SHORT Denny’s Corp (NASD: DENN) | Price: $19.32; Target: $11.

50
Thesis Denny’s (DENN) is a structural short with ~40%
$21.0
downside return over 12 months driven by (1a) revised
guidance and missed overly optimistic consensus on $19.0

restaurant opens (+35-45) and net opens (+/-0), $17.0

EBITDA(+$99m), EBITDA and restaurant margins (18.2, $15.0

15.7%) due to accelerating shifts in underlying business $13.0

model economics from minimum wage increases in key $11.0

states and the success of GRUB / UberEATS / AMZN / $9.0

Postmates / Doordash which feeds into; (1b) difficulty $7.0
executing on the as-guided refranchising plan as these $5.0
negative trends have an outsized impact on franchisee
2,500
economics with an estimated underlying franchisee 1,250
margin falling 100 bps per 5% increase in delivery order 0
share and, in my view, increasingly large net restaurant
5/12/2014 4/12/2015 3/12/2016 2/12/2017 1/12/2018 12/12/2018

closures an early indication for a headline trend beyond Source: Yahoo Finance
2019 and; (2) increased pessimism from tough comps against business-downsizing. Denny’s management is
pointing us in the direction of more attractive economics and a bright future while also accelerating stock sales into
accelerated share repurchase programs, amending rules so the CEO can defer 100% of his bonus (why not vest
here?) and their by-laws to protect from takeover, and altering the larger portion of comp away from adj EBITDA
growth and toward adj EPS growth (which they can influence with buybacks).
Background & Business Description Denny’s is a US-based 90% franchised 24/7 full-service restaurant chain
known for breakfast food with 1,705 locations, concentrated in California, Texas, Arizona, and Florida. Denny’s are
typically ~4,000-5,000 sq feet and accommodate 110-170 guests. Denny’s had been acquiring franchisee-owned
restaurants, net +18 between 1Q15-3Q18, but announced in 4Q18 they will sell 90-125 company stores (/170) and
become 95-97% franchised. They will also sell 24-29 of their owned locations (/95) through like-kind transactions
to “acquire higher quality real estate on higher volume restaurants”.
Management and bulls point to continued robust SSS growth in the softest restaurant sub-sector (full-service
family/casual), helped by continued progress in a modern remodeling (90% by YE19), as well as moving the
franchisee base to 4.5% royalty fees (vs an average ~4.17 now) and that the more franchisee-operated model will
offer less wage and commodity exposure and enable a greater debt load if needed.

Exhibit 1. Denny’s Corp Comp Sheet

Operating Results Valuation
Locations % Franchised Mkt Cap EV Revenue EBIT EBITDA Margin Leverage EV / Sales EV / EBIT EV/ EBITDA
Cracker Barrel CBRL 657 0% 4,080 4,310 3,077 285 385 13% .60x 1.40x 15.15x 11.20x
Darden Restaurants DRI 1,772 2% 14,488 15,112 8,415 827 1,155 14% .54x 1.80x 18.27x 13.09x
Cheesecake Factory CAKE 218 0% 2,272 2,368 2,332 148 244 10% .40x 1.02x 16.04x 9.72x
BJ's Restaurants BJRI 202 0% 1,088 1,153 1,117 64 134 12% .49x 1.03x 18.05x 8.58x
Texas Roadhouse TXRH 588 16% 3,816 3,579 2,520 203 308 12% na 1.42x 17.64x 11.64x
Red Robin Gourmet Burgers RRGB 573 16% 439 623 1,339 31 126 9% 1.46x 0.47x 20.29x 4.94x
Chuy Holding's CHUY 100 0% 353 345 398 20 40 10% na 0.87x 17.24x 8.66x
Bloomin' Brands, Inc BLMN 1,481 21% 1,811 2,801 4,138 189 390 9% 2.54x 0.68x 14.86x 7.19x
Biglari Holdings BH 850 25% 408 607 790 -13 7 1% na 0.77x na na

