Value Investing Congress Blog

Buying Wendy’s on the Cheap

When Triarc announced its takeover bid for Wendy’s in April, the stock deal was worth $2.4 billion, or $26.78 per Wendy’s share.  That same deal, which calls for Wendy’s shareholders to receive 4.25 Triarc shares for each Wendy’s share, is now worth just over $2 billion, as both Wendy’s ($23) and Triarc ($5.50) shares have pulled back.  In my book, $2 billion for Wendy’s is a steal.  Just last year, Nelson Peltz, (who owns 24% of Triarc and whose firm Trian Partners owns 10% of Wendy’s), had offered up to $41 per share for the company.

The combination of Wendy’s-the 3rd largest US hamburger chain and Triarc, parent company of Arby’s, the nations’ largest roast beef sandwich chain,  and 12th largest US quick service restaurant chain, will result in a 10,000+ store fast food empire, with annual sales in the neighborhood of$3.7 billion.  If estimates are correct, the merger will save the combined entity about $60 million in annual costs.

The big question is whether Peltz can do it again, “salvage” another company (salvage is a rather strong word in Wendy’s case–although the company should be doing much better, it is not in jeopardy) the way he did with the former DWG Inc in the early 1990s.  Value investors may recall DWG, parent of Arby’s, Royal Crown Cola, and a handful of other businesses, which was nearly run into the ground at the hands of Victor Posner, before Peltz and partner Nelson May stepped in.  DWG became Triarc in 1993.

As far as I can tell, the combined entity will have about 460 million shares outstanding once the deal closes, and at Triarc’s current price, the resulting market cap will be about $2.5 billion.  On an enterprise value basis, add in debt estimated at $540 million for Wendy’s and $745 million for Triarc, back out cash 0f $220 million for Wendy’s and $20 million for Triarc, and you arrive at an EV of about $3.5 billion.

Wendy’s is a great franchise which has disappointed recently, but one that I believe is capable of recapturing its former glory.  Known for fresh ingredients, and typically among the top rated fast food chains by consumers (it was ranked first in Zagat’s 2007 survey); it would be hard to imagine the right management team not having a decent chance of getting Wendy’s to run on all cylinders.  To that end, Triarc has recently announced several Wendy’s management changes; the jury is still out here.

For its part, Triarc’s Arby’s business appears to be doing ok, certainly not great (it’s often been difficult to tell based on Triarc’s results alone because of other transaction not related to the core business).  Same store sales fell 1 .8 % for the quarter ended June 30th, not surprising given the economic environment, but Triarc is focusing more attention on being a restaurant company, having recently shed some other assets, and announcing Wendy’s deal.

Another reason to own Triarc is the fact that once the deal is complete, the company will own the real estate for 632 Wendy’s restaurants (plus 572 locations where they own the building only) in addition to the 130+ Arby’s locations it currently owns.  That’s a nice little commercial real estate portfolio in addition to what might be a profitable restaurant marriage.

Jonathan Heller, CFA

Is Gannett a Value Trap?

Publicly traded newspaper companies have been taking it on the chin due to falling ad revenue, declining circulation, and belief by some that the internet will ultimately do to newspapers what the automobile did to the buggy whip.

Gannett shares currently trade at just one fourth of where they did three years ago; shares are so beaten down that prospective investors evaluating the company might think they were looking at a high-yield bond given the company’s current 8.39% dividend yield.   A dividend of that magnitude is telegraphing one of two messages to investors:  Either the dividend is not sustainable, and is likely to be cut, or the markets have all but given up on this company.

Although recent results have shown declining revenue and earnings, this company is in better shape than the stock price and dividend yield suggest.  Fiscal year 2007 revenue did fall 7.4% to $7.44 billion, while net income fell 9% to $1.06 billion.  Still, that equates to a healthy 14.2% net profit margin.  Second quarter results showed further declines: revenue fell 11%, while net income declined 36%, and that excludes a writedown (non-cash, primarily goodwill) in the neighborhood of $2.6 -$2.9 billion.  The company continues to generate cash-more nearly$800  million the past 4 quarters (q2 CF data not yet available) - and as long as that continues to be the case, you can’t write Gannett off just yet.

