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Executives

Enrique N. Mayor-Mora - Vice President of Planning and Investor Relations

Nelson J. Marchioli – President and Chief Executive Officer

F. Mark Wolfinger – Executive Vice President, Chief Administrative Officer, and Chief Financial Officer

Analysts

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

Reza Vahab-Zadeh - Barclays Capital

Brian Hunt – Wells Fargo Securities

Mark Smith – Feltl & Company

Stephen Anderson - MKM Partners LLC

Ken Bann – Jefferies and Company

Reed Kim - Merrill Lynch

Denny's Corporation (DENN) Q2 2009 Earnings Call August 4, 2009 5:00 PM ET

Operator

Good afternoon everyone and welcome to Denny’s second quarter 2009 earnings release conference call. At this time I would like to inform all participants that your lines will be in a listen-only mode. After the speakers’ remarks there will be a question and answer session.

In order to accommodate all callers, please limit yourself to one question and one follow up question. If you would like to ask additional questions we ask that you remove yourself from the queue and then reenter. (Operator Instructions)

I would now like to turn the call over to Mr. Enrique Mayor-Mora, Vice President of Planning and Investor Relations.

Enrique N. Mayor-Mora

Thank you, Lynn. Good afternoon and thank you for joining us for Denny’s second quarter 2009 investor conference call. This call is being broadcast simultaneously over the internet. With me today from management are Nelson Marchioli, Denny’s President and Chief Executive Officer, and F. Mark Wolfinger, Denny’s Executive Vice President, Chief Administrative Officer, and Chief Financial Officer.

Nelson will begin today’s call with an overview of our business and our strategic initiative. After that, Mark will provide a financial review of our second quarter results.

Before we begin let me remind you that in accordance with the Safe Harbor provision for the Private Securities Litigation Reform Act of 1995, the company knows that certain matters to be discussed by members of management during this call may constitute forward-looking statements. Management encourages caution in considering its current trends with any outlook on earnings provided on this call. Such statements are subject to risk, 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 risks and 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. Speaking of which, we will file our 10-Q this evening.

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

Nelson Marchioli

Thank you, Enrique. Good afternoon, everybody. Let me start by saying that I’m pleased that Denny’s has continued to deliver growth and profit despite the unprecedented pressures on same store sales in our industry.

Denny’s ongoing transition to a more franchise-based business model inclusive of a more effective organizational structure has allowed us to deliver profit growth consistently and with increased predictability.

Our second quarter performance also reflected cost reductions in our company-operated restaurants through efficiency gains. Our progress towards the more franchise-based business model was characterized in the second quarter by an adjusted income before tax increase of $1.6 million or 27% despite a $34 million or 18% decrease in revenue.

In addition, we opened 10 new franchise units in an environment where the restaurant and retail industries are cutting back development, sold 22 company operated units to franchisees, decreased G&A excluding bonuses, lowered interest and depreciation expenses, and voluntarily paid down $9 million of debt.

Since mid-2006, Denny’s has paid down $238 million or 43% of its debt. In addition, for the third quarter in a row, Denny’s franchise gross profit contribution exceeded that of the company units.

Denny’s transformation has increased our operating margins, earnings power, and system unit growth while lowering both our business and our financial risk. We firmly believe that our business model is now better suited to withstand and succeed in the challenging economic climate. The existing consumer environment is easily the most challenging that I’ve seen in my 8 years here at Denny’s.

NPD recently reported that the second quarter of 2009 was the worst sales performance in 28 years for the restaurant industry. [NapTrack] also reported a single digit drop in the casual segment for same store sales despite a fall in the segment’s check average.

The most important drivers of the industry’s sales challenges are decreasing consumer confidence and rising unemployment. In the short term, it does not seem that these indicators are expected to improve in any material fashion. That being said, we do recognize that some of our competitors are delivering same store sales results that are outperforming Denny’s. Plainly said, we are committed to improving our sales and guest counts.

Starting in mid-2008, our marketing programs pursued guest count growth through our positioning as Real Breakfast with strong lunch and dinner offerings and a clearly differentiated late night experience through our all nighter program. We believe this will continue to differentiate us from our competitors.

On the platform of Real Breakfast, Denny’s has a three-pronged approach to driving sales: a focus on core equity value, new product innovation, and improving the guest experience in our units. Denny’s is recognized as a great value for our guests.

