Denny's - 10-Q quarterly report FY

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As of August 1, 2006, 92,370,470 shares of the registrant’s common stock, par value $.01 per share, were outstanding.

See accompanying notes

See accompanying notes

See accompanying notes

Denny’s Corporation, through its wholly owned subsidiaries, Denny’s Holdings, Inc. and Denny’s, Inc., owns and operates the Denny’s restaurant brand, or Denny’s.

There have been no other material changes to our significant accounting policies and estimates from the information provided in Note 2 of our Consolidated Financial Statements included in our Form 10-K for the fiscal year ended December 28, 2005.

The components of the change in accrued exit cost liabilities are as follows:

Estimated net cash payments related to exit cost liabilities in the next five years are as follows:

Our subsidiaries, Denny’s, Inc. and Denny’s Realty, LLC (formerly Denny's Realty, Inc.) (the “Borrowers”), have senior secured credit facilities with an aggregate principal amount of $417 million. The credit facilities consist of a first lien facility and a second lien facility. At June 28, 2006, the first lien facility consists of a $222 million five-year term loan facility (the “Term Loan Facility”) and a $75 million four-year revolving credit facility, of which $45 million was available for the issuance of letters of credit (the “Revolving Facility” and together with the Term Loan Facility, the “First Lien Facility”). The second lien facility consists of an additional $120 million six-year term loan facility (the “Second Lien Facility,” and together with the First Lien Facility, the “Credit Facilities”). The Second Lien Facility ranks pari passu with the First Lien Facility in right of payment, but is in a second lien position with respect to the collateral securing the First Lien Facility.

The Term Loan Facility matures on September 30, 2009 and amortizes in equal quarterly installments of $0.6 million with all remaining amounts due on the maturity date. The Revolving Facility matures on September 30, 2008. The Second Lien Facility matures on September 30, 2010 with no amortization of principal prior to the maturity date.

The interest rates under the First Lien Facility are as follows: At the option of the Borrowers, Adjusted LIBOR plus a spread of 3.25% per annum (3.50% per annum for the Revolving Facility) or ABR (the Alternate Base Rate, which is the higher of the Bank of America Prime Rate and the Federal Funds Effective Rate plus 1/2 of 1%) plus a spread of 1.75% per annum (2.0% per annum for the Revolving Facility). The interest rate on the Second Lien Facility, at the Borrower’s option, is Adjusted LIBOR plus a spread of 5.125% per annum or ABR plus a spread of 3.625% per annum. The weighted-average interest rates on the First Lien Facility and Second Lien Facility at June 28, 2006 were 8.3% and 10.3%, respectively.

At June 28, 2006, we had outstanding letters of credit of $38.0 million under our Revolving Facility, leaving net availability of $37.0 million. There were no revolving loans outstanding at June 28, 2006.

The Credit Facilities are secured by substantially all of our assets and are guaranteed by Denny’s Corporation, Denny’s Holdings and all of their subsidiaries. The Credit Facilities contain certain financial covenants (i.e., maximum total debt to EBITDA (as defined under the Credit Facilities) ratio requirements, maximum senior secured debt to EBITDA ratio requirements, minimum fixed charge coverage ratio requirements and limitations on capital expenditures), negative covenants, conditions precedent, material adverse change provisions, events of default and other terms, conditions and provisions customarily found in credit agreements for facilities and transactions of this type. We were in compliance with the terms of the Credit Facilities as of June 28, 2006.

The indenture governing the Denny’s Holdings 10% Senior Notes due 2012 (the “Indenture”) is fully and unconditionally guaranteed by Denny’s Corporation. Denny’s Corporation is a holding company with no independent assets or operations, other than as related to the ownership of the common stock of Denny’s Holdings and its status as a holding company. Denny’s Corporation is not subject to the restrictive covenants in the Indenture. Denny’s Holdings is restricted from paying dividends and making distributions to Denny’s Corporation under the terms of the Indenture.

In January 2005, we entered into an interest rate swap with a notional amount of $75 million to hedge a portion of the cash flows of our floating rate term loan debt. We have designated the interest rate swap as a cash flow hedge of our exposure to variability in future cash flows attributable to payments of LIBOR plus a fixed 3.25% spread due on a related $75 million notional debt obligation under the Term Loan Facility. Under the terms of the swap, we will pay a fixed rate of 3.76% on the $75 million notional amount and receive payments from a counterparty based on the 3-month LIBOR rate for a term ending on September 30, 2007. Interest rate differentials paid or received under the swap agreement are recognized as adjustments to interest expense.

