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Denny’s Corporation (NASDAQ:DENN)

Q3 2008 Earnings Call

October 28, 2008 5:00 pm ET

Executives

Nelson Marchioli – Chief Executive Officer

Mark Wolfinger – Chief Financial Officer

Alex Lewis – Vice President of Investor Relations and Treasurer

Analysts

Karen Eltrich – Goldman Sachs

Michael Gallo – C.L. King & Associates

Reza Vahab-Zadeh – Barclays Capital

Brian Hunt – Wachovia Capital

Tony Brenner – Roth Capital Partners

Eric Wold – Merriman Curhan

Mark Smith – Feltl & Company

Steve Anderson – MKM Partners

Ken Bann – Jefferies and Company

Operator

Good evening! My name is Heather, and I’ll be your conference operator today. At this time, I would like to welcome everyone to the Denny’s third quarter 2008 earnings conference call. (Operator Instructions). I would now like to turn the call over to Mr. Alex Lewis. Sir, you may begin your conference.

Alex Lewis

Thank you, Heather. Good afternoon and thank you for joining us for Denny’s third quarter 2008 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. Mark will begin today’s call with financial review of our third quarter results. After that, Nelson will provide his overview of the business and our strategic initiatives. After our prepared remarks, management will be available to answer questions.

Before we begin, let me remind you that accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the company knows that certain matters to be discussed by members of management during this call may constitute forward-looking statements. Management urges caution in considering its current trends and any outlook on earnings provided on this call. Such statements are subject to risks, uncertainties, and other factors that may cause the actual performance of Denny’s to be materially different from the performance indicated or implied by such statements. Such risks and factors are set forth in the company’s annual report on form 10-K for the year ended December 26, 2007, and any subsequent quarterly reports on form 10-Q. One note, our form 10-Q for the third quarter will be filed later on this evening, so you can pick that up as well. With that, I’ll now turn the call over to Mark Wolfinger, Denny’s EVP, CAO, and CFO.

Mark Wolfinger

Thank you, Alex, and good evening. I’ll start my comments with a quick review of our third quarter sales performance. System-wise same store sales decreased 5.1% in the third quarter, comprised of a 2.7% decrease at company restaurants and a 6.1% decrease at franchise restaurants. There are many factors that might contribute to the difference in same store sales between company and franchise restaurants including the timing of pricing actions, geographical variances, and the exclusion of same-store sales from restaurants sold over the last year.

Looking at the details for company sales performance, an 8.8% decline in guest counts was partially offset by 6.7% increase in average guest check. Most of the growth in guest check was attributable to pricing actions taken over the past year to help offset minimum wage hikes and commodity cost pressures. The remaining growth in guest check was attributable to a reduction in discounting compared with the prior year period. In fact, our discounts per guest in the third quarter were down 26% compared with prior year as we have reduced our use of these less profitable sales drivers.

Company restaurant sales for the third quarter reflect a continued impact of our Franchise Growth Initiative or FGI, as sales decreased $56.2 million or 26% due to 137 fewer equivalent company restaurants compared with the same period last year. Since the beginning of 2007, we have sold 192 company restaurants or 37% of the company’s store base at that time. As a result, we have increased the mix of franchise restaurants in the Denny’s system from 66% to 78% over the last 21 months. As the successful execution of FGI is ongoing, the sequential decline in company units, company restaurant sales, and company restaurant income is expected to continue while franchise revenue and franchise income are expected to continue increasing.

Turning now to the quarterly operating margin table in our press release, our company restaurant operating margin in the third quarter was 13.3% of sales, an increase of 1.4 percentage points compared with the prior year period. We are pleased to have generated significant margin improvement in the third quarter as our primary costs, food, and labor, have been under pressure for more than a year from substantial commodity inflation and minimum wage hikes.

The most significant change in our second quarter in our P&L was a 1.4 percentage point decrease in food costs. In addition to price increases taken to help offset commodity inflation, we have been proactive in managing our menu mix in order to reduce our food cost per guest while still providing a compelling value offering to our customers. The Build Your Own Grand Slam continued to sell well throughout the third quarter after its second quarter launch and continues as one of our highest margin items.

Payroll and benefit costs increased a slight tenth of a percentage point to 40.8% sales in the third quarter as more efficient crew level and management labor costs in the current quarter were offset by a 1% increase in Workers’ Compensation costs attributable primarily to a benefit in the prior year period. Utility expense in the third quarter increased 0.6% due to higher energy costs which peaked in the third quarter and have since begun to subside.

On the franchise side of our business we were experiencing the offsetting positive impact from the FGI program as equivalent franchise restaurants increased by 141 units in the third quarter compared to the prior year. This contributed to a $4.1 million or 17% increase in franchise revenue. This revenue growth was comprised of $2.8 million increase in franchise rental income, a $1.2 million increase in franchise royalties, and a $200,000 increase in franchise fees. Franchise operating margin increased by $2.2 million as higher franchise revenue offset a $1.9 million increase in franchise cost, primarily related to rental expense on properties subleased to franchisees.

