Wendy's/Arby's Group (WEN)

Was able to ride the decline in WEN and closed out the position with the belief that even a dead cat will bounce but WEN is going from bad to worse.

The rest of ’09 and first quarter of ’10 are all about burgers for a buck. The obvious problem is the heavy fast food customer, young males, do not have the discretionary income or are not spending as much of their discretionary income as they did a few years ago. While the typical Arby’s (or Wendy’s) customer may not be the typical McDonald’s (McD) customer, a portion of the customer base overlaps with that of all fast food concepts. For the rest of this year, those customers who migrate among various fast food concepts are being drawn to McD and Burger King (BK). Specifically, McD has done everything right over the past few years and same-store-sales as well as the McD stock price have increased during that period. Now McD is struggling to keep the momentum (McCafe is not growing / driving as much traffic as was expected) and, as a result, have resorted to aggressively pushing 99 cent double cheeseburgers. Likewise, BK has entered the battle and is promoting 99 cent double cheeseburgers in an effort to hold onto market share. Wendy’s will ultimately have to participate in the burger war and Arby’s will continue to experience double digit same-store-sales declines since they lack a compelling value offer. Finally, there is seasonality in fast food (especially in colder, northern climates) and the first quarter of the calendar year is the slowest so things will get worse before they get better.

Same-store-sales declines = free cash flow squeeze. At an average-unit-volume (AUV) of $1.3 million, the typical Wendy’s will generate positive cash flow from restaurant operations if sales decline by 10% but obviously not as much free cash flow. Arby’s, on the other hand, has an AUV of slightly less than $900 thousand – uncomfortably close to break-even levels. When the double digit sales declines at Arby’s continue, the concept’s restaurant operations will be burning cash quickly. I say when sales decline because Arby’s is going to introduce a dollar menu. Currently, Arby’s has an average customer check in excess of $7.00 and the trade down effect from regular customers ordering from the dollar menu instead of their usual $6 Beef n Cheddar combo will cannibalize the overall sales. Make up for the lower average check by increasing the number of transactions? Don’t count on it. An Arby’s dollar menu will only slow the loss of customers.

Efficiencies have been achieved. At least the low hanging fruit like consolidating the corporate / executive functions of the merged companies has been completed. Operating efficiencies, like reducing food costs or other operating expenses, are a long and slow process. During a period of declining sales, like we are in now, any savings are offset by the higher percentage of sales that fixed costs account for. Q3’09 financial results improved at Wendy’s but primarily resulted from a drop in commodity costs (uncontrollable) and price increases. At some point, price increases will drive customers away and the current McD and BK $1 double cheeseburger war is likely to cause a trade down effect at all the burger chains.

Menu extensions, especially breakfast, have failed and nothing is in the pipeline. Breakfast is being abandoned everywhere but locations with strong morning traffic (where they should have had breakfast anyway). Approximately 300 Wendy’s or about 5% of the system that had introduced breakfast have now discontinued it. It’s not possible to be a player in breakfast without offering it at all locations (non-traditional locations like malls excluded). There is no convenience if customers have to figure out which Wendy’s offer breakfast and they certainly won’t go out of their way if they would have to drive past McD, BK or Dunkin Donuts.

Slowly expanding the number of units in operation. Cost of real estate, building and equipment do not allow for a sufficient ROI for any fast food concept (other than McD). If the ROI were favorable, WEN would be aggressively building new restaurants instead of buying back stock. In addition, financing sources for restaurant franchisees (like GE Capital) have exited the business.

Trian / Nelson Peltz holds an influential percentage of the outstanding stock. He always seems to make money but I’m not so sure about other investors. As an activist, he pushed Wendy’s (and Cracker Barrel for that matter) to financially engineer a higher stock price with non-recurring events like selling corporately owned restaurants and real estate but his actions when he controlled just Arby’s were the opposite – do as I say, not as I do.

Health trends do not materially impact fast food sales. Customers say they want healthier menu items but, when ordering, pay little attention of healthfulness. Convenience, impulse and/or cravings dominate what customers will order.

It may be waaay better than fast food but the stock should drop at least another 10%. Premium menu items will reward shareholders but not until unemployment is reduced significantly.