Denny's Corporation
Q3 2018 Earnings Call Transcript

Published: 31 Oct 2018

[Operator:]

Good day, and welcome to the Denny's Third Quarter 2018 Earnings Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Curt Nichols, Senior Director of Financial Planning, Investor Relations. Please go ahead, sir.

[Curt Nichols:]

Thank you, Ashley, and good afternoon. Thank you for joining us for Denny's Third Quarter 2018 Earnings Conference Call. With me today from management are John Miller, Denny's President and Chief Executive Officer; and Mark Wolfinger, Denny's Executive Vice President, Chief Administrative Officer and Chief Financial Officer. Please refer to our own website at investor.dennys.com to find our third quarter earnings press release, along with any reconciliation of non-GAAP financial measures mentioned on this call. This call is being webcast, and an archive of the webcast will be available on our website later today. John will begin today's call with his introductory comments. Mark will then provide a recap of our third quarter results, along with brief commentary on our annual guidance for 2018. After that, we'll open it up for questions. Before we begin, let me remind you that in accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the company knows that certain matters to be discussed by members of management during this call may constitute forward-looking statements. Management urges caution in considering its current trends and any outlook on earnings provided on this call. Such statements are subject to risks, uncertainties and other factors that may cause the actual performance of Denny's to be materially different from the performance indicated or implied by such statements. Such risks and factors are set forth in the company's most recent annual report on Form 10-K for the year ended December 27, 2017, and in any subsequent quarterly reports on Form 10-Q. With that, I will now turn the call over to John Miller, Denny's President and Chief Executive Officer.

[John Miller:]

Thank you, Curt, and good afternoon, everyone. I will spend a few minutes reviewing the results for the quarter, followed by some comments about our strategy to migrate toward an even more asset-light business model. We delivered total operating revenue growth as we navigated through a challenging competitive environment, characterized by strong value focus. Domestic system-wide same-store sales increased 1% as guests continued to respond favorably to our Super Slam value entrée, and our company-operated restaurants delivered positive guest traffic on the quarter. Top line growth, coupled with a disciplined focus on costs, resulted in strong cash flow generation and growth in adjusted net income per share. The consistency of our highly franchised business model, coupled with the momentum generated by our revitalization strategies, contributed to the relative strength of our results. I'm also proud of our team's execution against our 4 strategic pillars, which support our vision of being the world's largest, most admired and beloved family of local restaurants. These pillars include

[Mark Wolfinger:]

