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Executives

Anita Booe - Director of Investor Relations

James Morgan - Chairman of the Board, President, Chief Executive Officer

Douglas Muir - Chief Financial Officer, Executive Vice President

Analysts

Michael Gallo - C.L. King & Associates

Will Slabaugh - Stephens Inc.

Conrad Lyon - B. Riley & Co.

Nick Setyan - Wedbush Securities

Howard Rosencrans - Value Advisory

Jerome Kaplan - Value Line, Inc.

Krispy Kreme Doughnuts, Inc. (KKD) F3Q2013 Earnings Call November 19, 2012 4:30 PM ET

Operator

Good day, ladies and gentlemen and welcome to the 2013 Krispy Kreme Doughnuts Incorporated third quarter earnings conference call. My name is Kim. I will be your operator for today. At this time, all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of the conference. (Operator Instructions) As a reminder, this call is being recorded for replay purposes.

I would like to turn the call over to Ms. Anita Booe. Please proceed, ma'am.

Anita Booe

Good afternoon, and welcome to the Krispy Kreme third quarter conference call. My name is Anita Booe and I am the Director of Investor Relations. On the call with me today are Jim Morgan, President and Chief Executive Officer and Doug Muir, Executive Vice President and Chief Financial Officer.

Some of the information in today's press release and statements on today's call includes forward looking statements that reflect our expectations or beliefs about the future including but not limited to our expectations and beliefs regarding financial performance. We cannot assure you that we will achieve or realize these expectations.

Like any such statements, they are subject to a number of factors, risks, and uncertainties that could cause actual results to differ materially from our expectations or beliefs. These factors include items discussed today and in our SEC filings, including our annual report on Form 10-K for fiscal 2012.

I would now like to turn the call over to Jim.

James Morgan

Thank you, Anita, and good afternoon everyone. We enjoyed an outstanding quarter at Krispy Kreme despite the current economic challenges and overall consumer uncertainty. We have often referred to Krispy Kreme as an affordable indulgence and that description was strongly affirmed in the most recent quarter.

We had an 8.5% increase in total revenues with improvements in both revenues and operating income in each of our forward business segments. Revenues were driven in part by the 6.8% increase in same store sales at company stores, the 16th consecutive quarterly increase. This improvement was driven by higher traffic and was accomplished without any pricing assistance.

In the wholesale channels, we had an increase in average weekly sales per door in both grocery mass merchants and convenient stores, all of which was driven by higher volumes. We achieved impressive leverage of our top line growth as operating income and adjusted earnings per share grew 66% and 71% respectively, on an 8.5% revenue gain.

While we are very pleased with these results, we continue to see significant untapped opportunities for Krispy Kreme. Therefore, let's now talk about our ongoing initiatives to capitalize on those opportunities, initiative that we believe will substantially increase revenues, improve margins, and expand the Krispy Kreme domestic and international franchise system, while growing shareholder value over the long term.

On the development front, we added a net 20 Krispy Kreme stores in the quarter, including one new company store and 19 new franchise locations. We ended the third quarter with 731 Krispy Kreme stores system wide, over 85% of which are franchised. In the quarter, we announced a new international franchise development agreement for Singapore and earlier this year, we announced two new development agreements for India and one for Moscow. We anticipate announcing additional new international development agreements in coming quarters.

We continue to be a small factory shop with full doughnut making capabilities as a driver in developing domestic markets. Combined with our two primary satellite formats, we will have the suite of shops concepts we need to bring the Krispy Kreme experience to millions more consumers, and we expect to do so at lower investment costs and with superior operating performance compared to our traditional formats.

We opened a new small factory shop in the Greater Charlotte, North Carolina market last week and it features our new one 110M production line, a totally revamped production system that has the capacity to meet consumer demand but occupies much less square footage than our traditional production line.

In terms of domestic expansion, with only 238 shops in the United States, we clearly have lots of room to grow. We plan to open five to 10 new company shops next year and we expect existing franchisees to open as many as 15 new locations. We are interviewing candidates for our Vice President of franchise development position to lead domestic franchise marketing and we are taking other steps in preparation of expanding the number of domestic franchisees.