As has been well-documented, the Super Bowl giveaway event in February strengthened our value perception and drove tremendous goodwill and purchase intent from our consumers. With the objective of further reinforcing the benefits we accrued from this event, we had a subsequent free event as part of the NCAA Final Four. On April 8 we gave away a free Grand Slamwich, an outstanding new product that takes our iconic Grand Slam and delivers it in a new sandwich format to everyone in America who also ordered a Grand Slam. This event drove a 20% guest count growth on the day and helped produce the brand’s strongest comp traffic trends during Easter week in the past four years.

While smaller in scope than the Super Bowl event, it still produced coverage from 1400 TV broadcasts, 500 print and web outlets, and had 25 radio stations who interviewed Denny’s management. Those radio stations represented 30 million listeners. We believe this tremendous and continued response speaks to the power of our brand and how strongly it is embedded in the American culture.

The second quarter also saw Denny’s continue to offer our starting at and tiered price points against all day parts. As 50% of all menu items sold at Denny’s are breakfast items and our competitive differentiation is based on Denny’s offering Real Breakfast. This is where we have focused our value offerings.

Specifically, our new Abundant Burrito started at $3.99 and is tiered at $4.99 and $5.99. We also offered our new Grand Slamwich at the terrific starting price of $4.99 and our popular Pancake Puppies for $1.99. By the way, the first ever appetizer offered at breakfast.

In light of intense competitive pricing in the marketplace, Denny’s began offering in June the Everyday Value Slam for $3.99 available all week long. This plate was designed to protect our margins while delivering craveable value to our guests and Everyday Value Slam has been a popular seller with our guests and has performed to our expectations.

We also continue to offer 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 [in some its] rate to almost 20%, five times higher than the next most popular entrée. This product also has a very attractive food cost and has supported our food margin rate objectives.

While we are pulling similar levers of price, value, and product innovation at both dinner and late night, these day parts have been more negatively impacted than breakfast and lunch by the current economic environment. Dinner has also been impacted by aggressive pricing in the casual dining segment.

We have also been more active in targeted markets with the use of discounting vehicles that have historically driven return visits. Our second approach to driving sales is a focus on delivering new product and program innovation across all day parts. Since late 2008 Denny’s has been extremely active in this area.

In addition to the Grand Slamwich that was introduced in December, the second quarter of 2009 saw exciting new entrees, drinks, and salads that provide great appeal and strong value across all day parts. Our new entrees included four new Abundant Real Breakfast Burritos including the Bacon Avocado and Southwestern Steak 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 Sizzling Skillet Dinners including Sweet and Tangy Barbeque Chicken and the Tilapia Ranchero.

As a whole we’ve been pleased with the performance of our new products as they collectively mixed at over 10% or said another way, an average of approximately 50 plates per day per restaurant.

We also built on our signature beverage platform by rolling 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 shop and we’ve gone back to our roots with the introduction of a more robust and higher quality coffee, which by the way go great with our new Pancake Puppies. The increased incidence rate on our new coffee has exceeded our expectations.

Denny’s has also been proactive in offering healthier choices to our guests. Our new Better For You menu choices and our sports-themed kids menu were recently launched. The Better For You choices include delicious items with reduced fat or sodium such as turkey bacon, wheat pancakes, egg whites, fresh fruit, yogurt, and dippable vegetable sticks and apple slices for kids. Our new kids menu eliminated or replaced certain meals on the kids menu determined to be higher in sodium or fat.

While the economic environment has impacted the late night business, we’ve continued to update and strengthen our All Nighter platform. Our new Rock Star menu was recently rolled out and included a freestanding menu with items created by Rascal Flatts, Good Charlotte, Gym Class Heroes, and Sum 41. The incident rate for the Rock Star menu has climbed to 8% of our late night business. Our award-winning All Nighter platform is a strong competitive differentiator.

Denny’s third area of focus is to improve the overall experience of our guests. Toward this goal we’ve made systemwide progress along three fronts. First, our mystery shopper program has driven improved guest experience scores across the brand. Second, Denny’s has successfully tested a low cost kitchen equipment package focused on enabling faster table turns and higher volume units. This package is now available to all of our franchisees. Third, we recently began holding brand building committee meetings with our franchisees. These committees are organized by marketing operations and development and are expected to move the system forward through the sharing and implementation of best practice.

Our local marketing co-ops now in 15 DMAs representing 45% of our system units were relatively quiet in the second quarter as Denny’s was on national media for much of the quarter. As a reminder, Denny’s began this year to establish these co-ops and has made considerable progress in increasing our ability to communicate with our guests. We estimate that these co-ops will fill in approximately 12 additional weeks of media at the local level throughout the year at times when there is no national media.

