Wendy’s: Still Not Sold

by The Compound Investor

I quite like the business model of certain restaurant stocks like Wendy’s (WEN). The fast food firm is essentially a giant rent collector, albeit one in which rent is tied to the sale of hamburgers and fries. Around 95% of its 6,814 restaurants operate on a franchised basis as per the firm’s most recent 10-Q. I guess that makes the Ohio-based company somewhat comparable to McDonald’s, albeit less lucrative. The average McDonald’s outlet brings in around $2.5M each year in sales. For Wendy’s, the comparable figure is $1.4M.

In the United States – home to over 5,500 franchised Wendy’s joints – a typical franchise agreement looks a little like this. The franchisee agrees a site with Wendy’s, which then gives the franchisee the right to build and operate an outlet. The standard term is for twenty years, with ten-year renewal periods thereafter if all goes well. Once the place is up and running, Wendy’s takes a 4% cut of each month’s sales. Franchisees typically have to pay a $50K start-up fee as well.

As far as the company and its stockholders are concerned, the attraction of that set-up is pretty clear: it raises the prospects of recurring high-margin cashflows. In terms of some numbers, around $31B flowed through Wendy’s cash registers in the three years covering 2017 to 2019. The company reported cumulative free cash flow of around $0.5B during that period. When you consider that the vast majority of the costs associated with that systemwide sales number are not paid by the company, it seems like a decent set-up for stockholders.

Growth

Interestingly, the firm has actually managed to do okay this year. Global systemwide sales clocked in at $8.22B over the first nine months of FY20, an increase of around 0.5% year-on-year on a constant currency basis. Third quarter figures look even better since they obviously exclude the mayhem shutdown months of April and May. Global 3Q20 sales increased 6.1% on a ‘same-restaurant’ basis. Global systemwide sales came in at $2.98B over the same period, some 6.7% higher than in the comparable period last year on a constant currency basis. Quarterly operating profit rose to $81.3M, up from $79.3M in the comparable period last year.

The above figures strike me as pretty impressive in the year of COVID. Granted, most of the Wendy’s estate is concentrated in the United States, and the country has not shutdown to the extent of other nations. Still, to record positive growth after seeing traffic decimated earlier in the year is pretty darn impressive. The introduction of a new breakfast menu – now accounting for 7% of sales – plus digital sales via platforms such as Uber Eats helps explain things. The board subsequently re-hiked the quarterly dividend to 7¢ per share, having slashed it to 5¢ from 12¢ earlier in the year. The 28¢ per share annualized payout works out to a yield of around 1.2% at the current share price.

Still Not Sold

Wendy’s stock traded for around $22 per share when I first covered it back in January. Suffice to say, I wasn’t totally sold on the investment case back then. This was a $145M per annum profit generator trading with a market-cap of around 35x that number. That put it ahead of McDonald’s stock, which seemed underserved. Moreover, the firm still sports a net debt load of circa $1.9B as a result of a massive stock buyback program that saw it annihilate nearly 50% of the float in under a decade. Just to provide some context to that number, net debt is equivalent to over 20x annual retained profit generation here.

It is hard to believe that Wendy’s stock fell below $7 per share amid the market pandemonium back in March. The shares have since recovered to their current level of $23.17, which actually represents a circa 4% gain year-to-date. Anyway, the handful of analysts that have estimates out to FY24 have net profit coming in at 95¢ per share. That works out at a shade over management’s pre-COVID guidance for high single-digit per annum profit growth. It goes without saying, but a forward earnings multiple of 24x does’t scream value when the ‘forward’ part extends out another four years.

On that basis, I don’t see how the investment case adds up. It is certainly not superior to the one for McDonald’s, which is probably the benchmark for most investors here. The latter attains a profit tag of 24x earnings by FY22 based on current analyst projections. That is a whole two years ahead of Wendy’s. It is also more profitable, and looks set to grow profits at a similar clip. All-in-all, it just seems hard to justify that kind of premium for Wendy’s stock right now.

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