Denny's Corporation
Q2 2012 Earnings Call Transcript

Published: 1 Aug 2012

[Operator:]

Good afternoon. My name is Lacy, and I will be your conference operator today. At this time, I would like to welcome everyone to the Denny's Second Quarter 2012 Earnings Release Conference Call. [Operator Instructions] I would now like to turn the call over to Mr. Whit Kincaid, Senior Director of Investor Relations. Please go ahead, sir.

[Whit Kincaid:]

Thank you, Lacy. Good afternoon, and thank you for joining us for Denny's Second Quarter 2012 Investor Call. This call is being broadcast simultaneously over the Internet. 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. John will begin today's call with his introductory comments. After that, Mark will provide a financial review of our second quarter results. I will conclude the call with commentary on Denny's 2012 full year guidance. As a reminder, we will be filing the 10-Q by the due date of August 6. 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 notes 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 28, 2011, 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 CEO.

[John C. Miller:]

Thank you, Whit. Good afternoon, everyone. We are pleased with our second quarter results as we continue down the path of reenergizing Denny's. We achieved our fifth consecutive quarter of system-wide same-store sales increasing while growing our adjusted income before taxes 35% and generating $15 million of free cash flow. It is a testament to the resilience of our 59-year-old brand that we have been able to achieve these results in this challenging economic environment. We are most appreciative to our loyal guests and their guidance and their response in reenergizing Denny's. Our franchise-focused business model provides financial stability and flexibility, while enabling us to generate significant free cash flow that could be used to further strengthen our brand and increase long-term shareholder value. We remain focused on executing against our 3 key objectives implemented to help Denny's become one of the largest American full service restaurant brands in the world. Our first key objective is the revitalization of Denny's heritage as America's Diner, which provides the promise of everyday value, crave-able cooking of family favorites and indulgent items served in a come-as-you-are friendly and inviting atmosphere. We now have 6, going on 7, quarters under our belt with our America's Diner brand positioning efforts. But this is our compass. We are at the beginning stages of effectively broadening our approach from the more narrowly focused breakfast-all-day platform. Contributing to our second quarter results was our Build Your Own Pancakes Limited Time Only module, which played off the strength of our Build Your Own Grand Slam platform. It delivered upon our guests' desire for customization, while also offering add-on and upsell opportunities. The module performed well, as we saw higher-than-expected number of customers ordering our signature pancake creation rather than build their own creation. We were also pleased to see that our breakfast daypart traffic increased sequentially and was the strongest performing daypart in the quarter. As we entered the summer season, we brought back our successful Tour of America module, which will run until mid-August. Back by popular demand our the classic diner items like the Philly Cheesesteak Omelette and the Midwestern Meat & Potatoes Sandwich with new additions to the lineup like the Red, White and Blue Pancake Breakfast, Malibu Fish Tacos, Brooklyn Spaghetti & Meatballs, our Southern Slam and the Florida Sunshine Salad. Per check driving add-on sales, we brought back the popular Strawberry Pancake Puppies and introduced the new Red Raspberry Smoothie along with the new and innovative dessert, the Apple Crisp Milk Shake Parfait. Most importantly, we are pleased to report this sequel mixes at a higher level than last year's module. In conjunction with the launch of our Tour of America Limited Time Only menu, we launched a new core menu during the quarter, which leverages our successful America's Diner positioning. The menu introduces clever references to our heritage as your local diner with what we call diner-ism, along with appropriate iconography bridging days gone by to today. One of these is the use of the classic diner bell you hear when your order is up. This iconic symbol is used to identify Denny's guest favorites

[F. Mark Wolfinger:]

