The Wendy's Company - Reports Q3 EPS Wednesday AM - Stock Near High - Going Higher?

Summary

• Third largest hamburger fighting a market share battle.
• Moving to pure franchising model but leasing income (from franchisees) is substantial, not so "asset-light".
• Nelson Peltz's Trian owns 19.5%, very sophisticated financial strategist.

Upcoming Earnings Release & Conclusion

The Wendy's Company (NASDAQ:WEN) is scheduled to report its 16Q3 results Wednesday, November 9 at 7:30 AM EST with a conference call at 9 AM EST. Per Bloomberg, the consensus estimates of the 21 sell-side analysts covering the company are for comps at 1.2% (range 0.5% to 1.9%), revenues at $349.4M (range $313-367M) and EPS at $0.10 (range $0.08-0.12). The EPS and comp estimates were reduced very modestly following the Q2 report, but have remained stable since. However, the revenue estimates have very modestly inched up. Estimates for 16Q4 and FY17 have followed the same pattern. Also per Bloomberg, the mean target price is $11.75 (range $10-14.50), which is little changed since the Q2 report.

Though 11.5x trailing EBITDA (per our table below) is reasonable for a well-established (soon to be) pure franchisor, the number of Wendy's operating units are down over the last several years, and franchisees are remodeling rather than building new locations in the current challenging environment. The company is already leveraged so major additional debt to repurchase stock or support franchisees in one way or another, even at today's low rates, is unlikely. With earnings per share progress in the range of 10% annually, we think WEN is more than adequately valued right now. We don't expect any substantial upside surprise, unless it is a result of financial engineering rather than fundamentals at the store level. We obviously would not be trading WEN from the long side going into this earnings report.

WEN: Company Overview (1) Excerpted from WEN corporate documents and presentations, and assembled by Lipton Financial Services, Inc. (LFSI). As indicated by quotation marks, information was previously published on its website after Q2 earnings report. Quotation marks and (1) designate such previously published material. The conclusion stated above has not been previously published and is based on all past and current information available to the author.

"(1) Dublin, Ohio based Wendy's operates and franchises the third largest hamburger QSR chain with system wide sales exceeding $9.7B in the T12M ended at its 16Q2. As of that date, there were 6,490 units (5,908 franchised, 582 company-operated). Of this amount, over 5,700 were in the U.S., including all 582 company units, which, combined with the 354 Canadian franchised stores, constitute the North American (NA) segment. All of the 400+ international stores are franchised and are located in 27 countries (except Canada), giving it a smaller international footprint than its larger hamburger QSR competitors, McDonald's & Burger King. For the T12M through 16Q2, the company generated revenues of $1.7B from four sources: company stores (72%), royalties and fees from the franchisees (21%) and rental income on locations leased or sub-leased to franchisees (7%).

"(1) Wendy's has struggled for some time with inconsistent product introductions and promotions, a tired store fleet, changing consumer tastes, the encroachments of fast casual competition and a slow adoption of new technology. Todd Penegor, appointed CEO in May 2016, is implementing a plan he helped develop in his earlier role as CFO since June 2013. The plan attacks sales weaknesses with better offerings, a barbell merchandising approach (balancing value and premium items), and remodeling the stores. It also intends to free up capital by refranchising company stores and levering up its balance sheet to finance share repurchases. Specifically, by 2020 the company is targeting $2M NA AUVs (up from $1.6M company and $1.5M franchise in 2015) with 20% store-level EBITDA margins (The T12M margin to 16Q2 for company stores is 19.2%. The comparable margin for franchisees would be 15.2% assuming the same $1.6M AUVs of company stores and payment of royalties). By 2020, the company also aims to complete remodeling 60% of the NA system (more on this below) and adding 1,000 new (500 net) stores globally, of which 50 will be company units. To make store investment more attractive, it is developing a new store prototype requiring a cash outlay of 1.3X sales (or $2.6M at $2M AUV), implying unit level EBITDA of $400K, presumably net of royalties, and a cash-on-cash return of 15.4%. Finally, the plan envisions a 95% franchised system by the end of 2016, up from the current 90% level. If successfully executed, management expects consolidated EBITDA margins will grow from 25.5% (T12M at 16Q2) to 38-40% in 2020, and free cash flows will grow to $200M-250M annually.

"(1) As for its menu, Wendy's has refocused on its legacy strengths with its "Deliciously Different" campaign emphasizing its delivered fresh, never frozen beef, crisp and fresh lettuce and tomatoes, and bakery style buns. It has introduced, mostly on an LTO basis, premium products such as its Jalepeno Fresco Spicy Chicken, Gouda Bacon Cheeseburger, and sides, such as Pulled Pork Cheese fries. With its "4 for $4" value items, Wendy's balance of core, value, and LTO premium offerings is generating modestly positive comps, almost entirely from traffic gains, rather than the comps composed of higher pricing and lower traffic often prevailing in the sector. (Of note, the franchisees have generally taken more price than the company stores, perhaps the cause of their reduced traffic and lower comps than company stores.) This is a generally satisfactory performance given the current aggressively competitive environment and macro-economic headwinds.

"(1) Wendy's franchise agreement requires a remodel every seven years, but the requirement has not been enforced. As a result, its NA fleet could be considered something less than fresh, likely affecting market share. Management has proposed a range of remodel options costing $300K to as much as $1M. It has been slow to gain acceptance by the franchisees, uncertain that they will realize the sales lifts of 5% and 10% (with 40-50% flow-through rates) generated by company stores on remodels costing $300K and $400-500K, respectively. Still, 26% of the system has been remodeled as of 16Q2 against the aforementioned 60% target by 2020. This figure is up from 22% remodeled at the end of 2015.

