Wendy’s: Where’s The Beef?

Feb 03, 2024

In 1984 Wendy’s launched their iconic “Where’s The Beef” commercial. In it an actress receives a hamburger with a giant bun and tiny patty and angrily exclaims, "Where's the beef?"

History of Where's the Beef? — Comedy History 101

The campaign was so popular that sales grew 31% and sparked a merchandise line for fans. Walter Mondale even used the line to rebut Gary Hart in the March 11, 1984 Democratic primary debate.

Investors today are asking Wendy’s “where’s the beef?” Wendy’s stock has been flat since 2018 and its chairman and largest shareholder, Nelson Peltz, has threatened to acquire or sell the chain. In response, the company has shaken up Wendy’s management and committed to an aggressive dividend and repurchase program. It was enough to placate Peltz, but will it work?

Wendy’s is a simple, predictable, and profitable royalty business that generates lots of cash and has vowed to return virtually of it to shareholders. It yields 5.3% and buybacks should add another 1.4% per year (net of dilution). It’s in a defensive, non-cyclical industry that is unlikely to be disrupted. In other words, it's exactly the type of business Eagle Point prefers to invest in.

Wendy’s has its challenges though. Its scale is dwarfed by McDonalds and Burger King who can amortize technology costs over a larger sales base and who already have exclusive relationships with the most experienced franchisees. Fast food has zero switching costs which mean custom loyalty must be won each day. Competition is fierce and innovations are quickly copied.

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History

Wendy’s founder Dave Thomas was abandoned by his biological parents and adopted when he was six weeks old. He moved to Ft. Wayne, Indiana with his Dad when he was 15 and began working at Hobby House Restaurant. When his Dad prepared to move again, Thomas chose to remain in Ft. Wayne on his own and dropped out of high school to work full time.

Later in life Thomas would become an advocate for adoption and education. Dropping out of school was Thomas’s self-proclaimed “greatest mistake in life.” He regretted his decision enough to get his GED in 1993 at age 60. Thomas espoused a hard-working, no-nonsense approach to business and jokingly attributed his success to his MBA (“mop-bucket attitude”).

When the Korean War broke out in 1950 Thomas volunteered for the army rather than wait to get drafted so he could have some choice over his assignment. He requested to attend Cooks And Bakers School at Ft. Benning, Georgia and deployed to West Germany. As a Mess Sergeant he was in charge of feeding 2,000 soldiers.

Upon discharge in 1953 Thomas returned to Ft. Wayne and Hobby House where he became head chef. Around this time Kentucky Fried Chicken founder Col. Harland Sanders came to Ft. Wayne to sell restaurateurs KFC franchises. Thomas’s employer, the Clauss family, opened several.

Thomas worked closely with Sanders and the two learned from each other. Thomas encouraged Sanders to simplify KFC’s menu and focus on a signature dish. He also suggested Sanders personally appear in KFC’s advertisements. Thomas would later use both of these techniques at Wendy’s.

In the late 1950s the Clauss family sent Thomas to Columbus, Ohio to turn around four underperforming KFC restaurants. By 1968 the stores had become so profitable that Thomas was able to sell his interest for $1.5 million ($13.2 million in today’s dollars). This provided the seed capital for Wendy’s.

Thomas opened the first Wendy’s in Columbus, Ohio on November 15, 1969. He named the company after his daughter Melinda Lou. Her nickname was Wendy, which she got from the way she mis-pronounced her own name at a young age (“Wenda”). Thomas later regretted naming the restaurant after her because of the attention and pressure it put on her.

Wendy’s would prove to be an innovative company, with several firsts to its name.

