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Denny's Corporation (NASDAQ:DENN)

Q1 2009 Earnings Call

May 5, 2009 5:00 pm ET

Executives

Alex Lewis - Vice President of Investor Relations and Treasurer

Nelson Marchioli - President and CEO

Mark Wolfinger - Chief Financial Officer

Analysts

Reza Vahabzadeh - Barclays Capital

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

Brian Hunt - Wachovia Capital

Mark Smith - Feltl & Company

Tony Brenner - Roth Capital Partners

Stephen Anderson - MKM Partners LLC

Nicole Pecoulas - Babson Capital Management, LLC

Operator

Good afternoon. My name is [PK] and I will be your conference operator today. At this time I would like to welcome everyone to the Denny's first quarter 2009 earnings release conference call. (Operator Instructions)

I would now like to turn the call over to Alex Lewis, Vice President at Denny's Corporation.

Alex Lewis

Thank you, PK. Good afternoon and thank you for joining us for Denny's first quarter 2009 investor conference call.

This call is being broadcast simultaneously over the Internet and will be available for replay on our Investor Relations website, IR.Denny's.com, later tonight.

You may have noticed a change in the contact names for the Investor Relations on this afternoon's press release. I am transitioning roles here at Denny's and my duties related to Investor Relations are being picked up by Enrique Mayor-Mora. Enrique has been responsible for Denny's financial planning and analysis for several years and is well versed in the Denny's story. I will be available tonight, tomorrow, the rest of the week to answer questions regarding our first quarter results. Over the next few weeks we'll begin to transition the return of incoming analyst and investor calls. After this week I would ask that when you call in with questions you use the IR contact line as shown on each of our press releases. That number is 877-784-7167. If we are not available at that time one of us will be sure to get back to you as soon as possible.

Moving on, with me today from management are Nelson Marchioli, Denny's President and Chief Executive Officer, and Mark Wolfinger, Denny's Executive Vice President, Chief Administrative Officer, and Chief Financial Officer. Nelson will lead off today's prepared remarks with an overview of our operational and marketing efforts in the first quarter. Mark will follow Nelson with a financial review of our first quarter results. After our prepared remarks management will be available to answer questions.

Before we begin let me remind you that in accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 the company notes that certain matters to be discussed by members of management during this call may constitute forward-looking statements.

Management urges caution in concerning its current trends and any outlook on earnings provided on this call. Such statements are subject to risks, uncertainties and other factors that may cause the actual performance of Denny's to be materially different from the performance indicated or implied by such statements. Such risk factors are set forth in the company's annual report on Form 10-K for the year ended December 31, 2008 and in any subsequent quarterly reports on Form 10-Q. In regard to SEC filings, we intend to file our 10-Q for the first quarter this evening, so you will have that available for review as well.

With that I'll now turn the call over to Nelson Marchioli, Denny's President and CEO.

Nelson Marchioli

Thank you, Alex. Hello, everyone.

Let me start by saying I'm pleased with our results in the first quarter as we made significant progress on our primary goal of improving our sales and guest traffic trends. Our Super Bowl promotional event was an overwhelming success and allowed us to reconnect with lapsed and light users. Serving more than 1.9 million customers a free Grand Slam Breakfast has served as a catalyst for our marketing efforts in 2009.

Our objective was to create a disruptive, high trial event to attract customers to experience the new Denny's, resulting in ongoing increased frequency of visitation. Along that line, our first quarter guest comp performance reflected an encouraging improvement in trend relative to the last six months of 2008. We believe that the tremendous response we received to the Super Bowl event speaks to the power of our brand and how strongly it is embedded in the American culture.

Here are some highlights that exemplify this point: 50 million hits on our webpage, media coverage on almost every major TV and cable network, more than 500 newspapers covered the story with more than 2,300 TV airings in local affiliates, number three on Google's Hot Trend List, prominent on Facebook, YouTube and Twitter. All this led to the equivalent of over $50 million of public relations coverage. In addition, exit polling suggests that approximately 60% of the participants were in our target group of light and lapsed users and well over 97% of respondents said they were extremely or very satisfied with their experience and 95% said they would either definitely or probably come back within three months.

As one of our guests told us, Denny's gave America a big hug at the time it needed it. This kind of overwhelming goodwill and emotional connection is a testament to the strength of Denny's brand.

From a financial perspective, the total cost of the promotion was around $5 million. This includes advertising costs, which were around $3 million for the Super Bowl and follow up advertising. Those costs were part of the Denny's advertising fund, to which both company and franchise restaurants contribute, so there was no incremental spend but a reallocation of the 2009 marketing budget. We, Denny's corporate, also incurred approximately $2 million in additional costs for the program.

I'm also pleased with our earnings performance as measured by adjusted income before taxes. Despite the considerable economic challenges facing our industry, we have been able to consistently grow our adjusted income before taxes.

The successful execution of our strategic initiatives over the past several years, led by our considerable debt reduction along with the significant shift in our business model to a franchise-focused operation has increased our operating margins and earnings power, lowered both by our business and financial risk and contributed to a renewed restaurant development pipeline.

Our franchise income contribution now surpasses that of our company restaurant operations. Using the first quarter as an example of the business model transformation compared to the first quarter in 2007, when FGI began, we have grown adjusted income before taxes by $4.7 million while having $71 million less in revenue. In the same time period, we have reduced our asset base by 25% or $112 million.

