Finding some Sizzle in an Unsavory Restaurant Market

Spent some time trolling through the restaurant industry looking for ideas. First impression was - "Boy, what a tough environment." Issues include over-capacity, recent increases in minimum wages, health insurance penalties starting in 2014, high beef costs, pressure for more nutritional information, and weak demand during the recession. Not an environment where most investors want to pick. My second thought was - "Okay, who's got the most upside when the environment turns?" A hint, in my opinion, is my local Wendy's unit that is getting a makeover (taking a page from the Peter Lynch investment style).

WEN (Buy - $4.40): Wendy's/ Arby's Group

- Investment in turn-around offers potential growth drivers. Wendy's has done reasonably well pursuing the late night market and now is focused on serving breakfast at more units, a segment it has traditionally not competed. To enable this day-part expansion, management has focused resources on re-modeling units. Management plans to update 100 Wendy's and 100 Arby's company-owned units during 2010. From watching the local unit, it includes a full face-lift on the outside, which should increase traffic when completed. Finally, the advertising campaign should offer a good mix of value and premium items over the next few months.

- Clean-up goes beyond units. The company has turned-over some senior management and hired a new lead branding firm to bring the Wendy's and Arby's brands into complementary messages. Wendy's re-financed much of its debt last month, which simplified the structure and should decrease the annual interest expense by about $6 million. Stockholders also voted recently to the stock re-purchase authorization by $75 million as management believes the stock is under-valued.

- Valuation implies low expectations, which company should meet in ST. At an EV/TTM Adj. EBITDA of under 7x the stock appears reasonable when compared to MCD of about 10x. Most analysts have a Hold rating, offering upgrade opportunities. Finally, the company is just returning to profitability and the amount of operating leverage in the re-modeled units may offer upside surprises should sales tick-up. All-in-all, assuming management executes, the stock should start to move up in the second half of the year and offer multiple years of sustained growth.

Note: My time line for all stock picks is 1-5 years, unless otherwise noted.