Context
During my initial analysis of Wendy’s (NASDAQ:WEN) I examined a wide range of relevant operational and financial aspects. Since then, I have noticed some interesting developments in both the industry and its ’70/30 Expansion Strategy’ that I would like to share with you. But first, I would like to introduce some important context regarding the current QSR landscape within the American market.
One of the key points of the industry is crystal clear: guests are more price sensitive and are demanding value meals. This trend is being seen in both QSRs and FSRs. It turns out that there are two dynamics that differentiate these two segments.
The first is that for the past ten years, QSRs have been increasing menu prices at a rate that is more than twice the inflation rate over the period. I have already discussed this topic extensively here. Very interesting research, such as the one by FinanceBuzz, has already been published on this subject during the first quarter.
The second is that it is natural for QSRs to be much more dependent on low-income guests. When these guests stop eating out or switch to convenience stores or grocers, limited-service restaurants need to somehow make up for them. It turns out that this rapid price increase was already one way for limited-service restaurants to keep comparable sales stable or rising during a period when low-income guests were not eating out. This is evident in the following chart:
Note that both full-service and limited-service restaurants were increasing the average check to maintain some stability in comparable sales more strongly during 2022. 2023 was a turning point. Since the first quarter, guests were resistant to increasing their average check because they were fed up with having to pay higher menu prices. The increase in the average check has been declining until it remained relatively stable in 2024. At current levels, many restaurants are not able to compensate for weak traffic with a higher average check.
This reality can be translated into the recent survey conducted by the National Restaurant Association:
Note that throughout 2024, most restaurants claimed to have had negative comparable sales during every month. This is a reality that restaurants need to learn to live with, even when we take into account operating costs (especially labor costs) that have increased considerably. Especially in California, after the Fast Act made things more complex there in April.
With consumers becoming more price-sensitive, the traffic game is becoming more dependent on value promotions than ever before. This is a common paradigm for both QSRs and FSRs. A well-established promotional mix and a value proposition based on attractive pricing can be the key to driving traffic up (or, as seems to be more common, losing less of it). I say this because Black Box research found that during the second quarter of this year, the industry’s top quartile in traffic grew by 2%. If you recall in previous fiscal years, that was pretty mediocre growth.
Last month, I wrote about how some restaurants are successfully driving traffic through their value promotions. I cited examples like McDonald’s (MCD) $5 Meal Deal, Chili’s (EAT) 3 for Me, Buffalo Wild Wings’ (BWLD) new LTO of unlimited chicken wings for $19.99, and Starbucks’ (SBUX) Rewards Friday promotion. It turns out that sometimes, when these promotions are short-lived, we see rebound effects in traffic after the promotion ends. In addition, many locations are not prepared to handle peak times.
We saw this at Starbucks during the second quarter. Despite its Menu Pairings and 50% off Friday promotion, the company saw a 6% decline in traffic, even though it had four consecutive Fridays with much higher than normal traffic in May.
Looking at our main subject, Wendy’s, we see that even with a decline in comparable sales, signaling a reduction in traffic, it’s natural for almost all limited-service restaurants. And this is a big deal. Wendy’s has had a very balanced promotional mix for a long time. The ‘Biggie Bag’ is already top of mind for guests, which significantly reduces the advertising spend that is drying up some restaurants’ profits. They are introducing a value meal, and to generate appeal, they need to spread the word.
Picking up where I left off in my last analysis “Wendy’s: I Continue To Await New Developments From 70/30 Strategy”, we can see tangible developments regarding the international expansion that management was talking about. In addition to a clearer profile of the average consumer and what they prioritize in a restaurant.
An important addendum before we begin. The aspects related to financial structure and more complex corporate finance issues that I mentioned in the last article are still very relevant. I will focus here on the most recent developments and less on the company’s structural patterns. Just for the record, despite being high, Wendy’s debts are under control based on the company’s ability to pay and generate returns on debt.
