Sonic Corporation F3Q09 (Qtr End 05/31/09) Earnings Call Transcript

Executives

Pat Watson – Corporate Communications

J. Clifford Hudson – Chief Executive Officer

W. Scott McLain – President

Stephen C. Vaughan – Chief Financial Officer

Analysts

Matthew DiFrisco – Oppenheimer & Co.

Joe Fisher for Steven Kron – Goldman Sachs

Jeffrey Bernstein – Barclays Capital

Joe Buckley – Bank of America/Merrill Lynch Securities

Brad Livingstone – Keybanc Capital Markets

Greg Ruedy – Stephens Inc.

John Glass – Morgan Stanley

Nicole Miller-Regan – Piper Jaffray

Sharon Zackfia – William Blair & Co.

Thomas Forte – Telsey Advisory Group

Keith Siegner – Credit Suisse

Analyst for Steve West – Stifel Nicolaus

Christopher O'Cull – SunTrust Robinson Humphrey

Sonic Corporation (SONC) F3Q09 Earnings Call Transcript June 23, 2009 5:00 PM ET

Operator

Good day, and welcome to the Sonic third quarter conference call. Today’s call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Mr. Pat Watson.

Pat Watson

Good afternoon, everyone. This is Pat Watson with Corporate Communications. Sonic is pleased to host this conference call regarding results issued this afternoon for the third quarter of its fiscal year 2009, which ended on May 31, 2009. Today's audio and video presentation may be accessed at the Investor section of the company's website www.sonicdrivein.com.

Before we begin, I would like to remind everyone that management's comments in 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 risk.

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 Report 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 management's remarks during this conference call are based on time sensitive information, which is accurate only as of today's date, June 23, 2009. For this reason and as a matter of policy, Sonic limits the archive replay of this conference call webcast to a period of 30 days. 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.

With those announcements I'll turn the call over to Cliff Hudson, the company's Chairman and Chief Executive Officer.

J. Clifford Hudson

Good afternoon, Pat, and thank you for those introductory comments, and welcome to all of you who are on the line for our conversation this afternoon. We appreciate your participation in the conference call and your interest in our company.

There are a number of topics we want to talk about this afternoon during the conference call and you can see those on the screen: the overview of sales and company performance, we would like to visit that for a little while; progress we have made on a number of initiatives that we have placed throughout our system for improved sales and operational financial performance, we'll talk about those today; we're also going to review store development across our system, including the impact of the current credit markets and the overall economic outlook is having on our development activity; and then also a general review of our financial performance and outlook going forward.

So one of the first of those I would like to talk about does have to with the sales performance of the company. For the third quarter system-wide traffic, the customer traffic at the store level, remains just slightly negative, as you can see from the portrayal here. It said 0.006 negative. Average check, on the other hand, was slightly more negative with a decline of 4.9%.

Now, as we have rolled out Everyday Value Menu, from our viewpoint, we've been pretty successful in driving traffic. The NPD CREST data that we get, and many of you in the industry, many across the industry are getting this industry data, can also see that it indicates that we at Sonic have fared better in driving traffic than many of our competitors. From our viewpoint the Everyday Value Menu, as we rolled it out from January forward, has played a critical role in doing that.

It's also had, we think, minimal cannibalization on our current menu and a small impact on food and packaging costs. So good impact there in driving traffic. I have to say, though, January through April the vast majority of our advertising dollars were spent promoting the Everyday Value Menu and ordinarily that would be going to a number of premium items or trying to focus on the various day parts, so we really put the dollars behind the Everyday Value Menu to try to create awareness of it and drive traffic to our drive-ins and we believe we have done that.

At the same time, it does have a taxing effect on being able to drive other aspects of our business, including the premium items, so this can have a dampening effect in terms of driving check, but it's something we felt like we needed to do because value is the number one item driving traffic these days and we need to make sure that traffic is sustained.

Another impact on check, the evening and weekend business across our industry has been soft because of broader economic trends. We have seen this in our competitors' business evening and weekend and traffic with folks simply spending less money and staying home more.

Another factor on the quarter in terms of check versus a year ago, a year ago the stimulus rebate checks were really being utilized heavily by consumers across the country and that's not been the case in this past quarter and that has had a dampening effect as well.

