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Sonic (NASDAQ:SONC)

Q2 2013 Earnings Call

March 25, 2013 5:00 pm ET

Executives

Claudia San Pedro - Vice President of Investor Relations & Communications and Treasurer

J. Clifford Hudson - Chairman and Chief Executive Officer

Stephen C. Vaughan - Chief Financial Officer and Executive Vice President

Analysts

Nicole Miller Regan - Piper Jaffray Companies, Research Division

Matthew J. DiFrisco - Lazard Capital Markets LLC, Research Division

Will Slabaugh - Stephens Inc., Research Division

John S. Glass - Morgan Stanley, Research Division

Joseph T. Buckley - BofA Merrill Lynch, Research Division

Keith Siegner - Crédit Suisse AG, Research Division

Brian J. Bittner - Oppenheimer & Co. Inc., Research Division

Larry Miller - RBC Capital Markets, LLC, Research Division

Operator

Good afternoon, and thank you for standing by. Welcome to today's Sonic Corporation Second Quarter Fiscal 2013 Earnings Conference Call. [Operator Instructions] As a reminder, today's conference is being recorded. I would like to turn the conference over to Ms. Claudia San Pedro, Vice President of Investor Relations and Communications, and Treasurer. Please go ahead, Ms. San Pedro.

Claudia San Pedro

Good afternoon, everyone. We are pleased to host this conference call regarding results issued this afternoon for the second quarter of fiscal year 2013, which ended on February 28, 2013.

Before we begin, I would like to remind everyone that comments made during this conference call that are not based on historical facts are forward-looking statements. These statements are made in reliance on the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and are subject to uncertainties and risks. It should be noted that the company's future results may differ materially from those anticipated and discussed in the forward-looking statements.

Some of the factors that could cause or contribute to such differences have been described in the news release issued this afternoon and the company's annual reports on Form 10-K, quarterly reports on Form 10-Q and in other filings with the Securities and Exchange Commission. We refer you to these sources for more information.

Lastly, I would like to point out that remarks made during this conference call are based on time-sensitive information that is accurate only as of today's date, March 25, 2013. The archived replay of this conference call webcast will be available through April 1, 2013. This call is the property of Sonic Corp. Any distribution, transmission, broadcast or rebroadcast of this call in any form without the express written consent of the company is prohibited.

We have posted our second quarter fiscal earnings slide show presentation on the Investors section of our website for your review, both during this conference call and after the conference call for up to 30 days.

Finally, we have scheduled this call, which includes the Q&A portion, to last 1 hour. If we have not gotten to your question within that hour time slot, please contact me at (405) 822-4618 and I will make the appropriate arrangements to answer your question.

With that out of the way, I'll turn the call over to Cliff Hudson, the company's Chairman and Chief Executive Officer.

J. Clifford Hudson

Thank you, Claudia, and thanks to all of you for joining us this afternoon. We appreciate your ongoing interest in our company, and we're also, of course, particularly pleased this afternoon reporting the results for our quarter ended February, another solid quarter.

So as you know now, a few highlights from that second fiscal quarter includes the fact that our earnings per share doubled on the quarter from $0.03 a share last year to $0.06 this year, and reported same-store sales at our company drive-ins increased almost 2%, 1.9% during the second quarter, and the system was flat during the quarter. But if you exclude the impact of the additional day from leap year that we had in 2012, the systemwide same-store sales would have been 1.3% and company drive-ins would have been 3.3%.

We also experienced what I would describe as more normal winter weather patterns this year than we did last year, which was really unseasonably warm during the winter quarter. So with these 2 items in mind, and then also combined with a still pretty challenging broader environment of the economy, we're really pleased with our second quarter results and particularly pleased with the performance of our company drive-ins.

Now some other highlights for the second quarter include the fact that at our company drive-ins, we had 140 point basis -- 140 basis-point improvement in drive-in level margins. This is, of course, driven by the 1.9% same-store sales growth at our company drive-ins that I referenced a moment ago. And then also with regard to our capital allocation, we repurchased $6 million of our common stock during the quarter, or 626,000 shares. We also paid down $23.7 million of debt.

As a reminder, since the new share repurchase authorization in August of last summer, August 2012, we've repurchased $25.6 million of common stock. This represents about 4% of our outstanding shares since the beginning of the year.

So looking to the results of the continued improvement that we're experiencing, the improvements we made in the business over the last year really provided a nice foundation to help drive that. This includes several things, including improved customer service, and as a matter of fact, in that topic or that category of improved customer service, in recognition of this improvement, a recently published TIMKEN EXPERIENCE ratings report, the 2013 edition, which measures customer satisfaction across 19 different industries, Sonic received the highest customer rating in the Hamburger QSR category and was one of 3 QSR concepts that ranked in the top 12 businesses in the TIMKEN report. So we were very positive about what this meant for our improved customer service.

But other elements of that foundation, in addition to improved customer service, we've effectuated more effective product pricing, improved our product quality and improved our media -- the efficiency of our media buying. And these initiatives really have provided a solid foundation to help move our business to another level. And it's important to note that the consistency of our sales and profit improvements have demonstrated over the last 2 years that our result of not just any one of these but all of these initiatives working together, effectively supporting each other.