To the extent the swap is effective in offsetting the variability of the hedged cash flows, changes in the fair value of the swap are not included in current earnings but are reported as other comprehensive income. The components of the cash flow hedge included in accumulated other comprehensive income in the Condensed Consolidated Statement of Shareholders’ Deficit for the two quarters ended June 28, 2006 and June 29, 2005, are as follows:

We did not note any ineffectiveness in the hedge during the two quarters ended June 28, 2006. We do not enter into derivative financial instruments for trading or speculative purposes.

The components of net pension cost of the pension plan and other defined benefit plans as determined under Statement of Financial Accounting Standards No. 87, “Employers’ Accounting for Pensions,” are as follows:

We maintain four plans (Denny’s Corporation 2004 Omnibus Incentive Plan (the “2004 Omnibus Plan”), Denny’s, Inc. Omnibus Incentive Compensation Plan for Executives, Advantica Stock Option Plan and the Advantica Restaurant Group Director Stock Option Plan) under which stock options and other awards granted to our employees, directors and consultants are outstanding. On August 25, 2004, our stockholders approved the 2004 Omnibus Plan which replaced the other plans as the vehicle for granting share-based compensation to our employees, officers and directors. The 2004 Omnibus Plan is administered by the Compensation Committee of the Board of Directors or the Board of Directors as a whole. Ten million shares of our common stock are reserved for issuance upon the grant and exercise of awards pursuant to the 2004 Omnibus Plan, plus a number of additional shares (not to exceed 1,500,000) underlying awards outstanding as of August 25, 2004 pursuant to the other plans which thereafter cancel, terminate or expire unexercised for any reason. The 2004 Omnibus Plan authorizes the granting of incentive awards from time to time to selected employees, officers, directors and consultants of Denny’s and its affiliates. However, we reserve the right to pay discretionary bonuses, or other types of compensation, outside of the 2004 Omnibus Plan.

The Compensation Committee, or the Board of Directors as a whole, has sole discretion to determine the exercise price, term and vesting schedule of options awarded under such plans. Under the terms of the above referenced plans, optionees who terminate for any reason other than cause, disability, retirement or death will be allowed 60 days after the termination date to exercise vested options. Vested options are exercisable for one year when termination is by a reason of disability, retirement or death. If termination is for cause, no option shall be exercisable after the termination date.

Additionally, under the 2004 Omnibus Plan and the previous director plan, directors have been granted options under terms which are substantially similar to the terms of the plans noted above.

Under SFAS 123(R), we are required to estimate potential forfeitures of share-based awards and adjust the compensation cost accordingly. Our estimate of forfeitures will be adjusted over the requisite service period to the extent that actual forfeitures differ, or are expected to differ, from such estimates. Prior to the adoption of SFAS 123(R), we recorded forfeitures as they occurred. As a result of this change, we recognized a cumulative effect of change in accounting principle in the Condensed Consolidated Statement of Operations of $0.2 million in the first quarter of 2006. Additionally, in accordance with SFAS 123(R), $2.2 million related to restricted stock units payable in shares, previously recorded as liabilities, were reclassified to additional paid-in capital in the Condensed Consolidated Balance Sheet during the first quarter of 2006. Our previous practice was to accrue compensation expense for restricted stock units payable in shares as a liability until such time as the shares were actually issued.

Options granted to date generally vest evenly over 3 years, have a 10-year contractual life and are issued at the market value at the date of grant.

A summary of our stock option plans is presented below:

The following table summarizes information about stock options outstanding at June 28, 2006 (option amounts in thousands):  

On November 11, 2004, we granted options under the 2004 Omnibus Plan to certain employees with an exercise price of $2.42 (included in the table above). These options vest 1/3 of the shares on each of December 29, 2004, December 28, 2005 and December 27, 2006, respectively. The vesting of these options was subject to the achievement of certain performance measures which were met as of December 29, 2004. As a result of performance criteria and the issuance of the options with an exercise price below the market price at the date of grant, prior to the adoption of SFAS 123(R), we recognized compensation expense related to these options equal to the difference between the exercise price of the options and the market price of $4.40 on December 29, 2004, the measurement date, ratably over the options’ vesting period.

