Rewards Network, Inc. Q4 2008 Earnings Call Transcript

Mar. 2.09 | About: Rewards Network (DINE)

Rewards Network, Inc. (IRN) Q4 2008 Earnings Call February 19, 2009 10:00 AM ET

Executives

Evan Makela – Investor Relations

Ronald L. Blake – President, Chief Executive Officer & Director

Christopher J. Locke – Chief Financial Officer & Senior Vice President

Analysts

Gary Prestopino – Barrington Research Associates

[Alan Aparso]

Operator

Welcome to the fourth quarter earnings conference call. At this time all participants are in a listen only mode. Later, we’ll conduct a question and answer session. Please note that this conference is being recorded. I’ll now turn the call over to Mr. Evan Makela.

Evan Makela

With me are Ron Blake, President and Chief Executive Officer and Chris Locke, Senior Vice President and Chief Financial Officer. During today’s call Ron will provide you with his comments and Chris Locke will review our fourth quarter and full year 2008 results as issued over the newswires earlier this morning. At the end we’ll have time for your questions.

I will point out that statements made on this conference call that are not strictly historical are forward-looking statements and are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are based on managements’ current expectations or beliefs and are subject to risk, trends and uncertainties.

Actual results, performance or achievements may differ materially from those expressed or implied by these statements due to changes in economics, business, competitive, technological and/or regulatory factors and other factors affecting Rewards Network. A description of the factors that could cause actual results to differ materially from those included in the forward-looking statements and that among others that should be considered in evaluating our outlook can be found in the company’s most recent annual report on Form 10K filed with the Securities & Exchange Commission.

We undertake no obligation to and expressly disclaim any obligation to update or revise any forward-looking statements to reflect changed assumptions, the occurrence of anticipated or unanticipated events, changes to future results over time, or otherwise except where required by law. Now, I’ll turn the call over to Ron Blake.

Ronald L. Blake

In 2008 Rewards Network had an 8.8% increase in sales and full year operating profitability. These results were made possible by our response to the changing economic environment throughout the year. Our unique position in the restaurant industry gives us a bird’s eye perspective on developing trends and shifts in customer dining preferences.

We have well over 9,000 restaurants in our program and a sales force spread across the country that’s talking with restaurant owners every day. This comprehensive view allows us to quickly see the impact of the worsening economy on our restaurants, particularly the shift in consumer demand to lower priced higher valued menus.

Even diners at more expensive restaurants spent less by cutting out an appetizer, a dessert or an extra glass of wine. And, it’s not just consumer spending, many businesses canceled their holiday parties in December and we’ve seen a decline in weekday sales at many restaurants because businesses are cutting back on business lunches and dinners. These are the realities of the restaurant industry today and this is the environment which we must navigate.

We were able to remain profitable in the fourth quarter despite these headwinds because we began preparing for a slower economy in the fourth quarter of 2007. Our full year results show evidence of improvements we have made in the business. Sales and net revenues increased over 2007, we also improved net income and operating expenses excluding the reversal of litigation expenses.

We all know that the economy worsened seriously in the fourth quarter of 2008. The economic situation put to test two areas that we had been working on before 2008 began, the quality of our dining credits portfolio and the managing of our operating expenses. As we’ve discussed in previous calls, beginning in December of 2007 and early 2008 we anticipated a decline in consumer spending and a period of economic uncertainty in the restaurant industry.

In response to the economic environment and recognizing that we needed to retire our convertible debt in October, we implemented more conservative dining credit purchasing policies and aggressively managed our operating expenses. Once we implemented the process for tightening dining credit purchasing policies we were able to quickly make further adjustments to become more conservative on our dining credit decision in the fourth quarter of 2008 as our view of the overall economy developed.

Our data indicates that people are eating out as frequently as before but they’re spending less when they do dine out. We have focused on adding merchants with lower prices to our portfolio in order to reflect changing consumer demand as diners look to spend less and find more value. We must also thoroughly evaluate all of the potential dining credit purchases we made in light of this environment.

