Should You Buy The Growth Story Of Wendy's?

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About: The Wendy's Company (WEN)
by: Aristofanis Papadatos
Summary

WEN is expected to grow its earnings per share by 16% this year.

The company has several growth drivers, such as new store openings, same-store sales growth and share repurchases.

The article discusses whether the growth story of WEN is appealing.

The stock of Wendy’s (WEN) passes under the radar of most investors whereas McDonald’s (MCD) is one of the most popular stocks in the investing community. This is somewhat surprising, as the latter is a mature company whereas the former is still in its high-growth phase. In this article, I will analyze whether the growth story of Wendy’s is appealing.

Business overview

Wendy’s is the third-largest hamburger quick-service restaurant chain in the world, with more than 6,600 restaurants worldwide. It generates 95% of its revenues in North America, so investors should mostly focus on the performance of the restaurant chain in this region.

During the last decade, Wendy’s has consistently grown its same-store sales in North America. However, in the latest quarter, the company reported a 0.2% decrease in its same-store sales in this region. In addition, its operating margin fell from 15.9% to 15.7% whereas the analysts were expecting an operating margin of 17.9%. The disappointing performance was primarily caused by increased labor and insurance costs. Consequently, the stock initially plunged 10% on the day after its earnings release. However, as management provided guidance for 1.0% same-store sales growth in North America for full-year 2018 and raised its guidance for earnings per share from $0.56 to $0.57, the stock retrieved most of its losses.

Growth prospects

With only one quarter left to be reported for 2018, it is safe to assume that Wendy’s achieved earnings per share around $0.57 in 2018. The company has thus almost doubled its earnings per share in the last five years, from $0.30 in 2013 to $0.57 in 2018.

Even better, Wendy’s is likely to continue growing thanks to a series of growth drivers. First of all, it grows its revenues via opening new stores every year. For instance, in the first nine months of last year, it opened 106 new stores (1.5% of its store count). Unfortunately, the company also closes a meaningful number of stores every year due to poor business performance. For instance, during the first nine months of last year, Wendy’s closed 71 stores. Consequently, the net new stores were only 35. This means that the company increased its net store count by only 0.7% last year. The same trend was witnessed in 2017 as well.

On the other hand, Wendy’s is likely to continue growing its earnings thanks to some initiatives. The company is in the process of reimaging its stores in order to improve the dining experience and thus attract more customers. It has remodeled approximately half of its stores and expects to remodel another 20% of its stores until the end of 2020. It is worth noting that McDonald’s and Domino’s Pizza (DPZ) have implemented similar strategies in recent years.

Wendy’s is also pursuing growth via the expansion of its delivery service. Delivery was available in approximately half of its restaurants in North America at the end of the third quarter and management expected to expand this service to 60% of the North American restaurants by the end of 2018.

Another growth driver is the aggressive share repurchase program of Wendy’s. The company has reduced its share count by 37% during the last four years. Moreover, it will continue to implement meaningful share repurchases, albeit at a slower pace. The company currently has $220 M in its buyback program, which expires at the end of the year. This amount can reduce the share count by approximately 5% at the current stock price.

Thanks to all the above growth drivers, Wendy’s is expected to grow its earnings per share by 16% this year, from $0.57 to $0.66.

Debt

Unfortunately, the aggressive share repurchases of the last few years have taken their toll on the balance sheet of Wendy’s. Its net debt (as per Buffett, net debt = total liabilities – cash – receivables) has increased from $1.8 B in 2013 to $3.0 B in the most recent quarter. This debt load is approximately 21 times the annual earnings of the company and hence it is excessive. Moreover, the interest expense currently consumes 42% of the operating income. As a result, it greatly hurts the bottom line of the company while it also renders the company exposed to unforeseen headwinds.

Valuation

Wendy’s is trading at a trailing price-to-earnings ratio of 30.8. While the restaurant chain is expected to remain in growth mode for the foreseeable future, this is certainly an extremely rich valuation level. As long as the company remains in fast growth mode, the stock is likely to maintain its premium valuation. However, whenever Wendy’s faces an unexpected headwind, such as the recent deceleration in North America or an economic downturn in the U.S., the stock is likely to plunge. The high sensitivity of the stock to negative news was prominent in the latest earnings report, which caused a temporary 10% plunge of the stock despite the positive surprise in earnings per share.

Final thoughts

Wendy’s is likely to remain in growth mode for several years. However, the market has already priced a great portion of future growth in the stock. Moreover, the company does not seem to be efficient in the execution of its expansion strategy, as evidenced by the high number of store closures. Furthermore, the company has remarkably leveraged its balance sheet and hence it has become more vulnerable in the event of a recession. As a recession has not shown up for almost a decade, this risk factor should not be undermined. Given all these factors, the stock of Wendy’s does not seem attractive right now, despite the growth trajectory of the company.

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.