Description

Denny’s / Advantica

BUY - 12.75% Senior Notes due 2007 Price = 91 YTM = 14%
BUY - 11.25% Senior Notes due 2008. Price = 45 YTM = 25%

Investment Thesis: Denny’s faces significant over-leverage and a possible Chapter 22 filing. Nevertheless, I recommend long positions in the 12.75% Senior notes due 2007 and the 11.25% Senior Notes due 2008. The common take on Denny’s is that the company suffers from the weaker sales and higher costs that come with an oversaturated and highly competitive industry. I think this perception is misguided. I believe that the company is plagued by operational mishaps that are reversible. Because of this distinction, I think there is significant value left in the ’07 and ’08 Notes.

Depending upon how hard current operational mishaps have hurt the franchisees (something we will discuss below), a liquidity crunch could drive the company into bankruptcy. While the bonds would certainly trade down in this scenario, you could use this opportunity to increase your position in the company and reap greater profits in the future. If the franchisees have weathered the storm for the most part, we can expect the bonds to start trading up in the near-term.

Denny’s 11.25% notes tumbled from the 70s to the 40s when the company announced Q2 (ending June 25th) earnings and July same-store sales. While Q2 earnings were weak – continuing the year-over-year EBITDA decline we saw in Q1 – the July same-store sales were jaw-dropping. Denny’s company-owned same-store sales fell 4.9% (year-over-year) this July. In one of the best months for restaurants since 2000 (and a month when McDonald’s same-store sales shot up 10%), Denny’s had its worst performance since its failed “Don’t Serve the Black Guys” marketing campaign in the mid-1990s. Over the previous six years, I don’t think Denny’s had ever had a month where same-store sales declined over 3.5%.

Denny’s emerged from bankruptcy in 1998 as a highly levered company. A $592MM issue of 11.25% unsecured senior notes has slowly been trimmed down to $379MM as the company has offered bondholders 12.75% unsecured senior notes that are structurally senior to the 11.25%s. There are now $120MM of 12.75% notes and $379MM 11.25% notes outstanding. A $125MM credit facility is secured by all the company’s assets including first priority mortgages on all 247 properties. It is important to note that Denny’s is significantly overleveraged. The company has nearly $600MM in debt - a figure that might rise if the company needs to fight off a liquidity crunch at year’s end.

Franchises
Over the past 10 years, Denny’s has gradually turned to the franchising model. In 1992, the company operated 1,013 restaurants while its franchisees operated only 382. Today, the company only runs 563 vs. 1,085 franchises. Denny’s takes 7% of gross sales for each franchise, plus a start-up fee of $35,000. The company also generates a little revenue by leasing owned properties to franchisees.
The performance of the franchisees is a major concern, because we do not yet know how hard the company’s mishaps have hit their franchises. Unfortunately, there is little visibility into the dependability of earnings in franchising companies. On Denny’s income statement there are two lines: “Franchise Revenue” and “Cost of Franchise Revenue.” If profits dwindle at company owned stores, we can assume that they are doing the same at the franchise locations. Still, the numbers do not take a major hit until franchisees close locations. When Denny’s closes a company-run underperformer, they are usually amputating an appendage that is a drain on earnings and returns. When franchisees close underperformers, Denny’s loses a revenue stream and takes a hit to the bottom line. There are some warning signs that this could happen a lot in the near future:
1) Unit sales per store have always been higher for company-owned restaurants. This makes sense, since Denny’s has chosen to keep its best performers to itself. Franchise same-store sales have significantly underperformed company owned-stores over the last three years, indicating that some of the franchisees might have over-expanded into unprofitable sites. Poor 2003 comps – and particularly poor July comps – have hit the franchises harder than they hit the company-owned stores. This could drive struggling franchisees to close more underperformers.
2) 2002 was the first year in which franchise closings outnumbered openings. Franchise revenues also decreased for the first time and they continued to decrease into the first half of 2003.

Financing Options

Denny’s weak performance thus far in 2003 is putting a strain on the company’s liquidity. After the July 15th interest payment on the ’07 notes, the company only has $26MM of availability on its credit facility. Things could get hairy in January, when Denny’s has a $21.3MM interest payment due as the company works through the first quarter, when liquidity is generally the weakest. During the second quarter of 2003, the company amended its new credit facility (12/02) to alter the covenants. The most restrictive covenant was the minimum EBITDA test: The 2003 $105MM minimum was reduced to $90MM. Pursuant to the new amendment, new indebtedness may be used for general corporate purposes without a concurrent reduction of the facility commitments.

The company is in negotiations with its lenders to expand their credit facility. Under the current agreement, they cannot enter into any more sale-leaseback transactions and they cannot offer more than $10 million more 12.75% notes.

Financials and Valuation

Capital Structure:
- $125MM Credit Facility ($99MM outstanding) secured by liens on AR, cash and first priority mortgages on all 247 company owned restaurants.
- 12.75% Senior Notes due 2007 - $120.4MM outstanding
- 11.25% Senior Notes due 2008 - $379.0MM outstanding
- $29.6MM in capital leases
As discussed above, the ’07 notes are guaranteed by both the parent company and the Denny’s Holdings subsidiary, so they are structurally senior to the ’08 notes.

The ’07 notes are easily covered and seem undervalued at 91% of face.