General and administrative expenses decreased $1.1 million from the prior year period, due primarily to lower salary and other compensation costs attributable to the new organizational structure we announced in the second quarter. Depreciation and amortization decreased $2.1 million from the prior year quarter due primarily to the sale of restaurant operations and real estate assets over the past year. Operating gains, losses, and other charges increased $4 million from the prior year period due primarily to a $2.9 million decrease and restructuring impairment charges and $1.1 million increase in asset sale gains from with the prior year period.

Including these items, operating income for the third quarter increased $4.8 million to $20.7 million. If you exclude the gains, losses, and other charges from both periods, operating incomes increased $800,000 in the quarter despite a decrease in total revenue of $52.1 million. Below operating income, interest expense in the third quarter decreased by $1.7 million or 17% to $8.8 million as a result of a $70 million reduction in debt from the prior year period. We reported net income in the third quarter of $10.6 million or $0.11 per diluted common share, an increase of $5.6 million compared with the prior year period.

Because of the significant impact to our P&L from non-operating, non-recurring, or non-cash items, we give earning guidance based on our internal profitability measure, adjusted income before taxes. We believe this measure best reflects the ongoing earnings of our business. Our adjusted income before taxes in the third quarter was $8.5 million, an increase of $2.7 million, or 47% over the prior year period. We are very pleased that we were able to generate significant income growth despite the difficult sales and margin environment for the restaurant industry. We believe this is evidence of the progress we are making in our strategic initiatives, in particular the success of FGI as well our debt reduction efforts.

To the summarize our P&L for the third quarter, the sale of company restaurants to franchisees resulted in a $56.2 million decline in company-restaurant sales and a $4.5 million decrease in company restaurant income. We more than offset this lost company restaurant income through the combination of a $2.2 million increase in franchise income, a $1.1 million decrease in general and administrative expenses, and a $2.1 million decrease in deprecation and amortization expenses, and a $1.7 million decrease in interest expense. We expect our P&L will continue to reflect these income and expense shifts as we continue our transition to a more franchise-based business model.

To put this income shift into perspective, in 2006, our company operations generated two-thirds of our gross profit, and our franchise operations contributed one-third. In the third quarter of 2008, the contribution from our much higher margin franchise operations had increased to 48%. We expect to continue this beneficial shift from company operations with margins around 12% to franchise operations with margins of approximately 70%. By the end of 2008, we expect one-half of our gross profit will be contributed by our franchise business. This income shift allows us to lessen the risks and increase the predictability of our P&L. The optimization of our business model is evident in our increasing company restaurant margins, our increasing company average unit volumes, the decrease in our capital spending, and ultimately in our long-term free cash flow generation.

Turning to activity in the Denny’s restaurant portfolio during the third quarter, the system decreased by a net seven units as 8 new restaurants opened while 15 were closed. The new 8 openings were all franchise restaurants bringing the year to date franchise openings to 19 which all surpassed the franchise opening total in 2007 of 18. We updated our guidance today for full year 2008 franchise openings to a range of 26 to 29. This is a slight decline from our previous estimate as the difficult financing environment has slowed the development process and pushed a few expected openings into 2009. Of the 15 closures in the third quarter, 14 were franchise restaurants and 8 of those related to one failed franchisee.

Moving on to capital expenditures, our cash capital spending for the third quarter was $6.3 million, a decrease of $1.5 million compared with the prior year period. We expect our cash capital spending to continue trending downward as we reduce our company restaurant portfolio and limit our new restaurant investments. Today, we lowered our cash capital guidance for 2008 to $27 million which would imply a $6 million decrease from the prior year fourth quarter and the prior year.

Turning to asset sales in the third quarter, we generated net proceeds of $8.2 million from the sale of 21 company restaurant operations and an additional $2.2 million from the sale of certain real estate. On a year to date basis, we’ve generated net sales proceeds of $30.2 million from the sale of 62 restaurant operations and $3.8 million from the sale of certain real estate. Excluding those receivable taken for $2.7 million of the sales proceeds, we took in $31.4 million in cash during the first nine months of the year. We used these proceeds to reduce our outstanding debt by $15 million during the year. In addition, we held back a portion of the proceeds in cash, as you can see in our cash balance which increased from $12 million at the end of second quarter to $21.4 million at the end of third quarter. We chose to take a conservative approach to our cash management, particularly in advance of our October 1st semiannual interest payment on our senior notes of $8.8 million. We have made that payment and are once again building up our cash reserves. We expect to apply the majority of any fourth quarter asset sales to debt reduction and may choose to make additional voluntary prepayments as we have done in the past.

Given the challenges facing our national economy and our industry, we are very pleased to have reduced our debt by $216 million or 39% over the last 2-1/2 years. Through our efforts over the past few years, we are now in a financial position to manage through difficult operating environments like we find ourselves in now. I think it is worth restating that we have no material debt maturities in the near term as our revolver is in place through December 2011 and our term loan through March 2012.

That wraps up my review of our third quarter results. Before I discuss or revise guidance for the year, I would like to take a minute to talk about the status of our Franchise Growth Initiative or FGI. We have made considerable progress through FGI to optimize our business model and energize growth across the Denny’s system. Despite the headwinds in our industry and in the financing markets, we closed the sale of 21 restaurants in the third quarter consisting of 4 sold in August and 17 sold in September. As you saw in our release, we still expect to meet our original guidance range and close the sale of 75 to 85 company restaurants this year, implying 13 to 23 more restaurants to be sold in the fourth quarter. Transactions have certainly become more difficult to complete and lender are requiring more conservative financing terms for buyers, but we still have considerable demand for the FGI program, and we are still working on new deals.