As Denny's franchisees continue to open new restaurants and purchase company stores, under FGI we anticipate further margin improvements and core earnings growth. While we are pleased with our recent sales trends, we recognize the critical need to build on the recent first quarter improvement in our guest traffic performance with the goal of surpassing our competitors. We are focused on driving profitable guest count growth.

Starting in mid-2008 our marketing programs pursued guest count growth through our positioning as real breakfast and along two paths, value and new products. Let me begin with value.

Denny's is recognized as a great value for our guests. While the Super Bowl giveaway event certainly strengthened our value perception, we have also been focused on offering everyday value to our guests. In particular, we have given a great value and choice to our customers with the Build Your Own Grand Slam offered at $5.99. The combination of the incredible equity in the Grand Slam name and a very attractive price point has driven the incidence rate to the high teens, five times higher than the most popular entrée. This product also has a very attractive food cost and has supported our margin improvements.

In the first quarter we also alternated between a national and regional $4 Grand Slam promotion. The latter was supported by local media funded through our newly established local marketing cooperatives. We also have been more active in targeted markets in response to the local economic environments with the use of discounting vehicles that have historically driven return visits.

In the first quarter we also continued to see consumer acceptance of our new $1.99 Pancake Puppies and for our Late Night value menu. On April 21st we rolled out new menus and have continued to value for our consumers through starting at price points for our latest Real Meals. At breakfast our new Abundant Burrito start at $3.99. At lunch our new sandwiches start at $4.99 and our new salads begin at $5.99.

With the objective of further reinforcing our value positioning while building on the tremendous success of the Super Bowl, we had a subsequent free event as part of the NCAA Final Four. On April 8th we gave away a free Grand Slamwich to everyone in America who also ordered a Grand Slam. This event drove a positive 20% guest count growth on the day and helped produce the brand's strongest comp traffic trends during Easter week in at least the past four years.

While smaller in scope than the Super Bowl event, it still produced coverage from 1,400 TV broadcasts, 500 print and web outlets, and had 25 radio stations who interviewed Denny's management, which was worth 30 million listeners. Highlights included coverage from the Wall Street Journal, Good Morning America, CBS Evening News, MSN Monday, CNBC, and Business Week. In all, public relations coverage was estimated at $25 million.

This event also allowed us to continue to make progress toward our second marketing goal, new product. The Grand Slamwich is an outstanding new product that takes our iconic Grand Slam and delivers it in a new format. Since its introduction in December 2008, we've been very pleased with its incident rate.

As I mentioned earlier, our new menu, which was launched on April 21st, also had exciting new entrees - drinks and salads that provide great appeal and strong value across all day parts. Our new entrées include four new Abundant Real Breakfast Burritos, including the Bacon Avocado and Grand Slam Burritos, three new salads including Cranberry Pecan and Baja Chicken in both full and half portions, new lunch melt sandwiches, including a prime rib melt and our new Sizzlin' Skillet Dinners, including Monterey Sirloin and Sweet and Tangy Barbeque Chicken.

We also rolled out our new Lemon Tea and Mango Lemon Tea Chillers in addition to our new Breakfast Roast Coffee. Denny's started out as a coffee house and we're going back to our roots with the introduction of a more robust a higher-quality coffee, which, by the way, go great with our new Pancake Puppies.

As we have already communicated publicly in June, we will be introducing our new, Better for You menu choices. These will include delicious items with reduced fat or sodium such as turkey bacon, wheat pancakes, egg whites, fresh fruit and yogurt. There will also be terrific choices for kids, including dippable vegetable sticks and apple slices. Denny's will also be eliminating or replacing certain meals on the kid's menu determined to be higher in sodium or fat.

We have also made progress on key programs to build our relevance and strengthen our ability to communicate with our customers. Specifically, we continue to see our to go business hover around 5% of sales. This is a positive improvement to the 3.5% we had been seeing prior to the national rollout.

Our late-night Allnighter focus has also resulted in improved day part guest count performance. Prior to our targeted approach to the late-night demographic, 18 to 24 year olds, we had been experiencing double-digit guest count declines due to intense competitive pressure. Through the introduction of new product, a new value menu, aggressive public relations, and targeted communications through media and online, we've been able to improve our guest count performance in the late-night day part.

Recently our efforts were recognized by the nation's Restaurant News' prestigious Menu Masters Awards for 2009. Denny's Plain White Shake, which was part of our late night Rock Star menu, won the best limited time offer award. This drinkable dessert was inspired by the rock band the Plain White T's.

With a view of increasing our share voice, we've begun to rollout local marketing coops across the country. At the end of the quarter we had signed up 13 DMAs across the country representing about 40% of our system units. In these markets both the company and franchise restaurants contribute 0.7% of their sales, with our national ad fund contributing another 0.3% of sales, for a total of 1% of sales. These funds are then spent in their respective DMAs, mostly on media. We anticipate that more markets across the country will sign up for the program throughout the year.

We firmly believe that we are proactively and aggressively taking the right steps forward in terms of driving profitable guest count with our programs and our real breakfast positioning. We have never been more excited about the opportunity here at Denny's and believe we are well positioned to achieve further success in the years to come.

As always, thank you for your interest in Denny's. I'll now turn the call over to Mark Wolfinger, Denny's CAO and CFO.

