Can America's Diner Make a Grand-Slam Comeback?

Can America's Diner Make a Grand-Slam Comeback?

Table-service restaurant Denny's has seen some tough times: proxy battles in 2010, huge debt, and declines in free cash flow, as well as declining same-store sales from 2006-2010. In 2011, it brought in industry veteran John Miller as CEO to engineer a comeback.

For years there have been lingering questions about whether Denny's, or "America's Diner" as it's trying to restyle itself, is just a place to tie up a four-top and nurse an endless cup of coffee. Even after two years on the job, analysts still ask Miller the "lingering" question.

The lingering question
On the second-quarter call, he once again assured analysts that "We're in the coffee game. We sell 90 million cups of coffee a year. We like them to linger longer and have a piece of pie. Maybe stay for another day-part (a different meal or menu segment of the day)." He earlier noted average guest tickets were rising, offsetting a decline in traffic.

But industry trends aren't looking good for "diners." As Fellow Fool Jon Quast wrote,"According to Technomic, two of the fastest-fading restaurant segments are diners and buffets."

The company isn't taking such dire forecasts lying down. In the last quarter, Denny's opened its first location in Mexico in five years, and another in El Salvador. Currently the company runs 165 restaurants, while franchisees run 1,525 restaurants, of which 98 are located in nine foreign countries.

Innovations like Baconalia! and its $2/$4/$6/$8 value menu were credited with improving adjusted net income per share by 21% year-over-year on the second quarter earnings release.The company generated $24 million in free cash flow in the first half and bought back 1.7 million shares.

In this quarter, the company has revamped its core menu and is offering "build your own omelette" specials for a limited time only. By year-end, Denny's expects to remodel an additional 17 locations for a total of 20 this year.

The caveats to all this good news are that the company still has high debt of $176 million to $2 million in cash. That said, it has been paying off debt (over $365 million of debt outstanding paid down since 2006) and currently has a 2.3x leverage ratio. The company also entered into a $60 million term loan and new debt revolver of $190 million on more favorable terms.

Full-year revenue has declined steadily from $548 million in 2010 to 2012's $488 million, but revenue ticked up slightly in the second quarter. And in the first half of 2013, 26.4% of cash from operations was dedicated to capital expenditures like the remodeling of three company locations.

Tough competitors
Denny's faces tough competition from IHOP, owned by DineEquity , the privately-owned Waffle House chain, and Bob Evans Farms .

DineEquity is a formidable rival, with 3,600 Applebee's and IHOP restaurants, of which 99% are franchisee-run. That's even better than Denny's 90/10 franchisee/company-run ratio. DineEquity is attractive to dividend investors with its 4.5% yield at a 25% payout ratio.

The company trades at an 11.4 trailing earnings multiple and has a fairly large insider hold of 16.9%. However, at 4.8x, DineEquity has more than twice the leverage ratio of Denny's.

But Denny's may be losing market share to its IHOP restaurants, which saw a 1.9% rise in same-store sales. The growth was not just based on higher guest tickets; it also saw increased traffic.

Analysts still think there is 16.5% EPS growth ahead for Denny's, as opposed to 10% for DineEquity. This is reflected in Denny's PEG at 1.1, the lowest of these three companies.

A Barron's bump
Bob Evans Farms is trading at a 52-week high of $55.72 after a Barron's article touting 30% upside thanks to location refreshes. More than 70% of Bob Evans restaurants have been refreshed recently, boosting same-store sales at those locations by 2%, according to Barron's, even as non-remodeled stores have seen 1% same-store sales declines. The remainder of refreshes are expected throughout 2014.

FrontFour Capital analyst Nikhil Gupta, whom Barron's quoted, gives a sum of the parts valuation of $83 per share. Other analysts give the company a five-year EPS growth rate of 10% and a median price target of $54.50.

These refreshes include beefing up catering carryout, bakery, and family meals to-go operations as the company strives for off-premise sales to hit 25% of the restaurant sales mix by fiscal 2018. The restaurants also offer a $5 carry-out value meal to drive off-premise traffic. Value meals are expected to generate $45 million-plus this year.

The stock is valued at a forward earnings multiple of 17.1 and offers a 2.5% yield. Although its yield isn't as high as DineEquity's, it has doubled since 2009, and the company has repurchased $270 million worth of stock since 2008.

Bob Evans also has a packaged-foods segment (sausage, sides, frozen food) that comprises 26% of sales.

A longer-term catalyst is its new downsized fast-serve concept, Bob Evans Express, similar to Denny's initiative. Denny's is further along on the plan with a dozen university locations of smaller food-court sized restaurants.These can fit in neatly near a university, in an airport, or in the case of Bob Evans' Express first location, at the BMW USA manufacturing plant.The company also expects to open 10 new full-size restaurants annually starting in fiscal year 2015.

Despite the Barron's call, only 14% of the company's 560 restaurants are franchised, which can be a drawback for a restaurant stock. Another drawback is that these refreshes have caused capital expenditures to climb, with net debt now at $193 million. The company is targeting a 3.0x debt/EBITDAR ratio once refreshes are complete.

The Foolish takeaway
Denny's is in the first innings of its turnaround. Its leverage ratio is lower than these rivals, and once remodels are complete it should fulfill the promise analysts believe it has.

DineEquity has a scrumptious yield and the highest franchisee rate, but has a similar growth rate to Bob Evans. It also has a high leverage ratio.

Bob Evans may have 30% upside, but has already run up 33% in the last year. Denny's may be the most speculative, but also has the lowest short interest as more investors "linger" in the stock.

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AnnaLisa Kraft has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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