Several of the recent or pending deals are second FGI transactions meaning the buyers completed an FGI deal last year or early this year and are back negotiating for more. The financing bottleneck is challenging, but as long as we continue to have a strong demand to grow with Denny’s, we will continue to move forward on this important strategic objective. As a reminder, it is important to remember that we are selling these restaurants because it is the right strategic action not because we have a financial requirement to do so. In fact, our liquidity remains very strong with cash and revolver availability of over $70 million at quarter end.

As for other guidance, we have updated certain metrics for the full year based on our year to date results and management’s expectations for the fourth quarter. Given the economic pressures that continue to impact our customers, we expect our fourth quarter same-store sales will be similar to our third quarter results, yielding a full year company store comp of -1% to -2% and a full year franchise comp of -4% to -5%.

The challenging sales environment has not kept us from making significant improvements and profitability during the year. We now expect adjusted income before taxes of approximately $20 million for the year. This is a substantial increase from our original guidance of $8 to $14 million and a 90% increase over the $10.5 million in adjusted income reported for 2007.

In addition, our expectation for capital spending has been lowered to $27 million as we continue to adjust our capital expenditures based on our business model transition and in order to meet our cash flow objectives. The other guidance metrics provided in our press release have been updated moderately based on our year to date trends and the impact of FGI transitions during the year. That wraps my commentary on guidance. I’ll now turn the call over to Nelson Marchioli, Denny’s President, and CEO.

Nelson Marchioli

Thank you Mark, and good afternoon everyone! Let me start by saying I’m pleased with the earnings growth we have generated this year. Our franchise growth initiative and the other strategic initiatives we have undertaken to optimize our business model are clearly making a positive impact. A 47% increase in core income this quarter would be welcome in any period, but to realize that achievement in such a difficult environment confirms our strategic direction. While our strategic successes have provided some insulation against the current macroeconomic pressures, they do not lessen the critical need to reverse our negative guest count trends. The improvements in our restaurant operating margins have resulted from higher menu pricing to offset cost pressures to promotion of menu items with exceptional food cost margins and the sale of lower volume, less profitable restaurants. All of these factors have contributed to earnings growth as we had anticipated, but we did not have the opportunity for organic sales and margin growth.

Consumers are eating out less, and when they do eat out, they are far more focused than ever on price. Our most successful promotion this year was Build Your Own Grand Slam, which offered a strong value to our customers, but also provided Denny’s a strong food cost margin. A couple of weeks ago, we launched our $4 Weekday Express Slam which provides a full breakfast at a compelling price point. We must continue to deliver value-driven promotions such as these along with a continuous lineup of new product introductions in order to build profitable and sustainable sales growth. Value has always been one of Denny’s primary consumer core attributes. Our marking team is following a plan that is focused around real breakfast and builds upon that core attribute with new messaging, new business opportunities, and new product news. We are proud of the new initiatives we launched this year for late night as well as to-go.

The Denny’s All Nighter Campaign is consistently putting Denny’s in front of an important demographic, 18 to 24-year-olds four our late night business. Our to-go initiative allows Denny’s to enter the consideration set for off-premise consumption. We must continue to provide the support necessary to build consumer awareness for these opportunities to grow the Denny’s business in all day parts. We have also been encouraged by the reception to our new product launches including the Sizzling Skillet Breakfast and more recently the Sizzling Skillet Dinners. The repurchase intent on these items has been strong, but we haven’t been able to drive the incremental traffic we had hoped for. Attracting new customers or more frequent visits from existing customers is more difficult than ever to reduce consumer spending and increase competition. We believe in the components of our marketing plan, but understand that in this environment, it will take continued reinforcement for a significant period of time before we can expect to reverse our sales trends. For that reason, we do not foresee a material change in our sales results over the reminder of 2008 and quite possibly for much of 2009.

This year, we have successfully focused on profitable sales programs, cutting operating costs, and improving the efficiency of our corporate support structure as we transition from a company to a primarily franchise-based business. We will continue these initiatives along with a conservative capital budget to ensure that we continue to produce positive free cash flow. As you know, Denny’s is a strong brand that has stood the test of time. Over the past few years, we have greatly strengthened Denny’s financial position. While many in the industry were adding leverage, we were aggressively reducing debt and extending our maturities. We are now in a favorable position to manage through these very difficult times. We will continue to focus on our core strengths of breakfast and value. Through our strategic initiatives and day-to-day execution in our restaurants, we believe that we can continue our financial performance improvements and enhance shareholder value over time. As always, I thank you very much for your interest in Denny’s. I’ll now turn the call back over to Alex.

Alex Lewis

Thank you, Nelson, and I’ll ask Heather to prepare the Q&A.

Question-And-Answer Session

Operator

(Operator instructions). Our first question comes from the line of Karen Eldridge with Goldman Sachs.

Karen Eltrich – Goldman Sachs

First off, obviously with corn coming down where it is, I think probably the outlook for commodity costs next year has been altered. How has it altered your view? What have you locked in for next year and are there some things that maybe you’re waiting on?

