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Investment Conclusion
Denny’s Corporation (NASDAQ:DENN) is scheduled to report F1Q2022 earnings on May 2, 2022, following market close. The average consensus revenue and earnings per share estimates for the quarter are ~$102 million and $0.13. Based on our analysis, it appears likely that the company’s actual financial outcomes will come in ahead of analyst estimates for the period. Our conviction is driven by DENN’s solid recent quarterly performances.
In that regard, we were highly encouraged by the firm’s F4Q2021 financial results. Despite dealing with the impact of Omicron and that Christmas and New Year’s eve fell on weekends, the company generated significant growth in revenues on a year-over-year basis and compared to two years ago. The surplus revenues were driven by increase in dine-in sales (as Americans sought out the full-service restaurant experience), as well as persistent growth in off-premise sales. The surge in retail sales over the quarter was reflected in franchise and license revenues, as well as in franchise operating margins, which were substantially higher than a year ago.
Indeed, because of the revenue leverage from sharply higher sales, DENN was able to absorb inflationary pressures related to commodities and labor, and expand margins by some basis points. The shortfall in staffing improved somewhat leading to an increase in the number of restaurants open 24/7 to ~50%. The company made good headway with the kitchen modernization project and the cloud based technology platform over the quarter. During F4Q2021, DENN opened seven new franchisee operated restaurants, including one in Mexico, and permanently shuttered 14 franchisee led restaurants, ending FY2021, with 1,640 domestic and international locations.
Over upcoming quarters, we expect the momentum in dine-in transactions to escalate substantially on a year-over-year basis and compared to three years ago, as folks begin eating out more frequently than they did during the pandemic. Moreover, as evidenced over recent quarters, off-premise sales will continue to expand driven by millennials preference for take-out and delivery, in our judgment. In addition to uptick in traffic, sales growth will be fueled by shift in customer preference towards premium priced items and increase in menu pricing. Further, we believe that revenue leverage associated with the substantial growth in sales, combined with efficiencies related to the kitchen modernization initiative and the roll-out of the technological platform, as well as lack of one-time items, will reflect in some margin expansion. As a byproduct of higher revenues and margins, earnings and free cash flows will expand considerably over the next few quarters.
Longer-term, given that comparable store sales growth is expected to remain below mid-single digits, DENN is planning on accelerating new unit development, to expand revenues. Based on management commentary, it appears that they view footprint development a key strategy to ignite growth. In that regard, the company expects to ultimately expand the number of restaurants by double digits every year. Comparable store sales growth will be propelled by: menu innovation, the loyalty program, and convenience. As a flow-through of significantly higher sales, margins, driven by lower fixed costs/dollar of sales, and economies of scale associated with: corporate spending, the digital platform, and advertising, will expand. The increase in sales and operating leverage will invariably lead to boosts in profits and free cash flows, on a secular basis.
Considering that F4Q2021 results have not altered our long-term outlook on DENN, we remain convinced that the firm will handily meet and exceed our conservative 10-year normalized revenue growth rate of 6% and 10-year straight-lined operating cash flows growth rate of 15%, incorporated in our 10-year Discounted Cash Flow model. Therefore, we’re maintaining our 1-year Price Target of $21/share for DENN. Reiterate Buy Rating. (Please go through our initiation report “Denny’s: Positioned For Imminent Turnaround And Accelerated Growth” and associated notes for our long-term opinion on the stock.
Key Takeaways From The Fourth Quarter
F4Q2021 Results Summary. For the quarter, revenues at ~$108 million (+34.4% on a year-over-year basis) missed consensus estimates of ~$113 million, and earnings per share of $0.67 (compared to $0.04 over F4Q2020), was above analyst projections of $0.17. In addition, on a year-over-year basis, same store sales improved by ~49% at domestic restaurants. Net income for the period was ~$43.5 million vs. ~$2.4 million generated over the previous year’s same quarter. Restaurant margin for the period was ~14.8% compared to ~4.3% over F4Q2020. At the end of F4Q2021, operating cash flows and adjusted free cash flows were ~$12.9 million and ~$3.4 million.
Over FY2021, DENN generated: domestic same store sales growth of ~41.1% over the prior year, ~$398 million in revenues reflecting an uptrend of ~38% on a year-over-year basis, restaurant margins of ~16%, ~$78.1 million in net income, $1.19 in earnings per share, ~$76.2 million in operating cash flows, and ~$40.8 million in adjusted free cash flows.
Number of 24/7 Units Continued To Expand. By the end of January, ~50% of DENN restaurants were operating 24/7, up ~2% from F3Q2021 levels. As per management, the only gating factor limiting additional stores from remaining open around the clock was labor shortage. In that regard, it is noteworthy that at limited hours restaurants, highest sales were attributed to weekends, followed by breakfast, late night, and lunch. However, at 24/7 restaurants, the graveyard shift generated the largest sales volumes. In addition, given that overnight customers are younger and more affluent, they are more likely to be adventurous in their culinary choices, providing franchisees the perfect addressable population to market the new menu items DENN is rolling out, as the kitchen modernization project continues to progress. Further, DENN appears to be one of a few full service restaurants with scale that are open 24/7, providing franchisees an unique opportunity to generate sales with limited competition. Moreover, it is noteworthy that sales growth associated with 24/7 stores is ~20% higher than that linked to limited hours stores.