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. Furthermore, our continued migration towards a more heavily franchised business continues to provide us with a more profitable and predictable financial model. We’ve 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, I thank you for your interest in Denny’s. I’ll now turn the call over to Mark Wolfinger, Denny’s CAO and CFO.

F. Mark Wolfinger

Thank you, Nelson, and good evening everyone. I’ll start my comments with a review of our second quarter sales performance. Systemwide same store sales decreased 4.2% comprised of a 2.7% decrease at our company restaurants and a decrease of 4.7% at our franchise restaurants.

Looking at details for company sales performance, a 4.9% decline in guest counts was partially offset by a 2.3% increase in average guest check. Days guest counts have been most negatively impacted in the areas of the country that have been hardest hit in the recession. Those include California, Florida, and Arizona, which account for 41% of our system units.

Most of the growth in guest check was attributable to pricing actions taken over the past year to help counterbalance commodity cost pressures. Partially offsetting the increased pricing was the unfavorable impact of a stronger value-oriented menu mix compared with the prior year period.

The decline in total company restaurant sales in the second quarter largely reflects the continuing impact of our franchise growth initiative of FGI as sales decreased $38 million or 23% due to 96 fewer equivalent company restaurants compared with the same period last year.

I will now turn to the quarterly operating margin table in our press release. The increase of 1.8 percentage points in the second quarter was due to a combination of price increases taken during the last 12 months to help offset commodity inflation, a decrease in unit level labor as well as lower utility rates. These were partially offset by rising occupancy costs as well as by an investment and marketing to the establishment of local co-ops.

Payroll and [deficit] costs improved in the second quarter, decreasing by 0.7 of a point to 41.6% of sales due to more efficient crew labor and due to the reduction in management labor that took place in Q2 2008. The reduction in management labor contributed 0.3 of a point of leverage in the second quarter despite fallen same store sales.

This benefit is not expected to carry forward to the third or fourth quarters as a result will affect our year-over-year company margins rate. Our operations team continues to do a solid job improving crew labor efficiency in the quarter which resulted in an increase in field bonus compensation which partially offset further reductions.

A quick update on the impact of the latest round of recent minimum wage hikes. While Denny’s has been materially impacted since the inception of the program, at this point the near term impact is minimal as the existing program winds down. Occupancy expense increased 0.3 of a percentage point due to sales deleverage and due to FGI. In the case of FGI where Denny’s owns the real estate, occupancy costs delivered due to the loss of company sales that were not incurring any lease expense.

Our utility expense in the second quarter decreased 0.5 of a point. Denny’s is benefiting from the natural gas rates that have fallen considerably from the levels seen in 2008. Marketing costs rose 0.4 of a point in the second quarter as Denny’s continued to establish local marketing cooperatives across the country. As of the end of the second quarter, we had local co-ops in 15 DMAs. Each of these DMAs had all of the company and the majority of the franchise restaurants participating. These DMAs represented approximately 45% of our system units.

Other costs decreased 0.5 of a point on lower legal expense and lower new company unit pre opening expense which was partially offset by a loss of business and eruption income as Denny’s prepares to reopen one of our units on the Las Vegas strip. It is scheduled to reopen in Q3 2009 and we believe it could be one of the system’s highest volume units.

In summary, the gross profit from our company operations decreased $2.5 million on a sales decline of $38 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. Specifically, the gross profit from our franchise operations increased $1.1 million or 6% to $19.6 million on a revenue increase of $3.3 million or 12% in the second quarter.

Denny’s franchise revenue increase consists of $800,000 increase in royalty revenue, a $2.2 million increase in franchise occupancy revenue, and a $200,000 increase in up front franchise fees. Royalties on rents were higher due to a 95 unit increase in equivalent franchise units. The franchise fees were higher due to 8 more franchise unit openings in the second quarter of 2009 compared with the second quarter of 2008.

Franchise costs increased $2.2 million primarily related to the rental expense on property subleased to franchisees. This subleases are the primary driver of 3.8 percentage points decrease in the franchise operating margin to 64.7%. Denny’s is on the primary lease and subleases these properties to the franchisee. We recognize our sublease income as franchise revenue but there is an offsetting cost in franchise expense for the primary lease. Therefore, the overall franchise margin rate on a percentage basis will decline.

From a gross profit standpoint, the franchise side of our business contributed more than our company restaurants for the third consecutive quarter. This income shift allows us to reduce the risk and increase the predictability of our earnings.

General and administrative expenses increased by $400,000 in the second quarter. The benefits from a lower salary and other compensation costs are attributable to the new organizational structure we implemented in the second quarter of 2008 were offset by a $1.7 million increase in incentive compensation, an $800,000 increase in share based compensation, and a $500,000 negative impact related to the accounting for our deferred compensation plan.