In addition to these initiatives, we are working to enhance the value of our most cherished asset, our Krispy Kreme brand. We recently shared the key findings from our domestic consumer research which said more consumers will buy more doughnuts if we provide them with reasons and opportunities to do so. Therefore, our immediate focus remains on enhancing our core doughnut offerings, continuing to enhance the doughnut experience and creating more doughnut use occasions.

Consumers also view our beverage program as complimentary to our doughnuts and we continue to focus on building top of mind awareness for our entire beverage line-up and for drip coffees, iced coffees and specialty coffees in particular. Consumer response has been positive. We remain excited about our enhanced beverage program and are relentlessly pursuing its growth but we must emphasize that it remains a work in progress.

We continue to enhance our local relationship marketing programs to drive traffic and we are encouraged by early results from our ongoing programs of limited time doughnut offerings paired with exciting beverage offerings and believe they will continue to generate consumer interest and drive sales. In the coming weeks, we will be launching our annual holiday program featuring some original new doughnut creations and special beverages in conjunction with our traditional holiday offerings.

Now I will turn the call over to Doug to review our financials.

Douglas Muir

Thank you, Jim, and good afternoon, everyone. Total revenues in the quarter increased over 8% to $107 million and each of our four business segments generated top line growth. Consolidated operating income rose 66% to $9 million, while adjusted earnings per share rose 71% to $0.12 a share, that’s compared to $0.07 a share last year. In the company store segment, revenues increased 7% to $72 million.

Same-store sales rose 6.8% driven by higher traffic. We had no pricing benefit in the third quarter.

In the wholesale channel, revenues rose 2.6% driven by higher sales to grocers and mass merchants. Average weekly sales per door to grocers and mass merchants rose 6.9% year-over-year and that was our 15th consecutive quarter of improvement while the average weekly number of doors served declined about 3%.

Higher unit volumes accounted for substantially all of the increases in average weekly sales. Although the average weekly number of doors served declined 4.5% in the sea store channel as we rationalized accounts and eliminated some low volume doors, the reduction in doors was offset by a robust 4.7% gain in average weekly sales per door.

The company stores segment posted operating income of $2 million compared to an operating loss of $600,000 in the third quarter last year. We thought that was a pretty good improvement.

Looking forward, we expect fourth quarter costs for doughnut mixes, sugar, shortening and packaging will, in the aggregate, be slightly higher than what we experienced in the third quarter.

In the domestic franchise segment, third quarter revenues rose 7%. They were driven by higher royalties resulting form 6% increase in domestic franchisee sales including a strong 5% increase in domestic franchise comps. Operating income in the segment rose to $1.2 million.

Over in the international franchise segment, revenues increased 12% to $6 million, driven by higher royalties. Sales by international franchise stores rose 12.6%. Adjusted to eliminate the effects of changes in foreign exchange rates, same store sales at international franchise stores fell 7.7% reflecting, among other things, honeymoon effects from the substantial number of international store openings in recent years as well as cannibalization as markets develop.

The international franchise segment generated operating income of $4.3 million, up nicely from $3.3 million in the third quarter last year. That represents a big leverage improvement over last year as the international franchise segment operating margin expanded to over 71%. This is a profitable business but as we continue to add resources to develop and support our international franchise operators, we expect operating margin will decline somewhat from what we achieved this past quarter.

In the supply chain, revenues, including sales to company stores were $53 million, up about 5% from last year. The supply chain generated operating income of $7.3 million, compared to $7 million a year ago.

Turning to G&A expenses. We were pleased that G&A decreased 30 basis points to 4.7% of revenues. Our goal is to continue to leverage costs and operate efficiently as we grow the business.

Adjusted net income was $8.3 million, $0.12 a share, compared to $4.7 million or $0.07 per share in the third quarter last year. Adjusted net income and adjusted EPS reflect income tax expense only to the extent currently payable in cash. We think that’s the most appropriate metric to judge our performance because we have substantial net operating loss carryovers and the amount of tax as payable in cash is expected to remain insignificant for the foreseeable future.

