Denny’s To Benefit From Lower Food Inflation And Weaker Consumers (NASDAQ:DENN)

We like Denny’s Corporation (NASDAQ:DENN) stock on the next pullback. The stock has had a huge run with the market over the last 6 weeks, and in our opinion, this is overdone here as DENN stock approaches $13.

Folks, let this stock come down, then consider buying. Why buy Denny’s Corporation on a pullback? First, we think the near-term upside is limited for the overall market. The market in our opinion is expensive. We think you will have a much better chance to buy DENN stock for around $10 in the coming weeks.

With that said, we think Denny’s, the quick service diner style restaurant, is going to benefit from reduced food inflation, especially when egg and meat prices retrace, as well as a weaker consumer. We believe that as the economy worsens this year, the consumer will trade down on its spending habits, and Denny’s will become a prime example of a discounted restaurant that may benefit from this phenomenon. Let the stock fall and consider buying.

Even with high inflation, Denny’s Corporation is growing and is performing well. The company just reported quarterly earnings. We cover a range of stocks and sectors but are very selective about the restaurant business in general because of how hit-and-miss it can be. But the setup for success is there for Denny’s.

First, inflation is rampant and causing input costs to rise. Denny’s does pride itself on providing quality food at a reasonable cost, but it cannot keep its prices low and maintain its margins. Food is just too expensive, especially eggs and meat, two of the biggest cash costs for the company. Another issue is that labor costs are also high, and it has been hard to find workers in the service industry. The stock has suffered the last two years, and only recently made a run with this market. We think the market is disconnected from reality and will soon correct. But as the economy softens some, we think it helps Denny’s.

What to look for with Denny’s

When analyzing the restaurant business, there are several key metrics we like to look for. First, we like to look at revenue to see if the restaurant chain is growing top-line sales. Second, we look to see how well the company controls expenses to ensure any rise in sales generates net income growth. Margins are key. Third, we look for trends in store count fluctuations such as the closing of underperforming stores and opening of new shops in favorable heavily trafficked locations. Finally, comparable sales are absolutely key and a measure we frequently use to determine whether investing in a restaurant is worth it. In our opinion, Denny’s is delivering on some of these fronts but has more work to do. We think that if shares pull back, however, the risk-reward makes sense.

Just reported numbers strong

In Q4, a trend of growth in sales continued despite the pain in markets and pressure on restaurants from high costs and a possibly weakening consumer. We think the latter is a benefit to Denny’s Corporation’s low-cost options. Denny’s, of course, is facing challenges with its own costs and seemingly overcoming them. The company’s growth will continue long-term. The company is delivering strong sales results, all while controlling expenses. In this quarter, Denny’s delivered a topline showing growth that was essentially in line with expectations, and it beat earnings.

Sales are rising

Denny’s Corporation sales were up in Q4 and grew 12.3% over last year. Volumes were strong, but what about same-store sales? Well, their domestic system-wide same-restaurant sales grew 2.0% compared to a year ago. This includes a 1.7% increase at domestic franchised restaurants and a 6.0% increase in same-store sales at company-owned restaurants. This is strong. Revenues came in at $121 million. This was a great result. Remember, we also look for trends in store count. The company opened 13 franchised restaurants, including 5 international locations and 1 Keke’s location, all of which will help add to revenue growth. For the year 2022, Denny’s opened 30 franchised restaurants, including 8 international locations and 2 Keke’s locations, and did 49 remodels, including 38 franchised restaurants.

Costs weigh

While sales were up, we do note that Denny’s Corporation’s costs to generate these revenues were higher than we would like. The so-called franchise operating margin was $31.6 million, or 47.6% of franchise and license revenue, compared to $31.1 million, or 51.6% a year ago. That is a noticeable 450 basis point decline, and it stemmed from higher costs as well as kitchen modernization equipment that was sold to franchisees at cost. The company-operated store margin was $6.8 million, or 12.6% of company restaurant sales, and this was a decline compared to $7.0 million, or 14.8%, a year ago. Why? It was due to commodity and labor inflation, and energy costs. We were pleased to see total general and administrative expenses decline to $17.0 million, compared to $17.7 million a year ago. Much of this was from reduced share based-compensation.

That said, turning to income, we saw net income of $12.8 million, or $0.22 per share, down sizably from $43.5 million, or $0.67 per share on a GAAP basis. If we back out costs related to selling real estate, and other related expenses, adjusted net income per share was $0.18 compared to $0.16 a year ago. This was a beat of $0.02 per share versus estimates. But the valuation and growth metrics of the company are mixed, in our opinion, although the latter has shown some resolve. We think the risk-reward for both valuation and growth is much more attractive on the next pullback. The balance sheet has some debt, but we like the cash being given back to shareholders.

Denny’s balance sheet

Denny’s Corporation has a debt burden of $272.7 million. This is a very manageable burden. Further, the company has $3.5 million in cash and another $260 million available on its credit facility to draw from. Net cash provided by operating activities was $14.5 million in the quarter, and Denny’s spent $1.7 million on CAPEX. Denny’s Corporation is repurchasing shares, too, and we love that, the company having bought back $7.8 million, and continues to have $153 million remaining on the authorization.

Looking ahead

As we look ahead, Denny’s sees domestic system-wide same-restaurant sales growth between 3% and 6%. It plans to open 35 to 45 new stores, including 8 to 12 new Keke’s restaurants but will be closing several dozen, so it sees a net decline of 15 to 25. That will impact revenue. Commodity inflation is an issue and the company sees food costs rising between 4% and 6% while labor inflation will be approximately 5%. Putting it together, Denny’s Corporation sees EBITDA of $86 to $90 million, up from this year’s $77.5 million.

Take home

Let Denny’s Corporation stock pull back. We think food costs will be coming down, but also anticipate that the consumer will be weaker later this year and may cause consumers to trade down to more quick service style dining. This is a benefit for Denny’s. We love the Denny’s Corporation share repurchases and believe DENN shares have the potential to move higher, but let it come back down to the $10-11 area first.