Brinker EAT 1,685 41% 1,619 2,874 3,174 232 389 12% 3.23x 0.91x 12.39x 7.39x
DineEquity DIN 3,652 98% 1,546 2,791 830 195 230 28% 5.42x 3.36x 14.31x 12.16x

Denny's Consensus DENN 1,705 90% 1,181 1,491 626 75 101 16% 3.06x 2.38x 19.99x 14.70x
Denny's MSR 581 97 93 16% 3.35x 2.57x 15.37x 16.12x
@ At MSR Price Target: $11.50 732 1,042 581 97 93 16% 3.35x 1.80x 10.74x 11.27x
Accelerating Headwinds Will Cause Downward Revision of Guidance/Consensus Adj EBITDA The
restaurant industry has suffered stagnating traffic, with family dining hit hardest, as consumers shift toward fast
casual, delivery, and groceries. Food delivery platforms (GRUB/Postmates/Amazon/UberEATS /Doordash) have
driven most of the industries’ SSS growth.

Exhibit 2. 3rd Party Delivery Sales (UberEATS/Postmates/AMZN Restaurants/Doordash/Caviar)

1,200 1
1,039
963
0.9
1,000 951
914
0.8
789 798 821 764 814 820 837
753 0.7
800 692
647 625 671 0.6
553 554
600 497 474 522 0.5
475 464 464
371 0.4
400
0.3
0.2
200
0.1
0 Nov-17 0

Nov-18
Jun-17

Dec-17

Jun-18

Dec-18
Jan-17
Feb-17
Mar-17
Apr-17
May-17

Aug-17
Sep-17

Jan-18
Feb-18
Mar-18
Apr-18
May-18

Aug-18
Sep-18

Jan-19
Oct-17

Oct-18
Jul-17

Jul-18
In my view, food delivery platforms have two key competitive consequences: (1) deterioration of physical presence
as a point of differentiation/advantage by introducing vast optionality at near-zero switching cost (delivery fee
differentials), and (2) 20-30% delivery fees dramatically alter restaurant economics. The first point is a broad
negative for nearly all restaurants as this was a key point of success in the restaurant business (location, location,
location as they saying goes) and the second points out that this might make some sense for low menu cost and
high transaction/low employment per sq foot restaurants but this is much less feasible for low transaction
volume/high employment per sq foot, 24/7, and franchised restaurants: Denny’s. It’s also worth mentioning that
customers are less likely to buy high margin supplemental items like drinks.
In mid-2017 Denny’s enthusiastically embraced an opportunity to add “highly incremental” sales to less-reached
demographics (ex. Urban 18-30 year olds) at a “mid-teen to high-twenties” margin. Initial metrics were
encouraging, with a roughly equal time-of-day distribution capped with a 27% late-night praised by management,
and a younger skew (68% of digital transactions as of 2Q17 at sub-34 years old). Denny’s delivery has driven
~100% of overall growth, expanding from est. ~0.5% of sales in 1Q17 with 28% restaurants active to 5.4%
of sales in 1Q19 with 79% of restaurants active, with q/q share of system-wide sales consistently accelerating.

Exhibit 3. System-Wide Restaurant Sales, Delivery and Non-Delivery

728,000 8.0%

715,000 6.0%

702,000 4.0%

689,000 2.0%

676,000 0.0%

663,000 -2.0%

650,000 -4.0%
1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18 4Q18 1Q19
Restaurant Sales Less Delivery Delivery Sales Reported Domestic SSS
Exhibit . Denny’s and Delivery as % of Sales

1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18 4Q18 1Q19

Aggregate Company Sales 686,534 709,206 705,200 718,554 706,699 704,483 714,756 719,863 705,375
Q/Q 3% -1% 2% -2% 0% 1% 1% -2%
Off-Prem Share 7.1% 7.6% 8.1% 8.7% 9.3% 9.9% 10.5% 11.2% 12.0%
Q/Q Share Expansion (bps) 5 5 6 6 6 7 7 8
Delivery % of Total 1 0.5% 1.0% 1.5% 2.1% 2.7% 3.3% 3.9% 4.6% 5.4%

