This write up is towards the March 2011 Gurufocus contest.
Wendy’s/Arby’s Group, Inc. (NYSE:WEN) is a holding company for two major fast food chains, Wendy’s and Arby’s. The Group has over 10,000 units in its two restaurant system making it the third largest fast food chain in the US (behind McDonalds and YUM).
The entity was formed in September 2008 after the activist investor Nelson Peltz acquired Wendy’s through his holding company Triac, then also the owner of Arby’s. Wendy’s had been under-managed for many years, so its old management was quickly shown the door. Nelson Peltz brought in his team to manage the new company. Since then, the executive team has made significant progress at the turnaround at Wendy’s.
Despite this, Mr. Market continues to misprice this security. As you will see in the article, WEN at $5 a share (Mar 3, 2011) offers a 35-50% of margin of safety from its intrinsic value in the range of $6.8 - $7.6 a share.
Why is it so cheap? Even though Wendy’s turnaround has been a success so far, Arby’s has been struggling since the merger. Sell-side analysts are valuing the group on a consolidated multiple, rather than as sum-of-parts of a decently performing restaurant and a poorly performing restaurant. At today’s price, Mr. Market is offering Wendy’s at a discount and giving away Arby’s for free
As of Jan 2011, the Wendy’s system has 6500 restaurants, of which 20% are company owned and the rest are franchises. The number of restaurants as well as the percentage of company owned restaurants verses franchises has stayed the same since the takeover in 2008.
Wendy’s is known as a quality brand among its customers. Zagat® has named Wendy’s as top fast food restaurant for two years in a row now and rated it very highly in many categories.
Triac’s primary objective for the merger was the potential to improve operations at the Wendy’s company-owned restaurants. For many years prior to the takeover, restaurant margin at the company owned stores had lagged significantly than that at the franchise stores. The new management set a goal to improve restaurant margin from 11.7% in 2008 to 16.7% in 2011.
In its recently reported 10K for 2010, restaurant margin at the company owned stores stood at 15.2% showing that the new management team was making good progress at the turnaround at Wendy’s.
In addition to the margin expansion initiative, management implemented three other initiatives:
- In 2009, a G&A savings plan of 60 million realizable due to consolidation of Wendy’s and Arby’s.
- In 2010, management formed a co-op for Wendy’s restaurant system to consolidate food and related product purchases as well as to provide distribution services. This entity provides for purchasing efficiencies while at the same time reducing G&A requirements on the corporate. Prior to establishment of the co-op, these functions were provided by the corporate.
- In 2010, in order to drive same store sales and further margin expansion, management introduced a strategic pricing initiative. Historically, Wendy’s stores were priced on a national basis. Now, it began to move to a store-to-store pricing strategy. The benefits of this initiative are expected in 2011 and beyond.
Now, let’s turn our attention to Arby’s. As of Jan 2011, the Arby’s system has 3650 restaurants, of which 30% are company owned. The number of restaurants as well as the mix has stayed the same over the period since the takeover.
Historically, Arby’s had been known for its quality food but at a premium price. Average check at its restaurant was the highest in the industry at $7.5 compared to $5 at its competitors. It achieved this by not focusing on the “value” meals, which many of its peers did. But this strategy proved to be disappointing in the recession of 2007-2009. Customers of the fast food industry who are known to be very price sensitive fled very quickly from Arby’s. As per a study, Arby’s was then rated lowest in “worth what you pay for it” category.
At the same time, competitors were discounting heavily impacting same store sales at Arby’s significantly. The sales deleveraging resulted in restaurant margins decreasing by a huge margin.
Eventually, management introduced a “value” menu in April 2009 but business at the restaurants had deteriorated significantly. Based on the disclosures in the 10Ks, we estimate that Arby’s EBITDA took a dive from $130 million in 2008 to $70 million in 2009 to only $50 million in 2010.
Despite the decline, we do not think that the business is permanently impaired. Instead of slashing price on its premium products, management introduced new value products using a 3-tier approach.
This was smarter than what many of other fast food restaurants did during the recession. Slashing prices on its core menu caused major dissent among its franchises of some of its peers and risk of impairment to the value of the brand. With Arby’s 3-tier approach, margin compression is mainly due to sales deleveraging rather than due to discounting. Thus, if and when Arby’s business gains momentum, restaurant margin will probably rise as quickly as it fell as customers become less price sensitive than during the recession. Furthermore, Arby’s brand image continues to be healthy among its customers.