So our current focus is to look to driving traffic, but then also check. We look to improve check in a variety of ways over time but the most immediate circumstance we will talk about today is focusing on increased combo sales with some strategic pricing associated with that and thus our current summer promotion, which provides a free upgrade to a Route 44 with a purchase of a combo meal.

So this is the focus we have currently on driving check, coming after the intense focus on driving traffic.

Shifting a little bit to the financial performance in the quarter, our third quarter sales and earnings were not what we would have wanted them to be. From our viewpoint, it's important to keep in mind that a number of positive accomplishments have occurred, have been achieved, that position us well for improved performance in the future and I would like to kind of talk through what those are.

One of the first ones would be the refranchising of drive-ins that we began talking about late last summer, early fall with the refranchising of 177 drive-ins. This kind of evolution of our business to emphasize the franchising part of it not only reduces the operational financial risk to our business, but also our stockholders. It provides a more consistent and stable cash flow. It also provides a better ability to focus on improving operations at the fewer remaining partner drive-ins that we have in our portfolio.

The benefits of this, the increased franchise royalties, investment income from the 82 stores where we retain the minority ownership interest in those stores, and the increased rental revenues, these elements should continue to provide solid earnings growth potential of a different sort versus the portfolio of the past.

The impact of these changes started to take shape in the third quarter and we will see more of that then going forward.

We saw increased royalties shifting in minority interests and rental income with the refranchise drive-ins for a portion of the quarter and as the performance of these drive-ins improve, we expect to see continued upside to royalty and rental income so the niceness of this, the higher percentage flow-through from this type of income versus what we would have seen previously with the partner drive-ins.

Our restaurant level margins also saw less deterioration in the third quarter compared to what we saw earlier in the fiscal year in a more challenging environment. It's due to a variety of factors, including the fact that commodity costs have moderated versus two and three quarters ago at a year ago. Also the refranchising of our lower-performing drive-ins has contributed to this and we believe that the improved operational controls have been put in place in the remaining partner drive-ins in our portfolio have also impacted this so that we've seen less deterioration in restaurant-level margins.

The reduced interest expense has come into play as a result of debt repurchase that we executed in the second fiscal quarter of this year, but also because the principal payments of principal reductions in our outstanding debt.

And then a significant increase in our cash position is also a key element of our financial performance in the more recent past. The refranchising proceeds that we've pulled in in the recent past in the third quarter totaled more than $50.0 million but throughout the year this has improved our total cash position to something in excess of $100.0 million.

Now, all these factors have worked together to really improve our financial position so I would like to talk a little more broadly about the progress and then on the initiatives that we've had in place to improve the performance of the company, performance of the system, but also to improve our balance sheet.

What I'm referring to here is initiatives to drive sales, initiatives to improve operations, initiatives to pay down debt to ensure that we're well positioned to meet customers' needs, but also stockholder interest in the near and long term.

First, our promotions and initiatives are designed to provide, as you would expect given our brand, unique and differentiated products and unique and also differentiated service to every customer either seeking our customary historical premium products, but even the value menu being made to order and the same personalized carhop service.

We remain focused on these types of efforts and believe that they will yield improved sales and operational performance over time, particularly over time as the economy normalizes.

What we are aiming for is a balance of promotions that drive not just traffic, as we've already talked about, but traffic, check, and loyalty, or put differently, in a different order, traffic, loyalty, and check.

And so let's spend a moment talking first about traffic. So that's why, to address our consumers' current economic need, that's why we implemented the value menu, to drive traffic and ensure that people knew that there's always a good value offering at our drive-in. Not something we've done historically but clearly implemented at the first of January.

The first four months following this introduction virtually, as I pointed out earlier, virtually all the advertising dollars were focused towards this Everyday Value Menu. So our traffic has improved versus when before we implemented it. So since the implementation of the value menu our research indicates that we've attracted quite a few customers, some of whom we had lost and some of who were new to the business altogether but had those we had lost returning to the business. So good increase in traffic and good increase in share of business growth.

As it relates to loyalty, we have done some things of this in the past. We have had extremely good loyalty and better repeat customer business in the industry for decades, across to CREST's data. But we have become more keenly sensitive to that. That is one of the reasons we implemented Happy Hour in November 2007 and as a result of that implementation our afternoon and drink sales—afternoon sales generally but drink sales in particular—overall have been strong.