In 1970 Wendy’s opened the first drive through pickup window. The concept was so revolutionary that drivers initially needed instructions on how to talk through the speaker to place an order.
In 1979 Wendy’s introduced salad bars. These were a hit, but ultimately phased out in 2006 as customers demanded more portable salad options. In 1988 Wendy’s expanded its salad bars into full-blown buffet’s called Superbars. These were popular but too difficult to maintain and shut down in 1998.
In 1983 Wendy’s added baked potatoes to its menu as a healthier alternative to french fries or as a side for chili. Wendy’s chili and baked potatoes have stood the test of time and remain unique among QSRs.
In 1989 Wendy’s launched the first Super Value Menu with nine items available for 99¢ every day.
In 1990 Wendy’s began offering grilled chicken sandwiches as a lighter, lower calorie option.
In 1996 Wendy’s was the first major QSR chain to launch a spicy chicken sandwich. It was well received and quickly became a permanent menu option.

While Wendy’s was innovative, they did not capitalize on their innovations as best as they could. Fast food is a brutally competitive industry where innovations are quickly copied. McDonald’s has been a master of stealing other people’s best ideas and rolling them out bigger, better, and faster than anyone else.

In 1995 Wendy’s acquired Tim Horton’s. Bill Ackman bought 9.9% of Wendy’s in 2005 and pushed for them to spinoff Tim Hortons and refranchise their system. Wendy’s took Tim Horton’s public in 2006 in a partial IPO and spun off their remaining interest six months later. Wendy’s continues to own a 50/50 JV with Tim Horton’s (now owned by Restaurant Brands International) called TimWen. TimWen owns real estate in Canada leased to franchisees of both Wendy’s and Tim Horton’s.

In 1982 Thomas resigned from day-to-day operations at Wendy’s. In 1989 he returned to appear in commercials as the company’s spokesman. His folksy and self-deprecating manner was a hit with consumers. Thomas appeared in over 800 commercials and became a household name. In 2002 Thomas passed away at age 69. He was the face of Wendy’s and the company struggled to produce effective marketing without him.

On April 24, 2008, Triarc acquired Wendy's. The acquisition was part of CEO and controlling shareholder Nelson Peltz’s strategy to transition Triac from a conglomerate into a focused food and beverage business. Triac already owned Arby’s and renamed the combined company Wendy's/Arby's Group, Inc.

In 2011 the group sold Arby’s, which had underperformed since the merger. Roark Capital bought Arby’s and later merged it with Buffalo Wild Wings to form Inspire Brands. Today Inspire owns Arby's, Buffalo Wild Wings, Sonic Drive-In, Jimmy John's, Mister Donut, Dunkin' Donuts, and Baskin-Robbins chains.

Peltz became non-executive chairman of Wendy's/Arby's Group upon their merger and remains in that position at Wendy’s today. Nelson’s son, Matthew Peltz, is currently Wendy’s non-executive Vice Chairman and a director. Nelson Peltz beneficially owns 17.7% of Wendy’s worth $700 million.

In 2012 Wendy’s began its Image Activation program which aimed to update the brand with modern restaurant designs, innovative products, and new advertising. In 2015 Wendy’s announced that it would sell 500 company-owned stores to franchisees in order to achieve a 95% franchised system. The sale sped up Wendy’s brand transformation by requiring franchisees to remodel restaurants as a condition of purchase. The Image Activation initiative also rolled out self-ordering kiosks, a mobile app, and rewards program.

If you’re interested in more details about Wendy’s the book Dave’s Way offers an excellent history.

Wendy’s Today

Wendy’s is the third largest burger chain in the world by store count and the second largest by traffic share. There are 7,166 Wendy’s – 6,010 in the US (84%), 423 in Canada (6%), and 1,564 in 32 other countries and territories (10%).

Wendy’s is big, but it is significantly smaller than rivals McDonalds and Burger King. There are more than double the number of McDonald’s (13,897) and 22% more Burger Kings (7,323) in the US.

New unit growth (NUG) has historically been 1-2% per year. Unit growth between 2008 and 2015 was affected by the merger with Arby’s and the refranchising initiative.

Management has been trying to accelerate NUG but pandemic-induced supply chain constraints have worked against them. Now that supply chains are fairly normal, NUG should accelerate. Management targets 2% growth in 2024 and 3-4% growth in 2025.