Delivery Sales 3,433 7,092 10,578 15,090 18,728 23,050 28,130 33,431 38,090

Restaurant Sales Less Delivery 683,102 702,114 694,622 703,464 687,972 681,433 686,626 686,433 667,284
Implied Q/Q Organic Growth 2.3% -2.1% -0.2% -4.3% -3.6% -2.5% -4.0% -7.3%

% of Restaurants Active 2 28% 34% 42% 50% 60% 69% 71% 79%
Total Sales of Active Restaurants 198,578 239,768 301,793 353,350 422,690 493,182 511,103 557,246
Delivery Sales as % of Sales at Active Restaurants 3 3.6% 4.4% 5.0% 5.3% 5.5% 5.7% 6.5% 6.8%

Delivery Sales Per Active Restaurant 14.7 18.0 20.8 21.7 22.3 23.7 27.5 28.2
Company-Operated Margin 17.0% 16.9% 16.9% 16.4% 14.2% 15.7% 15.2% 16.2% 14.6%
Reported Domestic SSS -1.1% 2.6% 0.6% 2.2% 1.5% -0.7% 1.0% 1.4% 1.2%

1
Delivery sales are assumed to be off-prem sales in excess of the long-term pre-delivery ~6.6% trend. This implies pickup remained stable at 6.6%, neither growing nor cannibalized by delivery, which I view
as somewhat conservative
2
Given on company presentations and earnings calls
3
This is assumes that sales at delivery restaurants are average, though majority of early adopters were company-operated which have greater average revenue per store (~560 vs 400).

The initial metrics management pointed to have also shifted away from the younger demographic (55% sub-34
years old vs 68% prev.) and is now concentrated at breakfast (30% of orders vs 22% late-night). These shifting
delivery metrics point to broader adoption overall in delivery, despite management initially recognizing it as a
“fad”, as well as cannibalization of core in-restaurant customer base (ex. 20% of delivery is over 45 years old vs
13% at start).

Exhibit. Delivery Metrics Shifting Away from Young/Late-Night Demographic

100% 100%
4% 4% 6% 6% 6% 7% 8% 7%
9% 9% 25% 23% 25% 25% 22% 23%
10% 11% 11% 11% 12% 13% 27% 27%
80% 80%
20% 19%
20% 23% 22% 22%
25% 25% 25% 25% 22% 22% 23% 23%
60% 60% 25% 24%

37% 34%
36% 25% 25%
40% 41% 40% 39% 40% 26% 26% 24% 24%
26% 24%
43% 44%
20% 20%
31% 34% 28% 25% 26% 25% 28% 28% 30% 29%
19% 21% 21% 22%
12% 11%
0% 0%
2Q17 3Q17 4Q17 1Q18 2Q18 3Q18 4Q18 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18 4Q18 1Q19
18-24 25-34 35-44 45-45 55+ Breakfast Lunch Dinner Late Night

Source: Company presentations Source: Company presentations

Most importantly, while Denny’s continues to argue they get mid-teens to high-twenties margin, I estimate the per-
sale margin at in low single digits with Denny’s total margin to decline as these sales represent a greater mix share,
against guidance and consensus estimating a ~30 bps y/y margin expansion. This is exacerbated for franchisees,
which typically pay ~4.2% royalty fees, and is even less economical beyond a certain mix threshold (ex. I estimate
a 0-delivery franchisee at 4.5% royalties has a 19% margin, vs 16.6% at 10% deliveries).
Exhibit . Denny’s Claimed Delivery Margins Seem Way Off; Impact of Delivery on Franchisee Margin
Denny's
Worst Best Avg 170 Units
Revenue $100 $100 $100 $100

