Denny's Breaking Out of a Slump

Mired in debt, Denny’s is getting some hits by improving service and boasting about breakfast.

By David Farkas, Senior Editor -- Chain Leader, 7/1/2004

Nelson Marchioli has helped Denny’s Restaurants rack up nine consecutive months of same-store-sales gains.

One evening in late May, a Denny’s manager in Mayfield, Ohio, approached a customer finishing dinner. She asked if the server had explained the guest-satisfaction survey, which involves a toll-free call and a chance to win $10,000. When the man nodded, the manager said to give the server “5s,” the highest score possible.

“Good for her,” declares Denny’s Corp. CEO Nelson Marchioli upon hearing the story during an interview at the company’s headquarters in Spartanburg, S.C. “I encourage managers to ask for a 5. We are working really hard and have a lot of initiatives in place to improve our hospitality.”

They appear to be working. Guest counts had steadily climbed an average of 3 percent for the first four months of this year until May, when they dropped 1.2 percent. Crucial same-store sales have remained positive for nine months in a row. “Franchisees and employees are realizing Denny’s is back,” declares Marchioli, who arrived at the 1,621-unit chain in April 2001.

The 54-year-old executive blames May’s shortfall on a “mismatched” year-to-date Memorial Day weekend; last year’s holiday was included in the May totals. “With the exception of the mismatch, we have seen nothing in the economy that indicates a slowdown. We are actually participating in the economic recovery,” maintains Marchioli, president of El Pollo Loco from ’97 to ’01.

It’s hard to argue that point. The company’s uptick in sales and guest counts is the longest run in recent memory, officials say. And while a lot of restaurant companies posted great results this spring, the gains at Denny’s may signal that the beleaguered company is finally putting its operational difficulties behind.

For the first quarter, ended March 31, Denny’s reported that its comparable sales rose 6.4 percent. The increase catapulted the chain ahead of family-dining rivals Cracker Barrel (4.9 percent), Perkins (3.7 percent) and Bob Evans (1.6 percent). Only IHOP (7.1 percent), also a turnaround company, did better.

Revenues climbed 4.9 percent to $229 million in the same period. Net losses fell to $8.7 million from $9.1 million in the first quarter of last year, largely due to tighter cost controls. Marchioli has trimmed payroll and health benefits, slashing about 300 jobs at headquarters since his appointment. Slightly fatter margins bumped up operating income $500,000, to $10.9 million.

Marchioli’s turnaround is making up for lost time. Denny’s service and food quality collapsed in the early ’90s, dragged down by racial-discrimination lawsuits, towering debt and bankruptcy under parent company Flagstar (later dubbed Advantica, now Denny’s Corp.). Restaurants & Institutions’ “Choice in Chains” perennially ranked the 24-hour restaurants last in service and near the bottom in most other attributes. When the magazine publishes its new rankings this September, Marchioli can judge whether his hospitality initiatives are benefitting the chain.

Looking for Cash
For the time being, however, Marchioli has a more pressing problem: a $508.4 million bond debt he’d like to get out from under. To date, the company remains cash-flow negative with annual interest payments of $70 million.

“Their cost of debt is ridiculously high,” says New York-based Goldman Sachs’ Karen Eltrich, a bond analyst, citing a rate of 11.25 percent on a bond that’s due in 2008. “All the free resources are going to maintain the capital structure, and that’s not positive for the company long term.”

Indeed. Denny’s, market-share leader in the $32.2 billion (according to Chicago-based Technomic) family-dining category, has been shrinking in size over the past few years. Management continues to shutter underperforming company and franchise units. Lately, several fast feeders, including McDonald’s, have strayed onto Denny’s all-night turf with later drive-thru hours. In a May 6 conference call, Marchioli suggested competitive intrusion hasn’t hurt business. “Late night had the strongest [guest counts],” he claimed.

Last year, Denny’s remodeled 170 of its company units at a cost of $150,000 each.

Short-term, Marchioli and Chief Financial Officer Andrew Green are looking for ways to de-leverage the balance sheet. A big issue is shareholder dilution should the officials propose trading debt for equity, though a straight swap isn’t likely. “The irony of all this is that eight months ago the company was in a good position to de-leverage because its stock was essentially worthless,” says bond analyst Andrew Ebersole of KDP Investment Advisors in Montpelier, Vt.

The stock, the value of which tumbled 36 percent last year, traded at less than $1 last fall. Early in June, however, a share of Denny’s (DNYY:OBB) was changing hands for $2.08, a dollar off its 52-week high.

With an appreciating stock price and improving fundamentals, shareholders are less inclined to participate in a transaction that dilutes equity. On the other hand, even if Denny’s were to demonstrate it could boost EBITDA to $120 million in ’04—a figure Eltrich has proposed—the company still may be unable to grow into its capital structure. “Shareholders and bondholders have to work together. Nobody wants to give up something they are entitled to,” Marchiloi says. “We are facilitators at this point, trying to demonstrate to them that the business is a very good one.”

