Wendy's (WEN) Rides on System Optimization Despite High Costs

The Wendy's Company WEN is continuously relying on menu innovation, technological upgrades, international expansion and re-imaging of units to drive top-line growth. It is also benefitting from its transition to a franchised business model.

In the fourth quarter of 2018, the company’s revenues gained from increased franchise royalty revenues and fees driven by restaurant development and lower franchise incentives. Earnings also beat the Zacks Consensus Estimate in the reported quarter. In fact, earnings surpassed estimates in three of the trailing four quarters, the average beat being 4.4%.

Backed by this impressive earnings trend, shares of Wendy’s have gained 4.1% over the past year, outperforming the S&P 500’s rally.

Factors Likely to Continue Driving Growth

Wendy’s sincerely focuses on expansion to fortify brand presence and drive revenues. The company expects global net new unit growth to be 1.5% in 2019. With the advancement of Image Activation, it is making progress with its unit development goals.

Notably, Wendy’s achieved total net new development of 97 restaurants globally in 2017, mirroring 1.5% year-over-year growth. In 2018, it opened 159 restaurants as part of its expansion endeavors. This suggests roughly 1.2% global net new restaurant growth in 2018. Also, at the end of 2018, 50% of the global system was image activated.

Wendy’s also continues to improve its franchise relations, which further facilitates expansion. In 2017, the company had several first-time builders and it doubled the number of franchises from 2015 by building restaurants. It plans to continue facilitating franchisee-to-franchisee restaurant transfers through its buy-and-flip strategy. This strategy ensures that restaurants are put in the hands of well-capitalized franchisees, committed to long-term growth.

In 2017, Wendy’s facilitated 540 buy-and-flip transactions, with 130 in the fourth quarter. In 2018, it facilitated 96 Franchise Flips. In 2019, the company expects to complete 100-200 Franchise Flips.

The company’s brand transformation initiative also includes menu innovation, promotional offers and bold new packaging intended for boosting sales. We expect solid menu pipeline, limited time offers (LTO), marketing initiatives, and increased emphasis on core and price value offerings to maintain the trend.  By virtue of such initiatives, Wendy’s remain on track to achieve its 2020 target of achieving $12 billion in system-wide sales.

Concerns

While system-optimization initiatives are likely to bolster top-line growth in the quarters to come, Wendy’s would incur additional capital expenditure in the coming years. This might lower free cash flow in the near term. Though the company transitioned toward a franchise-based model that downscales capital expenditure, it will take time to reap benefits. In fact, it expects capital expenditure of approximately $75-$80 million in 2019.

Meanwhile, in order to compensate for these costs, the company is taking steps to re-align and re-invest resources. Though these initiatives might benefit Wendy’s over the long term, these are expected to increase costs in the near term, thereby hurting margins. Furthermore, it expects labor inflation of roughly 3-4% and commodity inflation of around 1-2%. The company would also have to increase its focus on cost savings and increasing same-restaurant sales in order to cope up with these inflations.