I am recommending the purchase of Denny’s as I believe the market is not fully appreciating management's initiatives to generate cash, reduce debt and increase free cash flow. In addition to improving sales productivity and operating margins, management initiatives include: (1) monetizing non-core real estate assets to reduce debt; (2) refinancing a very expensive credit facility that should yield further significant savings in interest expense; and (3) the potential refranchising of a meaningful number of company-owned restaurants to reduce the capital intensity of the business.  Additionally, after 5+ years of rationalizing the store base and implementing better operating procedures across the system, we believe that Denny’s is poised to start growing units on a net basis as soon as next year.  Factoring in the real estate sales (most of which have been completed) and the imminent debt refinancing, we believe Denny’s trades at a 2007 and 2008 P/FCF multiple of 13.2x and 10.7x.  We believe the valuation is quite attractive for a highly-franchised restaurant concept that is at the transition point between stabilization and growth.      

 

Denny’s is the leading nationwide family dining chain with 1,559 restaurants in 49 states and 4 countries.  The Company has heavy concentrations in California (26% of units), Florida (10% of units) and Texas (10% of units).  Because of their geographic exposure, the business is levered to travel and tourism and is most active during the summer months.  Roughly 2/3 of the Company’s restaurants are franchised, which creates a very stable base of earnings through franchise fees and rental income.  The Company is most known for their value-oriented breakfast offering, which is offered throughout the entire day (restaurants are open for 24 hours).  Most of you are probably aware of some of their signature breakfast dishes, including the Grand Slam and the new Super Slam dishes, where you can get 3 strips of sizzling bacon, 3 savory sausage links, 2 eggs, hash browns and 3 fluffy buttermilk pancakes for $5.99.  For a typical restaurant, breakfast items comprise approximately 50% of entrees sold in a day.           

 

Denny’s has only been a standalone-concept restaurant company since 2002.  Prior to that, Denny’s was part of a larger, overleveraged company called Flagstar (later named Advantica) that also owned concepts such as El Pollo Loco, Quincy’s and Cocco’s and Carrow’s.  Denny’s operations suffered during this time as Flagstar struggled with its debt burden and ultimately filed for bankruptcy in 1997.  The current CEO, Nelson Marchioli, was hired in 2001 to turn around the operations at Denny’s.  His main initiatives included instituting best practices across all the restaurants, improving the food quality, focusing on customer service, adding new menu items and remodeling existing restaurants to restore a more attractive atmosphere.  Over the past five years, approximately 60% of the Denny’s system has been remodeled.  In addition, the Company closed down underperforming units, invested in IT systems and continued to spend on national network advertising, all of which contributed to a marked improvement in average unit volumes.  AUVs at company-owned stores grew from $1,461,000 in 2002 to $1,643,000 in 2005 (+13%).  AUVs at franchised stores grew from $1,210,000 in 2002 to $1,408,000 in 2005 (+16%).  The Company’s 2008 target AUVs are $1,800,000 for company stores and $1,575,000 for franchise stores, implying growth over 2005 levels of 10% and 12%, respectively.

 

Denny’s same store sales performance has been equally impressive, posting positive comp store sales for the past three years.  During the second quarter of 2006, however, the Company broke its streak of 10 consecutive quarters of positive same store sales at company owned restaurants by posting -0.4% growth, as Denny’s core value customer increasingly felt the pinch from elevated gas prices and rising interest rates.  In response to this, the management team did a fantastic job of reinforcing the “value” aspect of Denny’s offering.  The Company had a very successful coupon promotional strategy, where they managed to increase guest traffic (amidst a very weak industry environment) without sacrificing average guest check.  One reason why the Company has been able to maintain its guest check is the successful introduction of new dinner menu items, which has higher price points.  The effectiveness of the Company’s response can be seen in their third quarter results, where same store sales rebounded to +4.2%. 

