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Wendy's: Great Fast Food, Bad Investment

February 17, 2013 | About:
Originally posted on my blog in November.

About a month and a half ago I wrote an article stating that I believe Jack In The Box Inc. (JACK) to be overvalued despite the recent positive hype around the company. Lately I have been researching Wendy's (WEN) because it has had JACK's opposite problem — very negative recent press — and wanted to see if this might turn out to be a potential contrarian value play or a value trap.

I will be referencing and comparing Wendy's to Jack In The Box and the other fast food companies I wrote about in my JACK article so if you would like to see how Wendy's compares to other fast food companies, please reference my JACK article that I link to above.

Wendy's Overview

Wendy's is an owner, operator and franchiser of 6,543 fast food restaurants, 1,447 of the restaurants are owned directly by Wendy's with the remaining amount owned by franchisees. Wendy's offers hamburgers, chicken sandwiches, salads, wraps, fries and the rest of the typical fast food restaurant offerings, but at a higher quality profile than most of its other fast food competitors. Higher quality also leads to higher prices for its individual product offerings and meals which greatly affected the company during the recession, with customers generally looking for cheaper food. In the past several years to combat the low cost offerings of its competitors, Wendy's has brought out its own value and extra value menus with prices generally under $2 per item.

Since the recession, Wendy's has streamlined operations by selling off its Arby's subsidiary, enacting cost cutting measures, updating its menu to offer new products including breakfast at some locations, and has started reimaging some of its restaurants by starting its Image Activation Program. The program has been put into place to update its restaurants making them look more modern, offering more amenities to get customers to stay longer at its restaurants and making the food ordering and cooking process more efficient so customers can get their food faster.

Unlike JACK who has recently finished up its reimaging of its restaurants and who should see at least small margin growth due to lower capital expenditures, Wendy's has only just started this process with only a few dozen restaurants having been updated thus far. Wendy's hopes that by 2015 about half of its company-owned restaurants will be reimaged, so this process is going to take a while. As we saw with Jack In The Box that will lead to generally higher cap ex for the foreseeable future, most likely lower or stagnant margins, possibly more debt, and potential loss of sales due to having some of its restaurants closed for construction periods of as long as eight weeks currently.

Valuations

These valuations are done by me and are not a recommendation to buy stock in any of the following companies mentioned. Do your own homework.

All numbers are in millions of U.S. dollars, except per share information, unless otherwise noted. The following valuations were done using its 2011 10-K, 3Q 2012 10-Q, and its 3Q 2012 investor presentation slides.

Asset Reproduction Valuation

Assets:Book Value:Reproduction Value:
Current Assets
Cash And Cash Equivalents454454
Accounts Receivable (Net)6555
Inventories128
Prepaid Expenses & Other Current Assets3216
Deferred Income Tax Benefit9548
Advertising Funds Restricted Assets7550
Total Current Assets734631
Properties1241745
Goodwill877439
Other Intangible Assets1315658
Investments11889
Deferred Costs & Other Assets5729
Total Assets43402591


Number of shares are 390

Reproduction Value:

With goodwill and intangible assets:

  • 2591/390=$6.64 per share.
Without goodwill and intangible assets:

  • 1494/390=$3.83 per share.
EBIT and Net Cash Valuation

Cash and cash equivalents are 454

Short term investments are 0

Total current liabilities are 344

Number of shares are 390

Cash and cash equivalents + short-term investments - total current liabilities=454-344=110.

  • 110/390=$0.28 in net cash per share.
WEN has a trailing twelve month EBIT of 120.

5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments:

  • 5X120=600+454=1054/390=$2.70 per share.
  • 8X120=960+454=1414/390=$3.63 per share.
  • 11X120=1320+454=1774/390=$4.55 per share.
  • 14X120=1680+454=2134/390=$5.47 per share.
TEV/EBIT and EV/EBIT Valuation

Total enterprise value is market cap + all debt equivalents (including the capitalized value of operating leases, unfunded pension liability, etc.) cash - long term investments - net deferred tax assets.