Thank you, John, and good afternoon, everyone. Our second quarter performance was highlighted by positive system-wide same-store sales, a 35% increase in adjusted income before taxes and a 15% increase in free cash flow compared to the prior year period. Denny's is a reenergized brand with a franchise-focused business model, which provides stability to our profitability and cash flows, while generating excess cash that we're using to further strengthen our balance sheet and return value to our shareholders through share repurchases. In the second quarter, system-wide same-store sales increased 0.8%, same-store sales at franchise restaurants increased 0.9% and same-store sales at company restaurants were flat compared to the prior year quarter. This is the fifth consecutive quarter that system-wide same-store sales have been positive and the strongest 2-year quarterly same-store sales we've seen since the third quarter of 2007. Looking at the details for company same-store sales performance, the guest check average increased by 1.7%. The higher guest check average included a 1.5% increase from menu pricing taken in January of this year and June of last year. In the second quarter, company same-store guest counts decreased 1.6%. Around 20 basis points of this decrease was driven by the honeymoon period -- the honeymoon impact of the new company-owned units we opened in 2010 and 2011, as new units become part of our same-store calculations after being opened for 12 months. Franchise same-store sales increased 0.9% in the second quarter, primarily driven by a 2% increase from menu pricing, offset by lower same-store guest counts. I would like to remind everyone that we will cease reporting same-store company guest count and guest check average at the end of this year. Since our franchise units account for 89% of the system, we believe that franchise and system-wide same-store sales metrics better reflect changes in unit level performance throughout our system. Denny's total operating revenue, including company restaurant sales and franchise revenue, decreased $11.1 million compared to the prior year quarter, primarily driven by a decline in company restaurant sales in the quarter. Sales at company-owned units decreased $12.8 million, primarily due to 36 fewer equivalent company restaurants compared with the same period last year, reflecting the continuing impact of selling company-owned units to franchisees as part of our ongoing refranchising strategy we call FGI. In the second quarter, Denny's opened 9 new franchise units, closed 5 franchise and company units and sold 17 company-owned units to franchisees, leading to an increase of 4 net system units this quarter. I'll now review the quarterly operating margin table provided in our press release. The second quarter company restaurant operating margin of 14.8% represents a 1.5 percentage point increase compared to the prior year quarter and was primarily impacted by the following items

[Whit Kincaid:]

Thank you, Mark, and good afternoon, everyone. I would like to take a few minutes to address a few topics related to the full year 2012 guidance described in the business outlook section of today's press release. Our current thinking is that commodity cost pressures will be in the 2% to 3% range for 2012. We are currently locked into around 60% of our needs for the remainder of 2012 and hopeful that we will see the lower end of the range. In the first half of this year, we sold 23 company-owned units to franchisees and anticipate selling an additional 7 to 12 units in the second half of the year, which translates into 30 or 35 units for the entire year. Our goal remains to complete the FGI program by the end of 2012. As a reminder, the FGI program helps adjusted income before taxes but places downward pressure on our adjusted EBITDA. Although our year-to-date capital spending was $4.3 million, our annual guidance for capital spending remains $15 million to $16 million. This is primarily driven by the timing of the openings of the company-owned unit in downtown Las Vegas and remodels of the company-owned units. Based on year-to-date results, management's expectations at this time and changes I just noted, Denny's is reiterating its guidance ranges for the full year. That wraps up our guidance commentary. I will now turn the call over to the operator to begin the Q&A portion of our call.

[Operator:]

[Operator Instructions] Your first question comes from Will Slabaugh with Stephens.

[Will Slabaugh:]

I just had a quick housekeeping question to start off, to double check I'm getting to the right adjusted EPS number. When I look at your pre-tax income number of $12.9 million adjusted, I'm getting to an EPS number around $0.08. So I'm just wondering, I know it's a tough number to get to considering EPS as it has been sort of moving around with you guys in the past year or 2. But wondering if that's -- if you think I'm looking at that correctly?

[Whit Kincaid:]

Yes, I guess it depends on what you want to exclude, Will. So the refinancing, the $7.9 million, that's about $0.05. And then kind of the operating net gains and losses, that's probably another, what, $0.03 in terms of -- if you wanted to back that out. Those are the 2 biggest items.

[Will Slabaugh:]

Okay, makes sense. And then just broadly speaking, I wonder if you could -- you guys could speak to traffic and sales dynamics throughout the quarter, how they may be played out month-to-month and then just general views about how your consumers are doing this environment?