Shifting to initiatives that we believe that will sustain our sales and profit growth going forward, our multi-layer growth strategy, we've highlighted this for many years, and this continues to be a key to producing double-digit earnings growth going forward. Historically, we've achieved solid, consistent earnings growth by layering the same-store sales growth, operating leverage, new drive-in development, the ascending royalty rate unique to us in our business and the effective deployment of our free cash flow.

When you look at these layers in total, sustaining positive same-store sales is a key component to providing the momentum for the others as well. The additional layers are also necessary in order for us to achieve a double-digit growth rate that we've seen over the last several quarters and saw for a number of years before the recession.

So as we work to assess our confidence in driving consistent earnings over the next several years, the confidence is buoyed by the strong initiatives we have in place for each of these layers, and in turn, we believe each layer can make a meaningful contribution to the solid double-digit earnings growth rate.

For our fiscal year 2013, our revised media buying and innovative new product pipeline combined are expected to drive positive same-store sales, and in turn allow us to leverage drive-in and operating income margin improvement.

When these are combined with the effective use of our cash -- excess cash to reduce debt and repurchase stock, we've demonstrated that solid earnings growth in the first half of the -- first half of our fiscal year 2013, we expect that this is going to continue through the rest of the year.

So we look into 2014 and subsequent years, we expect that other initiatives, some which we've discussed in the past, like the implementation of a new point-of-sale system and supply chain management system, these will work to improve our profits and our margins really for the entire system, for our company as well. When you couple the improving sales and profits with the new small building prototype, we expect to see development, new store development pick up in 2014 as well.

And in 2015, as you may recall, we have a license conversion and renewal, which is expected to result in approximately 850 stores, or the licenses for those stores, going to a higher royalty rate. This will be a meaningful contribution to our earnings growth in 2015 as well. As these initiatives are implemented, we also expect, as you would, improved sales, profits and unit growth, which will result in increased operating cash flow for us. As always, we'll evaluate the most effective use of our cash to ensure that we achieve the right balance of investment in our brand, our company's leverage and share repurchases.

So the combination of these components of our multi-layer growth strategy, that we've talked about over the years, where those elements working together should result in sustained earnings per share growth and in turn increased shareholder value, both in the near and -- near term and over a longer period of time.

Now that multi-layer growth strategy and specifically looking at the same-store sales drivers. For this fiscal year, there really are 4 main initiatives that resulted in our same-store sales growth rate during the first 6 months of the year, and we expect those to continue, though, as the year progresses. That would include a more effective media strategy, innovative product pipeline, a layered day-part promotional strategy and our iconic television creative.

So working back through those, with regard to the media strategies, our investments in media and the allocation of media have been important drivers, not only to same-store sales but also new store development for our brand over time. In the last decade, the early part of the decade from 2003 to 2005, we experienced same-store sales growth and new unit development, which we believe is really directly related to our increased -- to an increase in our allocation of media dollars from local television to national cable, in conjunction with other initiatives. This was particularly beneficial to our development efforts in newer markets.

As we've noted beginning in January 2013, approximately 70% of our media dollars will be invested in national cable, with the remaining portion in local television and other mediums. This is up from roughly a 50-50 split, previously, and that is between local and national, and should have the impact of increasing the number of times our average customer or potential customer in every market will see our commercials. We expect this increase to drive increased sales in all of the markets. It's a great thing with that efficiency, it's not just in new or developing markets but all markets. And we also expect this to have a positive impact on new store development over time.

Looking at the layered day-part promotional strategies, for a lot of years, innovative, distinctive products have been a hallmark of our brand. And in this year, fiscal 2013, we've continued that tradition with a number of new items that are a step-up from what you may have seen in the recent past.

Particularly exciting for us is that we'll have distinctive new product news across all of our day-parts, which is very important given the role that individual day-parts have historically played and continue to play for our brand. During the second quarter, our new product news highlighted our distinctive ultimate grilled cheese sandwiches with the Philly Steak Grilled Cheese Sandwich and the BLT Ultimate Grilled Cheese Sandwich, as the entree items that we offered and 2 new premium breakfast toasters, to emphasize our breakfast day-part.

This was in addition to our premium chicken sandwich that we offered earlier in the quarter and our new Sweetheart Shake. So current examples for the third fiscal quarter include our new Spicy Jumbo Popcorn Chicken for lunch and dinner, Sweet Potato Tots as an afternoon snack, our new Molten Lava Cake Sundaes for afternoon and evening. In addition, we're excited to be introducing new freshly brewed iced green tea. We're one of the leaders in offering a product of this kind in the QSR, and it's available in regular and diet. This addition increases the number of drink combinations at our drive-ins and it also demonstrates our continued commitment to innovation in the drink category.

As I alluded to earlier, in contrast to most of our competitors, growing each day-part is a critical element for us in driving same-store sales growth, given that over 50% of our sales occur outside of lunch and dinner hours. The layered day-part promotional growth strategy -- excuse me, promotional strategy that features a variety of our products in a relatively short 60- to 90-day time frame to drive sales across all day-parts, this is important to sustaining positive same-store sales for us.

So reintroducing the "Two Guys" last year was a key piece of this strategy, primarily because of the recognition they provide in each of our commercials, enabling us to promote all day-parts, all of our day-parts in shorter time frames, or promote all of the day-parts within the same quarter, which is our objective, and the iconic creative that they presented as a great brand-builder for consumers, and we're continually looking for ways to keep them fresh and relevant because they have worked so hard for us and so closely associated with our brand.