In addition, I mentioned some problems with the company’s profitability on invested capital. Here we have some problems concerning the receivables cycle that are not worth dwelling on for now. I will prefer to wait for the annual balance sheet. Otherwise, I reaffirm here that I do not see any structural problems in the company. Having said that, let’s continue.
Despite growing more than its direct competitors, it still fails to outperform the industry
First, let’s see how comparable sales have performed for Wendy’s and its main competitors within the limited-service restaurant segment:
Given the lack of more recent data from the other companies in the chart, except McDonald’s, Wendy’s appears to have a weak, but positive, comparable sales performance during the second quarter.
This result was the result of a combination of declining traffic of approximately 2% and an increase in the average check per guest of 2.6%. It is worth mentioning that the average traffic for QSRs according to Revenue Magazine for the second quarter of 2024 was -2.3%. And according to the same source, the increase in the average check per guest was 4.2%.
This means that Wendy’s exceeded the average traffic, but did so by not forcing a price increase on the menu. I say this because this is the simplest way (although not very efficient) to increase the average check. We saw that due to the massive use of the previous price increase, the traffic cooled off.
Average check per customer growth data was impacted by higher prices in California. Wendy’s has 296 locations in California and I do not have data to reference the composition of owned and franchised stores within that state. The relative growth in average check per customer there was 6.8% compared to the national average. We should see more vivid trends in this regard when we analyze the quarterly results of companies with a large concentration of locations in California, such as Jack in the Box (JACK).
Remember when we talked about traffic at limited-service restaurants? We talked about it in both the Jack and Denny’s (DENN) articles. Basically, the dynamic that’s happening is that guest perceptions of value, due to the increase in prices at QSRs there, are driving traffic from QSRs to FSRs. It turns out that during my BJ’s Restaurants (BJRI) article, I mentioned an interesting phenomenon that’s stemming from this dynamic. Many FSRs are seeing a decrease in average check that offsets some of the effects of this increase in traffic.
Furthermore, up until last month, comparable QSR sales in California were holding steady. I say this because I believed that it would not be possible to maintain an SSS. This may be a temporary phenomenon, but I would like to state that it is indeed happening. Take a good look at this data from Black Box:
Regardless, for fiscal 2024, Wendy’s has lowered its systemwide sales growth forecast from 3% to 5% (up from 6% to 5%). Additionally, Wendy’s expects its comparable sales to grow 1% to 3% in fiscal 2024. That’s a bold target. QSRs are expected to grow comparable sales in a range of -0.8% to -0.2% year-over-year. Let’s take a look at Wendy’s revenue on a quarterly basis:
You can see that revenues have been growing, especially when we look at the second quarters, which are historically strong for Wendy’s. The catalyst for this during this quarter was not its own sales, but rather the royalties that the company has been receiving from its 208 franchisees in its operations within the United States and 108 in its international segment. We’ll talk more about restaurant openings in both the American and international segments soon.
Another catalyst for revenue growth (especially when we look at the domestic segment) was digital sales. We saw a 40% growth in the global digital sales mix year over year. One point of note here is that Wendy’s has a digital sales mix of 17% compared to total sales.
Burger King (QSR), for example, had a similar movement to what we are seeing at Wendy’s in 2022-2023 and currently has about 50% of its total sales mix coming from digital. Other Restaurant Brands’ brands, such as Popeyes and Firehouse Subs, have a digital sales mix of 25% and 40% respectively in 2023. Another example is Taco Bell (YUM) which saw its digital sales mix grow to 31% after implementing kiosks in 2022.
In my opinion, comparable sales for Wendy’s and most QSRs will tend to be negative due to both weak traffic and the inability to increase the average check. Of course, these trends can be mitigated (and even reversed, as in the case of a few players who manage to maintain positive traffic and an average check in line with inflation) through value promotions.
By adopting value promotions and using indirect techniques to increase the average check (and let alone new price increases, as we are seeing with the example of California that this is still a weapon, just to a lesser extent) limited service restaurants will be able to maintain their comparable sales in areas that vary between low digits, both negative and positive. In terms of positioning, Wendy’s has everything to maintain this SSS range for the year 2024.
