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The long term investment appeal of well established franchising companies is accepted by the investment community. Most of the prominent franchisors’ equities sell at price to trailing twelve month EBITDA multiples in the mid to high teens (Denny’s (DENN), Dine Brands (DIN), Dunkin’ Brands (DNKN), Pollo Loco (LOCO), McDonald’s (MCD), Restaurant Brands (QSR), Wendy’s (WEN), even higher in a couple of instances Domino’s (DPZ), Shake Shack (SHAK), Wingstop (WING), lower in a number of “challenged” situations like Jack in the Box (JACK), Red Robin (RRGB), Brinker (EAT), Fiesta Rest. (FRGI).

The attraction of asset light franchisors revolves around the presumably free cash flow for franchisors, a steady stream of royalty income unburdened by capital expenditures to build stores. The operating leverage is at the store level.  Franchisees are responsible for building the stores, then controlling food costs, labor, rent and all the other operating line items. Franchisors receive the royalty stream and have the obligation of supporting the system with brand development, site selection advice, marketing support, and operating supervision. These supporting functions, it should be noted, are optional to a degree, and we have written extensively about system support sometimes being short changed by corporate priorities such as major stock buybacks.


We acknowledge that in every franchise system there will be some operators less satisfied than others. In the same way, customer reviews on Yelp or Facebook are more frequently written by critics. Bad news is more noteworthy and more customers are inclined to criticize than applaud, so we have to listen to the complaints but dig further for the reality. With that in mind, we hear the following from franchisees of various restaurant systems:

“I’ve been in this business for thirty years, and I’ve never seen it this bad. Everyone is making money but me; the landlords, the franchisor, the banks. My margins have been killed, and I’m up against my lending convenants”.

“All the franchisors want to do is build sales to build their royalties. The dollar deals are trading people down. My franchisor doesn’t care about my margins. I can’t maintain my margins, especially with the increasing cost of labor, let alone build it”.

“The franchisor is putting pressure on me to sell, even though I’ve always been considered a good operator, with high performance scores. I’m up to date on my development agreement, but they want somebody else to take me out, and the new buyer will agree to what I consider to be a ridiculously aggressive development contract”.

“The franchisor has replaced experienced long term field support with lower priced (and inexperienced) younger people. They’re cutting corporate overhead, but these kids, who never ran a store, are telling me to how to control costs.””

“I’m doing my best with the development objectives, but it is almost impossible to build stores with today’s economics. Rents are too high, labor costs are killing me, and I can’t raise prices in this promotional environment”.

“As if things aren’t tough enough, I’m being nickeled and dimed with demand for higher advertising contributions and fees on services (including software) that I thought would be provided”.

The valuations provided to the publicly held companies do not reflect the situation as described by the admittedly anonymous franchisees. The commentators quoted above don’t want to aggravate their franchisor, and we don’t want to be unfair or misleading to particular companies by relying on just a few conversations, though they do support one another. For the most part, franchisees are strongly discouraged from talking to the press or investment community. The companies will say that “competitive” issues require some secrecy, but there are few secrets in this industry.

The optimistic view, as represented by the valuations in the marketplace, is that the comments above are not typical or representative of the health of the subject franchise systems. Allow me to provide a short story which leads to a suggestion.


Twenty six years ago, in 1992, IHOP had just come public. I was a sell side analyst, thought the numbers were interesting and the stock was reasonably priced. The company, led by the now deceased CEO Kim Herzer, invited me to attend their franchisee convention, which I did. I obviously had the opportunity to interface with many franchisees and it was clear that, while all was not perfect, the franchisor was providing a great deal of support that was embraced by an enthusiastic franchise community. IHOP stock tripled over several years for me and my clients who owned millions of shares. I attended several more of their annual conventions and maintain some of those relationships to this day. Obviously, the conviction I gained from their open attitude was critical to the success of the investment. I should add, that many of those buyers in 1992 owned the stock for many years, not living and dying on quarterly reports.


As you are no doubt by now anticipating, my suggestion to publicly held franchising companies: open up your franchisee conventions to the investment community. The companies may quickly respond that lenders are already invited to franchise conventions, but franchisees are unlikely to express their system oriented concerns when they are making a pitch to a potential lender. Companies may also respond that their lawyers think it would be a bad idea, not consistent with full disclosure and analysts would be getting “inside information”. Let’s not allow the lawyers to provide “cover”. A good lawyer will provide a solution to the problem, not just provide the pitfalls. Analysts attending a franchise convention are not being told what sales or profits are going to be. Attending a franchise convention is  a “channel check”, no more than talking to a supplier or customer of a manufacturing company, which any decent analyst will do.

