Description

Okay. . I originally posted this on the thread for my write-up of Denny’s bonds. I wanted to give it a little bit of a larger audience, so I’m posting it as a new idea. I’m fully aware that there is little margin of safety in this investment. . .it is not out of the realm of possibilities that Denny’s equitizes the 11.25% notes and greatly dilutes the current equity holders. Still, I think this is a risky but attractive investment opportunity. And besides, I think it is an interesting situation that is worth reading about. Most importantly, I think this restructuring does not need to happen. . .and if it gets scuttled, this equity is worth multiples of its current market value.

______________________
I wrote up Denny’s Bonds as an investment idea this past September, and I would like to update that write-up with a discussion of the common stock. Though the investment thesis is essentially the same, we are now at an interesting juncture because restructuring discussions are currently taking place. I’m not sure of our chances of avoiding a pre-packaged bankruptcy, but I feel like it’s important to begin the discussion now. If management treats the equity fairly in this process (or better yet, if they scuttle pre-pack plans altogether), then I think we are looking at a home-run. Incidentally, I still think the bonds are a very good buy. The entire capital structure seems undervalued to me, so you can obviously hedge out your deal-risk by owning both the equity and the junior notes.

Original Thesis:
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 still significant [unrecognized] value [in Denny’s].

Original Concern:
I always felt that the danger in this investment was the lack of clarity regarding the financial health of the franchisees. Since we could deduce that most Denny’s franchises were cash-flow negative over the first half of 2003, and since we know that many franchisees are very highly levered, I was afraid of a huge spike in franchisee bankruptcies and franchise closings that would greatly impair the corporation’s earnings power.

As this situation has played out, it seems that the thesis was correct and the franchisees managed to weather the storm.

Evidence that the thesis was correct:
The reversible operational mishap I discussed above was Denny’s 2003 marketing plan that focused on promoting different “dayparts” as the year progressed. For example, “Classic Lunch” ads were aired at the beginning of the year, “Hoagie Melts” were the focus as spring came around, May ads targeted late-night customers, and June saw the beginning of the “Barbecue Days” summer promotion. As Denny’s CEO Nelson Marchioli said on a July 2003 conference call, “This was a big step for us because in recent years our advertising programs focused solely on breakfast.” The problem with this strategy, as one franchisee told us, is that “Denny’s has very little credibility as a dinner spot.” During the company’s busiest and most profitable season, Denny’s embarked on an ad campaign that completely neglected breakfast. This was a disaster that sliced deeply into margins (breakfast margins are about 200 bps better than lunch and dinner margins) and same-store sales.

At the end of July 2003 (while bonds traded into the 40s and sell-side analysts blamed the company’s decline on a tired brand-name and competitive industry), Denny’s scuttled their marketing plan and returned to breakfast-focused advertising. The results since August have been good. Same store sales were down .6% in August and have been positive since then. While sales in 2002 were not stellar, the real decline did not begin until February of 2003, so these monthly figures are not comping against the marketing disaster. Recently, January 2004 comp sales were up 5.7% against a decent 2003 January. (Going forward, Denny’s will be comping against a disastrous February through July, so we’ll have to dig into the sales numbers a little more to get a feel for their real progress.)

The Q4 results released last week provide the best evidence yet in support of the thesis. In the first full quarter of the year that was not impaired by the failed dayparts marketing campaign, results were great. In fact, this quarter was a marked improvement over the 2002 Q4 despite significantly higher food costs. It is clear that the company could easily have replicated - or improved upon - 2002 results with a breakfast-focused advertising campaign. Currently, if you assume par bonds, Denny’s trades for exactly 5 times 2002 EBITDA. If you sub 2003’s stellar Q4 (and adjust down for the extra week) into the 2002 EBITDA figure, we have a company that trades at about 4.85 times. I will discuss below why I think this is a bargain.