[John C. Miller:]

It's John Miller. Thanks for the questions. And the quarter was -- let's see, price was -- we're carrying about 1.5x price and that'll be -- so we took a little bit of price mid-year last year then first of the year this year and none in the recent menu print, so it'll be 1.5x that's carrying through the quarter. So obviously -- and then I think you asked month-to-month. I think the best way to answer it is we saw reasonably consistent sales. We led mid-scale throughout the quarter. We're tracking very consistent with the KNAPP-TRACK family numbers, if that helps you answer how we perform.

[Will Slabaugh:]

Great. And then just last thing for me. I wonder if you could talk to the broader diner positioning that you mentioned a minute ago. You guys have been focusing on it for a while now and just sort of your assessment of how's that resonating, how it's playing out with guests versus some of your peers that have chosen more recently to go to a bit more narrowly market and focus the menu on one daypart or another.

[John C. Miller:]

Well, that's -- it's interesting. In fact, Restaurant News' cover page about 2 weeks ago focused on that. There are narrow menu brands just doing great, and there are really broad strategies that are doing great. So each brand has to decide what's best for its positioning and its consumer. For us, big picture -- and I'll let Whit speak to dayparts a little bit -- but we've seen overall dinner improved. It means the diner positioning is resonating. We think we're just now at the early stages of getting traction for these initiatives. Even though we're quite a number of quarters behind us now, these are modest investments compared to our continued strong investment in the breakfast daypart, and we have a long history many, many, many years of being famous for grand slams in the breakfast daypart. So this is a long, slow building the heritage of the diners, is a long, slow transition -- but we are getting traction from consumer scores around new product introductions, affection for those products and just overall mix has been strong, and that's without the compromise to breakfast. As you know, the pancake promotion we did in Q2 gave us really, really strong breakfast and sequential breakfast numbers year-over-year, quarter-to-quarter. So I'd say in general, big picture, it's faring as we hoped.

[Operator:]

Your next question comes from Michael Gallo with CL King.

[Michael W. Gallo:]

John, it seemed like the commentary in the release was a little more forthcoming about the opportunities in international. Can you frame a little bit more about what areas you see opportunity? How big can this brand be internationally? Obviously the company has had a presence -- or the Denny's system, I should say, has had a presence in Japan for -- I don't know, since 1984, although clearly you don't get any benefit from it. So I was just wondering if you could just frame for us what the opportunity is. Obviously, the China deal was exciting, but it seemed to me that there's a lot of places around the world that certainly Denny's would have recognition that you don't find a Denny's today.

[John C. Miller:]

Sure, Mike. Thanks for the question. I think the world's getting smaller, actually, and the best way I can frame it is brands that are growing and Denny's is certainly one of those. And we're pleased to be able to say that in this environment -- would just quite naturally, especially with 59 years behind us -- want to explore. And with good reception we've had in the international markets where we currently operate, we just quite naturally want to continue to explore and exploit that with high-quality developers that we've been seeking and lately securing. So as you can imagine, our ambition is to continue along those lines. And when I say the world's getting smaller, I don't think that Asia, the rest of China, Central and South America, Middle East, that's basically where the riper or larger development opportunities exist, certainly as pioneered by QSR, and other American brands that are bigger in their global footprint than we are. So we saw no reason -- especially in light of signing our first China agreement -- not to be forthright with our comments. But we want to do more. We've stepped up our investment to chase it, and we're hopeful that, that will continue to get more results.

[Michael W. Gallo:]

Okay. John, and then just a follow up on that. Any update on domestic development? How you build the pipeline there?

[F. Mark Wolfinger:]

Mike, it's Mark. On the domestic side here, clearly, as we talked about our guidance, the annual number for openings, obviously, it's still -- most of our openings will be in the domestic U.S. and we haven't moved to offer any new guidance for the year, which is in that 45 to 50 range for openings. Now the first half of the year was a bit light, but -- so the other question might be it looks a little bit back-end loaded on openings, it is. We're watching it very closely, but again maintain our guidance for the year. We continue to see development agreements across the board that takes us probably well over 100 as far as new store openings, as far as in develop agreements. And in fact, the refranchising activity in the second quarter where we talked about some of the markets we sold during the second quarter, both those FGI transactions included new store development agreements with them. So we continue to see an interest there and very excited about that. I think the other comment I'd make on unit openings in the U.S. is we continue to see some very strong opportunities in conversions. So yes, we continue to build greenfield sites, but one of the opportunities that comes out of a tough economic environment from a recessionary standpoint is opportunities to use existing structures, existing buildings out there. And we have seen conversion opportunities certainly in the QSR space and certainly in the video retail space, et cetera. So obviously, maintain our guidance for the year as far as openings.

