Fast Food at a Slow Simmer

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Symbol	Price	Change
WEN	4.34	+0.05

{"s" : "wen","k" : "c10,l10,p20,t10","o" : "","j" : ""}

The recent pullbacks in restaurants may be another opportunity to selectively pick up some shares at a discount. While it's not the time to buy anything and everything just because of a price dip, there's one restaurant stock in which I've recently expanded my position.

Thanks in part to a recent analyst downgrade to neutral, Wendy's shares have fallen 12% in the past two weeks. It's also down 21% in the last two months and 12% year to date. For perspective, consider that restaurants with market caps greater than $50 million have averaged a 22% total return year to date. Of course, price is relative, and just because it's fallen off a given level is never a good reason to buy a stock (fundamentally speaking, that is).

I believe that the Wendy's story, primarily the merger with Arby's, has been misunderstood, because it's a curious combination of businesses -- one of higher- and lower-priced fast-food brands. It's also been difficult to understand the financials in a historical context, and I'm sure this has given some analysts a fit or two, yours truly included.

But you can boil my Wendy's/Arby's thesis down to a few points. It's the third-largest quick-service restaurant chain in the U.S., with about 10,500 restaurants (6608 Wendy's and 3745 Arby's), it owns a lot of real estate (at year end, the company owned the land and buildings for 629 Wendy's, the buildings only for 585 and land and/or buildings for 138 Arby's), management is focused on cutting costs and raising margins, and it's still a solid brand name.

Last quarter, the company earned $14.9 million, or $0.03 per share on revenue of $913 million, the first somewhat "clean" (easy to understand) quarter since the merger. Absent special charges, earnings would have been $0.06 per share. More importantly, Wendy's showed restaurant margin improvement of 370 basis points at company-owned stores that have been a drag on operating performance. The environment for Arby's restaurants, which account for about one-third of the company's total revenue, was still very challenging, with same-store sales down 6.9%. This was an improvement over the prior quarter, but clearly, Arby's higher pricing points are not faring well in this economic environment.

Last quarter, the company also announced a $50 million stock-buyback program. While the completion of this would put just a small dent in the currently massive 471 million shares outstanding, I believe this is still a modest positive and that management will follow through.

The company will report third-quarter earnings on November 5, prior to market open. Consensus estimates are calling for earnings of $0.06 per share, although I'm not one that gets too focused on the results of just one quarter. The 2010 consensus is calling for $0.24 cents per share, so the forward P/E is 18x, certainly not cheap. But I believe the company has the wherewithal to do better and, ultimately, exceed that number. Clearly, little is expected, and "Mr. Market" is still skeptical that margin-improvement initiatives will be successful, let alone that the Wendy's/Arby's marriage will work.

In my view, Wendy's is a nice turnaround story -- a $3 billion enterprise value company with $1 billion in real estate, in an industry that will do better with as the recession ends. Frankly, I like all of the skepticism surrounding this story: it creates opportunity.

At the time of publication, Heller was long WEN.