Management failed to hit its NUG goals the last few years but seems more confident about the future. Ambitions have been dialed back to more realistic targets. 70% of NUG is slated for international markets and 30% in the US.

The company’s international-heavy growth plan is a little puzzling. Wendy’s says they have plenty of whitespace to fill in the US, where their brand is already established and well-known.

“In the U.S., we continue to be under-penetrated with thousands of potential trade areas that sit untapped and without a Wendy's. We know this leaves a ton of white space for us and our franchisees to provide even more access to the brand over the short term and the long term.”
March 2023 Conference Call

Wendy’s has historically struggled to grow abroad, having tried and retrenched in several markets. Their current push is in the UK and Philippines. The issue is finding franchisees with the right experience and capital. McDonalds and Burger King already have huge international businesses and have signed category-exclusive master franchise agreements with the best operators. Wendy’s international growth ambitions aren’t impossible, but they’re not low hanging fruit either.

During the pandemic Wendy’s signed a deal for 700 new units with Reef Technologies. Reef operates ghost kitchens that look like food trucks. They can be located in dense, urban markets where suitable real estate is expensive and hard to find.

The experiment didn’t pan out as well as Wendy’s expected, with AUV of just $0.5 million in the US. Reef’s results were better abroad. Reef owns and operates the trucks as a franchisee and has been pushing to allow Wendy’s to let them cook for multiple brands out of one truck. That’s been a non-starter for Wendy’s and the two have dramatically downsized their ambitions. In March Wendy’s announced all remaining US Reef units would be closed. The Reef failure is the main reason Wendy’s failed to deliver on its prior NUG guidance.

For Wendy’s to succeed opening new stores, they need to have strong same-store sales and strong franchise profitability. Growing same-store sales is a prerequisite for profitable unit growth. It’s the market giving the brand permission by demonstrating that the demand exists. It is no coincidence that McDonald’s strong recent performance coincides with its first push to grow its US store count since 2017. Same for Home Depot, which is also opening its first new US stores in years.

Wendy’s is on pace to report a 13th year of positive same-store sales later this month. Results were ahead of Burger King but behind McDonalds, and in-line with inflation.

According to Morningstar:

Wendy’s has generated an impressive 12 straight years of comparable store sales growth (through 2022), but its annual average same-store sales growth of 3.7% falls just short of annual food-away-from-home inflation of about 4.3% over that period, suggesting difficulties staying abreast of inflation.

This is a decent showing. Not the best, but no disaster. Many businesses struggle merely to pass through inflationary pricing. Few can actually raise prices above the rate of inflation. Those that can price ahead of inflation demonstrate a strong moat.

QSRs tend to benefit during periods of food inflation because consumers perceive value on their value menus versus increasingly costly food at grocery stores and sit-down restaurants. A WSJ article from August 2022 pointed out that July 2022 saw the biggest inflationary gap between grocery stores and restaurants since the 1970s.

Wendy’s aims to grow same-store sales at a low single-digit pace. Future price increases will probably mirror inflation but may be slightly higher over the short term to catch up. The company thinks it has pricing power.

“We definitely believe we have pricing power. We have now taken significant pricing the last couple of quarters. We are up to 10% in the company restaurants…
We're still seeing a flow-through of about 80%. So we have not yet reached a breaking point, and we think there is, therefore, more pricing power there.”
November 2022 Call

Wendy’s is getting more sophisticated about when and where they take price. The WSJ wrote about their efforts in May.

Franchise profitability is the other key to unit growth. If franchisees are making lots of money, they’ll be eager to invest more capital to build new stores, renovate, and invest in new equipment to make innovative products. Strong same-store sales also encourage franchisees to build more stores within their existing territories (what Domino’s calls “fortressing”) to spread demand across more restaurants and avoid overwhelming traffic which degrades service quality.

Average unit volumes (AUV), restaurant margins, and the cost to build a new restaurant are good gauges of franchise profitability.

