Denny's Corporation
Q1 2010 Earnings Call Transcript

Published: 10 May 2010

[Operator:]

Welcome everyone to the first quarter 2010 earnings release conference call. (Operator Instructions) Mr. Enrique Mayor-Mora, Vice President of Investor Relations, you may begin your conference.

[Enrique Mayor-Mora:]

Thank you. Good afternoon and thank you for joining us for Denny’s first quarter 2010 investor conference call. This call is being broadcast simultaneously over the internet. With me today from management are Nelson Marchioli, Denny’s President and Chief Executive Officer and Mark Wolfinger, Denny’s Executive Vice President, Chief Administrative Officer and Chief Financial Officer as well as Debra Smithart-Oglesby, Denny’s Board Chair. Nelson will begin today’s call with an overview of our business and strategic initiatives. After that, Mark will provide a financial review of our first quarter results. Debra will conclude the call with remarks related to our proxy contest. As a reminder, the 10-Q will be filed today. Before we begin, let me remind you that in accordance with the Safe Harbor provision for 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 annual report on Form 10-K for the year ended December 30, 2009 and in any subsequent quarterly reports on Form 10-Q. With that, I will now turn the call over to Nelson Marchioli, Denny’s President and CEO.

[Nelson Marchioli:]

Thank you, Enrique. Good afternoon, everyone. In the first quarter we had two major accomplishments that we expect will accelerate sales growth and improve long-term profitability. First, during the first quarter we completed the testing of our $2, $4, $6 and $8 everyday value menu and our test results demonstrated a strong impact on guest traffic trends. In the 320 system units and 6 DMA’s where we tested the menu we saw a positive five percentage point improvement in guest count trend with only a 2.5% decline in guest check average. We were pleased to see these results and believe they reflect guest acceptance of everyday value at Denny’s. While this wasn’t in place long enough to impact first quarter same store sales it resonated with consumers in the test market and based on those strong results we have rolled it out system wide in the second quarter. The entire Denny’s system is very excited about this program and its potential impact on our future sales growth. In fact, over 95% of our franchise community voted to roll this value menu. Second, we were chosen as the full service restaurant operator of choice by Pilot for up to 140 Flying J Travel Centers. We expect to start converting these locations into Denny’s in the second quarter pending final FTC approval of the Pilot Travel Center and Flying J merger. We believe this opportunity will further spur unit growth through the entire system. Once complete, Travel Centers will make up at least 10% of our system. In addition, we continue to benefit from our migration to a more heavily franchised business model. Despite the backdrop of a challenging sales environment we have continued to drive improvements and profitability, free cash flow and restaurant unit growth. We also continued in the first quarter to further rationalize our operating costs and G&A and improve our operating margins all while reducing our debt levels and leverage ratio. First quarter sales [audio break] the back half of 2009 and to the midscale segment. We also anticipate sales will build throughout the year as our guests who have been particularly impacted by the economy and among the slowest to emerge begin to return from the challenging albeit seemingly improving economic environment. Our renewed focus on everyday value, new product innovation through LTOs and a greater weight placed on national and local media is expected to drive sales for the balance of the year. This improvement in trend is implied in our full-year guidance. Since the $2, $4, $6 and $8 everyday value menu rolled on April 3rd with ads during the NCAA Final Four Tournament, results have behaved similarly to those in the test markets. Key learnings have been first the program builds over time. The markets that rolled out the program during the test have outperformed the markets that rolled it out in April. Second, certain markets are slower to build guests than others. Specifically, since April our Northern California markets have been slower to embrace the value menu. Accordingly we are diving into these markets to learn how to optimize the program. In an effort to broaden our customer base and drive traffic we began advertising with AARP in late March of this year. In conjunction with the advertising program we are currently offering AARP members a 20% discount between 4 p.m. and 10 p.m. daily and $1 coffee all day at participating restaurants nationwide. With the positive initial response we have seen to these offers, we are excited to have signed a multi-year agreement with AARP to provide continuing discounts to its members. The relationship will enable Denny’s to promote these ongoing offers to millions of AARP members and leverage AARP’s brand equity as an organization that enhances its members lives as they mature in age. We anticipate this relationship will augment our efforts to drive increased frequency of visitors among 50 plus consumers who currently comprise 40% of total Denny’s guests. Officially the relationship will launch on June 1. In respect to our Super Bowl Grand Slam giveaway event this year, our objective was to reinforce the tremendous brand building benefit we experienced from last year’s event. Second to increase the stickiness of Denny’s with the consumer. From a sales perspective this year’s event drew in 7% more guests than last year and delivered even more public relations outreach than last year. We had over 4,900 TV and radio airings and appeared in over 500 newspapers. We are also focused on growing the brand by expanding our traditional footprint as well as other points of distribution that have been in development for several years. Here are the results we are excited to be able to share. In the first quarter we opened 10 units and grew the net system by 8. Four of these 10 units were company openings in Flying J Travel Center sites. Since these openings, sales have met our expectations and trended at over $30,000 a week on a pace to perform at approximately the system’s average unit volume. This is particularly attractive since the Travel Centers have yet to convert to Pilot contract trucking business. The level of initial investment is around $550,000 with higher than average unit level margins. As mentioned, we anticipate converting up to 140 of these Flying J sites in less than a 12 month period pending FTC approval of the Pilot/Flying J merger. We also opened our first Fresh Express site on a University Campus. This is a test of our new concept with emphasis on value, Denny’s great products and grab and go. This site is located on the campus of Cal State San Bernardino with Sodexo, a great partner and licensee. The site is meeting sales expectations and we anticipate this channel will represent a strong avenue of growth for the brand this year and beyond. On the international front we also recently signed a deal in Central America with a franchisee to open eight units in four countries. This is the first step in our ambitious effort to grow our business internationally using local partners. We anticipate signing two more international market deals by the end of this year. We are committed to growing the Denny’s brand and believe we are executing towards this goal. Our ability to grow the brand sales and unit count will be largely driven by the health of our relationship with our franchisees. We believe we have made tremendous strides over the past six months in our relationship with our franchisees as echoed by the Denny’s Franchisee Association. We are working together through the brand building committees in operations, development and marketing and by actively engaging and collaborating with our franchisees in our decision making processes. Together we will grow this iconic brand. I will now turn the call over to Mark Wolfinger, Denny’s CFO and CAO.

