AFC Enterprises Inc. F3Q 2008 (Qtr End 10/5/2008) Earnings Call Transcript

AFC Enterprises Inc. (AFCE)

F3Q 2008 Earnings Call

November 13, 2008 9:00 am ET

Executives

Cheryl Fletcher – Director, Investor Relations

Cheryl Bachelder – Chief Executive Officer, President

H. Melville Hope III – Chief Financial Officer

Analysts

Michael Gallo – C.L. King & Associates, Inc.

Chris O’Cull – Suntrust Robinson Humphrey

Presentation

Operator

Good day ladies and gentlemen and welcome to the third quarter 2008 AFC Enterprises Incorporated earnings conference call. My name is [Stacy] and I will be your conference moderator for today. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Miss Cheryl Fletcher, Director of Investor Relations. Please proceed.

Cheryl Fletcher

Thank you Stacy and good morning. Before we begin I’d like to read the following forward-looking statements. There are statements made on this call regarding future events and developments that our future performance as well as management’s expectations believe are projections relating to the future are forward-looking statements within the meaning of the Federal Securities laws.

These forward-looking statements are subject to a number of risks and uncertainties. Among the important factors that could cause actual results to differ materially from those indicated by such forward-looking statements are competition from other restaurant concepts and food retailers; our ability to franchise new restaurant units and expand our brand; increases in food and labor costs; disruptions in the financial market; volatility of gasoline prices and other general economic conditions; and the risk factors detailed in our 2007 annual report on Form 10-K and other documents we file with the Securities and Exchange Commission.

You should not place undue reliance on any forward-looking statements since those statements speak only as of the date they are made. During this call, references may be made to non-GAAP terms of EBITDA and free cash flow. The company defines EBITDA as earnings before interest expense, taxes and depreciation and amortization. The company defines free cash flow as net income plus depreciation and amortization plus stock compensation expense minus maintenance capital expenses.

The company’s computations and reconciliations to GAAP measures of the numbers referred to for those terms are contained in our earnings press release that can be found on the company’s website at www.AFCE.com. I would now like to turn the call over to Cheryl Bachelder, our CEO and President.

Cheryl Bachelder

Thank you and good morning everyone. We welcome you to our third quarter earnings conference call. Despite the significant economic slowdown in the third quarter, Popeye’s has delivered a solid earning performance in line with consensus expectations. We remain on track to implement the new strategic plan that we announced in the first quarter.

As you will hear today, we have launched the planned menu, marketing and operations initiatives that we believe will stem our traffic declines and build our market share. We’re confident that our strategies position us well in this intensely competitive QFR marketplace. These times also demand conservative financial practices. Accordingly, we have tightened up our G&A expenditures to the mission critical initiatives in our plan.

We’ve increased our cash position and made debt repayment a priority. Our highly franchised business model provides a steady cash flow stream, with low capital spending requirements. In times like these we believe we have a model that yields financial flexibility and stability for us and for our investors. I’ll now review our third quarter performance and update you on the four pillars of our strategic plan. Mel Hope, our CFO will then review the quarter and the year-to-date financials in more detail.

Our total domestic same-store sales were negative 2.8% for the third quarter. Our lower same-store sales during this quarter reflect two factors, the successful introduction of our new Big Deal value sandwiches at low, affordable prices that drew in traffic to lunch and snack day-parts and secondly the reality that our Popeye’s dinner guests cut back their business significantly during this quarter, as that is the more expensive day-part. In this day-part we sell our high ticket, family dinners.

So going forward we remain committed to our strategic plan to improve our guest count and grow our market share. And we’ll do that through a balance of core menu value offerings at dinner and these new, portable lunch and value menu offerings previously announced. On a full year basis, we expect our domestic same-store sales to be at the lower end of our guidance of negative 1 to 2% consistent with previous guidance.

Our international same-store sales increased 7.4% during the third quarter, due primarily to continued strong same-store sales in the Middle East where we benefited from the Islamic holiday of Eid, marking the end of the fasting period of Ramadan. Eid occurred last year during the fourth quarter.

