Forget McDonald’s — This Smaller Competitor is the Better Stock to Own

Being the premier name in a business category doesn’t necessarily make it the ideal investment opportunity in that particular sector.

Take McDonald’s (NYSE: MCD) for example. While it’s the undisputed king of fast food restaurants, its competitor-crushing edge five years ago led to a dangerous complacency, opening the door for a competitor to step up to the plate and surprise everyone with a major turnaround. And right now, that smaller competitor may be the bigger investment opportunity.

Six years ago, Wendy’s (NYSE: WEN) was such a mess that the company was publicly seeking suitors to save it from extinction. More alarming than the clear desperation of begging for a buyer was the fact that it couldn’t find one, despite the stock’s slide from more than $20 early in 2007 to below $7 late in the year. Valuation wasn’t the issue; nobody wanted to touch a company that looked like nothing but a huge headache.

Finally, in September 2008, after the stock’s price had slumped to $6, Triarc Companies, owners of the Arby’s fast-food chain, took the plunge and merged with the flailing Wendy’s chain, forming the Wendy’s/Arby’s Group.

Luckily for Wendy’s, Triarc CEO Roland Smith had the experience necessary to help the struggling business. He had already turned Arby’s around in 2006 when it faced similar problems. By the time 2009’s full-year numbers were reported, EBITDA was up 16%. However, the combination of the two fast food restaurants was more of a burden than a benefit, with the hoped-for synergies never giving either chain a clear edge.

Meanwhile, the stock price has been stuck in the $5 area since late 2008, even though the broad market has doled out decent gains during that time. This has left disappointed investors wondering if Wendy’s can ever turn itself around.

As it turns out, a lot can happen in a year.

The sale of the Arby’s arm in mid-2011 put $130 million in cash into Wendy’s war chest, and meant the company could proceed with the big turnaround effort — a plan that consisted of an increase in the number of units that serve breakfast, remodeling its aging restaurants to the tune of $800,000 each, and expanding overseas.  

Since then, Smith has retired, and Taco Bell and former Wendy’s veteran Emil Brolick has taken over. Brolick has updated Smith’s original vision to keep the progress ball rolling and is focusing on pricing, product and promotion. Like his predecessor, the current CEO’s plan appears to be working.

The proof is in the numbers, which show that Wendy’s is on the right track. The company’s per-share profit of 15 cents in 2011 was only a penny better than 2010. But 2013’s forecasted earnings of 20 cents per share shows the company is turning up the heat a bit.

Wendy’s just reported it fifth consecutive quarter of positive same-store sales in North America, which increased 3.2%. Revenues are growing too, projected to be up 4% in 2012 and another 4% in 2013. It may not be red-hot growth, but all big trends start out as small ones.

In other words, the overhaul is working, yet still gaining momentum. In many ways, though, that’s the ideal entry point for investors… before a trend becomes obvious.  

Risks to Consider: The fast-food business is fiercely competitive and takes aim at price-conscious customers. Part of Wendy’s new strategy is to position itself as more of a premium brand, which may backfire if consumers feel like they’re paying too much compared with other options in the industry.

Action to Take–> McDonald’s isn’t likely to be dethroned as the industry’s king. On a relative basis, however, Wendy’s is better positioned for big-time growth over the next few years as it continues to work its way through a surprisingly effective turnaround. Realistically, based on the company’s plausible growth forecast, shares could be worth somewhere around $7 by the end of 2013 or mid-2014 — about 60% higher than current levels.