  • TEV/EBIT=3310/120=27.58
  • TEV/EBIT without accumulated deficit counted=2833/120=23.61
  • Regular EV/EBIT=2946/120=24.55
The average EV/EBIT in the fast food industry that I found when analyzing JACK was 15.68 and the only company to have a higher EV/EBIT than Wendy's is Chipotle Mexican Grill (CMG), which had an EV/EBIT of 26.53.

I usually like to buy companies that have an EV/EBIT multiple under 8, so the fast food industry as a whole appears to be massively overvalued to me. Not only that but Wendy's current EV/EBIT multiple is comparable to Chipotle's which generally has very high margins, which is exactly the opposite of Wendy's. As we will see later Wendy's margins do not even come close to Chipotle's and are generally much worse than even the rest of the fast food companies margins, so its extraordinarily high EV/EBIT multiple is astounding. I will explain later why it is so high.

I also did my normal other valuations but they did not work because after you take out the company’s debt and or goodwill and intangibles from the other valuations, you get negative estimates of intrinsic value for Wendy's equity.

Margin comparison

Please reference my JACK article above to see my thoughts on each of the other company’s margins as I will only be commenting in this article about Wendy's margins. The below chart has been updated to include Wendy's margins for comparison to the other fast food companies. The industry averages are still only including the previous five companies I talked about.

All numbers in the table were put together using either Morningstar or Yahoo Finance.

Jack in the Box (JACK)Sonic Corp (SONC)McDonald's (MCD)Yum Brands (YUM)Chipolte Mexican Grill (CMG)Company AveragesWendy's (WEN)
Gross Margin 5 Year Average16.28%34.30%37.94%26.20%24.28%27.80%25.70%
Gross Margin 10 Year Average17.08%43.38%40.42%35.59%11.73%29.04%39.86%
Op Margin 5 Year Average7.46%16.24%27.42%14.22%12.76%15.62%-1.70%
Op Margin 10 Year Average7.07%18.05%22.62%13.50%6.64%13.57%0.21%
ROE 5 Year Average20.16%66.33%30.26%131.56%18.55%53.37%-6%
ROE 10 Year Average18.77%43.71%23.19%105.85%10.27%40.36%-4.68%
ROIC 5 Year Average11.17%3.38%17.38%24.97%18.49%15.08%-3.77%
ROIC 10 Year Average10.91%8.97%13.37%23.54%10.22%13.40%-2.45%
FCF/Sales 5 Year Average-0.26%6.48%15.90%7.70%6.92%7.35%1.07%
FCF/Sales 10 Year Average0.80%7.10%12.86%6.70%2.26%5.94%-3.74%
Cash Conversion Cycle 5 Year Average0.781.230.91-36.35-5.24-7.92-4.18
Cash Conversion Cycle 10 Year Average0.271.14-1.22-49.02-5.21-10.81-4.53
P/B Current2.912.46.714.38.28.90.9
Insider Ownership Current0.38%6.12%0.07%0.50%1.64%1.74%6.83%
EV/EBIT Current14.259.6512.1615.8126.5315.6824.55
Debt Comparisons:
Total Debt as a % of Balance Sheet 5 year Average30.78%80.91%35.28%45.24%038.44%34.03%
Total debt as a % of Balance Sheet 10 year Average26.84%50.77%35.22%40.72%0.14%30.74%38.58%
Current Assets to Current Liabilities1.021.381.240.974.131.752.13
Total Debt to Equity1.039.690.971.602.660.81
Total Debt to Total Assets30.50%71.20%41%37.21%035.98%36.87%
Total Contractual Obligations and Commitments, Including Debt$2.6 Billion$1 Billion$27.20 Billion$11.42 Billion$2.20 Billion$8.88 Billion$1.9 Billion
Total Obligations and Debt/EBIT21.678.853.155.45.828.9813.33


As you can see from the above margin comparison, Wendy's margins are almost all quite a bit worse or at best about even with industry averages in comparison to its fast food competitors. Even if we were to exclude Wendy's absolutely horrible 2008 from its numbers, its margins are still quite a bit lower than its competitors.