Furthermore, Wendy’s will continue to seek new openings as a positive driver for its long-term revenue growth. This is where I consider the most important point to be analyzed. These are the developments of the ’70/30 Expansion Project’, and that is what we will address now.
How is the 70/30 Expansion Project going?
If you haven’t read my last article about Wendy’s, you may not know what the ’70/30 Expansion Plan’ is all about. It’s simpler than it sounds. This expansion plan foresees that 70% of Wendy’s growth will come from its international operations, through the franchising model. As of early July 2024, Wendy’s had approximately 1,248 locations in the international segment. This comprises approximately 17.18% of the total number of locations.
These operations span approximately 31 countries (including U.S. territories). Of these 1,248, approximately 1,236 (approximately 99% of the international locations) are franchised by 108 different operators. Wendy’s has only 12 wholly owned locations in foreign territories, all of which are located in the United Kingdom.
The focus of the expansion project is to increase system-wide sales through new unit openings in international markets, reaching a substantial level of international sales by 2025. Unlike the market within the United States, comparable sales in the international segment are growing rapidly.
That is, when compared on a quarterly basis with the same period in 2023, the SSS of the international segment grew 2.5%, approximately 1.9% higher than domestically. This difference can also be seen in a six-month cut, where the SSS of the international segment grew 2.8%, a difference of 2.2% from the domestic market.
In addition to accelerated growth, the franchise model allows Wendy’s to expand without the need for large capital expenditures. Royalties will then supplement the free cash flow. This is essentially the plan to establish Wendy’s as a mature, cash cow company by 2025.
That said, we did receive some encouraging news this past quarter, mainly from franchisee unit developments and development commitments. The goal was to open 250 to 300 units in the international segment through franchisees. This would represent an approximate 25% increase in the number of units in the international segment. It may be a bold goal, but knowing that Wendy’s has already signed 250 global restaurant development commitments makes me believe that this number is entirely achievable by the deadline set by the company.
These commitments usually have clauses that determine the volume of annual openings. We saw this in Potbelly’s (PBPB) FGA Agreements recently. However, I am not aware of the details of this type of clause in Wendy’s agreements with its international franchisees, but these agreements will likely be fulfilled by the year 2025.
Within these agreements, we should highlight some interesting points. The first is that within the European continent, Wendy’s – which already has some presence in the United Kingdom – intends to expand to Ireland and Romania. As the CEO said at the last conference, the expansion to Ireland is a natural result of its already established operations in the United Kingdom, precisely because of the geographic factor. Romania, on the other hand, is part of an expansion to Southeast and Eastern Europe, a region where the company sees significant growth potential in partnership with local operators.
In Australia, Flynn Group LP acquired Wendco, becoming the sole operator in that market. Flynn is no stranger to franchising brands such as Applebee’s (DIN), Taco Bell, Arby’s and many others. In addition, Flynn generates approximately $4.7 billion operating almost 3,000 locations. The franchises acquired from Wendco are considered small businesses for Flynn, since they consist of 20 units in total.
However, Flynn has money to invest and is interested in developing (in addition to the existing 2025 schedule) around 200 restaurants by 2034. Of course, these subsequent developments will depend on the performance and market acceptance of the concept. But this is encouraging news, nonetheless.
In Asia, an undisclosed franchisee that owns approximately 150 units has also increased the number of units under development commitment.
Last but not least, the company has made commitments to double its presence in Quebec by 2024. This means developing 17 more locations in the region by the end of 2024, bringing the total to 34 locations by the end of the year. According to the CEO himself, Canada has proven to be a great market for Wendy’s, with sales growth of almost double digits and profit growth of 25% in the last twelve months.
Unfortunately, I don’t have cost data per unit to carry out financial feasibility studies at the unit level here. It would be interesting because we have a lot of data from QSR and fast-casuals for comparison.
Given the caveats regarding the unit-level margin still being below what I consider ideal (approximately 16.5%), the number of international operators that have signed development commitments encourages me regarding Project 70/30. With so many developments in 2024 alone, as we have seen in four different continents, it really makes me believe that the company could have very interesting growth drivers for 2025.
