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Alexander Nicolau

DENN AT A GLANCE

P/E ► 9.22 LOW EV/EBITDA ► 7.00 AVG ROA ► 14.2% HIGH Debt to Equity ► -3.25   Current Ratio ► 0.688 AVG Interest Coverage Ratio ► 1.98 AVG

 

 

 

 

 

 

Denny’s Corporation (NASDAQ:DENN) is one of America’s largest family-style (served by a waiter/waitress) restaurant chains. Denny's diners are open 24 hours a day, 7 days a week, and they are known for offering large portions at low prices. With 1,471 restaurants in the United States, however, over-expansion is becoming an issue for the company, and in 2007 Denny's focused on downsizing and shifting its focus from a restaurant operator to a franchising corporation. The company closed 127 of its company-owned stores (a 24% decrease) in 2007 while signing agreements to increase its number of franchised stores by 12%. ^[1]. The company used the proceeds from these asset sales to pay down approximately $100 million of its outstanding debt.^[2].

In 2008, in a U.S. economic slowdown that has curtailed consumer spending, Denny's restaurants have stayed busy - in the first quarter of '08 Denny's revenues increased while other casual & upscale restaurants struggled. While Denny's low price, high quantity menu makes it attractive in times of lean spending, it also puts pressure on its restaurants' operating margins, so the company must minimize costs at every opportunity.

Denny’s food purchase agreements with numerous vendors limit its exposure to commodity price increases relative to others in the industry, and most of its employees are paid minimum wage. In 2007 Denny’s labor costs increased 3% as a percentage of sales (3% increase), but changes in federal and state minimum wage legislation that set in during the summer of 2009 will create a 26% increase in the cost of Denny's labor. The company will have to change its cost structure in order to maintain its operating margins after these increases take effect.^[3].

Business Overview

Denny's offers traditional American-style food such as breakfast items, appetizers, sandwiches, dinner entrees and desserts. Denny's restaurants are best known for their breakfast items, such as the Grand Slam (two each of: pancakes, eggs, bacon, sausage), currently priced at $4.99. Breakfast menu items comprise approximately half of all Denny's sales - these menu items are served at any time of day, and are popular late at night. From 2002-2007, however, Denny’s has reduced its share of breakfast menu items from 55% of sales as it has shifted some of its focus towards selling higher-margin lunch and dinner entrees during the lunch and dinner hours.

Traditionally, Denny's core demographic has been moderate-income households (in the $35,000-$50,000 range), a group which has been hit hard in 2008 by rising gas prices and a slowing economy. Since Denny's emerged from bankruptcy in 2002, 60% of the system (company owned and franchised locations) has been remodeled and nearly 300 unprofitable locations have been closed.

As of December 26, 2007, Denny’s operated 1,546 restaurants, 1,152 (75%) of which were franchised restaurants and 394 (25%) of which were company-owned and operated. Denny’s restaurants operate in 49 states, the District of Columbia, two U.S. territories and five foreign countries with concentrations in California (26% of total restaurants), Florida (10%) and Texas (10%). Revenues primarily come from company-owned restaurant sales (90%) and franchise fees/ royalties (10%). This approximate 9:1 revenue relationship has persisted over the past 3 years, but as seen in the chart below, the company is moving towards a higher franchise percentage^[4].

From 2006 to 2007, total revenues declined 5.5% led by company-owned restaurant sales which declined 6.6% as a result of closings and weak same-store sales growth. At the same time, operating margins decreased from 11.1% in 2006 to a mere 8.9% in 2007. While revenues have decreased, cost of goods sold has increased because of commodity price increases and increased labor costs^[5].

As mentioned above, in 2007, Denny’s had weak company-owned same-store sales growth of only .3%, compared to 3.3% in 2005 and 2.5% in 2006, due to the fact that while average guest check amounts increased 4.6%, the guest count in Denny’s restaurants decreased 4.1%. Denny’s franchised restaurants had same-store sales growth of 1.7%^[6].

Key Factors and Trends

Denny's primary business focus has shifted from operator to franchiser

During 2007, Denny's sold 130 restaurant operations and real estate in certain geographic clusters to 30 franchisees for net proceeds of $73.2 million. Meanwhile the company signed agreements to open 120 new franchise restaurants over three years, beginning with eight in 2007.^[7]. These moves will reduce the 9:1 ratio of company-owned to franchise restaurant sales. However, it might also lead to decreased revenues overall, as Denny's makes only $40,000 as an initial franchise fee and 4% of gross sales from all franchises. In order for Denny's to maintain current earning levels, the volume of franchise agreements must increase substantially, which will be difficult given the state of the economy in early 2008 (decreased spending, less credit available).

