Wendy’s is a company heading in the right direction but we would look elsewhere for exposure to the QSR category at this point in time. We anticipate the stock continuing to trade in the $4.50 - $5.50 range that it has been in for the last three years until management provides investors with clearer guidance as to the timeline for the system reimaging to reach completion.
President and CEO Emil Brolick, CFO Steve Hare, CMO Craig Bahner, SVP of Strategic Initiatives and Planning Abigail Prince, and others presented at the Wendy’s Investor Day yesterday in Dublin, Ohio. Hosting its second Investor Day this year, the company was expected to share good news and that came in the form of a preannouncement of +3% same-store sales growth for 2Q at company stores versus expectations of 1.5%, according to Consensus Metrix. McDonald’s same-store sales growth slowing has definitely been picked up by other domestic QSR chains, including Wendy’s. However, we have not seen participate in any rally in QSR stocks over the past number of years. The second chart, below, highlights the price action in the stock versus domestic QSR competitors over the past nine months; we believe that a lack of visibility on cash flow is keeping investors on the sidelines.
The Crux of the Debate
Our view remains that gaining clarity on the timeline for the system to go through the reimaging process is essential before establishing an intermediate- or long-term position in the stock. The company’s priority is shifting from dividends and share repurchases to “strategic investment” related to the brand revitalization. The company offered a timeline for reimaging 50% of the company-owned restaurants by the end of 2015 (70% of the company-owned stores need reimaging longer term) but no such specificity was offered with respect to the franchised portion of the system (~78% of total restaurant count). We see several unresolved components to this story that will keep us on the sidelines until the facts change.
Below, we address several key takeaways from the meeting:
Reimaging: CFO Steve Hare presented what, to us, was the most important part of the presentation as he offered some details around what management expects the financial implications of the reimaging initiative to be.
- 10 Company reimages in 2011, 50 in 2012, and 100+ expected in 2013
- 50% of total ~1420 company stores reimaged by end 2015 with $500mm of CAPEX during 2013-15
- Three tiers of image activation investments depending on needs/location/economics of each store
- Tier 1 = $650-700k
- Tier II =$500k
- Tier III = $300k
- The company expects annual positive free cash flow during those years
- Of 372 franchisees, 28% own 78% of the franchise stores
- Management believes that reimages may bring 25% sales lifts with a 30% flow-through to profit
This could all play out as Mr. Hare outlined but we think there is too much risk to the company’s assumptions to place capital behind them at this point in time. For instance, franchisees’ enthusiasm for the reimaging program will likely depend on negotiations between corporate and the franchise community; royalty relief and other options will surely be discussed. Recent conversations we have had with prominent members of the franchisee community have expressed concerns about the “eye-popping” numbers involved in the reimaging program. Such concerns may prolong the process. The benefits of the reimaging program, it seems, will need to be proven over a broader span of time and a larger number of restaurants before franchisees join the effort en masse. The reimaged Bethel Road, Dublin, prototype location that we visited on Wednesday night reopened its doors 10 months ago in a core Wendy’s market. While the ~$700k sales lift on the restaurant was impressive, we believe that the franchisees we have spoken to will seek further evidence that a positive yield can be expected from any investment they make in the reimaging initiative.
The next meeting between management and the company’s franchisees, in October, is the next major milestone for the long-term Wendy’s story. The support of the franchise community is important for the company to attain the benefits of the reimaging program. Management believes that when 35-40% of dominant marketing areas have reimaged the restaurants, the long-term improvement in traffic should become material.
Cash Priority Shifting: Management is changing its focus to reimaging and reinvestment in the brand.
Marketing: Wendy’s has picked up its marketing game from non-existent to evidently effective over the last few quarters and the results, of 3% positive comps in 2Q, are clear for all to see.
Stinky Carpets: Good food is important and it was encouraging to see the distinctive new offerings Wendy’s is bringing to the consumer. As Emil Brolick admitted to a group of analysts at a lunch in New York shortly after he was appointed CEO, increasing traffic in the lobby depended very much on the asset base being upgraded; essentially, (our words) stinky carpets will lessen the appeal of new food offerings. Management recognizes this and rightly asserts that the asset base should not preclude the company from leading in terms of product. We agree, but believe that the broader system will continue to struggle versus major competitors in terms of traffic until the reimaging process reaches a satisfactory run rate.
Breakfast Yet to Leave the Station: The company has a strong pipeline of breakfast products and its coffee sales have grown encouragingly (up 25% since rollout of “Red Headed Roasters”). 22% of QSR traffic occurs during breakfast and the day part represents all of the growth in QSR over the last 5 years. Wendy’s is missing out on the only rising tide in the industry and is forced to battle it out with competitors for traffic growth in other day parts. The product, for what it’s worth, seemed very competitive to us but is real estate a problem? Are the stores on the wrong side of the Street? Are franchisees going to want to roll out breakfast while so many other changes are taking place? We don't know the answer to these questions but that they persist is a concern in and of itself.
Wendy’s has a great management team that is aware of the challenges it faces. That said, this Investor Day was loaded with statements that hinge on many uncertain factors. If, for lack of available details, we conservatively assume that the average reimage will cost $500k, it would imply $2.6 billion of investment required to revitalize the franchised portion of the asset base. Reimaging remains a dark cloud hanging over the Wendy’s story and we expect the stock to remain range-bound until investors gain more visibility as to the timeline and the cost associated with this core component of the brand revitalization effort. There will be a time to get behind this stock but, for the foreseeable future, we will stay on the sidelines until we gain clarity on the company’s timeline and future cash flow generation.