You will see that our dining credits portfolio continued to decrease as we became more conservative in our use of cash. We became more selective in what merchants we purchased dining credits from based on our credit analysis of potential merchants. When we did do deals with merchants, we purchased fewer dining credits.

You can see the results of these actions in the decline in our dining credits merchant count. We more than offset the decrease in the dining credits merchant count with growth in our marketing services merchants. The growth in our marketing service program reflects the fact that we’ve enhanced the value of our marketing services product and we’re better able to demonstrate that value to restaurants.

We also have offered our marketing services products to those merchants from whom we’ve declined not to purchase dining credits. With our participation in the marketing services program we can evaluate the restaurants performance and consider purchasing dining credits from them in the future.

The results of our efforts with the dining credit portfolio are also evident in the fact that we had no major write offs in the fourth quarter and our loss experience was where we expected despite the decline on the economy. Hand-in-hand with our work on the dining credit portfolio, we began to examine every aspect of our business beginning in December of 2007.

We reduced operating expenses by $2.5 million throughout 2008. We also implemented changes to our rewards program to manage member benefit expense which we were able to reduce by $7 million despite having higher sales and while improving the overall level of member engagement. We initiated these expense reductions ahead of the dire economic headlines in the latter half of 2008 because we wanted to strengthen the business, improving our operating leverage and generate liquidity to address the repurchase of $55 million of convertible debt that we completed in October.

As the economy deteriorated, these actions became even more important. We had the business in a good position as consumers began to spend less dining out during the fourth quarter. We managed to implement these reductions and expenses while maintaining effective marketing capabilities. As we shifted away from print marketing materials to focus on Internet and email marketing, we have new ways to measure the effectiveness of our marketing.

Rewards Network emails are in the 90th percentile for open rates and the 75th percentile for click rates among clients of exact targets. We also began asking our members who complete our post dine surveys whether restaurants participation in our program affected their decision to dine at the restaurant and over 70% said it did. These are powerful messages about member engagement that we can deliver to our restaurants.

We want to build on these steps that we have taken in managing our dining credits portfolio and expenses and engaging our members. To do that we are looking to open our network to many ways that people communicate with each other today. You can become a fan of Rewards Network on Facebook, or share rewards network restaurants on your Facebook wall.

iPhone users can go to the Apple iTune store and download our free iPhone application. Our iPhone application has already been downloaded over 5,000 times since its release on February 3rd. Our free Blackberry application will be available to Blackberry users soon. These GPS based applications give you information on participating restaurants that are near where you are right now.

These are just the first steps we are taking to open our network and expand the marketing we provide to our merchants. Merchant marketing and member engagement are built on the foundation of strong business fundamentals. Most importantly our dining portfolio and well managed expenses. These fundamentals require focus and discipline. Our results for 2008 include our strong cash flows, our debt free position, our reduction in operating expenses and a more conservative growth profile of our dining credits portfolio reflecting the positive impact of our disciplined approach.

Our sales force is talking to restaurant owners every day. We survey our sales people weekly to get their view of restaurant sentiment and the message we are seeing is that restaurants remain cautious. Although our expectation in 2009 will be a very challenging year, we believe we are positioned competitively and financially to take advantage of the current market conditions in a prudent and disciplined way.

Christopher J. Locke

Overall, we’re pleased with our 2008 financial results given the economic issues that are facing both the restaurant industry and consumers. Sales, net revenue and operating earnings increased. We lowered the cash flow and profitability breakeven point of the business by restructuring our approach to member marketing and reducing operating expenses which allowed us to have a profitable fourth quarter despite a significant shift in consumer spending on dining.

Finally, through increased profitability and aggressive management of our dining credits portfolio and capital expenditures we generated enough free cash flow to retire our convertible debt in October and end the year with $9 million of cash reserves and no borrowings against our $25 million credit facility. Not only did our actions throughout 2008 result in improved financial results but, we believe we have taken prudent and necessary steps to better position the company to weather the current economic storm. However, we remain cautious.