5-Foot Rule
Meanwhile, Marchioli has been working the hospitality angle. Today, Denny’s employees obey the “5 foot rule,” meaning any worker who passes within 5 feet of a customer must say hello and offer assistance. At the restaurant in Mayfield, a service assistant toting spray cleaner quickly seated a party while the hostess was attending a table.

Last year, Denny’s sponsored a series of two-day workshops throughout the country. Employees role-played and discussed case studies. “The workshops were about how to treat people nice. It helped,” recalls franchisee Ben Bagnas, chairman of Denny’s Franchise Association, which represents the interests of franchisees. But once isn’t enough, he adds: “We’ve cautioned headquarters that one two-day seminar can’t be the end of it.”

It might have to be. Much of ’04’s capital expenditures—about $39 million—will go toward sprucing up a dated infrastructure that requires new roofs, hoods and bathrooms accommodating the handicapped. A new company unit, to open later this year, will cost $1.5 million.

Big food: Denny’s new Super Scramble, $4.99, features two eggs, two sausage links, two bacon strips, hash browns and three pancakes.>

Last year, the company remodeled 170 units; it will rehab another 60 company restaurants this year and next; franchisees will tackle 120 units this year and 100 in ’05. The cost to remodel runs about $150,000, the company says. “I want to do them quicker,” Marchioli says, “because we get a very positive response from guests, both in attitude surveys as well as in sales.”

He may get the chance soon. In early June, Mellon HBV Alternative Investment Strategies, Denny’s second-largest shareholder, was rumored to be planning an equity infusion of roughly $33 million. The sum won’t put a dent in the company’s capital structure, but the funds could help defray remodeling costs, say bond analysts. A spokesman for the New York-based investment bank declined to comment.

Denny’s has also been getting good response to its ads, which now air with popular television programs like “American Idol” ever since the chain switched to network advertising last year. The ads help define Denny’s “abundant value” strategy. Gone is the $2.99 Grand Slam. In its place, the chain advertises prodigious breakfasts called Super Scrambles for $4.99. Hungrier customers can upgrade to the $5.99 Meat Lover’s Breakfast, which includes bigger protein portions. And the Grand Slam Slugger now runs $6.79.

Customers haven’t flinched at the chain’s higher breakfast prices, according to Chief Marketing Officer Margaret Jenkins. “The Meat Lover’s Breakfast has become the No. 1 seller on the menu,” she explains. “And so if the customer was concerned about sticker shock, they would not have gravitated to it.”

Denny’s will air only breakfast commercials this year, despite the chain’s other new items, including a $6.29 chicken melt on ciabatta bread and several luscious desserts. The strategy is to leverage its two big—and to date, only—positives: breakfast anytime and being open 24 hours every day.

“People trust Denny’s for breakfast,” Marchioli says.

Spot vs. Network
Some observers have wondered about the effectiveness of switching from spot buys—a benefit to advertising co-ops in large markets—to network buys, which level all franchise markets. It’s a sensitive subject about which few people are willing to speak openly. Two large franchisees in Texas and the Midwest didn’t return calls seeking comment.

Says franchisee John Romandetti, who operates 16 units in south Florida, one of the companies largest markets: “We can have a discussion on the pros and cons of network versus spot advertising, but I will defer to Margaret’s strategy and what she thinks is best for the brand.”

Still he adds, “Anytime you go to a network buy, some of the larger markets will lose share of voice. It’s simple mathematics.”

Jenkins insists that “all of our franchisees are receiving more TV coverage than they have in previous years.”

According to Bagnas, who operates two Denny’s in San Diego, company and franchise stores in his market are now cooperating on local campaigns as a way to boost their reach. So far they have produced a free-standing insert and are planning a promotion in concert with Lego Land. “We want to fill in gaps in national advertising, and this is a great way,” he says.

Franchisees are crucial to Denny’s survival. The franchise department is already the second largest in the company with 25 employees. It will spend twice as much this year as last prospecting for franchisees.

Over the next two years, dozens of existing franchise agreements will end, says Mounir Swada, vice president of franchise and development. The company will have the right of first refusal on some of the properties, because it owns or has a partial interest in about 300 locations.

The chain now uses a global information system to increase the probability of finding a successful site, something it is eager to share with franchisees. So far, the software has instructed him to open more restaurants in Las Vegas; Orlando, Fla.; and McAllen, Texas.

“We asked the system to come up with sites that would generate $2 million plus annually,” Swada recalls. The first new company store in more than two years opens in Las Vegas later this year near developer Steve Wynn’s new resort on the Strip.

Denny’s also has a new prototype to hook prospects, filled with soft, earth-tone fabrics and soothing colors. It’s currently in test in Chicago. “I think it looks great,” says Swada, “but the consumer has to tell us.”

Denny’s is listening to customers again—one of the hopeful signs that operations vs. finance rules the day. “The debt is the debt,” Marchioli says. “I will do my very best making the debt as good as it can be, whatever it is. But I’m in the restaurant business here.” That remark alone gets him a “5.”