Especially of note are the horrible-in-comparison-to-its-competitor’s margins: ROIC, ROE, FCF/Sales, EV/EBIT, and total obligations and debt/EBIT ratios, are all a lot worse than its competitor’s ratios. Wendy's EV/EBIT is especially inflated due to its high amount of debt in comparison to its profitability, which is why it has a comparable EV/EBIT to the much higher-margin Chipotle. My calculations of ROIC are a bit different than Morningstar's numbers and help out Wendy's a bit, but even at 5.4% without goodwill and 3.85% with goodwill those numbers are still generally quite inferior to its competitors.

About the only thing that Wendy's has in favor for itself out of the entire above table is that its P/B ratio of 0.9 is a lot lower than its competitors. A P/B ratio that low generally means that the company could be undervalued. That P/B ratio in this case is a bit of a farce because goodwill and other intangible assets make up the vast majority of current book value as just those two combine for an estimated $2.2 billion in value. After subtracting goodwill and intangible assets, tangible book value is actually negative. The $2.2 billion is actually more than the current market cap, so I think that it is fair to say that those values are probably massively overstated and may soon have to be restated or written down to a more reasonable level, thus eliminating some further perceived value and bringing the P/B value up closer to its competitors.

I also think that Wendy's debt levels and costs are too high in comparison to its profitability, as 83% of operating profit (EBIT) goes to interest expenses. Costs and other expenses, not including interest expense and loss on extinguishment of debt, take up 95% of total sales. Other expenses include general and administrative, depreciation and amortization, etc. If you include interest expenses and loss on extinguishment of debt that takes total costs and expenses over 100% of sales, which is why Wendy's recent earnings have been negative.

Pros

  • Pays a dividend and recently upped it 100%.
  • After a lot of the stores are reimaged margins should improve due to lower cap ex and higher same store sales. Of the stores that have thus far been reimaged Wendy's says they have seen 25% increases in sales.
  • Has positive net cash.
  • Has a good amount of cash on hand.
  • Same store sales have risen for 6 straight quarters and a total of 2.3% in the past 9 months.
  • Wendy's has recently paid off some of its 10% coupon debt by taking out lower interest debt, which should lead to lower interest expenses going forward.
  • Wendy's recently overtook Burger King as the second biggest fast food burger chain.
  • Owns a lot of its restaurants and the property underneath the buildings so Wendy's does hold some valuable assets in case it has some problems.
  • Just fewer than 80% of its restaurants are owned by franchisees that pay a 4% royalty to Wendy's. Collecting franchise royalty fees is a very high margin business.
  • The company produces positive FCF excluding capex.
Cons