Additionally, Latin America and Canada experienced strong same-store sales which were partially offset by negative performance in Mexico. Our international franchisees faced similar economic conditions to the U.S. including higher commodity costs. They are responding with similar strategies, raising prices where necessary to cover costs and also offering strong value offerings in their promotion windows.

During the third quarter we opened 28 restaurants, bringing our total year-to-date openings to 97 units compared to 85 during the same period last year. The third quarter openings included 12 domestic and 15 international restaurants in existing markets. With our progress year-to-date we are confident in our full year guidance of 115 to 130 global openings.

We had 24 closures in the third quarter which included 16 domestic units and 8 international. In 2008 we expect our closures to be similar to the past few years. As a result, net openings throughout 2008 are expected to be consistent with our previous estimate of 5 to 15 net units.

Our operational performance and tight G&A focus resulted in third quarter earnings that were in line with consensus expectations at $0.16 per diluted share. Importantly, we continue to expect our full year earnings to be within the $0.75 to $0.77 per diluted share. Our business model continues to generate solid cash flow at $22.3 million for the third quarter year-to-date and our EBITDA margins at 30% for the third quarter year-to-date remain among the highest in the industry, making us a reliable, stable, long term investment.

Let me now take a few minutes to update you on the progress made against the four pillars of our Popeye strategic plan. First talking about building our distinctive and relative brand, I mentioned to you previously that Popeye’s had three gaps in our menu that needed to be addressed and they were value, portability and lunch. As of today, Popeye’s has launched seven permanent new products since August 25 to fill these gaps. In August the company rolled out the Big Deals platform which features three new value priced products at $1.49, the Loaded Chicken Wrap, the Delta Mini with our new Delta sauce and a Chicken Biscuit.

At the end of September Popeye’s rolled out the portable and boneless Louisiana Travelers platform which consists of two products, our Louisiana Tenders and Louisiana Nuggets. This platform is a relevant choice for the customer who’s looking for our great tasting chicken along with portability and convenience for eating in the car. Both of these products have a competitive price point of $1.99 with new packaging designed for eating on the go.

The third menu platform, the Big Easy Lunch platform rolled out in late October. This platform features two new products, a unique Chicken sandwich which is served with our signature zesty Delta sauce on a diamond shaped bread that’s easy to handle in the car. And our new rice bowl consists of a base of red beans and rice, topped with our signature Louisiana pulled chicken and a sprinkling of cheese and parsley. Packets of sour cream and hot sauce add a lot of flavor to this new lunch item.

All three of these menu platforms are designed to drive new traffic during lunch, snack and late-night day-parts as well as to help us gain share in chicken QSR. We’ve also transformed our restaurants with the nationwide rollout of our new menu boards. The new menu features our four key product platforms, bonafide bone-in chicken, value, portability and lunch and it showcases the Louisiana distinctiveness of our brand.

The boards have a bright and colorful design that communicates our new brand image, shows our menu variety and our value to our customers. They’re simple and easy to order from. The restaurant managers and our customers have responded enthusiastically to this change.

As we indicated in our press release, in connection with our expanded menu we have shifted the majority of Popeye’s media advertising funds to national cable advertising. This decision was taken in full partnership with our franchisees. The majority of Popeye’s franchisees agreed to contribute an additional 1% of their restaurant sales to the Popeye’s advertising fund and the company agreed to invest additionally $2 million in 2008 advertising dollars.

As a result, Popeye’s television media weight for the latter half of 2008 has two-and-a-half times more media impact in the marketplace, evidence of our commitment to grow traffic and market share in these slow economic times. In late August we ran the first flight of national cable featuring the new Big Deal value sandwiches. According to NPD SalesTrac Weekly during this advertising window Popeye’s same-store sales outpaced chicken QSR by 1.7 percentage points.

So while our same-store sales remain negative in the quarter, the new value items and greater media weight going forward are the beginning of improving traffic trends for Popeye’s. And as expected, we saw the value priced offerings lower our average ticket as I mentioned earlier. Going forward our promotions will be a balance of core bonafide chicken events and innovative new items on these new, portable lunch and value platforms.

