challenging circumstances surrounding the quick service restaurant sector, same-store sales at Wendy’s are not declining much. The key metric, which compares favorably with that of its peers, got a boost from price increases initiated during the second half of 2008. Meanwhile, margins were boosted by lower labor costs. Management is now well on its way toward achieving its three-year target (through 2011) of $100 million in restaurant-level incremental EBITDA and $60 million in synergies and SG&A cost reductions. WEN has updated their menu and advertising to focus on younger consumers – recent success at WEN shows that it’s a successful launch.

WEN has a positive mind share.
Wendy’s is still a premium fast-food brand. The franchise business model often generates lots of free cash flow. A number of customers we informally “surveyed” love Wendy’s. When Wendy’s closed its doors in Japan after almost 30 years, they attracted long lines that spilled onto the sidewalk at some of the hamburger chain’s 71 restaurants. The Wendy’s/Arby’s Group was unable to renew a franchise agreement with the Zensho Company of Tokyo (ZSHOF.PK) this month.

$4.15 could be the downside floor price inserted by Peltz.
Controlling shareholder seems willing to get more shares for $4.15 per share. On November 5, 2008, Trian Partners and certain of its affiliates (collectively, “Trian”) commenced a cash tender offer for Wendy’s/Arby’s Class A Common Stock. On December 11, 2008, Trian announced that as a result of the tender offer it had purchased 49,395,394 shares of Wendy’s/Arby’s Class A Common Stock at a purchase price of $4.15 per share, for a total purchase price of $204,990,885.


Ackman of Pershing Square sold all his WEN shares.
Why did Bill Ackman of Pershing sell out his stake in WEN? Did he sell out at a loss? We need to find out his arguments against Wendy’s turnaround. There is a rumor that Ackman is valuing Wendy’s at around $6 per share. That’s perhaps why he sold out around $5.7 or so when he needed cash to invest in something else.

Arby’s same store sales declined by almost 7%.
Arby’s is doing poorly competing against Quiznos and Subway. The declining same store sales (SSS) could be due to poor differentiation and innovation. There is very little detail publicly available information on standalone Arby’s as previous performance are consolidated with Triarc's (TRY) other businesses. Arby’s relatively higher-priced items are suffering a nearly 7% sales decline during the recession. Persistently weak results have led the company to shutter a number of properties. This shows the discipline of the current management team. Arby's struggled with comp store sales decreasing 4.3% in 2008 and down 8.7% in Q1 of 2009. In addition to marketing missteps made during 2008, Arby's has a high average ticket while the recent trends in QSR have tended to more value-based offerings. Consequently, other sandwich-based chains, notably Subway, have significantly outperformed Arby's over the last year. Stabilization at Arby’s is important for the stock.

Burger King seems to be gaining strength against Wendy’s.
Some people prefer the taste of Berger King whose innovative marketing could be stealing market share from Wendy’s.

10.5% interest rate on $565 million new senior debt is a puzzle.
To finance the company’s growth in the breakfast segment and in international markets, WEN issued $565 million senior debt On June 23, 2009 at 10.50%. They put aside $50 million for potential share repurchases which is a plus. We are a little concerned about this 10.5% interest rate which is above the company current return on asset. Considering the Company's consolidated total long-term interest-bearing debt is about 2.6x trailing EBITDA, this 10.5% pricing was a puzzle. However, the Company demanded the flexibility to employ the cash opportunistically and latitude on covenants.

Will Peltz treat passive shareholders fairly in complex related party transactions?
There are many Related party transactions and millions of consulting fees rfor the controlling shareholder. The pay package for the current CEO Roland Smith is about $1.5 million. Very reasonable. But Forbes listed that the total compensation for Nelson Peltz, Wendy’s controlling shareholder, is around $70 million. Yet Wendy’s listed no compensation for Mr. Peltz. This could be a concern.
Where was the $70 million coming from? $50 million could be from Triarc or Trian selling out Deerfiled Capital (DFR). But after all the complex restructuring, it’s hard to evaluate Peltz’s performance at DFR.

Although Wendy's/Arby's is generally unwinding some of the major entanglements that Triarc had with Nelson Pelz/Trian prior to the merger, the Company did enter into a new services agreement with Trian. The services fee will fall from $1.75 million per quarter to $250,000 per quarter, but the Company may not totally dissolved this inter-relationship with its largest shareholder. There could be a conflict of interests.
Legacy Triarc-related overhead costs, which were approximately $36 million in 2008, are projected to fall away over time based on management's statements on bringing these costs down to an annualized $8.5 million. The Company entered into a two-year transition services agreement (the “Services Agreement”) with Trian Partners beginning June 30, 2007 pursuant to which Trian Partners provides the Company with a range of professional and strategic services.

Under the Services Agreement, the Company paid Trian Partners $3,000,000 per quarter for the first year of services and is paying $1,750,000 per quarter for the second year of services. The Company incurred a total of $9,500,000 of such service fees for 2008. In addition, effective as of December 28, 2007, the Company and Trian Partners entered into an amendment to the Services Agreement providing for the payment to Trian Partners in 2008 of additional fees of $2,750,000, for services rendered during 2007.

Recession could delay WEN’s turnaround and stock price advances.
Consumer spending patterns and QSR traffic are troubling, forcing WEN to reinvigorate the Wendy's value menu. Food commodity costs could go up. WEN is changing their reports on restaurant level margins removing detailed breakdowns of cost of goods sold (COGS), Advertising and General/Advertising Expenses. They stopped giving segment breakdowns and estimates. Just like Warren Buffett and Eddie Lampert, Peltz may not want to waste time with Wall Street analysts.

Key Statistics:
Price per share: $4.62
Shares outstanding: 463
Market Cap: 2.14B
Enterprise Value : 3.05B
Price/Sales: 0.61
Price/Book: 0.91
Enterprise Value/Revenue : 0.85
Enterprise Value/EBITDA: 7.852
Net Debt (in $M): 864.2M
Total long-term debt/EBITDA: 3.9x
Net debt/EBITDA: 2.2x
P/E: 25x
P/FCF: 19.0x
EBIT: 230 M


  • Progress on turnaround plan
  • International growth
  • New and successful breakfast launch

Disclosure: We are long WEN, BKC and reserve the right to buy/sell at any time or change our opinion without updating these research notes. Never rely on opinions from others. Always do your own research and consult with your own investment advisor.