Wendy’s AUVs are around $2.2 million in the US, which is substantially lower than McDonald’s $3.2 million. Burger King’s US data is harder to find but QSR Magazine indicates that they’re significantly lower at around $1.4 million.

Restaurant margins are more of the same. Wendy’s lies between McDonald’s and Burger King.

Margins dove in 2022 as soaring commodity prices bit. Management raised prices 10% in 2022 and more in 2023. Now margins have normalized back to their pre-pandemic range. Management forecasts 15-16% margins for 2024. New stores have been opening with $2 million AUVs and above-average margins, which is a promising sign.

Why Does Wendy’s Underperform McDonald’s?

McDonald’s had a nearly 30 year head start on Wendy’s (1940 vs 1969) which helped it nab better real estate and achieve more broad brand recognition. McDonald’s is significantly larger than Wendy’s and has a proportionally larger ad budget.

McDonald’s has not only built the McDonald’s brand, but also many sub-brands. McDonald’s says it has several “billion dollar brands” like the Happy Meal, McMuffin, McFlurry, Big Mac, Quarter Pounder with Cheese, Big Mac, Chicken McNuggets, and, the most recent addition, the McCrispy. These items are iconic and recognizable in their own right. That didn’t happen overnight. It happened because McDonald’s has been consistent. Although the exact products have changed over time, the names have remained consistent.

Wendy’s has not been so consistent. They lack an iconic, signature burger to compete with the Big Mac and Whopper. Wendy’s burgers are recognizable for their trademark square patties. Thomas thought the square shape showcased how much beef was on each burger and how juicy and fresh they were. At one point this backfired when customers began to assume that the unusual shape implied that they were more processed and less natural than round patties. Wendy’s slightly rounded their patties in response.

Wendy’s does have a few brands of its own. The Baconator, launched in 2007, is unique. So are Frostys, Junior Bacon Cheeseburgers (JBCs), and Biggie Bags. These aren’t quite as iconic as McDonald’s products, but they’re something. It’s interesting to think that Wendy’s led QSRs in offering a Spicy Chicken sandwich and yet failed to build a strong brand around theirs.

Wendy’s marketing has focused on showcasing their quality ingredients and fresh, never frozen promise rather than individual products. They’ve always positioned themselves at the top end of the QSR market. That means they’re targeting a slightly narrower market segment than McDonald’s and Burger King. Chili and baked potatoes are good, but they’ll never be as craveable as McNuggets and Whoppers.

When Dave Thomas was the face of Wendy’s, the company’s marking was unified and consistent. When he passed the company struggled to replace him. McDonald’s never tied itself to a person, preferring animated characters. As Buffett says, the best part about GEICO is that the gecko doesn’t have an agent.

Unit Economics

Building a Wendy’s costs anywhere from $2 to $4 million, which assumes the owner pays cash for the land, building, improvements, equipment and signage. The variance depends on the market’s real estate and labor costs.

Wendy’s says its franchisees can get a 15-20% cash-on-cash return by building one of its newest next-gen designs.

“Previously, you would get a cash-on-cash return of 10% to 15%. With the new next-gen design, you're actually getting a step-up of 15% to 20% cash-on-cash return.”
November 2022 Call

Most franchisees aren’t paying cash though. Financing brings the out of pocket costs down to $0.6-1.4 million, according to Franchise Direct. Franchisees can expect levered returns in the 20-50% range, which is attractive enough that Wendy’s should still be able to be choosy about its partners. (The actual returns will be a little lower given the interest expense).

Wendy’s has a few incentive programs for franchisees. Pacesetter was a new program in 2023 that slashed the levered payback period from three years to two. The company is using Pacesetter to build its development pipeline in the 2025-2027 timeframe.

Wendy’s also has a Built To Suit program that they’ve committed $100 million to ($95 million remains). Build To Suit requires even less upfront capital from franchisees in exchange for a slightly higher royalty rate (6% vs 5% for Pacesetter and 4% for the Groundbreaker program that Pacesetter replaces).

