There Is Big Upside To Buying Denny's Shares

| About: Denny's Corporation (DENN)

Summary

DENN’s recent results indicate that the company’s revitalization initiatives are working according to plan.

DENN’s capacity to generate FCF is very impressive.

According to my DCF model, DENN’s shares have a fair value of $12.24.

Denny's Corporation (NASDAQ:DENN) recently announced its Q4 2015 results and the company narrowly managed to beat analysts' estimates. Keeping in mind DENN's annual guidance for 2016, I discuss DENN from a valuation perspective in this article.

DENN has a franchise driven business model with a restaurant portfolio mix of 90% franchised and 10% company operated restaurants. This model has served the company well as it has been able to operate profitably with lower risk. The success of DENN's brand is largely dependent on the company's revitalization strategy driven by its heritage remodel program. It's been nearly 5 years since DENN launched its revitalization initiatives and the results clearly indicate that the company is on the right track. The revitalization strategies have been definitely improving the quality of food and overall service because barring Q1 2011 and Q1 2013, DENN has posted positive system-wide same-store sales in every quarter since 2011. In addition to this, DENN ended 2015 with the highest overall guest satisfaction scores in 5 years.

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(Source: Investor Relations)

Despite the franchised acquisitions and capital expenditures related to remodeling of company restaurants, DENN has managed to generate more than $230 million FCF since the start of 2011. Currently DENN generates roughly $11 for every $100 sales, which is very impressive considering the fact that the company has not resorted to cutting investments. As the charts below illustrate, capital expenditures as a percentage of sales have risen steadily, reflecting DENN's goal of completing an increasing number of remodels, but this has not drastically hampered FCF generation. This tells me that DENN is in a great position to not only keep making investments in its brand but also expanding its global footprint and returning value to its shareholders through share repurchases.

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(Source: Investor Relations)

Click to enlarge

(Source: Morningstar)

Click to enlarge

(Source: Morningstar)

To determine the intrinsic worth of DENN's shares, I use a 5 year DCF model modeling for 2% terminal FCF growth rate. My model uses WACC, calculated using the CAPM, as the discount rate. The model is based on important assumptions concerning DENN's revenue growth and (adjusted) EBITDA margin, which I'll explain.

So far only one-third of DENN's system has the improved atmosphere. As the number of remodels increases, I project DENN's total revenue to swell to $554 million by 2020. This represents a CAGR of ~2.4% for the 5-year period 2016 to 2020.

For 2016, the same-store sales growth of 1.5% at both company and domestic franchise restaurants, along with the sales contribution from at least 44 new restaurants, should propel consolidated revenues to $506 million. This figure is right in the middle of analysts' 'average' and 'high' revenue estimate for 2016. For 2017 I project revenue growth of 3.2%, slightly higher than the growth in 2016, and beyond that I conservatively assume revenues to grow at 2% annually until 2020.

DENN's adjusted EBITDA margin for the past 5 years has ranged from 14.9% to 17.2%. I cautiously forecast an EBTDA margin of 20% for DENN in 2016. This is a rather pessimistic expectation because it implies that DENN would end 2016 with $56 million FCF, lower than the company's expectation of generating at least $59 million FCF. Beyond 2016, I project an EBIDTA margin of 18.8%, in line with analysts' expectations.

Furthermore, I see DENN's D&A, tax rate and net working capital running close to their 5-year averages.

Terminal FCF Growth Rate

WACC

Fair Value

Low

2.0%

7.5%

$9.62

Mid

2.0%

6.5%

$12.24

High

2.0%

5.7%

$15.36

Projections

Fiscal Years Ending

Dec-15

Dec-16

Dec-17

Dec-18

Dec-19

Dec-20

($ in Millions)

Revenue

491

506

522

533

543

554

% Growth

4.0%

3.0%

3.2%

2.0%

2.0%

2.0%

EBITDA

84

101

98

100

102

104

% of Revenue

17.2%

20.0%

18.8%

18.8%

18.8%

18.8%

Calculation of FCF

Projected Unlevered Cash Flow

Dec-16

Dec-17

Dec-18

Dec-19

Dec-20

Terminal

EBITDA

101

98

100

102

104

104

D&A

(23)

