The Combined Wendy's and Arby's Looks Appetizing

CONFIDENCE IN THE WENDY'S/ARBY'S GROUP has been shrinking like an overcooked hamburger on a sizzling grill. Declining sales at Arby's, plus the company's reluctance to specify how it will use most of the proceeds from a recent $565 million bond offering, worry investors. Since late April, Wendy's/Arby's stock (WEN) has slid more than 30%, to around $3.70.

But investor Nelson Peltz, who with his partner Peter May owns 22% of the shares, argues that "this is a phenomenal company that is truly misunderstood and was mismanaged for years.... We think the company is significantly undervalued." His assessment isn't based on earnings -- operating net is likely to be just 19 cents a share this year and 28 cents in 2010.

Instead, Peltz's view reflects expected cash flow, measured by earnings before interest, taxes, depreciation and amortization (Ebitda). Based on analysts' forecasts of annual growth, Wendy's/Arby's Ebitda should hit $420 million this year. And, if the company hits its mid-teens growth target, it should generate roughly $555 million in 2011. Historically, the fast-food group's Ebitda multiple is nine to 10 times -- though today, only McDonald's (MCD), which has far outpaced its rivals, rates close to a nine. Wendy's/Arby's fetches almost six.

If investors put a multiple of nine on 2011 Ebitda, as Peltz suggests is reasonable, the company would be valued at $5 billion. After subtracting $1 billion of net debt and dividing by 470 million shares outstanding, the stock theoretically would be worth $8.50. That is a big if. But even a multiple of seven would translate into a $6 stock.

While Peltz's multiple assumption might be aggressive, his operational expectations aren't. They don't include any benefit from putting the company's substantial cash to work or from new products, better marketing or the reintroduction of breakfast slated for late next year.

Peltz and May, both Wendy's/Arby's directors, doubled down on their bet late last year, spending $205 million for 49.4 million shares at $4.15.

This didn't escape the attention of some value investors, including Robert Gebhart, a partner at New York City-based money manager Grisanti Brown & Partners, which owns shares. He contends that, if the stars align, shares could reach $9 in three years.

Wendy's/Arby's was formed last September, when Arby's, then owned by Triarc, an investment company controlled by Peltz and May, merged with Wendy's. When announced, the all-stock deal was valued at $2.86 billion. Wendy's shareholders received 4.25 Triarc shares.

Wendy's was founded 40 years ago in Columbus, Ohio, by Dave Thomas, a food-industry veteran who tried to separate it from the pack by offering better food. Its hamburger patties aren't frozen, and it offered salads before they became a staple at rivals. Wendy's has floundered since Thomas, who had become its public face, died in 2002. Trian, an investment firm run by Peltz and May, bought a 5.5% stake in Wendy's in 2005, when the shares traded mostly in the mid-teens.

Arby's is smaller than Wendy's -- kicking in only about a third of Wendy's/Arby's $3.7 billion of 2008 sales and about 35% of its operating income. Its specialty: roast-beef sandwiches. Last year, Wendy's/Arby's posted a loss of $3.05 a share, in large part on costs related to the merger.

Wendy's/Arby's Chief Executive Roland Smith aims to improve results at the company with $60 million in cost efficiencies and $100 million from boosting the 12% operating margins at Wendy's company-owned stores, which vastly trail franchise stores' 17%. (About 20% of Wendy's are company-operated.) For its part, Arby's should benefit from new products; it's even considering a catering and delivery service for large orders.

Smith hired David Karam as Wendy's president last year. Karam also had bid for Wendy's and was among the larger and more successful franchisees. Pamela Thomas Farber -- daughter of Wendy's founder and the owner of 33 Wendy's in Ohio -- says that she has known Karam all her life, and that now, for the first time since her father died, she has had confidence in corporate management.

The $565 million bond offering, however, is a bone of contention. Out of the proceeds, Wendy's/Arby's will use $132.5 million to repay some of its bank debt. As for the remainder, it has said only that the money will be used for general corporate purposes, meaning anything from working capital to acquisitions to dividends and buybacks.

Some investors fret that the new company didn't need the money. Wendy's/Arby's is expected to generate more than $100 million of free cash flow, and had $137 million of cash and $116 million in investments at the end of the first quarter. Its next payment on notes, $189 million, is not due until 2011; and $250 million of bank loans aren't due until 2012. So Howard Penney, an analyst at Research Edge, calls the bond deal a "head-scratcher."