Nelson Marchioli

If you look at corn, you are absolutely right. It has dropped quite a bit, but keep in mind 2 years ago, it was half the current selling price, so we still are in quite an inflationary period as we look at corn. The only corn that we have locked in at, at this particular time has been in our formula as we purchase our liquid egg product which is considerable, but that is the only corn that we’ve locked in on, and I don’t recall what we locked in on it at, but it is a place where we can live.

Karen Eltrich – Goldman Sachs

What about some of the other commodities? What is your outlook right now in terms of locking at current prices if you can or to wait and see if they come down lower as well?

Nelson Marchioli

As we look at commodities as we have always looked at commodities, you can’t be greedy. You have to look at it and find a place where you can live with the price. I don’t know where they are going to drop, if they are going to drop anymore. There are a number of buys compared to what we have seen over the last 2 years, last year particularly, so we are locking in some things, but we are being very careful, and there are others that candidly we are going to continue to ride the market on because it just doesn’t make any sense at this point in time.

Karen Eltrich – Goldman Sachs

A lot of things don’t make sense right now so I can appreciate that. I do think a lot of the strategies you’ve undertaken with your menu this year have been beyond innovative and creative and it sounds like you are a little frustrated that they haven’t necessarily taken hold. I’m curious to see what traction are you seeing that keeps you encouraged particularly for the late night menu as well as for the takeout. Do you feel that with additional marketing or just with time and a better economy, they will take hold? What are your thoughts so far on the progress?

Nelson Marchioli

In the past, and I’m probably going to quote some numbers here that haven’t been quoted before and my CFO will look at me here in a moment and wonder why I said this, but our average on takeout sales across the chain for company store sales was 3.6%, and when we introduced our new takeout packaging and began talking about takeout on television at the backend of commercials, we saw that rise to almost 5% incidence, and of course, takeout is very profitable for all of us in the restaurant industry because candidly it doesn’t take a lot of effort and doesn’t take a lot of incremental labor. So one of the reasons why we continue to talk about takeout and we want to encourage takeout sales and continue to put that in front of our customer is that it is profitable and they have responded. On late night, almost the same story, but not quite. Late night with fast food a couple of years ago and many of our competitors entering the 24-hour market which we frankly almost owned alone is our second most frequently mentioned core attribute from our consumers, that being 24x7. We saw a significant decline in guest count over the last two years. We have stopped that decline and in fact reversed it, although I’m still negative, far less negative, and we began to speaking to our 18- to 24-year-olds. 48% of our customers between 10 p.m. and 5 p.m. are 18 to 24-year-olds, and we spoke to them before, so we began internet advertising. I think I mentioned on one of the earlier analysts’ phone calls that we invested $5 million earlier this year in internet advertising and MTV late night things like Adult Swim and other things frankly that we hadn’t spoken to 18- to 24-year-olds before. So they have responded. It in fact is one of our strongest day parts now, and now we need to do the same thing with the other day parts, but I’m particularly encouraged by the fact that our late night customer has responded when we’ve spoken to them. We’ve changed the environment and the level of friendliness and menu items and offering value at late night, and going back to the takeout, we obviously are giving it more visibility, and that’s why I’m encouraged by those two things, and where we have to continue to work to build our business for the future and why I’m encouraged by it is when people think of Denny’s, they still think of Denny’s first and foremost as a breakfast place, and our weekday breakfast candidly for the entire history of the brand from what I can tell on weekdays has never been our strong suite, and that is a huge business. Thanks to fast food and now participating at a $4 level, we’re now a player, particularly if you consider takeout, and you don’t have to settle for a real breakfast, and our research is telling us that, and we are seeing improvement in that day part, although it’s too early to make a call.

Karen Eltrich – Goldman Sachs

I knew there was more to brag about than what you led on in your opening comments.

Management

There’s more than that. Hopefully, I’ll restrain myself for the balance of the call.

Operator

Our next question comes from the line of Michael Gallo with C.L. King.

Michael Gallo – C.L. King & Associates

Obviously you guys have done a very good job over the last couple of quarters of improving profitability even as you obviously have had some topline softness. My question is as we go forward assuming we’re going to be in a difficult topline environment for the foreseeable future, are there still things that you can continue to do to improve results from here? Do you feel like you’re going to need to see the topline turn around in order to continue to see improvement, or any just any comment you can give us on some things you’re working over the coming 12 months? Certainly it sounds like your expectations for ’09 are that you’re going to continue to see a tough topline environment.

Nelson Marchioli

I’d respond, Michael, by telling you that this is a group of management that is focused on continuous improvement all the time. That’s how we’ve been able to achieve what we’ve achieved, and we continue to do that every day and every quarter and every year. My team and I spend an extraordinary amount of time looking for improvement, but our primary focus beyond being well managed and making smart decisions, as Mark likes to say, there’re three things we have to do, and that’s sales, sales, and sales. We have to give the consumer a compelling reason to visit Denny’s. Topline would solve a lot of issues for all of us in the industry, but I think Denny’s has a unique position because of its brand, the visibility, the fact that it’s an American icon. We just have to work much harder at putting Denny’s in the consideration set to the consumer that is eating out, and we’ve got to give them reasons to choose us. Value is part of it, but service and comfort is another part of it, and particularly in lunch and dinner, the entire industry is being hit by lunch and dinner and so are we. We’ve got some initiatives. We are going to our franchise convention here next week, and we are going to talk about sales, sales, and sales. It’ll be the most hard-driving sales driven discussion this brand has ever had, with its franchisees, so everyone understands that that is the focus. We have the systems in place. We understand how to buy commodities, and we understand how to flow cash to the bottomline. As one major investor said more than two months ago, he made the comment that children are no longer running Denny’s; it’s run by adults, and ultimately the long-term view will bear that out.