The anecdotal critical comments, as described above, have likely been heard by others, but may be atypical of most restaurant franchising companies. There are no secrets in this business. One of the investment appeals of this industry is its transparency. Notable news is going to leak out anyway. The objective of any publicly held company is to build stock ownership by well informed investors. Investment analysts pride themselves on their ability to “build a mosaic”, enhance the information provided in quarterly reports, SEC filings, and conference calls, with “channel checks”. What channel check would be more pertinent than meeting the franchisees of a company that is dependent on franchisee success? Putting it another way, and taking the highest valuation relative to EBITDA as an example: Wingstop (WING) is a company I have the highest regard for. However, you could call it irresponsible to pay almost fifty times trailing EBITDA for Wingstop stock (and I haven’t) if I couldn’t talk to franchisees of my own choosing?

There’s no particular need to invite this writer if I’m not considered influential enough. I have not spoken to these analysts on this subject, but qualified industry followers such as David Palmer, Nicole Reagan, Matt DiFrisco, David Tarantino, Jeff Bernstein, Andy Barish, Bob Derrington, Mark Kalinowski, Michal Halen, Gary Occhiogrosso, Howard Penney, Jonathan Maze, Nicholas Upton, John Hamburger and John Gordon provide the beginning of an invitation list.  I rest my case.

Roger Lipton

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                                                               The Wendy’s Co. (WEN)

Overview (2016 10-K) (Investor Slides Feb’17)

Dublin, Ohio based Wendy’s operates and franchises the third largest hamburger QSR chain with system-wide sales of $10.1B in the TTM through 17Q1. As of that date there were 6,551 units (6,220 franchised, 331 company operated). Of these, 89% are located in the US, 5% in Canada, which together constitute the North American (NA) segment. All WEN’s company units are located in the US. The remaining 6% of system units are located in 29 other countries (the International Segment), giving it a much smaller international footprint than its larger hamburger QSR rivals, McDonald’s and Burger King.

Of global system sales the US company stores generate 6% of the total, the NA franchisees 89% and international franchisees 5%. The NA restaurants (company and franchisee) are supplied with a cooperatively operated entity to leverage purchasing power, and efficiently manage quality, distribution, inventory, etc.

WEN’s consolidated revenues in the TTM through 17Q1 were $1.342B of which 60% were contributed by company stores, 28% from franchise royalties and fees and 12% from franchise rental income.


Wendy’s has struggled for some time with inconsistent product introduction and promotions, a tired fleet, changing customer tastes, the encroachments of fast casual competitors and a slow adoption of new technologies. As a result, by 2012 growth and profitability stagnated, with virtually no store growth and a decline in EBITDA margin to 13%. To renew growth, Todd Penegor, appointed CEO in May 2016, is implementing a plan he helped devise in his earlier role as CFO since June 2013. The plan aims to upgrade the menu with better offerings merchandised with a better balance of core value items, premium items and LTO’s. It resolved to transform to a highly franchised model from its traditional 50:50 mix, to expand profitability and enhance value. The plan included upgraded technology based on a single common POS platform.

Specifically, by the end of 2020, management is aiming for $12B system sales (including $1B internationally) from 500-550 net new NA stores, refranchising 95% of the system (done in 2016), remodeling (“Image Activation”) of 70% system stores (up from 32% in 2016), low single digit comps, store level EBITDA margins of 20%+ (up from 14% in 2012), consolidated adjusted EBITDA margins of 38-49% (up from 13% low in 2012 and 27.3% in 2016). Key to achieving the EBITDA margin target is reducing G&A to 1.5% of system sales (down from 3.1% in 2013). If the plan succeeds, management expects free cash flow to grow from negative $44M in 2014 to $275M in 2020. With increased cash flow and a possible expansion of borrowings, the company expects to increase returns to shareholders in the form of dividends and share repurchases.