The promotion of each of our multiple day-parts with fresh, relevant, compelling products was a large reason why we achieved 2 decades of positive same-store sales prior to the recession, and we believe returning to this strategy is a major reason why we've seen more consistent same-store sales growth through the past few quarters. We feel confident that we can sustain positive same-store sales looking forward.

Now as you've seen in our results, improved margins have followed our improved sales, and looking ahead, we expect further improvement in drive-in and operating margins from the implementation of a new point-of-sale system. The new point-of-sale system will provide integrated back-office tools like labor management, inventory control to increase profitability at the store level, which we believe will help us achieve return to a 16%, 17% drive-in level margins on an annualized basis.

We believe this point-of-sale system initiative, combined with complementary supply chain rationalization, will benefit the entire Sonic system in the mid-term and for years to come. So overall, we're really very pleased with the consistency of our sales and profit improvements, driven by our multi-layer growth strategy. Historically, these strategic elements have worked together to drive consistent strong earnings growth.

Many of you may remember our efforts from 1996 to '99 when we expanded our media coverage, emphasized the uniqueness of our frozen and fountain offerings and implemented retrofit for our entire system; or the same type of process to 2003 to 2007, during which we switched our media effort to national cable, added breakfast to our day-part mix, implemented pace [ph] and focused on rebuilds and relocations, which combined to drive an average of 6% annual sales increases and average EPS growth of 19% during that time frame.

So for the past several quarters, we've seen the benefit of 3 of the 5 layers in our multi-layer growth strategy, positive same-store sales, improved operating margins and use of cash flow. And we've seen that drive double-digit earnings growth. So these improvements, combined with initiatives we've outlined, give us the confidence that we're positioned well for consistent sales and earnings growth in the near and long term.

So with that, I'm going to turn it over to Steve Vaughan.

Stephen C. Vaughan

Thank you, Cliff. New store development and our unique ascending royalty rate are 2 important components in our multi-layer growth strategy, and we expect to see a significant step-up in the contribution from these layers in fiscal 2014 and subsequent years.

Our core franchise business remains very solid. While we have noted that the ascending royalty rate will be constrained by development incentives and franchisee workout efforts in FY 2013, we expect positive same-store sales to produce corresponding increases in royalty revenue. And in fact, in the second fiscal quarter, we saw a 3 basis-point improvement in the effective royalty rate. This increase was primarily a result of some agreements transitioning to a different form of the license agreement with a higher royalty rate structure. We expect our royalty rate to increase on a consistent basis in FY 2014 and subsequent years as same-store sales improve, development incentives wind down and development increases.

Over the past year, we've seen improved same-store sales performance in both new and developing markets, which we believe is the result of our emphasis on service and product improvements, combined with improved media efficiency, including increased national media expenditures. We are confident this national media initiative will further strengthen the trends in these markets.

We had 3 new Franchise Drive-In openings during the second quarter, and as of the end of February, we had 3,526 total drive-ins operating in 43 states. While store closures, fiscal year-to-date, are higher than the prior year, we continue to expect the number of closings in fiscal 2013 to be on par or slightly less than 2012. Given the seasonality of our business, closures are typically more concentrated in the first half of the fiscal year.

The improvement in our sales and profit momentum has helped to increase our franchisees' overall confidence in the business. Calendar year 2012 profit increases for our franchisees were the strongest they have been in 5 years. As our store-level profits have grown, our franchisees' appetite for new development likewise appears to be growing, and we're seeing more activity in looking at new sites.

With the improved store-level profitability and a new small building prototype that improves the return on investment, we also expect development to accelerate beginning in fiscal year 2014 and subsequent years. We expect new Franchise Drive-In openings this fiscal year to be slightly more than fiscal 2012, similar to prior years. However, our new drive-in openings tend to be concentrated in the second half of the fiscal year.

One of the reasons we expect stronger development over the longer term is the work we've done to improve new store return on investment through a new smaller building design, which reduces non-land costs by 15% to 20%. We have opened several of these drive-ins to date, and we expect that this will become the primary layout for new stores in the future.

To further incentivize our franchisees, we'll also continue to offer development incentives in the form of a lower royalty rate, schedule offering License Type #6 instead of the #7, if franchisees build new drive-ins within a certain time period. As we have noted, this development incentive does not provide for royalty abatements, and the #6 agreement has a higher average rate than our overall average royalty rate, so it will not have an adverse impact on our royalty rate. Over time, we expect these franchisee incentives to yield long-term benefits with increased brand penetration and improved sales, in addition to an ascending royalty rate, as new drive-ins are built and volumes continue to grow.

I'd now like to spend a few minutes talking about our financial performance. As Cliff mentioned, excluding the extra day last year, company drive-in same-store sales would have increased more than 3% and system-wide same-store sales would've been up approximately 1.3%. Given the more challenging consumer environment during the first part of the calendar year, we were particularly encouraged by these solid results. Our sales increase resulted in operating income margin improvements and helped drive a substantial $0.67 increase in earnings per share on an adjusted basis, to $0.05 versus $0.03 per share last year.

Included in our second quarter results were a $492,000 charge from the write-off of debt origination costs associated with a $20 million early paydown of debt, and a net tax benefit of $857,000 from the retroactive reinstatement of WOTC credits, as well as the resolution of other income tax matters. Combined, these items had a $0.01 positive impact on our fully diluted earnings per share.

