Wendy's (NASDAQ: WEN ) shares have nearly doubled in the past year. Does the revamped fast-food chain deserve that boost -- or will investors go home hungry?
The recession hit Wendy's hard since the company's higher food costs allowed for less wiggle room on pricing. But investor optimism has grown as Wendy's works to solidify its image as something further away from Burger King Worldwide (NYSE: BKW ) and closer to Panera Bread. Wendy's offers higher quality ingredients than most of its fast food brethren, but that also leads to higher costs. And its image overhaul isn't cheap. Given all of these factors, and the fact that the summer launch of a new burger could lead to a third quarter boost, is now a good time to invest in Wendy's?
Innovation to drive sales
Wendy's has a new menu featuring deluxe items that the company hopes will drive up comparable-store sales, or comps. Wendy's same-store sales for the second quarter were up 0.4% for company-owned stores and 0.3% for franchises. This compares to first quarter growth of 1% and 0.6% respectively.
The recently launched pretzel bacon cheeseburger was one of Wendy's most-hyped products of all time. And that could lead to a large boost in comps for the third quarter. But the company's still not putting all of its growth eggs in the new menu's basket.
The reinvention comes with a new look at some locations. Image remodels include fireplaces, lounge-style seating, and Wi-Fi. Wendy's launched the refurbishing program in 2011 and plans to update up to 50% of company-owned stores by 2015.The project could lead to long-term financial improvements, but in the short term, sales will fall as stores close for renovations. Can Wendy's afford to lose sales while remodeling?
Divesting franchises, cutting costs
To its credit, Wendy's has shown the ability to cut what isn't working and move on. The company sold off Arby's in 2011 and discontinued its breakfast menu at underperforming locations. What has historically worked for the company the best? Selling off franchises.
The second quarter showed Wendy's with 6,544 stores systemwide with franchises accounting for about 78% of that number.Wendy's plans to sell 425 of the company-owned restaurants to proven franchise owners. That would drop the percentage of company-owned stores from 22% to 15%. Wendy's hopes to have the sales finalized by the second quarter next year.
High costs...high dividend?
But for all of the solid moves, Wendy's still has a couple of concerning issues. Wendy's hit the recession skids harder than any other fast-food restaurant because the chain also has higher costs. This point has not changed.
Wendy's food and paper costs for the second quarter equaled nearly 33% of total sales. Burger King's costs were 6%. Sonic, the drive-in chain with similar quality to Wendy's and its own growth story, had 21%. Yum! Brands (NYSE: YUM ) -- the nearly $32 billion owner of Pizza Hut, Taco Bell and KFC -- has food and paper costs totaling 27% of revenues.
Despite its tight margins and expensive remodels, Wendy's is still paying out a hearty dividend. Wendy's increased its dividend payout by 25% in the second quarter to $0.05 per share. That's an enticement for income investors. But can Wendy's afford to pay that dividend?
Sustainable dividends require a healthy cash flow. Wendy's has paid out about $55 million in dividends over the past year with a free cash flow of about $70 million. Free cash flow per share at the end of the last fiscal year was -$0.02, which would also make for a negative FCF yield. It's not the best time for tossing out dividend money.
Wendy's has both under and outperformed the S&P 500 in the past.
The Wendy's growth story isn't as slow and steady as the Yum! megabrand. But it's still a growth story.
Foolish final thoughts
I'm probably going to gift myself some Wendy's for the holidays. The new growth plans will take years to payoff, but I'm comfortable waiting. The dividend is still concerning, but the share price seems reasonable even with the large bump. I'm also making a Wendy's CAPScall of outperform.