For the first nine months, company SSS was +2.8%, and LTM EBITDA was $120.7 million.  The Company’s guidance for 2006 is to grow company unit SSS by 0.5% - 1.5% and for EBITDA to be between $113-$118 million.  Considering their performance year-to-date, it seems fairly clear that these guidance levels are very conservative.  The following table breaks down the SSS performance of their company stores for the past three years.

 

	Company SSS	Guest Check	Guest Count
FY2004-Q1	6.4%	3.0%	3.3%
FY2004-Q2	4.6	3.4	1.1
FY2004-Q3	6.8	3.8	2.9
FY2004-Q4	5.8	6.0	(0.2)
FY2005-Q1	6.3	3.2	3.0
FY2005-Q2	4.1	5.1	(1.0)
FY2005-Q3	1.5	4.1	(2.5)
FY2005-Q4	1.7	5.4	(3.5)
FY2006-Q1	4.6	8.0	(3.1)
FY2006-Q2	(0.4)	4.0	(4.2)
FY2006-Q3	4.2	3.7	0.6

   

In addition to improving top line performance and profitability, management has focused on several initiatives to further unlock value, including monetizing non-core real estate assets and refinancing some high-cost debt.    

 

As part of the Company’s strategy to generate cash and reduce debt, the Company decided to monetize some of their non-core real estate assets.  At the beginning of the year, Denny’s owned 231 restaurant properties, including 139 company-owned restaurants, 88 franchised restaurants and 4 surplus restaurants.  Initially, the Company has targeted the sale of its franchise operated properties.  As of September 30, 2006, the Company has sold 80 properties (including 60 franchise properties) for approximately $81 million, the proceeds of which were used to pay down debt. 

 

There are 21 remaining restaurant properties that are being marketed for sale.  The vast majority of these are expected to be sold within the next twelve months, and the Company estimates net sales proceeds of approximately $1 million per store.  Therefore, this should generate an incremental $21 million.    

 

Altogether, the Company anticipates selling the real estate underlying 80 franchise units.  The Company currently receives rental income from these franchise units in the amount of $7 million per year, which they will obviously forego as part of the sale.  In exchange, the Company is receiving an estimated after-tax amount of $80 million ($1 mm per store), implying an attractive sales multiple of 11.4x EBITDA. 

 

The Company is currently in the process of refinancing its existing credit facility to further improve cash flow and financial flexibility.  Currently, they have $262 million in term loans plus $43 million of drawn LCs.  The credit facility currently has a blended rate of roughly L + 410 bps.  We believe based on current price talk that the new facility will be priced at L + 225 for incremental savings of around $5 million, and run-rate net interest expense would be approximately $42 million.  This compares to cash interest expense in 2006 of about $55 million.  The remaining delta is attributable to the reduction in debt from FCF and the real estate sale proceeds. 

 

The Company’s current and pro forma capital structure is as follows:

 

 

			Sale of			Pro Forma
		Actual	Remaining	PF		Interest
	L/Cs	O/S	Real Estate	O/S	Rate	Expense
First Lien Facility:
Revolver Loans	42.5	-		-	7.55%	3.2
Term Loans		261.6	(21.0)	240.6	7.55%	18.2
Capital Lease Obligations		33.3		33.3	12.00%	4.0
Senior Notes		175.0		175.0	10.00%	17.5
Total Debt		$469.9		$448.9		$42.9
Less: Cash		(26.1)		(26.1)	3.00%	(0.8)
Net Debt		$443.8		$422.8		$42.1
Market Capitalization
Stock Price	$4.54
F.D. Shares O/S	97.4
Market Capitalization		$442.3		$442.3
TEV		$886.2		$865.2

 

 

 

The following table lays out my thinking on what free cash flow will be in 2007 and 2008.  I am assuming zero growth in units for 2007 and 2008, which is a fairly conservative assumption given that the Company has stated that net unit growth could resume as early as 2007.  In terms of SSS, I am assuming moderate levels of growth in 2007 and 2008.  I also factored in a moderate increase in capex from 2006 levels, and I assume that all FCF is used to further pay down senior debt.  Regarding the tax line, the Company has significant NOLs which will shield any pretax income for the forseeable future.  According to the 2005 10-K, the Company has roughly $113 million in regular NOLs and $160 million in AMT NOL carryforwards.  The $1 million outflow for taxes you see in the table below reflects what they typically pay in state taxes.

