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In December 2012, Richard McGuire's hedge fund Marcato filed an amended 13D on DineEquity (DIN) proposing that the company renegotiate its credit agreement with its lenders and call its high coupon debt to allow for a 100% payout of free cash flow. (Mr. McGuire is a former partner at activist William Ackman's Pershing Square Capital Management.) On January 18th, 2013, DIN management filed an 8K, and disclosed that it does plan to:

hold discussions with certain lenders to seek amendments, including a re-pricing, of its senior secured credit facility.

In this article, I will look at DIN's closest competitor in the family dining space, Denny's Corporation (DENN), to see what might happen to its share price if it adopted a plan similar to the Marcato proposal. While DENN has been very aggressive in returning approximately $40 million in free cash flow to shareholders in the last two years, it does appear as though the stock could get a significant boost if management chose to return the free cash flow to shareholders in the form of a dividend and not stock repurchases.

Brief Background

DIN is the franchisor of the Applebee's and IHOP brands. After several tough years, DIN was able to complete its plan to become a 99% franchised company for both concepts. While DENN only has one concept, the company is the second largest family dining concept behind IHOP. IHOP operates approximately 1,550 restaurants and controls 11% of the market. DENN operates 1,668 restaurants and controls 9% of the market. Both concepts are a nearly 100% franchised business model (IHOP 99%, DENN 90%). Over the last five years, both companies significantly reduced debt loads and boosted free cash flows. Both concepts are using franchisees to grow internationally. Because the two dining concepts are similar in size and strategy, Marcato's proposal to DIN is interesting for DENN shareholders to consider.

The Marcato Proposal

The Marcato proposal is rather straight-forward in what it believes DIN management should do to boost the share price of the company. I provided a link to the amended 13D in the first paragraph, but I will summarize the basic terms of it below.

  • Amend the credit agreement to remove most restrictive term which is mandating the company to use 50% of excess cash flow in any given year to prepay debt. (page 40)
  • Set an explicit leverage target of 5.0x-5.5x Net Debt / EBITDA ratio. (page 35)
  • Look to other banks to refinance the senior credit facility on similar terms, but without the 50% excess cash flow "sweep." (page 40)
  • Refinance DIN's 9.5% bonds. (page 21)
  • Announce an annual dividend of $6 per share to be paid quarterly, starting in Q3 2013. (page 30)

As Marcato correctly points out, there are only 4 options that a franchisor model has for deploying its free cash flow. Here is a look at the options and a comparison between DENN and DIN.

Option 1: Pay down debt

  • Several franchisor models like Burger King (BKC), Sonic (SONC), Domino's (DPZ) and DIN have traditionally leveraged up to 6-7X to buy back stock or make acquisitions. The leverage is supported by the stable-to-growing free cash flow and debt levels are returned to the 3-4X level within a few years.
    • DENN is already below the 4-5.5X debt / EBITDA level that Marcato and others suggest is an optimal debt load for such a business model. For this article, I am assuming that DENN's 2.4X debt level is somewhat conservative, even when its smaller size is considered, which would require no mandatory amortization for the most bullish scenario.

Option 2: Reinvest in the existing business

  • With a pure play franchisor model, there is little need for large reinvestment needs.
    • DENN does still own 170 stores that require maintenance capital expenditures ($11-$15 million a year).
    • DENN has occasionally used its balance sheet to finance franchisee growth and special situations like the Flying J store conversions.

Option 3: Make acquisitions

  • Neither DIN nor DENN seems to need to make acquisitions at this time.

Option 4: Return cash to shareholders

  • Directly to shareholders through stock repurchases or dividends.
    • Indirectly through debt paydowns.
      • DENN has chosen a dual strategy of debt paydown and stock repurchases.
      • DIN has focused solely on deleveraging.

DENN management has signaled its intention to continue aggressive distribution of free cash flow.

