Can This Company Turn It Around?

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Wendy's (NASDAQ: WEN), the fast food chain known for its square burger patties, is in the middle of a brand rejuvenation. CEO Emil Brolick, on the job since September 2011, has led the attempt to differentiate Wendy's from its competitors by focusing on higher quality offerings. Along with this Wendy's has been remodeling many of its stores to give them a more modern and high-end look, similar to what McDonald's (NYSE: MCD) has done over the past decade. In 2012, 66 Wendy's restaurants were remodeled, resulting in an average sales increase of over 25%. Encouraged by the results, the company expects to aggressively remodel existing stores and build new stores over the next few years.

<img src="/media/images/user_13886/wen-pres-1_large.png" />

By 2015 the company expects a total of 1,331 stores to have the new look, 20% of the total system restaurants and 50% of the company-owned restaurants. If all goes to plan then Wendy's should start seeing consistent same-store growth in the coming years.

Company presentation here

A Renewed Focus

Wendy's was founded in 1969 by Dave Thomas. Since then, the company has grown to over 6,600 stores to become the third largest hamburger fast food chain in the world. After merging with the parent company of Arby's in 2008 the company sold the Arby's franchise in 2011 to refocus on the core business.

In 2011 Wendy's recorded $2.43 billion in revenue, a decline from the previous year due to the Arby's sale. As Wendy's reported earlier this month, the company saw an increase in same-store sales of 1.6% for the year. This pushed total revenue up to $2.505 billion, a 3% increase from 2011. The company expects same-store sales growth of 2-3% in 2013 along EBITDA of $350-$360 million compared to $333 million in 2012, a 5-8% increase.

In November the company announced a 100% quarterly dividend increase, from $0.02 per share to $0.04 per share. This pushes the dividend yield up to about 3.1%. This may draw dividend investors into the stock, as the yield is now comparable to that of McDonald's. Although this increase is impressive, the company was forced to drastically cut its dividend due to the financial crisis in 2009. This increase puts the annual dividend at half the value from 2007.

I don't expect too much dividend growth for the next few years due to increased capital expenditures related to store remodels. The company expects to spend a total of $245 million in capex in 2013, $145 million of which is from new stores and store remodels. This spending should accelerate over the next few years as the company increases the pace of store remodels, thus suppressing free cash flow and limiting dividend growth.

Is Wendy's A Buy?

The results of the rejuvenation strategy thus far have been encouraging, but does Wendy's offer value at the current stock price of around $5 per share? The company is guiding for EBITDA to increase by high-single-digit to low-double-digit rates annually in the long-term, and expects the EPS to be about $0.20 per share in 2013. This puts the stock at about 25 times next year's earnings, which isn't particularly cheap.

Free cash flow isn't a particularly useful number to look at here because of the elevated level of growth capex going forward, so I'll instead turn to owner earnings and use only maintenance capex in my calculation. This will give an idea of how profitable the company is now assuming that it doesn't spend money to grow. I'll use TTM values since Wendy's has only released preliminary results thus far and estimate maintenance capex at $100 million. This leads to owner earnings of $237 million, or $0.60 per share. The company has a net debt of $2.24 per share, which puts the market capitalization plus net debt at around $7.30 per share. This is 12.17 times owner earnings, not particularly cheap but not nearly as expensive as the P/E ratio makes it appear.

If we assume that owner earnings will increase by 10% per year, in line with the company's EBITDA projections, then by the end of 2015 owner earnings will sit at about $0.80 per share. If the level of net debt remains the same a 12.17 multiple (calculated the same as above) would put the stock price at around $7.50 per share, or a nearly 50% increase in three years.

Data from Morningstar

Competition

McDonald's is the dominant fast-food hamburger chain, with annual revenue more than ten times that of Wendy's. What's more, McDonald's has built itself an economic moat with its enormous scale and highly efficient operations, as I wrote about here. Wendy's best chance is to market itself as a higher-end alternative to McDonald’s, becoming a more niche player in the fast food market. I think the company is well on its way to doing just that with its turnaround strategy.

Newly public Burger King (NYSE: BKW) is a more equally matched competitor to Wendy's. With similar revenues, Burger King is also attempting a turnaround in an attempt to better compete with McDonald's.

In terms of valuation, Burger King is much less desirable than Wendy's. Burger King's owner earnings per share are roughly $1.28 in the TTM period, with a net debt of $6.68 per share. With a current stock price around $17.80 this puts the ratio calculated above at 19.13, compared to Wendy's 12.17. Burger King pays a small dividend yielding just 0.9%, less than a third of Wendy's yield. I don't expect Burger King to be able to grow any faster than Wendy's, so Burger King looks seriously overpriced here.

The Bottom Line

Wendy's is a lot cheaper than it appears, but it’s no screaming value at current prices. The stock was trading closer to $4 per share a few months ago, and I'd be much more comfortable with that entry price. I do believe that the turnaround strategy will pay off in the long run and that Wendy's will be able to carve out a niche in the higher-end fast food market. If the stock gets pushed down closer to $4 per share I'd be more interested than I am now. It's not a bad buy at these prices, certainly better than Burger King, but I'd wait for a lower price to open a position.


TheBargainBin has no position in any stocks mentioned. The Motley Fool recommends Burger King Worldwide and McDonald's. The Motley Fool owns shares of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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