The weighted average fair value per option of options granted during the quarter and two quarters ended June 28, 2006 was $3.86 and $3.20, respectively. There were no options granted during the quarter ended June 29, 2005. The weighted average fair value per option of options granted during the two quarters ended June 29, 2005 was $3.05. The fair value of the stock options granted in the periods ended June 28, 2006 and June 29, 2005 was estimated at the date of grant using the Black-Scholes option pricing model. Use of this option pricing model requires the input of subjective assumptions. These assumptions include estimating the length of time employees will retain their vested stock options before exercising them (“expected term”), the estimated volatility of our common stock price over the expected term and the number of options that will ultimately not complete their vesting requirements (“forfeitures”). Changes in the subjective assumptions can materially affect the estimate of the fair value of share-based compensation and consequently, the related amount recognized in the Condensed Consolidated Statements of Operations.  We used the following weighted average assumptions for the grants:

The dividend yield assumption was based on our dividend payment history and expectations of future dividend payments. The expected volatility was based on the historical volatility of our stock for a period approximating the expected life. The risk-free interest rate was based on published U.S. Treasury spot rates in effect at the time of grant with terms approximating the expected life of the option. The weighted average expected term of the options represents the period of time the options are expected to be outstanding based on historical trends.

As of June 28, 2006, there was approximately $3.6 million of unrecognized compensation cost related to unvested stock option awards granted, which is expected to be recognized over a weighted average of 1.56 years.

We granted approximately 3.4 million restricted stock units (half of which are liability classified and half of which are equity classified) with a grant date fair value of $4.22 per share and approximately 0.6 million restricted stock units (half of which are liability classified and half of which are equity classified) with a grant date fair value of $4.06 per share to certain employees. As of June 28, 2006 and December 28, 2005, approximately 3.3 million of these units were outstanding.

These restricted stock units will be earned in 1/3 increments (from 0% to 100% of the target award for each such increment) based on the “total shareholder return” of our common stock over a 1-year performance period (measured as the increase of stock price plus reinvested dividends, divided by beginning stock price) as compared with the total shareholder return of a peer group of restaurant companies over the same period. The first such period ended on June 30, 2005. Subsequent periods end on June 30th of each year thereafter with any amounts not earned carried over to possibly be earned over a 2-year or 3-year period. The full award will be considered earned after 5 years based on continued employment if not earned in the first three years based on the performance criteria.

Once earned, the restricted stock units will vest over a period of two years based on continued employment of the holder. On each of the first two anniversaries of the end of the performance period, 50% of the earned restricted stock units will be paid to the holder (half of the units will be paid in cash and half in shares of common stock), provided that the holder is then still employed with Denny’s or an affiliate.

Compensation expense related to the equity classified units is based on the number of units expected to vest, the period over which the units are expected to vest and the fair market value of the common stock on the grant date. Compensation expense related to the liability classified units is based on the number of units expected to vest, the period over which the units are expected to vest and the fair market value of the common stock on the date of payment. Therefore, balances related to the liability classified units are adjusted to fair value at each balance sheet date. We recognized compensation expense of approximately $0.3 million and $1.9 million for the quarter and two quarters ended June 28, 2006 and $1.2 million and $2.6 million for the quarter and two quarters ended June 29, 2005, respectively, related to the restricted stock units, which is included as a component of general and administrative expenses in our Condensed Consolidated Statements of Operations.

At June 28, 2006, approximately $2.9 million of accrued compensation was included as a component of other current liabilities (based on the fair value of the related shares for the liability classified units as of June 28, 2006) and $11.5 million was included as a component of additional paid-in capital in the Condensed Consolidated Balance Sheet related to the equity classified restricted stock units.

Total share-based compensation included as a component of net income was as follows (in thousands):

Prior to the adoption of SFAS 123(R), we accounted for our share-based compensation plans under the provisions of SFAS 123, while continuing to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” or APB 25, and related interpretations. The following table illustrates the effect on net income (loss) and net income (loss) per common share had we applied the fair value recognition provisions of SFAS 123 to share-based compensation for the quarter and two quarters ended June 29, 2005 (in thousands, except for per share amounts):

The components of Accumulated Other Comprehensive Income (Loss) in the Condensed Consolidated Statement of Shareholder’s Deficit are as follows:

In the fourth quarter of 2005, Denny’s Corporation and its subsidiary Denny’s, Inc. finalized a settlement with the Division of Labor Standards Enforcement (“DLSE”) of the State of California’s Department of Industrial Relations regarding all disputes related to the DLSE’s litigation against us. Pursuant to the terms of the settlement, Denny’s agreed to pay a sum of approximately $8.1 million to former employees, of which $3.5 million was paid in the fourth quarter of 2005. The remaining $4.6 million was included in other liabilities in the accompanying Condensed Consolidated Balance Sheet at December 28, 2005 and was paid on January 6, 2006, in accordance with the instruction of the DLSE.