Our strong results continue to demonstrate our ability to grow earnings at a double-digit rate, with moderately positive same-store sales, leverage from that sales growth and effective deployment of our excess cash flow. We are pleased with our overall business trends and believe the improvements we have made over the past 3 years in our products, pricing and service, in combination of the refinement of our promotional strategy and a robust product pipeline, will continue to yield improved and more predictable sales growth.

Going forward, we continue to target same-store sales increases in the low single-digit range. We remain pleased with the performance of our company drive-ins from both a same-store sales and a margin perspective. Overall, company drive-in margins improved 140 basis points in the second quarter to 11.8%, reflecting leverage from solid same-store sales growth, a favorable commodity cost environment, and to a lesser extent, the timing of expensing our annual business meeting, as well as the refranchising of underperforming drive-ins during the second quarter of 2012.

The improvement in drive-in margins was a major factor in our second quarter earnings growth. These improvements in drive-in and corporate level margins demonstrate the potential to show significant operating leverage, as we achieve positive same-store sales going forward.

Looking at each individual line item for the second quarter. Food and packaging costs were slightly favorable. This improvement reflects benign commodity cost inflation, effective management of food costs and menu price increases. We are currently running approximately 3% in pricing at company drive-ins.

We have locked in the cost for over 80% of our commodities in FY 2013 and currently expect inflation to be in the 1% to 2% range for the remainder of the fiscal year. We will be lapping over a 1.5% to 2% price increase in May of this quarter. We are planning to take a small price increase in May. However, the new price increase implemented this May will be conservative in light of the still fragile consumer environment. Overall, we expect to see continued moderate improvement in food and packaging costs for the year.

Payroll and employee benefits were essentially flat as a percentage of sales. For the remainder of FY 2013, we expect to see some year-over-year improvement in our payroll and employee benefit costs with our seasonally stronger third and fourth quarter volumes.

Other operating expenses were favorable by 130 basis points as a result of leverage from increased same-store sales, the refranchising of lower-performing drive-ins in Q2 of last year, and a 30 basis-point reduction as a result of a change in the method by which we expense our annual business meeting. As a reminder, there will be a 25 basis-point reduction in other operating costs in the third and fourth quarters this year, as the business meeting expense was a timing change only.

Looking forward, we expect to continue to see improvement in our drive-in margins dependent upon the degree to which same-store sales are positive and anticipate 2013 drive-in margins to be in the 14.5% to 15% range. Looking longer-term, we believe we have an opportunity to drive further margin expansion with the implementation of a new point-of-sale system. As with most technology initiatives, development has taken a little longer than originally projected, and we now expect to roll out the new system to a full test market this summer. We would then expect to implement the new system in company drive-ins over the fall and winter months.

Further, we expect to roll out the new system to franchise locations over the next 1 to 3 years. As that rollout progresses, we will provide updates on timing and quantification of margin improvements we expect.

The implementation of our new supply chain management solution is under way, with the benefits from rationalizing our supply chain expected to be seen in fiscal 2014 and beyond. We are pleased that positive same-store sales has resulted in higher store-level profits at both company and franchise locations. These improved sales trends have translated into improved financial health on the part of our franchisees. Driving positive sales and profits across the Sonic system remains our primary focus.

For the second quarter, our SG&A expenses decreased approximately 4%. This decrease was largely attributable to 2 items. First, our prior year SG&A second quarter expense included a catch-up accrual on variable compensation costs. In addition, bad debt expense decreased this year, which is a result of improved drive-in level profits. We anticipate SG&A will be higher in the third and fourth quarters, coming in at between $17.5 million and $18 million each quarter. However, we will continue to closely monitor our overhead and we'll add resources as necessary to drive our key initiatives.

As I mentioned previously, our tax rate was down in the second quarter compared to the prior year, primarily as a result of a tax benefit associated with the retroactive reinstatement of the Worker Opportunity Tax Credit and the resolution of some income tax matters. The states have fallen behind on processing WOTC applications, making the estimation process a bit more difficult. However, with the reinstatement of the WOTC credit, we expect the tax rate to be between 37% and 38% for the third and fourth quarters of FY 2013, but this rate may vary depending upon future developments.

Our business model is, first and foremost, focused on franchising. As a result, we generate significant amounts of stable and predictable cash flow with only moderate capital needs. This model gives us the flexibility to invest in our brand if it meets our return on investment criteria, repurchase shares and pay down debt. As Cliff mentioned earlier, we have purchased approximately $25.6 million of stock since the new share repurchase authorization in August of 2012, and we also increased that share repurchase authorization by $15 million to $55 million in January of this year, leaving us with approximately $29.4 million of availability under our current program.

Combined with our FY 2012 repurchase program, these repurchases were accretive to second quarter earnings and are anticipated to be nicely accretive in fiscal 2013.

I also want to point out, we closed on the previously announced real estate transaction at the end of December. A franchisee exercised his option to acquire land and buildings we leased or subleased to him related to drive-ins we refranchised in 2009. As a result of this transaction, we realized approximately $30 million of cash proceeds and will receive another $9 million over the next 24 months.

As a result of this sale, we expect to see a reduction in lease revenue to approximately $750,000 per quarter. This reduction in lease revenue should result in combined lease and other revenue of $2 million to $2.5 million per quarter in the third and fourth quarters, respectively.

