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.

Analysis On Winn-Dixie Stores

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Although I'm waiting until they release their earnings next week, one stock I've been looking in to and have gone long on for my motley fool account is Winn-Dixie Stores Inc. (WINN), the southern grocer. I'm waiting for the earnings announcement so I can go in to more detail for my analysis rather than simply guesstimating what is going to happen. That doesn't seem prudent based on how close their earnings announcement is.

But here's a little preview of some numbers I ran off their Q1 10-Q:

As you can see, even after discounting intangibles and basically anything that you can't put your hands on, they still have a P/B of less than one. I'm not quite sure how I feel about their Property Plant and Equipment (PPE), since it appears they only own 8 stores and 1 distribution center, but I guess trading below hard assets is all I can really ask for.

If you ask me this seems very very cheap, especially since they have no long term debt, but I'll be interested to see how their Q2 earnings come out. Mean analyst estimate is a loss of $0.16, with a high estimate of -$0.09 and a low estimate of -$0.27. If they surprise on the upside it might push them past this price to tangible book ratio of one, but I think that's a risk you have to be willing to take.

Jackson Hewitt Tax Service: Don't Be Fooled Into Thinking It's In Value Territory

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I stumbled upon Jackson Hewitt Tax Services (JTX) during one of my stock screens and had to investigate since it had an eye-popping 0.41 Price to Book (P/B) ratio. As some might know, I try to find profitable companies trading at a P/B of less than one, with the ideal scenario being that they can have all of their Goodwill and Intangibles written off and still have a P/B of less than one.

First, however, a little information on Jackson Hewitt:

Market Cap: $ 84.58 MM
Enterprise Value: $ 412.21 MM
P/E: 4.02
Forward P/E: 4.82
PEG Ratio: 0.82
P/S: 0.41
P/B: 0.41

And Yahoo! Finance description:

[The company] engages in the computerized preparation of federal, state, and local individual income tax returns in the United States. As of April 30, 2009, its network comprised 5,610 franchised offices and 974 company-owned offices. The company was founded in 1985 and is headquartered in Parsippany, New Jersey.

The Surface of Things

Just looking at the above mentioned numbers, JTX looks pretty attractive. Forward P/E and trailing P/E are both low and do not vary significantly, Price to Sales (P/S) is less than one, PEG is less than one and most importantly to me, P/B is less than one, and to boot, very low.

That all being said, even just glancing over the recent news bulletins for this company, and today's stock movement (down 16.5%), suggest that all is not necessarily well in the Jackson Hewitt household. It seems that the big market moving data piece was that JTX was not going to have enough funds to extend profitable tax return loans to customers.

This hits on two levels. The first is that it indicates a lack of cash and a lack of access to credit markets, both issues that are negative. The second, another negative, is that the business will not have access to a profitable fringe line of their business, especially during the most crowded season for individual tax work.

While negative press is something I think an investor should always be aware of, it shouldn't be the most significant factor in selecting an investment. In fact, I'm of the persuasion that oftentimes negative press can expose large amounts of value for investors to capitalize on. That being said, it's time to look under the hood and check out JTX's balance sheet.

For Want of Cash

I mentioned above that the recent negative press on JTX likely spoke to a lack of cash. This is very quickly confirmed after looking at their most recently filed 10-Q from the quarter ended October 31st, 2009, in which one discovers that they only had $60,000 at the end of the quarter. This is likely due to the net loss of $41.3 MM they reported for the quarter, but is still slightly chilling because they borrowed $85 MM under a revolving credit facility.

Now this isn't immediate grounds for dismissal since they've cut Accounts Receivable by 48% from the prior quarter, a positive sign that they're not just making sales on credit to try and boost revenues. Especially since the tax preparations business has seasonal cyclicality (centering around April 15th, the Christmas for the industry), a loss in a quarter that does not include tax season loses some of its significance.

However, after looking farther down the balance sheet, the Goodwill and Other Intangibles jump, since together these make up 85% of the company's total assets. This is somewhat understandable given that companies such as Jackson Hewitt rely on human capital (their accountants) and branding as a means of running their business. You can't really observe the value of these two items on a balance sheet, so when there's an acquisition, the bulk of the recorded assets is going to come in as goodwill.