Next, depreciation and amortization expense decreased by $1.9 million from the prior year quarter due primarily to the sale of restaurants and real estate assets over the past year. Operating gains, losses, and other charges on a net basis decreased $6.8 million from the prior year period due primarily to a $6.4 million decrease in restructuring charges. These restructuring charges were primarily severance costs related to the organizational changes we made in the second quarter of last year as we transitioned our company focus towards becoming a franchisor of choice in the restaurant industry.

Including these items, operating income for the second quarter increased $6.9 million to $17.4 million. If you exclude the gains, losses, and other charges from both periods, operating income increased by $100,000 in the quarter despite a decrease in total revenue of $34.5 million. To post the $100,00 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 second quarter decreased by $600,000 or 7% to $8.2 million, primarily a result of a $22.2 million reduction in debt from the prior year period. Other non-operating income decreased $900,000 in the second quarter, due primarily to the recognition of unrealized gains and losses related to our interest rate swap.

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 second quarter was $7.3 million, an increase of $1.6 million or 27% over the prior year period. We are pleased that we were able to generate significant adjusted income growth despite the difficult sales environment for the restaurant industry. We believe this success is a direct result of our FGI program, debt reduction efforts, and cost containment activities.

To summarize our P&L for the second quarter, the sale of company restaurants to franchisees contributed to a $38 million decline in company restaurant sales and a $2.5 million decrease in company restaurant income. We more than offset this loss company restaurant income through the combination of a $1.1 million increase in franchise income, a $1.9 million decrease in depreciation and amortization expense, and a $600,000 decrease in interest expense.

Turning to activity in the Denny’s restaurant portfolio during the second quarter, the system decreased by a net 2 units as 10 new restaurants opened while 12 were closed. The 10 new openings were all franchise restaurants bringing the year-to-date franchise openings to 20 and year-to-date system openings to 21. Denny’s year-to-date net system growth as of the end of the second quarter is plus 3. These 21 units represent significant unit development progress for the Denny’s brand and are also impressive in the con text of an industry that is pulling back on growth.

Moving on to capital expenditures, our cash capital spending for the second quarter was $4 million, a decrease of $3.9 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 second quarter spending this year was partially lower due to the timing of remodel spin anticipated in 2009.

Turning to asset sales in the second quarter, we generated proceeds of $7 million from the sale of 22 company restaurant operations, an additional $2.7 million from the sale of real estate. On a rolling 12 month basis, we have generated net cash proceeds of $25.3 million from the sale of restaurant operations and $5.8 million from the sale of certain real estate. In total we have taken in $31.5 million in cash proceeds during the past 12 months.

We used these proceeds to reduce our outstanding debt by $22.2 million over the past year. In addition we held back a portion of the proceeds in cash as you can see in our cash balance which increased from $12 million at the end of second quarter 2008 to $20 million at the end of the second quarter 2009. This cash balance combined with access to our credit facility provides us with ample liquidity of approximately $70 million.

Given the challenges facing our national economy and our industry, we are very pleased to have reduced our debt by $238 million or 43% since mid-2006. We believe we are in a financial position to manage through this difficult operating environment. We have no material debt maturities in the near term as our revolver is in place through December 2011 and our term loan through March of 2012. Our senior notes mature afterwards in October of 2012.

To conclude, the progress we made in our sales trends in the first quarter slowed in quarter 2 as restaurant industry traffic continued to feel the impact of rising unemployment and lowered consumer confidence. It is important to consider that any further sales declines could have a negative impact on the company margin rate and earnings benefits that we have been generating through our ongoing business model optimization and cost containment initiatives.

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 with the following refinements: for both adjusted income before taxes and adjusted EBITDA, we expect to perform at the higher end of the ranges previously communicated. For the prior, the range was $15 million to $20 million and for the latter the range was $73 million to $78 million. As a reminder, last year’s adjusted income before taxes of $23 million was positively impacted by $3 million from the 53rd week.

With respect to the FGI program to date through the second quarter of 2009, we have sold 261 company restaurants or 50% of the prior company store base. This includes 22 sold in the second quarter of 2009. As a result we’ve increased the mix of franchise restaurants from the Denny’s system from 66% to 83%.

While demand remains strong and we expect the mix to continue moving towards a more heavily franchised systems, the current credit environment limits our visibility into the balance of 2009. Denny’s will continue to provide updates on the progress of the FGI program each quarter.

