WEN - Wendy's Has Juicy Burgers But Juicy Dividend Yield Of 4.6% Is A Hard Bite

2023-03-07 06:00:00 ET

Summary

• Wendy's recently announced a doubling of its quarterly dividend, bringing its forward yield to 4.6%.
• Shareholder distributions are further juiced up by its $0.5 billion share buyback plan running until February 2027.
• Investors who think that Wendy's is an attractive high-yielding stock should tread carefully: the new dividend payments alone would eat up last year's free cash flow.
• We are suspicious of Trian's involvement, which recently reduced its stake in Wendy's after last year's saber-rattling. Does it not believe its own story?
• Income investors should look elsewhere for good income.

America's favorite burger joint The Wendy's Company ( WEN ) published its Q4 earnings announcement last week, and while you can read the news about the earnings here and here and here , this article is addressed to income-investing folks who might be lured to the stock because of its high dividend yield of 4.6%.

We think that the announced shareholder distributions are too aggressive and that the company might end up undermining its future growth. We are also suspicious of Trian Capital's (Wendy's key shareholder) various moves over the past year, which, we suspect, forced Wendy's management to announce the enhanced distributions, and now culminated in Trian selling 10% of its stock.

We don't like these dynamics and rate Wendy's a Sell.

Doubling of dividend and annual buyback plan could boost shareholder payouts above 7%

One of the highlights of Wendy's earnings announcement was the doubling of its quarterly dividend from 12.5 cents to 25 cents, bringing the forward dividend yield to a juicy level of 4.6%. Wendy's also announced its intent to resume its share repurchase program, enabling it to buy back shares worth $488 million until February 2027, or on average about $120 million per year. At a market cap of $4.63 billion, the buybacks would carry an implied return of 2.7%, bringing the total returns to shareholders from distributions alone to 7.3%

Dark clouds on the horizon

Yet it comes in a time when clouds seem starting to brew for the restaurant industry. Like-for-like sales of Wendy's increased by just 4.9% and analysts expect a further slowing in 2023 to only +3.2% growth. Even more worrying is the contraction of almost 3 percentage points in operating margin for company-operated restaurants, which dropped to 13.8%. Although the company itself operates only around 5% of all the restaurants (the rest is franchised), it signals that the pricing power of companies is hitting its limits. Costs are increasing faster than revenues and businesses may not be able to pass on the input cost increases to consumers anymore. If inflation is more persistent than previously thought, we may start seeing cracks in the real economy. Signals of weakness in consumer spending at quick-service restaurants came recently from Domino's Pizza ( DPZ ), which suggests that consumers are starting to cut back on out-of-home dining and instead opt to cook meals at home to save money.

Dividend is just-about safe for now

Looking at Wendy's cash flows, we have questions around the long-term sustainability of the dividend and buybacks. The $1 dividend per share translates to dividend payments of around $210 million annually. On top of that, buybacks could average up to $120 million per year. In addition, the company has regular CAPEX needs of $70 and $80 million per year (excluding acquisitions), bringing the total cash-out from shareholder distributions and investments to at least $280 million per year.

The issue is that Wendy's generated $284 million, $346 million and $260 million in operating cash flow in 2020, 2021 and 2022, respectively. While there is just-enough cash to cover the dividend from free cash flow, Wendy's would have to tap into its cash buffer of $746 million to fund the share buybacks. The cash position was boosted by debt issuance of $500 million in 2022, so using the cash pile for share buybacks would be akin to a dividend recap. If the softness in consumer spending is confirmed over the next couple of quarters, Wendy's may not even have enough cash flow from operations to cover its dividend and would have to either reduce it or tap into the cash buffer. You can call that anything but sustainable.

One particular issue we see with this plan is that it doesn't leave much room to ramp-up investments to fund the slowing top-line growth, which will be a prerequisite to make the promised shareholder payouts sustainable in the long-run. Wendy's annual depreciation & amortization is around $130 million, but the company has been investing only $70 to $80 million in the past couple of years. In other words, Wendy's seems to be underinvesting . Well, if you are underinvesting, how do you want to achieve growth in EPS?

Trian's role at Wendy's looks ominous

Wendy's largest shareholder is Trian Capital Management managed by activist investor Nelson Peltz. Trian and its affiliates hold 38 million shares in Wendy's ( 17.85% of its stock) . Trian's stake tracks back to 2005, which makes it a long-term shareholder in the business. This is a bit untypical for Trian, which often takes stakes in companies for brief periods of time in an effort to push the company to change. True to his craft, Peltz started to press Wendy's management in May last year and rattled his saber by 'threatening' to take it private. Trian dropped its threats last month , coincidentally at a time when the company announced the dividend increase. To add insult to injury, Trian has recently reduced its share in Wendy's by around 3.7 million shares (around 9% of the stock it previously owned). It doesn't seem to believe its own story apparently, even though it pushed the management into these changes. Peltz is Non-Executive Chairman of Wendy's board, so he probably has good reasons to sell.

This raises a couple of questions. To what degree were management and board independent in its decision making? Why did Trian reduce its stake after the circus of the past 12 months? Are the dividend's really in the interest of the company and its shareholders, or rather in Trian's? If Trian has higher opportunity costs in investments elsewhere, it may have a strong interest to receive cash as soon as possible rather than to wait for another year of mediocre returns from Wendy's stock.

What makes us particularly suspicious is that Wendy's CFO Plosch announced in the earnings call that the dividend increase came after 'the board had an opportunity to revisit capital allocation plans, given the high cash balance'. So, the CFO of the company is telling us that he raised $500 million in new debt in the beginning of the year, but revisited its capital allocation plans more than half year later in order to be able to decide what to do with the money...? Yeah, right...

Summary

We do not think that Wendy's is a 'sleep-well-at-night' dividend stock. We have a strong suspicion that Wendy's was pushed towards the higher distributions by Trian, who may be able to deploy the money at better returns elsewhere, rather than keep it on Wendy's balance sheet. While this might be in the interest of Trian, it may not necessarily be in the interest of Wendy's and its shareholders, because it reduces Wendy's growth potential in the long run (and, obviously, they can't co-invest with Trian). Not even Peltz seems to trust this company and is watering down his stake. We do not like these dynamics!

Other chains like McDonald's ( MCD ) and Yum! Brands ( YUM ) have outperformed Wendy's on a total return basis by 120 and 220 percentage points since Trian invested in Wendy's years ago. Over the past 5 years, McDonald's managed to generate annualized total returns of around 15%, while Wendy's only around half that (8%). Trian, and Peltz in particular, do not seem to be managing the investment all too well compared to competition, in our opinion. Given the low difference in valuation to other players, we would advise investors to look into McDonald's, Yum! Brands or other competitors, if they are interested in the QSR sector.

We therefore rate the company a Sell until it gets cheaper.

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