Denny’s: Strong First Quarter Results Validate Our Thesis (NASDAQ:DENN)

Investment Conclusion

Denny’s Corporation (NASDAQ:DENN) delivered upbeat F1Q2022 financial results. Despite, the surge of Omicron in January, inclement weather patterns during January and February, and the impact of rising inflation in food costs and gas prices on the firm’s target demographic of low income and middle income Americans, and supported by easier comparables as COVID related restrictions were in effect in F1Q2021, system sales and same-stores sales, expanded substantially on a year-over-year basis. The sales upside was fueled by higher menu prices, a shift in menu mix towards premium priced items, incremental sales from the virtual brands, increase in dine-in transactions, and sustained dollar value of off-premise sales, which remained 2x of that experienced during the first quarter of 2019.

In addition, although cost inflation related to commodities and labor remained a headwind, revenue leverage from the sharply higher sales volume, drove higher margins on an annualized basis at the restaurant level, as well as at the corporate level. 51% of DENN’s restaurant footprint is now operating 24/7, and 80% of the base is now open for at least 18 hours/day, an 8% uptrend from the prior quarter. During the period, five new franchisee operated restaurants were launched, including two ghost kitchens in Baltimore, and one full-service restaurant in Canada.

Over upcoming quarters, although comparables will be tough as COVID restrictions were lifted during the second quarter last year, we expect the sales momentum experienced over the first quarter to persist, fueled by: seasonality led strong second and third quarters, a significant increase in operating hours, as more and more Americans decide to rejoin the workforce, as the national average saving levels continue to deplete, and additional promotions focused on value deals. Further, even though, we believe gas prices are likely to remain elevated over the near-term, wage inflation associated with jobs typically held by middle America, DENN’s target demographic, will ensure enough discretionary income, to support spending on leisure activities, such as dining out, in our opinion.

With respect to margins, we anticipate revenue leverage from sharply higher sales, possibly two menu price increases, easing cost inflation related to labor and commodities towards the back half of the year, and labor efficiency due to improved staffing, to result in margins above that experienced over the first quarter, at the restaurant level and the company level. Based on higher year-over-year: sales and margins, we expect some surge in both the bottom-line and free cash flows, for FY2022.

Longer-term, given that same-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. Same-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 F1Q2022 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 First Quarter

F1Q2022 Results Summary. For the quarter, revenues at ~$103 million (+28% on a year-over-year basis) beat consensus estimates of ~$102 million, and earnings per share of $0.34 was above analyst projections of $0.12. In addition, on a year-over-year basis, same-store sales improved by ~23.3% at domestic restaurants. Net income for the period was ~$21.9 million vs. ~$23.2 million generated over the previous year’s same quarter. Restaurant margin for the period was ~12.2% compared to ~10.1% over F1Q2021. At the end of F1Q2022, operating cash flows and adjusted free cash flows were ~$7.1 million and ~$10.7 million.

Acquired A Diner Chain To Support Additional Growth. During the first quarter, DENN’s purchased Keke’s Breakfast Cafe [Keke’s], a breakfast focused diner chain with 52 locations in Florida for $82.5 million, in an all cash transaction. The acquisition price reflects an EBITDA/sales multiple of ~12x, which is above the industry average of ~10.1x. The business expects to deliver between ~$6.5 million to ~$7 million in adjusted EBITDA, high teens to low 20’s restaurant margins, and average unit volumes of ~$1.9 million, for FY2022. Keke’s will maintain its independence in regards to marketing, products, operations, and development. Synergies are expected to be derived from joint operations associated with support functions at the corporate levels, such as tax and treasury, HR compliance, and technology.

Considering that based on financial projections, the acquisition will likely be accretive to DENN’s bottom-line out-of-the-gate, that its restaurants are located in areas where DENN does not have a presence, and that its target group skews to millennials and higher-end (versus DENN’s middle aged and middle America), we are excited about the potential the transaction presents. That the agreement launches DENN into a whole new demographic in the fastest growing food service category of breakfast is particularly alluring. Further, given that Keke’s is for the most part operated by franchisees (with only 8 out of 52 restaurants owned by the company), franchisees are likely to drive most of the footprint expansion. Therefore, DENN’s will be required to provide relatively limited funds to support new unit development. In that regard, it is noteworthy, that a key objective of the deal is to utilize DENN’s significant franchisee development infrastructure to rapidly open scores of new Keke’s to maximize shareholder returns.

Overall, we are supportive of the transaction, and believe the premium EBITDA multiple DENN purchased Keke’s for was wholly warranted.

Improvement In Staffing Levels Represents A Tailwind. Considering that DENN’s restaurants that operate on a 24/7 schedule, generate on an average 20% higher sales, are generally fully staffed, the ~50% of the brand’s restaurant footprint that is running on a ~18 hours schedule, is likely to experience a substantial surge in sales as the shortfall in employee availability currently gripping the country eases.

In that regard, by the end of F1Q2022, DENN was able to hire general managers for its entire footprint of restaurants, a development that is typically followed by improvement in hiring of front-line workers at the associated restaurants. Further, as per management, the number of job applications received over the first quarter, was significantly higher than the historical average. Although, based on recent statistics, it appears that there has been some headway in availability of employees on a national level, that DENN’s hourly wage workers on an average receive ~165% of the minimum wage mandated in states the company operates, is likely to be equally attractive to potential employees, in our assessment.

Technology Roll-Out On Track. 300 of DENN’s restaurants have been fitted with new kitchen equipment, that is expected to improve the food served, such as crisper bacon, more evenly browned sausage, and better proofed breads. Moreover, as per management, the kitchen upgrade equips the firm with the wherewithal to execute the roll-out of new and innovative menu items. The plan is to have the appliances installed in kitchens of all DENN’s restaurants by YE2022. In addition, the cloud based restaurant technology platform, is currently on track for beta testing, with the initiative positioned for a roll-out across DENN’s restaurant footprint by YE2023. The objective behind both technologies is to enhance guest experience and drive operational efficiencies.

Considering that the technology upgrades are likely to have a favorable impact on DENN’s bottom-line, we believe the substantial spending on the initiative is justified, and support the venture.

Balance Sheet Appears Reasonable. At the end of F1Q2022, the company had cash and cash equivalents of ~$6.09 million and long-term debt of ~$184 million, on its balance sheet. Including the revolving credit facility that was restated to $400 million (from $350 million) during last year’s third quarter, DENN has ~$213 million in funding liquidity available for use. At the end of the period, the firm had a debt/EBITDA ratio of 2x, consistent with the long-term debt/EBITDA ratio target range of 2x to 3x.

Bottom Line

DENN is going to be fine even if a recession hits. Its target demographic of middle American families is typically financially resilient enough to absorb occasional visits to full-service restaurants, despite a downturn. In addition, we expect the firm to hold menu prices in case of a contraction, preferring to gain the loyalty of customers, rather than losing demand due to onerous prices. Moreover, in order to sustain guest satisfaction, they are unlikely to cut portion sizes, in our judgment. Overall, we expect demand to be sustained but moderation on the bottom-line, over the next twelve months, if our prediction that a recession is imminent comes true.