That wraps up my review of our second quarter results and I will now turn the call back to Enrique Mayor-Mora.

Enrique N. Mayor-Mora

Thank you. We will now move to the question and answer portion of the call.

Question-and-Answer Session

Operator

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

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

As you look at the trends to date in the third quarter, I guess you were at $11.9 million of adjusted income before taxes due to first half. Your strongest seasonal quarter is still ahead of you here in Q3 so it would seem like unless there is a major trend change that you should be setting up to probably do better than the prior guidance. Is there anything that you’ve seen in terms of change in trend to date in the third quarter that makes you a little more cautious towards the back half or is it just the general uncertainty of the consumer environment given that… obviously the comparisons you have in the second half certainly are a lot easier than the first set.

F. Mark Wolfinger

As far as the seasonality, obviously in the second quarter we did capture what all called the first month of the summer depending on where you are in the country and so that’s already in the second quarter. We talked about our guidance and obviously from an adjusted income standpoint we’re moving that guidance towards the higher end of the range. I think those are the comments that I made. I think what you’re hearing from us is just a level of conservatism as we go into the second half of this year and as things can change. I know one of the things that concern management here clearly is looking at GDP in the second quarter which again was a negative number. I think from a consecutive quarter standpoint that was the highest number of consecutive, that was four consecutive negative quarters for GDP which I think was a record since 1947 if I recall. I think the second piece is just looking at some of the consumer confidence numbers that have come out most recently that clearly are concerning sort of what I would term a mixed message. I haven’t specifically answered your question from a math standpoint but I think what I wanted to sort of introduce is the tone in which we approached our comment on guidance.

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

I think you did answer the question with what sounded like a no in terms of was there any real material change in trends that gives you pause other than just the general consumer environment and I think it sounds like it’s just a conservatism on the tone. Is that a fair way of --

F. Mark Wolfinger

I think the positive news that comes out of our discussion here is the fact that our guidance range was $15 million to $20 million and obviously we’ve moved up towards the high end of that guidance range in our commentary without setting a specific number but at the same time, this is a very tough, rocky economy that we’re in and clearly the consumer is directly being impacted and as I mentioned in my comments, 41% of our system units are in those three states, California, Florida, and Arizona which have been exceptionally hard hit in this recession.

Operator

Your next question comes from Reza Vahab-Zadeh - Barclays Capital.

Reza Vahab-Zadeh - Barclays Capital

Under same store sales front, Nelson, is the weakness in the second quarter versus maybe the first quarter or perhaps versus your own indications, is that due to heavier discounting in casual and QSR and if you are losing a share of the pie, is it to eating at home or is at eating at some other venue, can you tell?

Nelson Marchioli

I would suggest to you it’s probably eating at home. Casual obviously has been discounted significantly but I would suggest if it was over capacity and I don’t know that they’re taking anything away from us. I think folks are staying at home at night more often than not. I think NPD recently said or Technomic said that about half the folks that ate out a couple years ago are eating out less. 50% less as a matter of fact then they were a couple years ago. I think we’re dealing with consumer confidence and unemployment across the country. Remember our demographics, everyone is offering a value today. It’s hard to find anything in retail no matter what sector you look at that isn’t talking about value, trying to get the customer to come out. So we deal with headwinds every day, whoever provides the best value and compelling argument for the customer to come in. Wins, I do clearly understand that there are winners and losers but also as I said in my prepared remarks that there were some competitors in our segment that were outperforming us and as I plainly said, we are addressing sales and customer counts, not forgetting obviously the necessity for profitability.

Reza Vahab-Zadeh - Barclays Capital

As far as franchise health, you’re comfortable with the financial health of your franchise system base?

Nelson Marchioli

Based on what we know, our accounts receivable, based on how we collect our funds, is probably one of the lowest if not the lowest in the industry and for the most part, we have good operators and they’re well funded. I don’t see any red flags at this point. I’m cautiously optimistic.

Reza Vahab-Zadeh - Barclays Capital

Mark, I couldn’t catch the Cap Ex for the quarter or for the year.

F. Mark Wolfinger

Cap Ex for the quarter was about $4 million which I think I mentioned was about $4 million less than prior year. I think our guidance for Cap Ex was something in the low $20s on an annual basis. $23 million was the annual number. That’s our guidance and that’s what we still hold to at this point.

Operator

Your next question comes from Brian Hunt – Wells Fargo Securities.

Brian Hunt – Wells Fargo Securities

Nelson, I was wondering if you could talk about the menu. You guys have been very active in creating lots of new craveable items and I was wondering if you could talk about how many items you have on the menu today versus a year ago and maybe what’s your menu target in terms of the number of items that you may have.