I would now like to update our full year outlook. Based on year-to-date results and other factors, we are raising our operating income guidance and now expect to be in the $34 million to $36 million for fiscal 2013. That would represent year-over-year growth of between 30% and 40% and represents at least $2 million increase from our prior guidance.

We estimate fiscal 2013 adjusted EPS which again includes income tax expense only to the extent expected to be currently payable of between $0.44 and $0.47. That compares to $0.31 in fiscal 2012. I should remind you that fiscal 2012 adjusted EPS also excludes a gain of about $0.06 a share from the sale of our interest in KK Mexico.

On a GAAP basis, we project EPS of between of $0.26 and $0.27 which reflects and estimated book income tax rate of 45%. I should mention that this is a 53-week year and our fourth quarter will therefore be 14 weeks instead of the normal 13 weeks. In order to facilitate comparisons, the fiscal 2013 guidance I just shared does not include the anticipated but irregularly occurring benefits of that extra week.

Turning to next year, we would like to provide our preliminary thoughts for fiscal 2014. In terms of operations, we plan to open five to 10 company stores and have capital expenditure somewhere in the range of $20 million to $25 million. We expect domestic franchisees to open as many as 15 new stores and international franchisees to open more than 75 new locations. We expect organic same store sales growth in our domestic stores, both company and franchise.

International franchise same store sales are likely to remain modestly negative as a result of our substantial and continuing growth in international markets but we expect a continuation of the trend of improving comps internationally that we have seen over the past four years.

On the costs side, prices of agricultural and other commodities are expected to remain volatile and we will continue working to reduce consumption of key ingredients while taking other measures to combat higher input costs as an alternative to strictly just raising prices. As previously disclosed, we have purchased sugar well into fiscal 2015 at prices only slightly higher than we are now paying. We have already purchased about half of next year's shortening requirements at prices slightly lower than current year levels. It's been more difficult to nail down favorable pricing on flour and we currently have only about 10% of next year's requirement locked in.

On balance, based on current market forward prices, we expect our ingredient costs to rise modestly compared to fiscal 2013 levels and well within our ability to recover them through pricing or other measures but I should emphasize that next year is still a way off and much can change in volatile times.

Based on these factors, our preliminary guidance for fiscal 2014 operating income is between $38 million and $42 million. That range should produce adjusted earnings per share of between $0.49 and $0.55. That range reflects estimated income tax expense of $2 million which is our estimate of fiscal 2014 taxes payable in cash.

On a GAAP basis, we project fiscal 2014 EPS of between $0.29 and $0.32 and that reflects an estimated book income tax rate of 45%. I should emphasize that these are preliminary estimates and we plan to refine them when we release our fourth quarter results in March.

With that, I will turn the call back over to Jim.

James Morgan

Thank you, Doug. Before we begin the Q&A, I want to leave you with the following thoughts. Fiscal 2013 is shaping up to be a banner year for Krispy Kreme and we could not be more proud of our achievements across all business segments, as well as the achievements of our franchisees. None of this would be possible without the hard work of our team members as well as our franchise partners who bring passion to their tasks and delight in sharing our one-of-a-kind products with our customers and our guests.

Our strategic plan is the guiding force behind everything that we do and we believe that successful implementation is key to building a platform for sustainable growth in revenue and earnings. As proud as we are about third quarter and year-to-date results please remember that do not and we will not manage this business for the short term rather we will always make decisions based upon what we believe is the best for the long term interest of our business and our shareholders.

In our estimation, we have many years of growth ahead of us as we continue to improve sales volumes and profitability at existing company stores, building new company stores in core market, development a pipeline of international and domestic franchise locations and over time appropriately broaden our menu. All in all, we could not be more excited about our future.

We thank you for being with us today and operator we are now ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Michael Gallo with C.L. King. Please proceed.

Michael Gallo - C.L. King & Associates

Congratulations on another terrific quarter. Jim, the company ended operating margin, certainly the best we have seen in a long time. You were able to do that without any pricing at all in the quarter. So does it speak to just the sustainability of those margins? I know you have a little bit more pressure on food costs but presumably at some point maybe next year you may have some pricing coming in to the equation as well. So help us a little bit with company stores, how much of that improvements will just be in the labor line, and just elaborate what's in the comp and anything unusual that would affect the sustainability of that. Thank you.