Now shifting to operations, our operations and field support teams continue to stay focused on improving our consistency and guest experience. The guest experience monitor is now in use at more than 90% of our domestic restaurants. Our general managers are becoming familiar with the tool and we’re seeing the beginning of operational improvements. During the third quarter, our operations team designed and implemented the new scorecard rolled out to all of our restaurants.

The scorecard brings together the guest experience data, our operational assessments, our manager’s certification, as well as sales and profitability data. It gives us a benchmarking tool to rank each restaurant’s overall performance compared to national, regional and market level performance and helps us hold every operator accountable for running a better restaurant. These tools are helping our franchisees see improvement opportunities at the restaurant level and they’re helping our leadership target and measure steady improvement in restaurant operations going forward.

Now to speak to unit economics, like many in our restaurant industry the commodity costs have continued to be a challenge. For Popeye’s our Quarter 3 year-to-date commodities cost for the system has increased 10% year-over-year for both boneless chicken and other food items. This increase in food costs translates to approximately a 300 basis point impact at the restaurant level operating profit margins before any pricing actions.

As we indicated on our last call, to offset some of this pressure in the second quarter we took a 2% price increase at our company operated restaurants, and most of our franchisees have typically taken a 3 to 5% price increase during this period. We expect to see continued cost pressures in the fourth quarter with commodities costs projected to be up 10 to 13% for the full year basis. That translates to 300 to 400 basis points impact on restaurant operating profits before pricing. In our company restaurants we expect to recover approximately half of that increase.

The company remains committed to improving our restaurant level margins across the system. In October at our international conference we rolled out a web-based key item variance tool that helps a restaurant operator diagnose the variances between their theoretical and actual food costs. The new tool is being embraced widely in our system. We continue to identify and share with our system cost savings opportunities such as labor scheduling, cooking oil management, utilities and many more. As we indicated, we still believe our small and medium sized operators can find approximately 2% margin level improvement to help offset the commodity cost pressures.

Our new openings development remains on track for 2008, both in the U.S. and internationally. To date the lending environment has not impacted our near term openings. As we move into 2009 and understand where the credit markets settle out, we will review and adjust our unit guidance accordingly. But we feel committed and on track to meet our 2008 new unit openings.

Finally, I’ll touch on the re-franchising sale of our restaurants. As indicated in the press release, we have re-franchised 11 company operated restaurants in Atlanta. Mel is going to talk about this in more detail in a few minutes.

I’d also like to share that our partnership with our franchisee owners remains strong. I believe this is evidenced in their commitment and the support from the majority of our franchisees to use national cable advertising for the balance of 2008. We’ve just recently been at our international business conference. We re-energized our system around this strategic road map we’ve established for Popeye’s future and we intend to stay tightly aligned with our franchisee business partners as we move through these times.

In closing, the economic times have certainly impacted this quarter, so we reiterate that we remain committed to our strategic plan to expand our menu offerings; to use national cable to build awareness and trial of these new products; to improve our guest experience in our restaurants; to strengthen our restaurants profitability; and work closely with our franchisee leaders to insure the sound execution of these plans in the marketplace.

Despite the challenges of the marketplace we remain confident in our full year earnings and our operational guidance and the long term financial health of the Popeye brand. Thank you. I’ll now turn the call over to Mel Hope.

H. Melville Hope III

Thanks Cheryl. Good morning everybody. As Cheryl indicated our 2008 third quarter earnings were $4 million or $0.16 per diluted share which was in line with consensus expectations. Total revenues for the third quarter were $38.3 million versus $38.9 million in the third quarter last year. During the third quarter sales from company operated restaurants were $17.4 million, representing a decrease of $1 million over the third quarter of last year.

This decrease was primarily due to a $1.2 million decrease in sales as a result of re-franchising 11 company restaurants in the Atlanta market and $1 million due to negative same-store sales. This decrease in sales was offset by $1.2 million attributable to new company operated restaurants opened in the Atlanta and Tennessee markets, and the re-opening of restaurants which were temporarily closed in New Orleans.

