The Wendy's Co. (WEN, Financial) is a highly leveraged quick-service restaurant business that has been an investor favorite for years. The company has grown its presence to approximately over 6,000 restaurants all over the world and generated good profitability, providing fantastic returns to equity shareholders. Not only has the stock appreciated wonderfully, but the company has paid good dividends and carried out regular share buybacks.
Recently, management delivered a good quarterly result, and it wonderfully handled the issue of rising labor costs through an increase in food prices without affecting same-store sales. There has been a strong positive sentiment around the stock that had pushed to unreasonable valuations.
International expansion with the franchise model
Wendy’s is on track to reach its goal of having 7,500 restaurants globally by the end of 2020. The management already has long-term agreements with franchisees in the Middle East and North Africa, Russia, Argentina, Japan, Chile, Ecuador, Azerbaijan and Georgia. They are exploring the possibility of expanding Wendy’s reach to other emerging economies like the Philippines, China and Brazil.
The franchise-based business model coupled with regular innovations in the menu and new restaurant openings are the reasons for the improving profitability and the strongly positive market sentiment in favor of Wendy’s. The company has doubled the number of franchisees since 2015. Recently, management has been aggressively trying to expand its franchise base in Canada, a country where 100% of its restaurants are franchises.
New initiatives – more kiosks and a greater focus on digital knowledge
In terms of new initiatives, the management is making a strong push for kiosks across its restaurants, just like its stronger rival, McDonald's (MCD). Also, the company has engaged Yext (YEXT) for the use of its Knowledge Engine in order to have a greater control over its brand experience. The digital knowledge provided by the platform will help Wendy’s in managing various aspects such as the different menu items available across its restaurants, the nutritional information of these items, the hours of operation of each restaurant, and so on.
High leverage and high valuation ratios
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If we analyze the one-year chart of Wendy’s, we observe that the price has appreciated well and has factored the impact of the good results and management’s growth initiatives. The stock has a strong support at the level of $16, but it does not seem to have a near-term catalyst that could push it to new highs.
From a financial viewpoint, the biggest risk lies in the high leverage of the company. Wendy’s has a debt-Ebitda ratio of 7.43, which has worsened as the debt levels have gone up faster than the Ebitda. Also, the debt-equity ratio of 6.51 is on the higher side.
There is no doubt that the high margins inspire the confidence of investors. Per GuruFocus data, Wendy’s has an operating margin of 19.2% and a net margin of 15.87%, which are not only above most industry peers but are also higher than the results Wendy’s used to deliver a few years back. There is certainly no doubt that the management has done well in terms of margin expansion.
But the valuation ratios indicate that the upside associated with these high margins has already been taken well into account. The company is trading at a price-sales ratio of 3.01 and a forward price-earnings ratio of 25.71, which are both higher than its competitors. The EV-Ebitda of 17.57 is also on the higher side. Itt can be concluded that Wendy’s is not a cheap stock. The high leverage also makes it riskier and is one of the key reasons why Gurufocus has a 1-star Business Predictability rank on the stock.
Conclusion
Currently, Wendy’s stock is a double-edged sword. On one hand, the company has good fundamentals, strong growth in franchises, innovative practices by the management and an excellent history of shareholder returns. On the other hand, it is trading at high valuations, has a very high leverage and a possibility of low future free cash due to upcoming capex.
The biggest risk lies in the fact that the stock's appreciation is highly dependent on the discretionary spending, and one poor quarter with a slightly weakened guidance could send the stock price crashing down. The additional capex associated with the management's re-imaging program is expected to reduce free cash flows in the short term, which might be risky given the high leverage.
Overall, it can be concluded that Wendy’s is not for the risk-averse given its current valuations and its leverage.
Disclosure: No positions.