Certain forward-looking statements are included in Management’s Discussion and Analysis of Financial Condition and Results of Operations.  Words such as "expects", "anticipates", "believes", "intends", "plans", and "hopes", variations of such words and similar expressions are intended to identify such forward-looking statements, which reflect our best judgment based on factors currently known.  These statements involve risks, uncertainties, and other factors which may cause our actual performance to be materially different from the performance expressed or implied.  Such factors include, among others: our ability and the ability of our franchisees to open and operate additional restaurants profitably; our ability to attract and retain qualified franchisees; our ability to control restaurant costs; the level of success of our operating initiatives; the level of success of our advertising and promotional efforts; adverse publicity; changes in business strategy or development plans; terms and availability of capital; competitive pressures from within the restaurant industry; changes in minimum wage and other employment laws; regional weather conditions; overall changes in the general economy (including with regard to energy costs), particularly at the retail level; political environment (including acts of war and terrorism); and other factors included in the discussion below, or in Part II. Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Part I. Item 1A. Risk Factors, contained in our Annual Report on Form 10-K for the year ended December 28, 2005.

The following table contains information derived from our Condensed Consolidated Statements of Operations expressed as a percentage of total operating revenues, except as noted below.  Percentages may not add due to rounding.

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(a) Costs of company restaurant sales percentages are as a percentage of company restaurant sales. Costs of franchise and license revenue

percentages are as a percentage of franchise and license revenue. All other percentages are as a percentage of total operating revenue.

During the quarter ended June 28, 2006, we realized a 0.4% decrease in same-store sales, comprised of a 4.0% increase in guest check average and a 4.2% decrease in guest counts. Company restaurant sales decreased $3.0 million or (1.3%). Decreased sales resulted primarily from the decrease in same-store sales for the current quarter and a nine equivalent-unit decrease in company-owned restaurants.

Total costs of company restaurant sales as a percentage of company restaurant sales increased to 88.4% from 86.5%. Product costs decreased to 24.9% from 25.3% due to shifts in menu mix and the impact of a higher guest check average. Payroll and benefits costs increased  to 41.6% from 41.5% due to increased wages rates and slightly higher group insurance costs, partially offset by a reduction in management incentive compensation expense. Occupancy costs decreased to 5.7% from 5.8% primarily due to an improvement in general liability expense.  Other operating expenses were comprised of the following amounts and percentages of company restaurant sales:

The increase in utilities is primarily the result of higher natural gas and electricity costs.  The increase in legal is the result of a $2.0 million increase in legal settlement accruals related to pending litigation.  The increase in other expenses is primarily related to a scheduled reduction in coin-operated game machines in our restaurants resulting in a $0.7 decrease in ancillary restaurant income.

Franchise and license revenues are the revenues received by Denny’s from its franchisees and include royalties, initial franchise fees and occupancy revenue related to restaurants leased or subleased to franchisees. Costs of franchise and license revenue include occupancy costs related to restaurants leased or subleased to franchisees and direct costs consisting primarily of payroll and benefit costs of franchise operations personnel and bad debt expense.

Franchise and license revenue and costs of franchise and license revenue were comprised of the following amounts and percentages of franchise and license revenue for the periods indicated:

Royalties increased $0.1 million (0.6%) resulting from a 1.4% increase in franchisee same-store sales, partially offset by the effects of an eight equivalent-unit decrease in franchised and licensed units.  The decline in occupancy revenue is attributable to the decrease in franchised and licensed units.

Costs of franchise and license revenue decreased $0.2 million (2.9%), primarily due to a decrease in incentive compensation and bad debt expense, partially offset by an increase in other direct costs related to an incentive award program for franchisees who achieve certain performance criteria in 2006.  

Other operating costs and expenses such as general and administrative expenses and depreciation and amortization expense relate to both company and franchise operations.

The decrease in general and administrative expenses resulted from a $1.0 million decrease in incentive compensation expense and a $0.8 million decrease in share-based compensation expense, offset by an increase in payroll costs.  The decrease in share-based compensation expense is primarily due to the adjustment of the liability classified restricted stock units to fair value as of the June 28, 2006 balance sheet date.

The overall increase in depreciation and amortization expense of $0.4 million is primarily due to the implementation of our new point of sale system.

The increase in interest expense primarily resulted from the effect of higher interest rates on the variable-rate portion of our credit facilities.

We have provided valuation allowances related to any benefits from income taxes resulting from the application of a statutory tax rate to our net operating losses generated in previous periods. In establishing our valuation allowance, we have taken into consideration certain tax planning strategies involving the sale of appreciated properties in order to alter the timing of the expiration of certain net operating loss, or NOL, carryforwards in the event they were to expire unused. Such strategies, if implemented in future periods, are considered by us to be prudent and feasible in light of current circumstances. Circumstances may change in future periods such that we can no longer conclude that such tax planning strategies are prudent and feasible, which would require us to record additional deferred tax valuation allowances.