Nelson Marchioli

We probably have the same number of items on the menu this year as we did last year. There may be few more. One of the things our consumers told us, we did some research here about a year ago and we asked lapsed users specifically, “Why don’t you come back to Denny’s more often?” and they told us very clearly, “We know what Denny’s is. You don’t have anything new. Grand Slam is great but hey, we know what that is” so we realized we needed to pump up the system if you will with new, innovative craveable products and our Chief Marketing Officer and Chief Innovation Officer, Mark Chmiel has worked hard with the product development team which I think he has upgraded quite nicely.

We added I think with this last Better For You entrée, I think we added about 17 new items that we’re quite proud of and as I said about 50 plates a day, 10% of our mix, so of the new products that we’ve introduced in the 8 years I’ve been here, it’s probably one of the most successful product introductions that we’ve seen, so it is about craveable. It is about new. Customers are looking for different things. They want things that they can’t have at home and we’re about providing that to them.

Brian Hunt – Wells Fargo Securities

Looking at the advertising co-ops, you have 15 DMAs covering 45% of the store. What’s the target goal by the end of the year for that measure and when should we start to see benefits from leveraging the local advertising?

F. Mark Wolfinger

I would suggest to you there’s probably 20 top DMAs. What would we expect to see this year, maybe 16. I think we’re there for this year. When will you begin to see the benefit? I already see the benefit. I have to tell you, it’s given us in those markets on average 12 weeks of incremental spend or media coverage. I shudder to think what my sales and profit performance would have been if those co-ops weren’t there and I’m particularly proud of my franchisees and my company folks in operations for stepping up if you will in investment spending in these critical markets that we have. I think it’s already working. I wish but wishing doesn’t make it so, but I wish the system wide same store sales had not decreased by 4.2% in the quarter just ended, but I have to tell you, I think it would be more than that had we not had the co-ops.

Brian Hunt – Wells Fargo Securities

On the kitchen package, what’s the cost of that new kitchen package and will it give you greater flexibility to add new menu items in the future?

F. Mark Wolfinger

A couple things. First of all, it’s about $10,000 to $11,000 per restaurant and what it does, it gives us the opportunity in peak periods to increase our output in a restaurant hourly by probably 10% to 25% which obviously is significant. It does give us some flexibility for new menu items but more importantly it’s about increasing production and improving profitability during peak periods and of course as I often say, we’ll do over half our business between Friday noon and Sunday at 2 pm so those are key hours for us to perform.

Operator

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

Mark Smith – Feltl & Company

First off, Nelson, can you talk a little bit about your product mix and also the day part mix and if you’re seeing evidence that the current marketing message of Real Breakfast is working for you?

Nelson Marchioli

Well clearly product mix tells me that the marketing is working. As I mentioned in my script, 20% incidents on Grand Slam, first time in I can’t remember when that we have a non-price pointed commercial on air for Build Your Own Grand Slam. Grand Slam gives us an incredible, particularly the Build Your Own Grand Slam, an incredible food cost into the 20% incidents. It is clearly one of our great weapons in this particular environment to ensure profitability and operations is just executing well and whenever you give operations, one thing to do to focus on, the better they do.

So I’m very proud of the company and the franchise operators in that regard and I’m very proud of my purchasing people who have made such incredible buys and finance holding them accountable, candidly to get them to the bottom line consistently and predictably and if you followed us for a number of years, that’s a change over the last several years and in the last year and a half it’s been quite rewarding to see that performance.

In fact, I’ll quote a franchisee, a long time Denny’s employee and now franchisee with us for almost 35 years total said he has never seen profitability at a Denny’s restaurant, company or franchise, as good as it is today. So mix and the marketing message is working. We just have to get more feet in the door and that’s the consumer confidence piece in this overall economy that we’re all of us in this industry are working against.

Mark Smith – Feltl & Company

Mark, can you talk a little about the financing environment, what your franchisees are seeing and in particular these last 22 that were done?

F. Mark Wolfinger

I think a little bit of my commentary is going to echo what I said in the first quarter and that is it continues to be a tough financial environment in general in the restaurant sector when it comes certainly to our business. At the same time, as I said in my comments, the demand out there for our company operated stores continues to be very strong. Certainly we have I think even with our guidance when we started this year, we’ve been cautious about giving a sense of direction as far as specific numbers on FGI. The number of 22 in the second quarter I believe brings us to 52 on a year-to-date basis so 52 in the first half. So 52 stores sold in a difficult financing environment off the base of company stores that we started with I think is reasonably strong performance again against the headwinds of financing. It’s one of the times, I think as I mentioned in my first quarter commentary, the financing is there, the terms and conditions need to be a little bit tougher at times, and it simply takes longer to get those deals put in place.

