by Dan Burrows | November 7, 2013 11:44 am
Wendy’s (WEN) posted a beat-and-raise quarter — Wall Street’s favorite kind of earnings report — and yet WEN stock plunged in early trading.
So what gives?
Well, WEN revenue came up short of analysts’ estimate. True, the selloff in Wendy’s stock seems pretty severe considering that we’ve seen plenty of weak top-line growth this earnings season, and stocks are still notching all-time highs.
But in the case of WEN stock, that’s what happens when shares nearly double in less than a year. It gets priced for perfection, meaning traders are willing to bail on the slightest blemish.
WEN has shot to more than $9 a share from less than $5 at the end of 2012, all thanks to encouraging results from its comprehensive turnaround plan. Among other efforts, Wendy’s is selling hundreds of restaurants to franchisees (a margin-boosting move), making over its menu and revamping its stores in a bid to create a more modern, sophisticated image. As CEO Emil Brolick said in a press release:
“We are contemporizing our consumer touch points and transforming our brand, with bold restaurant designs, new packaging and innovative menu introductions such as our Pretzel Bacon Cheeseburger.”
OK, the Pretzel Bacon Cheeseburger doesn’t exactly shout sophistication, but the strategy has been a boon to the bottom line. On a net income basis, WEN narrowed its quarterly loss to $1.9 million, or less than a penny a share, vs. a loss of $26.2 million, or 7 cents, in the year-ago period.
So although revenue growth disappointed the Street in the latest quarter, the bigger picture looks pretty bright. But after rallying 93% for the year so far, all that progress could easily be reflected in WEN stock. Should you buy Wendy’s at these lofty levels — or wait for a pullback?
To help decide, let’s look at some of the pros and cons:
Good for Growth: Wendy’s is much smaller than rival McDonald’s (MCD), the largest burger chain in the world, but then, it’s much easier to grow rapidly off a modest base. Analysts forecast WEN to grow earnings at an average rate of more than 16% a year for the next five years or so. McDonald’s, by comparison, has a long-term growth forecast of just 8%.
Cash Back: WEN is smart to keep any restive shareholders happy by returning cash to them. It also juices the total return. The dividend of 2.3% doesn’t match MCD’s payout, but it is highly competitive compared with the rest of the industry. Additionally, WEN repurchased 5.5 million shares in the third quarter and wants to spend another $59 million on buybacks over the next two months.
Technical Strength: Chart-watchers should be bullish on the short-term prospects for WEN. On a technical basis, WEN gets a 10 out of 10 for price momentum from Thomson Reuters Stock Reports. Not only is this an especially bullish time of year for WEN stock, but its relative strength indicates that this momentum stock’s trajectory will remain on track.
Top-Line Weakness: As popular as the Pretzel Bacon Cheeseburger and other promotions were with customers last quarter, sales essentially were flat at $640.8 million. Cost cuts, debt refinancing and selling stores to franchisees is a good way to lift margins, but at some point WEN has to grow the top line. Unfortunately, sales are projected to be flat this year and decline 13% next year.
Valuation: Like most momentum stocks and stocks that double in such a short time, WEN is no bargain. The forward price-to-earnings multiple (P/E) stands at 32.5. That’s a 16% premium to the WEN five-year average. WEN is also more than twice as pricey as the S&P 500. Yes, WEN has a strong growth forecast, but not strong enough to justify that kind of outsized multiple.
Risky Revamp: WEN is betting big on changing its image, and that bet better pay off because it’s costing a small fortune. As WEN said in its earnings release, the company will incur significant capital expenditures over the coming years — not quarters. WEN expects to spend $440 million to $500 million for store overhaul and openings from 2013 to 2015. That’s going to cut into free cash flow.
After having come so far so fast, WEN is a hold. Don’t sell it if you own it, but don’t commit new money at current levels either. The market’s reaction to Wendy’s earnings shows that as promising as the re-imaging strategy may be, the good news is indeed already baked into the share price.
In the medium to longer term, WEN has more upside ahead. But WEN earnings need to grow into the overheated valuation — or the stock needs to cool off.
Until then, expensive shares set new money up for disappointing returns.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.
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