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We are reverting to a Neutral recommendation on restaurant company The Wendy’s Co.  (WEN - Analyst Report) from Outperform on mixed second-quarter 2013 results.

Why Back to Neutral?

While Wendy’s second-quarter 2013 adjusted earnings, reported on Aug 7, 2013, grew year over year, mainly through effective cost control measures, the sales scenario remained sluggish. Sales missed the Zacks Consensus Estimate and grew just 0.7% year over year.

Comps were also soft in the quarter. Company-owned comps nudged up 0.4% in the quarter while franchised units saw a 0.3% rise in comps. The removal of breakfast items at certain restaurants marred comps by about 1%.

Restaurant companies are highly exposed to fluctuation in food costs. Beef represents almost 20% of Wendy’s total food cost. Higher beef and chicken costs are expected to be more pronounced in the second half of 2013 and thus might restrict margin expansion.

Further, Wendy’s will incur significant capital expenditure (capex) in the coming years in a bid to boost the re-imaging program. This will lead to lower free cash flow. The company estimates expenses of about $440 million–$500 million for store overhaul and openings from 2013 to 2015.

Although Wendy’s has signed franchise development agreement for international growth, its peers – McDonald’s Corp. (MCD - Analyst Report) and Yum! Brands Inc. (YUM - Analyst Report) – operate on a much larger scale. Also, Wendy’s operates at a disadvantage relative to burger behemoths McDonald's and Burger King Worldwide Inc. (BKW - Analyst Report), the scale of which supports greater advertising strength.

We believe the positive impact of multi-year turnaround plan, international expansion, extensive refurbishment of units, focus on franchising and dividend hike are reflected at current levels and there is little room for further upside. Wendy’s currently has a Zacks Rank #3 (Hold).

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