Mark Smith – Feltl & Company

In a way is it weeding out and giving you a stronger franchisee who’s coming in and buying these?

F. Mark Wolfinger

Not necessarily. I think we again, to Nelson’s comment to an earlier question about the strength of our franchise system, I don’t necessarily think that’s an issue at all. I think it really comes down to it’s just a slow, arduous process again. The restaurant sector is what is already a very difficult credit market environment. The restaurant sector is obviously even more challenging sector as it relates to lending but again we continue to focus on FGI and the appropriate geographic focus and as I said, 52 in the first half is certainly fine from our perceptive.

Mark Smith – Feltl & Company

Of the 52 that you’ve done this year, if you can tell me offhand about how many of those may have been in the California market or any of the other markets that you mentioned that have been troublesome this year.

F. Mark Wolfinger

It was a wide distribution. There was a rather large transaction that took place in New York and New York State and that was probably greater than 50% of those units sold and probably something maybe in the high single digit number was probably sold in the State of California of the 52.

Mark Smith – Feltl & Company

So of the company base, you’re still looking at a third or more that are in California.

F. Mark Wolfinger

We still have a very strong base. Again, overall obviously California is where the brand started, in Southern California, very strong base of both franchise and company operations there. Highly penetrated in several of those DMAs.

Operator

Your next question comes from Stephen Anderson - MKM Partners LLC.

Stephen Anderson - MKM Partners LLC

Circling back to the proceeds issue of the asset sales, back of the market calculations suggest a per unit proceeds of about a little over $300,000 which is certainly better than what we saw in the first quarter. Can you give any color as to where most of these assets align in terms of the quintile scale?

F. Mark Wolfinger

You’re absolutely right. The average was a little bit over $300,000 of the 22 that we sold in the second quarter. I think the first quarter was around $140,000 so basically probably twice as much approximately on a per unit basis versus the first quarter. Again, our focus has been towards the lower quintiles. If you recall, that chart that we’ve shown in a number of our analyst presentations where we took the original company base and divided it into the five quintiles. Our focus has been to the lower quintiles that’s certainly an attractive investment on the part of our franchise system. Depending upon the market there may be a mix of different quintiles in there obviously to finish out a market but I think as we’ve said in our presentations on average, we have been selling the quintile four type of store. Again, I think we’ve also mentioned that those proceeds per store can range significantly depending upon what part of the country and the underlying profitability of the store. Overall our discipline is to make sure that these transactions remain accretive to our shareholder and we’re focused overall on that as well.

Stephen Anderson - MKM Partners LLC

To get back to the quarterly comp story, do you provide any kind of color as to what you saw in April, May, and June?

Nelson Marchioli

We no longer break out the monthly performance. We just provide quarterly comp sales.

Operator

Your next question comes from Ken Bann – Jefferies and Company.

Ken Bann – Jefferies and Company

I was just wondering looking at next year and you present you’re beginning to your capital expenditure plans going into 2010 and given the difficulty in the industry, can you give us an idea will you continue to spend in the low $20 million range for Cap Ex or will you maybe cut that back with the idea of not building any new stores on the company basis?

F. Mark Wolfinger

We obviously haven’t thought about guidance yet for 2010 but I think to answer your question strategically, obviously in transitioning to this franchise business model, one of the things that we have seen consistently since the transition began was the continued reduction. That’s obviously with a lower asset base, certainly from a maintenance capital standpoint, but also with the majority of the growth taking place in the franchise system, our Cap Ex numbers have come down. Our guidance for 2009 again was $23 million for the full year.

I think if you go back to probably 2005, that’s probably half of the number we spent in 2005. We spent something in the mid-40 plus range in 2005. We will continue certainly if the locations are available to open on a very selected basis, company stores. In the first quarter we opened a store in Hawaii that is doing exceptionally well for us. I mentioned in my comments we have a store that will be a company operated store opening on the Strip in Las Vegas probably late third quarter early fourth quarter time frame.

Again, on a selected basis, we’ll continue to make those investments but a majority of the new store growth will come from our franchise system. So the model overall is obviously to transition to the franchise model more and more and obviously that will continue to require less Cap Ex but we have not given guidance for 2010 at this point.

Ken Bann – Jefferies and Company

On food costs, have you begun to move into 2010 in terms of purchases of commodities and can you give us any idea whether things are continuing to be fairly benign on the commodity front for the next several quarters?

