Wendy's: At Least 25% Downside From Here
Summary
- DCF analysis indicates substantial downside, with minimal (and unrealistic) pathways to justifying the current valuation.
- Industry labor shortage, limited growth opportunities, and intense competition add to the downside story.
- Breakfast menu upgrade is not something to hang your hat on given past track record.
After over a year of operating in uncharted waters during the pandemic, the restaurant & fast food sector didn’t exactly need a labor shortage crisis. Ask almost anyone, and they can tell you about their local favorite restaurant that closed doors due to the industry-wide shortage. The situation has gotten so bad, we’re now even reading of robots being “hired”. Amidst this environment, some restaurants have actually held up quite well by getting new customers that otherwise would have liked to dine-in but are now ordering or using drive-ins. Over the last twelve months, Darden Restaurants (DRI), who’s dine-in restaurants had a bare-bones menu the last time I visited several weeks ago, roughly doubled its value. Yum! Brands (YUM) has soared ~45%, outperforming the S&P 500’s ~35% return. McDonald’s (MCD), meanwhile, also delivered a ~28% return. The laggard? Wendy’s (NASDAQ:WEN), which has been roughly flat.
Part of the problem with Wendy’s is that the company is a bit of an also-ran business relative to the industry giant, McDonald’s. It has tried to revitalize the business through refranchising and is introducing a breakfast menu, but true game-changing growth opportunities seem hard to come by. Even the breakfast menu idea has already been tried by almost every game in town (including Wendy's), so it’s not exactly the kind of growth initiative that are going to get investors excited long-term, in my view. With that said, there is such a thing as buying a slow grower at an attractive price. Does Wendy’s fit into that bucket? According to Seeking Alpha data, roughly half of the Street is “neutral” on the stock. Since Wall Street is generally bullish, we can take this as lukewarm sentiment. As for my view...
DCF Analysis Indicates Substantial Downside
To get a sense of the company’s intrinsic value, I ran a DCF analysis. No DCF analysis can provide a perfect picture of future returns for shareholders; however, they can provide an illustrative “story” of the likelihood of different scenarios. In my DCF analysis, I assumed 5% revenue growth. I also assumed flat EBIT margins at 16.7%, which may actually be generous given that margins are at a peak after the restructuring. I flat-lined depreciation, changes in net working capital, and capex assumptions, which have been relatively consistent across the years.
Source: Created by author
Assuming an EBITDA multiple of 15x and a 7% discount rate, the stock has ~25% downside. Worse yet, the 15x multiple is very generous, since Wendy’s has traded in the 11-14x range for the bulk of the 2010’s. Even the industry leader, McDonald’s, has generally traded in the 11-14x. Accordingly, there is perhaps even more downside for Wendy’s should the market correct itself. Generally, a trading premium is awarded for a strongly performing business with multiple catalysts; however, Wendy’s is somehow able to defy gravity despite the lack of a high growth momentum story.
Source: Created by author
As my sensitivity tables above illustrate, if the stock were to contract to a 13x EBITDA multiple, at a 3% growth rate, the stock would have nearly ~50% downside. Even if the growth rate were to accelerate to an unlikely clip of 9%, the downside would still be ~15%. It would take the multiple holding steady at (1) 17x and a 7% growth rate or (2) EBIT margins expanding 200 bps and a 7% growth rate to justify the current valuation, which are not realistic assumptions.
Downside Catalysts
As bearish as I am on the stock, I am assuming that the market corrects the trading premium. It would take several “downside catalysts” to result in such a correction. The main one is if margins start to contract. After years of margin pressure, the company’s gross margins have started to expand from around 35% in 2020 to 36.7% today. Investors are implicitly assuming that this either continues or doesn’t reverse, and this is particularly important since Wendy’s has consistently been less profitable. However, given the degree of competition, wage inflation, and commodity inflation, I believe a realignment of expectations may be in order.
The next largest downside catalyst is the company’s market share gains during the pandemic proving to be unsustainable. The company has tried several times over the past two decades to enter breakfast and has generally thrown in the towel within two years, and I don’t anticipate this go-around being any different, especially given the uncertainty around attracting quality workers. McDonald’s currently has 20-30% of its sales attributable to breakfast, so, in any event, Wendy’s has an incredibly high bar to meet. With management updating its global systemwide sales growth forecast for 2021 from 6-8% to 8-10%, investors are likely to be very reactive to any miss, as management is clearly signaling where it sees the value of its business. At the current historical trading premium, management can’t afford to miss expectations.
Risks
There is one big piece to the equation that is hard to predict: the restaurant & fast food sector is undergoing significant upheaval. With the popularization of Uber Eats, DoorDash, and even the rollout of grocery pickup services, like Instacart, the “food economy” is very different than how it was several years ago. Consumers are not only changing how they are ordering, but what they are finding important in an ordering / restaurant / fast food experience. It’s hard to say how Wendy’s may fare in this environment long-term. To its credit, Wendy’s delivered global same-restaurant sales growth of 12.8% in the first quarter, driven by digital acceleration to ~10% of the sale mix. Wendy’s has an impressive ~13 million U.S. rewards members that are now enrolled in digital services, so it may very well be that the market continues to reward the company with a trading premium in such a new economy. The company is simply continuing to execute on the delivery front, so this could be a new normal.
In addition, Wendy’s has upside potential in expanding its footprint. The recent launch of a new incentive program to reward franchisees for new restaurant growth has helped with goal-alignment. At the same time, the franchise recruiting pipeline continues to grow, with now roughly 150 new potential franchisees globally at different stages of the process. With developments in Central Asia, the international case is becoming clearer by the quarter.
Lastly, the stock has potential to get caught up in the meme stock movement. It spiked 16% less than two months ago, and there's really no saying what can happen on this front in the short-term.
Conclusion
Although it’s hard to predict where the fast food sector will exactly go from here, Wendy’s lacks the economic moat and timelessness of McDonald’s. The stock trades at an unbelievable forward PE multiple of 27.2x, which is at a premium to the latter’s 24.7x. At the same time, Wendy’s is not exactly poised for the strongest growth—this is a business that generated revenue of $3.4 billion in 2010 and only $1.7 billion in 2020. At the current valuation, as my DCF analysis above indicated, there are minimal pathways to upside. On the flip side, should the market correct itself, there are many pathways to significant downside. While the company prides itself on its generous capital allocation policy of 50% payout, investors should not be mistaken: the dividend yield is only 1.7%, below McDonald’s 2.1%. Accordingly, I strongly recommend investors hold out.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
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