Shares in Wendys Co (NASDAQ:WEN) shrugged off a downbeat Wall Street research report Wednesday, but the analyst did raise some important points over WEN stock. Namely, has Wendy’s stock performance gotten ahead of its growth prospects?
Any time shares in a company go on the kind of extended rally we’ve seen with WEN stock, it’s time to take a step back and look at the valuation.
No matter how great a company is doing and how bright the future might be, a rising stock can still become divorced from reality, setting it up for underperformance or even a fall.
Valuation, which reverts to the mean over time, can take a while to factor into share performance, but when it does, it can be a killer. Microsoft Corporation (NASDAQ:MSFT) is a famous example of this.
During the bubble of the 90s, MSFT was as hot a tech stock as they come. On the eve of the meltdown some 15 years ago, the software giant’s valuation peaked out at 43 times trailing earnings. It took the next 10 years for MSFT to work off the excess, trading as essentially dead money for a decade.
With Wendy’s stock up 25% in just the last three months, it could easily have gotten ahead of itself. On the other hand, maybe WEN stock deserves a premium valuation. Maybe the market is rightly excited about the fast-food chain’s growth prospects at a difficult time for the industry.
So should you buy WEN stock at current levels? To help decide, let’s look at some of the pros and cons:
WEN Stock Pros
Competition: In some ways, Wendy’s has never faced more competition. In addition to traditional hamburger chain rivals, Wendy’s faces assaults from everyone from Starbucks Corporation (NASDAQ:SBUX) to Chipotle Mexican Grill, Inc. (NYSE:CMG) to Dunkin Brands Group Inc (NASDAQ:DNKN). But in other ways, the landscape has never been easier now that big kahuna McDonald’s Corporation (NYSE:MCD) finds itself in a multiyear — and seemingly endless — slump.
Transformation: It’s a long and costly process, but Wendy’s is getting out of company owned-and-operated stores to become a franchise-based model. True, that’s been tough on the top line lately, but in the long term, trading revenue now for a franchise model later is a smart move. Owning restaurants is capital-intensive. The franchise model means more earnings, more return on equity, more revenue from rents and royalties, and more free cash.
Same-store sales strength: Same-store sales — sales at stores open at least a year — are a critical measure of a retailer’s health, and by this measure, some big names are in sick bay. MCD’s U.S. same-store sales are in the toilet. Yum! Brands, Inc. (NYSE:YUM) — owner of Pizza Hut, KFC and Taco Bell, has been struggling with same-store sales growth, especially in China. Wendy’s, however, posted a 1.9% increase last quarter and projects 2.5% to 3% gains by year-end.
WEN Stock Cons
Valuation: Credit Suisse analyst Jason West believes Wendy’s strategic transformation has already been priced into the stock. And since he’s expecting minimal or possibly no store growth both domestically and overseas, the analyst rates WEN at “underperform” (“sell,” in other words). WEN stock does indeed look pricey, trading for 28 times forward earnings with a long-term growth forecast of just 12%. That’s more expensive than Starbucks or Panera Bread Co (NASDAQ:PNRA).
Millennials: Like McDonald’s, Burger King and Yum Brands’ nameplates, Wendy’s doesn’t resonate with millennial consumers, who flock toward what they perceive as fresher, healthier offerings. Thanks to millennials preferences, chains like Chipotle and Panera are enjoying torrid growth. The old-line names? Not so much. That’s especially worrisome going forward, as Millennials start families of their own.
Capital ideas: Growth is critical to the success of WEN, but what the market really seems to be betting on is that the transformation program will unlock a flood of cash to be returned to shareholders. WEN spent $375 million on dividends and repurchases last year and analysts think it could return another $1 billion. But if the WEN can’t restart revenue growth and hang on to margin-expanding same-store sales growth, there’s no guarantee that extra cash will be there.
The Verdict:
Wendy’s doesn’t have anywhere near the growth prospects of Wall Street’s favorites like Dunkin, Panera, Starbucks or Chipotle, but it sure trades like it does. The valuation is a serious concern, even if management is able to to shuttle reams of cash back to shareholders in the near future.
At the same time, WEN stock has traded at such lofty multiples for years now and it hasn’t disappointed yet. Indeed, WEN stock is actually a little bit cheaper these days than its own five-year average, a time when shares rose about 130% (vs. 76% for the broad market.) The market is quite comfortable paying up for this stock.
That said, it’s hard to say WEN is a buy at current levels. The fruits of the transition strategy appear to be baked into stock — just look at the action over the last three months on pretty much no other news. Furthermore, in the longer term, the viability of the Wendy’s brand remains vulnerable as a new generation increasingly turns its back on traditional fast food.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.