(23)

(24)

(24)

(25)

(21)

EBIT

79

75

76

78

79

83

Pro forma Taxes

(27)

(25)

(26)

(26)

(27)

(28)

NOPAT

52

49

50

51

52

55

Capital Expenditures

(20)

(21)

(21)

(22)

(22)

(22)

NWC Investment

2

2

1

1

1

0

(+) D&A

23

23

24

24

25

21

Free Cash Flow

56

54

54

55

56

54

% Growth

4%

-4%

1%

2%

2%

Calculation of Equity Value

Model

Low

Mid

High

Market

Enterprise Value

909

1,111

1,351

937

(+) Cash & Equivalents

2

2

2

2

(+) Investments & Other

0

0

0

0

(-) Debt

(170)

(170)

(170)

(170)

(-) Minority Interest & Other

0

0

0

0

(-) Preferred Stock

0

0

0

0

(-) Other

0

0

0

0

Value of Common Equity

741

943

1,183

769

Diluted Shares Outstanding

77

77

77

77

Implied Stock Price

9.62

12.24

15.36

9.98

Upside / (Downside)

-3.6%

22.7%

53.9%

Historical Financials

FY

FY

FY

FY

FY

Latest

Dec-11

Dec-12

Dec-13

Dec-14

Dec-15

Feb-16

Revenue

539

488

463

472

491

491

Growth

NA

-9.3%

-5.3%

2.1%

4.0%

Cost of Revenue

(341)

(300)

(284)

(286)

(294)

(294)

Gross Profit

197

197

178

187

197

197

R&D Expense

0

0

0

0

0

0

SG&A Expense

(55)

(60)

(57)

(59)

(67)

(67)

Other Expenses / (Income)

(432)

(372)

(358)

(356)

(362)

(362)

Total Operating Expenses

(488)

(432)

(415)

(415)

(428)

(428)

EBIT

51

56

48

57

63

63

(+) D&A

30

23

22

21

21

21

(+) Asset Writedown

0

0

0

0

0

0

(+) Restructuring

0

0

0

0

0

0

(+) Merger / Acq Exp

0

0

0

0

0

0

(+) Goodwill Impairment

0

0

0

0

0

0

(+) Litigation

0

0

0

0

0

0

(+) Other Non-recurring

0

0

0

0

0

0

Adjusted EBITDA

81

79

69

79

84

84

% Margin

15.0%

16.3%

14.9%

16.6%

17.2%

17.2%

Adjusted EBIT

51

56

48

57

63

63

% Margin

9.5%

11.5%

10.3%

12.1%

12.8%

12.8%

Depreciation & Amortization

Projections

Dec-16

Dec-17

Dec-18

Dec-19

Dec-20

Terminal

Depreciation & Amortization

(23)

(23)

(24)

(24)

(25)

(21)

% of Revenue

4.5%

4.5%

4.5%

4.5%

4.5%

Terminal Deprec. % of Capex

95.0%

FY

FY

FY

FY

FY

Latest

Historicals

Dec-11

Dec-12

Dec-13

Dec-14

Dec-15

Feb-16

Depreciation & Amortization

(30)

(23)

(22)

(21)

(21)

(21)

% of Revenue

5.6%

4.7%

4.6%

4.5%

4.4%

Average

4.8%

Tax Rate

FY

FY

FY

FY

FY

Historicals

Dec-11

Dec-12

Dec-13

Dec-14

Dec-15

Income Before Taxes

28

35

36

49

54

Income Taxes

84

(13)

(12)

(16)

(18)

Effective Tax Rate

NM

36.4%

31.9%

32.9%

33.0%

5-Year Average

33.6%

Selected Tax Rate Assumption

34.0%

Capital Expenditures

Projections

Dec-16

Dec-17

Dec-18

Dec-19

Dec-20

Terminal

Capital Expenditures

(20)

(21)

(21)

(22)

(22)

(22)