"(1) A key element of WEN's plan relies on a substantial increase in rental income from refranchised restaurants and from franchised units purchased for resale to other franchisees (which the company calls "flips"). The most lucrative source of rent occurs with from leasing owned refranchised restaurants where WEN obtains 7-7.5% of gross sales. When the company subleases a refranchised location where it is the prime tenant (or becomes prime tenant in executing a flip), it earns a spread between its sublease revenue and lease expense. The company has not provided much detail quantifying the potential magnitude of this income stream, but it may be down to earning a spread on leases of remaining refranchisings, having exhausted the refranchising of owned sites. Management disclosed during the 16Q2 conference call that 2016 rent income is expected to be about $80M, up 17.6% from 2015, implying leasing profitability is dropping ($170M revenue, $90M expense in 2016 vs $87M revenue and $19M expense in 2015). Another possibility is that WEN is accepting lower rental income to stimulate refranchising transactions.

"(1) A last element of the plan is WEN's utilization of technology to better manage operations and to adopt the increasingly standard industry applications for communicating with and marketing to customers, as well as improving their purchasing and dining experience. On this score, the foundation is the installation of a modern Point of Sale (POS) system tied into the entire chain, a step which is expected to be substantially complete by the end of 2016. As designed, The POS system will be the digital platform on which the company can add capability for online and mobile ordering. It also envisions layering on increasingly sophisticated functions, such as order preparation staging (using customer location technology to sequence order preparation so it is "fresh and ready" upon arrival of the customer). The platform will also enable the development of loyalty and focused marketing programs.

"(1) It is too soon to say how the plan is working. The AUVs for both the company and the franchised store are growing, and margins are improving for company stores (although part of the margin improvement is because the company refranchised many of its poorer performers). Consolidated corporate margins, adjusted for the transitional costs and benefits of implementing the plan, have increased 850bps in the last two years. On the other hand, the company is investing heavily (capital expenditures: the remodels, new stores and technology, and P&L initiatives: "G&A re-alignment" program to reduce corporate overhead, and expense to execute the refranchising program). Where everything comes together-free cash flows (FCF) and ROICs - WEN's results are better than in the past, but not yet demonstrating much progress towards its stated objectives. The company's cash flows from operations (CFO) have averaged $243M in the last five years, and at $271M in the T12M to 16Q2. CFOs are now only modestly better than average. In the same period, FCFs have averaged about $19M, and at $81M in T12M FCF is also only modestly better than average. Meanwhile, T12M ROIC, at 4.9%, is better than the five-year average of 3.4%, but well below WEN's cost of capital.

"(1) Overall, most of the current investment has the objective of modernizing the fleet. The more difficult part of the plan may be accelerating system unit growth and achieving its relatively modest goal of a 1,000 (500 net) store increase by 2020. Assuming the fleet modernization effort results in acceptable store operating margins, corporate objectives for FCFs & ROICs require that franchisees vote with their pocket books and build new stores. Since existing franchisees have so far been reluctant to embrace the suggested remodel approach, as discussed above, we'll view franchisee sign-ups and development rates as one of the most relevant indicators of the long-term success of the plan.

"(1) In the past year, WEN has added about $1B in new debt, resulting in ratios of debt to EBITDA and debt to EBITDAR of 5.7X and 6.0X, respectively, which is comparable with other highly franchised operators. With the proceeds of the new debt, sales of refranchised locations and CFOs, the company has financed over $1.1B in share repurchases and $63M in dividends and the capital expenditures noted above. The Wendy's Co. has several JVs and investments, the most significant of which, is its 18.5% stake in Arby's, which distributed a $54.9M dividend to WEN in 2015. The Arby's investment is a residue of the merger between the two companies in 2008 and ended in 2011. Arby's is owned by Trian Fund Management LP, a hedge fund. Trian's founder and CEO, Nelson Peltz, is also WEN's non-executive chairman, and with Trian, controls 19.5% of WEN's outstanding shares.

WEN: Current Developments Per Q2 Report

"(1) In its 16Q2, the company narrowed its guidance range for adjusted EPS from $0.38-0.40 to $0.39-0.40 and adjusted EBITDA from a down 1% to up 1% range to a flat to up 1% range. It also lowered full year comps guidance from up 3% to a plus 1-2%. These revisions reflected continuing QSR traffic struggles, including competition with eating at home, which WEN management seems especially sensitive to, stating the "continued gap between the cost of eating at home and the cost of dining out is now at its widest point since the recession". 2Q16 QSR traffic was 0.2%, a sequential deceleration from the 0.7% seen in 1Q16 but a 30bp improvement on a two-yr stack. WEN, perhaps uniquely in the industry, has not taken any pricing except in select high wage inflation markets, implying the 1.2% company-store comp, while modest, was largely the result of traffic gains. The company purchased 5.9M shares for $61M in the quarter. In the first half of 2016, the net increase in stores has been 11 stores, the result of six new company and 43 franchised stores, while closing three company and 35 franchised stores. Year to date, it has completed the sale of 55 of the 315 stores it expects to refranchise in 2016."

Our conclusion relative to WEN common stock is discussed above.

Disclosure: I/we 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.