Product $30 $25 $28 $24

30% 25% 27.5% 24.0%
Labor $42 $38 $40 $39
42% 38% 40.0% 39.0%
Occupany and Utilities $11 $12 $12 $12
11% 12% 11.5% 11.5%
Marketing and Other $8 $7 $7 $10
7.5% 7% 7.3% 10.0%

Restaurant Profit $10 $18 $14 $16

Margin 10% 18% 14% 15.5%

Delivery Fee Cut 23% 17% 20% 20%

Delivery Fee $23 $17 $20 $20

Restaurant Profit on Delivery ($14) $1 ($6) ($5)

Delivery Sale Margin -14% 1% -6% -5%
Denny's Claimed Margins 15% 29% 22%

with … % delivery
5% 8.4% 17.2% 12.8% 14.5%
10% 7.2% 16.3% 11.8% 13.5%
20% 4.9% 14.6% 9.8% 11.5%
41.5% 0.0% 10.9% 5.5% 7.2%

But as a Franchisee at 4.5% Royalty …

Franchisee Profit 5.00 13.50 9.25

Margin 5.0% 13.5% 9.3%

Profit with Delivery ($18.00) ($3.50) ($10.75)

Delivery Sale Margin -18% -4% -11%

with … % delivery
5% 3.9% 12.7% 8.3%
10% 2.7% 11.8% 7.3%
20% 0.4% 10.1% 5.3%
22% 0.0% 9.8% 4.9%

Dine Equity, the operator of Applebees and IHOP, similarly embraced the “highly incremental” opportunity but
commentary has shifted from excitement around new sales to referencing a renegotiation of fees as “a necessity,
given the margin implications of third party delivery”. Darden’s CEO has repeatedly argued that the economics
make no sense and wants analysts to stop asking him about it. McDonalds is considering reimbursing franchisees
with above a delivery sale threshold and is negotiating directly with UberEATS to for enterprise-wide discount. I
think food delivery platforms are cohesive with already-evolving social trends including time spent at home and
‘X… on demand’ and are in early stages of adoption. I also believe Denny’s move to refranchise their restaurants
(rather than the prior multi-year acquisition trend) is to lessen exposure to negative industry shifts including more
expensive labor and the margin impact of delivery sales.
Denny’s will also see minimum wage increases in key states. California (35% of company-operated, 23% of
franchised; minimum wage increases from $11 to $12 and will increase annually until $15 in 2022), Arizona (6,
8%; increase from $10.5 to $11, then to $12 in 2020) and Florida (11, 5%; increase from $8.25 to $8.46) in 2019.

Exhibit . Minimum Wage Increases in Key States

Minimum Wage and Minimum Cash Wage

California Tipped Arizona Tipped Florida Tipped
2018 $11.00 $11.00 $10.50 $7.50 $8.25 $5.23
2019 $12.00 $12.00 $11.00 $8.00 $8.46 $5.44
chg 9% 5% 7% 3% 4%
2020 $13.00 $13.00 $12.00 $9.00
chg 8% 9% 13%

% of Company Locations 35.3% 5.8% 11.0%

% Franchised Locations 21.5% 6.6% 4.3%
% Total Locations 22.9% 7.1% 5.4%

Denny’s typically employs 1-3 managers and 45 hourly employees to staff large square footage 24/7 restaurants.
High real estate valuations have also led into higher rent expense

Exhibit . TTM Restaurant Operating Margin; FY19 Guided and Consensus Margin vs MSR

19%

18%
17.8%
17%
16.6% 16.8%

16% Guidance
Consensus
15.3%
15%

14%
13.6% 13.7% MSR
13%

12%

11%
4Q13
1Q14
2Q14
3Q14
4Q14
1Q15
2Q15
3Q15
4Q15
1Q16
2Q16
3Q16
4Q16
1Q17
2Q17
3Q17
4Q17
1Q18
2Q18
3Q18
4Q18
1Q19

Source: Company filings, FactSet

These factors together will result in lower than guided/consensus restaurant operating margin, feeding into a
miss on EBITDA margin. Overall, I think management has poor/incomplete visibility into their cost structure due
to commodity volatility and an increase in % of sales from delivery and Sellside is just modeling in their
comments. Sellside, meanwhile, has been muted on their delivery commentary.

