Wendy’s: Waiting For More Visibility On Turnaround
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Wendy’s Company (NASDAQ: WEN), on its June 28 investor day, reasserted its focus on premium brand positioning driven by product innovation and an aggressive reimage program. The company is developing a product pipeline with emphasis on quality and freshness through improved menu innovation. For the second quarter ending July 1, 2012, the company expects to report a same-store sales increase of nearly 3.0% for its North American company-operated restaurants. This will be the fifth consecutive quarter of positive same-store sales.
The company’s stock is currently priced at $4.67 and is attracting speculative investors because of its low price and the possibility of a meaningful turnaround in the business. But we feel the stock is likely to remain range bound until there is greater visibility into the execution of its plans and would therefore recommend remaining on the sidelines. We have the following concerns regarding the company’s future performance.
Remodel prototype still expensive
The reimage design is structured such that its Tier 1 prototype costs $650-700k, down from the test prototype of $1.2 million. Tier 2 and Tier 3 prototypes cost $500k and $300k, respectively. Despite these cost reductions, the program still requires a high capital commitment and a high sales hurdle, putting additional pressure on the company to attract and retain successful franchises. Moreover, Tier 3 remodel economics may not work in units with sales significantly below the average unit volume of $1.4 million and will result in very low returns on investment.
Re-Image Program will take time to implement
Wendy’s outlined its plan of reimaging 70% of the company-operated units, with a target of 50% by 2015; but these units represent only 15% of the system. It also remains unclear how the company will support franchise reimages. With only one of the re-engineered Tier 1 proto types built and the Tier 2 and 3 designs still in development, the reimage program is still in its early stages, so it will likely take several years to implement and cannot drive a dramatic hike in sales in the near to medium term.
Trading at higher valuation
Wendy's is not particularly efficient in terms of execution when compared to its peer group of McDonald's (NYSE: MCD) and Yum! Brands (NYSE: YUM). Wendy's gross margin is 25.20%, as compared 38.95% for McDonald's and 26.97% for YUM Brands; its profit margin is just .97%, compared to 20.26% for MCD and 11.69% for YUM.
The following chart provides a comparison of gross profit, profit margins, return on equity, and forward PE for the three companies.
It is clear from the above chart that Wendy’s has the lowest gross profit, lowest profit margin, and lowest return on equity, yet it has the highest valuation with a forward PE of 22.24 as compared to 14.63 for McDonald’s and 16.79 for Yum Brands. Wendy's higher valuation is not justified, as it is still early for its reimage program, whereas McDonald’s has been a consistent past performer and YUM has a high international expansion rate. There is a further risk that fast growing casual competitors will reach down the value curve to sustain sales momentum, which would influence Wendy's consumer base, and thus we recommend avoiding this stock.
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