Mark Wolfinger

Thank you, Nelson, and good evening, everyone. I will start my comments with a review of our first quarter sales performance.

Systemwide same-store sales decreased 0.9%, consisting of a decrease of 1.4% at our franchise restaurants and an increase of 0.3% at the company restaurants.

Looking at the details for company sales performance, a 0.2% decline in guest counts was partially offset by a 0.5% increase in average guest check. We estimate that the impact on the quarter as a whole from the one day of our Super Bowl promotion on February 3rd was an increase in guest count of 1.8%, with an offsetting decrease in guest check of 1.8%. The benefit of the Super Bowl promotion carried past the day itself and helped to drive a significant improvement to our trend.

The system sales decrease of 0.9% in Q1 2009 was markedly better than the 5.5% decrease we experienced in the last six months of 2008. In the first quarter of 2009 we also experienced our best guest count performance in company restaurants since Q3 of 2006. While pricing was taken to help offset minimum wage hikes and food cost pressures, it was partially offset by our focus on the outstanding value of the Build Your Own Grand Slam and an increase in discounts, including a bounce-back coupon program launched on the day of the Super Bowl promotion.

The decline in total company restaurant sales in the first quarter reflects the continuing impact of our franchise growth initiative or FGI as sales decreased $34 million or 20% due to 93 fewer equivalent company restaurants compared with the same period last year. Program-to-date through the first quarter of 2009 we've sold 239 company restaurants through the FGI program or 46% of the prior company store base. This includes 30 sold in the first quarter of 2009. as a result, we have increased the mix of franchise restaurants in the Denny's system from 66% to 82%. We expect the mix to continue moving towards a more heavily franchised system.

Turning now to the quarterly operating margin table in our press release, our company restaurant operating margin in the first quarter was 11.7% of sales, an increase of 1 percentage point compared with the prior year period. The increase in operating margin in the first quarter was due to the continued benefits from menu management and pricing as well as a decrease in operating costs. These were partially offset by rising occupancy and commodities, as well as by an investment in marketing through the establishment of local co-ops.

Our continued success with menu management helped to further reduce product costs, which decreased 0.9 percentage points in the first quarter. Starting in the second quarter of 2008, our promotional activities have focused on menu items with a lower food cost that still provide a compelling value to our customers. Our customers showed their approval by driving up the purchase mix of our Grand Slam Breakfast, but also with a strong reception to the new menu items, like our Sizzlin' Skillets, our Allnighter menu, which features a value menu, and our new Pancake Puppies.

The combination of these factors has resulted in Denny's lowest product cost as a percentage of sales since 2002. This is a terrific accomplishment given that we continue to experience commodity inflation, albeit at a lower rate of increase than we had anticipated as recently as late last year.

The second factor positively impacting our margins in the first quarter were price increases taken over the past year to help offset inflationary pressures. Payroll and benefit costs also improved in the first quarter, decreasing by 0.9 percentage points to 42.6% of sales due to more efficient crew labor and due to the reduction in management labor that took place in Q2 2008. These reductions were partially offset by an increase in field bonus compensation. Our operations team continued to do a solid job improving labor efficiency in the quarter.

Occupancy expense increased 0.5 percentage points. There was an increase of 0.3 percentage points due to unfavorable developments in certain general liability claims and an increase of 0.2 percentage points due to the sale of owned property as part of certain FGI transactions.

Our utility expense in the first quarter increased 0.2 percentage points. We have entered into a natural gas hedge which should yield favorable utility cost comparisons beginning in the second quarter of 2009.

Repairs and maintenance in the first quarter decreased 0.3 percentage points due to a combination of modest sales growth in company units, the sale of units through FGI, and the timing of certain maintenance activities into the balance of the year.

Marketing costs rose 0.2 percentage points in the first quarter as Denny's has successfully begun the establishment of local marketing cooperatives across the country. As of the end of the first quarter we had local co-ops in 13 DMAs. Each of these DMAs had all of the company and the majority of the franchise restaurants participating. These DMAs represented approximately 40% of our system units.

Other costs increased 0.2 percentage points from a loss of business interruption income as Denny's prepares to reopen one of our Las Vegas units. The unit is being rebuilt as part of the ambitious City Center Development Project in Las Vegas. It is scheduled to reopen in Q3 2009 and is projected to be one of the system's highest volume units.

In summary, the gross profit from our company operations decreased $2.3 million on a sales decline of $34 million. While the profit contribution from our company restaurant operations is trending down due to the sale of company units, the offsetting effect is driving strong growth in the franchise side of our business.

In the first quarter franchise revenue increased $3.8 million or 14%, comprised of a $1.1 million increase in royalty revenue, a $2.3 million increase in franchise occupancy revenue, and a $400,000 increase in upfront franchise fees.

Royalties and rents were higher due to an 82-unit increase in equivalent franchise units.

The franchise fees were higher due to nine more FGI transactions in the first quarter of 2009 compared with the first quarter of 2008.

Franchise operating margin increased by $700,000 in the first quarter to $18.9 million as higher franchise revenue offset a $3.1 million increase in franchise costs. These increased costs were primarily related to rental expense on properties subleased to franchisees and to the $1.1 million investment the company made in franchise food costs related to the Super Bowl promotion.