In 2010, Arby’s increased its national media rate from 1.2% to 2.4% to increase customer awareness about its quality as well as value positioning. It is important to note that Arby’s appointed Hala Moddelmog who is an experienced veteran of the fast food industry as its new president in 2010. She spent 10 years at Church’s Chicken from 1995 – 2004 reimaging the brand and driving eight consecutive years of same store sales growth.
Management is taking two main initiatives to improve business at Wendy’s - (a) introduction of breakfast and, (b) international expansion.
Breakfast corresponds to only 2% of total sales at Wendy’s, but breakfast represents 23% of all the traffic at fast food restaurants. To understand the opportunity, it is important to note that McDonald’s and Burger King derive greater than 20% of their revenue from breakfast sales. Industry-wide breakfast sales have grown at 13% from 2002 to 2009 versus dinner sales have declined by 8% during the same period.
This category represents a good opportunity to add to average unit volume (“AUV”) by leveraging current operations during the part of the day (known as expanding “daypart”) that is currently underserved. Without breakfast, AUV is at $1.4 million. As per management, national implementation of breakfast can add $140K-$150K to AUV i.e. a 10% growth in revenue.
In 2010, management implemented phase one of their plan to roll out breakfast by first testing it in four markets: Pittsburg, Kansas City, Phoenix and, Shreveport. Results from the test markets have been very encouraging. First time visitors rated the items exceptional and higher than the competition. This is not surprising given Wendy’s high reputation for quality as seen in its Zagat survey. Also, the test markets have helped them identify key demographic and geographic factors that drive breakfast sales. In the second phase, management is refining its financial model to improve breakfast margin, codifying operational procedures for efficiency, and developing a go-to market strategy. In the third phase, management plans to expand to other markets so that by year end 1000 stores are serving breakfast.
Wendy’s/Arby’s are underpenetrated significantly in foreign markets relative to all its peers.
This represents another opportunity for growth. Management’s plan for expansion in the international markets is based on recruiting franchisees with experienced restaurant experience with real estate access and adequate capital.
This business is very attractive for multiple reasons: low requirements of capital, higher AUV in international markets, sound economic and population trends, and rising standards of living.
The company already increased future store commitments from 151 in 2008 to 610 in 2010. Here is a list of deals they signed since the merger:
- May 2009: 35 Wendy’s restaurants in Singapore in 10 years.
- June 2009: 135 dual-branded restaurants in Middle East in 10 years.
- June 2010: 100 Arby’s restaurants in Turkey in 10 years with 50 in the first five years.
- Aug 2010: 180 dual-branded restaurants in Russian Federation in 10 years.
- Aug 2010: 24 Wendy’s restaurants in Eastern Caribbean in 10 years.
- Jan 2011: 50 Wendy’s restaurants in Argentina in 10 years.
- Same store sales growth
- Company owned restaurant margin improvement
- Daypart expansion because of breakfast initiatives
- New unit growth in international markets
- Possibly growth in franchise royalty as a result of the above factors
On Jan 2011, management announced it was looking for buyers for the Arby’s. Going forward management plans to focus on its operations at Wendy’s and has given guidance that it expects a sale in 2011. As per the announcement, key reason for doing so is to focus management’s effort on Wendy’s which is currently the key driver for shareholder return (since Arby’s has shrunken to 12.5% of EBITDA). Management also listed the following on one of its slide during the investor day as benefits of such a sale:
- Reduce corporate G&A to support single brand
- Eliminate $200 million of capital lease obligations related to Arby’s.
- Reduce future capital expenditures related to Arby’s.
- Proceeds from sale available for reinvestment
- Sale accretive to earnings and cash flow
My valuation is based on using management provided estimate for EBITDA for Wendy’s assuming a sale of Arby’s, and then valuing by using a reasonable EV/EBITDA multiple based on a comparable peer’s acquisition in a private transaction.
As per management, 2011 EBITDA is estimated to be $345-355 million and EBITDA is estimated to grow at 10-15% thereafter. I believe that these are conservative numbers since 2010 adjusted EBITDA was $396 million and Arby’s EBITDA (as per the Q4 conference call transcript) was $50 million. So, 2010 EBITDA for Wendy’s by itself was $346 million. Thus, the estimate assumes no growth in EBITDA in 2011 and growth thereafter because of the various initiatives outlined in the article earlier.