The company ended Q1 with more cash on the books ($166 million) than it has in any of the past 20 quarters and long term debt below $4 billion for the first time since 2004.  Gannett continues to buy back stock, having reduced shares outstanding by 6 million shares, or 2.6 % since the first quarter of 2007.  While there are additional risks if the economy (and ad revenue) slips further, it appears as though the market may have this one wrong, at least longer term.

What may be forgotten is Gannett’s impressive array of assets which includes 85 daily US newspapers with paid circulation of 7.3 million, plus 900 non-daily publications in 31 states.  The flagship is mega brand USA Today, the largest US newspaper in terms of circulation (2.3 million).  The company’s broadcasting operation consists of 23 TV stations, reaching 20 million viewers, while the internet site attracts more than 25 million unique visitors per month.  As value investors, we might call this a value play (others might call it a value trap), while we may freely admit that growth drivers are difficult to identify.

Of course, one burning question is whether Gannett will cut its dividend, as the current stock price is suggesting.  That possibility appears remote at this point, given cash flow that is more than adequate to cover the current dividend.  As for catalysts to get this stock back on track, it’s all about the economy.  Ad revenues need to stabilize, which should happen once the economy starts to pick up steam.  When that will happen, given all the current risks, is uncertain at best.

As a postscript, I know firsthand the devastation that falling advertising revenues can bring:  I saw it firsthand when Bloomberg pulled the plug on Bloomberg Personal Finance magazine, (for which I served as Senior Markets Editor) in early 2003.

Jonathan M. Heller, CFA
Author is long Gannett

Hello Ruby Tuesday (RT, $7.25) 

Shares of this casual dining chain have been pummeled recently, along with many others in the sector.  Down 30% year to date, and 72% from this time last year, its’ a reflection of the economy and overall market conditions as well as the company’s lackluster operating performance.  Ruby Tuesday was also recently booted out of the S&P Midcap Index, and added to the S&P Small Cap Index. 

The fact is that when the consumer is getting squeezed, they will ultimately cut back discretionary spending, and restaurants are a casualty.  Compounding this situation is a huge run up in materials, a huge part of operating costs, second only to labor—and to add insult to injury, there’s a minimum wage hike on the way in late July.  Its’ difficult to pass along increasing costs if customers decide they can no longer afford to eat out.  

Restaurant stocks typically get pummeled during a severe economic slowdown or perhaps even the appearance of one, and from a valuation perspective often get very cheap as a result.  Post recession, however they tend to do very well.   As the economy picks up, consumers resume their dining out habits, and since the supply of new restaurants lags during a slowdown, this creates a supply/demand situation that can be beneficial to restaurant stock investors

This brings us back to Ruby Tuesday. For the past several years, profits have been falling. While 4th quarter results (announced recently) beat expectations, for the most part recent results have been lackluster, and same store sales challenged to put it nicely. What sounds like a no-win situation does have a bright side, especially if you believe this economy of ours will ultimately begin to show some life.

Ruby Tuesday happens to be a rarity in the restaurant business, one of the few publicly traded restaurant chains that owns a substantial amount of its real estate.  In this case, the company owns the land and buildings of 330 locations, and the building only (land leased) at another 200+.  That’s a potentially very nice portfolio of commercial real estate, especially given the company’s market cap of just $350 million, and an enterprise value of $944 million.  On an enterprise value to owned location (land and building) that works out to $2.86 million.  (That isn’t to suggest that each location is actually worth $2.86 million, but rather for perspective.)

 Ruby Tuesday currently trades at 13.4 times trailing, and 12.9 times forward earnings, (although I would not put a great deal of stock in the forward estimates at this point).  At just .8 times book, with a real estate portfolio in the mix, shares are currently cheap.  But, they may stay that way for awhile. 

The company recently had to re-work some credit agreements, and as a result no longer pays what appears to be very fat 7.3% dividend yield on many data financial data vendors’ profiles of the company.   (That’s what we in the data business (as a 17 year Bloomberg veteran) call stale data.) They may decide to resume paying a dividend in the future, but only with lender approval.

