The Best Turnaround Story in the Fast Food Industry

A business model transition is the best sign of a turnaround, and this fast food company is firing on all cylinders.

Jan 21, 2014 at 1:11PM

Wendy's (NASDAQ:WEN) appears to be in full-blown turnaround mode. This fast food chain has undertaken a refranchising strategy similar to what Burger King did back in 2012. As part of Wendy's plan to streamline its business model to achieve higher margins, it sold off Arby's in 2011. With the majority of its stores franchised, Wendy's will enjoy lower overhead expenses which will ultimately boost margins. Wendy's ultimately plans to divest some 425 company-operated stores.

As mentioned, moving to a franchise model will also allow the company to generate higher levels of cash flow. What's more is that Wendy's isn't just refranchising, it's also looking for new ways to boost sales and drive brand recognition.

The company has been active on the marketing side as well as the menu innovation side. Lately, Wendy's has been playing a game of trial and error. The pretzel bacon cheeseburger worked fine for a bit, and now the company has launched a Spicy Chipotle line which features a chicken sandwich and a junior cheeseburger. Both of these items also happen to be part of Wendy's value menu initiative "Right Price, Right Size Menu."

Through it all, Wendy's has been a shareholder-friendly company which currently pays a 2.1% dividend yield. Back in the fourth quarter of 2012, Wendy's boosted its dividend by 100%. Then, Wendy's upped its dividend again in the second quarter of 2013, this time by 25%. Meanwhile, Wendy's also has a share buyback program in place. During the third quarter of 2013, Wendy's bought back some $40 million worth of its shares. The buybacks should continue as Wendy's starts to generate higher returns from rents and royalties. Wendy's should also continue to collect cash from the sale of company-owned stores.

Granted that Wendy's prices are slightly higher than the likes of McDonald's, the counter argument is that Wendy's serves better, higher-quality food. Let us not forget Wendy's staple chili and baked potatoes. Other major, heavily-franchised restaurant chains are Sonic (NASDAQ:SONC) and Domino's Pizza (NYSE:DPZ). Both of these chains have been performing nicely, with each of their share prices up over 60% over the last twelve months.

Domino's and Sonic enjoy operating margins of over 15% which compare to 8.2% for Wendy's. Once Wendy's gets the refranchising done it should see similar success. Sonic has been very successful by differentiating itself from other burger restaurants by offering hot dogs and frozen drinks. Frozen and fountain drinks make up nearly 40% of the company's revenue.

Domino's focuses on pizza, but it's bringing it to customers in a variety of ways. It's all about the delivery. The company has a state-of-the-art ordering system and its digital mobile ordering app was downloaded over 6 million times in 2012. Beyond that, Domino's just launched the first fast food app for auto systems--Domino's and Ford got together to create an app that allows Ford drivers to place an order using the Ford Sync AppLink.

Wendy's looks to be one of the best bets in the fast food industry for 2014. The company is transitioning to a franchise business model which will allow it to enjoy higher margins and higher cash flow. Ultimately, with analysts expecting Wendy's to grow EPS 16% this year, while the industry-average expected growth rate is 4%, the stock could reach the top-end analysts' price target of $11, which means an upside of over 25%.

Marshall Hargrave has no position in any stocks mentioned. The Motley Fool recommends Ford and McDonald's. The Motley Fool owns shares of Ford and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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