Wendy’s positioning in a scenario where guests are looking for value promotions
In my last analysis of Wendy’s, I discussed breakfast and how the company was successfully maximizing park turnover in both the morning and late night hours. This specific strategy falls into the category I mentioned in my last industry analysis. We can think of it as a two-in-one strategy. In addition, it also has a strong appeal to low-income guests, as it is available for as little as $3, like the Cinnabon Pull-Apart that was very popular during the first quarter.
It appears that this trend has continued. The company reported that breakfast and late night were a major contributor to positive comparable sales. The revenue generating capacity per unit level per week for the morning hours is approximately $3,000 or $156,000 per year. However, this growth came at a price.
The company experienced a decrease in free cash flow due to an increase in incremental advertising investment for breakfast. The CEO expects these investments to pay off in the coming quarters and help sustain traffic, even with so many options during the breakfast and late night periods.
We are once again seeing this period as a war zone after remaining weak during the pandemic.
Now, getting back to the specifics of value, Wendy’s likes to point out that unlike companies like McDonald’s, which has had some friction with franchisees over the long-term sustainability of the $5 Meal Deal at the unit level, it has had value built into its value proposition since its inception. In other words, the company was already offering the Biggie Bag before the big chains’ shift to value.
This puts it at an advantage in terms of advertising. People already know what to expect when they buy into its value promotion.
And not only that. Franchisees were already aware of what they would have to give up in order to have fixed value promotions on the menu. This avoids friction and enables not only the cohesion of the promotion mix, but the continuity of this mix after other restaurants give up their value promotions.
We know that the $5 Meal Deal, despite generating increased traffic, has an expiration date; McDonald’s would have a hard time extending the end of the promotion until the end of the year. Burger King did this and gained a competitive advantage over McDonald’s, for example. This forced the giant to extend the validity of the $5 Meal Deal for the entire month of August. To do this, it needed to negotiate some support from Coca-Cola (KO) to extend this period.
With a value promotion like the Biggie Bag already known to guests, Wendy’s has been working on barbell pricing and other options that help build loyalty through the app. I already wrote about barbell pricing in my last analysis, considering that in 2023 the company was committed to developing burgers with premium pricing to capture incremental dollars from guests willing to spend.
Among these new developments, I found the launch of the digital promotion of a Honey Bud for $1 that directs new users to the Wendy’s app quite interesting. In addition, there were some innovations on the limited menu. Last month, the Triple Berry Frosty and Saucy Nuggs were introduced.
The new Frosty can be purchased starting at $1.49 and can range up to $3.39 for the largest size (before taxes). Saucy Nuggs can be offered for $2.99 (with four units) up to $24.99 (with fifty units), also before taxes.
These are just a few examples of menu innovations that Wendy’s is starting to add to its limited-time menu. We’ve seen this strategy used to a greater degree at The Cheesecake Factory (CAKE), which managed to maintain a negative 0.2% traffic, virtually flat year-over-year. This has allowed the company to avoid the promotional environment by adding innovation and rotating the menu a few times a year.
What is the potential upside for Wendy’s?
In my last analysis, I did a DCF. This time, to broaden our scope of valuation a bit, we will use other methods to see if Wendy’s is discounted. Even after the almost 10% drop in the share price.
First, I separated a group of comparable companies that are limited-service restaurants. These are: McDonald’s, YUM Brands, Jack In The Box and Portillo’s (PTLO). I used the following comparable metrics: P/E, P/S, P/CF, PEG, EV/EBITDA, EV/EBIT and EV/Sales. This way, we were able to analyze some sector-specific sensitivities and different nuances (considering and not considering capital structure).
From a weighted average of the different ‘comps’ we obtained a value of$23.50. This is approximately a 40% upside from the value at which the stock closed last Friday.
Another way to measure Wendy’s intrinsic value is to apply the concepts of cash flow to shareholders under the nuances of DDM. And this is especially important in this case because of the company’s recent commitment to maintaining its dividends at high levels.