We also anticipate a reduction in depreciation expense of approximately $500,000 per quarter going forward, resulting in depreciation of $10 million to $10.5 million in each of the third and fourth quarters. With the real estate sales proceeds, we've prepaid an additional $20 million of debt in January and expect a $600,000 reduction in interest expense in the second half of the year as a result of this paydown.

On a related note, we recorded a $492,000 charge from the write-off of debt origination costs associated with the early debt extinguishment. In fiscal year 2013, we project we will generate between $45 million and $50 million in free cash flow, which we define as net income plus depreciation, amortization and stock compensation expense less capital expenditures.

Looking forward, we will continue to use our free cash flow to enhance shareholder value by investing in our brand with initiatives such as the replacement of our legacy POS system, repurchasing stock or paying down debt.

As we have noted, our goal over the next couple of years is to reduce our net debt-to-EBITDA level to the 3x range through a combination of growing our earnings and reducing our debt. We are very pleased with our progress towards this goal as our current net debt-to-EBITDA was approximately 3.3x as of the end of the second quarter. However, we will continuously evaluate all options to determine the best uses of our excess cash to provide the greatest impact to shareholder value creation. We continue to have a very solid balance sheet and exceed our debt compliance covenants by a wide margin.

So to summarize, for fiscal 2013, we expect positive same-store sales in the low single-digit range; slightly more Franchise Drive-In openings in fiscal 2013 than fiscal 2012; drive-in level margin improvement of between 50 and 100 basis points; SG&A expenses in each of the third and fourth quarters of $17.5 million to $18 million, respectively; depreciation and amortization expense of $10 million to $10.5 million in each of the third and fourth quarters; net interest expense of approximately $28 million to $28.5 million, excluding the debt extinguishment charge recorded in the second fiscal quarter; a tax rate of between 37% and 38% for each of the third and fourth quarters; and capital expenditures of $30 million to $35 million, which includes partial implementation of the point-of-sale system in company drive-ins and supply chain management for the Sonic system.

I'd now like to turn the call back over to Cliff for some closing comments.

J. Clifford Hudson

Thank you, Steve. As you can see, we continue to be confident in our multi-layer growth strategy. We remain confident that it can deliver double-digit earnings growth from a foundation of improved service and product quality, as well as the effective use of promotional media strategy and a good creative format from a television standpoint as that helps keep us distinctive within our industry.

So from our viewpoint, with this consistent and sustained same-store sales we'll continue to benefit from increasing franchising revenue, improving operating margins, and over the next 2 or 3 years, the implementation of a new point-of-sale system and supply chain management system.

And this, combined with the effective use of our cash, will be the primary drivers of our earnings growth in the near term. So for fiscal 2014 and subsequent years, new unit growth and the ascending royalty rate will also add to boost -- add a boost to our earnings growth.

So this concludes our prepared remarks, and we'll be happy to respond to any questions you might have.

Question-and-Answer Session

Operator

[Operator Instructions] I will now take our first question from Nicole Miller with Piper Jaffray.

Nicole Miller Regan - Piper Jaffray Companies, Research Division

One quick numbers question. In terms of the comp, I think you talked about the 3% price right now. Can we understand the rest of the comps to be mix and traffic and could you specifically call out if you are benefiting from positive or negative mix, as well as traffic?

Stephen C. Vaughan

Yes, Nicole. We are seeing the majority of our same-store sales growth is coming from a combination of price and mix, so our traffic has been basically just maintaining at existing levels, so relatively flat.

Nicole Miller Regan - Piper Jaffray Companies, Research Division

And that's where if you back out the leap year, it would be up, it would be into the slightly positive territory then?

Stephen C. Vaughan

At Company Drive-ins, that's correct.

Nicole Miller Regan - Piper Jaffray Companies, Research Division

Okay. And then a big-picture question. If you look at the limited service arena, so not just QSR and not just fast casual but the whole limited service umbrella. I'm going to ask about loyalty programs. Traditionally, QSR hasn't had them but fast casual has, and more recently, they are becoming more popular, even in some of the limited -- more of the QSR type concepts. Is that something that you would consider doing in the future? And if so, how would you do it?

J. Clifford Hudson

Well, I'll treat that as 2 questions. First is would we consider doing it, and the answer is yes. We are exploring that now and developing that now. And so as we reach the point where we're ready to roll that out in a more public format, we'll share that with you. We do think it has a place in our business, and we have many very regular customers, and so it makes sense to reward them for being so but also help drive additional traffic with customers who might appreciate that as well. Now as to how we would do that, we are working on that, we're working on it quite -- in a quite focused manner. However, that's not something that I really want to lay out the details of that today. It will take a variety of forms over time but we'll -- as we -- as that evolves and we're ready to share elements of it, we'll do that.

Operator

And we'll take our next question from Matt DiFrisco with Lazard.

Matthew J. DiFrisco - Lazard Capital Markets LLC, Research Division

Gentlemen, I guess I'm just thinking longer term as you've talked now a couple of quarters about some of the initiatives where you think the point-of-sale system could be a margin driver in the company-owned stores. I'm assuming also the pace that you're talking about throughout the system being rolled out. Could this also be somewhat more of a traffic driver? Or how do we look at this as far as your margins are improving pretty quick already without your comp turning around. So the targets you've set, not ambitious, especially given the point-of-sale system that could be pretty meaningful. Are you going to reinvest this potentially so you reach 16%, 17% margins? And I think you and the franchisees would rather see a couple of hundred thousand dollars of sales at a 16%, 17% margin maybe and start to see some pretty meaningful comp growth and reinvest and help your value position? Or is this going to be let's just drive the margin as much as we can? And I'm wondering how do you balance that as far as reinvesting and giving some of that value back to the customer if you could speak to that?