Franchise operating margin as a percentage of franchise and license revenue for the first quarter was 62.6%, a decrease of 6.5 percentage points compared with the same period last year. This decrease is due primarily to the investment in the Denny's Super Bowl event.

In summary, the gross profit from our franchise operations increased $700,000 on a revenue increase of $3.8 million despite the $1.1 million investment in food costs related to the Super Bowl promotion. From a gross profit standpoint, the franchise side of our business for the second consecutive quarter contributed more than our company restaurants. This income shift allows us to lessen the risk and increase the predictability of our earnings.

General and administrative expenses decreased $1.8 million in the first quarter due primarily to lower salary and other compensation costs attributable to the new organization structure we implemented in the second quarter of 2008 as well as to lower legal fees driven by timing. Partially offsetting the reduction in G&A was an increase of $500,000 in incentive compensation and a $300,000 increase in share-based compensation.

Next, depreciation and amortization decreased by $1.5 million from the prior year quarter due primarily to the sale of restaurant operations and real estate assets over the past year.

Operating gains, losses and other charges on a net basis decreased $9 million from the prior year period due primarily to a $9.2 million decrease in asset sale gains compared with the prior year.

Including these items, operating income for the first quarter decreased $7.3 million to $11.9 million. If you exclude the gains, losses and other charges from both periods, operating income increased $1.7 million in the quarter despite a decrease in total revenue of $30.2 million. To post a $1.7 million increase in adjusted operating income despite a significant revenue decline is testimony to the efficiency of our transitioning business model.

Below operating income, interest expense in the first quarter decreased by [$700,000] or 8% to $8.5 million primarily as a result of a $26.5 million reduction in debt from the prior year period.

Other non-operating expense decreased $5.9 million in the first quarter due primarily to prior year expense resulting from the discontinuance of hedge accounting treatment on Denny's interest rate swap agreement.

The benefit from income taxes for the first quarter of 2009 was $400,000 compared with a provision for income taxes of $0.5 million for the prior year quarter. The first quarter included a one-time benefit of $700,000 resulting from the enactment of certain federal laws during the quarter.

We reported net income in the first quarter of $4.3 million or $0.04 per diluted common share, an increase of $200,000 compared with the prior year period.

Because of the significant impact to our P&L from non-operating, non-recurring or non-cash items, we give earnings guidance based on our internal profitability measure, adjusted income before taxes. We believe this measure best reflects the ongoing earnings of our business. Our adjusted income before taxes in the first quarter was $4.6 million, an increase of $2.6 million or 135% over the prior year period.

We are pleased that we were able to generate significant adjusted income growth despite the difficult sales and margin environment for the restaurant industry. We believe this success is a direct result of our strategic initiatives, in particular our FGI program and our debt reduction efforts.

To summarize our P&L for the first quarter, the sale of company restaurants to franchises contributed to a $34 million decline in company restaurant sales and a $2.3 million decrease in company restaurant income. We more than offset this lost company restaurant income through the combination of a $700,000 increase in franchise income despite a $1.1 million investment in franchise support for the Super Bowl promotion, a $1.8 million increase in general and administrative expenses, and a $1.5 million decrease in depreciation and amortization expenses, and a $700,000 decrease in interest expense.

Key operational themes that supported the overall improvement and performance included a positive 0.3% growth in same-store sales for our company units as well as a 1 percentage point improvement in company restaurant margins driven by a reduction in labor and food costs.

Turning to activity in the Denny's restaurant portfolio during the first quarter, the system increased by a net 5 units as 11 new restaurants opened while 6 were closed; 10 of the 11 new openings in the quarter were franchise restaurants, with the sole company unit being opened in Hawaii. Our renewed emphasis on growth over the past two years is delivering results.

Moving on to capital expenditures, our cash capital spending for the first quarter was $3.9 million, a decrease of $3 million compared with the prior year period. As we reduce our company restaurant portfolio and remain selective in our new restaurant investments, we expect capital to decrease year-over-year. Our first quarter spending this year was partially lower due to the timing of remodel spend anticipated in 2009.

Turning to asset sales in the first quarter, we generated proceeds of $4.8 million from the sale of 30 company restaurant operations. The cash proceeds were $3.4 million as we took a $1.4 million note on one of the transactions.

Again, as we have stated consistently, on a quarter-by-quarter basis the proceeds and gains driven by FGI will fluctuate. Proceeds and gains from last year's first quarter FGIs were well above our program average, while this year's gains and proceeds in the first quarter were well below the program average. Denny's employs a diligent process by which to ensure that these transactions are accretive.

On a rolling 12-month basis we have generated net cash proceeds of $21.8 million from the sale of restaurant operations and $4.7 million from the sale of certain real estate. In total we have taken in $26.5 million in cash proceeds during the past 12 months.

We used these proceeds to reduce our outstanding debt by the same amount of $26.5 million over the past year. We continue to take a conservative approach to our cash management. Denny's made $1.3 million in scheduled debt payments during the first quarter. We did not make any voluntary debt paydown in the first quarter of 2009 as we chose to keep $20 million in cash given the uncertain outlook for the economy and the capital markets. We also made interest payments of $8.8 million on our senior notes on the last day of the quarter versus the historical timing of the second quarter.

We will continue to balance our debt reduction goals and our commitment to maintain an ample liquidity cushion. We ended the quarter with approximately $70 million of liquidity.

