WEN Leveraged Recap Puts Pressure on YUM

YUM remains on the Best Ideas list as a long.


Key Points

  • YUM’s balance sheet is significantly underleveraged, highlighted mostly recently by the WEN recapitalization.
  • Management must de-risk the business from its significant exposure to China.
  • YUM is significantly undervalued and has many levers to pull to enhance shareholder value.

 

YUM’s Underleveraged Balance Sheet

“We plan to take advantage of the current capital markets environment and low interest rates to recapitalize our balance sheet, targeting a leverage ratio of five to six times net debt to 2014 Adjusted EBITDA.”

–Wendy’s CEO, Emil Brolick

 

This morning, Wendy’s announced recapitalization and additional refranchising plans.  Through a leveraged recapitalization, management plans to take net debt to 2014 adj. EBITDA up to 5-6x in order to raise money and, in turn, allow them to return substantial cash to shareholders through share repurchases and, to a lesser extent, dividends.  Wendy’s shares are up more than 5% on the news.

 

In our view, this news exposes YUM’s underleveraged balance sheet in a very public manner.  A leveraged recap was a critical component of the long thesis we laid out in December in a Black Book.  The market is allowing restaurant companies to lever up to 5-6x “for free.”  BKW (now QSR) levered up to 7-8x and was rewarded handsomely for it.  In the case of YUM, all we are asking for is close to 5x, which would allow the company to repurchase ~40% of its equity value. 

 

The stock has been flat for the better part of the past three years, making it an ideal time to announce a transaction of this nature.  If management refuses to go this route, we find it highly likely that an outside force will step in to push for it. 

 

Opportunity to De-Risk the China Business

“We expect that the net result will be a reduction in Company-operated restaurant ownership to approximately 5 percent of the total system by the middle of 2016.  We believe this reduction in ownership will result in pretax cash proceeds of approximately $400 to $475 million and significantly reduce future capital expenditure requirements.”

-Wendy’s CEO, Emil Brolick

 

Wendy’s initiative to further evolve its system optimization initiative by reducing the percentage of company-operated restaurants from 15% to 5% is a stark reminder of the attractiveness of the franchise model. 

 

In particular, it reminded us of the opportunity for YUM to refranchise aggressively in China in order to de-risk the business from the recent and, likely, ongoing volatility.  Yum China represents a nasty mix for YUM – the business is under pressure and it is a significant part of the company’s overall financial performance. 

 

Not only are global asset light models are trading at a premium to the group, but it’s also an ideal time to be a seller of restaurant assets.  If you're sitting on the board, you must consider that now is the right time to pursue a transformational transaction of this nature.

 

SOTP Analysis Suggests Significant Upside

YUM is a great company, with great brands, that has dramatically underperformed its peers over the past one, three, and five years.  We believe both the external (sales trends are positive, multiples are at peak levels, strong demand for restaurant assets, strong demand for global brands) and internal (management changes, structural changes, underleveraged balance sheet) environment make for a perfect time to affect change at YUM. 

 

Despite significant global unit growth potential, high margins, significant FCF, and high returns, the company continues to trade at a significant discount to its intrinsic value – which may not last for long.  Management has a number of levers at its disposal to enhance shareholder value and must pull them – before they no longer have a choice.

 

WEN Leveraged Recap Puts Pressure on YUM - 1


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