James Morgan

Mike, I will give you general answer to that and let Doug give you a little more specific. The general answer is, I think what we are seeing is a result of the last few years of laying the foundation to allow us to get those margins to begin to improve. I think we are probably would be very happy with comp store sales on unassisted by pricing next year lower than they are this year, obviously low single digits. But I do think the foundation is laid for that growth to continue and I do think the foundation is laid for the margins to continue and have the potential to increase.

So having said that generically, I will let Doug give you a better specific.

Douglas Muir

Yes, Mike. There are several things at work and let me just touch on them. I would say, first and foremost, a little top line goes a long way in this business and is a significant uplift in the quarter just purely from higher revenue through a fixed cost base and, of all the items that affected the quarter, that is the largest one. But there are lots of other good news.

You mentioned commodities may have been volatile. Compared to the third quarter last year, our math suggests that we benefited by about $700,000 from lower commodity costs all in the quarter compared to last year. Sustainable or not, we will all see what markets do, but there were some other good stories.

Material consumption improved in the quarter, compared to a year ago. Our shop labor improved in the quarter compared to a year ago. There's just a whole litany of things that I think, really our SG&A indicated reflective of what we have accomplished over the long term and I think there is more to be had.

There is nothing in the quarter in terms of one-off kind of items. So I think, I wouldn’t necessarily want to predict that we are going to make $2 million every quarter in that business but we think we are headed in the right direction and the numbers reflect that.

Michael Gallo - C.L. King & Associates

Okay, great. Then the second question, could you give us an update on what you are seeing in the beverage program? What you saw in increases in beverage sales? To what degree that helped your overall transaction count? Was it again just doughnut sales just outweighing everything else? That business was growing much like the second quarter or help us just with a little information on the beverage business. Thank you.

James Morgan

Mike, this is Jim again. It was an interesting quarter on the beverage side. Number one, total beverage business did go up nicely. It should when you have got that kind of same store sales increase but we were going against the introduction quarter, a year ago, on the coffee. If you remember we launched it on Labor Day, a year ago. So the number of units did not go up the way we would have, well on moments that we would hoped.

If we would have thought about it, we would have realized that was going to be a tough comparison and we really pushed it during that quarter last year. So I am excited that we are underway with both coffee and beverage overall becoming more significant to us. I think probably slowly but surely you will be seeing numbers in participation contribution from that become more and more significant over the next couple of years.

Michael Gallo - C.L. King & Associates

Any early read on lattes and espresso based drinks?

James Morgan

Too early on that but we have got them out there. We got the equipment out there. We are beginning to have fun with it.

Operator

Your next question comes from the line of Will Slabaugh with Stephens. Please proceed.

Will Slabaugh - Stephens Inc.

Congrats on the quarter. Wonder if you can speak to the promotional activity in the quarter and your successes there? More particularly the National Coffee Day promotion, Pirate Day, you guys have had, Halloween promotion and just how all those play out relative to expectations?

James Morgan

Will, again, I will give a generic answer and let Doug fill in the blanks. But I am beginning to think none of those, if you take the individual day of those, were life changing in terms of what happened that day but what we are learning with the tremendous work that’s done through, PR and social media, from our marketing group, is that it is much more than a one day. The energy that gets created in our stores, within our stores and around our stores with our customers and guests has a halo effect and the shortages get as much more front of mind and we see the period of time leading up to that and the period of time after those events picking up.

So that’s something we are having fun with. Those days are surely good. Its high-high traffic but, as you know, we are used to doing a pretty nice promotion but then the aftereffect seems to last longer than we would have thought and so I think that benefited the quarter that way more than the specific day. Doug?

Douglas Muir

Yes, just some color on that. Pirate day, National Talk Like A Pirate day was September 19. I don’t have daily comps, but the overall comp for the week of that week was up 6%. So not really out of line in what we saw for the quarter as a whole.

Coffee day was probably a little bit less lift. We were about 4% that week but given that we are not known the world over for coffee just yet. I am not sure I would characterize that by any means a disappointment. We just certainly viewed it as a way to introduce customers to the product and give away some coffee, get people to try it.

