Wendy's In For A Long, Hard Road

By Stephen D. Simpson, CFA | May 09, 2012 AAA

It's hard enough to make hay competing against well-run businesses like McDonald's (NYSE:MCD), and it's not made any easier by the intense price and brand competition that goes with the restaurant industry. What makes matters even worse for Wendy's (Nasdaq:WEN) is that the company is trying to establish itself as a "premium quick service restaurant (QSR)" in a market that just doesn't seem to want to pay premium prices for hamburgers and quirky sides like baked potatoes.

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First Quarter Results not Showing the Expected Progress
Perhaps I'm being unkind, but it feels like Wendy's is always a step or two behind the market. Based on first quarter results, it definitely seems that they're a step or two behind where the stock market thought they'd be.

Revenue rose 2% this quarter, with system-wide North American comp growth of 0.7%. That was well below the 3 to 4% improvement expected by many analysts, and it's made all the worse by the fact that the year-ago comps (-0.9%) should have been a little easier to outdo. Traffic trends weren't great, and it looks like the much-discussed W burger launch has not gone well.

Not only did Wendy's miss on revenue, but margin compression continues to be a problem. Restaurant operating margin fell 160 basis points, and at 11.8% Wendy's is way behind McDonald's (18.8%), Panera (Nasdaq:PNRA) (20%) and Chipotle (NYSE:CMG). Granted, higher beef costs are taking a toll ((as seen in the earnings reports of Tyson (NYSE:TSN) and Sysco (NYSE:SYY)), but it's not as though the food cost inflation is dramatically different from one restaurant chain to the next.

All in all, reported operating profit fell 25%, with EBITDA down about 13%. With this poor start to the year, management revised its EBITDA growth outlook from 1 to 4% to -3% to positive 1%.

SEE: Understanding The Income Statement

Does Wendy's Strategy Reflect Reality?
I believe that Wendy's has made some strategic missteps that have done some real damage to the company's brand and reputation. At a time when companies like McDonald's and Yum Brands (NYSE:YUM) focused on providing as much food as possible for a buck, Wendy's tried to hold itself out as a high-end QSR option. Unfortunately, while there does seem to be a real market for "premium value," customers seem to have a different kind of food in mind - more along the lines of Panera's offerings.

I'm also a little skeptical on the company's expensive store upgrade program. Although I don't doubt management's projections for improved sales, I'm not sure an expensive program with a five to seven year payback period makes a lot of sense when there are others issues to address.

One area where I do agree with management is in its efforts to build out its breakfast offerings. This is a no-brainer for almost every QSR and can be surprisingly successful - few people had much optimism when McDonald's and Dunkin' Brands (Nasdaq:DNKN) announced a renewed focus on details like the quality of the coffee they offered.

SEE: Earning Forecasts: A Primer

The Bottom Line
If Wendy's is worth owning, it's on the premise that the company can lift its historically pathetic free cash flow conversion rate to a level more on par with better restaurants like Yum Brands. At this point, even Sonic-level (Nasdaq:SONC) performance would be a nice improvement, let alone getting to par with McDonald's or Chipotle.

Unfortunately, today's price already assumes industry-average level free cash flow production by 2017 and further upside hinges on Wendy's becoming a better-than-average performer. If you believe that's likely, Wendy's may look like a value to you today, but I can't bring myself to share that level of optimism.

SEE: 5 Must-Have Metrics For Value Investors

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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