Turnarounds can be interesting if the price is low enough. If you can buy a poor business at a discount to the value of a poor business - as a result of extreme pessimism or the like - that is showing tangible signs of becoming a good business, even a mediocre one, then it seems logical that you could make some money. Seahawk Drilling, one of my least favorite mistakes, qualifies as the wrong type, but a business less bankruptcy risk can be attractive. Wendy's is potentially such a business.
I hit up Wendy's every now, but when they reintroduced the bacon mushroom melt burger, which I was a fan of when they had it 5 years ago, I looked at the stock. It seemed like a turnaround that Bill Ackman had touted once upon a time was actually underway. Not only my specific experience, but Wendy's seemed to be improved the customer experience and trying to create reasons to get people in the store. The nice thing was that the stock price hasn't really moved since then as the turnaround in product offerings and operations has been dealt the blow of hard economic times and food commodity inflation.
Nelson Peltz and Peter May are the guys behind the turnaround at Wendy's. This appeals to me because they can be financial engineers if you go back in their history (National Can) but their focus over the past decade has been activist investing in a way that builds real value. They push for improvements in leveraging the brand and margins. They've been successful at Heinz and Tiffany's. The extent of their recent financial engineering was agitating Cadbury to spinoff DrPepperSnapple. They aren't activists per se at Wendy's since they basically control the company. The corporate structure is that of the former Triarc parent because Wendy's was acquired in a reverse merger with the smaller company taking over the bigger one. Peltz's hedge fund, Trian, has been kind enough to lease the private jet and prior office space from Wendy's. Wendy's still pays for insurance and calendar maintenance on the jet since they own it. Trian should have bought this outright. This ticks me off but it won't make or break an investment.
Wendy's has so far under delivered on expanding the store margins, but this is probably due to a weak economy and commodity prices. There has been an uptrend since 2008 despite all this, although 2011 has been pretty bad due to commodity costs. So far, 2011 has been bad for margins. Prices fluctuate, but it seems like part of the pessimism over the stock lies in continued commodity pressures. A case for optimism might be made since 40% of the corn crop is used for ethanol and the government may or may not be coming around the insanity of this proposition. The company has the system in place to get at least a couple points in margin improvement once commodity costs come under control.
The company is also under represented internationally. They are taking steps to get franchisees abroad and seem to be doing a decent job knocking off country after country with franchising deals. This will increase the high margin, high return royalty stream. This is happening as more deal are being signed and the first restaurants in new countries are beginning to open.
The rollout of breakfast is a catalyst for the stock as it would provide a ~10% boost to sales if the $150k+ in additional unit sales projection is to be believed. That's less than 100 customers buying $5 worth of breakfast stuff daily or 17 customers/hour if breakfast is served 5am-11am (even less on a transaction basis, ex. 2 construction workers on their way to a site). This is reasonable assuming they do a good job with the rollout. Management has also claimed people have been ordering burgers in the morning where breakfast hours have been rolled out, so maybe the breakfast products don't have to be all that successful.
Like I said, there is a lot to like about the company. It is taking steps in the right direction that I would expect of a fast food restaurant to improve its brand and operations. This is the problem though. The business model (franchising) is a great business that generates tons of cash flow. Naturally it is a fiercely competitive field. That McDonald's is easily the most swaggering it's ever been in its history creates a very steep obstacle to overcome. There is plenty of room for McDonald's, Wendy's and plenty others to exist.
The problem is that I think a lot of the bull case for Wendy's is based on them replicating McDonald's. This may very well be the case. The problem is that McDonald's is an 800 lb. gorilla because as the largest of the pack, it can stomach the commodity pressures the best, and if Wendy's or BK raises their prices on the menu - especially value menu - then price conscious people will just go to McDonalds, increasing their volume, and reinforcing their advantage. McDonald's is still increasing sales and has higher margins currently than Wendy's is even targeting. This is a wide gap to overcome, all Wendy's would be very valuable were it to successfully accomplish this.
Breakfast strikes me as the hardest segment to gain momentum in simply because less people eat out for that meal, let alone eat it in the US. Wendy's doesn't have breakfast mindshare and isn't in people's routines. Burger King - maybe for reasons not having to do with mindshare (PE deal maybe) - has not been effective in rolling out breakfast. Products aren't the only thing that need to be strong, but service as well. Breakfast isn't a slow, casual time for most people, so one bad experience waiting 15 minutes in a drive thru line could scuttle a location's hope of gaining traction in breakfast. McDonalds has a really strong breakfast offering - their coffee offering is highly regarded by Consumer Reports and has the most loyal coffee consumers. On the downside, Wendy's franchisees will be annoyed and reluctant for further change if breakfast is a flop after they had to purchase additional equipment. While Peltz's influence would make me lean towards conceding that breakfast has a good chance on succeeding, Wendy's isn't arriving early to an untapped market.