Thank you, John, and good afternoon, everyone. Our third quarter highlights include delivering adjusted EBITDA of $27.3 million and growing adjusted net income per share by 24.3% to $0.17 a share that will generate $13.7 million of adjusted free cash flow. We ended the quarter with 1,715 total restaurants as Denny's franchisees opened six restaurants and an additional company restaurant opened in Las Vegas. These openings were offset by 12 franchised restaurant closings. As a reminder, 2018 financial results include the impact of adopting new revenue recognition standards in accordance with Topic 606, which clarifies the principles used to recognize revenue. A more detailed explanation of these revenue recognition changes can be found in our third quarter 2018 earnings release and in our quarterly report on Form 10-Q. Because we adopted these new standards on a modified retrospective basis, prior year quarterly results were not adjusted and continue to be reported in accordance with our historical accounting. Denny's total operating revenue, which includes company restaurant sales and franchise and license revenue, grew 19.4% to $158 million, primarily due to recognizing franchise advertising revenue on a gross basis in accordance with Topic 606 and an increase in company restaurant sales. Franchise and license revenue grew 57.9% to $54.4 million, primarily due to recognizing $19.5 million of advertising revenue and a rise in initial fees, both of which were impacted by Topic 606, partially offset by lower occupancy revenue due to scheduled lease terminations. Franchise operating margin was 48.2% compared to 72.5% in the prior year quarter, primarily due to recording advertising revenue and related costs on a gross basis, in addition to an increase in initial fees and improving occupancy margin. Absent revenue recognition changes, franchise operating margin would've been 76.0%, which represents an improvement of approximately 350 basis points over the prior year quarter. Moving to our company restaurant. Sales grew by 5.8% to $103.6 million due to an increase in the number of company restaurants over the past 12 months and a 2.1% growth in same-store sales. Company restaurant operating margin of 15.2% was impacted by labor inflation, third-party delivery costs and a $700,000 benefit from favorable workers' compensation experience compared to a $1.3 million benefit in the prior year quarter, partially offset by higher sales. Total general and administrative expenses of $16.0 million improved by 2.8% or approximately $500,000, primarily due to a reduction in share-based compensation, partially offset by an increase in core G&A and market valuation changes in our deferred compensation plan liabilities. Adjusted EBITDA was $27.3 million. Depreciation and amortization expense was approximately $800,000 higher at $6.8 million, primarily due to the acquisition of franchised restaurants during the past year. Net operating losses increased approximately $200,000 to approximately $800,000, primarily due to a $1.4 million impairment charge, partially offset by a $700,000 property insurance gain. Interest expense rose by $1.2 million to $5.3 million, primarily due to increases in the balance of our credit facility and related interest rates. The provision for income taxes was $2.8 million, reflecting an effective income tax rate of 20.6%, driven by the new 21% federal statutory income tax rate. Adjusted net income per share grew 24.3% to $0.17 per share compared to $0.14 per share in the prior year quarter. And adjusted free cash flow, after cash interest, cash taxes and cash capital expenditures, was $13.7 million compared to $12.9 million in the prior year quarter, primarily due to decreases in cash taxes and cash capital expenditures, partially offset by an increase in cash interest. Cash capital expenditures of $7.8 million included remodel costs for 6 restaurants and construction costs associated with our latest restaurant on Las Vegas Boulevard, which opened during the quarter. This compares to $8.5 million in the prior year quarter used to acquire one franchised restaurant, construction costs associated with opening a new company restaurant and the relocation of a separate high-performing restaurant. Our quarter-end debt-to-adjusted EBITDA leverage ratio was 2.94x. And at the end of the quarter, we had approximately $309 million of total debt outstanding, including $278 million under our revolving credit facility. During the quarter, we allocated $8.6 million towards share repurchases. At the end of the quarter, basic shares outstanding totaled 62.9 million shares, which represents a reduction of 2.8 million shares or approximately 4% from 1 year ago. And since beginning our share repurchase program in late 2010, we have allocated approximately $393 million to repurchase approximately 46 million shares at an average price of $8.62 per share, leading to a net reduction in our share count of approximately 37%. We ended the quarter with approximately $159 million remaining in our share repurchase authorization. Now let me take a few minutes to expand on the business outlook section of our earnings release. Based on third quarter results and current expectations, we have updated our annual guidance expectations for 2018. We are tightening our same-store sales expectations for company restaurants to between 1% and 2% from our previous guidance of 0% to 2%. Similarly, we are up -- we are tightening our expectations for domestic franchised restaurants to between 0 and 1% compared to our previous guidance of 0 to 2%. Based on the net restaurant closings to date, we are now expecting net decline of 10 to 20 restaurants versus our previous guidance of a net decline of 5 to 10 restaurants. We are reaffirming our current guidance for adjusted EBITDA of between $105 million and $107 million. Our efforts to continually outpace -- optimize the value of our real estate portfolio have yielded an opportunity to sell property under some lower-volume stores in order to acquire higher-quality real estate through a like-kind exchange. Cash proceeds from the sale of property is not captured in the guidance metrics we provided -- we provide while purchases of property are included. Accordingly, we are adjusting our guidance for cash capital expenditures to $37 million to $39 million from our previous expectations of $33 million to $35 million to reflect the impending purchase of real estate. Finally, we are revising our guidance for adjusted free cash flow to between $44 million and $46 million from our previous expectations of $48 million to $50 million to reflect the quality upgrade in real estate I just mentioned. I would like to provide a few more details on the refranchising and development strategy John mentioned earlier. Over the next 18 months, we intend to sell between 90 and 125 company-operated restaurants with future development commence -- commitments as we migrate toward a business model that is between 95% and 97% franchised. We will continue to operate a portfolio of company restaurants in our highest-volume trade areas, such as the Las Vegas Strip. The adjusted EBITDA contribution of the restaurants we intend to refranchise will be partially offset by royalty revenue and rental income. Further, we are carefully evaluating a number of additional cost-savings initiatives related to the refranchising strategy, which we will discuss in more detail in future quarters. Our transition to a more asset-light business model is expected to reduce annual capital cash expenditures associated with maintenance and remodel costs by between $7 million and $10 million. We also anticipate generating pretax refranchising proceeds in excess of $100 million. The reduction in ongoing maintenance and remodel capital, coupled with refranchising proceeds and future royalty revenue on the associated development commitments, will further support our commitment to shareholder-friendly investments and returns, including the return of capital to our shareholders. We are also reviewing our debt leverage and anticipate moderately increasing our leverage from the current level of 2.94x to a level appropriate from a highly franchised -- for a more highly franchised model. While this transition to a lower-risk business model initially will have a dilutive impact on adjusted EBITDA, we anticipate accretive impacts on adjusted earnings per share and enhanced free cash flow, which, combined with refranchising proceeds, enable us to generate more compelling returns for our shareholders. We're very excited to use this refranchising strategy to stimulate additional growth for our franchised partners and to attract new franchisees to the Denny's brand. We will also upgrade the quality of our real estate portfolio through a series of like-kind exchanges. We anticipate generating a total of approximately $30 million from the sale of between 25% and 30% of the 95 properties we currently own. Proceeds from the sale of real estate under lower-volume restaurants will be redeployed to acquire higher-quality real estate. The 2018 cash capital expenditures guidance adjustment I mentioned earlier contemplates the first of these like-kind exchanges. As a reminder, the approximately $30 million in total real estate proceeds is not captured or netted against real estate purchases in cash capital expenditures. The good news is that our team that successfully led our transition from a 60% franchised business to a 90% franchised business is still in place and, accordingly, provides us with a high degree of confidence in our ability to execute this refranchising and development strategy as we move to a more asset-light model. That wraps up our prepared comments. I'll now turn the call over to the operator to begin the Q&A portion of our call. Operator?