That being said, compared to H&R Block (HRB), their biggest competitor, JTX's ratio of Goodwill and Intangibles to Total Assets looks absurdly high. H&R Block's Goodwill and Intangibles only make up 25.5% of their total assets, and they're currently sporting a P/B of 6.81. This leads me to think that JTX's low P/B is more of a warning sign than a value investing trigger.

Conclusion

Further examining JTX's balance sheet, if one were to write off all Goodwill and Intangibles the company would be left with a deficit of $304 MM for Shareholder's Equity. Additionally, for Shareholder's Equity to maintain a positive value (i.e. SE is greater than or equal to one), the combination of Goodwill and Intangibles can only withstand a writedown of 40%. To have a P/B of 1 or less, these same areas could only withstand up to a 24% markdown.

Given this information, I can say that I needn't do more analysis as to JTX's future prospects since these items point me to strongly reject JTX as an investment. While if you're the adventurous type JTX might be an interesting roller coaster, I find the risk-reward payoff unsuitable. In this instance, the P/B is probably a signal to look for the life boats on this Titanic.

In addition, one can almost categorically reject service industry investments such as Jackson Hewitt from my value investing perspective when their operational competitiveness is based primarily on human capital. People are the only assets that have legs, and you can bet if things go in to a bankruptcy scenario they're going to try and get out of there. Further, since this stock is going through a flux and the business model seems to be struggling, I'd bet money that JTX's most talented accountants are trying to jump ship, if they haven't already.

To look at the spreadsheet I used for my analysis, please see below
JTX Analysis

Mirant Corp (MIR): Is There Significant Value Behind this Coal-Burning Utility?

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As I noted in my write-up for The Pantry (PTRY), my investing strategy focuses on finding value stocks trading at a Price to Book (P/B) of less than one. From these, I try to find seemingly boring and unsexy companies that I think will keep posting positive free cash flows to equity holders long enough for the market to re-evaluate the company, presumably at a P/B of greater than one.

One company that's held my interest for a while now is Mirant Corporation (MIR). Again some basic information:

Market Cap : 2.35B

Enterprise Value: 2.93 B

P/E : 1.99

Forward P/E : 10.23

PEG Ratio : 0.18

P/S : 0.79

P/B : 0.53

Yahoo! Finance description:

"Mirant Corporation produces and sells electricity in the United States. It generates electricity through coal-fired and oil and gas generating facilities. The company'’s operations primarily consist of procuring fuel, dispatching electricity, hedging the production and sale of electricity by its generating facilities, managing fuel oil, and providing logistical support for the operation of its facilities. The company was founded in 1982 and is headquartered in Atlanta, Georgia."

The Crux of It

The main sell for Mirant is that even after taking away intangibles, goodwill, and other non-current assets, the stock still maintains a P/B of less than one. Looking at their balance sheet from their most recent Q3 filings, using today's closing stock price and subtracting the value of intangibles, derivative contracts, deferred income taxes, prepaid rent and other, I get a P/B of 0.87.

From that P/B, Mirant is being priced practically like it's going in to bankruptcy. When all of these values are netted from shareholder's equity as reported on the balance sheet, one essentially arrives at a post-bankruptcy value to shareholders because I would consider these netted assets ones that would only remain valuable to the business were it to remain a going concern. Arguably if the derivative contracts were exchange traded they could probably be easily sold off, however since Mirant noted that they dealt quite significantly in OTC derivatives I subtracted this value to be more conservative.

If Mirant was going in to bankruptcy, I wouldn't want any part of it. I'm not a lawyer or a vulture and don't want to speculate whether there's going to be more than the current share price left over once senior stakeholders have been paid. The company's large cash reserves and a question regarding whether or not Mirant actually has excess cash from their recent Q3 earnings call have lead me to believe, however, that this company is not being priced because of bankruptcy risk. In light of this, it's necessary to look at other possibilities.

So Why the Discount?

Typically, if something sounds too good to be true, it probably is. That being said, with Mirant I think the reason for the dramatic under-pricing is a market perception that companies like Mirant, generating electricity from coal and gas, are carrying unstated environmental liabilities and could potentially get thrown under the bus as the United States' economy moves toward "green" energy.

If you look at Mirant's competitors, this story is supported. The AES Corporation (AES) and Calpine Corp. (CPN) are both trading at P/B values of over one (2.01 and 1.19, respectively), and in both companies' business descriptions they note being involved in one or more alternative energy generating activities, including geothermal and wind. RRI Energy, Inc. (RRI), however, is only trading at an unadjusted P/B of 0.47. The distinguishing difference of RRI? They're not involved in alternative energies, much like Mirant.

