RealMoney Silver - No Confidence in WEN

No Confidence in WEN
By Ron Thomas
RealMoney Contributor
2/4/2008 1:09 PM EST

Updated from 2:58 p.m. EST on Feb. 1.

Wendy's reported fourth-quarter 2007 EPS from continuing operations of 21 cents vs. the 23 cents that was expected and 14 cents last year. Sales of $596 million were 0.7% greater than estimates.

Quarterly comp-store sales at company-owned restaurants declined 0.8%, and franchisee sales rose 0.2%. The cost of sales declined 60 basis points from 62.2% via menu price increases and favorable product mix shifts, as well as labor efficiencies. Operating costs at company-owned restaurants decreased from 28.4% to 27.5% of sales via cost savings initiatives and lower bonuses. General and administrative expense was 10.2% of revenue, down from 11.3%, because of reduction in salaries and benefits and via job eliminations and lower bonus accruals. There were 19% fewer outstanding shares outstanding.

Complete guidance could not be given because of the workings of the company's special buyout committee. (My God, is the management team sitting around contemplating their navels? Yes, the capital markets are shut down, but that has been the case for six to nine months!) Management said that it sees a challenging first quarter. Commodities costs are up -- a 180 basis-point effect is expected -- and are expected to be offset with price increases and expenditure reductions.

Fiscal 2008 earnings before interest, taxes, depreciation and amortization is expected to be at the lower end of Street ranges. The Street low EPS estimate for 2008 is $1.16 per share, and the average is $1.41.

Most of the Q&A was concerned with tactics and strategies for better sales in 2008. Management is rolling out a new premium fish sandwich. There will be extensions of the Frostee (very heavy milkshake) and additions to Snack Attack (low-priced value items). Management is afraid of pushing prices too high, and it wants to get more sales of sandwich, drink and side order combos.

An analyst asked, if 45% of company-owned stores are serving breakfast vs. only 7% of franchisees, why are company comps negative while franchisee comps are up? Management said that there were comparable sales trends in the same geographies for franchisee and company stores. But management also said that it is seeing cannibalization of breakfast against lunch and dinner sales (???). Regarding breakfast, it just seems to be an absolute no-brainer now that, if you want more combo sales and you are rolling out a new breakfast, you should be doing it with some pizzazz in your coffee offering, which Wendy's is not doing.

Management also said that its market research shows that, within the company's core 18- to 34-year-old buyer, "the younger you are, the less likely it is that you have a connection with the brand." That speaks, I think, to relatively ineffective advertising and probably not enough new product offerings as well.

Management had a question on where costs are being cut in restaurant operations and should have given some concrete examples of why the costs it has cut were not needed. The company tends to give me the impression that this may be seen as a restaurant version of Nardelli's Home Depot (HD) in coming years.

Overall, the operations side seems to need a lot of work on new products to get people back in the stores. The first quarter 2007 had monthly comps of 4.8%, 3.3% and 3.6%, so the first-quarter result will be pretty lackluster. Analyst estimates will come down.

This $24 stock will require 13% five-year EPS growth to justify the price. I cannot have confidence in that now, though I see no reason that the company cannot turn itself around over the next few years.

WEN Preview: Comps Will Be Key

Wendy's (WEN) stock has come down from around $40 in May to $24 on the giving up of an acquisition in this capital markets environment and worries over poor sales overall vs. quick-service competitors.

Wendy's is expected to report EPS of 23 cents vs. 9 cents last year and have a 0.7% sales decline, to $592.43 million. Revenue will be flattish with a negative comp of about 1%, I would guess.

Analysts are looking for restaurant-level margins to increase around 150 to 200 basis points from cost cutting on food and labor. The gross margin will be down from higher commodities costs.

Shares could be down 18% to 20%. If performance veers away too much from this, it will probably be to the downside, and guidance is unlikely to be a positive.

The stock still looks like it is going to be vulnerable to cuts in the $1.41 average estimate for 2008. Using the $1.41 estimate, which has some lift from the $1.20 estimate from 2007, gives some effect to the continued rollout of a successful breakfast program, more new products, more franchising of company-owned restaurants and some new advertising that connects with consumers (unlike the latest "red wig" ads). There also might be some upscale coffee offering in there, too.

A $24 price, however, implies an 8% five-year EPS growth rate, which I believe is about right given that Tim Hortons (THI) is no longer part of the earnings base, and McDonald's (MCD) and Burger King (BKC) are much tougher competitors than they used to be.

But I do not believe that McDonald's poor 0.8% U.S. comp-store sales reported for December (somewhat weather-affected) and poor expectations for January are factored into the Wendy's estimates yet. Using the lowest Street estimate for 2008, $1.16, as with other consumer discretionary stocks, the present price discounts a 13% five-year growth rate. That is the top end of management's long range target of 11% to 13%.

I could talk to some normalized earnings number based on prior year's history. The trouble is that, without a chief marketing officer and with a recession likely coming and permanently weakening consumer spending, I would have trouble making a case for higher normalized earnings.

Another problem with discounting higher earnings in this environment, in my opinion, is all of the labor cuts. I am still afraid for service because the labor cuts have come in the wake of Nelson Peltz.

Also, it seems to me that Wendy's best way to raise earnings could be to move upscale a bit toward competing with the fast casual segment. The company's made-while-you-wait sort of operation could allow for items similar to the panini sandwiches at Panera Bread (PNRA) or the burritos at Chipotle Mexican Grill (CMG) . These are higher-margined items that McDonald's and Burger King are not set up for, and they would require higher (not lower) labor content.

Comps will be very important as will evidence of some movement back to focusing on core operations.