Wendy's Co quarterly report, Q1 FY2018

The Wendy’s Company: Q1 2018 Form 10-Q Summary

Business context and reporting period

The filing covers the 13-week fiscal quarter ended April 1, 2018, compared with the quarter ended April 2, 2017. Wendy’s franchises and operates quick-service restaurants, primarily in North America, and reports one operating segment. The system included 6,633 restaurants at quarter-end: 337 company-operated and 6,296 franchised. The company operated 337 restaurants and franchised 6,296 restaurants, including 512 international franchised locations.

Financial performance and key metrics

Metric	Q1 2018	Q1 2017	Change
Total revenue	$380.6 million	$285.8 million	+$94.8 million
Operating profit	$55.3 million	$60.7 million	-$5.4 million
Income before taxes	$14.4 million	$32.1 million	-$17.7 million
Net income	$20.2 million	$22.3 million	-$2.1 million
Diluted EPS	$0.08	$0.09	-$0.01
Cash flow from operations	$68.7 million	$42.1 million	+$26.6 million

Sales increased to $153.7 million from $148.2 million, supported by 0.8% company-operated same-restaurant sales growth, strategic pricing, and higher sales at new and remodeled Image Activation restaurants. Inclement weather partially offset growth.
Franchise royalty revenue and fees increased to $97.9 million from $94.7 million, while franchise rental income rose to $50.1 million from $42.9 million.
Advertising funds revenue and expense each contributed $78.9 million following the adoption of the new revenue recognition standard; these largely offsetting amounts materially increased reported revenue and expenses without a comparable impact on operating profit.
Restaurant margin declined to 13.9% of sales from 16.0%. Cost of sales increased to 86.1% of sales from 84.0%, primarily because of commodity costs, labor-rate increases, and adverse weather, partly offset by menu pricing.
Global systemwide sales increased 3.3% on a constant-currency basis to $2.532 billion. North America systemwide sales increased 2.8% and international franchised sales increased 13.7%.
Operating margin was approximately 14.5%, compared with approximately 21.2% in the prior-year quarter. The comparison is affected by the consolidation of advertising funds and the absence of a comparable prior-year advertising-fund presentation.
Cash, cash equivalents, and restricted cash totaled $242.3 million at April 1, 2018, compared with $212.8 million at December 31, 2017. Cash and cash equivalents alone were $187.7 million.
Cash used in investing activities was $11.1 million, including $10.6 million of capital expenditures. Cash used in financing activities was $25.7 million and included $39.4 million of share repurchases and $20.4 million of dividends.

Debt, liquidity, and capital allocation

Total long-term debt, including the current portion and excluding unamortized issuance costs, was approximately $2.855 billion at April 1, 2018. Reported total debt after issuance costs was $2.808 billion.
On January 17, 2018, Wendy’s completed a $925.0 million refinancing through fixed-rate Series 2018-1 Class A-2 notes bearing interest at 3.573% and 3.884%. Proceeds refinanced the Series 2015-1 Class A-2-I notes and funded transaction costs and general corporate purposes.
The refinancing generated an $11.5 million loss on early extinguishment of debt. A related revolving facility permits borrowings of up to $150.0 million; no amounts were outstanding under it at quarter-end.
Management stated that available cash and operating cash flow should be sufficient to meet operating requirements for the next 12 months. Planned 2018 capital expenditures were approximately $75 million to $80 million, and expected dividends were approximately $61 million.
The company completed its prior $150 million repurchase authorization and received a new authorization for up to $175 million through March 3, 2019. It repurchased approximately $39.4 million of shares during the quarter, including shares acquired for employee award-related tax withholding.
The company was in compliance with its debt covenants at April 1, 2018.

Material changes versus the prior comparable period

Revenue recognition guidance was adopted on January 1, 2018 using the modified retrospective method. Franchise fees are generally recognized over the franchise agreement term, and national advertising funds are now fully consolidated.
The adoption reduced opening stockholders’ equity by $70.2 million, principally because franchise fees are deferred over longer contractual periods and advertising-fund equity was reclassified to accumulated deficit. Prior-year results were not restated.
Reported revenue increased substantially because of the $78.9 million of consolidated advertising-fund revenue, matched by advertising-fund expense. Excluding advertising funds, reported revenue increased by approximately $15.9 million.
Operating profit declined despite higher sales, primarily because of lower restaurant margins, higher franchise support and rental costs, higher depreciation and amortization, $2.6 million of G&A realignment costs, and a $0.6 million system optimization loss versus a $1.4 million gain in the prior year.
The effective tax rate was a benefit of 40.5% in Q1 2018 versus a 30.5% tax expense rate in Q1 2017. The 2018 benefit included a $6.1 million share-based compensation tax benefit and a $3.6 million provisional Tax Cuts and Jobs Act benefit.
Other comprehensive loss was $5.9 million, primarily from a $6.0 million foreign-currency translation loss, compared with comprehensive income of $24.8 million in the prior-year quarter.

Guidance, outlook, management commentary, and risks

Management expects approximately three-quarters of the targeted $35 million G&A expense reduction from its realignment plan to be realized by the end of 2018, with the remainder in 2019. Total plan costs are expected to be approximately $28 million to $33 million, including $23 million to $27 million of cash expenditures, with additional costs expected into 2019.
Long-term growth priorities include same-restaurant sales growth, Image Activation remodels and new restaurants, international expansion, increased daypart utilization, mobile technology, financial management, and continued system optimization.
The company expects the new lease accounting standard effective in fiscal 2019 to materially affect its balance sheet and disclosures. Operating lease commitments not currently recorded on the balance sheet totaled $1.565 billion at April 1, 2018; management does not expect a material effect on earnings or cash flows.
Key risks include competition and pricing pressure, food and labor inflation, adverse weather, food safety, franchisee financial health, restaurant development and remodeling execution, commodity volatility, labor availability and wage increases, cybersecurity incidents, legal proceedings, debt covenant and refinancing risks, and the ability to generate sufficient cash flow for debt service and capital allocation.
The company continues to face legal proceedings related to previously reported payment-card malware affecting certain franchise-owned restaurants. Management stated that it has adequate accruals and insurance coverage and does not expect the matters to materially affect consolidated results, but the aggregate possible loss cannot be estimated.
Wendy’s has lease guarantees of $56.7 million, outstanding letters of credit of $31.6 million, and no reported material developments in previously disclosed legal proceedings.

Important facts for investors to verify

Separate the underlying operating trend from the accounting-driven consolidation of advertising funds when assessing revenue growth and margins.
Verify the effect of revenue recognition adoption on franchise-fee timing, accumulated deficit, deferred franchise fees, and comparability with 2017.
Assess whether restaurant-margin pressure from commodities, labor, and weather persists and whether menu pricing offsets these costs.
Monitor the refinancing structure, anticipated repayment dates, fixed-rate debt, capital lease obligations, covenant compliance, and available revolving capacity.
Reconcile planned capital expenditures, dividends, and share repurchases with operating cash flow and leverage.
Track remaining G&A realignment costs and the timing and sustainability of expected savings.
Evaluate the future balance-sheet impact of the 2019 lease accounting adoption and the company’s substantial operating lease commitments.