% of Revenue

4.0%

4.0%

4.0%

4.0%

4.0%

4.0%

FY

FY

FY

FY

FY

YTD

Historicals

Dec-11

Dec-12

Dec-13

Dec-14

Dec-15

Feb-16

Capital Expenditures

(7)

(1)

(15)

(22)

(27)

(27)

% of Revenue

1.4%

0.3%

3.3%

4.7%

5.5%

5-Year Average

3.0%

Net Working Capital

Projections

Dec-16

Dec-17

Dec-18

Dec-19

Dec-20

Terminal

Net Working Capital

(66)

(68)

(69)

(70)

(72)

(72)

% of Revenue

-13.0%

-13.0%

-13.0%

-13.0%

-13.0%

-13.0%

NWC Investment

2

2

1

1

1

0

FY

FY

FY

FY

FY

Latest

Historicals

Dec-11

Dec-12

Dec-13

Dec-14

Dec-15

Feb-16

Total Current Assets

61

65

54

56

36

36

(-) Cash and Equivalents

(14)

(14)

(3)

(3)

(2)

(2)

(-) Short Term Investments

0

0

0

0

0

0

(-) Total Current Liab.

(87)

(92)

(74)

(80)

(102)

(102)

(+) Current Portion of Debt

7

13

7

8

3

3

Net Working Capital

(33)

(28)

(16)

(20)

(64)

(64)

% of Revenue

-6.1%

-5.8%

-3.5%

-4.2%

-13.0%

Average

-6.5%

NWC Investment

(5)

(12)

4

44

0

Discounting Periods

Dec-16

Dec-17

Dec-18

Dec-19

Dec-20

Balance Sheet Beginning Date

2/17/2016

12/31/2016

12/31/2017

12/31/2018

12/31/2019

Balance Sheet End Date

12/31/2016

12/31/2017

12/31/2018

12/31/2019

12/31/2020

Mid-Year Convention

7/25/2016

7/1/2017

7/1/2018

7/1/2019

7/1/2020

Discount Periods

0.33

1.26

2.26

3.26

4.26

Terminal

4.76

Valuation Date

3/26/2016

Discounting Factors

Discount

Low

Mid

High

Dec-16

0.33

97.6%

97.9%

98.2%

Dec-17

1.26

91.3%

92.3%

93.2%

Dec-18

2.26

84.9%

86.7%

88.2%

Dec-19

3.26

79.0%

81.4%

83.4%

Dec-20

4.26

73.5%

76.5%

78.9%

Terminal

4.76

70.9%

74.1%

76.8%

Discount Rate

7.5%

6.5%

5.7%

Calculation of Enterprise Value

FCF

Low

Mid

High

Dec-16

20

20

20

20

Dec-17

54

49

50

50

Dec-18

54

46

47

48

Dec-19

55

44

45

46

Dec-20

56

41

43

45

Terminal

54

(NYSE:A) PV of Discrete Cash Flows

200

205

209

Terminal Growth Rate

2.0%

2.0%

2.0%

Terminal Discount Factor

70.9%

74.1%

76.8%

(NYSE:B) PV of Terminal Value

709

906

1,142

(A + B) Enterprise Value

909

1,111

1,351

Terminal Value

Low

Mid

High

Selected Terminal Growth Rate

54

2.0%

2.0%

2.0%

Terminal Value

1,001

1,223

1,487

Implied Exit Revenue Multiple

554

1.8x

2.2x

2.7x

Implied Exit EBITDA Multiple

104

9.6x

11.7x

14.3x

Click to enlarge

According to the calculations shown above, we get DENN's market value of equity equal to $942 million in the 'mid' scenario by subtracting the market value of debt and adding back cash and investments to enterprise value. Dividing this figure by the diluted shares outstanding, we get a fair value of $12.24, representing an upside of 22.7% from the closing price on March 24, 2016.

Conclusion

To sum up, I am bullish on DENN. This is a company whose best is yet to come and the management has the right plans in store to meet any challenges going forward. At 18.1 times next year's earnings DENN isn't terribly expensive and its shares actually possess decent upside potential.

Disclosure: I am/we are long DENN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.