Wendy's Lookin' YUMmy?

Shares of Wendy's (NYSE: WEN  ) took a jump late last week on takeover rumors involving fast food giant Yum! Brands (NYSE: YUM  ) and maybe even former Yum! parent, PepsiCo (NYSE: PEP  ) .

As usual, management pleaded the Fifth, uttering no comment, and pointing out what some of us already know: Yum! is so busy with overseas growth prospects that it hardly has time to consider adding to its stateside stable of food establishments. Wendy's would only be a distraction.

Or would it?

Where's the beef?
Taco Bell has long suggested we "think outside the bun," and Yum! Brands is known to most investors as the fast-food giant that's got nothing to do with burgers. But, truth be told, Yum! brands is not just about tacos, KFC chicken, or Pizza Hut pies. Folks often forget Long John Silver's, and in most parts of the U.S., Yum!'s burger chain, A&W, seems a distant relic. So Yum! does have some "exposure" to the bun, but from my way of thinking, it's not nearly enough.

I don't want to read too much into a comparison here, but McDonald's (NYSE: MCD  ) and Burger King Holdings (NYSE: BKH  ) clearly show that the meat-and-potatoes biz hasn't gone completely out of style. True, recent growth at Mickey D's has been attributed to innovative menu concepts like the snack wraps, but there are times when, for all of us, nothing will do like a burger and fries. Wendy's may not be operating like a premium business, but I think most consumers recognize it as a pretty strong brand, which is why we shouldn't dismiss a takeout offer out of hand.

Who will get burned?
As a stock, Wendy's has been a long-term bridesmaid, and it announced a while back that it was putting itself up for auction. Well, technically, it was the old "strategic alternatives" thing, but with the money being thrown around by buyout firms today, we all know that means "Door's open, boys! Come an' git it!"

What a buyer would be getting is a firm that's struggling to stay relevant and becoming less profitable by the year.

FY Ended

FY Ended

FY Ended

FY Ended

FY Ended

 

12/29/02

12/28/03

1/2/05

1/1/06

12/31/06

Gross Margin

28.2%

26.8%

21.4%

20%

18%

Operating Margin

14.2%

13.2%

9.1%

6.4%

3.8%

Net Margin

8%

7.5%

4.2%

3.5%

1.5%

FCF Margin

4.1%

2.8%

13.4%

12.1%

6.6%

SG&A Margin

7.9%

8.3%

8.4%

9%

9.7%

Capex Margin

12.1%

10.9%

6.7%

7.4%

4.5%

All margins represented as a percentage of revenues. Data from Capital IQ.

As gross margins have dwindled, operating margins have shrunk drastically. It certainly hasn't helped that Selling, General, and Administrative costs have steadily increased as a proportion of revenues. The free cash flow line has bounced around, but something that worries me is that capex line. Is Wendy's spending enough to keep its stores spiffy and attractive? That's the kind of scuttlebutt prospective investors will want to consider -- if they're actually interested in being owners, rather than quick flippers.

Pirate equity or a big brother?
And there's the rub for this investor. Though a cash bid from private equity might provide some instant relief for current shareholders, to my mind, it would likely not compensate them for the long-term gains to be had if the chain were given a more rigorous overhaul. The big-money sharks these days aren't usually buying for the long term. They're too-often looking for a quick flip. After loading a company up with debt, they pay themselves a nice fat dividend, then spin the limping entity back onto the suckers in the public market, hanging onto a fat share despite already having been paid.

On the other hand, in the arms of Yum!, there'd be no lack of cash flow to keep Wendy's locations looking inviting. There'd be no lack of expertise in marketing, menu creativity, or more pedestrian management considerations. And if a combination with Yum! couldn't cut some of that SG&A out via (buzzword alert) "synergies," I'd be very surprised. Depending on how the change purses are jingling, an offer from Yum! might even come via shares, which would give current Wendy's holders a chance to wait for the reward that could come down the road.

Finally, let's take another look at some of the numbers from Yum!.

FY Ended

FY Ended

FY Ended

FY Ended

FY Ended

 

12/28/02

12/27/03

12/25/04

12/31/05

12/30/06

Gross Margin

48.9%

24%

23.9%

24%

25.4%

Operating Margin

13%

12.8%

12.2%

11.8%

13%

Net Margin

7.5%

7.4%

8.2%

8.2%

8.6%

FCF Margin

4.2%

5.2%

6%

6.7%

7.2%

SG&A Margin

31.7%

11.3%

11.7%

12.2%

12.4%

Capex Margin

9.8%

7.9%

7.2%

6.5%

6.4%

All margins represented as a percentage of revenues. Data from Capital IQ.

By the same metrics we saw above for Wendy's, Yum!'s numbers clearly show better control of costs and more reliable cash flows. Some of this is to be expected from a more diversified and more international group, but bringing another well-regarded burger biz into the fold would not upset this apple cart. In fact, once it was well absorbed, it could become yet another chunk of ballast to offset the inevitable stumbles that hit every restaurant chain.

Is it on the dollar menu?
So I like the idea of a Wendy's buyout by Yum!, but what's the right price? That, alas, is the wild card. To take a very broad brush, at its current enterprise value, Wendy's sells for about 1.5 times revenues. That doesn't strike me as amazingly cheap, but it's nowhere close to what its peers get. Yum! sells for 2 times revenues. McDonalds gets 3 times that number. Sonic (Nasdaq: SONC  ) earns a 2.8 and fast-growing Chipotle Mexican Grill (NYSE: CMG  ) warrants a 3.2.

Clearly, these multiples reflect greater faith in the growth story as well as greater faith in the profitability story. In fact, by enterprise value-to-EBITDA, Wendy's multiple is higher than all of these peers except Chipotle. That may seem backward, but think of it this way: The earnings portion of this multiple is the one that provides the lever.

Since Wendy's sales aren't broken, it's the earnings that count. Better earnings would lower that EV/EBITDA multiple, but would be rewarded by the Street with higher share prices. The only problem is, current management doesn't seem to be able to work the levers to keep growing the cash flow for Wendy's shareholders. Given their experience and greater resources, I believe the folks at Yum! could do better. Here's to hoping they crunch the numbers and give it a shot.

Comments? Bring them here.

At the time of publication, Seth Jayson had shares of Chipotle and Yum! Brands, and was feeling guilty about yesterday's post-workout run to the border for a Crunchwrap Supreme, though he is considering a "baconator" as a follow-up. He had no position in any other firm mentioned here. See his latest blog commentary here. View his stock holdings and Fool profile here. Chipotle is a recommendation of Motley Fool Rule Breakers and Motley Fool Hidden Gems (B shares). Fool rules are here.


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