J. Clifford Hudson

Well, we continue to look at ways to refine our offering, you might say, and part of that's service, part of it's food, part of it also relates to other ways we're working to improve the engagement of the customer. So even as our profitability improves, there are additional ways, Matt, that we are looking to improve the customer experience so that our -- so it's not just a question of improving margins and keeping the experience constant. Now your next question was going to be, "Well, could you lay out what those different approaches of engagement would be?" And my answer to that would be much the same as it is on the loyalty program question a moment ago that Nicole asked, and that is in the near term, as we look to what those initiatives are, as we're -- I should say, as we're ready to discuss those, we'll lay it out for you. But you're -- I think you're -- it's an interesting question and you're right to ask how are we looking at ways to, in essence, improve the customer -- you might say -- we might say engagement but I think it's -- from a customer standpoint, we would say the customer experience and elevate the results of what's occurring at the drive-in. I'm not sure that I have a more specific answer for you than that but it's an interesting question and one we are actively exploring.

Matthew J. DiFrisco - Lazard Capital Markets LLC, Research Division

I guess it will be a good problem to have if you're already at those targets of that 16%, 17% by the time you start rolling out the point-of-sale system, so you'd be going north of those targets, I would assume. I guess just also as a follow-up, I think it was Steve that reiterated the guidance for slightly more openings, and I guess the inference is there that slightly more net openings as well, as I think you took some time to explain at the closings that's not a pace that you'd expect. So I guess, what was going on behind that? Was it just that you thought it's best during the wintertime to close some of those stores down, and we're not going to see 3Q and 4Q degree of closings because I think 4Q was a pretty heavy closing period last year? So is that just baked into, assuming that better positive comps are going to keep those stores open? Or would you have -- would you know already right now what type of closings you'd have for 4Q coming down the pipe?

Stephen C. Vaughan

Matt, yes, so a couple of things. One, we do anticipate that the closings over the winter months will represent the majority of the closings. We are able to, for the most part, forecast when the closings will occur based on communications with franchisees and just monitoring their financial results. So at the end of the day, yes, we do expect to have a more net openings this year than last year.

Operator

Will Slabaugh from Stevens.

Will Slabaugh - Stephens Inc., Research Division

I want to ask you about the product pipeline. I guess you've obviously been very active there as you've been putting up these more consistent, strong, low single-digit same-store sales. Wondering what that looks like now, how you feel about it, maybe if you'd go into -- through what that pipeline looks like now versus maybe the past 4 quarters and how far out that goes, if you would?

J. Clifford Hudson

Well, we've made an investment in human resources in the last year and more that has paid off. And so our product pipeline, new product pipeline looks better than it did 12 and 18 months ago. It looks better in terms of refinements of existing lines of products by day part. But it also, I think it's stronger from the standpoint of new product news that's coming down the pipe. So from either standpoint, it does look much improved versus a year ago. And I think with the talent pool we have on board, it will continue to improve on the coming -- in the coming quarters.

Will Slabaugh - Stephens Inc., Research Division

Great. And then one other question I had. Whenever you referred to some of the newer and developed markets putting up some good performances as likely benefited from some of that shift toward a more national media campaign, I wonder if you'd talk any more specifics around what that gap may be and what you might expect from some of these new and developing markets as you do put more media dollars into national TV?

J. Clifford Hudson

You mean a gap from a sales standpoint or what...

Will Slabaugh - Stephens Inc., Research Division

Right, from a same-store sales growth standpoint.

Stephen C. Vaughan

No. We haven't really talked about that specifically.

J. Clifford Hudson

But you need to keep in mind that the lion's share of our sales come from our core markets anyway. 75% of our sales are going to come from the core markets. But the -- so well, I hope I'm not redundant here but so lion's share of the sales come from the core markets, however, the objective of the reallocation of media dollars was intended to help the whole system, which it has, a better use of -- so more -- greater gross rating points across the entire system including core markets. Now these new and developing markets are disproportionate beneficiaries of this. And so a bit more of -- it's a good near-term play in terms of the impact of same-store sales, but it's also intended to be a long-term play because of the sustained benefit to these new and developing markets.

Operator

John Glass with Morgan Stanley.

John S. Glass - Morgan Stanley, Research Division

How much visibility on the 2014 development pipeline do you have at this time of year typically? Is there -- and is it greater than in the past? How much of these are firm commitments versus just sort of an idea of where development schedules shake out when you talk about an increase in development in '14?

Stephen C. Vaughan

Well, we have, John, we do have limited visibility into that. At this point, it tends to be more expressions of interest. As we've talked about our area development agreement pipeline, we had gone through and really kind of cleaned that pipeline up just to a great extent. But we are seeing a lot more interest from existing franchisees and also a greater interest from new franchisees. So from that perspective, we see more development in the pipeline today than we saw at this time last year.

