Despite going through a rough patch over a several year period, the strengthened economic expansion of the past few years has provided fresh momentum for the restaurant industry. That being said, the industry remains highly competitive with only the best-run businesses thriving. We believe that Wendy’s (WEN) is one of the top five restaurant stocks and is likely to generate decent total returns for investors over the next half decade.
Recent Financial Results Show Continued Growth
Wendy’s is the third largest hamburger quick-service restaurant chain in the world, with more than 6,700 restaurant locations globally and a market capitalization of $4.5 billion. While it has a global presence, it maintains an overweight concentration in the United States, with more than 90% of the company’s locations in the country.
The company recently reported strong first quarter results. Global systemwide sales grew by 3.3% and 43 new restaurants opened worldwide. North American same restaurant sales grew 1.3% year over year and 2.9% on a two year basis.
In addition to adding to the top line, profitability improved, with restaurant margin increasing by 110 basis points, adjusted EBITDA spiking by 12%, free cash flow surging by 17%, and adjusted earnings per share growing a whopping 27% year over year. Perhaps most impressive was the fact that G&A expense only grew by 2.2% year over year – trailing revenue, free cash flow, and earnings growth by a wide margin – signifying the highly scalable model that the company enjoys.
Source: Q1 Investor Presentation, Page 8
These numbers illustrate the success of Wendy’s two-pronged growth strategy: (1) accelerating same restaurant sales in North America via increasing foot traffic, improving operations, and increasing the company’s digital presence with consumers and (2) expanding the restaurant presence globally by increasing the restaurant count in both North America and abroad.
The company plans to increase foot traffic by offering attractive promotions such as large value combo meals for only $5 and introducing new Made to Crave Hamburger innovations such as the Peppercorn Mushroom Melt, the S’Awesome Bacon Cheeseburger, and the Barbecue Cheeseburger.
Operational excellence will also improve sales by noticeably enhancing the customer experience. Management is striving to achieve this by driving efficiency and accuracy on drive through orders, higher quality food preparation, and improved customer interaction during dine-in orders.
Catalysts For Future Growth
By accelerating Wendy’s digital platform growth, management is confident that the company’s same restaurant sales will increase. It aims to achieve this by activating mobile ordering across the entire North American restaurant network by the end of this year, expanding the delivery footprint to 80% of North America by the end of the year, and using promotions and advertisements to drive customer awareness across digital platforms.
Meanwhile, the global expansion will be driven by continued store count growth both in the United States and internationally. In the first quarter, the company opened 43 restaurants globally, which is an acceleration over the 33 that they built in the first quarter of last year. 29 of these restaurants were in North America while 14 were in international markets.
Management expects to reaccelerate net new unit growth in 2019 to approximately 1.5% with about a third coming from international and two-thirds from North America. In the first quarter, international was slightly negative on net new development due to the planned closure of the company’s Malaysian market (14 restaurants).
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Further boosting Wendy’s growth prospects is the fact that it has a solid balance sheet. The leverage ratio currently stands at 4.9x, which is well within the company’s target range of between 4.5x and 5.5x. The company also has a well laddered debt maturity ladder with no debt due until 2022 and the majority of their debt not due until 2025 or later. This will enable them to continue executing against their capital allocation strategy, which is to invest in growing the business while simultaneously returning cash to investors with an attractive dividend (consisting of slightly over half of earnings) as well as share repurchases as cash is available.
The share repurchase program has actually turned out to be quite aggressive, with Wendy’s management drastically reducing the share count in the last four years. This has turned out to be a great investment of shareholder capital as the share price has doubled over the past three years alone. Furthermore, management continued their strong dividend growth program as they recently raised the dividend by 18%, bringing the payout ratio to 64%. As a result of the elevated payout ratio, the elevated share price, and the increasingly leveraged balance sheet, we anticipate dividend growth and share repurchases to slow in coming years.
The 2019 outlook sees global systemwide sales growth of 3%-4%, adjusted EBITDA growth of 2.5%-4.5%, adjusted EPS growth of between 3.5% and 7%, and free cash flow of $230 million – $240 million. We believe that the strong start to the year combined with the positive industry fundamentals as well as the company’s large global growth runway and highly profitable scalable business model will enable them to achieve the high end of their earnings per share growth target of 7% on an annual basis over the next five years.
Adding in the company’s 2% dividend yield brings the total return potential to around 9% annually. However, we see the recent share price surge as bringing earnings multiples out of their fair value range. Therefore, we expect to see substantial multiple contraction over the coming five years, leading to mid single digit annualized total returns.
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Overall, we see the company as continuing to be a solid dividend growth stock, thanks to its solid restaurant performance and international expansion program. However, the pace of dividend growth will likely slow as the balance sheet enjoys less flexibility than it once did, the elevated share price makes share buybacks less attractive, and the payout ratio is above its typical level.
Additionally, the fast food burger space continues to be highly competitive, which will force the company to work hard to maintain market share, much less grow. As a result, we view the stock as a hold at current prices.