Once again, Denny’s is likely the worst suited restaurant for the shifting model toward delivery due to large square
footage, low transaction volume, open 24/7, and franchised with a fragmented franchisee base. Given the current
environment, franchising a Denny’s now would need to be, on some level, a bet that delivery doesn’t exceed a
certain threshold of sales.
As-guided refranchising plan is threatened by rapidly shifting economics of operating a franchised 24/7
full-service restaurant Denny’s announced their refranchising plans in 4Q18, with an intent to sell 90-125
restaurants over 18 months, which would end May 2020. In the first 6 months, Denny’s has sold just 14 restaurants.
I think that Denny’s will likely fall short of their refranchising plans either in (1) stores sold with a ~108 midpoint
or (2) amount raised ($100m pretax) due to the rapidly shifting economics of operating a franchisee preventing
them from selling either at a ~4.5x multiple or from a lower than expected margin.

Denny’s annual disclosure on their domestic franchisee development pipeline was 60 in FY17. In the FY18 10-K,
management references a plan to increase the domestic development pipeline by +40-70 through development
commitments, though does not disclosure the current development pipeline.

Exhibit. Company-Guided Refranchising Process

Low High Mid

Restaurant Revenue $1.90 $2.00 $1.95
Margin 10% 12% 11%
EBITDA $0.19 $0.24 $0.21

Sale Multiple 4x 5x 4.5x

Proceeds $0.76 $1.20 $0.98
Stores Sold 90 125 108
Total Proceeds $68.40 $150.00 $105.35

Increasingly significant net restaurant closures are telling of the appetite for Denny’s franchises and will accelerate
due to margin issues discussed above (minimum wage, commodity volatility, shifting franchisee economics due to
delivery). Denny’s has acquired several restaurants from franchisees over last few years, just to close down 1 or 2
years later (Iowa, New Hampshire, Wisconsin, Texas).

Exhibit . TTM Net Restaurant Opens (Opens less Closures) and Total Franchisee Change

30 19%

20 18%

17%
10
16%
-
15%
(10)
14%

(20) 13%

(30) 12%
2Q18
4Q13
1Q14
2Q14
3Q14
4Q14
1Q15
2Q15
3Q15
4Q15
1Q16
2Q16
3Q16
4Q16
1Q17
2Q17
3Q17
4Q17
1Q18

3Q18
4Q18
1Q19

TTM Total Net Opens TTM Net Franchisee Change

TTM Restaurant Operating Margin
Source: Company filings

Denny’s ownership base is heavily fragmented and weighted toward smaller owners with 40% of locations owned
by franchisees with fewer than 10 locations. The ten largest Denny’s franchisees own 33% (503 locations). By
comparison, the top ten Applebees franchisees own 72% (1,175) of locations.
Denny’s failure to successfully sell the stores would lengthen their exposure to continued margin pressure but
more importantly would point to serious issues underlying the business model for years to come. Additionally, it
would inhibit their ability to either take on more debt or delever from their current ~3x, with their credit
agreement pulled beyond 3.5x, including their share buybacks.

Increased Pessimism from Tough Comps against Business Restructuring Denny’s adopted 606 only on a go-
forward basis, which ended up grossing up revenues which were previously netted and providing the appearance
of topline growth. While few restaurant analysts pay close attention to top-line, instead favoring SSS and margins
(which were unchanged from the accounting), I think this change and the reported y/y numbers is partly
responsible for the premium valuation (~14.7x consensus FY19E Adj EBITDA), which will be difficult to sustain as
Denny’s laps 606-adoption and very strong 2018 results.
Denny’s also began to defer start-up-related franchisee fees over the life of the agreement and recognizes the
remaining amount if terminated, vs previously recognizing at the start (this arrangement is better in a net closure
environment while the previous method was better in a net open). Additionally, gift card breakage is now
recognized as revenue rather than as a credit to expenses.