So I would characterize promotion as good solid repeatable and replicable performance in the quarter and that’s really what we would like and not to have a business that is dependent upon hitting home runs.

Will Slabaugh - Stephens Inc.

Got you. So its safe to assume there is a fairly strong pipeline of additional promotions or at least similar marketing going forward?

James Morgan

Yes, I think we are looking forward to having other reasons to have fun with it and let our guests and buyers have fun as well.

Will Slabaugh - Stephens Inc.

Great. Then, you touched on this earlier but wondered if you could speak again to pricing and how you think about that in to next year as the commodity environment being as volatile as Doug mentioned earlier?

Douglas Muir

Well, you are reading our minds. We are watching that in conjunction. We are seeing those as being tied together. It's been about 18 months since we took in new pricing. That’s a round figure but that’s pretty close. So we are watching it and feel very comfortable that it appears to be the right thing to do that we are in a position to be able to accomplish that in a positive way for results. No decision is made yet.

Will Slabaugh - Stephens Inc.

Okay, and lastly for me, could you break out the traffic in an average check movement during the quarter?

James Morgan

Yes, hang on a second, well I have to find the right paper. I have flipped through the other page and I got to find this one. Yes, here is the breakdown.

The overall comp was plus 6.8 in the quarter, 7.1% of that was driven by traffic. It was a minus 0.3 on check and that’s pretty much it. The rest is little teeny numbers.

Operator

The next question comes from the line of Conrad Lyon with B. Riley & Co. Please proceed.

Conrad Lyon - B. Riley & Co.

I am still scratching my head on that traffic. That's impressive. So just pure execution is what it is. There wasn't any particular LTO that jumped out or anything like that?

James Morgan

There really wasn’t, Conrad. Listen, we spent the last couple of weeks trying to make sure that there wasn’t because were pleased with it too. I really do believe though, I don’t think we can emphasize enough the work that has been done in the last couple of years to get us in the position for this to begin to happen for us. So I am really thinking that when you add the work that has been operationally and the marketing team has now been together for a couple of years, that those are the major factors and the fact that we are just blessed with an incredible product and an incredible brand.

Conrad Lyon - B. Riley & Co.

It sure is. Question regarding this Hostess thing, not that it's going to create anything in particular for you guys. But do you think that is a potential opportunity to gain share with the wholesale business?

James Morgan

Well, we would probably rather not comment on that. Although, if you saw the latest news, it looks like they are back at the table with the union. So my guess is that we will be back to "status quo" sooner rather than later.

Conrad Lyon - B. Riley & Co.

Yes, exactly, okay. Question on G&A, fantastic job controlling that. Should we expect that type of run rate to continue going forward also into next year?

James Morgan

You certainly should not expect that run rate into the fourth quarter. As you know from studying our past filings, we have a disproportionately high charge for share-based comp in the quarter because that’s when the annual grants are made to executive officers and a number of us are retirement eligible which results in an immediate P&L charge on the grant date for the entire value of the award. All things equal, that adds about $1.2 million to G&A in the fourth quarter relative to the third quarter. But I think, our goal, as we look next year, if you just look at the G&A line in total, is that needs to be a pretty flattish number and that’s what we are working on.

Douglas Muir

We really see that one as opportunities to leverage the top line potential that we have and we are pretty committed to that. We think we can do that without any harm to being able to provide proper support for the growth that we see coming.

Conrad Lyon - B. Riley & Co.

Okay, in terms of growth next year on the company side, how many of those will incorporate the 110M?

James Morgan

Hang on, I got a list. I just have got to find it. Okay, and keep in mind this is forward-looking and things can change. It looks like, as of right now, my count right now is about seven of them.

Conrad Lyon - B. Riley & Co.

So does that imply that you like what you are seeing with it?

James Morgan

It implies that we think what we have seen so far is by no means just positive but we haven’t seen anything about it that we don’t like so far and again it’s the physical size of the machine, the gating item to the 2,200 square foot box. So we have said all along, we like this model. We think it's going to work. So we are going to build it.

Conrad Lyon - B. Riley & Co.

Got you, any particular geographic region that you plan to go into?