The Happy Hour initiative was designed to provide both value but also emphasize the leading position we have in the drink business and it has grown quite nicely. We really view the Happy Hour initiative to be a very successful one, but we will be implementing other promotions over time that we'll talk about over time that are geared towards continue to drive loyalty with our customers. We will talk about near-term and continue to work on this, in spite of the fact that we view ourselves really at the top of the industry, from a loyalty standpoint.

As it relates to the check portion, we like the traffic piece in this environment. We have to drive it. The awareness of the value menu has done that. We have to balance it with check-driving promotions because it's not just enough to get the customers in. So when we focus on our check, we know that one of the main reasons our check has declined over the past couple of years is the decline in the sale of combo meals. We have seen a lot of CREST data that indicates this, not just in our business but across the industry. We have seen combo meals in our competitors in fact decline in real numbers, and so this is something we have worked to address.

I would think our own decline has been in part due to pricing decisions because our decline has been more severe than the industry. We think part of this has been pricing decisions that really reduce the discount, the difference between the individual items and the price of the combo meal. It reduced the discount that the customer expected to receive when they purchased a combo meal.

So by adjusting the prices on the individual items, the a la carte items, and then adjusting the combo meal price as well, we have worked to increase the discount the combo meals provide and we expect and believe that this in turn will help undo the decline that we have seen, or at least reduce the decline that we've seen in combo meals.

So to further emphasize the value in purchasing a combo meal and so drive traffic and drive check, our June promotion has aimed towards driving that discount, that is the difference between the a la carte items and the combo meal price, more to a 20% to 25% range. And we do that by offering the free upgrade to the Route 44, a 44-ounce drink with the purchase of a combo meal.

We've also added more combo meals on our new menu that we're rolling out across the system right now and we have increased the portion size of our size orders in these combo meals so we are adding more value to the customer as they consider the combo meal.

Now this promotion we talk about, the Route 44, we are doing in the month of June and we're not commenting today on the sales performance of the first three weeks of June. We will need to see how this continues to play out because the Route 44 promotion is going to continue through the summer, but the initial sales data that we've seen arising from this shows that it is having some good impact on reversing the decline in combo meal sales.

So this will be a very important contributor to driving check to match the fact that we've done a pretty good job at driving traffic as well. We will continue to focus on that traffic, loyalty, and check to try to drive our business and initiatives that we pursue will fit in one or more of those categories.

Moving to the next issue in terms of initiatives we have across the system, the second one would be from an operations perspective. We have implemented some key features of initiatives to improve customer service, and then pricing for improved sales.

One area we identified as needing improvement was customer service, particularly at our partner drive-ins and I think as you can see from the next slide, our partner drive-ins are well on the way to narrowing the gap with franchise drive-ins.

In November 2008 all the partner drive-ins implemented a more strategic pricing initiative than we had had previously. The prices items at the drive-in level rather than across the market or some other basis and emphasizes unit profitability based on the characteristics of that marketplace.

The objective here also as part of the pricing, is to incentivize people to purchase combo meals, which by the way, when we have that, the check averages over $10. Our franchisees are also participating in this pricing initiative and our early research indicates that the stores that have adopted, or are using this methodology, are more likely to retain customers and also more likely to increase store-level profitability.

I should say it's worth pointing out that the pricing initiative that we have underway is not one that yields all of its results at a single moment in time but rather is one that is implemented over time and builds to excess over time as a result of moving the various pieces of the menu in a more strategic way, but none of them in a sudden way that would drive away customers.

As it relates to the service gap that he have seen historically, in October 2008 we implemented this Fan Track, we call it. The tool provides direct consumer feedback, which by its very nature is richer and more robust than the tools we have used historically, and since implementing Fan Track our measurement of the same elements that Fan Track shows us, the customer service scores, have improved, particularly at our partner drive-ins, our own drive-ins. And when I say that, we are tracking same drive-ins. This isn't because a change in the portfolio.

So I know our operators are more in tune with what our customers' need are and what they expect from us. The partner drive-ins are now close on par with what we're seeing with franchise drive-ins. So it is a very positive trend for our partner drive-ins and one as we, from a marketing and promotional standpoint, are able to drive traffic, one which will show that our partner drive-ins I think are in a better position to do well by those customers that come to us.

