The bullish case for WEN, as put forward by management in the company’s 10-K published last week, is summarized by the points below:
- Improving the North America (USA and Canada) business by elevating the total customer experience through core menu improvement, step-change product innovation and focused execution of its brand positioning.
- Investing in an Image Activation program for new and remodeled restaurants.
- Continuing to develop the breakfast program.
- Growing more units internationally.
Given that the Wendy’s brand has been so poorly managed over the past five years, the initiatives the company is undertaking today are, for the most part, defensive in nature as the company is playing catch-up within an industry that kept moving while Wendy’s stood still. Our point is certainly not that Wendy’s is beyond repair but we hold some serious concerns about the cost of recovery. The $3.7 billion price tag, as we have been writing since the Analyst Day on 1/30, is set to be a massive drain on cash flow over the next three years. Below, we go through several incremental thoughts pertaining to our bearish stance on Wendy’s following our perusing the 10-K filed last week. The filing offers additional insight into cost issues facing the company.
BREAKFAST STILL A TEST
2011 10-K: The newly released 2011 10-K included 438 additions to the 2010 10-K. One of the more interesting ones to us was that Wendy’s is now seeking to encourage franchisee participation in the expanding testing of the breakfast daypart.
Wendy’s will “continue to lease equipment to certain franchisees that are testing the breakfast program. At the time breakfast becomes a required program, the franchisees will be required to purchase the equipment from Wendy’s based on its then book value plus installation costs… Additionally, Wendy’s is providing loans to certain franchisees for the purchase and installation of equipment required to implement the breakfast program. The loans are expected to not exceed $25,000 per restaurant, carry no interest charge and be repayable in full 24 months after the installation is completed.”
Furthermore, for the first three years of an early adopting franchisee’s participation in the breakfast program, “a portion of franchise royalties (on a sliding scale) will not be payable to Wendy’s but will be required to be reinvested in local advertising and promotions for the breakfast program. Lastly, another addition to the annual filing states that “contributions otherwise due to The Wendy’s National Advertising Program, Inc. (“Wendy’s National Advertising Program”) based on breakfast sales will not be made but will be required to be reinvested in local advertising and promotions for the breakfast program until Wendy’s National Advertising Program begins to purchase national advertising for the breakfast program.”
HEDGEYE: It seems that the company has to offer substantial concessions to the franchise community to boost participation in what has been a prolonged testing period for the Wendy’s breakfast effort. At a time when the company is likely to be cash-strapped for the next few years, these additional obligations are burdensome. Additionally, purely by the fact that these incremental concessions seem to be necessary to convince franchisees to get in the game, is seems likely that confidence in the ability of Wendy’s to take share in the breakfast daypart is low.
INCENTIVES TO GROW UNITS IN NORTH AMERICA
2010 10-K: “Wendy’s has announced a program to encourage the development of new restaurants in the United States. Under the program, provided certain conditions are met, the technical assistance fee for franchised restaurants opened from April 2011 through December 2013 will be reduced to $15,000, and royalties paid on sales from those restaurants will be reduced to 2% for the first 12 months and to 3% for the second 12 months. After 24 months, the monthly royalty rate reverts to the prevailing 4% rate for the remaining term of the franchise agreement”
2011 10-K: “In order to promote new unit development, Wendy’s has established a franchisee assistance program for its North American franchisees that provides (with certain exceptions) for reduced technical assistance fees and a sliding scale of royalties for the first two years of operation for qualifying locations opened between April 1, 2011 and December 31, 2013. In addition, Wendy’s Canadian subsidiary has established a lease guarantee program to promote new franchisee unit development for up to an aggregate of C$5.0 million for periods of up to five years.”
HEDGEYE: That the company is now subsidizing new unit growth as well as the breakfast initiative is not a good sign.
FRANCHISEES SAYING “SHOW ME” FOR IMAGE ACTIVATION PROGRAM
2010 10-K: “Wendy’s has from time to time acquired the interests of and sold Wendy’s restaurants to franchisees, and it is anticipated that the company may have opportunities for such transactions in the future. Wendy’s generally retains a right of first refusal in connection with any proposed sale of a franchisee’s interest. Wendy’s will continue to sell and acquire restaurants in the future where prudent.”
2011 10-K: “Wendy’s has from time to time acquired the interests of and sold Wendy’s restaurants to franchisees. Wendy’s intends to evaluate strategic acquisitions of franchised restaurants and strategic dispositions of company-owned restaurants to existing and new franchisees. Wendy’s generally retains a right of first refusal in connection with any proposed sale of a franchisee’s interest.”
HEDGEYE: The current leverage on the balance sheet and the cost of the remodels will limit how many stores the company can buy. We are suspicious that some franchisees could want out at this point so the company needs to retain some dry powder to take advantage of strategic opportunities. Part of convincing the franchisees that the image activation program is viable may involve the company owning more stores and showing concrete results.
MORE NATIONAL AD FUND DOLLARS
2011 10-K: “As of January 1, 2012, the contribution rate for United States restaurants is generally 3.25% of retail sales for national advertising and .75% of retail sales for local and regional advertising. Prior to January 1, 2012, the rates were generally 3% and 1%, respectively. The contribution rate for Canadian restaurants is generally 3% of retail sales for national advertising and 1% of retail sales for local and regional advertising.”
HEDGEYE: Wendy’s still spends significantly less than the competition on advertising. Shareholders will be hoping they spend the money on an advertising campaign that resonates with the consumer.
THE MOVE TO DUBLIN IS EXPENSIVE
2011 10-K: “We expect to incur significant costs in 2012 for the closure of the Atlanta restaurant support center and its relocation to Ohio for employee severance, retention, recruiting and relocation. In addition, we may incur redundant compensation costs for staff overlap during the relocation transition. We anticipate that our relocation activities will be substantially completed by the third quarter of 2012. During the relocation transition period, we are likely to not retain the services of some experienced corporate personnel, which could distract from and adversely impact the performance of certain corporate, control and administrative functions. We expect to incur costs of approximately $23 million in 2012 for these costs.”
HEDGEYE: The move to Atlanta never made sense except to the old CEO.
A NEW INTERESTING DEBT CALL OUT (some expensive debt in a free $ environment)
2010 10-K: “Wendy’s/Arby’s Restaurants and its subsidiaries have a significant amount of debt outstanding. Such indebtedness, along with the other contractual commitments of our subsidiaries, could adversely affect our business, financial condition and results of operations, as well as the ability of certain of our subsidiaries to meet payment obligations under the Senior Notes and other debt.”
2011 10-K: “Wendy’s Restaurants and its subsidiaries have a significant amount of debt outstanding. Such indebtedness, along with the other contractual commitments of our subsidiaries, could adversely affect our business, financial condition and results of operations, as well as the ability of certain of our subsidiaries to meet payment obligations under the Wendy’s Restaurants 10.0% Senior Notes due in 2016 (the “Senior Notes”) and other debt.”
HEDGEYE: The leverage the company has is manageable but is limiting the company's ability turn the system around. The Senior notes become callable July 15th this year at 107.5 and we expect the company to refinance some debt, as was hinted at last week on the earnings call.
THE BOTTOM LINE
As we see it, nearly all of the company’s new growth programs are going to cost the company incremental earnings for the next few years. The company has yet to disclose how they are going to help finance the franchisees through the “image-activation” initiatives. Given the billions of dollars needed to remodel the system, these data points from the 10-K are not incrementally positive for the company. We believe that consensus may not be factoring in all of these issues given the current pace of same-store sales. A slowdown in top line trends will only compound the problems facing the company; we see any top-line disappointment as likely to lead to a significant decline in the stock price.