Add Wendy's to Your Menu?

S&P says the restaurant chain's superior growth prospects make the shares an excellent value

By Dennis Milton

Investors lost some of their appetite for restaurant stocks following the unexpected Sept. 17 announcement by McDonald's that it expected soft same-store sales for the third quarter. The group, already nagged by ongoing worries about slowing consumer spending, was hit by a sell-off that erased some of its recent gains. But Standard & Poor's believes that this recent weakness has created some buying opportunities. One name to consider: Wendy's (WEN ), which carries S&P's highest investment ranking of 5 STARS (buy).

Founded in 1969 by Dave Thomas (who also served as the company's pitchman in its well-remembered TV ads until his death earlier this year), the Wendy's chain encompasses more than 6,000 restaurants in the U.S. and in 26 other countries, and over 2,100 Tim Horton's units in the U.S. and Canada. Approximately 80% of Wendy's restaurants and 96% of Tim Horton's restaurants are operated by franchisees.

Fueled by an expansion plan and impressive comparable-store sales growth, Wendy's continues to capture market share from its larger competitors. According to an industry study by research firm Technomic, Wendy's share of the U.S. hamburger quick-service restaurant (QSR) market rose to 13.2% in 2001, from 12.7% in 2000 and 12.2% in 1999. The gain represented the fifth straight year of market-share growth. The company plans to open between 300 and 325 Wendy's restaurants in 2002.


  During the first six months of 2002, Wendy's restaurants posted healthy same-store sales growth of 6.1%, well ahead of its competitors. Restaurant operating margins improved by nearly a full percentage point, benefiting from a decline in food costs, improved operational efficiencies, and better leverage on fixed costs because of the higher sales levels. Although August same-store sales growth narrowed to 3.3%, the company remains well ahead of its peers and has weaker comparisons to meet for the rest of 2002.

By yearend 2002, management believes that Tim Horton's will surpass McDonald's as the largest QSR chain in Canada, in terms of market share. It now accounts for 70% of the coffee and fresh-baked goods market in Canada, and 21% of the overall QSR market. Tim Horton's remains in expansion mode, and it intends to open 200 locations in 2002. With only about 140 stores in the Ohio, Michigan, and New York, it's increasingly focused on growth opportunities in the U.S. market.

Tim Horton's posted robust same-store sales gains of 8.7% in Canada and 11.9% in the U.S. during the first six months of 2002. Although the sales trend cooled somewhat in August, S&P anticipates growth rates to continue to exceed industry averages. Tim Horton's accounted for 31% of Wendy's overall pretax earnings in 2001, and S&P projects that this percentage will grow over the next few years, especially as U.S. operations gain the critical mass needed to contribute meaningfully to profits.


  Wendy's isn't limiting itself to the QSR market to spur growth. In June, it acquired the Baja Fresh Mexican Grill chain, which operates or franchises over 170 restaurants in 16 states. The acquisition gives Wendy's a foothold in the increasingly important "fast casual" segment, which offers higher-quality food and a greater level of service in exchange for a higher ticket price.

We at S&P believe that Wendy's now has an excellent portfolio of restaurant concepts, representing a variety of cuisines, and at different stages of maturity, that should ensure revenue and earnings growth well into the future.

After reaching a record high of $41 in June, Wendy's shares have fallen more than 20% on economic concerns and fears that heavy discounting by competitors, especially McDonald's and Burger King, would eat into profits. However, Wendy's has successfully weathered these concerns in the past. Earnings per share grew 15% in 2001 despite a recession. Furthermore, Wendy's has been able to separate itself from competitors by offering a menu that's seen as higher in quality. And a high level of operational excellence has translated into quick service and high customer satisfaction.


  S&P expects Wendy's revenues to grow 8% in 2002, driven by expansion and same-store sales increases. We look for earnings per share to jump 18%, to $1.94, from $1.65 in 2001. Assuming continued growth, especially at Tim Horton's and Baja Fresh, and favorable food-cost trends, EPS should expand an additional 15% in 2003, to $2.23.

Given Wendy's impressive restaurant brands and its proven ability to contain costs, we believe it will meet the high end of its 12% to 15% annual EPS growth target over the next few years. S&P deems Wendy's earnings to be of relative high quality: In 2001, stock option grants accounted for less than 5% of operating earnings, or approximately 8 cents per share.

At a reasonable 14 times our 2003 EPS estimate, based on its recent share price, Wendy's trades at a slight premium to its peers, and at a discount to the overall market. But its superior growth prospects make it an excellent value, and we recommend purchasing the shares. S&P's discounted cash flow model, which assumes revenue growth of almost 9% in 2003, then gradually declining over the next decade, implies that the shares have an intrinsic value of approximately $44.

Analyst Milton follows restaurant stocks for Standard & Poor's

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