Upside Is on the Menu at Denny's

• ByJonathan Heller, RealMoney Contributor
• On 10:45 am EDT, Friday September 25, 2009

Since taking a position in Denny's , a nearly forgotten restaurant chain, I've been impressed by the way this company has executed and navigated this recession. In fact, the company has made it through with just one quarterly loss -- the fourth quarter of 2008. As of yesterday's close, the stock was also up 27% since I initiated the position.

Still, the company flies under the radar perhaps due to a combination of factors:

1. Size: With a market cap of just $237 million, Denny's is squarely in micro-cap land. While that happens to be a segment of the market I like very much and find great opportunity in, it's not for everyone.
2. Debt: The company has a somewhat well-deserved reputation of being bloated with debt. The fact that that Denny's failed once before, when parent company Flagstar Corp. filed for bankruptcy back in 1997, is not lost on anyone who has done his homework.
3. Lack of presence, lack of relevance: Truth is, I'd forgotten the company even existed, let alone was public after the bankruptcy. In order to stay current and in the public eye, restaurants must advertise, introduce new products, and stay fresh. The restaurant business is competitive enough; to fall off the consumer's radar is death.
4. Negative book value: That's the end of story right there for some value investors, especially given Nos. 1, 2 and 3 above.

There's not much I can say to dispel the first point; Denny's is a small company in terms of market cap. But add in the debt, and you've got an enterprise value of about $535 million. This company is still too small for many investors.

The debt load indeed is an issue, but the company has been paying it down. At year-end 2005, long-term debt stood at $546 million; as of the latest quarter, it's down to $308 million, a reduction of 44%. Denny's still has work to do here, and last quarter the company sold 22 stores to franchisees for an average of about $300,000 each, which went to reduce the debt. By my count, there are still about 70 owned locations, and a move away from company-owned/-run stores toward franchising should help to further reduce debt.

I had not eaten at a Denny's since I was a teenager, when as a last resort I somewhat grudgingly entered the Costa Mesa, Calif., store. To my surprise, the food was very good. The company has also done a much better job of advertising in the past year or so. The Super Bowl promotion last year, where Denny's gave away an estimated 2 million free breakfasts, was a stroke of genius, helped reignite some brand awareness and did not kill the bottom line. Since then, the company has had a couple of other promotions and introduced several new menu items, including healthier options. Now Denny's needs to keep itself in the public eye.

Book value is still ugly, at -$1.64 per share, but it's improving. At year-end 2002, it was -$7.85 per share. It's hard to get too excited about this, but overall, the balance sheet is looking better.

Although second-quarter revenue declined 18% from the same quarter last year, much of that was due to the fact that there were 96 fewer company-owned stores as the company continues to move toward a franchise model. While franchise revenues are smaller than company store revenues, franchises are typically more profitable. For the quarter, Denny's earned $9.3 million on revenue of $155.8 million for a 6% net margin, vs. $3.2 million on revenue of $190.3 million last year (1.7% net margin).

Denny's trades at less than 8 times 2010 consensus estimates. While the company still has some work to do, this is beginning to look like a nice turnaround story.

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Know what you own: Other companies in the restaurant industry include Bob Evans , Cracker Barrel , Cheesecake Factory , Benihana , Darden Restaurants and DineEquity .

Buzz up!