Should You Hold Wendy's (WEN) Stock Post Solid Q1 Results?

On May 12, we upgraded The Wendy’s Company (NASDAQ:WEN) by a notch to a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Last week, the company reported robust first-quarter 2017 wherein both the top and bottom line topped the Zacks Consensus Estimate by 2.3% and 12.5%, respectively. Additionally, the company announced details of its ongoing initiatives that are progressing well. Moreover, on the back of successful execution of its initiatives, Wendy’s increased its adjusted EBITDA guidance and confirmed the previously issued guidance on its other heads.

Notably, shares of the company have outperformed the Zacks categorized Retail-Restaurants industry over the past one year. The stock was up nearly 51%, while the industry gained less than 7% during the same time period.

Key Growth Drivers

One of the key initiatives taken by the company to boost shareholder returns is the shift to a franchised business model. Per this system optimization program, Wendy’s has reduced its company-operated restaurant ownership to approximately 5% of the total system. Though this reduction has been weighing on revenues over the past few quarters, franchising a large chunk of its system is expected to lower Wendy’s general and administrative expenses, thereby boosting earnings, 2017 onwards. Moreover, over the long-term, it would generate a higher return on equity by lowering capital requirements.

Wendy seems to remain on track to achieve its Image Activation goals for 2020 as a part of its brand transformation initiative. Hereby, the company plans to remodel at least 70% of its global system. Additionally, the company cited its Image Activation program to be one of the primary reasons behind a 140 basis points increase in its company-operated restaurant margin last year. Moving ahead, it also expects that the program will continue to be a tailwind to its comps growth.

Moreover, Wendy’s international business is poised to drive growth in the future. Notably, the company has growth plans and partnerships in Argentina, the Philippines and Japan. It also has long-term development agreements with franchisees in various countries. Furthermore, the company is exploring growth opportunities in China, Brazil and other key international markets. In fact, Wendy’s seems to remain on track to reach the objective of its 7,500 global restaurant count by 2020.

Potential Headwinds

Higher labor costs due to the implementation of affordable Care Act, commonly known as Obamacare, continue to have an adverse impact on restaurant operators like Darden Restaurants Inc. (NYSE:DRI) , Brinker International Inc. (NYSE:EAT) , Domino's Pizza, Inc. (NYSE:DPZ) and many others, including Wendy’s.

Moreover, Wendy’s would incur additional capital expenditure in the coming years in a bid to boost the re-imaging program. This might lead to lower free cash flow in the near term.

Currently, to compensate for rising costs the company is taking steps to re-align and re-invest resources. Though these initiatives might benefit Wendy’s over the long-term, they are expected to increase costs in the near term, thereby hurting margins.

Additionally, a soft consumer spending environment in the U.S. restaurant space raises concern as it may hamper comps growth.

Bottom Line

The company’s brand transformation initiative also includes menu innovation, promotional offers and bold new packaging, which are intended to boost sales largely. Notably, the first quarter of 2017 marked the 17th consecutive quarter of positive same-store sales growth, indicating long-term strength and relevance of the brand. Moving ahead, we expect the company’s solid menu pipeline, limited time offers (LTO), marketing initiatives, increased emphasis on core and price value offerings, and investments in technology-driven initiatives to maintain the trend.

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