We’ve outlined our concerns about Wendy’s cash flow, given the years of intensive capex required to fix the system, since the analyst day back in January when the price tag of the turnaround ($3.7 billion) was brought to light.
Thoughts on the Quarter
We expect fixing the Wendy’s system to take another two years. Years of deferred capex has turned the company’s store base from an asset into a brand liability. It has taken CEO Emil Brolick the better part of a year to get the upgrade cycle going. As things stand, the vast majority of the initiative remains to be done. The company is working frantically to reimage stores in order to produce data and assure the investment and franchisee communities of the initiative’s viability.
The desire to demonstrate results is a positive but, on the other hand, it also implies an accelerating pace of spending and an increasing risk of earnings misses. Yesterday’s earnings announcement was mixed, at best, as operational metrics came in light besides same-restaurant sales. This company, by any conventional measure, is not producing free cash flow and likely will not for the next two years.
The comps during 3Q have vindicated management’s recent introduction of new menu items to increase consumer appeal. However, Brolick has emphasized the long-term importance of the asset base upgrade for gaining full credit from consumers for the upgraded menu. Where same-restaurant sales are in the fourth quarter is the key question for investors as the company laps the introduction of the Dave’s Hot ‘N’ Juicy Cheeseburger in October 2011. It is a strong possibility that comps are negative in 4Q with consensus expecting +1%.
Nothing Better To Do With Cash?
The biggest concern from the earnings release, for us, was the doubling of the dividend and a new $100 million share repurchase program. The board seems to be throwing money at the stock in order to support the share price which has been flat-lining for five years now. An owner of the stock yesterday was happy to learn that the dividend was going higher but the truth is that the company does – or should – have a better use for its cash.
Near-Term Uncertainty for Franchisees
Management announced a franchisee incentive program to get the larger, better-financed franchisees on board with the reimage program. As an observer, it’s difficult to know how the impact of these initiatives will play out over the near- and intermediate-term. As management has alluded to, the transformation of the Wendy’s brand will involve substantial turnover among the franchisee base. The journey from “mom and pop” franchisees to “mega” franchisees will, we believe, have a positive impact on the long-term health of the Wendy’s system. It is worth bearing in mind, however, that these transitions rarely occur without a hitch.
There are other factors, on the macro and micro level that are adding to franchisee blood pressure. On the macro side, Obamacare, commodity prices, and the fiscal cliff and its myriad possible consequences from a tax and economic perspective are weighing on the minds of operators. On the micro level, there has been some discontent among smaller franchisees at the level of investment required of them to partake in this (largely unproven) reimage initiative.
While we believe management can allay the micro-level concerns, the macro issues are unknown but could be especially meaningful for a company, like Wendy's, that is in transition. Our industry contacts continue to state that the implementation of Obamacare will be a negative for the restaurant industry. Franchisee communities which operate on thin margins, like Wendy’s, are particularly vulnerable.
The Latent Risks of the Franchised Business Model
In June, we held a conference call with John Hamburger of the Restaurant Finance Monitor and discussed the general perception of franchised companies as stable cash flow generators and the premium multiple that investors award the stock of such companies. Shares of BKW, DIN, DNKN, MCD, WEN, YUM & DPZ are some of the most richly valued in the restaurant space.
It makes intuitive sense to award a higher multiple to the shares of franchised companies but an important caveat is the prospective health of the constituent franchisees. Yesterday, Wendy’s stated that the impact of the healthcare overhaul will be “less than” (read: “around”) $25,000 per store. Assuming the company-franchise mix of ownership remains as it is, we calculate that Wendy’s could be facing a $0.10 hit to earnings per share. Given the company and franchisees’ need to reinvest in the business, it is important to look at the impact on franchisee cash flow. The impact of this new cost may amount to as much as 18-20% of store level cash flow for a ten-unit franchisee.
The looming impact of this, and other risks, is adding a real sense of urgency to the Wendy’s reimage initiative. For those taking a shorter-term view of the stock, accelerating spending during such an uncertain time implies a higher risk of earnings disappointments.