Franchise revenues, which are the revenues realized from royalties and fees paid by Popeye’s franchisees, were $20 million in the third quarter compared to $19.5 million last year. This increase was primarily due to the opening of new franchise restaurants, partially offset by a decrease in domestic same-store sales. G&A expenses for the third quarter were $13.3 million versus $11.3 million last year. This $2 million increase was primarily due to our investment in the new national cable advertising which Cheryl mentioned.

Our EBITDA in the third quarter was $9.4 million or 24.5% of our total revenues. Operating profit in the third quarter was $8.1 million versus $11.9 million last year. Interest expense decreased by $400,000 to $1.6 million for the third quarter of 2008 compared to last year. This decrease reflects the favorable effects of our interest rates swap agreement on a notional amount of $100 million, which fixed our interest at 4.87% this year compared to 6.4% during the third quarter last year.

Our tax provision of $2.5 million reflects an effective tax rate for the quarter of 38.5% compared to 34.3% last year. Last year’s effective rate benefited from the reversal of tax reserves due to the expiration of certain statutes of limitation. As we indicated on our last earnings call, we expect 2008’s income tax rate for the full year to be 38.5 to 39% overall.

Our year-to-date third quarter performance, year-to-date our earnings were $17 million or $0.66 per diluted share which includes the favorable effect of $5.1 million of other non-operating income recognized in the first and second quarters of this year. That non-operating income is associated with insurance claim recoveries net of impairment charges that we recognized on our Atlanta and Nashville restaurants.

Total revenues for the third quarter year-to-date were $130.9 million versus $128.2 million last year. This increase in total revenues is primarily due to 24 additional system restaurants compared to last year during the same period and was partially offset by the effects of negative same-store sales and the re-franchising of 11 company operated restaurants in the Atlanta market.

Year-to-date our G&A was $42.1 million compared to $35.7 million last year. This increase reflects our investment in national cable advertising, the costs associated with hiring of new management and costs related to the development of our new marketing and menu. Our year-to-date EBITDA through the end of the third quarter was $39.3 million with margins at 30% and our operating profit was $34.3 million versus $37.6 million last year.

Let’s talk about our usage of cash. As we indicated in our press release, the company has generated free cash flow of $22.3 million through the end of the third quarter. During the third quarter the company reduced its borrowings under the credit facility by $2.8 million. At the end of the quarter our debt, including the $12.5 million we borrowed on our revolver was

$131.3 million. Our cash balance at the end of the third quarter was $10.4 million. During the quarter we did not repurchase any shares of our common stock and therefore year-to-date we’ve repurchased and retired 2.1 million shares of our common stock for $19 million.

Given the economic conditions, we will continue with our focus on reducing our net debt position through the balance of 2008. This focus means that we will be retaining cash and reducing our outstanding debt. We do not plan any additional repurchases of our common stock through the end of 2008.

With respect to the sale of the company operated restaurants, as we previously indicated the company completed the re-franchising of 11 restaurants in the Atlanta market. The company received $3.5 million in cash from the sale proceeds and fees associated with new franchise and development agreements. Since we had adjusted the book value of those restaurants during our second quarter based on the contract terms, the sale hadn’t any material effect on third quarter earnings.

The company is in negotiations to re-franchise the remaining 14 company operated restaurants in the Atlanta market. We now expect to complete the re-franchising of those restaurants before the end of our first quarter next year. In addition, we continue to seek qualified operators to re-franchise 4 restaurants in the Nashville market. Due to the challenging economic conditions, the company has chosen to postpone the re-franchising of our restaurants in Memphis and New Orleans until we are more certain we can realize appropriate value.

Before we open the lines for Q&A, let’s revisit our full year guidance. As Cheryl mentioned earlier we expect total domestic same-store sales for fiscal 2008 to be at the lower end of our range of negative 1 to negative 2%. We also expect global new restaurant openings for 2008 to remain in the range of 115 to 130 restaurants with net new openings in the range of 5 to 15 restaurants. For the full year of 2008, we expect earnings per share to be in the range of $0.75 to $0.77 per diluted share.

And as we indicated previously, with the $2.3 million investment the company has committed to make in national cable advertising and new menu board development during 2008, we expect our G&A expenses as a percentage of system wide sales to be approximately 3.3% of this year’s system wide sales. Thank you and Cheryl do you want to open the lines for questions?