[Operator:]

[Operator Instructions]. We will now take our first question from Will Slabaugh of Stephens Inc.

[William Slabaugh:]

I had a couple of questions on the refranchising strategy and what that might look like. First, just curious if you've had preliminary conversations with current or prospective franchisees and sort of what the demand might look like out there, if you do have a temperature of that. And then also, any anticipated impact to EBITDA? And with respect to that, how should we think about G&A as you refranchise your corporate stores? I know you mentioned you'd have some cost-savings plans coming our way at some point but didn't know kind of at a high level how we should think about that.

[John Miller:]

Yes. Well, this is John. I'll start by saying that there have not been preliminary conversations due to the materiality of the announcements, and we wanted to make sure that everybody knew what we were up to before we engaged. We do believe the interest level will be very high, starting in the West Coast running to the East. And so if -- so as you discern from the prepared remarks, that the idea is to take the qualified developer franchisees in the system and reward them with opportunities to bolt-on development agreements, in addition to what's already been committed, and then also to attract new franchisees into the family that will be committed to grow. And regarding -- we can certainly give a lot more color to the expectations of G&A treatment over time. Obviously, we expect the culmination of royalties and cost savings to be -- basically -- and then revenue -- by the time we get through the entire process, we expect EBITDA to be in a fairly similar position.

[William Slabaugh:]

Got you. That's helpful. And then as you think about debt, is there a level for us to keep in our minds in terms of a level that you would like to get to? And then given what's happened in the rate environment lately, how are you thinking about whether you would like to fix all of your debt at this point or leave some floating or how you're going through that process?

