A Turnaround Story to Sink Your Teeth Into?
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Denny's (NASDAQ: DENN) investors have not had a very smooth ride in the recent past. A 2010 proxy battle over management and board positions, as well as continually weakening performance over the past several operating periods -- free cash flow has been falling by nearly 25% per year between 2006 and 2010 -- have made the corporation's shares less than desirable to the general investing public.
However, with the recent hiring of CEO John Miller, a 30-year restaurant management veteran who recently invested nearly three-quarters of a million dollars in the company's stock, DENN has received a much-needed confidence boost. Will the new restaurant menu and operational direction make DENN one of 2012's most compelling turn-around stories?
Making several key improvements after a less-than-stellar five year operating period, the restaurant chain still has quite a ways to go before it will be considered a successful contender in the highly fragmented restaurant industry. Same-store sales (SSS) have increased 0.9% in the most recent quarter, marking the second consecutive quarter that both franchise and company-owned SSS have improved. This may not seem extremely impressive -- even 70-year-old McDonald's (NYSE: MCD) was able to boost SSS by 7.4% this past November -- but it does represent a turn-around point from the decrease of 5.2% and 3.6% experienced in 2009 and 2010, respectively.
Similarly, the corporation has made huge strides in reducing its once-bulking debt load. The debt burden has been decreased by nearly 44% per year since 2006, and DENN's interest coverage (defined as EBITDA/Interest Expense), has risen 14.5% over the same period. Gross profit, through the boost of increased menu prices that will continue to rise in 2012, increased to 81.1% over the last 12 months. This represents a 2.3% increase over the average gross margin between 2006 and 2010, and has helped to boost operating margins more than 300 basis points above their five-year average.
The restaurant's Franchise Growth Initiative (FGI) has placed an increased reliance on the use of franchisees to grow the brand, which should aid in faster growth and a shift of a considerable level of financial obligations away from the parent corporation going forward. From a 66% franchise rate in the early to mid-2000s, DENN's base of more than 1,650 restaurants is 86% franchise-operated.
At a current price of $4.06, how does DENN's market valuation compare with similar corporations in the restaurant space? The following chart contains both highly-franchised and non-franchised restaurant chains, and the enterprise multiple valuation (which takes into account each corporation's cash/debt position) is arguably the best metric on which to compare the firms.
Note: EV/EBITDA and P/E ratios calculated using trailing twelve month financials. Yum Brands (NYSE: YUM) contains brands such as Pizza Hut, Taco Bell, KFC, Long John Silver's, and A&W All-American Food Restaurants. DineEquity (NYSE: DIN) includes Applebee's and IHOP. Brinker International (NYSE: EAT) includes Chili's Bar & Grill and Maggiano's Little Italy. Darden Restaurants (NYSE: DRI) includes Olive Garden, Red Lobster, LongHorn Steakhouse, Capital Grille, Bahama Breeze, and Seasons 52.
As depicted, it appears that the market has valued DENN more closely to the non-franchised chains than to its more closely-related highly-franchised competitors.
For those who do not necessarily agree that a peer comparison using enterprise multiples is a suitable way to determine if DENN is undervalued, a reproduction value (back-of-the-envelope, so to speak) analysis may offer further evidence.
With 1,677 restaurant locations as of late September 2011, the corporation's enterprise value implies a per-restaurant value of around $360,000. The simple fact that it would take a considerably larger investment for a new entrant in the industry to recreate a restaurant base of this size makes an investment in DENN worthy of closer examination.
How much is a DENN restaurant worth? On a per-restaurant revenue basis, they are definitely not worth as much as a McDonald's or Darden Restaurants location. MCD's current enterprise value implies a per-restaurant value of $3.4 million. DENN hardly deserves such a high multiple, as it owns a fraction of the worldwide brand value that fast-food king MCD commands. Ignoring the firm's brand value only acts to supply additional conservatism into the valuation, as the brand does carry some reproduction value that a new entrant would need to overcome. Not all consumers have a positive image of the restaurant chain, but who hasn't heard of the famous "Grand Slam" breakfast?! In focusing on an analysis of DENN's land and land improvements -- consisting of building, kitchen equipment, fixtures, etc. -- the corporation's enterprise value appears quite undervalued.
Among the nation's counties with the hardest-hit property values over the past several years are Contra Costa, CA and Virginia Beach, VA. These linked articles refer to home values, but falling private property values and increasing foreclosure levels in a given area undoubtedly have a negative financial implication on local business values.
The local DENN restaurant in each of these counties was examined more closely, and the assessments of the land/building values from the local governments' property appraiser is as follows:
- 2006 Somersville Road, Antioch, CA. 94509
- Assessed land value: $673,000
- Assessed improved value: $783,000
- Total assessed land value: $1,456,000
- 3337 Virginia Beach Blvd. Virginia Beach, VA. 23452
- Similar breakdown for total assessment, as of 1/6/2012, of $1.28 million
Does each DENN location deserve this high of an appraisal? Maybe not -- the sample size is too small, and the DENN location in my hometown of Palm Coast, Fla., was run-down for years and recently sold to a competing chain. Does the above valuation imply that DENN shares are worth four times as much as their current market valuation ($1.3 million average / $0.36 million)? Probably not -- the effectiveness of the new leadership team and its operational direction has yet to be fully proven through improved financials.
However, whether or not the local property appraisers in the example above are spot-on with their assessments, it would be very hard to argue that the market's valuation of $360,000 per location is fair, reproduction value. Even in some of the hardest-hit counties in the nation, land values for lots of these sizes are much more than DENN share prices imply. Also remember that each of DENN's company-operated locations generated around $2 million in revenue in 2010 alone. Most people would probably buy a restaurant if they could generate 5.5x the purchase price in revenue the first year.
The difficult side of such an investment in DENN shares is that the hypothesis lacks a catalyst with a known timeframe. This is essentially a waiting game to see if the new CEO can turn around the failing business concept. However, the CEO's personal investment in the corporation, the restaurant's revamped menu, and the focus on franchise-based growth do present a compelling argument that the corporation's performance may continue to improve throughout 2012.
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