I want to spend a minute talking about our refranchising activity. That's kind of the third initiative I wanted to visit about today. As you know, we set out at the beginning of the fiscal year to reduce the percentage of partnership drive-ins from our system from roughly 20% to down to 12% or 14% of the total system.

Our goals in doing that were two-fold. One, we believe we can improve partner drive-in operations more effectively if we have a smaller base to focus on. Also, by increasing the number of franchise drive-ins, we are reducing both the operational and financial risk of our business model. The result should be that we should have a more consistent cash flow and more consistent earnings growth over time as a result of that smaller base of partnership drive-ins.

At the end of the third quarter we had succeeded in reducing the percentage of partner drive-ins from 20% to about 14%. We are pleased at how well this has gone, especially when you consider the current economic and credit environment and no small feedback at the time we started doing that, including some of the folks online about the concern about whether we would be able to pull this off, and yet it's gone quite well.

I think anyone who is a shareholder could see today that small impact, as you look at the third quarter income statement, but we believe we will see increasingly positive effects in the coming months and years.

Finally, we have a significant amount of cash, which we hold in such a way that we can use for opportunistic purposes. We successfully completed the purchase of $25.0 million in debt at a nice discount in the second quarter. The 177 stores franchised in the third quarter, as I mentioned earlier, provided $50.0 million in cash proceeds for us, bringing the cash balance to more than $100.0 million. So we will be in a position to consider various alternatives that make sense to drive shareholder value, including the repurchase of debt or other initiatives over time.

So the success of these various initiatives should put us in a good position to have a renewed focus on doing what we've done best in the past, which is in particular from a marketing standpoint, providing a unique, high-quality, differentiated product and product offerings that resonate well with consumer taste and preferences, and doing so in our fun, kind of different kind of customer service experience setting.

The operational and service initiatives we're working on should really position us well for consumer and operating success. We anticipate that the initiatives combined with our capital management strategies should also yield positive results for our stockholders. Our view is that our approach and our strategies really lay a pretty good foundation for the evolution and the building of the business and will build on each other over time for a more successful transition to a stronger and a more national brand.

With that I'm going to turn it over to Scott McLain, who is going to review development activity for the third quarter of this year.

W. Scott McLain

Our overall franchise development activity remains relatively solid, especially in light of general economic conditions and the ongoing turmoil in the credit markets. Our franchisees opened 90 new drive-ins during the first three quarters of the fiscal year and relocated or rebuilt 40 drive-ins, slightly fewer on both fronts than in the same period a year ago. Our franchisees have also completed 287 retro fits this fiscal year, which puts us at roughly 70% of the system with a new look.

We continue to have a strong pipeline for future development with almost a thousand drive-ins scheduled to open over the next several years. However, as was the case in the second quarter, our near-term development is clearly going to be challenged by the effects of the difficult credit market and the tough business environment. We have yet to lose a project because of financing but the slowdown in the credit markets had resulted in significant delays in almost every current project and will continue to affect the pace of our openings in the coming months.

Projects continue to require a great deal more equity and significantly more time and effort to get through the system. This is particularly true for new franchisees who do not have a significant history of Sonic Drive-In performance. We are working with our franchisees to navigate these challenges, but the current environment is causing development delays.

On the positive side, we are seeing real estate prices fall in most areas, and in some places, including some of our new markets in the upper Midwest and Northeast, by over 30%. Overall competition for sites is also diminished and we're getting access to much better sites. More property is also becoming available for sale as opposed to lease, which greatly helps the financing process since it's very difficult to finance a ground lease today. In addition, construction costs are also decreasing as many contractors are hungry for work.

These factors, together with lower interest rates, will be very good for us over the longer term as they will only serve to increase our franchisees return on investment and nothing is more important to our long-term development prospects than new store ROI.

However, in such an environment, franchisees will often take more time than usual to make sure they have negotiated the best deal, which may even further constrain near-term openings.

Given all the uncertainty, it is somewhat difficult to project openings over the next few quarters. However, we currently anticipate opening roughly 130 to 135 franchise drive-ins this fiscal year.

Another positive factor is the continued strong performance of new drive-ins with overall average opening volumes at approximately $1.25 million, roughly 25% greater than what we were seeing just three or four years ago. Specifically, new stores and new markets continue to experience very strong sales. Wyoming, Michigan, recorded $686,000 in sales in the first six weeks. Seattle, Washington, was $668,000 in their first six weeks, and San Diego, California, reached $1.0 million in sales in just 70 days.