Menu and Dayparts

To execute on its menu targets, the company is renewing its legacy “Deliciously Different” brand promise, emphasizing its never frozen beef, crisp and fresh lettuce and tomatoes and bakery style buns. It has also improved its chicken offerings with more tender chicken after limiting bird size, which it says average 7.5 lbs, 20% smaller than the 9.7 lbs of many QSR rivals. It has upgraded its premium offerings with such items as its Jalepeno Fresco Spicy Chicken, Gouda Bacon Cheeseburger and its sides, such as Pulled Pork Cheese Fries. The core value offerings balancing its premium items have been strengthened to include its “4 for $4” value selections and promotional pricing in the afternoon daypart ($2 Baconator Fries + Small Drink and half price beverages and discounted Frosties). Management credits its now 17 quarters of positive comps in company stores to traffic gains from the upgraded and rebalanced menu rather than price increases, no doubt also benefiting from restaurant remodeling. This contrasts with the more typical traffic declines outpacing price increases prevailing in the industry currently.

Unit Level Economics

The company’s unit level economics disclosure is limited. In 2016 AUV’s for company stores were $1,783K, franchised stores $1,551K and international stores $1,138K. Company store-level EBITDA margins were 19.1%. Given the importance of franchised stores now that they comprise 95% of system units and that nearly all future growth is dependent on franchisees, we’ve attempted a rough profile of the unit level economics of a NA franchisee in the table below. Our estimates are based on 2016 company store level EBITDA margins with rent backed out (EBITDAR) and information from the company’s Franchise Disclosure Document (FDD) regarding the full cost to construct and equip a new store and the cost for equipping a leased store. Comparisons, between Company and Franchisees, of Cash Return on New Restaurants (CROI) is provided below:

The outlays for new units in the table reflect the current prototype which incorporate the features of the Image Activation remodeling program and includes design advances to lower energy usage by 20%, improve throughput, reduce build time and contemporary digital and upgrade technology with kiosks, online ordering etc.

The optimistic take on the unfavorable comparison of franchised unit profitability with company units is that it points up the potential realized by “best practices” among peer franchisees and validated by company stores. After years in which more franchised stores were closed than opened, in the 5 quarters since FY2015 net store growth has been 58 stores (168 opened vs 110 closed). The company expects at least 170 net new stores will open in 2017 a milestone on the way to its target of 500-550 by 2020.

Similarly the franchisees have stepped up their investment in remodels. It is the the franchisees who have driven the remodels up from just 13% at the end of 2013 to 32% in 2016. Management expects that proportion to increase to 42% by 2017 year end on the way to the 70% target by 2020. The acceleration in franchisee investment in new stores and remodels is likely the result of the performance of the new prototype as demonstrated by early adopters in the franchisee community as well as validation of the performance of the remodels at the company stores. Undoubtedly the franchisees’ renewed investment is also sparked by the company’s development incentive, as described below. It is noteworthy that the AUV’s of newly opened franchised stores are on a par with company $1.8M AUVs, while closed stores average only $1.1M.

In an effort to stimulate growth in the franchise system, the company has also introduced a creative incentive program for franchisees. While previously it provided a 3 year royalty abatement of 2% (i.e. halving the rate) for new units, it now offers a 2 year incentive totaling 9.5% for net new units. The program consists of a year 1 abatement of 2% in the royalty rate and 3.5% in the advertising contribution and a year 2 abatement of 1% in the royalty rate and 3% in the required advertising. Aside from incentivizing new development on a net basis, the benefit of this structure is that the reduction to WEN royalty revenues totals only 4% (the royalty abatement) vs the previous 6%, as franchise contributions to the national advertising fund are outside WEN’s direct financials. Presumably, the smaller contribution to the advertising fund will not materially affect the total marketing effort.

Relative to the ongoing need to refresh the stores physically, the franchisees, after initial pushback against the apparent high costs for remodeling, now seem convinced. The costs for remodel range from $300K to as much as $1M and provide a sales lift of 7-10% and cash ROI’s of 10-15%. The franchisees have an additional incentive to remodel from a 1% royalty rebate for 12 months. Accordingly, franchisee buy-in has driven reimaging from just 13% of the system at the end of 2013 to 32% today, on the way to the targeted 70% by 2020.

