As the investing world continues to embrace indexation, it assists us in sourcing truly attractive investments in areas that are structurally overlooked (or created) by the mainstream. Wendy’s, a relatively recent purchase and significant holding, is one example.
The Wendy’s Company (WEN) has long been unloved. It is the world’s third largest hamburger-oriented quick service restaurant (“QSR”), behind McDonald’s (MCD) and Burger King (BKW). A common criticism is that it has chronically underperformed its larger peers in many key areas, particularly profit margins. Accordingly, the company “screens” poorly by nearly every quantitative measure of business performance and valuation. The stock price was essentially unchanged for 2010, 2011, and 2012. Although it has almost doubled during the past year, it is lower now than it was over 10 years ago, in 2003. However, many of our most successful investments over the past two decades have been in companies that, like Wendy’s, underperform their competitors. Operational/financial underperformance is, in fact, an opportunity, if the underlying business is fundamentally viable and an actionable plan exists to improve operating performance.
Wendy’s operating results are clearly deficient: the company’s cash operating earnings margin (before interest, tax, depreciation, and amortization) (“EBITDA”) of 14.1% can be compared with the McDonald’s and Burger King Worldwide restaurant-level margins of 35.9% and 56.4%, respectively. Yum! Brands (YUM) averages a lower margin through its KFC, Pizza Hut, and Taco Bell restaurants, but at 20.9%, it is nevertheless almost 50% more profitable than Wendy’s. One of the several reasons for Wendy’s deficiency here is the ratio of franchised restaurants to company-owned stores. The franchisee in the QSR industry typically pays 4% of gross store revenue to the parent company, the parent only being responsible for corporate overhead and limited marketing costs. Thus, this 4% revenue is a very high margin business, over 80% for both McDonald’s and Burger King Worldwide. Company-owned stores not only require much larger balance sheet commitments, but also have much lower margins that seldom exceed 20%. Only about 82% of Wendy’s stores are franchised, compared to nearly 100% at Burger King Worldwide.
The franchise/company-owned mix is not the only factor impairing Wendy’s profitability; at 1%, the company also has nearly no locations outside of the United States. McDonald’s and Burger King generate 69% and 42% of company revenue outside of North America. The mix is even higher for Yum! Brands, although this figure is inflated due to a concentration of “strategic” company-owned stores in international markets.
The untapped potential for Wendy’s is readily apparent, and although this is beginning to be recognized (i.e., the shares increased 85.5% in 2013), one can observe that considerable upside remains. Wendy’s currently trades at approximately 11.8x 2013 EBITDA, compared to 10.7x for McDonald’s, 18.0x for Burger King Worldwide, and 13.3x for Yum! Brands. The modest relative multiple assigned to McDonald’s likely reflects recognition of the market saturation that the company has achieved worldwide. Burger King Worldwide, on the other hand, has recently re-emerged as a public company after having been taken private by the esteemed private equity company 3G Capital Partners, in 2010. The current company strategy is “asset light,” as evidenced by the minimal proportion of company-owned restaurants, and is focused on international expansion (42% international revenue mix in 2013) and paying down its debt. The inflated cash flow multiple is likely in recognition of the company’s strategy and its value-oriented private equity management team. Yum! Brands also has market saturation issues to contend with, yet the high cash flow multiple may reflect the company’s early-mover status in entering various emerging markets.
Wendy’s, on merely the two sub-par ratios (franchise/company-owned store mix and absence of international presence) has superior margin and revenue expansion possibilities relative to all of these peers, yet trades at a multiple that fails to reflect this fact. Moreover, the methodological approach, popular though it is, of comparing a company’s earnings multiple to those of its peers is an error in this case. After all, with an EBITDA multiple of 11.8x, does Wendy’s seem so very much cheaper than Yum! Brands at 13.3x? The problem here, as mentioned at the beginning of this discussion, which is also the opportunity, is that the current earnings are irrelevant in this instance. One must estimate what the normalized Wendy’s earnings will be at the conclusion of its program to rebalance its franchise mix and refurbish its out-of-date stores, which is a third major factor in its valuation. That project, described below, will be a four year process at a minimum, with an important cross-over point in about four years. But Wall Street consensus earnings estimates only go as far as next year.
Accordingly, standard-time-horizon investors are unlikely to be holders of Wendy’s shares due to the lack of a tangible short-term catalyst for value realization. While it is true that there is no short-term catalyst, there is undoubtedly a catalyst. Nelson Peltz, and Peter May, along with the investment fund that they control (Trian Fund Management, L.P.) currently hold over 23% of Wendy’s shares, and Mr. Peltz acts as non-executive chairman. These two investors have extensive experience in the food and beverage industries, beginning with a 1993 activist investment in Triarc Companies (“Triarc”), which owned Arby’s franchises and Royal Crown Cola, amongst a variety of other businesses. Subsequently, through Triarc, they acquired Snapple Beverage Corp. in 1997 for $300 million, only to sell the business for a $480 million profit just three years later, after having fixed some of the management and structural problems that Snapple suffered under its prior corporate owner, Quaker Oats. Ultimately, Triarc merged with Wendy’s Corporation in 2008, creating Wendy’s Arby’s Group; however, the name was changed back to The Wendy’s Corporation in 2011, after the sale of the majority of the interest in Arby’s. A cursory review of the investment and operating history of Messrs. Peltz and May, even exclusive of the Snapple coup, reveals their capacity for exceptional shareholder value creation.
Beyond the international and franchise model initiatives at Wendy’s, management is also focused on repositioning the brand within the QSR market. This primarily involves “reimaging” stores, which essentially refers to a company-wide model to follow for modernizing stores, some of which are over 25 years old. The initial investment costs vary depending on the requisite work, but a successfully completed test period indicates 10-20% sales lift for reimaged stores, and a 25-35% increase for “scrapped” and rebuilt stores. The profit flow-through of each strategy is expected to be 40%.
However, this process is in its early stages, such that the enhanced profitability of the newly reformatted stores will be obscured by the incentives and financing that Wendy’s will provide to induce additional franchisees to participate during this phased program. The cost per store can be $0.5 million or higher. Management intends for 85% of the company-owned stores to be updated by 2017, amounting to 35% of the overall Wendy’s system. It can be presumed that the full profitability of this transition will not be reflected in the financial statements until 2018. There will come an important cross-over point when more stores will have been reformatted than those that remain, such that the latent profitability of the program will become more apparent in the financial statements.
Concurrently, Wendy’s is also engaged in a “system optimization” strategy aimed at selling 425 company-owned stores, completed a few weeks ago, for proceeds of $325 million. The incremental cash facilitated a $275 million share repurchase program, for 7.5% of its shares, completed earlier this year.
In sum, there does not appear to be any natural impediment to Wendy’s being able to achieve a profit margin closer to those of its major competitors, in which case profits could be 50% or 100% higher. It is now executing a tactical and strategic set of plans, under the direction of two activist owner-operators, to correct its deficiencies. There are several levers and sources of earnings expansion, which jointly can be very powerful in success mode, and one of the sources of return is simply the operation of the equity yield curve: that however successful the financial outcome might be, it will be too far in the future to be relevant to most investors and, thus, that as-yet-unrealized success is excessively discounted in the present.