J. Clifford Hudson

In addition to that, the reduction in the cost of new building that we've worked on in developing -- implementing primarily in core markets to date is increasing. So with Steve's reference to existing franchisees, some increase in interest, the lower-cost building has really enabled us to go back and look at markets that we might not have looked at over the last number of years, including a number of franchisees that might consider a secondary market in a core market, core state. So this is part of what's improving the pipeline as well, the combination of new franchisees, new and developing markets and then the lower-cost and smaller building allows us to go into some secondary markets. The other thing, though, I should say in terms of the interest in development and the interest in capital expenditures by franchisees is augmented with our experience in calendar 2012. Obviously, the way they would look at the business, calendar year not fiscal, not our fiscal, but in calendar year, sales and profits at the average store being up materially, and the average franchisee then beginning to look at the business differently than they might have 2 or 3 years ago.

John S. Glass - Morgan Stanley, Research Division

And then related to that, you mentioned that you're going to open some stores under the new -- the #6 agreement versus the #7, so lower royalty. What qualifies a franchisee for that? Is it all openings in '14 will be under that? Or is it only new franchisees or only new markets? How many stores do you think, I guess, or percentage of stores do you think will be opened under that new or that #6 license?

Stephen C. Vaughan

John, at the beginning of the fiscal year, we set out a plan for our franchisees, where basically in order to try to get them to kind of expedite their development, we offered up this incentive and it was really tied to how quickly they open up the drive-ins. So we anticipate all drive-ins opened in the current fiscal year will be under the #6 license agreement. That, over time, that incentive will go away. Some of those are for a limited period of time. But for the most part, what you'll see is in 2013, the #6 agreement will be what new stores will open up under.

Operator

Joe Buckley with Bank of America Merrill Lynch.

Joseph T. Buckley - BofA Merrill Lynch, Research Division

Can I just follow up on the new development pipeline? Your fiscal year is only 5 months away so I don't know what the lead time is on construction, but is there enough visibility at this point to think you'll have net unit growth in 2014?

Stephen C. Vaughan

Joe, we do believe we'll have net unit growth. We have -- a couple of things. As Cliff mentioned, we've been more aggressive in exploring opportunities with our franchisees in developing in some smaller markets, the rural markets where you tend to need less lead time than you might have in a more urban market. So that does add a little bit of additional -- another variable to new store development that we haven't had historically in terms of focusing on some of those smaller markets with the new small building prototype. But overall, based on what we see today, we would expect to have net unit growth in 2014.

Joseph T. Buckley - BofA Merrill Lynch, Research Division

And if a franchisee showed up today to talk about new unit growth for next year, is the #6 deal still available to them or would it be under #7?

Stephen C. Vaughan

I think, at this point, if a new franchisee came in, it would be under a #7 agreement.

Joseph T. Buckley - BofA Merrill Lynch, Research Division

And how about existing franchisees, Steve?

Stephen C. Vaughan

I'd have to go back and look at the specifics of what -- we laid out a pretty specific plan, so I'd have to look at whether it was in a certain market type that we were trying to incentivize franchisees to open in. So I think there are some other qualifications that would have to be met.

Joseph T. Buckley - BofA Merrill Lynch, Research Division

Okay. And then one more just number-specific question. The other operating expense line, you got a lot of leverage and I'm aware of the timing of the expensing for the general manager meeting. Is there anything else that bleeds out in that 130 basis points overall improvement?

Stephen C. Vaughan

Well, I'd mention also that we had the 34 drive-ins that were refranchised in the second quarter. Those added a little bit of a benefit, about 25 basis points, Joe. That, in the third and fourth quarters, we will have lapped over that so you won't have the same tailwind from that -- those refranchised drive-ins. But those were the 2 kind of unusual items.

Operator

Keith Siegner with Crédit Suisse.

Keith Siegner - Crédit Suisse AG, Research Division

Just a quick question on the timing of the relaunch of the "Two Guys" last year. When did that campaign first relaunch? And then how did the media weights ramp over the couple of months after the launch?

J. Clifford Hudson

The media, the -- excuse me, the relaunch of the "Two Guys" began at the end of February, the first full month was March of 2012. And the media weights were improving as the year progressed but primarily because of our hiring of a new media firm. And in '11, they had effect of part of the year in terms of becoming our media buyer. Our prior media buyer would have had some upfront buys that were staged in over time. So the new firm that came in, Zenith out of New York, would have had a partial impact in early '12 -- no, partial impact in '11 and progressively -- a progressive impact in '12 as the earlier part of the year -- as the year progressed, their impact became greater and greater because it was more -- a larger portion of the media was their purchases. So we got great efficiencies from their buying, as well as, over time, some of their strategy development as well. We've lapped that at this point, I suspect, in terms of the -- well, we're well into a period of time where they're doing 100% of our purchasing.

Keith Siegner - Crédit Suisse AG, Research Division

Steve, one quick question for you. To follow up on Joe's question, one of the things you mentioned was maybe some smaller rural areas. I guess, is there an AUV difference between those smaller rural areas and some of the other openings? In other words, if there is a meaningful percentage of mix, will that have an impact on what we should use for our average unit volumes for that future growth?

Stephen C. Vaughan

Yes. I would say the smaller rural areas tend to have a little bit lower volumes than some of the urban areas, although we've had -- with a limited number of those that have occurred to date, they've actually been more successful than what we had anticipated. So I would maybe model in a slightly lower AUV, although I think it will still be above our existing system average.