James Morgan

Well, in the Southeast, generally. I can be a little more specific on that. We are looking at, locations you should look at for next year, are Knoxville, Jacksonville, Florida, that is, Atlanta, Tidewater, Virginia, right down the road in Burlington and potentially Richmond.

Douglas Muir

And, Conrad, I think, about year-end you will see, I would be surprised if you don’t see couple of those in the domestic franchisee world as well. We just don’t know exactly where those are going to be at this point.

Conrad Lyon - B. Riley & Co.

Got you, okay. In terms of CapEx next year, any color on that?

James Morgan

Not a whole lot. Our track record on that is usually under-spending to our guidance. The one thing that I expect to occur next year, that is different from what you have been seeing, is the technology spend. We are in the process of selecting a new ERP package to replace the one that we currently have. It's close to 20 years old. That is a significant amount of dollars associated with it.

We are seeing those dollars in P&L this year as we go through requirements definition. All those costs are being charged off, but once we select the packages go and into implementation next year you will see some CapEx for that.

Since we haven’t selected the package, we are designing the implementation plan. I can't speak to you how much that might be but ultimately it's clearly well in to a seven figure number.

Conrad Lyon - B. Riley & Co.

Got you, okay. Last question here on the international, more a qualitative thing. I like the improvement, but they are still seeing the honeymoon effect. Is there an average that you are seeing for the honeymoon effect, as a means to try to gauge when we should see the comp or the rate of improvement with that comp?

James Morgan

There is not that we have been able to find a terribly useful gauge, and that is simply because the experience that we see vary so much from market to market that it is just hard to draw conclusions about how high the honeymoon curve is on the front end and how long it takes to reach a normalized level. It is just very difficult to generalize so far.

Douglas Muir

It is literary ranging from months to years.

Operator

Your next question comes from the line of Nick Setyan with Wedbush Securities. Please proceed.

Nick Setyan - Wedbush Securities

Thanks, congrats on a great quarter. It seems like free cash flow for this year will pretty conservatively exceed $35 million, probably even $40 million. You guys don't need too much of that in terms of the CapEx guidance. Can we possibly see a one-time dividend or another share buyback or maybe even with the accelerating cash on cash returns in the company units, why couldn't we see a few more stores?

James Morgan

Well, I think you are right in our script. I think I am just going to say this. Everything is on the table. We are talking about that. Trying to decide what would be in the best interest of our shareholders and in the best interest of our long-term growth but certainly the idea of increasing our investment into our company stores is one of the possibilities as well as something more direct for the shareholders such as a dividend or such as another stock buyback but no decision has been made on any of those.

I think that the last buyback, we feel good about that right now. It was definitely accretive and therefore beneficial to all of our current shareholders and so we can do something that’s beneficial to all the current shareholders without handcuffing our ability to grow the company is something we consider.

Nick Setyan - Wedbush Securities

Great, and I maybe looking ahead a little bit. The healthcare impact discussion has been a topic among your peers. So I was wondering maybe if you could maybe take a stab at talking about whether you have discussed it or you have looked at the possible impact starting in calendar 2014 for at least the company units?

Douglas Muir

Yes, we sure have and here is what it is. There is further detail on this on in the second quarter Q, but just to recap it, we have currently about, give or take, about 1,500 employees to whom we do not currently provide subsidized healthcare benefits. As near as we can tell, we would be required to provide them some benefits if the law is implemented as it is currently structured. That represents about 35% or so of our entire workforce.

There are a number of unknowns in trying to figure out the cost of all of this because a number of requirements are subject to regulatory action and the regulations haven’t been written yet. So we are shooting in the dark to some extent because we don’t know exactly the scope of the benefits that we are going to have to provided and I can't give you an exact number but our current prognostication is this that we do not think that our incremental healthcare cost in calendar '14 will increase over calendar '13.

At the outside, we would call the number $5 million. We think it is probably less than that and it may in fact turn out to be substantially less than that. As we get some more information from the regulators and have a chance to plan and think through our mitigating activities to try and control that cost pill we have to swallow, will be able to sharpen up that estimate.

James Morgan

Our intent is to work as hard as we can to fully mitigate it, but it's going to take us a little while to determine exactly the manner in which we go about that.