This is one to keep an eye on, but don’t expect a quick recovery.  As the economy goes so will the Ruby Tuesday and the restaurant sector in general. 

Jonathan Heller, CFA

No position in RT  

A company I have followed on and off is O’Reilly Automotive ( ORLY )—the (previously) regional auto parts retailer.  Given the struggles retailers of all kinds are having, and expected to continue having in the short- to mid-term, Mr. Market has trimmed almost 25% off O’Reilly’s market price since the beginning of the year.
Why am I interested in O’Reilly now?  Well, the company is also undergoing fundamental change: it’s acquiring another regional player—CSK Auto—for approximately $1 B, including the assumption of debt.  The acquisition will give O’Reilly a little over 3,200 stores and puts that number within spittin’ range of Advance Auto Parts (approximately 3,300 stores) and AutoZone (approximately 4,200 stores).  O’Reilly has already arranged to refinance CSK’s debt at what-should-be a lower rate with corresponding interest expense savings.  O’Reilly also forecasts $100 MM in cost savings beginning in 2010 through increased buying power juicing gross margins and streamlining CSK’s SG&A to firm operating margins up to O’Reilly’s level.

The CSK acquisition is similar in relative-size as O’Reilly’s acquisition of Hi/Lo in 1998, so I’ve spent some time reviewing the Hi/Lo precedent.  Here are some of the more relevant data points:

• The CSK acquisition moves O’Reilly from a leading regional auto parts retailer into a larger national footprint with a big move into California . AutoZone has approximately 430 stores in California .  After the CSK acquisition, O’Reilly will have 500 stores in California .
• The Hi/Lo acquisition also gave O’Reilly 7 stores in California which O’Reilly chose to divest rather than hang onto as a toehold in a growth-at-any-cost effort.
• In 1997 AutoZone had 264 stores in Texas ; 382 after its 1998 acquisition of Chief Auto Parts.  O’Reilly’s  Hi/Lo acquisition moved the company into Texas —where 25% of all      O’Reilly stores were located at the end of 2007.
• O’Reilly has continued its Midwestern regional success even with the continuing outsized exposure to Texas .  I believe O’Reilly’s management will be similarly successful in the assimilation of Southwestern and California stores from the CSK  acquisition and prudent in its choice and timing of store branding  conversions.

Keep in mind that CSK’s total cash cost will ultimately end up being higher than the $1 B due to investments in CSK’s distribution centers and store conversions, but a quick back-of-the-envelope calculation puts the combined entity’s Total Enterprise Value (TEV) around $4.2 B with LTM EBITDA around $470 MM—before the $100 MM in cost savings and margin improvements.  Based on this simple estimate of $570 MM for 2010 EBITDA, O’Reilly is currently trading at less than 7.5x 2010e EBITDA.

There are a number of macro concerns (increasing gasoline costs, decreasing mileage driven, increasing manufacturer pricing power, etc.) when looking at O’Reilly, so additional research is crucial to any decision.

Photochannel Networks (PNWIF)

One of the interesting microcap ideas presented at the Value Investing Congress West in May was Canada-based Photochannel Networks, whose business is providing online digital photography solutions for retailers.  If you’ve ever electronically sent photos to a retail store for pick up, you may have used Photochannel technology.

Aaron Edelheit, of Sabre Value Management, presented the bull case for Photochannel , stating his belief that the company will continue to align with major retailers, and partners, pushing company growth.  The company recently announced deals with Kodak China, Kodak Australia, Sams Club USA. A previous agreement with Costco is expected to launch this month.

Earlier this month the company announced record revenues of $3.3 million, up 147% from the same period last year, and a loss $2.6 million (vs. $718K).  The loss was attributed to ramp-up costs, and the company believes it will be cash flow positive in the near future.  Perhaps the best news of the quarter was that transactional revenue-the catalyst for growth- nearly tripled to $1.9 million.

Shares of Photochannel currently trade for $3.67, up 22% in the past year.  Prospective investors need to keep in mind that Photochannel is an extremely tiny company, with a market cap of around $120 million, and light trading volume of less than 100,000 shares per day.

Jonathan M. Heller, CFA
No position in PNWIF