And this is happening in the midst of its international expansion project, which, as I said before, does not require a large amount of capital due to the international operators.
I’m glad Wendy’s is not cutting its dividend, at least for now. Cracker Barrel (CBRL), a full-service restaurant that I recently analyzed, had to severely cut its dividend for its restructuring and its ‘Five Pillars Program’. I recommend reading it.
Unlike the ‘Comps’ we did previously, here we only count on the flow of dividends to shareholders. In this way, DDM analyses are less dependent on the perceptions of discount on shares in a specific category. This discount may be validated by the market in a day, a month, or a year. I say less dependent because with Single Period DDM and Multi Period DDM we need to assume a P/E for the future sale.
Let’s start with the Gordon Model, or Constant Dividend Growth Model. To do this, we must first make the assumption that the dividends that the company has been distributing since 2004 will continue to be distributed in this way. Another assumption is that this dividend will grow at a specific growth rate in perpetuity. These are difficult assumptions to accept, but they serve as a basis for the pricing we are aiming for.
For the discount rate, we will use the cost of equity, in order to reflect the intrinsic risk of the stock. This is 7.48%. Below, I have compiled some results based on different perpetual dividend growth rates so that we will increase the scope of our conclusion by not stating a single possible growth rate.
Note that for Wendy’s, based on the intrinsic assumptions of the Gordon Model, to be considered fairly valued, dividends need to grow approximately 1.5% perpetually. We know that this is out of step with what we have been seeing since 2004.
Unlike the Gordon Model, the Single Period and Multi Period DDM Models show that the estimated P/E for 2024 and 2025 are fairly valued.
Let me explain better. According to analysts’ estimates, Wendy’s P/E at the end of the year will be 17.06 and EPS will be $0.99. In this case, we would consider two cash flows. The first is the dividend received in that year ($1) and the second is the sale price of the stock at the end of the year 2024. These two cash flows discounted to present value using the same discount rate used in the Gordon Model show that Wendy’s would be at $16.64. This is slightly less than the stock is exchanged for today.
Let’s do the same thing but simulate a sale of the stock in fiscal year 2025. First, we would have two cash flows from dividends and one from the sale. Let’s assume that in 2025 the dividend grows timidly to $1.05. The P/E in 2025 is estimated at 15.76. This would mean a value of $16.58 for Wendy’s, which is also close to the value we have today.
My recommendation
In the first quarter, we only had a glimpse of what this 70/30 Expansion Project would really be like. Today, I feel much more comfortable believing in management, especially given the development commitments that already exceed the target set for 2025.
That said, and considering the valuation models that I incorporated into my analysis of Wendy’s, I now consider the company a ‘Buy’. But don’t be so quick, I have some reservations about the profile of the investor to whom I am recommending it.
If you are looking for quick capital gains, boosted by the dividends that the company pays in a short/medium-term time horizon, I say that this stock is not for you. As we saw previously, when we calculated the cash flow to the shareholder for the next two years, the investment would not become profitable.
I say this because we are seeing how the price of many consumer discretionary stocks are suffering with the weak employment and consumption data. So, if you are not willing to give up profitability in the short term or have more interesting options in other sectors, this stock is not for you.
This is further confirmed when we put into perspective the annual variability of returns based on the share price and dividend yield. Wendy’s has an average return of 13.32% and a standard deviation of 37.98%. This is higher than McDonald’s (with an average return of 19.06% and a standard deviation of 22.03%) and Restaurant Brands (with an average return of 12.92% and a standard deviation of 15.67%).
Now, if you intend to hold Wendy’s in your portfolio for a long period of time or even compose a dividend portfolio, I suggest considering Wendy’s for its predictability and reliability in delivering shareholder value in the form of dividends and repurchases.
Operationally, I think I’ve already conveyed my opinion throughout the text. The company has a mix of promotions that are quite relevant and this means that traffic doesn’t decline as much as we’re seeing with other brands out there.
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