WEN - Wendy's: SSS Growth Is Positive But Units Growth Is Still Uncertain

2023-09-15 11:29:45 ET

Summary

• I recommend a neutral rating as I have doubts about WEN's ability to accelerate unit growth.
• Recent results show positive traction with improving SSS and innovative menu initiatives.
• There is a need for WEN to demonstrate sustainable SSS growth and successful unit growth acceleration to re-rate valuation positively.

Overview

My recommendation for The Wendy’s Company ( WEN ) is a hold rating, as I remain skeptical of WEN's ability to accelerate unit growth. The good thing is that WEN has been showing positive traction and that SSS is growing way better than in the past, supported by organic initiatives (a new menu and penetration into other dayparts). I will be on the lookout for WEN to show that unit growth can accelerate before I turn positive.

Recent results & updates

I believe there are two key debates that investors have. First is whether WEN can continue to sustain its current SSS (same store sales) profile, which is quite an improvement from its historical SSS profile. In the past, SSS was in the low single digits, but it is now in the mid-to-high single digit range. The second debate is whether WEN can continue to grow units at the current pace or at an accelerated pace.

In the first debate, domestic SSS grew 4.9% last quarter, with check growth offsetting some of the negative transactions. While there is still a chance of a decline in traffic, I believe recent trends have a better chance of continuing than they did before, thanks to the constant innovation of menus at both ends of the price spectrum. In addition to the creative menu items, I appreciate how the management is always looking for new ways to break into the late-night daypart market. My positive view on WEN establishing more presence around the clock is that, not only does it increase the utilization rate of each store, thereby driving SSS growth and higher restaurant-level margins, but it also increases consumer mind share. Arguably, the last point is a major one. The more "mind share" WEN occupies, the more likely a consumer will return to the store as they crave WEN’s offerings. From a customer acquisition perspective, this is perfect for WEN as these are organic visitors.

We've got some innovation that's going to be announced and launching soon. We've got more consistent promotional activity to drive trial and repeat, and we're really going to focus our operations teams on ensuring that we are breakfast-ready with lights on, and where we want the dining rooms opened and breakfast both lights out, and have a message around returning for breakfast into the future.

All in, we continue to expect the breakfast daypart will deliver outsized sales growth in 2023 and beyond. Finally, our recent push into the late-night daypart paid off with double-digit sales growth versus both the prior quarter and prior year.

Up to 90% of our US restaurants are now open until midnight or later, and as expected, we're seeing higher average checks, and a skew towards delivery, which further supports the restaurant economic model. from: 2Q2023 earnings call

The second debate regarding WEN is unit’ growth. For the recent 2Q23 quarter , WEN added 20 net new units, including 4 in the US and 16 in international markets. Based on management comments, challenges in the US are persisting, particularly with permitting and construction, which is delaying an otherwise healthy pipeline of development agreements. As such, I am expecting unit growth to slow in the near term. If we look at the US historical growth rate, we should see a bounce back in unit growth to low single digits of 1.5%, which means 1H24 is likely to be more than 2% (since FY23 is likely to be at 0.5% level based on 1H23 performance). The interesting aspect here is that international trade is growing much faster than in the US. Franchisees' hunger for expansion and the remaining international opportunity are two reasons why management is positive about a multi-year ramp with improvements in profitability. It's worth noting that WEN and Flynn Restaurant Group have recently signed a master franchise agreement that will eventually lead to the opening of 200 WEN locations across Australia.

“looking further out, our progress towards solidifying our restaurant pipeline keeps us on track to achieve our long-term global net unit targets of 2% to 3% in 2024, and 3% to 4% in 2025. We know there's substantial runway for the Wendy's brand and continue delivering meaningful global growth and we believe our momentum and strategies across our three growth pillars will drive shareholder returns for years to come.”

However, I would also like to highlight my concern about the accelerating unit growth expectations of 4 to 5%. Using the 2Q23 global store unit count of 7,115 as a base, a growth rate of 5% a year would mean that WEN is adding 300 to 400+ stores a year, net of closures. Historically, WEN has opened stores at a pace of 70–140 a year, which means a huge step is required. Given that WEN is not a new brand in the US QSR industry, I find it hard to believe they can accelerate the pace of unit growth (remember, this is net of closure) that easily (why haven’t they done so if it were so easy?). Hence, the growth would likely come from overseas. If the US follows the same rate of unit opening as the past 20 to 50 units, it implies that International would need to open 300+ units a year (based on the 5% growth on 7,115 units as of 2Q23); this would imply close to 30% growth using the International 2Q23 1,122 unit count, which I think makes it hard to underwrite the growth assumption simply based on management comments.

Valuation and risk

According to my model, WEN is valued at $21 in FY24, making it fairly valued. My model assumptions are that growth will remain in the mid-single digits, driven by both low-single digit growth in units and SSS, far from the management estimate for mid-single digit unit growth. I remain conservative in my assumptions as I wait for WEN to show actual results showing that unit growth can accelerate.

WEN is now trading at 18x forward earnings, which I believe is reflective of the uncertainty that the market has with WEN's outlook. While this is cheap relative to history, I think it is cheap for a reason (because of the uncertainty mentioned above). For the stock to re-rate, I think WEN needs to continue showing SSS growth sustainability and unit growth. For the former, WEN is already seeing traction, but the former remains a question.

Summary

I recommend a hold rating for WEN. While the company has demonstrated positive traction with improving SSS and innovative menu initiatives, there remain uncertainties regarding its ability to accelerate unit growth. The debate over sustaining SSS growth is encouraging, especially with expanded menu offerings and efforts to tap into different dayparts. However, unit growth challenges, particularly in the US, are impeding progress, with permitting and construction delays. Although international expansion holds promise, achieving the ambitious 4 to 5% unit growth target appears challenging. WEN's current valuation reflects market uncertainty, trading at 18x forward earnings. To re-rate positively, WEN must continue to prove the sustainability of SSS growth and demonstrate successful unit growth acceleration. Until then, a cautious hold stance is recommended.

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