DENN management is clearly committed to returning free cash flow to shareholders. Since November 2010, the company has bought back $40 million worth of stock at an average cost of $4. This has resulted in a 4% reduction in diluted shares outstanding. On page 22 of its latest ICR XChange presentation, management states that it expects to reach its Total Debt Ratio threshold of 2.0X by 2014. As the following table shows, this is an extremely conservative assumption. If the company only pays the minimum amortization required by its credit agreement ($19 million per year), the company will meet that goal easily. This assumes no growth in EBITDA over the next two years. Therefore, it appears as though DENN management is implying that it intends to continue to return all free cash flow ($30+ million a year) above the required debt amortization to shareholders. However, the current mechanism for this appears to be stock buybacks, which can boost the stock price long-term as the float shrinks but the value of the equity grows. Since there are only 94 million shares outstanding and the company's equity value is less than $500 million, there is a point where continued share repurchases would reduce the float, reducing the liquidity for institutional demand in the stock. Using the Marcato proposal as a guideline, it appears as though the company could achieve a higher stock price by returning that free cash flow to shareholders in the form of a dividend and maintaining the liquidity in the stock.

DENN

2012E

2013E

2014E

Debt

$190

$171

$152

Debt Amort

$19

$19

$19

EBITDA

$80

$80

$80

Debt/EBITDA

2.4

2.1

1.9

A Marcato-like strategy for DENN could produce a significantly higher stock price.

Here are three basic scenarios for a dividend payment strategy. No matter which strategy is used, switching to a strategy of paying out most of the company's free cash flow by the initiation of a dividend appears to have the potential to boost the stock price.

Scenario 1: Marcato-like

Under this scenario, DENN is able to renegotiate its credit agreement with its lenders to eliminate the $19 million annual debt amortization payments and any restrictions on the return of excess cash flow to shareholders. This scenario is very similar to Marcato's proposal to the DIN board of directors. Unlike DIN, DENN would not have to take any action with bondholders to reduce a coupon to lower interest expense and increase free cash flow. This option could clearly boost the stock price (50-200%) depending on the ultimate yield investors are willing to accept), but I view it as a remote possibility. While lenders have been willing to lower the interest rate on the term loan and allow for the resumption of the return of excess cash flow to shareholders as debt has declined, they also mandated that DENN continue to reduce its debt every year. The argument can be made that the company's debt-to-EBITDA ratio of 2.4X is already conservative (Marcato is arguing that 4.5X is conservative for a similar business model). But I believe that relatively smaller size of the company, the lack of a second concept and the recently revised guidance of flat YOY growth in EBITDA since the last amended agreement reducing the possibility lenders would accept this proposal.

Stock Price at Different Dividend Payouts and Yields

FCF Payout Ratio

80%

90%

100%

Dividend

3%

$14.34

$16.13

$17.92

Yield

4%

$10.75

$12.10

$13.44

5%

$8.60

$9.68

$10.75

6%

$7.17

$8.06

$8.96

Assumes $50 million is available for dividend

Scenario 2: Reducing the debt amortization to $10 million per year

Under this scenario, DENN is able to renegotiate the annual amortization requirement to $10 from $19 million. I believe that this scenario has a better change of happening than Scenario 1 for several reasons. First, DENN already has one of the lowest leverage ratios of any franchisor business model. Second, if DIN is able to successfully renegotiate its credit agreement, then there would be precedent for management to point to. Third, lenders would still see a reasonable amortization of its term loan. Fourth, with debt markets wide open, DENN could issue a 5-7 year note to replace the outstanding balance (albeit at a higher interest rate) and reduce the lender's interest and fee income. Fifth, management could indicate to the lenders that it would continue to apply any excess cash flow after a dividend payment to debt reduction. This scenario would seem to be acceptable to all parties.

Stock Price at Different Dividend Payouts and Yields

FCF Payout Ratio

80%

90%

100%

Dividend

3%

$ 11.47

$ 12.90

$ 14.34

Yield

4%

$ 8.60

$ 9.68

$ 10.75

5%

$ 6.88

$ 7.74

$ 8.60

6%

$ 5.73

$ 6.45

$ 7.17

Assumes $40 million is available for dividend

Scenario 3: No change in credit agreement, redirecting free cash flow to dividend

