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It's Time for Wendys Co. Stock to Cool Off

By Jeremy Bowman - Jan 12, 2016 at 5:00PM

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The burger chain has been on a tear over the last few years, but the future may not be as rosy as investors hope.

Wendy's Co. (WEN 0.52%) has been one of the surprise winners on the stock market over the past three years.

Shares more than doubled over that period, tracking with earnings per share, which also doubled. Investments in store improvements and an improved menu helped out, but the biggest boon seemed to be its refranchsing plan and share buybacks.    

Refranchising is the new black
The refranchising play has been a popular one in recent years as Restaurant Brands International (QSR 0.28%)-owned Burger King now franchises 100% of its stores, and McDonald's Corp. (MCD 1.12%) announced earlier this year it will sell thousands of stores back to franchisees with a goal of having 90% of its global fleet belong to franchisees. 

Brand Transformation

A remodeled Wendy's location. Image source: Wendy's.

The move can be an appealing one. It brings in quick cash, reduces capital expenditures, and creates a predictable cash flow through royalties, but it also sacrifices future profit to do so. Wendy's growth is expected to slow from its torrid growth over the last two years. Analysts actually expect EPS to fall by a penny for 2015 to $0.33 and then increase to $0.36 for fiscal 2016.  

Management has outlined a goal of high-single-digit EPS growth in 2016, growth in the high teens in 2017, followed by EPS growth of 20% in 2018, and views long-term comparable-sales growth at 2.25%-3%. By 2020, it envisions opening 1,000 new restaurants, restaurant level operating margins of 20%, average unit sales volumes of $2 million, and the remodeling of 60% of its restaurants.  

Those are all bold goals. As of fiscal 2014, average unit volumes were $1.6 million, and restaurant operating margin was 15.8%, meaning both metrics will have to improve by 25% in order for the company to meet its goal. Unfortunately, even with 3% comparable-sales growth, the high end of management's projected range, it would only reach average unit volumes of $1.9 million in 2020 and that's without including the impact of new stores. Sales are almost always lower at new stores than at mature ones, meaning that comparable-sales growth would probably have to be 5% or higher in order for the company to open 1,000 new stores and reach a $2 million AUV by 2020.

Reaching its restaurant operating margin goal of 20% may be even more difficult for Wendy's. Unlike sales, which should grow naturally over time with the help of inflation, there's no inherent reason for margins to expand over time. Though management projects restaurant operating margins of 17%-17.5% for 2015, a solid improvement over 2014, upcoming minimum wage hikes in several states and cities are expected to squeeze margins at restaurants like Wendy's. Furthermore, the addition of 1,000 restaurants should also weigh on operating margin as it will take years for them to mature. 

Restaurant operating margins at 20% have also remained unreachable for Wendy's peers. McDonald's was just at 15.9% last year , while Sonic Corp. (SONC) reported 16.5% in its most recent fiscal year. 

The valuation question 
Wendy's shares are priced for big things to happen. The stock trades at a trailing P/E of 30, and that's since it fell off from its highs last year near $12. Compared to its peers, the Dave Thomas-founded chain is the highest-priced.

CompanyP/E Ratio (ttm)Comparable Sales (mrq)
Wendy's 30 3.2%
Sonic 23.8 5.3%
Restaurant Brands International 28.5 6%
McDonald's  25.3 4%

Data source: Yahoo! Finance and company reports.

Not only are Wendy's shares expensive than its peers, but the company is also growing comparable sales more slowly. The stock been bid up on a combination of refranchising stores, share buybacks, and bold growth goals for 2020. But with the highest P/E in the sector and the slowest growth, the share price seems to have gotten ahead of itself. That should hold the stock back over the next couple, and the risk of falling short of its growth adds further downside to the stock.

Wendy's peers offer better options in the restaurant industry to put your money.  

Jeremy Bowman has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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Stocks Mentioned

The Wendy's Company Stock Quote
The Wendy's Company
WEN
$21.40 (0.52%) $0.11
McDonald's Corporation Stock Quote
McDonald's Corporation
MCD
$262.18 (1.12%) $2.90
Sonic Corp. Stock Quote
Sonic Corp.
SONC
Restaurant Brands International Inc. Stock Quote
Restaurant Brands International Inc.
QSR
$60.48 (0.28%) $0.17

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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