[F. Mark Wolfinger:]

Thank you Nelson. Good afternoon everyone. Our first quarter can be summarized as follows; the continuation of Denny’s growth and profitability, free cash flow, return on assets, margin rates, new unit development and net system unit expansion. In addition we continue to lower our operating expenses including G&A and our debt levels and debt ratios. While the quarter was also characterized by negative but improving same store sales, we did outperform consensus EPS by $0.01 delivering $0.05 per share. I will start my comments with a review of our first quarter sales performance. Same store sales at company restaurants decreased 5.5% and decreased 6.3% at our franchise restaurants. Looking at the details for company sales performance the 5.6% decline in guest count was partially offset by a one-tenth of a point increase in average guest check. Weather negatively impacted comparable sales by approximately 90 basis points. This was partially offset by a positive 40 basis point impact to sales from the Easter/Spring Break shift. Denny’s guest counts continue to be most negatively impacted in California. Guest counts while showing improvement in trends still remain negative in other key states including Arizona, Florida and Texas. The slight increase in guest check was attributable to pricing actions taken in 2009 to help commodity and labor cost pressures. Largely offsetting the increase of pricing was the impact of a stronger value-oriented menu mix as well as an increase in discounts compared with the prior year period. The decline in total company restaurant sales in the first quarter largely reflects the continuing impact of our franchise growth initiative (NYSE

[Debra Smithart-Oglesby:]