We also opened our first drive-ins in two new states in the third quarter, New York and Maryland. Our drive-in in Kingston, New York, which has now been open five weeks, has already surpassed $400,000 in sales.

We ended the quarter with 3,526 total drive-ins and we're now operating in 40 states, making continued progress on our way to becoming truly a national brand.

And with that I will turn it over to Steve Vaughan, our Chief Financial Officer.

Stephen C. Vaughan

For the third quarter three components comprised our earnings per share of $0.27, which as down a penny from the same period last year. First, we earned $0.24 per share from the operating portion of our business, which reflected the decline in same store sales compounded by its deleveraging impact on restaurant level margins.

Second, we recorded a gain of $0.11 per share from the sale of the operating interest in 177 partner drive-ins during the quarter. And then third, we recorded an impairment charge of $0.08 per share related to 12 partner drive-ins whose performance indicated their book value had become impaired. This number also includes an impairment charge for a group of drive-ins that are expected to be refranchised in the fourth quarter.

On a year-to-date basis, earnings per share totaled $0.53, including the items I just mentioned, plus the second quarter gain on early extinguishment of debt of $0.06 per share.

On an operating basis our year-to-date earnings per share declined 31%, excluding these special items. Soft sales and partner drive-ins were compounded by restaurant level cost pressures and were a primary contributing factor in our performance.

Our franchising income, including franchise fees and royalties, increased approximately $900,000 during the quarter. The net increase in franchising income was comprised of increased royalty revenue from new drive-in development and refranchised drive-ins, which offset the decline in franchise same store sales.

The royalty rate for the quarter was flat versus the same period in the prior year, at 3.88%.

A number of factors impacted our operating margins during the quarter. Higher prices for several commodity items, as well as a year-over-year increase in hourly wage costs, were exacerbated by decline in same store sales and resulted in a decline in drive-in level margins of 200 basis points during the third quarter. While this decline was disappointing, it was a marked improvement from the deterioration that we experienced in the first six months of the year.

Our food and packaging costs are largely locked in on all major categories through August. We expect that commodity costs will be slightly lower year-over-year during the fourth quarter and then decline as we move into fiscal year 2010, based upon current trends.

Including the positive impact of recent pricing changes, which I will discuss further in a moment, we feel confident that we will flat to slightly higher year-over-year food and packaging costs in the fourth quarter, depending upon the level of discounting associated with our combo upgrade promotion this summer.

We completed our first round of pricing adjustments at partner drive-ins utilizing the new strategic pricing methodology last November and we are currently in the process of implementing our second round of adjustments utilizing this tool.

As of June 1 approximately one-third of our partner drive-ins had installed the new menus. The remaining two-thirds will be installed by the end of this month. After these pricing changes, our average menu price of partner drive-ins will be approximately 3% to 3.5% higher on a year-over-year basis due through the remainder of this month. We will then lap last July's price increase, which will reduce the average pricing to 2% to 2.5%.

These increases represent an average in actual price increases at individual drive-ins will vary. This is in line with our new pricing strategies, to customize price increases by trade area and take smaller, targeted increases throughout the year. These percentages do not take into consideration the impact of the Everyday Value Menu, which has had an offsetting impact on pricing.

As a side note, our franchise drive-ins have begun utilizing this same pricing tool for the adjustments that are currently in process.

On the labor line, we face another increase in the minimum wage, which will go into effect near the end of July. This increase will continue to pressure our labor and benefit costs going forward.

A large portion of our other operating costs are fixed, so margin performance on this particular line item is very dependent upon sales.

Overall, we were encouraged by our restaurant operating margins, which were improved on a relative basis as the quarter progressed. We believe the refranchising initiative and renewed focus on operating a smaller number of drive-ins is having some positive effects.

Looking to the fourth quarter, we expect to see further stabilization of operating margins, particularly if we are able to see some improvement in our negative sales trends.

During the third quarter SG&A grew 4% while depreciation and amortization declined by 12%, reflecting the disposition that 194 drive-ins in the first nine months of the fiscal year and moderated partner drive-in development. We would expect SG&A growth to moderate further in Q4 while depreciation and amortization will continue to decline at a rate in the low to mid-teens due to dispositions.