[Operator:]

Your next question comes from Tony Brenner with Roth Capital Partners.

[Anton Brenner:]

I have 2 questions. First, Mark, what would be an appropriate tax rate going forward?

[F. Mark Wolfinger:]

Yes, Tony, our guidance for the year is 35% to 40%. This quarter, I know, was a little bit higher than that range. We had a onetime item from the prior year that impacted that. So yes, we're still comfortable with that annual guidance range.

[Anton Brenner:]

Okay. And then, second, while you are still reporting guest counts and price check averages, I'm kind of concerned with the ongoing decline in customer traffic 3 quarters in succession despite an awful lot of effort devoted to the $2/$4/$6/$8 Value Menu. And just looking back, there's been only one quarter since 2005 with as much as a 2% year-over-year increase. With a commodity outlook for next year troublesome to say the least, and probably some price increases next year being required, it seems like that's going to put even more pressure on that customer count. So you've tried a lot of things and there just doesn't seem to be a lot of traction generating increased traffic. I'm wondering what your thoughts might be.

[John C. Miller:]

Tony, this is John. I believe our strategies are the right strategies. I think it's a very difficult consumer environment and then we continue to track along the lines of casual players where the customer is clearly focused on value right now, and we're working closely with our franchisees to further leverage our Value Menu. Certainly, first half of the year and find ways to more strategically target how that -- those ads and how that messaging takes place now throughout the balance of the year. I think it is, I guess, important to note and certainly not as an excuse by any means as we're very focused on this. But the '05 and '06 period was a period where people were sort of making hay in the industry and taking price and margin, at the expense of traffic, so to some degree, the sin [ph] of full service, and we certainly participated in those days. And then as you know from April of '07 forward, things started to decline, starting at dinner and then all dayparts followed. We went into the recession. And coming out, full service has been a struggle. However, Denny's is closing the gap on it. And we believe that quarter-after-quarter we get closer and closer and expect to ultimately prevail over that particular metric. We're confident we'll get there. We do think it's a tough environment right now. I might also add that the 5 states that hold better than 60% of our units -- California and Texas, in particular -- have shown that they found the bottom some time ago and were quite strong over Q1 and Q2 sequentially. And so these are good signs for our brand. But to your point, we're not there yet.

[Anton Brenner:]

Quite strong means what exactly, John? There were up in traffic or close to up?

[John C. Miller:]

Yes, Texas and California, were positive in both metrics, comps and track.

[Operator:]

Your next question comes from Mark Smith with Feltl and Company.

[Mark E. Smith:]

First question. I know Whit in his commentary talked a little bit about how many FGI transactions you can still have here through the second half. Is 90% still the long-term goal? Is there an opportunity to go higher than that as far as franchise mix? And then secondly, what's your goal in growth for company units? And what type of units do you want these to be?

[F. Mark Wolfinger:]

It's Mark Wolfinger. So I guess we'll start with the refranchising FGI side. I think as Whit commented we've got probably, call it 10 or a few more here that we anticipate in the second half. It'll -- we're at 89% franchised today, that'll pretty much finish out the refranchising activity, or FGI, as the program was called. It'll put us right around 90%. Now per our guidance this year, obviously, virtually all of the new store openings are going to be franchise. So just stepping back for a minute, we anticipate that we'll continue to do, from a company perspective, a flagship or prototype opening -- those things along those lines. As an example, obviously, our company opening plan this year is in Las Vegas where we have strong company operations along the Strip, et cetera. So I think from that standpoint, it's not going to be a perfect 90%-10%. But clearly, as more and more development takes place in the franchise side, that number could shift. But the target all along is at least we get to 90% simply through the refranchising activity. So hopefully, that's the first part of the question. I think the longer term, the aspirational target for our brand that we talked about historically is to get to a net opening number that's in sort of that 50 range. And clearly, as we view that, that's going to take the combination of successes -- that's obviously going to be to continue our traditional openings, we talked about the development pipeline there. John talked about the international spectrum, which has obviously been dramatically increased with the announcement around China. And then the other piece for us is the nontraditional piece, which speaks to the airport location in the Dominican Republic, our campus locations, et cetera. But that 50 net number is long term and we haven't put a specific time frame on that, but long term obviously implies something greater in the next couple of years.

