Forget McDonald’s: Buy This Fast-Food Stock Instead
Here’s one of my favorite investing maxims: “Better early than late.”
This sums up perhaps the biggest weakness is my investing approach. I have a pretty good nose for stocks that rise — eventually. But I can be premature by several months or several quarters as well. Yet, as long as my initial investment thesis remains intact, I continue to monitor many of these slow-to-develop trading scenarios. And when the time feels right, I pounce again.
#-ad_banner-#Right now, it’s time to take a fresh look at a suggested play which hasn’t paid off yet. But the stars are finally starting to align.
I’m talking about fast-food operator Wendy’s (NYSE: WEN), which looked poised to break out last spring, as I wrote then. Shares have risen 12% since then, but any further momentum has been blunted by the stock market: The S&P 500 peaked just two weeks later and has dropped about 100 points from that high. The fact that shares of Wendy’s lagged McDonald’s (NYSE: MCD) (which gained 33%) is the real sign that the investment strategy was ill-timed.
Indeed, McDonald’s has turned out to be one of the best places for your money in the past half decade. While the market has zigged and zagged, Mickey D’s stock has marched steadily higher.
Yet at $100, McDonald’s’ stock is starting to look too expensive. It trades at 17.5 times projected 2012 profits, which are expected to rise less than 10%. Trading at a premium to its growth rate makes sense. Trading at nearly two times the growth rate does not make sense.
Just looking at 2011 financial comparisons, both stocks look a tad pricey at 14 to 16 times 2011 EBITDA (all projections provided by Merrill Lynch). Shares of McDonald’s are nearly four times as expensive on a price/sales basis, because McDonald’s makes so much more profit on every dollar of sales. Indeed, 31% operating margins are fairly mind-blowing.
But changes are afoot at Wendy’s, as I’ll discuss in a moment.
Here’s a look at the numbers for both fast-food chains, based on projected 2012 results.
Note that McDonald’s’ operating margin is expected to remain flat at 31.3%, while Wendy’s operating margin is expected to rise from 7.3% to 9.1%. You want to find stocks that are just on the cusp of this kind of inflection point. And signs are emerging that 2012 may just be the beginning of a phase of longer-term margin improvement for Wendy’s.
Why the optimism? Because Wendy’s historically generated more robust margins prior to being acquired by financial engineer Martin Peltz. A decision to combine forces with lagging fast-food provider Arby’s was a huge mistake, as Arby’s weak same-store sales results consumed most of management’s attention.
As I noted back in April, Wendy’s has been remodeling stores, revamping its menu and taking advantage of the seeming drift at rival Burger King now that the burger chain has been acquired by 3G Capital for $4 billion. At the end of 2010, Burger King controlled 13.3% of the burger-focused fast-food market, ahead of Wendy’s 12.8% market share (McDonald’s holds a commanding 49.5% share). Yet in recent months, Wendy’s has picked up market share and could overtake Burger King when December chain store sales are announced, according to analysts at Janney Capital.
The momentum actually kicked in a few months ago.
“4Q is off to a very strong start with the October launch of Dave’s new burger line. In the past five weeks, comps have accelerated to their strongest levels since April/May of 2004,” noted Merrill Lynch in a Nov. 9 note to clients.
More gains could be in store for 2012 and 2013. Wendy’s is now being run by Emil Brolick, who took the reins in mid-September. He had recently led a successful turnaround effort for Yum Brands’ (NYSE: YUM) Taco Bell chain. During the 1990s, he was a senior brand manager for Wendy’s, which “was a period of great sales strength,” notes Merrill Lynch’s Joseph Buckley, adding that Brolick is “one of the best brand managers in the restaurant industry. We believe he has great insights into brands, consumers and the relationship between the two.”
Perhaps Brolick’s most important lesson learned from his tenure at Yum Brands was in the area of international expansion, where Taco Bell, KFC and Pizza Hut have all thrived. Perhaps it’s no coincidence that Wendy’s just announced plans to open 100 new restaurants in Japan in the next five years. Brolick may be in the early phase of identifying other global market opportunities as well.
Brolick’s plan is to re-establish what Wendy’s was once known for: a provider of the highest-quality food among peers. This should enable firmer pricing — and consequently profit margins — down the road. Rome wasn’t built in a day, and Brolick’s efforts are unlikely to fruit in less than a year. As such, it’s prudent to expect decent — but still not great — quarterly results this winter. Later in 2012 and coming into 2013, however, expect steadily rising results.
Risks to Consider: Wendy’s gains are likely to come in part from rival Burger King’s lack of focus. If that chain’s new owners come up with a better game plan, then Wendy’s recent market-share gains could be reversed.
Action to Take –> As noted earlier, Wendy’s operating margins are expected to rise from 7.3% in 2011 to 9.1% in 2012, and with just a little tinkering, could exceed 10% by 2013. This would still lag McDonald’s’ impressive 31% operating margin, but with a price-to-sales ratio roughly four times higher, investors may soon be overpaying for Mickey D’s. This isn’t an argument for a quick downturn in the stock, but is instead an argument for a potential robust rebound for Wendy’s.
We already know what this business is worth in terms of private equity. Burger King’s $4 billion buyout is noticeably higher than Wendy’s current $2.75 billion enterprise value, even though the two chains now have comparable sales bases. If we make $4 billion the benchmark “fair value” for Wendy’s, then we’re talking about 45% upside for the stock.