Weak economy decreases customer demand

During periods of weak economic growth, discretionary spending tends to taper off, leading to decreased sales at casual & upscale restaurants. Since the latter part of 2007, thoughts of recession have been looming, gas prices have increased substantially, credit is tight, and moderate inflation has been a growing concern. All of these trends affect Denny's foot traffic, as people are curtailing their discretionary spending habits, and guest count was down 4.1% in 2007. But in lean times Denny's has a leg up on others in the restaurant industry as their low prices and large volume meals attract customers with light wallets during periods of weak economic growth. The 4.1% decline in Denny's sales was less than the losses posted by others in the dining industry, in particular companies that manage casual & upscale restaurants. ^[8]

Commodity price increases and labor cost increases are tightening margins

Food and payroll costs are the heaviest weights on Denny's balance sheet. The menu in Denny's restaurants is so cheap that a slight increase in commodity prices can have a dramatic effect on margins. Denny's purchases food products based on market prices, but it “locks in” prices in long-term purchase agreements with various vendors, minimizing price volatility by establishing price ceilings and/or floors.^[9]. Over the past three years, global food prices have increased 83% and during 2007, commodity prices hit record levels. Denny's risks losing business if its passes all of these costs onto the customers in its restaurants.

Volatility in payroll costs comes primarily from changes in wage rates and increases in labor related expenses such as medical benefit costs and workers’ compensation costs. Many of Denny's employees are paid the minimum wage, so changes in this legislation can affect the company's ability to turn a profit. In 2007, the federal government along with many state governments passed bills to raise both federal and state minimum wage standards. The federal bill called for a $.70 increase by the end of the summer of 2007, another $.70 increase by the end of 2008, and a minimum wage of $7.25 by the summer of 2009.^[10] With guest counts decreasing at the same time, cost of goods sold increased as a percentage of sales in 2007^[11].

Debt levels have decreased and interest rates on debt are now fixed

Interest expense has a significant impact on Denny's net income (loss) as a result of their indebtedness ($430 million of long-term debt as of December 26, 2007). However, during 2007 and 2006, the company continued to reduce interest expense through a series of debt repayments using the proceeds generated from the franchise fees, large asset sales and cash flow from operations. These repayments resulted in an overall debt reduction of more than $100 million in both 2007 and 2006. Also, Denny's is subject to the effects of interest rate volatility since approximately 46% of their debt has variable interest rates. To minimize interest rate volatility, in 2007 Denny's entered into an interest rate swap on the first $150 million of floating rate debt. As of December 26, 2007, the swap effectively increases the ratio of fixed rate debt from approximately 54% of total debt to approximately 99% of total debt. In essence, Denny's is no longer affected by interest rate movements on its current debt because it is already fixed; however, interest rate fluctuations will still affect its ability to borrow money for future projects.^[12].

Competition

Denny’s competes in the $56 billion family dining segment against restaurants such as IHOP (IHP) and Waffle House, which are Denny’s primary competitors on a nationwide scale. It also competes with a number of regional family dining and buffet chains, and individually owned diners and coffee shops.

Top Competitors-

• Brinker International (EAT)-engages in the ownership, development, operation, and franchising of various restaurant brands principally in the United States. Its restaurant brand names include Chili's Grill & Bar, Romano's Macaroni Grill, On The Border Mexican Grill & Cantina, and Maggiano's Little Italy^[13].
• IHOP (IHP)-develops, franchises, and operates full-service restaurants in the United States and internationally. It owns and operates two restaurant concepts in the casual dining and family dining niches, which includes Applebee's Neighborhood Grill and Bar, and IHOP^[14].
• Waffle House-a privately held restaurant chain that operates more than 1,500 restaurants(company and franchisee owned). Waffle House holds the title as the world's leading server of waffles, omelets, T-bone steaks and more^[15].

Other Competitors-

• Big Boy Restaurants
• Bob Evans Farms (BOBE)
• Buffets Holdings
• Carlson Restaurants
• CBRL Group (CBRL)
• Darden Restaurants (DRI)
• Friendly Ice Cream (FRN)
• Huddle House
• Metromedia Restaurant Group
• OSI Restaurant Partners
• Perkins & Marie Callender's
• Ruby Tuesday (RT)
• Steak n Shake Company (SNS)
• VICORP Restaurants

Market Share

The top ten chains nationwide together comprise only 22% of total sales in the $56 billion family-dining (served by a waiter/waitress) segment. Although down from its peak of more than 1,800 sites in 2001, Denny’s remains a strong brand in this segment thanks to its nationwide footprint, 24-hour operations, economies of scale (i.e., better purchasing terms than smaller chains), well-defined niche in the breakfast daypart, and strong marketing support (Denny’s is the only family-dining (served by a waiter/waitress) chain to advertise on network television).

^[16]

References

1. ↑ DENN, 2007 10-K, Item 1, p.1
2. ↑ DENN, 2007 10-K, Item 7, p.13
3. ↑ DENN, 2007 10-K, Item 7, p.13
4. ↑ DENN, 2007 10-K, Item 7, p.13
5. ↑ DENN, 2007 10-K, Item 7, p.13
6. ↑ DENN, 2007 10-K, Item 7, p.13
7. ↑ DENN, 2007 10-K, Item 1, p.1-2
8. ↑ Eateries make adjustments as weak economy bites into sales
9. ↑ DENN, 2007 10-K, Item 7, p.12
10. ↑ Minimum Wage Hike Approved
11. ↑ DENN, 2007 10-K, Item 7, p.12
12. ↑ DENN, 2007 10-K, Item 7, p.12
13. ↑ EAT:Profile for Brinker International Inc.-Yahoo! Finance
14. ↑ IHP:Profile for IHOP Corp.-Yahoo! Finance
15. ↑ Waffle House-About Us
16. ↑ Restaurants and Institutions