Management Shifts Compensation Goalposts and Vesting While CEO Sells Management shifted the cash
payouts away from pretax income and toward adj EBITDA, presumably due to y/y declines due to larger interest
burden. Management also shifted the long-term incentive plan from 50% adj EBITDA and 50% “shareholder
return” (stock performance vs a basket of comps) to 50% adj EPS rather than adj EBITDA. This long-term incentive
plan was also amended so employees could defer their awarded LTIP PSUs.
CEO John Miller ended years of pairing sales with offsetting option exercises and (1) sold 32% of his stake since
2Q18 and (2) deferred 100% of his long-term incentive comp (target at 275% of base). In November, Denny’s also
rehauled their by-laws. Board can no longer vote out a director, this is only possible through majority vote of
shareholders through a special meeting, which can only be called by the Board, CEO (if delegated authority by
Board), or shareholders if they fulfill an incredibly detailed list of difficult 14 requirements which could easily be
used to prevent shareholders from naming anyone.

Exhibit . Management Compensation 2016-2018

Annual Cash Incentives Base and Long Term Incentive Plan Target
Threshold Payout Target Payout Max Payout Realized Payout CEO EVP SVP SVP SVP
2018 2018
Franchised SSS 0.0% 0% 3.1% 15% 6.0% 30% 0.6% 3% Base 900 550 383 367 362
Company SSS 0.0% 0% 3.0% 25% 6.0% 50% 1.8% 15% Target 275% 125% 100% 100% 100%
Adj EBITDA 87.2 0% 109 60% 130.8 120% 105.3 50% 50% adj EPS , 50% Total Shareholder Return
100% 200% 68%

2017 2017
Franchised SSS 0.0% 8% 2.3% 15% 6.0% 23% 1.1% 11% Base 875 525 378 340 355
Company SSS 1.0% 13% 2.9% 25% 7.0% 38% 1.0% 13% Target 275% 125% 100% 100% 100%
Adj Pretax Income 69.3 30% 71.7 60% 80 90% 69.6 34% 50% adj EBITDA, 50% Total Shareholder Return
100% 150% 57%

2016 2016
Franchised SSS 0.0% 8% 2.4% 15% 6.0% 23% 80.0% 10% Base 850 525 350 340 350
Company SSS 1.0% 13% 3.0% 25% 7.0% 38% 1.1% 13% Target 250% 125% 100% 100% 100%
Adj Pretax Income 62.9 30% 67 60% 75 90% 69.3 69% 50% adj EBITDA, 50% Total Shareholder Return
100% 150% 92%

Conclusion / Risks / The Trade Denny’s is a rarity as a 24/7 full-service restaurant business with no exact comps
(few full-service also opt for franchising as they view themselves as ‘experience brands’). I think delivery will prove
out to be a trojan horse for Denny’s business model and that 2019 will bring unattractive y/y margin and EBITDA
comparisons. I also think restaurant investors/others will need another metric than SSS due to delivery trends,
though maybe a few years out. I value Denny’s, which will be one of the first big casualties, at 9.5x $90m 2019E
EBITDA, a 44% downside, due to declining sales, margins, and net restaurant growth. The risk is that I’m wrong
about the margins, Denny franchisee demand, or these things fail to convince institutional ownership (92%; 61%
top ten) to sell, though I think the current valuation has limited upside due to the sector and growth trends, with
DENN unlikely to reach high teen EBITDA multiples of fully franchised fast food chains due to hugely different
economics and growth.
The risk is Denny’s success in refranchising leading into a renegotiation of their debt and more leverage.
Then more repurchases. Denny’s has $107m in share repurchase program as of 5/8/19 annual shareholder
meeting and will likely refresh when that disappates.