Operator

(Operator Instructions) Your next question comes from the line of Howard Rosencrans with Value Advisory. Please proceed.

Howard Rosencrans - Value Advisory

Congrats on the quarter. In one of the prior answers, you gave out a number of seven, is that the number of company stores you are looking at opening?

James Morgan

We would call the number next year, Howard, at five to ten company. I guess it is probably at the high end of that range. Seven is the number of those that we expect to be using our new 110M machinery.

Howard Rosencrans - Value Advisory

Okay, so are those the 2,200 square foot boxes?

James Morgan

Yes, sir.

Howard Rosencrans - Value Advisory

Okay, and how much do those decrease your cost by or just that the output is so much higher, can you just give us some more color in that regard?

James Morgan

Well, it’s a number of things. Just on the pure operating characteristics of the machine itself, So far we have found it to be a very efficient production line in terms of its consumption of raw materials. I think the bigger payoff perhaps on it though is that as we indicated, the small 110M machine is the enabler of 2,200 square foot box and not a 3,000 or 3,500 or 4,000 foot box. It's when you can do your retail business out of that small box instead of the big is when you really pick up your higher sales to investment ratio and other unit operating metric improvement

I should also add that these new stores are all retail only. They don’t serve the off premises business and that inherently makes them a lot simpler to operate, simpler to train new crew, train new management. I think there is just a variety of reasons that a smaller, simpler and less costly box, is likely to be the driver future.

Howard Rosencrans - Value Advisory

Okay, and the uptick of domestic franchisees has been a little slow. I am just wondering, do you feel like if it is bringing in somebody new is going to be the game changer or the new 110 machinery enabling the smaller box is going to be the game changer? Where would you like to be in a couple of years in terms of the domestic franchise? If you were to look out, say, two years, you get the right guy in for franchising and the box works, how many domestic franchises do you think we could have in a couple years?

James Morgan

Howard, its Jim and I will answer that as best as I can. Yes, I do think bringing the new VP is going to be significant but what we are doing behind-the-scenes, is doing a lot of things to prepare us for that. We have a lot of market surveying, things to kind of get us to where we want to go. We are not actually out soliciting at this point in time. So am I disappointed in the face of that hire?

I probably am, but it is not because we hadn’t had wonderful candidates come. We are really, really going about this methodically. I am making sure we bring the right person in to make a difference and to hit the ground running. So we are prepared for that person to be here.

I think you will hear a lot more about this during the coming year. As far as number of franchisees, two or three years from now, I haven’t really gotten to the point where that specific. We hope this new person coming in will help us architect the pace at which we can manage it. It will be a question of probably support resources more than it will be interest from potential franchisees.

Howard Rosencrans - Value Advisory

And any data points on the new stores, the new company stores that you opened up with the 110M machinery?

James Morgan

In terms of results, so far so good.

Howard Rosencrans - Value Advisory

But how many do we have and how many…

James Morgan

Yes, hang on, let me find the right piece of paper. We currently have, four of new small factories in operation. Two of those, we have operated for many years. The other two are both in the Charlotte market, Greater Charlotte. One of them has the 110M and one of them has a plain 110. We have opened those stores basically all within the past quarter and while they are running fine to this point I do not have an extended operating history to share with you. They are just too young at this point but as you know we have been running the 110M in an established store in Gastonia, North Carolina for probably a couple of quarters now with very, very good results.

Operator

Your next question comes from the line of Jerome Kaplan with Value Line, Inc. Please proceed.

Jerome Kaplan - Value Line, Inc.

Hello, guys, great quarter. I was just wondering about your franchisee in the Middle East because I noticed he has been selling stock in the last couple of months. Do you have any comments about that?

James Morgan

No. he has actually done that, I think for several months. The original head of that company actually passed away about a year or so ago. So we had to make a guess. Well, my guess is it has something to do with that but they are just reallocating portfolio over there as we can tell.

Operator

I have no further questions at this time. I would now like to turn the call over to Anita Booe for closing remarks.

Anita Booe

Thank you for your time today and we look forward to seeing you at the upcoming ICR Exchange Conference in Miami. Good night.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.\

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