I am a little perplexed about why Wendy’s needs development incentives. Why did they need to take an already attractive 3 year payback period and cut it down to 2 years? A 3 year backpack is competitive with other franchise concepts. With a two year payback period I’d expect the US to get covered in Wendy’s, and yet 70% of expansion will happen overseas.

Digital

Every company is a technology company these days, like it or not. Wendy’s digital sales are 13% of total, well behind industry leaders Yum Brands (45%) and McDonald’s (40%). However, digital sales are growing quickly (30%). Digital sales are important because they save labor and avoid mistakes. Customers who order digitally tend to order more and more frequently.

Wendy’s has 35 million U.S. loyalty members, including 5 million monthly active users. These are growing fast too, up 40% quarter-over-quarter. Loyalty allows Wendy’s to collect data about specific customers and tailor their marketing approach to them.

In 2020 Wendy’s hired a new Chief Information Officer, Kevin Vasconi, formly Domino’s Pizza’s Executive Vice President, Chief Information Officer. Domino’s is sometimes referred to as a tech company that sells pizzas. Vasconi has been instrumental in getting Wendy’s to lean even harder into tech. They are currently working on an AI chat box that can take drive-through orders.

Forward Returns

Wendy’s is a simple, royalty based business that offers predictable returns. Forward returns will be the sum of:

Same Store Sales Growth (SSS)
New Unit Growth (NUG)
Yield (Dividends + Buybacks)
Change In Stock’s Valuation Multiple

We’ve already discussed NUG and SSS. Same Store Sales are likely to track inflation. I’d pencil in 2-3%.

NUG is likely to grow 2-4%, at the lower end this year and at the higher end next year. Longer term NUG will depend on the success of Wendy’s international push. The company is building its ‘25-’27 pipeline now and will probably provide an update when they report in a few weeks.

Capital Allocation

Wendy’s recently shifted its capital allocation policy, a catalyst Buffett has often used to time investments.

Historically Wendy’s has made buybacks the centerpiece of their capital allocation policy. From 2008 through 2022 the company reduced its share count at a blistering 5.5%. The stock traded at a median P/E of 28. Even though Wendy’s converts 100% of earnings into free cash flow (and expects to continue to), the buybacks still required more than 100% of free cash flow. Wendy’s used capital from the sale of Arby’s, sales of company-owned stores to franchisees, and debt to make up the difference.

Wendy’s is 4.7x levered and plans to remain below 5x. This is a lot of leverage but fairly normal for highly franchised, non-cyclical QSR concepts like Restaurant Brands International and Domino’s Pizza. Wendy’s has $600 million of cash on its balance sheet and well laddered, securitized debt. The company says it can easily run with $300 million cash, which means they have $300 million excess.

In May 2022 Nelson Peltz, Wendy’s Chairman and 17.7% owner signaled that he was considering strategic alternatives for Wendy’s. An acquisition by Peltz, merger with a 3rd party, or other transactions were on the table. Peltz’s comments came as the stock was down 32% year to date and struggling with rising costs and weak traffic.

In January 2023 Peltz put his push for strategic alternatives on hold. It appears that he was pleased with Wendy’s business momentum, which saw a 12th consecutive year of same-store sales growth and 2% new unit growth.

Wendy’s and Peltz agreed to streamline management and put a new capital allocation policy into place. Leigh Burnside, Wendy’s chief accounting officer and U.S. chief financial officer, stepped down to become the financial chief of a different restaurant company. Kurt Kane, U.S. President and Chief Commercial Officer, also left after Wendy’s eliminated his position in a “broader redesign of its organizational structure” aimed at keeping G&A costs low in the years ahead.

In January 2024 Wendy’s announced that CEO Todd Penegor would leave and be replaced by PepsiCo’s Kirk Tanner beginning February 5th. Tanner has been the head of PepsiCo’s Beverages North America division since 2019.

Beginning in March 2023 Wendy’s doubled its quarterly dividend to $0.25, which produces a 5.3% yield on today’s $19 stock price.

