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Follow the smart money to Wendy's
Two high-powered investment groups are buying up the stock, and their pressure may make the burger chain a tastier deal for investors.
By Michael Brush
A new Wendy's advertising campaign now hitting the airwaves tells fast-food fans to Do Wendys. Do what tastes right.
Behind the scenes, two high-powered investment groups are buying up Wendy's shares because they want, simply, to do what makes money.
These big investors -- with a reputation for getting companies to make dramatic changes that drive up shares -- may soon pressure Wendy's International (WEN, news, msgs) to do what's right for shareholders.
Namely, to split off a profitable Canadian coffee and fast-food chain trapped inside Wendys and make other adjustments to unlock value and propel Wendys stock higher.
If it all works out, investors holding Wendys shares now at $48 could see gains of anywhere from 15% to 35% as the stock advances to $55 to $65.
Owning Wendys is just following the smart money, says John LaForge of the Sarasota, Fla.-based SRQ Capital Management. He has watched influential activist investors take positions in Wendys over the past few months and followed them into the stock -- hoping they will work some magic at the fast-food chain.
Heres a closer look at how the smart money might want to "do" Wendys.
The players
Two activist investment groups have staked out sizable positions in Wendys: Boston's Highfields Capital Management and New York-based Pershing Square Capital Management. Together, they now control 17.2% of the nation's third-largest fast-food chain.
In early June, their tactics took a fresh twist when Pershing Square Capital hired the Blackstone Group, an advisory firm known for cooking up restructuring plans that successfully unlock value for shareholders. Blackstone has advised on turnarounds at companies like Xerox (XRX, news, msgs) and Chiquita Brands (CQB, news, msgs), as well as headline-grabbing restructurings at disastrous companies like Enron and Global Crossing.
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No one is saying the two investment groups are working in concert. But if one of them comes up with a good plan that seems like it will increase the value of Wendy's shares, they and other big shareholders are likely to play along.
Wendys, the target, basically has three parts: - A flagship fast-food chain where growth has sputtered for the past three quarters.
- A highly successful Canadian coffee shop, Tim Hortons, that's so popular it's called the "Starbucks (SBUX, news, msgs) of Canada."
- A California-based Mexican food chain called Baja Fresh that has been looking hard for a way to spice up growth, so far with little success.
The plan
The activists and Blackstone declined to discuss their plans for Wendys. But theyve tipped part of their hand in filings with the Securities and Exchange Commission. Merrill Lynch analyst Rachael Rothman also offers some guesses about what they might do.
The spinoff of Tim Hortons. Founded in 1964 by a former National Hockey League player, this coffee shop and caf has blossomed into a Canadian icon. The chain serves coffee and baked goodies like doughnuts and croissants, as well as sandwiches and soups.
Canadians seem to love Tim Hortons as much as they love ice hockey.
Sales have grown by 18% a year over the past 12 years, and there are now 2,470 Tim Hortons in Canada and 251 in the U.S. The chain has a 70% share of coffee sales at fast-food restaurants in Canada, and a 26% share of the overall fast-food market. And it has more room to grow. Wendys says it can expand Tim Hortons to 3,500 units in Canada and 500 in the U.S. by the end of 2007. The chain accounts for 27% of Wendys revenue but 51% of its operating income.
Hidden inside Wendys, however, Tim Hortons doesnt get the full respect it deserves in the market. It is getting a fast-food multiple when it could be getting a Starbucks multiple, says LaForge.
LaForge thinks Tim Hortons is worth at least $40 per share on its own. Thats in line with estimates from Merrill's Rothman. She puts Tim Hortons value at anywhere from $36 to $41 per share on a standalone basis.
The conversion of Wendys to a pure franchise model. Profit margins at many Wendys company-operated stores keep dwindling. An obvious solution, says Merrill's Rothman, would be to sell Wendys-operated stores to franchise operators. That would not only produce a higher-margin take in the form of franchise royalties, it would shift the risk to franchise operators.
The move would also raise cash that could be used to pay down debt or repurchase shares. Rothman thinks the sale of Wendys-operated stores could raise enough money to let the company buy back anywhere from 27% to 58% of its outstanding shares. She puts the value of Wendys on a standalone basis at anywhere from $27 to $34 per share.
The sale of Baja Fresh. Purchased by Wendys in 2002, this Mexican food chain, located chiefly in California, contributes about 6% of Wendys revenue. But its a drain on operating income. A good option might just be to sell it, even though it wouldnt generate much in net gains. Merrill puts the value of Baja Fresh to shareholders at 35 cents per share.
Tally the gains from the three maneuvers and Wendys shares are worth between $64 to $76, says Merrills Rothman.
What Wendys says
Wendys wont comment on any of this, but top managers have been on the conference circuit offering shareholders a scenario of what could happen if they stay the course.
In short, the company says that flexible menus with new items like fresh salads and fruit, the new marketing campaign and the continued expansion of Wendys and Tim Hortons will reward shareholders. Theres also a new chief executive at Baja Fresh.
Together, those moves will produce 11% to 13% annual earnings growth over the next several years, the company predicts, continuing a 17-year track record of consecutive same-store sales growth.
The company already posted solid cash flow of $161 million in 2004 and has $177 million in cash. This supports an ongoing share buyback program and a small dividend, with a yield of just under 1%.
The outcome
But is Wendy's own plan enough to keep investors happy? Sell-side analysts like Merrills Rachael Rothman and Prudential Equity Groups Larry Miller are staying on the sideline, saying its too hard to tell.
But LaForge looks at the big positions taken by Highfields and Pershing, along with Dutch financial conglomerate ABN Amro Holding (ABN, news, msgs) -- which has a 5% stake -- and concludes its a safe bet theyll flex their muscles and pressure Wendys to make big changes. After all, thats what they do.
The fact that the three of them have 22% of this company in stock and options means they are going to force their hand, says LaForge, who says the downside of the stock is around $40. That may not sound like much, but the chances are other hedge funds are going to go along with them if they come up with a good plan.
Stock picks
With this column, I'll add Wendy's to my Company Focus portfolio for tracking, and we'll see how it does from here. I'll also add Walt Disney (DIS, news, msgs), which has fallen to an attractive price below $26 since I wrote about it here.
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