Operator

Brian Bittner with Oppenheimer.

Brian J. Bittner - Oppenheimer & Co. Inc., Research Division

Just a question on just the thematics of just using your own capital. You've got this lower-cost, higher return model. And if you could tell us what those returns are, that would be nice. But the real question is you have a franchisee base at -- I appreciate that net units are supposed to grow in 2014, but there seems to be a lack of visibility there. And it seems as though you're going to need development incentives to get them to grow, you're pushing them to grow yet you have great cash flow, these returns seem to be real strong. Why not put some of your own capital to use, it seems like it would be a good way to create shareholder value and really accelerate the earnings growth curve?

Stephen C. Vaughan

Well, Brian, a couple of things. One, we have, as we mentioned, we continue to see some growth in our company-owned drive-ins. We're targeting about 3 units per year currently. We see a lot of upside with driving the margins on our company-owned units, as you saw with the second quarter results. We want to continue to focus on really turning around the company-owned drive-in operations. We're seeing stronger same-store sales in the system and better margins. So I think that's something that certainly we may look at in the future, but currently, we're pretty comfortable with the level of growth that we're experiencing.

Brian J. Bittner - Oppenheimer & Co. Inc., Research Division

With the lower-cost model, what kind of returns are you seeing? I'm guessing there's a little bit lower AUVs like you guys just talked about but what -- is there a return, cash on cash return or total invested capital return that you could throw out there for us on the new models?

Stephen C. Vaughan

Yes, we are seeing close to about a 20% return. The most -- and we only opened one company drive-in last year, but we saw a very healthy return on that one opening. It's a little...

Brian J. Bittner - Oppenheimer & Co. Inc., Research Division

And that's with the new prototype?

Stephen C. Vaughan

It was actually with the old prototype, so it's -- the company drive-in -- well, we built 2 company drive-ins with the new prototype, but they were both -- one was a relocation, one was a scrape and rebuild, which we tend to see even higher returns on those investments, so they actually would have exceeded a 20% pretax return on investment. So it has been very encouraging.

Brian J. Bittner - Oppenheimer & Co. Inc., Research Division

So they'd be -- I mean, they're arguably above what your hurdle rate is for putting your own capital to use for a new unit, right?

Stephen C. Vaughan

That's correct.

Brian J. Bittner - Oppenheimer & Co. Inc., Research Division

But if there's -- I mean, if there's just -- if there continues to be kind of just lackluster unit growth among your franchisee base, is it something you consider?

Stephen C. Vaughan

Absolutely. We would definitely consider that. Our primary focus is making sure that we get a return on investment, and if we can do that reinvesting in the brand, whether it's existing initiatives like the point-of-sale system or building more company units if we can get our return, then we will definitely look to that first.

Operator

Larry Miller with RBC Capital.

Larry Miller - RBC Capital Markets, LLC, Research Division

Yes, I just have one question. Can you remind us the difference in same-store sales between the companies, which -- company has stores and the franchisees? It's been stronger at the companies for a couple of quarters now.

Stephen C. Vaughan

In terms of what it was this last quarter, Larry?

Larry Miller - RBC Capital Markets, LLC, Research Division

Yes. So sorry about that. So can you give us a sense on why the partner stores are stronger than the franchised stores right now?

J. Clifford Hudson

Well, I think you're seeing this sustained improvement here a number of quarters of our owned stores versus franchise, if I understood you correctly, if you're asking what's driving that. Part of it would be they are coming from a lower average unit volume, so obviously, if they get the same dollar of improvement, the percentage is going to be higher at company stores. Secondly, with some of the challenges that our owned stores experienced earlier part of the recession and new talent and leadership we brought into that group in 2009, 2010, we've seen the stabilization of management, not just in the executive ranks but at the store level. So we've seen reduced turnover at the management level in those stores, improved service scores from our customer survey feedback over a sustained period of time, so that the metrics we observe in terms of customer perception of performance, speed of service, accuracy of order, overall satisfaction, et cetera, have improved dramatically over the last 3 and 4 years to move into being on par with our franchised stores. So you -- in essence, there's been a real turn in that business and when you get the momentum, I think, in that business, from a lower volume, there's catch-up to do in terms of closing the gap from a sales and profit standpoint. But in order to achieve that with this turn of the business, you've got to have sales growth rate outstripping the franchise. So it's a nice story but it's mostly a nice story for our company stores in terms of, you might say, a turnaround from that 2009 time frame.

Operator

And it appears there are no further questions at this time. Mr. Hudson, I'd like to turn the conference back to you for any additional or closing remarks.

J. Clifford Hudson

Okay. We appreciate that very much. We appreciate each of your interest in our business. And as we said earlier on, we're very happy to report a very solid quarter particularly through such a challenging period of time, not just from a macro standpoint but the wintertime, which is always our most challenging portion of the year.

So we look forward to continue to talk to you about our business, as our business progresses, we remain very optimistic about the elements that drive the business and we look forward to visiting you, with you along the way. Claudia San Pedro and Steve Vaughan will be available via telephone if you need to talk to them in the coming days, weeks and months. But beyond that, we'll look forward to talking to you in the future about coming quarters and the very positive momentum of our business.

Thank you very much, and we look forward to talking to you along the way.

Operator

And ladies and gentlemen, that concludes today's conference call. We thank you for your participation.

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