Given the challenges facing our national economy and our industry we are very pleased to have reduced our debt by $227 million or 41% since year end 2005. We believe we are in a financial position to manage through this difficult operating environment. I think it is worth restating that we have no material debt maturities in the near term as our revolver's in place through December 2011 and our term loan through March of 2012. Our senior notes mature afterwards in October of 2012.

Based on the year-to-date results and management's expectations at this time, Denny's reaffirms its previous financial guidance for the full year 2009. While we are encouraged that we have made progress in our sales trends and that the industry is beginning to see subtle improvements in its indicators, we believe it is too soon to assume that we're out of the woods yet. We need to see these trends continue into our higher-volume summer months.

We remain cautious in the near term given the economic pressures on our customers and the volatility of consumer spending. We also caution that the impact of sales declines could lessen the margin and earnings benefits we have been generating through our ongoing business model optimization.

In respect to FGI, Denny's continues to have demand for company restaurants and is negotiating with interested buyers. Due to the difficulties in securing transaction financing, Denny's is unable to confidently predict the numbers of FGI transactions that could be completed in 2009. Denny's will provide updates on the progress of FGI each quarter.

That wraps up my review of our first quarter results. I'll now turn the call back to Alex Lewis.

Alex Lewis

Thanks, Mark. And that concludes our prepared remarks, so I'll ask the operator to begin preparing for the Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Reza Vahabzadeh - Barclays Capital.

Reza Vahabzadeh - Barclays Capital

On the marketing spend in the quarter and your initiatives on that front, do you have any visibility as to whether the spend on Super Bowl and the other activities, if you have any tail on those marketing initiatives here in the second quarter in terms of actual traffic count?

Nelson Marchioli

We were very encouraged by the promotions themselves. They exceeded our expectation. But I think it's too early to make a call on the tail, as you put it. We clearly continue to see the benefits, but I think it's too early to make that call. I think that'd be a great question for the third quarter.

Reza Vahabzadeh - Barclays Capital

And then on the cost of products, obviously that was off quite a bit from last year. Was that mostly because of commodity costs coming down or was that because of price mix? How should we think about that?

Nelson Marchioli

You should think about it as mix. We were very successful in our menu management and product mix efforts in steering our promotions toward the Grand Slam, which is one of our most profitable items on the menu and, frankly, the most popular item on our menu. So a combination of terrific purchasing and forward buying as well as great leadership on the menu management side to make sure that it flowed through extremely well.

Reza Vahabzadeh - Barclays Capital

So maybe a 50/50 contribution from mix and lower cost, would that be fair?

Nelson Marchioli

I'm not that good. I don't think I'm that good.

Mark Wolfinger

The thing to note there is we started selling the Build Your Own Grand Slam sort of halfway through the second quarter of last year, so we're getting ready to lap those benefits. If you go back and look at the year-over-year over the past four quarters it's been a lot to do with the Build Your Own Grand Slam, because we've had commodity pressures underlying that.

We still have commodity pressures. Commodities were up for us in the first quarter, certainly not as much as we projected in the middle of summer last year and even less than we would have when we put our plan together, but still commodities were up for us so the benefit was really mix, but we do caution you that we're seeing commodity or food cost prices at record lows for Denny's and a lot of that has to do with the Grand Slam and we will be lapping over that benefit beginning in the second quarter.

Reza Vahabzadeh - Barclays Capital

And then on the average check and the traffic count, obviously the checks rose less than the last couple of quarters and traffic was better than the last couple of quarters, so that 1.8% that you mentioned, was that the impact of your marketing initiatives in this quarter on both traffic and check?

Nelson Marchioli

That I think was only related to the Super Bowl promotion itself, the day itself.

Reza Vahabzadeh - Barclays Capital

And what about the free meal promotions, was that in the traffic and was that in the check as well?

Mark Wolfinger

Sorry, Reza, are you asking about the Super Bowl promotion or the one that was done around the NCAA?

Reza Vahabzadeh - Barclays Capital

Really, I mean, obviously your check and your traffic were materially different than the last couple of quarters and I'm just trying to find out what would have been a normalized -

Mark Wolfinger

Well, if you back out for just the Super Bowl, back out 1.8 in traffic and a hit to 1.8 to check for just that day - but then, again, we saw ancillary benefits to our guest counts for weeks after that and that's where we ended up for the whole quarter seeing, you know, even if you back out that 1.8, a material improvement from the fourth quarter trend.

Nelson Marchioli

It's also, Reza, a restatement and a recommitment by Denny's to continue to focus on value. I said many calls ago that we just didn't feel during certain times of this economy that we've had to deal with that discounting was the right answer; I didn't want to go buy customers because it just doesn't work long term. But clearly we see that in this economy we have to offer value and we have to engineer the product mix and the promotions to deliver the kind of profits that we need to have.

Mark Wolfinger

I think, Reza, what it shows you is how big that Super Bowl day was and the impact it had on the first quarter. So you're right on it; that was the full quarter impact based on that one day of performance.

Reza Vahabzadeh - Barclays Capital

I guess how much pricing do you have carrying into the second quarter is the other way to look at it.

Mark Wolfinger

You know, I mean, last year we were probably running, for the year we were running sort of the mid single digits, 4 or 5, those numbers. I think this year you'll see probably half of that.