Is this discount warranted? Looking at Mirant, they've had to spend $1.67 B, of which they still have $341 MM to go, on capital expenditures due to the Maryland Healthy Air act. They estimate further capital expenditures to bring them up to other environmental standards to be $12 MM in 2009 and $20 M in 2010.

While environmental liabilities will affect companies that are more heavily involved in the dirtier forms of electricity production more than those that are producing partially from alternative means, both companies are still retaining environmental liabilities were states and/or countries to become more adamant about reducing pollution. AES for example, while utilizing wind energy, only generated $28 MM of their Q3 $3.8 B in revenue from it. So while they may be better poised with operational expertise in this industry as it takes off, they're still generating the bulk of their revenues the old fashioned way.

Stability of Cash Flows

Mirant posted operating cash flows of $727 MM for Q3, with total net CFs of $198 MM. This included capital expenditures of $508 MM, well above depreciation charges of $37MM.

One of my concerns with Mirant's CFs was the amount coming from proprietary trading. Being familiar with Enron, several red flags went up when I read about this element of their business in their most recent 10-Q. However, upon noting that realized trading revenues only accounted for $32 MM (7% of total) and even after subtracting unrealized trading losses of $24 MM that the figure would still be positive at $8 MM, I was much calmer.

Looking forward to upcoming charges, Mirant notes projected capital expenditures of $225 MM in 2009 and $441 MM in 2010. These comprise expenditures for the Maryland Healthy Air Act (60% of 2009 and 46% of 2010), other environmental (5% and 5%), maintenance (26% and 26%), construction (4% and 18%) and other (5% and 5%).

As I understand it, a large chunk of this construction expenditure is going to come from building Marsh Landing, a "760 [Megawatt] natural gas-fired peaking" plant near Antioch, CA. From their Q3 earnings call, Mirant notes: "We expect [Marsh Landing] to begin construction next year, and we expect to have construction completed and go into commercial operation in May 2013". For some perspective, Mirant currently produces 10,112 MW of power, so Marsh Landing would expand production by 7.5%.

In terms of upcoming debt, Mirant has $535 in unsecured LT debt coming due in May 2011 and $374 MM in secured LT debt coming due between 2009 and 2013. Based on their positive net cash flows and large cash reserves ($2.0 B), I don't see Mirant having any issues either retiring the debt or rolling it over, especially as credit markets continue to unfreeze.

In terms of looking at operating revenues for 2010 and beyond, Mirant seems to have a very effective hedging program in place to smooth out volatile commodity movements. Mirant is 86% hedged for 2010 for power prices and 78% for fuel. Looking forward, they're 52% hedged for power and 61% hedged for fuel in 2011, with this hedging level continuing to taper off until effectively reaching zero in 2014. In light of this, I don't see a dramatic threat to Mirant's positive net CFs in the near future.

Outlook for U.S. Energy

While the prospect of the power generating assets of Mirant becoming impaired as environmental standards increase or alternative technologies become cheaper increases the risk of this company, I'm of the persuasion that the United States' need for energy will maintain the necessity for more traditional forms of power generation.

In a slide presentation from Mirant that accompanied their Q3 earnings call, the company included a graph looking at current and predicted reserve margins. For those of you unfamiliar, reserve margin is "the capacity of a producer to generate more energy than the system normally requires".

The earnings call noted:

“I point as I have before to the orange line toward the bottom of the page, which is PJM East, which is our most important market. This trend remains and takes into account all that's going on demand side management and other efforts, and it is for anyone who is responsible for making sure that there is an adequate electric supply to meet the needs of the American public, a worrisome situation. This is not how a system should operate. This is not a good trend. It is a good trend for incumbents. It is a good trend in our own narrow self-interest for Mirant, but this is not good for the system.”

While this is of course using their proprietary research, I think that when it is combined with other research it suggests that the United States and the world will increasingly need more and more energy, of which for the foreseeable future traditional energy generating techniques will remain a large part.

While I don't profess to be an expert on energy generation or utilities, I do feel that Mirant is priced at such a level as to be a very good investment possibility. Especially facing what I perceive to be an improving macro-economic climate, I strongly feel that Mirant possesses strong potential to be positively revalued by the market.

Disclosure: Long MIR

Too see the spreadsheet I used for my analysis, please see below

Mirant