Our other income line increased by approximately $1.3 million during the third quarter. This increase is primarily attributable to the rent income related to the real estate on refranchised drive-ins. We would expect that other income will be in the $3.0 million range in the fourth quarter.

One of the great features of our franchising business model is our strong operating cash flow. This feature allows us to maintain our capital expenditures at a reasonable level, while also servicing our debt requirements comfortable. As of the end of the third quarter we had $187.0 million outstanding under our variable funding notes, with interest expense on these notes currently averaging about 1.5%. Interest expense for fiscal 2009 for this portion of our debt will depend upon changes in LIBOR and commercial paper rates.

We are carrying approximately $100.0 million in cash instruments over and above our normal operating needs. We do not anticipate needing to utilize any of our cash investments, as our free cash flow, after planned capital expenditures of approximately $50.0 million and $38.0 million in mandatory principal payments, is expected to be positive.

We continue to comfortable exceed our debt compliance covenants and we anticipate this compliance will continue into the foreseeable future.

During the third quarter, our tax rate was 37.5%. We continue to expect our tax rate to be in the range of 38% in the fourth quarter, although new developments could impact that rate in any given quarter.

So in summary, while sales and earnings performance have been disappointing over the past year, the initiatives we have outlined and implemented these past few months provide a solid foundation and position us for earnings growth over the long term.

Improved sales and earnings performance will likely take time but we believe our corporate strategic focus on four key areas: driving same store sales growth; refranchising partner drive-ins; new unit development; and moving our business toward a more predictable and stable cash flow model will increase shareholder value over the long term.

As evidence of our financial strength, we continue to expect positive free cash flow after capital expenditures and debt payments now and in the longer term, which provides us with ample flexibility in utilizing our excess cash for shareholder-value-driving initiatives going forward.

This concludes our prepared remarks and we would be happy to accept your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Matthew DiFrisco – Oppenheimer & Co.

Matthew DiFrisco – Oppenheimer & Co.

Can you give us a break out of that 130 to 135 stores for 2009 as far as the break down between franchise and company?

W. Scott McLain

That was just franchise. It's 130 to 135 franchise stores and roughly 10 to 15 partner drive-ins on the partner side.

Matthew DiFrisco – Oppenheimer & Co.

15 for the partner side?

Stephen C. Vaughan

10 to 15, somewhere in that range.

Matthew DiFrisco – Oppenheimer & Co.

And as far as your overall capex, can you give us some insight into what that looks like ending for 2009 and what potentially direction will be for fiscal 2010? I guess what I'm trying to look for really is how much does it benefit from being now at the end of the company-owned stores being remodeled.

Stephen C. Vaughan

We expect this year we'll end up with about $50.0 million of capex, maybe a little bit less than that. We would expect 2010 to be below that amount. We are, as you mentioned, on the tail end of the retro fit for partner drive-ins and so we would expect that to probably be closer to $35.0 million to $40.0 million. We are in the process of working on our 2010 business plan so we'll give more specifics in probably two or three months.

Matthew DiFrisco – Oppenheimer & Co.

And with respect to the royalty rate, despite having the comps sequentially get lower for the franchisees, you actually held the line on the royalty rate. Is there a mitigating factor from a descending? Did you have a large portion re-up to the higher rate and go from, I think it's called the seventh agreement, to the 4.5 range from the prior older agreements, or how does that look going into the fourth quarter? I'm wondering how much do we get as a tailwind from the ongoing process of migrating people up to the higher royalty rate and offsetting some of maybe the dissension effect from the lower comps that the franchisees are experiencing.

Stephen C. Vaughan

Well, a couple of things. One, all new stores open up under a newer form of agreement, either the number six or number seven. So they have an average rate that's higher than our underlying average for the system. And then secondly, the newer stores that are opening up are opening up at higher volumes and so they have a higher effective rate.

So those two factors basically offset the descending portion for existing stores.

Matthew DiFrisco – Oppenheimer & Co.

And then as a full quarter, does the exit of the disposition of the 170+ stores company go into the franchise, does that have an impact on your mix from your royalty rate or is that just not significant or did we see it already in the third quarter?

Stephen C. Vaughan

It's not significant.

Operator

Your next question comes from Joe Fisher for Steven Kron – Goldman Sachs.