Nelson Marchioli

We have not moved into 2010 yet in terms of forward buying. We’re going to see how the market does. Currently we take a look at the future, we’re looking at maybe 2% to 3% inflation rate is what we’re seeing. However, for the time being, we’re going to watch the market more closely but we’re not locked in yet to 2010.

Operator

Your next question comes from Reed Kim - Merrill Lynch.

Reed Kim - Merrill Lynch

I was just curious if you could go over sort of the reasons why the average unit sales for franchisees, there’s that gap between your stores and theirs and sort of what was going on with the comps maybe in the quarter.

Nelson Marchioli

From a comp standpoint or from an AUV standpoint?

Reed Kim - Merrill Lynch

I guess both.

Nelson Marchioli

Let me start with the comp. From a comp standpoint, there’s a couple major things. One is pricing, historical pricing. Last year the company stores were a little bit more aggressive than the franchise stores in terms of taking pricing in the unit. Every year we go and we take a look at how we’re competing in DMAs across the country and we recognize we had opportunities in the company stores and we took them, moreso than what our franchisees who typically have higher prices than we do in the unit. So that’s one reason. The second reason is the exchange rate with Canada. Part of the franchise comp sales is the Canadian exchange rate impact. So those are the two primary drivers this year. Why there’s a difference between franchise and company.

In terms of AUVs what you see is part of that is driven by our franchise growth initiative so as we sell more and more of our quintile four units and to trend at the low end of AUVs so therefore the AUV spread will continue to widen between company and franchise.

Reed Kim - Merrill Lynch

The other question I wanted to ask is just in terms of remodels, how much that typically costs across your system, how many you did in the quarter and whether in this kind of an economic environment you’re seeing any noticeable sales pick up after you complete one versus historical?

Nelson Marchioli

Did you say a pick up in performance with the remodels we see about a 5 point increase in sales post remodel in the units that we go in and remodel and that’s for about 12 months, a rolling 12 months. In terms of franchises or remodels within the quarter, we remodeled about 30 units within the quarter, both company and franchise.

Operator

Enrique?

Enrique N. Mayor-Mora

Yes.

Operator

We currently have four minutes until call start time. Will you take any more questions?

Enrique N. Mayor-Mora

If there’s one more question, let’s go ahead.

Operator

Your next question is a follow up from Ken Bann – Jefferies and Company.

Ken Bann – Jefferies and Company

Sales of restaurants to franchisees, on the financing of that, is most of that being provided by more national firms or is it more local financing for those sales?

F. Mark Wolfinger

We’ve seen a little bit of both. I would say probably if you went back and looked at the entire program of FGI since it started in early 2007, most of the financing probably, and again I don’t have a percentage break out, but most of the financing probably came from national firms and that’ swell over $100 million in transactions. The other question we normally get asked is, is the company, is Denny’s taking any of the notes or paper in this process and I can tell you that we’ve been very focused on that and we have a minimal number of notes that we’ve taken back in total over the 2.5 years of the program.

Ken Bann – Jefferies and Company

Just one other thing on the late night program, in your prepared comments you sort of indicated that, or it sounded like it was being heard a little bit more than some other day parts to the economy. Is that the case and are you disappointed in some of the initiatives you’ve taken there and might you change that?

Nelson Marchioli

Late night and dinner have been affected in this economy. There’s no question about it. However, I’m quite pleased with how late night has kept us in the game and it has differentiated us from others that might be in the 24/7 business as we are so I’ve been pleased by the All Nighter platform. With the introduction of Rascal Flatts, Good Charlotte, Gym Class Heroes, and Sum 4, it really sets us apart and our new menu innovation keeps that area a strong competitor in that market so would I like it to be more? Of course I would. But we are using social networking, the internet, more aggressively and we are seeing a stabilization at late night but clearly we need to drive more traffic at late night. It’s a very profitable business for us but the economy is the main culprit here. People are choosing to go home because frankly they either don’t have a job or are running low on funds or they’re just trying to be careful because they know someone who’s out of work. So during the traditional summer holidays and other holiday periods, the kids are home from school, we get a bump on the weekends as we always do but during the week it’s a fight for whatever’s out there.

Operator

There are no further questions at this time. I would now like to turn the call over to management for any closing remarks.

Enrique N. Mayor-Mora

That concludes our call for today. Thank you for participating and we will talk to you next quarter.

Operator

You may disconnect.

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Source: Denny's Corporation Q2 2009 Earnings Call Transcript
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