3G capital acquired Burger King in Sept 2010 at EV/EBITDA of 9.3x (as per the M&A SEC filings). As we saw earlier, Burger King had poorer same store sales compared to Wendy’s for 2009. Also, as per its 2009 10K, its restaurant margin was 130 bps smaller than that of Wendy’s. In my opinion, Wendy’s restaurant (without Arby’s) should trade a slight premium or at least the same as Burger King in a private transaction. Thus, for valuation, we use:
- Worst case multiple of 8.4x – EBITDA multiple at which Triac acquired Wendy’s in 2008 when it was a poorer performing restaurant than today (multiple based on UBS Equity Research report)
- Mid Case multiple of 9.3x – EBITDA multiple at which 3G acquired Burger King in 2010
- Best Case multiple of 10x – 7.5% premium to Burger King’s acquisition multiple but slightly lower than the multiple at which McDonald’s is trading today.
We are using the following data from the 10K published on 3/3/2011 and from the Q4 earnings release presentation
Cash & Cash Equivalents
Long Term Debt
Arby’s related obligations
Arby’s EV (obligations + 1.7x EBITDA = ~5.7x EBITDA))
Net Debt (post Arby’s sale)
In my opinion, the downside is very limited from here on, baring a severe recession similar to that of 2007-2008. At today’s price, we are getting a free option on Arby’s improving further and thus commanding a reasonable EBITDA multiple (7-8x) in a private transaction. Our valuation exercise above assumes a multiple that is almost unheard of in this industry (based on peer group analysis and transactions in the last decade in Burger King’s tender offer solicitation/recommendation documents).
Another indication of the stock being undervalued is the high proportion of stocks repurchased by a management team that is known to be a good capital allocator. In the two years, 2009-2010, management spent $245 million retiring 52 million shares or 11% of outstanding stock. Thus, it retired at an average cost of $4.71 i.e. ~6 lower than stock price today.
Management and Majority Shareholders:
Nelson Peltz and Peter May are the Chairman and Vice Chairman of the group. As per the 2010 10K, they jointly control 24% of the company. Mr. Peltz is an activist investor widely known for turning around underachieving companies by burnishing famous brands. He is best known for buying the flagging iced-tea brand Snapple from Quaker Oats for $300 million, brilliantly reviving its blithe, quirky appeal, and reselling it three years later for more than $1 billion. To name a few other names, he took control of Heinz and Tiffany and forced rapid changes. He was lately in the news for his bid for Family Dollar for $7.3 billion that was rejected by the board. You can read more about Mr. Peltz in the Fortune article on him attached in the reference section. In summary, I believe that Wendy’s/Arby’s is led a capable business man and a smart capital allocator.
Speaking of capital allocation, the board has approved up to $250 million in stock repurchases. If management buys at similar levels as in the past, this represents 12% of outstanding stock. Management has also returned $55 million in dividends in the past two years.
Longleaf Small Cap Fund (run by the team at Southeastern Management) owns 7.1% of the company. They are the largest non-controlling institutional shareholder of Wendy’s/Arby’s. As many of you know, the team at Southeastern Management led by Mason Hawkins and Staley Cates are among the best value investors. They first initiated their position in WEN when Triac took over reinforcing my belief that Wendy’s is led by the finest. Most recently, they increased their position size by 18% from 25.13 million shares to 29.70 million shares from July to Dec 2010. WEN traded at a low of $3.89 to a high of $5.01 during this period. Although WEN is at the high range today and it obviously was a better buy then, it still offers a pretty attractive risk-adjusted return.
Finally, the CEO Roland Smith has a resume filled with turnarounds. In my opinion, he has done a decent job so far at improving operations at Wendy’s. You can read more about his background in the article attached in the reference section. Most recently, he climbed the Mt. Everest with his son after training for a year and a half.
- Sale of Arby’s
- Execution of business plan as per guidance
- Even though management’s guidance already takes into account inflation in commodity prices, a higher than expected rise in commodity price would lead to margin compression and/or pressure on sales growth.
- Decline in same store sales due to a severe recession like the one in 2007-2008.
- 10Ks 2008-2010, Wendy’s/Arby’s
- 2009-2010 Quarterly Conference Calls, Wendy’s/Arby’s
- 2009-2010 Investor Conference Presentations, Wendy’s/Arby’s
- 2010 10K, Burger King
- Tender offer Solicitation/Recommendation Statement, SC 14D9, Burger King
- Longleaf Partners, Quarterly Letters
- “The reinvention of Nelson Peltz”, Fortune, March 2007
- “Arby’s parent Triac to acquire Wendy’s in $2.34 billion stock swap”, NRN, May 2008
- “Roland Smith”, Veteran’s Advantage, Jul 2010.
The author has a long position in WEN that he initiated at an average cost of $4.79. This is not a recommendation to buy or sell any security. Please do your own research.