Should Denny’s Adopt Marcato Capital’s Plan For DineEquity?

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.

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