Alex Lewis

Clearly, we’ve made a lot of very positive moves on the product hotline. As we said we focused a lot this year on build your own grand plan. That one is going to be real hard to top to be quite honest. We’re working hard on our commodities plan. We’re working hard on our marketing plan for what we’re going to sell, but some of these things that we’ve done are going to be hard to repeat. Now that said, I think we’re still going to continue to have very competitive food costs versus a lot of different segments in the industry, and again it’s going to take topline to really make margins move a whole lot more.

Michael Gallo – C.L. King & Associates

Just a followup to a prior question. You mentioned that you saw some lessening of the guest count declines in late night. Have you see any changes in the weekday breakfast? I know that’s been an area that’s been under pressure over the last year or so as well.

Alex Lewis

We just launched that weekday price point just a couple of weeks ago. It’s too early to tell on that one, so I think we’re going to have to take more of a wait and see approach to that, but that’s the most competitive business there is right now probably for us, so we’re going to keep going after it.

Operator

Our next question comes from the line of Reza Vahab-Zadeh with Barclays Capital.

Reza Vahab-Zadeh – Barclays Capital

You talked about your focus on sales in your meeting coming up next week. I’m wondering if you have found the right balance between hitting on sales versus protecting your margins. Protecting margins, it seems like this was a quarter on that front, but 24% cost of products is the lowest cost of products ratio you’ve had in, I’d day, 20 quarters, so I’m just wondering if you need to move that in a different direction to strike the right balance.

Nelson Marchioli

You have to have the right balance. You have to have sales. They have to be profitable sales, and the margins have to be where they are. I think we mentioned in a press release the new alignment in our organization as it relates to how we’re managing operations, and I give operations frankly an incredible amount of credit both in managing our company and our franchise business with these strategic business units that was set up to have to experience that 24% that you just mentioned. I don’t see that as a one-time event. I don’t see that as a result of doing anything different. What we need to do is drive more sales and enjoy those kinds of margins, and I’m convinced that we can do that without candidly anymore effort in that regard.

Reza Vahab-Zadeh – Barclays Capital

What do you think is the key to getting better sales? Is it products, is it pricing, is it communication?

Nelson Marchioli

Yes, but I will tell you it isn’t all about value. This $4 value is in my opinion just terrific. It’s driving some guests in, but that isn’t the only issue. I think we have to do a better job of communicating. I think we have to give a better compelling reason to potential customers. I think it’s a concerted effort at the restaurant. It is about having the right sales team on our restaurant floors everywhere in the system, which is everybody’s job, especially now. Our franchisees, I think particularly understand that. Let’s face it. I’ve got what 80-20 at the end of this year? 80% franchise, 20% company. It isn’t so much about the marketing program, the communication piece, although that’s important to drive more people in. We still have a lot of people that come in every single week. We need to have them come in more often. Having the right sales team on the floor, providing the right service and the right product mix is really going to be the answer, and it’s not easy. If it had been easy, we would have done it long ago, but now that we’re properly organized and focused, I think all our operators, both company and franchise, understand that they have a huge responsibility in getting those customers to come back again and again. There was a time in this industry that we all got to enjoy where if the door open and the lights were on and you were prepared to serve, that was about all you needed to do. It’s no longer the case. You have to give people a reason to go because they don’t go all that often, and when they go, they are intolerant for being disappointed.

Reza Vahab-Zadeh – Barclays Capital

You’re going to have, Mark, a decent amount of free cash flow this year, whether from the base business or the re-franchising. What’s the primary uses of the free cash flow?

Mark Wolfinger

Obviously, we talked about the debt pay-down focus, and clearly as Alex mentioned, we basically built a little bit of cash into the third quarter given the timing of the interest payment on the bonds. Obviously in the fourth quarter, through asset sales and other free cash flow, we hope to continue to pay down the debt. On the free cash flow side again, this business and the way we look at this business is regardless of asset sales or the FGI strategy or even the previous real estate asset sales that we’ve been through, this business should generate, as you put it, decent organic free cash flow, to talk of metrics, and we continue to focus on that. One of the drivers there as well is obviously as we transition this model to a more franchise-operated model, you can see what’s happening to our capital expenditure side. That number has moved down from, I think, back in ’05, we spent something north of $40 million, and our current guidance for this year is in the $27 million range, so that’s a significant change obviously in that free cash flow calculation as well.

Reza Vahab-Zadeh – Barclays Capital

With the free cash flow and the debt pay-down that you are talking about, Mark, is that all bank debt or do you see a reason to reduce other debt like your bonds as well?

Mark Wolfinger

I’ll let Alex respond to that. That’s one of his treasury frustrations.