Any company that is in the process of a turnaround, even if its headed by a guy like Peltz, means an investor needs a margin of safety. Despite giving the impression that I think McDonald's torpedoes the entire turnaround, I don't think that. I think the valuation torpedoes the idea of investing in the turnaround with a margin of safety. Wendy's doesn't even have to be half of as good of a business as McDonald's in order for it to be an attractive business. It would have to be half of its valuation to be a good investment though. I would own an underperforming business at a low valuation that has identifiable reasons why the business can perform in the future. Even a turnaround of a poor company can be a good investment if you buy it at the right price and there are some signs that margins and profits will improve (SVU or WINN come to mind as potential candidates in that category).
Since people seem fond of the WEN/MCD comparison, WEN trades at 9x EV/EBITDA (their proforma TTM EBITDA and EV based on Q1 post Arby's sale) and MCD at 11x. While that may appear to already be a discount, WEN's Debt/EBITDA is ~4x while MCD's is only ~1x. Just focusing on capital structure, the large amount of debt on Wendy's balance sheet is deserving of a discount. This is nothing to say the premium MCD deserves for consistent top and bottom line growth, strong international presence, and higher margins. They also return almost all their FCF in the form of buybacks and dividends. Just to throw in one more comparison, YUM has many of the same characteristics of MCD give-or-take - you might say inferior brand, I say the amazing success in China. YUM also trades for about 11x EV/EBITDA and its debt/EBITDA is less than 1x.
The problem using an EV/EBITDA multiple is that even if the net debt is well below the gross debt, they still have to pay interest on the gross debt. There is a decent amount of cash flow to cover the interest in addition to cash. Even if the debt load is entirely serviceable, the cash used to do so does not accrue to shareholders. If the company fails at turning itself around, the debt load starts to look like more of an issue. They could halt capital expenditures and pay off the debt in 4-5 years with FCF, but that is assuming the business doesn't deteriorate. They could pay off some debt for 2-3 years to make it more manageable, but that would still give rivals time to take advantage. The debt load will be less of a knock if the business improves to consistent growth and more profits. While not the only sticking point, the debt requires an investor to demand a greater margin of safety and have greater confidence than usual that the company is being turned around.
To use a metric that actually looks at what a shareholder gets in terms of cash flow, I prefer owner earnings or FCF. I'm having a hard time pegging their FCF because of the Arby's numbers, but maintenance capex is probably around the levels it is at now and approximately depreciation - $145m for 2011. They are going to be revamping stores for the foreseeable future. Taking their TTM pro forma adjusted EBITDA for Wendy's of $328m and using $110m in adjusted interest and $145 in capex/depreciation results in $73m pretax and $51m in FCF. This is not a bargain and FCF really needs to boom for the valuation to make sense. If they get the recipe right - capex trails off, sales grow, margins widen, international gain traction, debt paid down - then the company could easily rack up $200m in FCF in a few years and be worth more than it is today. It begs the question though, why would you pay 11x 2015 FCF for this business? Is it that predictable or the downside that limited?
I would look at the FCF the company generates above all else because the company needs to revamp all its older stores if it is going to start to even remotely resemble just the sales growth of McDonalds (to say nothing of margins). On top of the capex, the interest payments mean that EBITDA is a very separate figure from which equity owners will benefit. Companies with plenty of debt can still generate tons of FCF. Maintenance cap ex would imply what the company could spend and still maintain it's position. Sales are declining or bobbing around the same number right now, so I don't know what the figure for zero change in sales is, but they need to spend money to at least ring up consistent sales even if the capex results in sales growth (implying it wasn't maintenance capex). If they invest their cash pile in the stores and distribute cash along the lines of EBITDA-tax, the EV/EBITDA calculation gets a huge boost in the wrong part of the equation for shareholders. It increases the net debt and raises the hurdle to overcome for earnings.
The market is already rewarding Wendy's with a reasonably high multiple since the QSR franchise business is a typically a high ROIC and FCF business. Wendy's is still a ways off from replicating McDonald's success. They have to remodel tons of stores, fire up sales growth, keep expanding margins, and solidify a strong international presence. One could play time arbitrage and just wait, but it looks contingent on Wendy's becoming another McDonald's, which seems hard to do. At best, a Pepsi to their Coke - although Pepsi is still a valuable business. Wendy's has a slightly inferior brand in terms of positioning and intangible value than Heinz ketchup (old Malcom Gladwell article on ketchup) or the Tiffany's box. I would caution people against following the McDonald's narrative or the past Peltz activist narrative when reading the tea leaves about Wendy's. I don't predict armageddon, but the valuation doesn't offer a margin of safety.
Please share dissenting views.
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