WEN – NOW A HEAD SCRATCHER

Given that Trian controls the company, I initially came to the conclusion that the use of proceeds from the bond offering will be used to pay a special dividend. Why? It's a classic move by a private equity firm that wants to get paid. While a dividend is still possible, it's less likely. If they do end up paying a dividend, it would be a long-term negative and would limit the operational flexibility of the company.


Without fully understanding the use of proceeds, the offering is likely dilutive annually by $0.04-$0.05; the announced $550 million of unsecured debt will likely carry a coupon of approximately 9%. To answer the question as to why do an offering now, Andrew Barber's June 12 post titled "RATES, VOLATILITY AND LINES IN THE SAND" provides an interesting perspective. It's probably because they can - the credit markets are open and it might not last. As Andrew pointed out, "In today's environment, the reality for mid and lower grade issuers is simple: they are simply taking liquidity whenever and wherever they can find it after a long drought, and are likely more focused on their cash needs in 2 months than prevailing rates in 2 years."


Given this thought and the background of the principles at Trian, speculation is rampant that WEN is going to make an acquisition. I guess it could, but an acquisition would be viewed as bad for the stock; this partially explains why the company traded massive amounts of volume last week. Right now WEN is a turnaround story; the company needs to fix what it has before it takes on another concept.


I view an acquisition as unlikely and of course, the company line is that there is "nothing imminent." The biggest opportunity for WEN is to fix the margins on its current assets. Layering in a dual brand at Wendy's to help breakfast and or dinner sales are a very complicated process and are a very high risk proposition.


Importantly, it could take years to have an impact on profitability. Every dollar of capital the company has needs to be reinvested into fixing the existing asset base. This management team needs to prove to the street that it can execute its current business plan before the street will accept additional risk.


In the minds of senior management it's not a question of whether margins can be restored, but instead, management is confident they will be fixed by 2011. With margins being fixed in two years time, management needs to be thinking now about restarting the organic growth engine by that time. Organic growth for WEN is going to come from domestic and international unit growth, dual branding of the Wendy's and Arby's brands and growing the breakfast day part. None of this will come easy and there will be skeptics about the company's ability to grow internationally, but the planning process needs to start now if it going to be in the 2011 business plan.


I am very skeptical about WEN's international opportunities, given that I have witnessed the company fail multiple times. The excuse provided for the company's failure to execute internationally in the past was not bad management, but failure of the brand to perform at the same level as it does in the United States. That being the case, there is no need right now for massive amounts of capital to fund the international growth initiatives. Aspects of these growth initiatives are in contrast to the company's cost cutting story as they require "infrastructure investment" to lay the ground work for growth.


Absent of buying a "breakfast" concept, there is no need for capital beyond the company's current capabilities to grow the breakfast day part. In the short run, WEN will be replacing the horrid Folgers brand they are currently selling by testing new products that hopefully will resonate with consumers. While there are huge opportunities for breakfast within the Wendy's system, the concept's real estate strategy never contemplated selling breakfast, leaving some units incapable of executing the daypart properly due to poor locations.


WEN needs to upgrade its asset base, particularly Arby's, but this needs to be done systematically. Remodels are not easy to execute and need to be done in a thoughtful way that enhances returns. Not all remodel programs are created equal and WEN does not need a war chest of cash to do this.


Lastly, we can't rule out buying back stock. Adding leverage to WEN's balance sheet just to give the money back to shareholders is a big mistake. Leveraging up the balance sheet WILL NOT create shareholder value and limits the company flexibility to navigate a difficult environment. The money WEN is borrowing is not cheap and needs to be reinvested in a way that will generate incremental returns to shareholders. Right now, it is difficult to see where the ROI is going to come from.


The uncertainty of the debt offering throws into question the direction of the company. WEN's business plan had relied on a cost cutting strategy to fix margins by 2011, but the company's decision to raise capital to fund future growth initiatives goes against that very strategy. Same-store sales trends ate stagnant, and there is limited visibility to what is going to put Wendy's products and marketing initiatives on the map. Arby's is also suffering from a consumer identity crisis.


Despite the fact that senior management feels comfortable working with Peltz and team, the recent services agreements reek of corporate excess in a challenged economic environment. This relationship only adds to the discounted valuation the company is currently getting.


Trading at 6.4x NTM EV/EBITDA, WEN is undervalued relative to its global restaurant peer group trading at 9.0x NTM EV/EBITDA but is trading in line with its small-cap domestic peers. Roland Smith and team now have a bigger hurdle to leap to gain confidence that they can execute on a business plan that creates value for shareholders.

 

 


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