[Mark E. Smith:]

If I look at -- you bring up nontraditional. I think John talked earlier a little bit about conversions as an opportunity. Does -- do you want to open some as corporate stores to kind of show best practices? And what kind of results you can get in nontraditional or in conversions and then maybe refranchise those units? Or do you want to focus primarily on bigger flagship-type units.

[F. Mark Wolfinger:]

Yes, I think our focus from a company operation standpoint would be more towards the flagship side. A lot of that nontraditional marketplace sort of has a -- sort of a special type of licensee or franchisee. So as an example, we've obviously had good success on campus but a large part of that campus institutional feeding contract is held by some of our partners like Sodexo and Aramark and Compass. So they service our licensee on campus. Alternatively, we have license relationships with the food service division of the university if they choose to run their own food operations on campus. So again, back to your question, I would say the company development would be more towards the flagship side than the prototype side.

[John C. Miller:]

One thing to add -- this is John -- just talking about company involvement in sort of the evolution of the brand which is not in your question but maybe inferred to some degree -- even in our traditional model, a brand continues to evolve with constant menu rollouts. And with that, there's equipment that modernizes today technology, different POS systems, ways in which you read and take orders. So add those kinds of things that the full service industry has access to those, we do a pretty good job of testing those in company operations, but also with our franchise community. And we found that that partnering with the franchise community is actually better, faster and quicker to get to the bottom line of a robust testing process then holding it at bay on just the company side and then sharing with franchisees later. Doing it together -- with warts and all -- is proving to be we think could be the better practice. And so not having a company operation per se to have your hands all over it to do that with company and franchisee personnel in a franchise restaurant is working really well for us.

[Mark E. Smith:]

Great. And then looking at the international pipeline that you've mentioned, I think, John, in your commentary, if we look at the next, let's call it, 12 to 18 months of those 80 unopened, what are we looking at if we call that near term?

[John C. Miller:]

Well, in a room like this I get stares when I talk about anything but the second quarter so it's hard to look out 18 months, and I'm certainly not trying to punt the question. I think it is just a little too early for us to comment at this stage. We're very optimistic about more -- adding more international partners. But until we know the scale of each transaction, it's just too early to guide.

[Operator:]

Your next question comes from Michael Halen with Denny's (sic) [Sidoti].

[Michael Halen:]

Can you expand a little bit more on the honeymoon period? It seems that your company-owned stores had a pretty nice jump in average unit volumes in the quarter. Can you talk to me -- give us a little bit more color on the honeymoon period for the company stores and also on the franchise stores, if possible?

[Whit Kincaid:]

Yes. Mike, this is Whit. We do a 12-month calculation. So what we see in -- what we've seen with the Flying J units is there's about a 3- to 6-month honeymoon period for these units. So you have kind of a big -- and this is on average -- kind of a big opening, maybe the first couple of weeks, maybe the first month. And then as you comp over that, you might comp negatively over that. Some units might comp positively. We've seen more of an impact of that on the company side and part of this is just a fact -- kind of a law of the numbers. So because we have a smaller company-owned base of units and we've opened -- actually originally opened 29 company-owned Flying J units -- that's had a larger impact on the company comp than it has on the franchise comp on the traffic side. One of the things that's kind of offset that impact on the franchise side is the number of remodels that the franchisees did at the end of last year, kind of completing our refresh program, and which helped carry over kind of into the first and even the second quarter here as well. So that -- there's kind of a differential there between the company and the franchise traffic fees.

[Michael Halen:]

Great. And can you give us a little more color on how those remodels are going? What kind of returns franchisees might be looking at right now?

[Whit Kincaid:]

Yes, we don't provide that information other than to say it certainly is -- it's on par with kind of the level of investment to make it worthwhile.

