WEN – NOT A GOOD QUARTER BUT UNDERLYING VALUE IS REAL

Wendy’s/Arby’s reported a disappointing quarter this morning.  Significant upside remains with the sale of Arby’s being the most important catalyst to this effect.

Wendy’s/Arby’s reported a poor quarter this morning.  Consolidated EPS came in at $0.01 ex-items versus consensus $0.02.  System-wide comps for Wendy’s came in flat versus consensus at +0.3%.  Arby’s North America system comps came in at +5.5% versus expectations of +2.1%.  1Q restaurant operating margins at Wendy’s and Arby’s were +13.4% and +10.6% versus consensus of 14.6% and 11.5%, respectively.  Arby’s has been on the block since January so, accordingly, much of the focus coming into the quarter was on the performance of Wendy’s.  MCD printing a strong first quarter was possibly a hint that comps could be disappointing and they were: Wendy’s company-owned comparable restaurant sales, in the first quarter, contracted -0.9% year-over-year.   Consensus was looking for +0.4%.  As the chart below indicates, Wendy’s company-owned comparable-restaurant sales still registered a sequential improvement in two-year average trends from 4Q10 and April is comping at +0.5%. 

WEN – NOT A GOOD QUARTER BUT UNDERLYING VALUE IS REAL - WEN wen pod1

April 2010 saw Wendy’s company-owned comparable restaurant sales decline 0.50% which, given the overall 2Q comp, implies that there was a significant fall-off over the following two-months in terms of comparable restaurant sales.  With this in mind, I would expect 2Q11 to come in closer to +2.5% to 3%.  Management reiterated FY11 guidance of +1% to +3% comparable sales growth at company-owned Wendy's restaurants.

Restaurant margins were a pressing concern coming into the quarter and the results showed that beef costs severely impacted margins at both WEN concepts.  As I wrote above, restaurant margins missed by 120 basis points and 90 basis points at Wendy’s and Arby’s, respectively.  At Wendy’s, the 200 basis-point year-over-year decline in margins was attributable to incremental advertising to introduce Wendy’s new breakfast in new markets and 80 basis points due to higher commodity costs. 

The overall commodity basket is now forecasted to grow 5-6% in 2011 due to an increase in beef costs of 20%.  In March, the company had guided to total commodity inflation for 2011 of 2-3% on the back of beef cost inflation of 10-15%.  Along with this revision, management has revised its EBITDA estimate for 2011 to be in the $330-340 million range versus the previous range of $345-355 million.  While management has stressed that 2011 represents a “transition” year for the company, it is clear that WEN is going to suffer more than most through the inflationary environment in 2011. 

WEN – NOT A GOOD QUARTER BUT UNDERLYING VALUE IS REAL - live cattle

Looking forward, two things stand out.  The first is the outlook for Wendy’s and the second is the sale of Arby’s – a move I have advocated ever since the acquisition (which I opposed).  Wendy’s is introducing Dave’s Hot ‘n’ Juicy cheeseburgers in the second half of the year.  Currently in seven test markets, WEN has high hopes for this launch as they see significant increases in hamburger unit sales.   Overall for 2011, I expect the commodity environment to pose a strong headwind for the company but the increased focus on the core menu, complimented by an increased focus on Wendy’s following the sale of Arby’s, should bring about significant progress at Wendy’s.

The sale of Arby’s was a welcome progression in my eyes and one of the main factors that convinced me that management means business in this particular turnaround effort.  The primary benefit of a sale would be management’s undivided attention being dedicated to Wendy’s.  Secondarily, the sale would deleverage the company’s balance sheet.  The $200 million of capitalized lease obligations on Arby’s balance sheet would be off the company’s books and this, along with the cash proceeds from the sale, would afford the company increased financial flexibility going forward. 

The 300 basis point upward revision in commodity inflation expectations is weighing on earnings potential for the year but the overall transition to a more focused and profitable company seems on track.  As Wendy’s new menu items continue to gain traction, management becomes more focused on operations at one concept, and the company has a healthy balance sheet to enable it to invest in the brand, I expect WEN to be a top-performing QSR stock over the next couple of years.

Howard Penney

Managing Director