Cheryl Bachelder

Yes. At this point we are open to your questions.

H. Melville Hope III

Is the operator there?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Michael Gallo – C.L. King & Associates, Inc.

Michael Gallo – C.L. King & Associates, Inc.

I just wanted to understand a little bit better what you’re seeing more recently as you have the combination of the rollout of the new value priced products as well as the shift to national cable. Is that lessening the traffic declines? It sounds like ticket’s come down a little bit with that. I mean, a little more color on what kind of impact you’re seeing from some of those initiatives. Thank you.

Cheryl Bachelder

Yes, Mike, as I said there was one of the platforms launched in this quarter. We subsequently launched two more of the platforms. The initial learning is that the new products are driving great lunch and snack day-part traffic. They’re well priced for the time. They’re helping us keep our guest traffic in restaurants and yes we are seeing trend improvement in traffic.

That has been offset by weakness in the dinner day-part which in fact is weak in the entire QSR industry, where customers are cutting back on dinner occasion, feeding the kids at home and not spending the money on the family box meals that remain an important part of our menu [bet]. So while we are pleased with the value offerings impact on our traffic, we also believe we have to continue to offer strong value offerings at dinner as well to balance that.

Michael Gallo – C.L. King & Associates, Inc.

How many [plates] of national are you going to have in the fourth quarter?

Cheryl Bachelder

I believe it will be one national and one local.

Michael Gallo – C.L. King & Associates, Inc.

And then as you look to 2009 it sounds like you’re shifting the focus more to national from local. Is that a fair statement or is it still kind of under review?

Cheryl Bachelder

We have a commitment with our franchisees to launch these new products with national cable and the impact is very bold for our system, 50% of our market has not had local television are receiving national advertising for the first time. So there is a lot of excitement in our system about national cable. We’re delivering two-and-a-half times the media impact that a local market can deliver through local television so I expect it to be a go-forward part of our strategy.

Michael Gallo – C.L. King & Associates, Inc.

On the Atlanta stores which are being re-franchised, my recollection was that those were some of the least profitable of the company unit – company operated units. I was just wondering if you could give us some idea of what some of the difference in profitability was at the store level between the Atlanta markets that are being re-franchised and the ones that are going to be remaining?

H. Melville Hope III

The 14 stores that remain include a couple of stores where the leases were very high and also they were – their AUV’s were not what we expected when we opened them. And so their performance within that group of 14 stores - there’s a couple of them that probably I would guess that their ROP margins or their profitability before rent is probably somewhere in the 10% area, where the stores that we sold in south Atlanta were north of 15%, something like that. That order of magnitude that’s probably fair.

Cheryl Bachelder

I want to clarify. Were you interested in the –

Michael Gallo – C.L. King & Associates, Inc.

We’re interested in what’s going to be remaining once the 14 is completed. And I’m more interested in the ones that you’re keeping, you know, for some indefinite period of time.

Cheryl Bachelder

And the stores in Memphis and New Orleans that we’re keeping have more margins, very close to in line with our franchisee ROP margins which range in the high teens, 18% ballpark. We have slightly higher benefit costs and system costs of being a corporate operation. But the core operating costs are very in line with a franchisee restaurant.

Michael Gallo – C.L. King & Associates, Inc.

I guess just the point I was trying to understand is that the units that you’re keeping are good performing units and you know you’re not in a position where you felt that you had to re-franchise them. Is that a fair way?

Cheryl Bachelder

They’re high AUV restaurants with solid profitability that as we’ve said repeatedly on our calls we are under no pressure to sell them below their market value.

Operator

Your next question comes from Chris O’Cull – Suntrust Robinson Humphrey.

Chris O’Cull – Suntrust Robinson Humphrey

Cheryl, how close – and my question really is to advertising, a follow-up on that. How close is the Popeye’s brand coming to spending the appropriate amount on advertising for a system its size?

Cheryl Bachelder

That’s an interesting question, Chris. I might have to write a thesis on that. You know, I would just tell you I think the important thing is that we have really stepped up our impact. Our share voice is up dramatically, you know. When you increase your ROP’s two-and-a-half times it’s a big boost. So I would say that our current spending is very much in line with the size of chain we are nationally.