Given these factors, it appears that franchisees benefit from operating restaurants around the clock, and that labor shortage is likely the reason preventing them from keeping stores open overnight. Therefore, and as management indicated, we would not be surprised if franchisees and the Franchisee Association Board are wholeheartedly behind the initiative to return the entire footprint to regular hours.
Revenue Expansion Opportunities On Tap. During F4Q2021, DENN launched three initiatives to support revenue growth. First, the firm resumed its Heritage 2.0 restaurant remodeling program that was deferred for two years due to the pandemic. Considering that sales growth associated with restaurants that have been remodeled to Heritage 2.0 is ~5% higher than that linked to stores that have not, franchisees inclination towards remodeling projects is high. In that regard, franchisees and the company remodeled three restaurants each during the fourth quarter. DENN expects that a substantial fraction of its stores will be remodeled over the year, reflecting in greater brand visibility and higher sales volume.
Second, the company with the support of REEF Kitchens plans to launch cloud kitchens, in large markets where it remains under penetrated, with the first of several ghost kitchens planned for FY2022, to be launched during the first half of the year.
The last initiative deals with incentivizing domestic franchisees with up to $400,000 in funding to launch restaurants in regions where DENN remains underrepresented. Given the enthusiasm among franchisees for the project, the firm expects new unit development to pick-up in FY2023.
Cumulatively, the strategies could reflect in substantial, incremental and sustainable, sales growth for DENN.
Margins Likely To Expand Over The Near-Term. Adding back the 2.9% in one-time items, operating margins for the fourth quarter would have been 17.7%, despite inflationary headwinds unfolding across the country. In addition, although DENN raised menu prices by 2% during the period, management indicated that a couple more price increases could be implemented over the year. In addition, the firm has allocated an additional employee over-time and training budget that would translate to between 50 bps and 100 bps in margin, which will disappear after the labor shortage issue is resolved. Moreover, initiatives such as shifts in menu mix and waste management, will provide further leverage. Given the above described scenario, margins should expand over the next few quarters, in our assessment.
Next Generation Customer Experience Being Rolled Out. DENN’s cloud based digital restaurant platform currently being rolled out is designed to integrate technology into the DENN experience, whether it’s related to customers and the manner in which they enter the restaurant, wait for their table, order their food, evaluate calorie information, and pay their check, or whether its associated with servers and their ability to accept table-side: orders and checks. In addition, this next generation best-in-class platform, will facilitate the execution of mundane tedious tasks such as: menu management, price updates, and menu mix changes, through the push of a button. Overall, the venture will enhance customer experience and propel DENN to the forefront of technologically savvy full-service restaurants.
Labor Shortage Situation Improved Considerably. Managerial positions at all company operated restaurants have been filled. The number of restaurants open 24/7 has improved by ~2% to ~50% due to progress in hiring efforts. Franchisee restaurants that are operating 24/7 have achieved staffing levels consistent with that available pre-pandemic, and those operating on a limited hours schedule are currently staffed at ~80% of pre-pandemic levels. However, although average operating hours across the footprint have grown to ~20 from ~18 evidenced during the third quarter, employee shortage continued to impact operations over the fourth quarter.
Nevertheless, DENN’s efforts to improve candidate flow through the launch of a common career website for company operated and franchisee operated restaurants has resulted in a significant improvement in job applications. In that regard, it is noteworthy that driven by competitive wages and comprehensive training programs, employee turnover at corporate restaurants is below the industry mean. On average, servers working at company restaurants earn ~165% of the full state minimum wage, if one were to include tips, not just the tip credit minimum wage. For 2021, DENN appeared in Newsweek’s list of top 100 most loved workplaces, being one of the only two restaurant companies awarded the honor.
Balance Sheet Appears Relatively Weak. At the end of F4Q2021, the company had cash and cash equivalents of ~$30.6 million and long-term debt of ~$183 million, on its balance sheet. Including the revolving credit facility that was restated to $400 million (from $350 million) during the third quarter, DENN has ~$214 million in funding liquidity available for use. At the end of the period, the firm had a debt/EBITDA ratio of 2.1x, consistent with the long-term debt/EBITDA ratio target range of 2x to 3x.
Bottom Line
Longer term, we have high hopes for DENN. They are primarily a sit-down restaurant group, which, although they scrambled and swiftly improved their off-premise service, was hit hard by the viral outbreak.
With pandemic conditions largely behind the country, not only will DENN’s dine-in sales come back, they will be supported by off-premise sales, much in excess of what they were pre-pandemic, as well as sales from initiatives such as cloud kitchens, restaurant remodels, technological advancements, and updated menu offerings. In addition, DENN’s plans to accelerate new unit growth to double digits, will gradually unfold, leading to significant growth in the footprint, domestic and international, invariably delivering additional sales growth.
Moreover, efforts to scrimp and save during the pandemic, have led to greater efficiencies, which will continue to deliver operating leverage. Further, as commodity prices come down to earth, the savings will be reflected in margins.
Clearly, DENN appears to be on a roll, working its way to a future that looks brighter every day.
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