Description

Background

Denny’s Corporation (DENN) is a diner-style restaurant chain with two concepts, Denny’s and Keke’s.  The namesake concept has nearly 70 years of history.  Its menu pricing is at the lower-end of the spectrum.

As of 2023, DENN operates or franchises 1,631 restaurants.  Most of the restaurants are located in the U.S.

Keke’s is a breakfast concept acquired in 2022.  Currently there are only 50 units and thus immaterial to the story.

Why Does This Opportunity Exist?

2023 is the first normalized year since covid.  Naturally, when evaluating the company, investors would compare 2023 financials with 2019, the last normal year before covid. 

This comparison places DENN in an unfavorable light.  Other restaurant companies typically have higher revenue and earnings relative to 2019. At first glance, DENN seems to be heading in the wrong direction. Declining trends in revenue, EBITDA and EPS prompted me initially to look at this as a potential short.

The small market cap and thin daily-traded volume (~$3mm) also make DENN uninteresting to many investors.

Thesis

On closer inspection, DENN is an attractive franchise business with highly recurring revenue, impressive FCF generating ability, a track record and commitment to return FCF to shareholders via share repurchases. 

Since it started repurchasing in 2011, shares outstanding are down from 101m to 56m. I expect DENN will continue to return all FCF with buybacks which in turn will drive EPS growth and provide downside protection for investors.

Transition to Franchise Business Model

Franchising restaurants to operators is a much better business model than operating restaurants. The benefits are priority claim to cash flow, high revenue visibility, better margins, capital-light, and low to zero operating risks at the restaurant level. 

20 years ago, DENN had 1,638 units: 1,077 franchised and 561 company-owned.  Fast forward to today, only 73 units out of 1,631 total units are company-owned, with more than 95% of units operated by franchisees.

Growth

The discount exists because DENN is perceived to be a value trap with questionable earnings sustainability. There are several reasons leading to this perception.

First,  key metrics (number of units, revenue, EBITDA, adjusted EPS) are down when comparing FY23 with FY18 or FY19.

Second, the timing of covid masked DENN’s transition to a nearly pure franchise model. In FY19, 105 company-owned units were franchised in several transactions weighted towards the back half of the year.  Then covid came.  The company had no chance to showcase its earnings power after the transition.

Third, the underlying economics of the franchise segment requires some effort to discern when looking at the consolidated financial statements. Operating Revenue is the sum of franchise revenue and company-owned restaurant revenue. Taken at face value, operating revenue would decline as the portfolio shifts towards franchise. Since DENN was shifting its business model, revenue growth appears much worse than the true underlying trend.

Once rearranged along the two business segments, the underlying trends look very different.

Key takeaways: 

1) Franchise represents the bulk of earnings.  The change is dramatic compared with FY18.

2) Earnings from Franchise is growing every year since 2020

3) This is a healthy, growing business, definitely not a melting ice cube.

Earnings Power 

Management expects same-store sales to be 0 - 3% and adjusted EBITDA to be $85 - 89 mm in FY24.  I estimate $16mm cash interest, $8mm maintenance capex (exclude new constructions; average post FY19) and $11mm cash tax.  Using the low-end, FCF will be roughly $50mm or $0.92/share.

Valuation

Starting in FY11, the company has returned capital to shareholders primarily through share repurchase, in some years levering up the balance sheet to do so.  The only year it stopped buying back stock was 2020.  Management-defined FCF was $44.7mm and it bought back $52.1mm in FY23.  

Organic growth should be in the 1 - 2% range, driven by 2 - 3% unit sales growth, offset by 1-2% decline in total units. Stock buybacks should drive EPS growth to at least in the 5 - 6% range.

Given the recurring and predictable revenue stream, capital-light business model and its earnings growth profile, I think the stock is worth at least 16x FCF or $14.7/share. 

Catalyst

Share Repurchase

I expect to return all FCF through repurchase.  If stock price stays the same, the company can repurchase more than 10% of the market cap in the next 12 months.