Chris O’Cull – Suntrust Robinson Humphrey

Is the expectation that the company will contribute in 2009 to the ad funds as well?

Cheryl Bachelder

Chris, we’ve not provided guidance on any detail of our 2009 plan yet at this point.

Chris O’Cull – Suntrust Robinson Humphrey

Question regarding the GEM surveys, after reviewing some of those guest satisfaction surveys would you tell us what some of the most important factors are to raise guest satisfaction for the brand?

Cheryl Bachelder

Yes. There are two. One is to provide a stronger value for the money which is the big part of our menu revamp. And the second is to improve the service in our restaurant experience, hospitality and speed of service.

Chris O’Cull – Suntrust Robinson Humphrey

Did the new product introductions, did they affect speed of service or order accuracy at all?

Cheryl Bachelder

I have not seen any shift of notice since we launched those new items. They were designed, Chris, to be super simple, those three sandwiches use one meat block. The Chicken Tenders, that’s already in the restaurant. The Sandwich Station was already near the Drive-Thru in most restaurants. I’ve just visited a huge number of restaurants in the last couple of weeks and the restaurant managers report that they’re able to handle these new products quite efficiently.

Chris O’Cull – Suntrust Robinson Humphrey

I guess I was looking at it from the standpoint maybe did it improve the guest satisfaction given that it is faster product execute?

Cheryl Bachelder

I don’t have measures yet, but I would tell you based on observation that our lunch service is improving with these wraps and bowls, which can be prepped and ready for the lunch hour.

Chris O’Cull – Suntrust Robinson Humphrey

Mel, would you remind me how much visibility your franchisees have to chicken and flour costs? I need maybe a refresher on the effect the co-op has on the commodity situation for franchisees.

H. Melville Hope III

Well, when you say visibility I’m sorry, what are you looking for?

Chris O’Cull – Suntrust Robinson Humphrey

In terms of what price they pay for poultry and for flour.

H. Melville Hope III

Poultry prices for our franchisees are now north of a dollar a pound for white meat. Isn’t that right, [Sonny]? So the real cost for them – looking out next year you should see poultry prices moderating somewhat through the year, but we’ve had such a run-up this year that year-over-year we expect it to be flat. The real benefit to them is if we can see diesel costs come down and fuel surcharges help moderate some of their cost of at the store deliveries.

Cheryl Bachelder

And we are wide open with them on the visibility of our corn contracts that directly impact the chicken prices. So they do get a regular newsletter that gives them upcoming visibility on those prices so that they can plan.

Chris O’Cull – Suntrust Robinson Humphrey

So if we see poult – spot prices like [whenever] prices for poultry fall, should we assume that the Popeye’s franchisees are also seeing their prices fall?

Cheryl Bachelder

Not in the immediate correlation because we buy – we contract out on our corn and we are currently contracted now well into ’09. So they will have good visibility of what Popeye’s prices will be, but they don’t immediately follow the spot market because of that corn contract transition.

H. Melville Hope III

On average, our purchasing contracts through SMS are favorable to the spot rates.

Chris O’Cull – Suntrust Robinson Humphrey

And then in terms of wheat, we’ve seen wheat costs come back and I’m sure that’s benefited flour costs, bags of flour for them. Are they seeing any benefit or relief from some of these other commodities?

H. Melville Hope III

I think it takes some time for some of the commodity savings to pass through the supply chain and actually reach the restaurants. So right now, to the extent that they’re realizing any relief it’s probably still just relatively high to where they’ve been.

Operator

With no further questions in the queue, I’d like to turn the call back over to Miss Cheryl Bachelder for closing remarks.

Cheryl Bachelder

We do thank you for joining us this morning and we appreciate your continued support of Popeye’s. Once again we are pleased with our earnings performance for this quarter and confident in our full year guidance. We appreciate your investment in Popeye’s and assure you that we are using this time to position ourselves for accelerated growth when the economy inevitably recovers. We look forward to future discussions with you. Have a great day.

Operator

Thank you for your participation in today’s conference. This does conclude your presentation. You may now disconnect and have a great day.

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