Denny’s (DENN) is an attractive long term investment at current levels. The company was written up last December at an approximately 10% higher level. Please see that well written write-up by humkae for detailed information on the company’s recent history, background and specifics on some of the real estate monetization that was and continues to be a source of value for the company. In this write-up I want to focus on a few key aspects of the company that I don’t believe are being correctly appreciated by the market. Denny’s currently trades at approximately 6.8x current year (2007) estimated EV / EBITDA on a consolidated basis. Despite the obvious near-term industry challenges related to consumer confidence, commodity prices, etc., this valuation is too low when one considers the following factors:
Royalty Streams: Approximately half of the EBITDA relates to fees from the franchise system and other related recurring royalty streams (real estate and licensing). To arrive at this figure requires a number of assumptions as the company gives only top-line and gross margin specifics for the two divisions of the company. Simplistically, we are assuming a fully loaded margin on the franchise side of around 50% pre-tax margins which we believe to be conservative. This franchise related cash flow is extremely valuable as it requires no capex and is highly leverageable. Further, this value should become clearer to the market as the growth initiatives described below which are primarily related to the franchise side of the business begin to meaningfully flow through the P&L in the coming years.
Growth: Denny’s has struggled to build momentum for new unit growth over its recent past as management has focused primarily on paying down debt, cleaning up the franchise system and dealing with under-performing units. It appears, however, that the company has laid the foundation for meaningful unit growth going forward. In addition to growth being a key management talking point in company presentations, the company has begun to drive expansion through agreements at the corporate level. For example, the company signed an agreement with Pilot Travel Centers in October which should add 20-25 truckstop-based units annually going forward. One key point that the market doesn’t seem to appreciate regarding the potential for growth at the company is that the brand is hardly at saturation. In fact, the total approximately 1,600 units are still heavily concentrated in CA, FL and TX leaving many under-penetrated opportunities including cities like Atlanta, Charlotte and DC which have all been cited as just a few examples of potential growth spots by the company. YTD, the company has received commitments for 36 new franchised units and this number should continue to grow moving forward.
FGI: The company has also made significant progress with its FGI (franchise growth initiative) program which will further contribute to new unit development. This initiative has several objectives but the basic gist is to take underperforming company units and sell them to franchisees (who are generally looking to pay less for under-performing stores that they believe can be better run) and then get those franchisees to also commit to developing additional new units. This positively influences the company a number of ways because it 1) receives cash for units that do not generate significant earnings 2) receives future royalties on these same units which also no longer require company supplied maintenance capex 3) allows the company to cut layers of management and 4) deepens the relationship with franchisees who are then more likely to build new units. YTD, this process has yielded the sale of 56 co-owned restaurants for proceeds of $30.6mm and also resulted in commitments for the additional development of 35 new franchised units beyond the 36 mentioned above.
Cost Savings: Denny’s also recently unveiled a cost cutting program that will result in savings of $5-6mm per year after $3mm of reinvestment into strategic intiative related G&A. This will be accomplished by the elimination of 90 positions mostly in areas of middle management. This (and additional pricing) should help to mitigate the effect of rising commodity prices which currently pose a significant challenge for the industry.
Improved Balance Sheet: The company has paid down $146mm of debt since 12-31-05 resulting in interest savings of over $14mm on an annual basis and vastly improved leverage ratios. Net debt to 2007 estimated EBITDA is now in the very comfortable mid 3x range adding a further layer of comfort to the story.
Summary: While the macro environment remains challenging for Denny’s and all other restaurant operators, the company continues to build value in a variety of ways that should ultimately result in both higher cash flow and a significantly higher valuation.