Alex Lewis

We’d love to be buying the bonds, obviously particularly at the current levels, but we’re prohibited from doing that by the credit agreement, and the syndicated banking world is in as much disarray as the bond market, and there is really just no opportunity to do anything different at this point in time, so all proceeds per our credit agreement calculation, the net number will be applied to paying down debt. It’s not optimal, but it’s debt, and we’re going to keep paying it down until the markets change to a point where we think we can get something else done.

Mark Wolfinger

I think that’s a critical point that Alex made there. Obviously we continue to focus on the capital structure long term, and although we are paying down the less expensive portion of our debt, ultimately it’s the long-term focus on our capital structure that we continue to make sure is the key trigger point.

Reza Vahab-Zadeh – Barclays Capital

One modeling question. Your franchise revenue growth seems to have exceeded the rate of growth in your franchise units, so are there any unusual factors driving revenue growth there?

Nelson Marchioli

The bigger piece is always the rental income, Reza, and I don’t know exactly how you’re modeling it, so it really depends on the mix of how many leased and subleased or how many owned and leased properties there are in any particular transactions. The Q will be out tonight, and we gave the detail in March, but it will have the breakdown in the Q where you can see what was rental income versus what was royalties and also fees as well. We get front-end fees every time a new unit opens or a unit is sold, so that fee runs through that income line as well.

Operator

Our next question comes from the line of Brian Hunt with Wachovia Capital.

Brian Hunt – Wachovia Capital

I was wondering if you could talk about where you are on your cost savings target. You had this big organizational change in Q2. SG&A came down by a little over $1 million this quarter year over year, and you were targeting 6 to 8 on a run rate basis. Do you think that 6 to 8 is still attainable, or do you think you might be able to do better than that? Could you describe where you are?

Alex Lewis

The actions that we took in the second quarter, if you go back and read that release, we said it really was going to transition in. There wouldn’t really be much savings at all in the third quarter, though we did see some. You’d see more in the fourth quarter, and then ultimately by the time we get around to first quarter of next year, they should be fully implemented. I think we’re going to try really hard to make sure we meet that target, and then we’ll keep looking at it from there, and this is the same issue obviously we talk about. A lot of the things that we do here in the corporate structure are not company store related; they are brand related. We do the purchasing for 1500 restaurants. We do the marketing for 1500 restaurants. There are a lot of things that we do that aren’t pro rate going to come out with company stores, so we think we’ve taken a big step in that direction over the two years in two separate actions, and we’ll continue to be committed to being as competitive on a support cost basis as we can be.

Brian Hunt – Wachovia Capital

Can I take that $1.1 million decline to…can I infer from what you just said that it really doesn’t reflect any of the 6 to 8?

Alex Lewis

No, it reflects some of it, just not all of it yet. It’s transitioning in. Not all those folks were let go on that day we announced that press release. There were many transitional type services that were going through, so we still think run rate will get to that $6 to $8 million, but it will be the ’09 numbers before you’ll see all of that.

Brian Hunt – Wachovia Capital

Some of my questions were taken on your sales growth initiatives, but I was wondering if you could talk about, Nelson, where do you see your biggest opportunity over the near term? Is it product in terms of new products as a promotion, or do you feel like you’re dome to go initiative is really your biggest opportunity over the next three to six months?

Nelson Marchioli

Our biggest opportunity is to encourage our existing customers to come back more often. That is really where our biggest opportunity is, and to build our weekday breakfast. That’s really where it is. Now, we have to continue to work on to-go program, and I think that’s an incremental build. This is my speculation and nobody else’s. I suspect if we continue to work on to-go, we could increase that business another two percent before we’re through next year, and that’s very profitable business for us. I see us still having an opportunity at late night to frankly as I say here take back the night and to get into positive territory. So we’ll continue to work on our late night initiatives to keep that fresh with new menu offerings, but our lunch and dinner business is under pressure as well. The great news is we have 4 day parts, and we’ve got all these business elements. The bad news is I have all these business elements, and I’ve got to talk to all these different consumers at the same time without confusing them about what we are, understanding our core strength is breakfast and value and 24x7, so the real issue here is about communication. So the easiest thing for us to do, the highest probability is to get our restaurant operations focused on getting existing customers to come back one more time, and that is huge for us.

Brian Hunt – Wachovia Capital

Mark, one last question, and I don’t want to leave you out. When I look at what you described with regard to continuing FGI in Q4 and who the potential buyers are, it sounds like you’re looking at a pool of very well capitalized buyers that obviously have access to capital in pretty much any environment. Is that a reasonable description of who these FGI partners are coming for the second helping.

Mark Wolfinger

I think on the second helping piece, Brian, I’d say they are reasonably well capitalized. Obviously, there is the normal range you would have with their specific asset bases, but I think what we’re seeing that continues to be very exciting regardless of how the credit markets are currently acting out there is the fact that there continues to be high demand for the product, and that high demand is coming from existing franchisees some of whom who did purchase stores in the first round of FGI, but some of those existing franchisees are coming to us for the first time, so we’ve got really two different groups out of the existing base, and we continue to see a solid level of interest from players outside our system, which again I think speaks to the economic model of Denny’s and the longstanding model of Denny’s having been in business for over 50 years. So it’s a combination, and before you ask your question which might be who are the lenders in this kind of environment, some of them are the ones you’d expect, the names you’d expect to hear, but there are other newer players out there that again see the opportunity in this restaurant sector long term and see the opportunity as some of these buyers and the experience level and the strength of these buyers and are willing to lend into this type of environment, which is obviously in general in the US, and the credit market and the restaurant sector are relatively volatile environment right now.