At the end of 2008 the total number of merchants in our programs grew to 9,888, a 3.6% increase over the count at the end of 2007. However, the mix of merchants changed throughout the year. During Q1 and Q2 dining credit merchants increased and drove increased dining credit sales over the prior year. During Q3 and Q4 in anticipation of economic uncertainty and the current credit crisis we implemented even more conservative dining credit purchasing policies and credit standards which decreased the number of dining credits merchants. We ended 2008 with 195 fewer dining credit merchants than the prior year.

Throughout the year we steadily increased the number of marketing service merchants ending the year with 545 more marketing service merchants than the prior year. Fourth quarter sales were 1% lower than the prior year due in part to a year-over-year decrease in dining credits merchants that was nearly offset by an increase in marketing services merchants. In addition, a shift in consumer dining habits as well as a decrease in overall consumer spending negatively impacted Q4 sales in both programs.

The total number of qualified transactions increased approximately 6% in the fourth quarter as compared to the prior year. However, the average transaction amount declined by over 5%. As Ron mentioned, we found that consumers changed their dining habits in the fourth quarter of 2008. While our data suggests that most of our members continued to dine out, they have shifted their restaurant selection from higher end establishments towards more valued based establishments.

Consumers are spending less on each dine than they have in the past. This is being driven by consumers simply ordering less as well as an increased offering of value menus by restaurants across all price points. These trends negatively impacted our sales in Q4 2008 and will likely persist until the economy recovers.

In addition, our merchants reported the cancellation of many corporate holiday events in the fourth quarter as well as a significant decrease in gift card sales as consumers pulled back holiday spending and also feared that gift card purchases could be lost due to restaurant closures. These two issues put additional downward pressure on restaurant sales in Q4. The fourth quarter is typically our strongest sales quarter of the year and sequentially higher than the third quarter. This year, the decrease in consumer spending, cancellation of holiday parties and loss of gift card sales resulted in a sales decrease from the prior quarter.

While we have consistently pointed to growth in our dining credits merchant count and the dining credits portfolio as critical to overall revenue growth, we previously indicated that we had adjusted our risk assessment approach within the dining credits program to ensure that the portfolio was appropriately conservative given the ongoing credit and economic issues facing both restaurants and consumers and to conserve cash to ensure that we could retire the convertible debt that was due in October, 2008.

We began this process during the fourth quarter of 2007 and became even more conservative throughout the course of 2008 as the economic outlook changed. The impact of our policy and risk assessment changes is evident in the year-over-year comparison of the dining credits portfolio in terms of size and usage period. The net dining credits portfolio at the end of Q4 2008 was $76 million significantly lower than at the end of Q4 2007 when it reached $95 million.

However, the net portfolio usage period in Q4 2008 was 7.5 months as compared to 9.8 months at the end of Q4 2007, 23.5% decrease. In other words, we have significantly lowered the risk we take with each merchant. We intend to continue this conservative approach during the ongoing climate of economic and credit uncertainty. Even with the steps that we have taken to manage risk in the dining credits portfolio we were still able to increase 2008 total sales and cash flow.

While these are positive results we are mindful that the shorter usage period for the dining credits portfolio means that we must more frequently renew our dining credits merchants. The decrease in dining credit merchant count as compared to the prior quarter and prior year is due in part to the need to renew deals more frequently which is not only a strain on sales resources but also results in merchants completing the program quicker than in the past.

While we have lowered our overall exposures by reducing the usage period of the dining credits portfolio and tightening credit standards we do continue to see merchants exit the program due to cash flow issues and store closures. As a result, the balance sheet allowance for dining credits at the end of the fourth quarter was 21% of the gross asset providing higher reserves against the gross dining credit asset than in any other period.

The capital needs of the restaurant industry have never been higher nor has the risk of restaurant failure. As a result, we have and will continue to be conservative in our dining credit purchases and significantly reduce or all together eliminate purchases from merchants we consider a high default risk. In addition, during the third and fourth quarter of 2008, we became significantly more conservative with our dining credits purchases from high end restaurant given the significant declines in sales at these establishments.

We have focused our dining credits purchasing on the types of restaurants that are the most appealing to consumers during these times. We will continue to manage the portfolio to mitigate risk and maximize our own liquidity during these uncertain times.

