Saturday, May 29, 2010

Wendy’s/Arby’s Group: Struggling Giant on the Rise or a Falling Knife?

It is difficult to write about a company focusing on such accessible and widely marketed products as those in the restaurant business. This is especially the case with the quick service (read: fast food) industry, whose price entry point makes it possible for essentially everyone to try their products if they wanted to. Every investor likely has a personal experience with places like Wendy’s, Arby’s, or some of their competitors, so it is important to keep personal perceptions from influencing the investment decision.

But to get past the typical hurdles when talking about companies that are so well known throughout our culture, the story behind Wendy's/Arby's Group's (WEN) faltering stock price has been one of profitability, debt burden and concern over the Arby’s side of the group. The stock has been down in the dumps lately, even passing the 1 P/B threshold that puts stocks on my radar. As of Friday’s close (5/29/10), WEN’s P/B was 0.86.

I will get to the assets equity holders are actually getting a hold of when they chase that 0.86 P/B ratio later, but to begin with I think it is important to understand what is going on with the business. While WEN does hold both Arby’s and Wendy’s, after reading through the holding company’s 10-K I did not get the impression that there was much coordination between the two. I did not see the pitch book for the merger, which took place in September 2008, but I would imagine that part of the idea was to achieve savings through shared resources and common supply contracts. This currently does not seem to be the case, since as far as I can tell Arby’s and Wendy’s are being run as two independent companies (although the company does mention adding more coordination as a goal going forward).

Focus on Arby’s: Isolating the Problem

To understand what has been happening with Arby’s, one need look little further than what has been going on with average stores sales over the years (especially in comparison to Wendy’s):

The fact that Arby’s stores count for roughly half of the stores that the holding company owns (the other half being Wendy's stores) makes one fully understand how important the success of Arby’s is to shareholders:
As has been cited by several people, Arby’s has been suffering from a schizophrenic product portfolio. On the one hand, there are the roast beef sandwiches and the fried foods (fries, poppers, etc,) and the other the slightly “healthier” and much more expensive Market Fresh sandwich line (along with other sandwiches...including a roast beef gyro!). While Arby’s recently introduced a dollar menu in an effort to help bring down their menu price (which by industry levels had been quite high), it still did not address the fact that their product portfolio still lacks a central focus.

There is optimism that Arby’s new president Hala Moddelmog, who started her career at Arby’s and has significant experience in the industry, can help Arby’s in their makeover. The one thing that I think that Arby's needs the most is to answer the question: "why roast beef"? Obviously Arby's has been suffering from demand issues, so maybe it is a problem with the market not appreciating their product. That is why I feel like you either convince the customer that they should want roast beef (maybe the protein content? studies associating eating roast beef with improved health?) or change up the game. But right now, without a product line to center around, the company seems without focus and undefined.

Furthermore, if you want to sell at the higher price points (with products like the market fresh line), you need to drop the elements that make your products seem low rent. This would include getting rid of the nacho-cheese like substance that goes on some of the roast beef sandwiches and dramatically scaling back the fried food sides. They would want to position their menu price between the McDonald's (MCD) and Burger Kings (BKC) of the world yet below the Subways and Quiznos, hopefully becoming known for being cheap, fast and relatively healthy.

Can You Buy WEN on Asset Quality?

After the stock for any company crosses the 1 P/B threshold, each person buying equity is technically getting more than a dollar in assets from the company. The statement it sends when a company drops below this level is that there is absolutely no "whole being greater than the sum of the parts", i.e. this company would be worth more broken up than is together. One would think from a prospective buyer position this would be great, but you really have to look at the assets you are getting a hold of before you make the plunge.

This is because items like Goodwill and Intangible Assets can quickly approach zero if the company starts really going through problems. This is especially the case with Goodwill, since it is technically the amount paid in excess to what the other company is worth in a merger or acquisition. My guess is that WEN's goodwill is from the merger, and while it is important to add this Goodwill in to the balance sheet to make everything balance out, the implicit assumption by accountants is that the price paid during a merger or acquisition was justified. One need not search too hard to find instances of terrible, terrible mergers and acquisitions (my personal favorite? Time Warner and AOL) where Goodwill was later slashed and burned.

With Intangible Assets, such as brands, these are usually recorded at cost since there is little room in U.S. GAAP to revise assets up on the balance sheet. In a period of duress, such as bankruptcy, brands can get tarnished and watch their value plummet. Because of this, I try and be really careful around Goodwill and Intangible Assets since these are probably the first to go once things start heading south, and since equity holders are the last in line, probably what they would get stuck with.

This being said, when you take out Goodwill and Intangible Assets there is no shareholder's equity left over, in fact it is negative. So what kind of writedowns can they withstand to Goodwill and Intangible Assets to still maintain a 1 P/B level? 14%. Not much, if you ask me.

The Final Take

As of their most recent 10-Q, WEN was standing at an S&P credit rating of B+, by technical definition highly speculative non-investment grade. Ironically, they have also been participating in a share buy back plan and at their 2010 shareholder's meeting they just approved another $75 million, bringing the total up to $325 million. Why a company with a terrible debt rating (which is also responsible for the crippling debt payments that are destroying the company) is buying back shares in addition to posting a dividend when they are making operating losses is a mystery to me and if I was holding their debt I would be incredibly mad.

This combined with the fact that the stock price is not low enough for current buyers to actually be getting a hold of real assets (instead of Goodwill and Intangible Assets) makes me feel like this is a company an investor should stay away from.

I'll personally never understand why there ever was a merger between Arby's and Wendy's. If it brings down Wendy's, others will wonder the same thing.

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