Simple multiple based valuation of the ’08 Notes:
Multiple
11.25% Note Recoveries 4 4.5 5 6
EBITDA: $70 MM 8% 17% 27% 45%
$80 MM 19% 29% 40% 61%
$90 MM 29% 41% 53% 77%
$100 MM 40% 53% 66% 93%
$110 MM 50% 65% 79% 100%
$120 MM 61% 77% 93% 100%
$130 MM 72% 89% 100% 100%

EBITDA from 2000-2002 was between $120MM and $130MM. Franchising accounted for operating profits of $43.5MM (2000), $58.3MM (2001) and $61.4MM (2002). For the first half of 2003, EBITDA was $48MM, which included operating profits from franchising of $29.7MM. From the beginning of the year through the end of July, 31 franchises have closed. There are expected to be 50 franchise closings this year.

EV/EBITDA : 3.48

This business is highly capital intensive. Denny’s CAPEX has been well below depreciation levels for the past several years, so we can assume that they have been grossly underspending on their company-operated restaurants. For my DCF valuation, I put CAPEX levels at 100% of depreciation.

A conservative DCF valuation (projecting out current margins and assuming very little growth) prices the ’08 notes around 55-60.

In the end, neither a DCF nor a simple multiple valuation should guide your decision regarding the ’08 notes. While there is a considerable margin of safety on the ‘07s – based both on valuation and restrictions on the company’s ability to add too much more senior debt – the ‘08’s are not so fortunate. Recoveries on the ‘08s depend heavily on the future of the franchise revenues. If we think that recent performance dealt the franchisees a heavy blow that will result in a large increase in restaurant closings, the valuation could drop as low as the high 30s.

I’ve talked to several franchisees and researched some franchisee companies. I encourage you all to do the same if you are going to seriously consider this idea. I think the ‘08s have the most upside, but you have to do enough work to make yourself comfortable with the risk. In the end, I don’t think the liquidity crunch and threat of bankruptcy is something we should worry about too much; at some point, these bonds will have to be equitized. My real concern is that recent mishaps have crippled the company and impaired its earnings power going forward.

Why the distress might be overstated:

There has not been a major change in the competitive environment in the last few years.
Analyst reports frequently cite Denny’s inability to generate positive same-store sales as evidence that the restaurant industry in general – and the Denny’s concept in particular – is fully saturated. There is little evidence to support this assertion. Denny’s had positive company-owned same-store sales increases from 1998 through 2001, including a whopping 2.7% increase in 2001. In addition, competitors like IHOP have consistently grown through this recession while showing decent same-store sales growth. Is the recent decline in Denny’s company-owned same-store sales ( -1.0% in 2002, -0.4% in 2003Q1, -0.6% in 2003Q2 and -4.9% in July ‘03 ) a sign that the competitive environment has changed drastically in two short years? No. This company is not doomed by the economics of their business. Instead poor management decisions, a misguided marketing campaign and severe overleverage are the cause of current distress.

The Nelson Marchioli 2-Pronged Attack
Nelson Marchioli became CEO of Denny’s in February 2001. His approach was to focus on 1) Cutting overall costs while actually increasing hiring and labor costs and 2) Transitioning Denny’s from a breakfast spot to a popular dinner destination. Marchioli has done a commendable job in cutting costs. Since he took the helm, Denny’s operating expenses outside of labor costs have come down 12% while labor has gone up 2%. The idea of increasing labor spending is fairly simple: If the stores are better and more fully staffed, they can move customers in and out faster and improve their overall dining experience. This is a 2% increase in cost that can be regained if it does not add value. For 2002, EBITDA increased over 8% to $131.8MM despite slightly weaker same-store sales.

The second initiative, toying with Denny’s food-offering and marketing approach, has proven to be disastrous. As a franchisee told me, “Denny’s has very little credibility as a dinner spot. This was a terrible move we opposed from the start.” Revenues have been poor since the company stopped advertising breakfast in 2002. June and July in 2003 have seen the Summer BBQ days campaign fall flat; especially compared to the Summer 2002 $2.99 Breakfast Slam campaign.

Quick Recovery is Very Possible
This industry is driven by advertising dollars; when the company diverts its dollars from failed campaigns to proven ones, we should see a quick pickup in revenue. Denny’s misguided dinner campaign should not continue to impair restaurant performance into the future. Franchisees report that August comps are looking better than July’s.

I myself would rather chew on plywood than tackle a Denny’s “Moons over my Hammy” platter. Nevertheless, I feel like people are too quick to dismiss this company. Yes – IHOP and McDonald’s are moving into the late-night market. Yes – this is a competitive industry that has seen many bankruptcies in recent years. Yes – Denny’s doesn’t really do anything special that others can’t and haven’t emulated. All these things are true. But between 1991 and 2002 Denny’s (or the Denny’s segment of whoever owned them at the time) never exhibited EBITDA under $120MM. Same store sales have actually *increased* 5 out of the last 6 years. The company has slowly moved to franchising and can look forward to a future of passing on risk to franchisees and enjoying high profit margins. Denny’s management emerged from bankruptcy with entirely too much debt. Restructuring this debt is inevitable and the bonds have traded down as another bankruptcy looms. Nevertheless, if we can use the ’08 Notes to cheaply buy into the equity of a delevered Denny’s, then Management has done us a great favor by driving this company back into the ground.

Catalyst

restructuring