Reza Vahabzadeh - Barclays Capital

And then lastly, how do you feel about the quality of franchise stores, just the physical plant, and is there much CapEx being incurred by franchisees to keep up those stores?

Nelson Marchioli

I feel relatively good about where the franchisees are. You know, our franchise agreement does require remodels. I don't think any management team here will ever be satisfied that we are as bright and shiny as we'd like to be, but I'm convinced that our franchise and company units are maintaining their restaurants at an acceptable level. We'd always like it to be better, but I think we're in a good place at this point.

And we're constantly testing at this time several different ways of spending less but spending more often to make sure that our restaurants are contemporary. But a brand that's 55 years old, I think the average age of our fleet, as my finance people like to tell me, is 35 years old. It is a constant challenge, but one that I think we are better equipped at than we have been in probably a couple decades.

Mark Wolfinger

I think the other aspect, Reza, is that in these FGI transactions that are occurring, obviously we talked a lot about the commitments to build new stores, the development agreements, but with those FGI transaction also come the remodel commitments based on timeframe that the franchisees make when they take on those transactions. So, again, there's a significant amount of capital committed on the part of the system.

Operator

Your next question comes from Michael Gallo - C.L. King & Associates, Inc..

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

Can you comment at all, Nelson, on where the comp trends were kind of pre Super Bowl promo versus post Super Bowl promo because it seemed like there was a pretty big change there in guest counts. And on that same front, is there anything that you've seen to date other than just the general economy that would lead you not to want to increase the comp guidance that you gave back in February when likely the trends were different than what you saw the last couple of months?

Nelson Marchioli

Well, something we haven't talked about because we didn't think it was material enough but it still causes us to look skeptically at performance and the economy is this Easter/Spring Break mismatch. And I can't really talk about the second quarter because we're talking about the first quarter, but we've had to deal with all kinds of - and every brand has, I'm sure - all kinds of blips, if you will, literally from one day to the next.

We do track sales on a daily basis by region and by area and there's some days, boy, I feel terrific about where we are, then there's other days I wonder what in the world happened and I go to the Weather Channel and say can it be weather? And sometimes it is, sometimes it's not.

But it's too early to make a call on comp at this point in time. And, you know, as Mark and I say often, it is a conservative management team here. We like doing what we say we're going to do. We would be hesitant to change performance.

I think that'd be a great question to ask, candidly, in October, after we get through the summer. The four most important months to this brand are June, July, August and December. The first quarter is actually one you want to get through and we got through it in a quality way, but it typically is our lowest-performing quarter as it relates to revenue and profits. Getting through the first quarter is a good thing, but it's not an indicator as to where you might wind up.

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

Were you able to quantify how much of an impact the Easter shift had and also were you impacted by the loss of the leap year day last year?

Mark Wolfinger

That wouldn't affect our comp because we don't do it on a month basis, we only do it on a day-to-day basis year-over-year, so the leap year wouldn't have come into play for us. But, I mean, there certainly was an impact from Easter, but we get that every year, it flip flops every year. We got some of it back in April.

But I think Nelson's point and the one we should focus on from a guidance standpoint is the first quarter isn't the one that makes or breaks our year. We really need to get into the summer, see how the consumer's going to respond to our marketing programs in the summer, and that will really dictate where we're going to be during the year. And if things go the way we hope, then hopefully we can have something new to say in July.

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

I guess as you look sort of by day part, where did you see the biggest improvements in traffic trends and what was the most challenging day part?

Mark Wolfinger

I think from the standpoint of day part, the significant improvement or the better improvement was in our breakfast and lunch day parts. Again, I think part of that is obviously the Super Bowl promotion, but also the fact that we are a very strong breakfast player and that fits very well, obviously, into those two day parts.

Nelson, I think, commented on late night. The dinner day part continues to be under a lot of pressure for a lot of difficult reasons and I think is a challenge for a lot of different players, not just in our part of the restaurant sector but in many other restaurant sectors. But again, the primary improvement was in breakfast and lunch.

Nelson Marchioli

And I would go on to say I was particularly pleased that weekday performance - you know, we always do great weekend business - but our weekday performance during those day parts that Mark mentioned showed significant improvement and I think it's a direct correlation to the value propositions that we offered with the weekday Slams for $4.00 across the country that our co-ops supported in many areas. So that was encouraging.

We still have work to do with dinner, just like most casual dining and family folks have to deal with.

Operator

Your next question comes from Brian Hunt - Wachovia Capital.

Brian Hunt - Wachovia Capital

I was wondering if you all could update us a little bit on what you're thinking on food inflation as well as how much of your commodities you locked in? As of last call you were thinking 4% to 5% food inflation and you had locked in roughly 50% to 60% of your commodity exposure. Could you give us an update on where you stand today?

Nelson Marchioli

I'd say it hasn't changed all that much. I actually see food inflation turning out to be less than that, probably closer to 3, maybe less. So that's pretty much where we see it. I haven't locked in that much more. There's too many opportunities to ride the market right now.

Brian Hunt - Wachovia Capital

And then you made obviously a lot of progress on your food margin in the quarter based on mix. How big could your Build Your Own Grand Slam and your Grand Slamwich become as a percent of your total mix? Do you have a target for that product, given where you are from a margin perspective? You're the lowest you've been since 2002.