[Mark Wolfinger:]

Yes. Well, it's Mark. And that's why we certainly wanted to mention in the script as far as leverage, and I'm glad you asked the question so we can come back to that. But obviously, we're slightly --- we're leveraged slightly under 3x currently. Basically, we floated between 2.9-ish, a little bit over 3, I think, in Q1, and then we were down below 3 in Q2 and obviously down below 3 in Q3. I think in my comments, I mentioned that there would be a -- we're looking at a moderate increase in leverage. Clearly, you know the history here. Obviously, there's one point in time, this was a very highly levered entity. And so we're obviously focused on it, cautious about it. I think to your point about rate increases, interest rates, obviously, it's one of the many factors we're looking at. But we do believe there is some additional leverage that we can take on, as I mentioned, and again, return additional cash to our shareholders. And just as a reminder, we do have a series of swaps in place right now. So to some degree, we're looking at, I'd say, a fixed rate predictability to it. But we did want to mention, though, and again, I appreciate you asking a follow-up question, that obviously we're looking at leverage, and right now, we're talking about a moderate increase in some manner. So I know it doesn't give you the specifics, but I think as John pointed out, more to come as the strategy unfolds.

[Operator:]

Our next question is from Michael Gallo of CL King.

[Michael Gallo:]

Just a couple of follow-up questions on the refranchising. I guess when I look at your overall company markets outside of California, Texas and Florida, they're really scattered. So do you plan to kind of exit specific areas? Or how are you thinking about the refranchising from that standpoint of that? How many of the properties that you're looking at franchising -- refranchising do you expect you'll have a rent component on?

[John Miller:]

So the first part of the question, Mike, is that we believe a good place for us to be is to be very focused. So we do plan to consolidate markets. I believe we're in some 21 DMAs now. We'll come down to 8 states, I believe, and dramatic reduction in DMAs that we operate in. And that'll -- that allows us to really optimize the EBITDA over time throughout the balance of the transactions, between now and the end of the overall process. And the second question, could you repeat one more time for me?

[Michael Gallo:]

In terms of properties where you may have a rent factor that you'll end up collecting on the -- after you refranchise it.

[Mark Wolfinger:]

Mike, it's Mark. And so again, we'll probably talk a little bit more details as we go through the next couple of quarters. But you're right, there's obviously a rent opportunity here. I think as I mentioned in my comments, that obviously, and you know the process well, as we sell EBITDA in these stores, there's a royalty inflow that takes place. There's rental opportunities. Though rental opportunities could be, obviously, on a fee property that we own currently that -- for the company store sits on top of. And obviously, we're on the headlease as we're on the primary lease. And so obviously that would also be an opportunity from a rental increase there or [indiscernible] as far as markup, so really both sides of that. We don't have a specific split today that we can provide between the fee or the headlease fees. But obviously, you can surmise from the discussion today that we've taken a real good look at our asset base, both real estate and the company stores. And again, the real estate piece is a parallel piece, obviously, to the sale of the refranchising of the company stores.

[John Miller:]

And Mike, I want to just jump back in. I said 21 DMAs. It's 21 states down to 8 states. So just to clarify.

[Michael Gallo:]

That's very helpful. And then again, Mark, just to kind of come back to the point on leverage. I know you said modest increase. Obviously, that would imply you could return the proceeds, plus increase in leverage. Is that something you'd have to kind of wait till the end of the program? Or is that something you deploy kind of opportunistically as, obviously, there'll be a lot of moving pieces as you move towards 95% to 97%?

[Mark Wolfinger:]

That's a very good question, Mike. I mean, I think that's -- you're describing obviously part of the process we're going through right now, obviously, looking at the way the proceeds would flow in. I think we talked about an 18-month time frame. And then obviously, in parallel with that, we'd be taking a look at our debt structure or leverage situation, also watching interest rates, because obviously, there have been several increases this year. But it's all of those things put together. I think -- again, I'll go back to John's comments and my comments and that is that we view this as a creation of value and our ability to return even more value to our shareholders, which is what we're very, very focused on.

[Operator:]

[Operator Instructions]. It appears there are no further questions in the phone queue at this time. I would like to turn the conference back to Mr. Nichols for any additional or closing remarks.

[Curt Nichols:]

Thank you, Ashley. I'd like to thank everyone for joining us on today's call. We look forward to our next earnings conference call in February during [indiscernible] to discuss our fourth quarter 2018 results. Thank you, and have a great evening.

[Operator:]

This concludes today's conference call. Thank you for your participation. You may now disconnect.