Brian Hunt – Wachovia Capital

Do you see anybody stepping up and buying into these new markets where you don’t have any stores, such as Charlotte or Nashville? Have any of those been taken down in the last quarter?

Mark Wolfinger

Not in the last quarter. As you recall, that’s a separate new store development program called the MGIP, the market growth inventive plan. We continue to offer that and provide that, and I believe of the 150-some odd development agreements, probably around half are probably MGIP-type of development agreements which means they were not related to an FGI, to a sale of a company-operated store, but I would agree with what your proposition is, and that is we have many large DMAs in the US where there is literally no presence of the Denny’s brand, and I think that continues to be a development opportunity for us.

Operator

Our next question comes from the line of Tony Brenner with Roth Capital Partners.

Tony Brenner – Roth Capital Partners

Can I just expand on that financing aspect a little bit? Mark remarked that the number of franchise openings in the fourth quarter would be a little bit less than had earlier been intended or expected due to financing restrictions, and I’m wondering if that slowdown simply reflects some franchisees that have less than pristine balance sheets, having a little more difficult time obtaining financing, or whether financing is amply available for financially healthy businesses? A lot of people seem to be worrying that banks will be going into plastics instead of lending money for the next 12 months or so, so I was wondering if you could just expand on that a little bit.

Mark Wolfinger

I’ll go back first to the change in guidance. Again, we’ve brought our guidance down by a couple of units as far as total openings for the year. The range on the franchise opening number is 26 to 29 stores. Again, in all of 2007, we opened 18, so it’s about 50-60% increase in openings for our franchise system. That slippage is clearly a little bit in the credit market situation, but part of it is again these folks are dealing with developers all over the US. Some of the metrics on the development side have obviously changed as well, partially due to the lending environment to developers, and slippage from a fourth quarter into a first quarter is not uncommon. We saw the same thing occur in the last couple of fiscal years. Again, certainly the lending market is tougher today than it was 90 days ago or 6 months ago, but I’d say given that environment and given the pressure that’s on the consumer right now, to open between 50 and 70% more stores this year than last year, I think, is very strong track record.

Nelson Marchioli

And most of those openings will be in the second half of the year.

Tony Brenner – Roth Capital Partners

The stores that you’re negotiating to sell, these will be financed transactions, I take it, judging from your release.

Mark Wolfinger

Yes, that’s right Tony.

Tony Brenner – Roth Capital Partners

Why was depreciation in the quarter higher sequentially than in the second quarter given the lesser number of stores owned?

Alex Lewis

I think it was related to franchise agreement write-off. You have to remember there is a big component of amortization that’s in that depreciation and amortization, so it’s not all asset depreciation that’s in that line.

Tony Brenner – Roth Capital Partners

Anecdotally, since much of it has happened subsequent to the end of the quarter, with gasoline prices about 50% lower all over the country just in a very short period of time and that having been cited as a major factor that hit Denny’s core customer, I wonder if any of that direct infusion into disposable income is being expended at Denny’s.

Nelson Marchioli

My view since it is so much speculative I would tell you that my customer is the Wal-Mart customer. You’ve heard me say that before. They really don’t work on Wall Street and typically don’t typically don’t work in the financial markets. They really haven’t been all that affected. If you own a home or you rent and you feel pretty secure in whatever the arrangement is, you clearly with this gas price drop far more money in your pocket today than you did literally thirty days ago, and that should have a real positive effect on my customer in particular. The problem is consumer confidence in my view. Until that customer believes that their life is getting better and yes their life is getting better. Commodity prices are going to come down. They don’t feel secure yet in my opinion, and until they do and maybe after the election, they’ll feel better, and I think that Denny’s will benefit from that if that’s the case, but I think it’s too soon. I think they need to be reassured and feel more secure because actually their life is getting better. I think they’ve just pulled everything back, and they’re waiting to see what happens, and I’m hopeful that after the election, consumer confidence will begin to go up, because that’s the problem at the moment.

Operator

Our next question comes from the line of Eric Wold with Merriman Curhan.

Eric Wold – Merriman Curhan

I want to make sure I’m not missing anything. With the guidance for the year of adjusted income before taxes of $20 million and doing $16.2 through the third quarter and $8.5 in the third quarter, what’s the main trend going into Q4 versus Q3 that would cause Q4 to be so much lower than Q3, or is it just conservatism?

Alex Lewis

I think we have some impact obviously that you’re seeing from the sales trend that obviously is going to be impacting numbers as well, but it’s really a year over year number, and frankly last year’s fourth quarter number had some benefits in it, Workers’ Comp and some other one-time numbers that made last number probably a little bit higher than normal as well in the fourth quarter.

Eric Wold – Merriman Curhan

Not even looking at year over year. If I take the $20 million and subtract out the $16.2 you’ve done year to date, that leaves $3.8 for the fourth quarter, and you did $8.5 in the quarter that just ended. I have to think that a lot of it just conservatism. I don’t think things deteriorate that quickly, and I don’t think they have been.