  • Wendy's is overvalued by every one of my valuations, sometimes in extreme cases, except when including the massive amount of goodwill and intangible assets.
  • Wendy's margins overall are generally a lot worse than its fast food competitors.
  • Book value is only positive because of goodwill and other intangible assets.
  • The company has had recent negative earnings.
  • 83% of operating profit went to interest expense.
  • The company's equity has negative value after subtracting goodwill and intangible assets on various valuations.
  • The company has been buying back a lot of stock at what I think are overvalued prices.
  • The company’s debt levels and costs are too high in my opinion in comparison to its profitability levels.
  • Wendy's will have higher cap ex for the foreseeable future due to the reimagining of its stores.
  • The reimaging of Wendy's stores could be going on for at least a decade if not more as it hopes to have around 750 stores reimaged by 2015 leaving around 5,750 stores to be reimaged after that, not including new stores that are opened by Wendy's itself or its franchisees.
  • Cap ex this year has been around $225 million and will likely stay close to that elevated level for many years due to the reimagining of its stores and which should either lead to lowering or stagnating margins for the foreseeable future.
  • The company has negative FCF when including cap ex.
  • This year the company spent $126 million in cash on cap ex with the remaining $99 million coming from other sources. To me that means Wendy's will have to either increase its margins and FCF to pay the remaining cap ex costs, or more likely it will continue to have to issue debt to fund the reimaging of its stores.
  • While sales have been rising within Wendy's, costs have also been rising at about the same amount which is why margins have not been increasing much as sales have improved.
  • The company has quite a few, what seem to me questionable related party transactions within the company, including with Mr. Peltz (former Wendy's executive and current chairman) and Trian Partners the investment fund Mr. Peltz has formed with a couple Wendy's other board members.
  • Just one example of the questionable transactions is that Wendy's paid just under $640,000 in security costs for Mr. Peltz who is a billionaire and could easily pay these costs himself.
  • Trian Partners currently owns just under 25% of Wendy's and has three members on Wendy's board of directors so Trian could exert a lot of pressure on Wendy's if it saw fit to do so.
  • Due to some of the what seem to me to be questionable transactions; I do not trust management to do what is right for shareholders and to increase shareholder value.
Potential Catalysts

  • The reimaging of its stores will most likely eventually lead to margin and sales growth.
  • If Wendy's can get its costs under control, which it is trying to do now, it could achieve some margin growth.
  • In my opinion Wendy's has overstated its goodwill and other intangible assets and may have to restate or write down some of the value of each. Wendy's warns it may have to do this in its most recent annual report, which would lead to less perceived value in the company, and would probably drop the price of the stock further.
Conclusion

Wendy's has recently overtaken the No. 2 spot for hamburger fast food chains in the U.S. from Burger King. Growth in this case appears to be bad for shareholders as its costs have been rising about in line with sales which are why margins have not seen much growth as Wendy's sales have been growing. Wendy's margins are also generally quite a bit worse than its other fast food competitors. Its debt levels and costs are too high, and I do not trust its management to do what is right for shareholders.

Wendy's appears to be destroying shareholder value with its high costs and debt levels, buying back its stock at overvalued prices, and continuing to grow its restaurant count and sales but not improving its margins. Because Wendy's margins have not improved as sales have been rising, it looks like Wendy's is growing at less than its cost of capital which has led to value destruction for shareholders. The destruction of shareholder value will not reverse unless Wendy's can cut its costs and debt levels and improve profitability, which probably will not happen for a while due to some of the reasons stated above. Unless something drastic happens, shareholders of Wendy's stock can only look forward to further value destruction of their shares into the future.

Having stated all of the above I would estimate Wendy's intrinsic value to be 5x EBIT and cash valuation of $2.70 per share. Due to all of what I stated in the above article I do not think that Wendy's is even worth its reproduction value and I would not even be a buyer of the company at my $2.70 per share estimate of value.

Even if Wendy's margins and sales do rise after reimaging of its stores, which should happen, that will not take place for many years as Wendy's has only recently started to reimage its restaurants.

I hope I am wrong about Wendy's because food wise it is by far my favorite fast food restaurant. I hope it can fix its problems, and hope that it starts to thrive as a company. However, as an investment I think Wendy's is the proverbial value trap and I plan to keep my investment funds far away from the company.

About the author:

Jason Rivera
I have been investing for about 4 years and really only dedicating myself to it since February of 2012. Self taught from books, websites, blogs, etc. Value investor and special situations investor, hoping to emulate and mix the philosophies of Warren Buffett, Benjamin Graham, Seth Klarman, and Joel Greenblatt. Aspiring to build my own "personal" MBA through the knowledge I am gaining.

If you like my work feel free to visit my blog at http://vijourney.wordpress.com/ where I write about various investing topics, post my articles, list my goals, and where I have posted my investing philosophy.

If you have any comments, questions, or potential job opportunities for me please contact me through Guru Focus, through my blog above, through twitter @JMRiv1986 or at jmriv1986@gmail.com

Visit Jason Rivera's Website


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