Shares of fast-food giant Wendy's are still struggling to find solid footing ever since Morgan Stanley analyst, John Glass, lowered his rating on the stock to "underweight" from "equal-weight" on March 1.
While setting a $5 price target, Glass suggested that the company's restructuring efforts may take longer than investors expect. However, it would seem the company's actually on schedule. And if fourth-quarter earnings serve as indication, Wendy's plan to be "A Cut Above" should produce gains above what the Street expects.
Change We Can Believe In
It wasn't that long ago that Wendy's was fighting for an identity. Despite its strong tradition of offering good food at competitive prices, the company could never overcome the dominance of McDonald's. And things got heated when Chipotle began to sizzle in the premium quick-service restaurant (QSR) segment. Wendy's was stuck in limbo. It could not beat McDonald's or Burger King on price and brand competition. But it viewed itself as "A Cut Above."
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From there, after years of underinvestment, the company decided on a program to remodel its stores to better compete with the likes of Panera and Chipotle. But it's not a new idea. McDonald's went through the same change years ago with its U.S.-based restaurants. And it's been successful to the extent that McDonald's is now considering doing the same on a global scale.
To that end, Wendy's recently said that it plans to remodel 20percent of its U.S. restaurants by 2015. Out of the 6,500 locations that it has in North America, that means 1,300 stores will get face lifts. That's a pretty aggressive goal, which will require significant capital. The question, though, is how well can Wendy's convince the Street that revitalization efforts can boost traffic and profit margins?
Morgan Stanley doesn't think it can—at least not at the pace to support a higher valuation. Granted, the company has not shown the innovative prowess of McDonald's. However, fourth-quarter earnings, which beat Street estimates by 1 cent a share, suggest that Wendy's is doing well enough. And although Glass cited stronger competition from McDonald's and Burger King as reason for the downgrade, Wendy's still posted in-line revenue.
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Glass did, however, complimented Wendy's management team, saying "it is the strongest in recent memory," and he believes re-positioning the company as a purveyor of more premium food makes intuitive sense. However, the timing of the downgrade does not offer a vote of confidence.
Can "A Cut Above" Hurt or Is It Working?
That's one of the risks to this change. But I think the bigger risk to Wendy's was the status quo. As noted, Wendy's was not going to beat McDonald's on price. But expectations took a new turn when it was revealed that Wendy's surpassed Burger in sales in 2011, behind McDonald's among the hamburger chains, according to Technomic. It was the first time since 1972 that Burger King had lost that No. 2 ranking. Was "A Cut Above" working already?
The optimist in me wanted to give Wendy's all the credit here. However, for Wendy's, there's still the risk that if the economy takes a turn for the worse, the new premium concept can backfire. What has made McDonald's and other chains such as Yum! Brands so dominant is that they're able to thrive even through tough economic periods. Essentially, they follow the same model used by Wal-Mart in that they are able to make the best of bad situations by offering customers as much as possible for their dollar.
While Chipotle has done well with a different focus, the company has suffered four consecutive quarters of declining comps. In Chipotle's case, it would seem that the premium QSR marking is diminishing. I think Wendy's needs to pay attention to that. By contrast, Yum! Brands just posted 5 percent in U.S. comparables, which was preceded by 6 percent in the third-quarter and 7 percent in the second-quarter.
If Wendy's wants to enter the premium food market, it has to tread carefully to not alienate customers, especially since it will be an expensive endeavor. Is the return worth it? In the meantime, I think these shares are worth a gamble for investors that are looking for value in a business with a strong brand that also pays a decent yield.
—By TheStreet.com Contributor Richard Saintvilus
At the time of publication, Richard Saintvilus had no positions the stocks mentioned.