Throughout 2007 and 2008 we focused on implementing changes to our websites, our email marketing and member reward structures to drive increased revenues and improved member engagement in a more cost effective way. These changes had a significant impact on both profitability and cash flow during 2008.

Since the beginning of 2008 our member reward structure began providing our highest level of benefits to members who provide us permission to send marketing to their email addresses, dine frequently and provide feedback regarding their dining experiences. These changes have had the dual impact of significantly decreasing the cost of member benefits and improving member engagement. As compared to the prior year the cost of our member benefits decreased $2.3 million for the quarter and $7.2 million for the full year.

Our online marketing initiatives have resulted in overall marketing expense decreases of $900,000 for the quarter and $3.4 million year-to-date. Throughout 2008 we’ve focused on tight management of our operating expenses. As I previously mentioned we reduced marketing expense by shifting from print to more effective online marketing channels. In the third and fourth quarter we eliminated a number of non-sales headcount resulting in annual savings of approximately $3.9 million.

While we significantly tightened up on operating expenses in the third and fourth quarters we specifically avoided cost reductions that would adversely impact our sales force. While we view the current economic environment as challenging, we also see an opportunity to add more merchants to our program. We have invested heavily in our sales force over the past three years and intend to maintain full staffing levels.

Operating expenses for the fourth quarter totaled $17 million or 29.5% of sales as compared to $18.1 million or 31.1% of sales for the prior year. Year-to-date operating expenses totaled $67.1 million or 27.4% of sales as compared to $69.6 million or 30.9% of sales in the prior year after adjusting for the reversal of litigation expense. We are focused on maintaining operating leverage through disciplined expense management.

The net impact of our efforts resulted in profitable full year and quarterly results. Diluted year-to-date EPS totaled $0.18 as compared to $0.26 in the prior year. 2007 EPS included a $0.33 per share favorable adjustment related to the reversal of litigation expenses. Excluding this adjustment 2008 year-to-date diluted EPS was $0.25 higher than the prior year. Diluted EPS for the fourth quarter of 2008 totaled $0.01 as compared to $0.02 in the prior year. Q4 2007 EPS included a $0.04 per share favorable adjustment related to the reversal of litigation expenses. Excluding this adjustment, Q4 2008 diluted EPS was $0.03 higher than the fourth quarter of the prior year.

Now, let’s move on to cash flow. Our efforts to increase revenues, reduce operating cost and reduce risk in the dining credits portfolio resulted in significant cash generation during 2008. We utilized this cash to retire our outstanding convertible debt, fund new dining credits purchases, invest in our infrastructure and create cash reserves. Throughout 2008 we retired $55 million of outstanding convertible debt including $14.8 million during the fourth quarter.

During 2008 the company funded approximately $140 million of new dining credits. We also invested $4.1 million in capital expenditures. Our investments were focused on maximizing our electronic marketing platforms as well as ensuring that we maintain strong data security standards.

We ended 2008 with $9 million in cash reserves and $25 million of availability on our revolving credit facility. We expect to utilize the facility going forward to fund our working capital needs and believe the facility provides adequate liquidity. Thank you for your time and we’ll now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Gary Prestopino – Barrington Research Associates.

Gary Prestopino – Barrington Research Associates

Just one quick housekeeping question for Chris first, can you give me a breakdown of the interest income and the interest expense for the quarter and then what the D&A was for the quarter?

Christopher J. Locke

The D&A for the quarter was about $1.4 million and give me a second to get the interest data. I’ll chime back in, in one second with it.

Gary Prestopino – Barrington Research Associates

Then one thing I noticed was that the sales yield on the marketing services business year-over-year was down about 140 basis points. What accounts for that? Is it just that you have to give a better and rich deal to start getting more merchants in to this marketing services program?

Christopher J. Locke

The yield is down simply because we’ve lowered the price a bit but if you look at the member rewards we’ve reduced the cost of the members’ rewards significantly. So, the overall net revenue on that program has increased from 47% in the prior year to 60% this year so our restructuring of the member benefits and improving engagement and the work on that side has allowed us to give some price back to the merchant which has helped us grow the merchant count in that program.

Ronald L. Blake

While equaling or improving margins.