Thank you Mark. I am pleased to joint today’s call to share some brief remarks at this important juncture for our company. For those of you whom I have not met I joined the Denny’s board in 2003 and I have been the board Chair since 2006. I have over 25 years of experience in the restaurant industry including initial concept development, multi-unit growth, brand re-energizing, turnaround, franchising and international at companies that are well known such as Brinker International and Noodles & Company. Before we open up for Q&A I wanted to take a few minutes to address our stockholders because many of you have asked about the current proxy contest. Let me make it very clear to all of you that this path is not of our choosing but the board is responsible for protecting the interests of the company’s stockholders and we firmly believe we are upholding that responsibility by strongly opposing the three candidates that have been nominated by the dissident group of hedge funds. From the very beginning it was clear to us this group was intent on waging a proxy contest since it never formally contacted the company prior to the filing and has still not responded to our communications to its members. This is despite the fact that Denny’s has a very active investor relations program where Nelson, Mark and Enrique have spent countless hours at conferences, in one-on-one meetings and phone calls with both current and prospective stockholders. Instead, the dissidents have chosen a highly public, costly and distracting process. They have also publicly criticized the franchise leadership of our Independent Denny’s Franchisee Association Board, the very livelihood of this brand. There are a number of reasons why the board has taken this position and I believe we have detailed them in the various communications that have been issued and filed over the past few weeks. Most importantly I want to stress that we firmly believe none of the three dissident candidates possesses sufficient relevant experience to bring value to the board or to the company and the three nominees they have specifically targeted, myself included, have far greater industry and relevant experience that will be essential to the board and the company at this time. I would also point out this is not just our opinion. The three leading independent proxy advisory firms have supported Denny’s. Two of them did so unanimously and while one recommended for one of the three dissident nominees we believe the clear consensus view of these independent organizations is that the company’s nominees have far more relevant experience to benefit the board and the company moving forward. As your Board Chair I want to emphasize the Denny’s board of directors is open to change and we actively embrace new ideas and fresh perspective. We have had a very dynamic board membership over the years, adding about one new director per year during the last ten and we frequently rotate the role of the Board Chair. The current board is comprised of very talented, hard working, diverse experienced members and we regularly review our board [compensation] for opportunities for further improvement. We know there is still much work to be done and as Nelson described earlier there are a number of initiatives to improve sales performance and our long-term profitability. It is very important not to lose sight of the accomplishments that have been achieved. We have transformed the balance sheet saddled with more than $550 million in debt only four years ago to less than $274 million at March 31, 2010. Our total debt level represents the company’s lowest level of debt since the mid-1980’s. Our debt leverage has declined from 5 times to 3 times during this timeframe. As a result, Denny’s is in a stronger position to refinance its 2012 maturing bank and bond debt on terms that we believe will provide much greater flexibility to redirect cash flow towards stockholder friendly activities. Through our franchise growth initiative (FGI) we have sold 290 company owned units at attractive multiples that have been accretive to Denny’s earnings and have driven incremental restaurant new unit growth. This initiative has been complemented by a significant new growth opportunity with Pilot and the Flying J Travel Centers which Nelson also talked about earlier. We have been focused on reducing costs. We have reduced our general and administrative expense from $67 million in 2007 to around $57 million in 2009, or a net reduction of 15%. We have also taken out an additional $7.6 million or 44% of our field supervisory costs since 2006 as we have reduced the number of company operated stores. We are prudently managing shareholder capital as we dramatically reduced our capital expenditures as we continue to complete this business model transition. For the past three years these actions have delivered consistent growth in restaurant count, profitability, free cash flow, return on assets and on margins. As an example, our return on assets have increased from 2.8% in 2000 to over 10% in the first quarter of 2010. Lastly, your board is a proactive board. We have board members who are actively involved in the financial restructuring of Denny’s. We were actively involved in the development and implementation of FGI. We were involved in the difficult senior executive changes that occurred in this past year and we have been very involved in the development of business strategies that have resulted in the Pilot and Flying J deal. We also maintain active dialogue with our franchise community. In fact, I have been invited and attended numerous franchise meetings from their annual conventions to their franchisee board meetings. We regularly review and scrutinize management’s performance relative to our business and financial plans. Lastly we regularly review our succession planning responsibility to make sure we have the right leadership to guide Denny’s into the future. I want to thank you for your time today. With that operator we would like to open the session to questions.