    

	2003	2004	2005	2006F	2007F	2008F
Units
Company operated	561	553	543	526	526	526
Franchised	1,077	1,050	1,035	1,020	1,020	1,020
Total	1,638	1,603	1,578	1,546	1,546	1,546
Company-owned SSS	0.2%	5.9%	3.3%	2.5%	2.5%	2.0%
Franchise SSS	na	6.0%	5.2%	3.3%	3.3%	2.5%
Company Restaurant Sales	$851.9	$871.2	$888.9	$897.3	$919.7	$938.1
Franchise Revenue	89.1	88.8	89.8	92.1	95.0	97.4
Total Operating Revenue	$940.9	$960.0	$978.7	$989.3	$1,014.7	$1,035.5
Adj. EBITDA	$107.5	$120.3	$120.3	$116.7	$125.6	$130.9
Less: Foregone Rental Income	-	-	-	-	(7.0)	(7.0)
PF EBITDA	$107.5	$120.3	$120.3	$116.7	$118.6	$123.9
Capital Expenditures	(32.0)	(36.1)	(47.2)	(40.0)	(42.0)	(42.0)
PF Free Cash Flow:
PF EBITDA					$118.6	$123.9
Capital Expenditures					(42.0)	(42.0)
EBITDA - CapEx					76.6	81.9
Cash Interest Expense					(42.1)	(39.6)
Taxes					(1.0)	(1.0)
FCF					$33.5	$41.4
Beginning Debt Balance					$448.9	$415.4
Debt Paydown using FCF					(33.5)	(41.4)
Ending Debt Balance					415.4	374.0
Reduction in Interest Expense @	7.55%				$2.5	$3.1
Total Debt / EBITDA					3.5x	3.0x

 

 

Based upon a stock price of $4.54, DENN currently trades at a 2007 P/FCF of 13.2x and 2008 P/FCF of 10.7x.  One may argue that the FCF is temporarily inflated by the NOL tax shield.  One other way to look at it is to “fully-tax” 2007 and 2008 FCF and reduce the market price by the present value of the NOL.  I estimate the PV of the NOL (excluding AMT tax shield) to be approximately $31 million.  Post 2008, I assumed growth in pretax income of 7% and at that rate, the NOL is used up sometime in 2012.  I then discount the tax savings at 10%.  On a per share basis, the PV of the NOL is $0.32, implying an adjusted market price of $4.22.  On this basis, DENN trades at a “fully-taxed” 2007 P/FCF multiple of 13.6x and a fully-taxed” 2008 P/FCF multiple if 11.7x. 

 

In calculating what “full taxes” will be, note the following:  reported D&A is higher than capex requirements.  The main cause of the difference is amortization of intangibles, namely franchise agreements.  Also, reported interest expense is roughly $5-6 million higher than cash interest expense, the difference being in amortization of deferred financing costs and interest accretion on other liabilities.  These two factors contribute to reducing their taxable income.  

 

			2007F	2008F
EBITDA			$118.6	$123.9
D&A			60.0	60.0
EBIT			58.6	63.9
Interest Expense			47.1	44.6
Pretax Income			11.5	19.4
Taxes	38.0%		4.4	7.4
Net Income			$7.1	$12.0
Actual FCF			$33.5	$41.4
FCF/Share			$      0.34	$      0.42
Price			$4.54	$4.54
P/FCF			13.2x	10.7x
Fully-taxed FCF			$30.1	$35.0
Fully-taxed FCF/Share			$      0.31	$      0.36
PV NOL / Share			$      0.32	$      0.32
Adj Price			$      4.22	$      4.22
Adj Price/Fully-taxed FCF			13.6x	11.7x