Gary Prestopino – Barrington Research Associates

Then in terms of your merchant base, what is it about close to 10,000 now, right? Can you give us an idea of what the mix is there in terms of percentage which would be the lower price tickets versus the mid price to high price and how has that changed over the last year with what you’re doing?

Ronald L. Blake

Gary, I don’t have the specifics with me at this point but let me answer that in general. In the past there would have probably been a reasonable to moderate concentration in restaurants that had average ticket prices above $75. Over the last year or so as we began the economy weakening and people becoming more conservative we significantly scaled back in that area.

The higher price restaurants in particular tend to have a significant amount of overhead they have to cover and as they saw declines in their dining activity, operating leverage cuts both ways and we had already made the decision to significantly reduce the amount of business we were doing in those segments. Overall, I think we were ahead of the curve on that, not that we completely avoided it.

On the other hand that price point that results in an average ticket of $25 to $40 right now is clearly where the value kind of conscious diner is headed to in using the program. We feel very good that we’ve repositioned an awful lot of our restaurant inventory to reflect that. As you see in some of the other public comps out there, the restaurants, the fast food in particular side of the world seems to be holding up okay.

Chris would you comment on the fact that just the sheer volume of activity and I know you noted it in your script about our diners?

Christopher J. Locke

What we’ve observed from our member base is the number of transactions in the fourth quarter was up year-over-year, the number of active members was up slightly year-over-year. So, we still have very good engagement from our members and they continue to dine out they’re just spending less. Some of it is the type of restaurants that they’re going to, lower price and also cutting back what they’re spending.

Then, the restaurants have now adapted and are offering fixed price menus and combo deals, throwing in a salad where they use to charge it ala carte, those types of things are causing the average ticket to go down.

Gary Prestopino – Barrington Research Associates

You can see that in the numbers it’s down. If you look at it on a qualified transaction number divided by transactions, it’s down about 5.5%?

Christopher J. Locke

Yes.

Operator

Your next question comes from [Alan Aparso].

[Alan Aparso]

Could you give me an update on what you’re seeing in the marketplace as far as other alternatives besides a company like yours financing restaurants today and what the restaurant situation really is here? In other words, how’s your competition? Where is your competition coming from today and is it more or less than its been?

Ronald L. Blake

I think overall there is an overall level of caution that goes from the extreme to the conservative. The banking side of the world as I think all of us are aware is going through a severe restructuring and the restaurant industry with notable exception of maybe one or two they have completely pulled back from providing any type of financing to. Obviously our program is significantly different than [Kerr Financing] but that is one of the competitors out there.

You also see the factoring types of companies out there and we have seen at least in certain markets either a pull back or an elimination of business activity in them or being done on terms that are extremely cautious. On the other side the electronic marketing side whether it be firms like Constant Contact or some of the other email marketing, I’d say they’re about the same as they were.

The restaurateurs clearly are focused on two things right now paying off debt and doing more electronic marketing. I think one of the reasons that you’re seeing the growth on our marketing services product has been our complete shift to electronic marketing. The value proposition that we have and the fact that we are now getting very good at proof of value with the restaurateurs. The fact that we were able to reduce benefit cost on drive up number engagement and expand our margins while we lowered the price to them I think competitively is making us a very attractive alternative.

Operator

At this time I’m showing no further questions.

Ronald L. Blake

Let me conclude by saying overall that the foundation that we laid in late 2007 and 2008 I believe have positioned Rewards Network to weather the storm relative to the current economy. As I noted in my remarks the strength of our activities will be demonstrated in how well we do in managing our expenses and just importantly the overall quality of our dining credits portfolio.

We moved quickly to respond to the economic conditions and to ensure adequate liquidity for the business under what I think are very trying circumstances and we believe that we are positioned as a value oriented service to the restaurant community. The work we have done on proof of value I think will continue to demonstrate that value going forward and it will position us well as the economy begins to recover and the benefits of the operating leverage that Chris referenced will then begin to materialize.

We thank everyone for joining us today and we hope you have a good day.

Operator

Thank you ladies and gentlemen. That now concludes today’s conference. Thank you for participating and you may all disconnect.

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