[Operator:]

(Operator Instructions) The first question comes from the line of Mark Smith – Feltl & Company.

[Mark Smith:]

First on FGI pace, you had said there is still pretty strong demand for some of these units. Should we read into no transactions happening during this quarter?

[Nelson Marchioli:]

I’m sorry what should you read into that?

[Mark Smith:]

Is there anything we should read into no FGI transactions?

[Nelson Marchioli:]

No. Again I think it is more timing than anything else. Obviously we pushed hard in the fourth quarter but we continue to see strong demand. We are in negotiations on several possibilities and again our target is to be 90% franchise which we believe is going to be accomplished through selected FGI as well as new unit growth coming out of the franchise community. So we remain still very strong in FGI and obviously the transformation of our model.

[Mark Smith:]

On the comps can you talk about the shift in the Easter holiday and the impact that had. Can you give us that number again? I am guessing we can assume the same thing inverted here for Q2.

[F. Mark Wolfinger:]

That was about positive 40 basis points.

[Mark Smith:]

A question on the same store sales guidance on maintaining that, just kind of modeling that on a two-year cumulative basis it looks like things were pretty good in Q1. You have talked a little bit about getting sales momentum and things you think improving throughout the year. Are you being conservative or any reason for being cautious on the same store sales guidance?

[F. Mark Wolfinger:]

No. Obviously our guidance when you look at the annual guidance reflects an improvement in trend as we go through the year versus the first quarter. We continue to maintain that position.

[Operator:]

The next question comes from the line of Steve Anderson – MKM Partners.

[Steve Anderson:]

Looking at your food cost line, I notice you are about flat year-over-year. Have you provided any guidance for the full-year on this line? How much of your commodity basket have you purchased for this year?

[F. Mark Wolfinger:]

Two questions. One is have we provided guidance for the full-year. No we have not. We were pleased we came in flat year-over-year in the first quarter. We had provided guidance in terms of what we expect commodities to be over the entire year which was flat to maybe up 1. That will give you some insight into the food costs. In terms of what percent we are bought in, for the rest of the year starting in April, the second quarter, we are bought into about [53%] or our commodities at this point.

[Operator:]

The next question comes from the line of Mark Argento – [Craig-Hallum Capital Group].

[Mark Argento:]

Can you give a little color on the pace of rollout once the Flying J acquisition gets past the DOJ and how quickly are you thinking you can ramp up into those units?

[Nelson Marchioli:]

Could you repeat the question?

[Mark Argento:]

The question is around the implementation of the Flying J units. Once the acquisition gets passed the DOJ what is your timeframe there in terms of getting those all up and running?

[Nelson Marchioli:]

We would expect we would begin that process assuming we get the governmental approval probably the middle of June. We would probably be looking at about five conversions a week at that point in time and allowing for holiday weeks and the like we are probably looking at 20 weeks. So somewhere in the neighborhood plus or minus of about 100 conversions this year out of the 140 plus the guidance we have already given for new store builds.

[Mark Argento:]

Those are going to be under the franchise model if I recall?

[Nelson Marchioli:]

Yes they are probably about 10% will be company operated.

[Mark Argento:]

You touched on it in the prepared remarks about being able to have some more flexibility in terms of shareholder friendly or equity friendly potential transactions going forward once the debt is essentially refinanced. Is there any specificity? Are you thinking share buybacks? How do you balance that out with just continuing to pay down the debt load?

[F. Mark Wolfinger:]

Clearly another part of our strategy here in our debt reduction efforts is to redo our capital structure and refinance our capital structure. From a stockholder friendly action standpoint that obviously could include share buyback or could include dividends but clearly we are somewhat restricted today. We are restricted today and we would like to see that in our new [inaudible].