A little talk about valuation and the Denny’s brand:
It is important to note that breakfast is the key daypart for Denny’s. Denny’s success as a breakfast destination makes it a stable and highly dependable business that differs greatly from high-flying casual dining concepts with higher margins but volatile sales results. As I wrote in the initial Denny’s thread: Denny’s has worse margins, an
undifferentiated product and little growth. Are there any positives? Yes: I think the consistency of the business lends itself to easy valuation. Denny’s EBITDA margins have been very stable – between 10% and 14% for over 10 years. Same-store sales have been level and seem dependable as long as the company keeps on advertising
breakfast. If you think, like Charlie Munger, that EBITDA is a bullshit number, then consider the Denny’s chain’s operating income (taking out 2 restructuring charges over the years) before the 1997 Flagstar bankruptcy (which resulted in huge amortization of reorg value charges):

1991 - $128MM
1992 - $130MM
1993 - $91MM (including a large goodwill write-off)
1994 - $123MM
1995 - $126MM
1996 - $114MM
1997 - $120MM

This is a good, dependable business that anyone should want to own. Unfortunately, the value of Denny’s had been obscured for years by the crappy companies that owned the brand and put its cash-flows to very very poor use. I do not feel like a business of this caliber deserves a 4.85x multiple. While management clearly learned their lesson about completely neglecting breakfast, I do not think they were mistaken by going after other dayparts. There is potential here - management just messed up by making such a drastic move in pursuit of growth beyond breakfast. A more balanced ad campaign is probably the answer. As I discussed in my previous Denny’s write-up, I think there is potential for growth in franchising.

I don’t really believe in specific price targets (I did not provide one for the bonds write-up either). I know that I’m not good enough to value anything with any real precision. . .it seems like a hazy enough science to me that I’m just happy when I come across a situation where the market value of a business is way below my perceived range of intrinsic values. I feel like Denny’s is such a situation. This is a company that is worth way more to me than the market’s $620MM valuation. I think Denny’s is easily worth $700MM (5.3x 2002 EBITDA) and probably worth north of $800MM. If management does not rush into a pre-pack, we could be sitting on a $5 stock or better. Either way, the entire capital structure seems undervalued and I would be happy owning both bonds and equity with the knowledge that no matter how the restructuring goes down, you’ll own equity in Denny’s heading into the future.

Restructuring (Alternative Title: I hope we don’t get screwed):
The company is now negotiating with the 11.25% bondholders, and it seems like they are leaning towards doing a pre-pack that leaves those bondholders with a new note and some equity. There are two obvious times when this write-up could have been timed– 1) when the common stock was so cheap that it was undervalued in any possible restructuring outcome or 2) when the restructuring outcome has been determined. When the stock was at 30 cents I was so worried about the franchisees that I thought there was no way the equity wouldn’t get cancelled. I recommended WRT against buying more equity, which was of course terrible, terrible advice. Sorry about that one!!! I owe you one.

Sadly, the equity has run a lot since I began thinking about this write-up. We no longer find ourselves in the situation that the equity is undervalued under most reasonable assumptions for restructuring outcomes. Still, I think the equity provides a good opportunity to buy into a great company at what could very possibly be bargain prices.

While the restructuring outcome has not yet been determined, I wanted to get some discussion going. I tried posting this on the bonds thread, but I’m worried that nobody gave it a fair glance. Because Denny’s has ample liquidity and is thus in a good negotiating position, there is little chance this stock will get cancelled in a pre-pack. (They don’t even really *need* to do this pre-pack. The only near-term maturity is over-secured bank debt.) Besides citing the board’s fiduciary duty to look after the interests of stockholders, management has repeated to me many times that they do not have to do this restructuring now and they will not go through with the process if it treats shareholders unfairly. (I will even forgive them for using my least favorite word: ‘proactive’.) I feel like this is an essential point. Denny’s has $62MM of liquidity, so shareholders, the rightful owners of the company, should be able to successfully fight off a pre-pack that totally screws over current holders. If you are uncomfortable with this level of speculation, I suggest waiting until the restructuring outcome is determined.

But anyway, I just wanted to give everyone the heads up that this is an interesting situation. While there is a lot of uncertainty, I think we’re looking at a company that people are quick to overlook and underappreciate.

Downside:
Worst Case: Bondholders get a new $100MM note and 90% of the equity. This would leave us with 7.5% to 10% of the restructured Denny’s.
EV $600 – Share prices : .43 - .57
EV $700 – Share prices : .62 - .82
EV $800 – Share prices : .81 – 1.07

Disclosure: We are long Denny’s common stock.

Catalyst

restructuring (or lack thereof) or refinancing