With so many stocks trading at all-time highs, avoiding those with sky-high price-to-earnings (P/E) ratios now seems to be a prudent strategy.
But it's a decision to make on a case-by-case basis. On closer inspection, it becomes apparent that some seemingly richly valued stocks have the fundamentals to support plenty more price appreciation.
The nation's third-largest fast-food chain, Wendy's Co. (Nasdaq: WEN), is such a stock. Its shares trade for more than 40 times earnings, a multiple that is well above the broader market multiple. Yet investors should anticipate continued outperformance.
Looking for a catalyst that will send this stock yet higher? A multi-year re-branding effort that is still bearing fruit is a clear one. Initiatives include logo and tagline revamps, as well as serious efforts to establish a meaningful digital presence (TV advertising was traditionally the preferred marketing method). There have also been wise menu changes that reflect evolving demographics and consumer preferences.
Menu innovations tend to target the enormous millennial generation, which is expected to be the economy's main growth driver in the coming decades. Thus, Wendy's is increasing its lineup of very spicy fare, a food category that's favored by many millennials and should also resonate with the burgeoning Hispanic population.
To better capitalize on the healthier food movement, Wendy's recently began offering an exclusive flavor of a leading organic green tea. A vegan black bean burger is being tested at selected locations, and the company is experimenting with premium options such as quinoa salad and grilled chicken on focaccia bread. The fast food chain is also considering a gluten-free bun option for those with gluten intolerance.
On the digital side, Wendy's is successfully connecting with customers through its website and social media. On the website, for example, there's an app for assembling a meal based on a set calorie limit. Social media campaigns solicit content and then highlight some of the most compelling submissions in web and TV ads, effectively making customers virtual spokespeople.
In another major initiative, Wendy's plans to refranchise 640 of its nearly 1,000 company-owned restaurants over the next two years (including the 240 locations refranchised in the first quarter). It's a smart move that will shift considerable ownership costs to franchisees and produce a reliable stream of royalty payments.
Management expects the process to generate pretax income of $400-to-$475 million. It should also markedly reduce operating costs, expand margins, increase earnings and enhance free cash flow.
Notably, refranchising also includes the sale of certain non-core assets, particularly an international chain of 21 bakeries that were used to supply Wendy's restaurants with buns and other bread products. Besides eliminating future capital expenditures, the sale frees up the company to pursue relationships with bread suppliers that are more cost-effective and better able to provide the increased variety needed to accommodate an evolving menu.
Efforts to stimulate business are already paying off. After averaging just 1.7% from 2012-to-2014, growth of same-store sales accelerated to 3.4% in the first quarter of this year. For the full year, management projects a 3% same-store sales growth rate, as well as a 5%-to-8% increase in adjusted EBITDA (earnings before interest, taxes, depreciation and amortization).
Per share profits should also receive a nice boost from a massive $1.4-billion share buyback program that Wendy's recently announced. The planned repurchases, which represent a third of the company's current market value, will occur over the next six quarters. Along with rebranding and refranchising, this should enable earnings to compound at a mid-double-digit rate in the coming few years.
Management has emphasized its commitment to raising Wendy's dividend in line with earnings growth. The current payout of $0.22 a share is nearly quadruple the recession low of $0.06 in 2009 and translates to a 2% yield.
Risks To Consider: Aside from its high stock valuation, Wendy's faces execution risk. For instance, it's not a given that menu changes or digital outreach will sufficiently attract target markets. Also, rising ingredient costs are a constant threat to profits, which have taken a hit in recent years from climbing beef and cheese prices.
Action To Take --> It's always a good idea to keep extra close tabs on portfolio holdings that have soared like Wendy's. A sharp correction is apt to occur at some point, and shareholders want to be able to take some profits in advance if shares start looking set to break down.
That said, growth investors can still look to Wendy's for substantially higher profits in coming years. Based on my projection of the company's earnings, shares have roughly 30% upside from current prices through the end of next year.
This assumes a more conservative P/E of 35. But if investors remain willing to pay more than 40 times earnings for the stock, gain potential could be nearly twice as great.
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