Operating Metrics

Despite the near halving of revenues due to refranchising, WEN’s TTM EBIT more than doubled to $311.7M in 17Q1 from $122.7M in 2012 (after which it began refranchising and launched the remodeling program). Similarly EBIT margins expanded from 4.9% to 23.2% in the same period. Rental income from the refranchised restaurants has been a notable driver in the increased profitability. Since 2014 rental profits from franchisees have expanded from 12.4% of EBIT to 26.8% in the TTM through 17Q1. The outsized expansion of profits is largely attributable to the rental of WEN-owned locations (as opposed to subleased locations). The other major driver of EBIT margin expansion has been progress in the plan’s key goal of reducing of G&A expense to 1.5% of system sales. By 17Q1 TTM G&A expense had been reduced to 2.3% of system sales (80 bps below the 2013 level).

Largely because of the company’s investments in remodels, FCF has been negative in 2014 and 2015, but turned positive in 2016 with the substantial completion of remodels on remaining company stores. In the TTM through 17Q1, FCF was nearly $47M (CFO $172.8M, CapEx $125.0M) or a FCF margin of 3.5%, a way station on the journey to the 2020 FCF target of $275M.

WEN carries substantial debt similar to most highly franchised operators, though its ratios of gross debt to EBITDA and lease adjusted debt to EBITDAR of 5.9X and 6.5X, respectively, higher than comparable ratios of 4.5X and 5.0X averages of >90% franchised peers (DNKN, DIN, DPZ, QSR, WING, PLKI, SONC, DENN and YUM).

The company has several JV’s and investments, the most significant of which is its 18.5% stake in Arby’s, a residue from a merger between the 2 companies in 2008 and which ended in 2011. Arby’s is owned by TRIAN Fund Management LP, a hedge fund whose founder and CEO, Nelson Peltz,is WEN’s non-executive chairman, and controls 19.5% of WEN’s outstanding shares.

The company has received about $100M in dividends on its Arby’s investment since 2012, the last distribution of about $15M in 2015. Wendy’s estimated the market value of its Arby’s stake at $325M (balance sheet carrying amount at $2.4M) as of the end of 17Q1, which implies a value of about $1.33 per WEN share before any tax on a sale.

Shareholder Returns

Since the end of 2012, WEN has spent nearly $1.6B repurchasing over 147M shares (average price $10.74) and distributed nearly $300M in dividends. In the same period WEN’s stock has appreciated 231% (30.2% CAGR) and the total return with dividends reinvested has been 267% (33.2% CAGR).

Recent Developments

Per Q3’17 Release and Conference Call For the purpose of this Project, we will discuss North American operations of Wendy’s. As indicated in our table above, N.S. same store sales were up 2.0% in Q3’17, on top of 1.4% a year earlier. For the nine months, SSS were up 2.3% on top of 1.8% in ’16. Company operated restaurant margin was down 170 basis points to 16.7% in Q3, primarily as a result of higher commodity costs. A major part of the corporate strategy remains Image Activation, with 39% of the global system now affected. Guidance going forward continues to be SSS at the rate of 2.0-2.5% in N.A., with company restaurant margin at 17.5-18.0 percent. Importantly, commodity cost inflation is expected to be 3-4% for all of ’17, labor inflation of about 4%. There was no indication that management expected any significant change in these trends. Delivery is being expanded throughout the U.S., using DoorDash as partner, targeting 2,500 restaurants by now. While management expressed enthusiasm for the program, said the sales were largely incremental, and the average ticket was higher, the overall economics were not discussed. As described by management, delivery demands have not affected in-store or drive thru operations, but we find that hard to believe if the demand is more than nominal. Mobile Order and Pay is still at a very early stage, though stores are being equipped rapidly and this rollout could become a factor in ’18. A Loyalty initiative is at a similar early stage. A “balanced” marketing approach is being pursued, but we must editorialize that with 4 for 4 still being emphasized, and the ingredients of that offering being “beefed up”, it seems like that is the primary focus. The Giant Junior Bacon Cheeseburger for $5.00 is also being featured. The Image Activation program apparently added 70 bp to N.A. sales in Q3, and that order of magnitude was expected to prevail for all of ’17. While Wendy’s is doing a credible job meeting the challenges of today’s QSR environment, generally holding market share, management comments such as “we continue to invest in the quality of our food, but we do know that we have to help our customers with value. And those things have to work hand in hand on both the high and low…mixed bag of things that we continue to do around keeping 4 for $4 fresh and ownable….bringing back the $0.50 Frosty… and give offerings to trade folks up into things like the $5 Giant Junior Bacon Club.” Our interpretation: It continues to be pretty tough out there.

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