[Mark Argento:]

Any specific plans in terms of just trying to get the debt redone at this point?

[F. Mark Wolfinger:]

I would tell you we have ongoing discussions. Clearly we are very focused on that. We recognize our bonds are at par in October of 2010 but we haven’t set a specific timeframe but we are very focused on it.

[Operator:]

The next question comes from the line of Nichole Miller Regan – Piper Jaffray.

[Nichole Miller Regan:]

I want to understand the economics of the Denny’s at the Flying J conversions. If I understood correctly did you say that would be a 7-8% sales lift? If that is the case what type of unit level economics is that based on?

[F. Mark Wolfinger:]

On the 7-8% sales lift specifically is the sales lift related to the overall size of our brand. So if you look at the 140 plus Flying J’s and the AUVs we anticipate it will be in that kind of a range on an annualized basis. So again total sales coming from those stores. On the economics itself I think as we mentioned we are looking at an average conversion certainly on the first four Flying J’s we did from a company perspective in the mid 500’s. Call it $550,000. Those stores have been running around $30,000 a week in sales. Overall, from a P&L standpoint at least what we have experienced with Pilot is better flow through on a P&L standpoint because of the relationship with utilities, security, [cam] things like that are shared. So we have been seeing something or we anticipate seeing something in the 100-200 basis point improvement as far as flow through.

[Nichole Miller Regan:]

It strikes me when you have a conversation about Denny’s the platform on the $2, $4, $6, $8 approach the second piece of that would be the convenience equation. Certainly Flying J has answered that to some degree but just in sort of the legacy restaurants as you become more competitive on price I think it is a strong position within the overall casual dining. What can you do to address convenience? Would you entertain things like to-go parking up front or anything of that nature?

[Nelson Marchioli:]

We have already implemented in many of our locations to-go parking at our restaurants. In fact this $2, $4, $6, $8 menu enables us to even focus more on portable items and we will be refreshing those items on an ongoing basis. Our next refresh will be the latter part of August. We are in fact addressing lower priced, fast to go items on that menu.

[Operator:]

There are no further questions at this time.

[Enrique Mayor-Mora:]

Thank you. Actually there is one more question I can see. Do you want to allow one more question?

[Operator:]

The next question comes from the line of Michael Gallo – C.L. King & Associates, Inc.

[Michael Gallo:]

I guess if I look over the last couple of years you have certainly done a good job of de-leveraging the balance sheet transitioning to a model that generates a significant amount of free cash but the part that has really been missing has been sustainable improvement or driving of guest count and comps. Even in light of the competitive environment. I am wondering obviously $2, $4, $6, $8 is helping. There isn’t a silver bullet. I was wondering if the company plans a shift in strategy more towards affordability as opposed to, I think if I look at the promotions the last couple of years it was more driven off of value and by value I mean a lot of food at a certain price point and whether we should expect $2, $4, $6, $8 to be the beginning of that transition or just something you see as an additional menu platform the consumer can use?

[Nelson Marchioli:]

Clearly we are embarking upon with $2, $4, $6, $8 an affordability strategy. That is exactly the direction we are going in which is going to be a combination, and I couldn’t pick better words than you did. $2, $4, $6, $8 is not a silver bullet but it is foundational. It is a platform. We will very definitely be looking for, as we have stated before, limited time offer items that really incorporate taste and quality to give a balance to our consumers. Many of our consumers very much want the value proposition to reach that affordability level but we still have folks on the weekend in particular that are looking for that breakfast, sweet, savory indulgence and we plan to satisfy that with an array of new products. In fact working closely with our franchisees we actually have developed an entire actually over a year’s calendar of new product introductions that not only will address $2, $4, $6, $8 but also address affordable, limited time offers. Thank you for your question.

[Operator:]

There are no further questions at this time.

[Enrique Mayor-Mora:]

Thank you for joining us on our call today. I am available after the call for any follow-up questions. Thank you and have a great evening.

[Operator:]

This concludes today’s conference call. You may now disconnect.