Wendy’s Is Destroying Itself To Repurchase Shares

If you’ve been following Wendy’s stock over the past few years, you may have noticed that the stock price has quadrupled in value from $4 in 2009 to $16 today while earnings have tripled over that same time frame from $0.20 to $0.60.

This strong ten-year performance is not indicative of a business that is positioned to deliver strong long-term returns over the coming generation.

While Wendy’s management deserves credit for realizing the advantages that come with the 4-for-$4 deal, making money by boosting traffic and earning high profit margins on the mandatory drink portion of the order to offset the lower profit margins on the food items, it has not been managing the company’s balance sheet as prudently.

A significant portion of Wendy’s earnings per share growth is the result of stock repurchases funded by debt, and as a result, Wendy’s now has a leveraged balance sheet that will limit this type of growth as an option in the future.

Over the past ten years, Wendy’s has own grown company-wide profits from $98 million to $140 million. That is only 3.63% annualized organic growth. The real returns have come from Wendy’s systematic reduction in the share count from 467 million shares outstanding to 239 million shares outstanding. About 6.5% of Wendy’s stock has been retired each year, which has blended well with the 3.63% core organic growth.

The problem is that Wendy’s balance sheet now carries $2.7 billion in debt compared to those $140 million in profits. Not only is Wendy’s capacity to further borrow constrained, but with interest rates rising and Wendy’s valuation now at 26x earnings, the effectiveness of any future buybacks is limited because the stock isn’t cheap and the costs of borrowing are higher.

It would not surprise me if a day comes in the late 2020s when Wendy’s stock trades somewhere in the teens. There is just too much leverage high, and future shareholders will have to pay the price for the quadrupling of the stock price that occurred between 2008 and 2018.

The real wealth in this segment is going to continue to come from McDonald’s. Not only does McDonald’s have vaster advertising capabilities, better economies of scale, and more optimal store locations, but it received an immense first-mover benefit by purchasing real estate in the 1960s and 1970s that is now paid off but the company receives rental income for use of the sites from the 84% of stores that are franchised rather than company owned. That translates into a huge structural advantage of modern competitors that have to pay 2018 prices to acquire their real estate holdings (whereas McDonald’s only has to pay 2018 property taxes on those long-ago acquired holdings–see the data point that 72% of U.S. store locations were purchased by McDonald’s real estate arm before 1995).

There are only two ways to invest in fast-food: (1) make a “growthy value investment” in a rising fast food enterprise, like Shake Shack at a price below $40 per share, and hold on for ten years so that you can reap the results of the company rolling out new locations across the country, or (2) if you are interested in making a one-time decision for multi-generational wealth, purchase shares of McDonald’s at a valuation of 17x earnings or lower, which would require waiting for McDonald’s stock to fall to $130 based on current earnings.

But a long-term investment in Wendy’s is not the answer. You know how when you consume caffeine, you are choosing energy now at the expense of an energy crash later? Wendy’s is the corporate equivalent of that. It borrowed and borrowed and borrowed to reduce its share count over the past ten years so it could reduce the share count by an eye-popping rate of 7% annually to drive returns, but the crash will inevitably come when investors see that they own a slow single-digit growth firm that is leveraged twenty-to-one and trading at 26x earnings. Rising stock markets and the recency of low borrowing costs create various illusions, and the idea that Wendy’s could be a suitable long-term investment is one of them.

This is a publicly available version of an article shared with The Conservative Income Investor’s Patreon followers on May 22, 2018.