Alex Lewis

Our guidance is our guidance, Eric.

Operator

Our next question comes from the line of Mark Smith with Feltl & Company.

Mark Smith – Feltl & Company

You talked a lot about the openings of franchisees, but I want to talk about the closing that we saw. It looks like one franchisee failed. Can you talk about the health of your franchisees and what if anything you’re doing and can do to kind of prop them up in difficult times?

Alex Lewis

It’s tough to predict that. It’s tough to accurately measure the health of the franchise system. I think we feel like over the past few years, our franchisees have done pretty well and probably have built up some strength there. We think we’ve added some very strong franchisees to the system here over the past couple of years with the actions that we’ve been doing, but that one particular franchisee has been on the list so to speak for quite some time. This wasn’t a third quarter economic issue. This was probably a 3-year, 4-year, or 5-year economic issue. It’s unfortunate when one of those things happen. With those units, if they’re viable, will be looked at by other people as they always are in these situations, but in this economy, you clearly are going to have some marginal operators that might have issues as you will with any brand. We’re in a very good position from a credit standpoint from the benefit credit card system that we’ve talked about a lot. We work a lot with our franchisees and try to do our best to help them, but these kinds of things are pretty hard to predict. We just feel like our franchisees have built up some strength over the past couple of years.

Mark Smith – Feltl & Company

Secondly, one of your favorite questions. Can you talk about the same store sales trend during the quarter, and outside of your guidance, how do you feel about October at this point?

Alex Lewis

We’re not going to go October. We’re not going to do that. Again, our guidance was that fourth quarter would look like third quarter, and third quarter wasn’t all that different through the quarter. It probably got a little tougher towards the end, but guidance is fourth quarter will look a lot like third quarter, and we’ll have to see about next year. It’s tough out there, and we’re not expecting any overnight changes.

Mark Smith – Feltl & Company

On same store sales, what availability do you have to still take any pricing and are there any plans to take any more pricing through the end of the year?

Alex Lewis

I don’t know about the end of the year, but as always, we’re going to look at our commodity costs and our utility costs and our labor costs and those things, and we’re going to adjust accordingly. We don’t have the luxury to pass through a whole lot of those pressures, so we’ll have to taking pricing where we do, but I think clearly, as Nelson said, we’re focused more on value. We’re really trying to make sure we have products that make money for our company restaurants and our franchise restaurants and products that are attractive to our customers. We’ll take more pricing. It’s not like we will stop taking pricing when commodities are up and labor is going to be up again and those things.

Operator

Our next question comes from Steve Anderson with MKM Partners.

Steve Anderson – MKM Partners

Talking about MGIP, have you noticed any kind of slowdown in requests for new franchise development areas because of the credit crisis?

Mark Wolfinger

I would say there’s clearly a reaction over the last 30 days, I think, just across the board in the US. Nelson mentioned consumer sentiment. I think there was a statistic that came out today about the lowest measurement in decades, but I just go back to the overall growth model for Denny’s and say that in the last 21 months, we have signed up for 150 new store development agreements. A little bit more than a dozen of those have already opened. We continue to see demand coming out of FGI, so again I think taking a long-term perspective, there’s some pretty strong vibrancy out there as far as development.

Nelson Marchioli

The difference between FGI and MGIP, it’s clear as it should be that you’d rather go in and buy a market and buy some restaurants and have scale from day 1. It is tougher to develop a new market. There is no doubt about that, and in these economic times, that makes that split even wider. We’ve put big new players from other brands into our system, and FGI was a great way to get them into the system because from day 1, they have the kind of scale that they’re used to to be profitable.

Operator

Our final question for today comes from the line of Ken Bann with Jefferies and Company.

Ken Bann – Jefferies and Company

With the reduction in company-owned restaurants, how much would that reduce your maintenance CapEx going into 2009, and I’m sure you’re formulating plans right now, but where do you think you can reduce CapEx in 2009 to?

Alex Lewis

We gave a pretty consistent metric for maintenance capital. We spent about in the neighborhood of $26,000 or so. That’s sort of what we’ve modeled out for maintenance capital on a per unit basis, and then on remodel, we throw in another $30,000 or so for an every 7-year remodel, so the remodel costs you a little over $200,000 probably, so that’s sort of what we look at, $55,000 or so per unit per year. Anything above that is typically capital for corporate type needs, any new development we do, any strategic initiative spending we do and those kinds of things, but clearly that number will continue to come down. Now the one delta that people continue to miss is frankly we’ve been remodeling at a level over the past couple of years that anticipated FGI, so remodeled dollars really haven’t come down the past two or three years because we’ve been remodeling to an endpoint rather than to the number where we were, but we’re not going to get into ’09 specifics at this point, but it will be less.

Ken Bann – Jefferies and Company

Will remodeling expenditures now that you’ve sold off quite a few units come down?

Alex Lewis

No, because again we’ve been remodeling to the number that we’re probably going to get to, not to the number we had.

Operator

There are no further questions at this time. Do you have any closing remarks?

Alex Lewis

Thanks everyone for joining us, and as always, if you have any followup questions, feel free to give me a call, and I’ll be happy to try and answer them for you.

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Source: Denny’s Corporation Q3 2008 (Qtr End 09/24/08) Earnings Call Transcript
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