Nelson Marchioli

Well, we certainly enjoy selling those products at the margins and at the price points that we have, but do we have a target? No. I will tell you depending on whether we promote it or not you'll see the Grand Slam go up as high as 25% of what we do. I've seen it drop when we take it off promotion to 16%. But considering it's not promoted, that's still pretty significant. So we see that as a good item, but do we have a target? No. We just talked about Real Breakfast and that's what our customers feel most comfortable with at this point.

Brian Hunt - Wachovia Capital

And looking at your to go items, you've made some progress on mix there. Do you have a target for this year, where you'd like to be with that product mix in terms of to go?

Nelson Marchioli

Well, internally we believe that there's more. Our Chief Marketing Officer and Chief Innovation Officer, Mark Chmiel, when we first started out on takeout, when we were down in the mid 3% range, we talked about with catering and other opportunities we should be between 10% and 15%, but that's over a number of years. Internally I'd like to see it go up a couple percent this year, but we haven't seen it yet. But we clearly continue to drive that because it's the most profitable.

Brian Hunt - Wachovia Capital

You pulled forward $3 million of advertising expense into Q1 and yet you reported a flat EBITDA number, which I thought was pretty impressive. If you were to outperform your guidance for the year, would you allow that to flow to free cash or would you try to reinvest it into the business and more marketing and try to drive more comps?

Alex Lewis

The one thing to note is we apply our marketing dollars on a percentage of sales basis, so while we may pay those dollars in cash, it's really not going to flow through on our P&L. It wasn't a $3 million hit to our P&L.

On the other front, we spend the proportion that we agree to along with our franchisees each year, so whatever that amount is based off of sales, whatever that percentage is their particular contract calls for and what our contribution calls for, we're going to spend that amount. That's not something that goes up or goes down.

Nelson Marchioli

I would say that from time to time there are exceptions. Last year we had an opportunity to buy into NFL wildcard playoffs and at Thanksgiving we had an opportunity to buy into the Macy's Day Parade and some NFL football and some NCAA football games around that weekend and the SEC Championship between Alabama and Florida, and we invested corporately incrementally to do that because it was such an opportunity for us and we felt we needed to support our restaurant operations, both franchise and company.

So there are times that we do investment spend, but that's more opportunistic than planned. Other than that we follow very closely what Alex indicated.

Operator

Your next question comes from Mark Smith - Feltl & Company.

Mark Smith - Feltl & Company

First off, Mark, could you talk about kind of the one-time impact in franchise expenses of the Super Bowl, just confirm that number for me?

Mark Wolfinger

Yes, that number I think I might have mentioned in the script was about $1.1 million and it was basically the absorption of the food cost expense relating to Super Bowl on the franchise side of our business.

Mark Smith - Feltl & Company

Okay, so that margin as we look at it on the franchise business -

Mark Wolfinger

Is directly impacted by that event, that's right, yes.

Mark Smith - Feltl & Company

Second, can you guys talk about pricing that you may have taken in your new menu or that is planned through the summer?

Nelson Marchioli

It's minimal. I'm trying to recall the exact number - 2% is what we see at this point in time.

Mark Smith - Feltl & Company

And then I believe lastly on the FGI transactions this quarter, the 30 that went through, do you feel like you've gone through all of the transactions that you'd worked out prior to the collapse of the debt markets?

Mark Wolfinger

Well, that's a challenging question. I guess I'll go back to some of the comments I made in the script and that is that we continue to see strong demand to purchase Denny's company operated restaurants by various franchisees, both existing in our franchise base as well as potential new franchisees. The challenge there as I mentioned as well is the financing side, but I would tell you that it is - I don't want to say it's gotten a lot better - it's gotten a little bit better on the financing side primarily because we've seen some different players come into that piece of the market.

And so I think we continue to push forward on FGI. Obviously, 30 in the quarter, given that situation as you described it and if you think about what the fourth quarter looked like in the credit markets, again, the credit markets haven't opened way up again, but clearly are a little bit more flexible than they were 90 to 120 days ago.

Nelson Marchioli

The one caveat I would add to Mark's comments is that as long as you're willing to put a significant amount of equity into the investment to Mark's point, it does seem to be getting a little better. But you have to be prepared as a buyer to frankly put more money down.

Mark Wolfinger

I think one of the comments we made last quarter was the fact that these transactions still occur, there's still demand there, it's just a harder, more diligent effort to get them done. And in many cases those terms and conditions from the lending environment especially may change sort of at the last minute, to Nelson's point there.

But I don't want to leave this call without stating again that we're very encouraged by the demand that we continue to see from the franchise community, both existing franchisees and new franchisees for the Denny's brand.

Mark Smith - Feltl & Company

Just one quick follow up on that. How willing are you guys to go out and do some of the financing on these deals?

Mark Wolfinger

We have taken some paper back, but it is not material in the scheme of looking at well over $100 million in transactions that we've done in the last two years. We do that on a selective basis, looking at a lot of difficult factors in that specific transaction. So I want to emphasize again not material and on a selected basis.

Nelson Marchioli

My quote that I go back to here often is Denny's is not a bank and to Mark's point, we have had to do some things, but it's very, very small and very limited. We've been able to find people that believe in the Denny's brand and will lend to it under the right circumstances.