Wendy’s also doubled the size of its buyback program to $500 million which will expire in February 2027. Spread over 4 years ($125 per year) at current stock prices, the buyback program would add 3.2% to annual yield. Wendy’s has committed to repurchasing at least $70 million of stock per year to manage their dilution and will be opportunistic on the remainder. Assuming that means Wendy’s expects to issue $70 million of shares a year, the net buyback yield will be 1.4%

Wendy’s dividend policy is unique and meant to catch Wall Street’s attention. The payout is more than 100%, which management eagerly points out. The point of the big dividend is two-fold. First, management wants to whittle down their excess cash. They plan to accomplish this over a few years. Second, management wants to show their confidence in their growth. In January 2023 they said:

We felt with the high cash balance we have, the high visibility we have in growth, the high visibility we have in future strong cash flow growth but it is the right action to actually be a little bit more attractive on the dividend side….
We want to signal to the financial markets that we have high confidence in growth, high confidence in high cash flow generation…
Again, all combined, if you do the calculation, you're getting to capital returns over the next several years of more than $1 billion. So we are signaling that our cash flow generation is going to stay very strong.

More recently in November Wendy’s reaffirmed their long-term growth outlook.

Turning to our long-term outlook, we continue to expect mid-single-digit annual systemwide sales growth and high single-digit to low double-digit annual free cash flow growth in 2024 and 2025.

If you add up Wendy’s NUG (3%), SSS (3%), dividend (5.3%), and net buybacks (1.4%) you get 12.7%. This strikes me as fairly achievable and reasonably attractive business return.

The stock can probably do better than the business under this scenario. Wendy’s trades for 19x PE and has a median historical PE of 28. Let’s say Wendy’s can hit its NUG and SSS growth targets and re-rates to 25x over 5 years. That would add another 5.6% to Wendy’s business return and bring forward stock returns to 18.6%. So you’re looking at a 13%-ish business return and 19%-ish stock return.

These are attractive numbers. But remember, Wendy’s stock hasn’t performed this well in the past. That’s one reason why this opportunity exists – value has welled up inside the business because the stock underperformed the business. In 2018 Wendy’s earned $0.60 per share and traded at a 28x PE. Today it earns ~$1.00 per share and trades at a 19x PE. Multiple compression offset all of the business’s growth. That’s the risk you take when you buy high-multiple stocks.

There doesn't seem to be much optimism baked into Wendy’s valuation, which helps make it a bit of an asymmetric bet. The stock's 5%+ dividend yield should lend some support to the stock. I suspect that most dividend investors are wary of buying Wendy’s with a payout ratio over 100%. On paper, it looks like a value trap. If the company hits its growth targets then it will grow into its dividend. A lower payout ratio would probably entice yield hungry investors to buy, bidding up the stock.

The biggest risk is that Wendy’s fails to achieve its NUG plans. I have more confidence that they’ll be able to grow SSS in-line with inflation since they have a track record of doing that. Their NUG record, particularly internationally, is spotty.

If NUG stalls then they may have to cut their payouts and the stock won’t re-rate. The growth in 2024 and 2025 should be baked in at this point with high visibility. Permits and construction have a long lead time. If Wendy’s has a growth problem, it probably won’t emerge until after 2025.

For now I’ll continue to watch Wendy’s and see how they perform. I’ll be curious to see how they describe building their NUG pipeline beyond 2025. If I were to buy, I’d prefer to pay a little less, say a few turns cheaper. That would boost the free cash flow yield high enough that I wouldn’t feel I needed much growth for the investment to succeed. At today’s price, you need at least a little growth.

I also want to hear from Wendy’s new CEO. Companies often report a “kitchen sink” quarter when a new CEO comes in and cleans house, airing all of the dirty laundry so it isn’t attributable to him in the future. This can depress stock prices in the short term and may create a buying opportunity.

I’ll also be curious to see what his incentives are. Last year’s proxy listed the incentives below.

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