[Michael Halen:]

Okay. And can you -- one last question. Can you give us a little bit more color in terms of the operating gains? I understand that there was 17 company-owned units sold to franchisees. But just by comparison, there were also 17 sold in the fourth quarter of '11, but the operating gains were significantly less in that quarter. Can you give us a little bit more color on that one?

[Whit Kincaid:]

Yes, so there's a couple of things -- so back in 2011, we sold -- I'm trying to get the number off the top of my head. I want to say maybe 5 Flying J units. So that was part of it. Jay [ph] is going to correct me, hopefully. No? So 5 Flying J, and this was in the fourth quarter of 2010 so that certainly -- those units had not been open for a very long period. And then -- so that's part of the driver. And the other piece is this year some of the units have been -- some places like California where we have -- often have a number franchisees who are interested in these units. And that was the case here in the second quarter where these units tend to get higher multiples because they have higher -- more than one bidder they can get a little bidding war going. So we've seen that historically, and we've seen that, I would say, phenomenon certainly in the first and second quarter of this year.

[Operator:]

[Operator Instructions] Your next question comes from Conrad Lyon with B. Riley & Company.

[Conrad Lyon:]

It's a kind of 2-part question on mix. First part is how -- is it more difficult to control mix nowadays in this consumer environment? And the second part is -- and it's really kind of philosophical, say, have a challenging commodity environment next year. Would you try to alter mix depending on how commodities shape up next year?

[John C. Miller:]

So I'll start, Conrad, and there's, I guess, multiple ways to answer. But just the blessing and challenge of 4 dayparts. So we say, is it harder to control [indiscernible] you can move it, but sometimes moving it. So we, as you can tell, we had a little bit smaller mix-shift lift Q2-over-Q2 and Q2-over-Q1. And part of that was we've run with the diner theme for a while and it's time to return to pancakes. So Q2 had a very successful premier on Build Your Own Pancake program followed by the current Tour of America, which has obviously back to some really quality diner programs, but also it doesn't abandon breakfast. You have Philly Cheesesteak Omelette, the Red, White & Blue Pancakes and we have a Southern Slam for $5.99 value offering. So in a tough economic or value season, those start to pick back up again. So we had the pancake module which is a little lower than module 1 Skillets and we went into this one and $2/$4/$6/$8 kind of popped up a little bit plus the Southern Slam at only $6 on the LTO menu sort of stole a little bit of that mix lift. So we're actually getting pretty good at this but part of it is a mixed strategy and part of it's a price strategy. And so when transactions are soft, as Tony pointed out just a little while ago, we want to be careful here not to push the lid off. And it's a balancing act. But it's a very good question. And Whit, do you want to add to that?

[Whit Kincaid:]

Yes, the only thing I think I would add to it, Conrad, as you probably heard us talk about this before, is we try to look at it as the whole entity. Like John said, all 4 dayparts, everything kind of playing together in concert. So that is kind of the way we think about it. So hopefully -- and certainly, commodities comes into play in some respects as well.

[Conrad Lyon:]

Yes, got you. Okay. Last question. You may have talked about this in the past. As -- I'll use the term, I guess, recycle stores, new stores, some stores come off, is there a -- do you see a changing demo in your customer at all, where you might desire to go in a different trade area? Or are your trade areas that you desire to go into pretty much the same as before?

[John C. Miller:]

Yes, I will just say that when we have a 59-year history with 1,700 units -- near 1,700 units and near 60th anniversary, and with that we have just about every kind of trade area you can imagine. So obviously, larger footprint brands get closer to the middle of America. So one might say you have a working-class consumer in Certainville, America, that's really the laws of averages. In an upscale neighborhood, we serve upscale consumers. So I would say that our strategy is to fill in places where we're not, and which by its very definition, we'll continue to redefine our customer list [ph] -- who need a family dining experience.

[Operator:]

At this time, there are no further questions. I would now like to turn the call back over to management for any closing remarks.

[Whit Kincaid:]

Thank you, Lacy. I'd like to thank everyone for joining us on our second quarter earnings call today. We look forward to our next earnings conference call to discuss our third quarter 2012 results. Thank you, and have a great evening.

[Operator:]

Thank you for participating in today's conference call. You may now disconnect.