Under this scenario, the company simply stops repurchasing stock and initiates a dividend at one of the ratios in the table. I view this scenario as having a reasonable chance of happening this year as well. As yields on bonds and other investment options decline to sub 1-2% levels, investors are beginning to demand higher dividend payouts from companies that have stable business models and large free cash flows. DENN management has been very shareholder friendly with the company's free cash flow with its buybacks. However, as the stock price increases faster than the increase in free cash flow, the impact on the reduction in shares outstanding is reduced. Remember, the company's cost for its repurchases is only $4 per share. Management may prefer the flexibility of being able to repurchase stock when it wants and does not want to be obligated to pay a dividend if business deteriorates; it is hard to justify not paying any dividend considering its operating model and lack of growth prospects. Einstein Noah Restaurant Group (BAGL), which has franchisor/ownership model and a $260 million market cap, has a current yield of nearly 4%. I do not believe that investors would bid up the yield on DENN to the 3% level that Marcato suggests DIN could receive, but I do believe that signaling a substantial dividend payout would be positive for shareholders. Shareholders of Meredith Corporation (MDP) have been amply rewarded since the company boosted its dividend 50% in late 2011. The yield at that time was 6.1% and the stock was trading for $22 a share. The stock currently yields 4.3% and trades over $35 a share. MDP also maintained a $100 million stock repurchase program.

Stock Price at Different Dividend Payouts and Yields

FCF Payout Ratio

80%

90%

100%

Dividend

3%

$ 8.60

$ 9.68

$ 10.75

Yield

4%

$ 6.45

$ 7.26

$ 8.06

5%

$ 5.16

$ 5.81

$ 6.45

6%

$ 4.30

$ 4.84

$ 5.38

Assumes $30 million is available for dividend

Ability to amend credit agreement seems possible.

In the first quarter of each of the last two years, DENN has been able to renegotiate its credit facility to include more favorable terms. As leverage has been reduced, lenders have been willing to lower the interest rate on the credit facility and allow the company more flexible uses of the excess cash flow. With the transformation for the company's model to 90%+ franchised, the business has achieved a relatively stable operating position. The company's leverage ratio of 2.4X compares very favorably to many of the other restaurant franchisor business models. Due to the continued improvements in the company's financial position, I believe the company could once again amend its credit facility to reduce the required debt amortization. If the company could achieve that in April of this year, I believe the company could begin to execute scenario 2 listed above. In any event, the current credit agreement doesn't appear to prevent the payment of a dividend instead of repurchasing stock.

  • Extended the maturity date to April 2017.
  • Reduced the interest rate from LIBOR +475bps and 1.5% floor to LIBOR +300bps with no floor.
  • Mandatory $19 million (10% per year) of the term loan.
  • Caps annual use of excess cash flow to $35 million for stock repurchases until debt ratio reaches 2.0X Debt/EBITDA.
  • Prepayment applied to future amortization.
Debt/EBITDA Ratio of Selected Franchisor Restaurant Companies
CompanyDenny'sTim Horton'sAFC EnterpriseSonicBurger KingDineEquityDomino'sDunkin Donuts
Debt/EBITDA2.4X0.6X1.0X3.9X4.1X4.7X5.0X5.2X

Source: Company filings and presentations

Since the new credit agreement was signed, the company has purchased about 3.4 million shares or $15 million worth of stock. The company still has about 5 million shares available to purchase under its current authorization. At $5.25 per share, that would be about $26 million or the equivalent of 90% of the company's next twelve month's estimated free cash flow.

Summary

While DENN management has been very shareholder friendly by aggressively returning free cash flow to investors via stock repurchases, this article shows that the Marcato proposal for boosting the stock price of DIN through the initiation of a large dividend might achieve a similar result for DENN. Other companies like MDP raised their dividends substantially and saw a substantial increase in their stock price as investors repriced it based on yield. While it is unlikely that the most optimistic scenario of reducing the term loan amortization to zero and paying out 100% of free cash flow as a dividend will happen any time soon, there is the real possibility that management adopts a more balanced approach to how it returns the company's free cash flow to shareholders. There has been a significant amount of activity in the restaurant industry in terms of LBOs (Morton's, PF Chang's, O'Charley's, etc.) and shareholder activism (Red Robin Gourmet Burgers (RRGB), Cracker Barrel (CBRL), DineEquity and Ruby Tuesday's (RT)) which could be directed at DENN in the future to campaign for change.

I never own a stock hoping that an activist will come in and be a "catalyst" to boost my investment returns. I am perfectly happy to own DENN based on the long-term fundamentals of the business. However, there is a possibility that the company can boost the share price for current shareholders using a plan similar to the one proposed to DIN by Marcato. In fact, the plan would be easier to implement and involve less financial leverage risk than the Marcato proposal to DIN. It is a plan that management should at least review and consider.

Source: Should Denny's Adopt Marcato Capital's Plan For DineEquity?