Mark Smith - Feltl & Company

So fair to say that I guess franchisees that you want and that are capable and able, they're able to find some financing out there?

Nelson Marchioli

They've been able to figure it out.

Mark Wolfinger

We like cash deals; that helps a lot.

Operator

Your next question comes from Tony Brenner - Roth Capital Partners.

Tony Brenner - Roth Capital Partners

First of all, given the timing of the Super Bowl promotion, how weak the market was in January and the run rate of your sales declines prior to that event, it would appear that guest counts subsequent to that promotion declined probably by less than 1%. Is that reasonable?

Alex Lewis

Well, again, I think you've got to remember that we had a mismatch in March from Easter being in March last year and not in this year.

I think, again, it goes back to what Nelson said in the press release in his quote and what we said here, if you go back, we actually had a positive comp in January before the promotion, so some other things we've done have moved the needle as well, but we still see volatility, we still see a lot of pockets in the country that are struggling. It just really isn't the time to be changing our outlook.

Tony Brenner - Roth Capital Partners

My second question regards FGI, the company store proportion is now 18% or 18% and a fraction and that percentage is going to decline as franchisees open new stores more rapidly than [inaudible]. Is there a proportion below which you are unwilling to go via selling stores?

Mark Wolfinger

I think we've been relatively consistent as to how we've answered that question. We approach FGI with the growth vehicle in mind here and that is that a lot of these FGI transactions have resulted in development agreements being signed for new store growth, so obviously that's been very positive, both in the existing fiscal year that we do those transactions as well as on an ongoing basis to grow the brand.

We've also mentioned that these are accretive transactions, so we run a very disciplined model as we do the analysis on these transactions and we run that accretion model before the addition of the new store growth that comes out of those development agreements.

So to go back to your question, you're absolutely right; the way the math works is obviously a majority of the development is being done on the franchise side of the business. We obviously have made significant changes in our system mix, moving from about two-thirds franchise to the 82% number. But there's also areas in the country where we own and operate stores that when you place a multiple against those cash flows it's extremely difficult to find a franchisee, either new or existing, that'll step forward and pay that kind of purchase price.

And, by the way, we also make a great deal of cash flow out of certain stores. As an example, the Las Vegas Strip is a company operated area and those stores do extremely well for us.

We've often been asked the question what the ultimate percentage looks like between franchise and company mix, and we've always said we'll sort of know it when we get there. Again, we're trying to find the optimal mix here from an overall shareholder value standpoint.

So that's a long-winded response and I apologize, but that's sort of where we're headed.

Operator

Excuse me, Mr. Lewis, I am showing that we are exactly at the end of the call, sir. Do you want to continue with questions or go into your closing remarks?

Alex Lewis

We'll take one or two more but if the parties on the line will try and make them brief.

Operator

Okay, no problem. Your next question comes from Stephen Anderson - MKM Partners LLC.

Stephen Anderson - MKM Partners LLC

Very quickly, just according to my calculations I arrive at a per unit proceeds of about $160,000 and that's obviously, as you mentioned, well below what you've been averaging. I think the last prior quarter it was about $300,000. Can we make any assumptions on the run rate as we try to determine what average proceeds have been and where they're going? Should we accept first quarter as a low water mark or is it something that can be said about the quality of the stores that were sold in the quarter?

Alex Lewis

Well, I mean, the price is certainly a reflection of the cash flow, so there's no doubt about that.

Again, I think as we said in the script, this was well below average; we have other units we sold last year well above average. I think we'll keep solving back to probably somewhere in that mid 400s average over the life of the program. We've seen I think in '07 it was 550 or so, '08 it was 450 or so. I think on average we'll still see that, but from quarter to quarter, depending on which units we're selling and where we're selling them and how much cash flow they generate, there will be wide swings in both the proceeds and in the gains that you see going through the P&L as well.

Operator

Your next question comes from Nicole Pecoulas - Babson Capital Management, LLC .

Nicole Pecoulas - Babson Capital Management, LLC

My question was also a little bit of follow up on the last one on FGI. To what do you attribute the lower proceeds this quarter? Is it the market? Is it the restaurants or the regions in which you sold the restaurants or a combination?

Alex Lewis

It is the cash flow generated by the restaurants sold.

Nicole Pecoulas - Babson Capital Management, LLC

Okay, solely? So you're not seeing -

Alex Lewis

Well, I mean, again, as we've said in the past, you see very different multiples across the country. I can tell you, well, I mean, these units were not sold in California. If these were Southern California units they would generate a bit higher multiple. But really, we haven't seen dramatic swings in the multiples across the country; it's generally more about the cash flow of the units generated.

Nicole Pecoulas - Babson Capital Management, LLC

Okay, so as you look at these units, this sort of level of proceeds, it sounds like it's about what you would expect?

Alex Lewis

Yes. That was for these units, but it's not what we would expect for all units and certainly not even for average.

Operator

There are no questions at this time. I would now like to turn the call back over to Mr. Lewis for any closing comments or remarks.

Alex Lewis

No, that's it. For anybody that didn't get any questions asked, I will be available tonight, tomorrow, whatever you need for follow up, and then, again, we'll start following that transition we laid out earlier. Take care.

Operator

This concludes today's conference call. You may now disconnect. Thank you so much for your participation.

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Source: Denny's Corporation Q1 2009 Earnings Call Transcript
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