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Domino's Pizza, Inc. (NYSE:DPZ)

Q3 2009 Earnings Call

October 13, 2009 11:00 am ET

Executives

Lynn M. Liddle - Executive Vice President - Communications and Investor Relations

David A. Brandon - Chairman of the Board, Chief Executive Officer

Wendy A. Beck - Chief Financial Officer, Executive Vice President - Finance

Analysts

John Glass - Morgan Stanley

Jeffrey Bernstein - Barclays Capital

Greg Badishkanian - Citi

John Ivankoe - J.P. Morgan

Joe Buckley - Merrill Lynch

Mark Smith - Felt & Company

Tom Forte - Telsey Advisory Group

Michael Wallowman - Sidoti & Company

Colin Guheen - Cowen & Company

Operator

Good morning. My name is Carmen and I will be your conference operator today. At this time, I would like to welcome everyone to the Domino's Pizza 2009 third quarter financial results conference call. (Operator Instructions) I would now like to turn the call over to Lynn Liddle, Executive Vice President of Communications and Investor Relations. Miss Liddle, you may begin your conference.

Lynn M. Liddle

Thanks, Carmen. Good morning, everybody. Welcome to our third quarter earnings call and I would like to direct your attention in the press release to our Safe Harbor statement as it relates to forward-looking statements and I would kindly ask the members of the media on the call to be in a listen-only mode. We have some prepared remarks this morning that we will follow with an open Q&A. So with us today we have our Chief Financial Officer, Wendy Beck; and our Chief Executive Officer, David Brandon. And we will start today with some prepared comments from Wendy, so if you want to take it over, Wendy.

Wendy A. Beck

Thanks, Lynn and good morning, everyone. We are pleased with our overall results for the third quarter. Our global retail sales increased through positive international same-store sales and flat domestic same-store sales growth. Equally as important, we grew our bottom line over prior year levels and drove improvements in our operating margins at all three divisions.

Additionally, we continued our trend of repurchasing debt this quarter which benefits our EPS, our balance sheet, and our debt service coverage ratio.

Walking down the P&L, let’s start by taking a look at our top line for the quarter. Our global retail sales grew 3.9% during the quarter when excluding the impact of foreign currency. However, when including this negative impact, our global retail sales were down 1.9%.

The increase this quarter was driven primarily by international same-store sales growth, as well as store count growth in our international business.

Now looking at the different business unit components, domestically our same-store sales were flat for the quarter versus the third quarter of 2008. Franchise same-store sales were up 0.3% while company-owned stores were down 2%. We continue to see domestic store closures with a net 30 stores closed this quarter. These were a result of our efforts to eliminate weak operators but also a sign of the difficult economy over the past 18 months. Going forward, we see some easing of this and are seeing some improvements economically.

Additionally, these net domestic closures are going to be buffered by our strong international store growth so we still expect to end the year with positive global store growth between 175 to 225 net new stores.

And speaking of our international division, our international same-store sales were positive 2.7% on a constant dollar basis and our international division grew by a net 43 stores in the quarter. As a result of this domestic and international top line performance, our total revenues for the third quarter were $302.7 million, a $20.9 million or 6.5% decrease from prior year. This was due primarily to lower cheese prices which affected our domestic supply chain revenues, the impact of the store divestitures in 2008 on our company-owned store revenues, and lower international revenues driven by the negative effect of foreign currency.

Breaking down the decrease, domestic supply chain revenues decreased approximately $14.7 million, or 8.3%, which is primarily the result of lower cheese prices during the quarter versus the prior year quarter. Our company-owned store revenues declined $5.1 million, or 6.6%, mostly due to the 82 stores we divested in 2008 and to a lesser extent, lower same-store sales.

International revenues declined $700,000, or 2.1%, due to the negative impact from foreign currency, partially offset by higher same-store sales and store count growth.

Throughout the year we have discussed the negative impacts caused by the strengthening of the U.S. dollar. Our royalty revenues were again negatively impacted during the third quarter by approximately $2.3 million.

Based on our current forecast, we do not anticipate to be negatively impacted in the fourth quarter of this year versus the fourth quarter of 2008. As you may recall, we were negatively impacted $3.6 million from the significant strengthening of the U.S. dollar in the fourth quarter of 2008.

Foreign currency also negatively impacted international supply chain revenue by $600,000 during the quarter. These declines in international revenues were offset by approximately $2.2 million of revenue improvements, primarily due to higher same-store sales and increased store count.

Moving on to our operating margins, our consolidated operating margin as a percentage of revenues increased 3.2% in the third quarter versus the prior year period. The increase in our consolidated operating margin was mainly caused by the impact of lower cheese prices. Lower cheese prices hurt our supply chain revenues but do not impact our supply chain dollar margin. They do however impact our supply chain margin as a percent of revenues.

Our supply chain margin increased 1.9% from the prior year quarter. Commodities have dropped significantly year over year. The majority of this increase was due primarily to lower cheese prices in the quarter that had no impact on dollar margins. The average cheese slot price in the third quarter was $1.19 per pound versus $1.98 last year, or approximately a 40% decrease.

Also contributing to our margin improvements was a deflation in other non-cheese commodities. Additionally, our supply chain margins benefited from reduced fuel prices and operating efficiencies put in place over the past year.

Our company-owned store operating margin increased 4.5% from the prior year period. Lower food, delivery, and utility costs accounted for a majority of the margin increase. Food costs as a percent of revenue dropped 4.2%, mostly due to commodity price deflation. As a reminder, the third quarter of 2008 was our highest peak when looking at commodity costs and we are seeing the effect of this in 2009.

Delivery costs were lower because our driver delivery reimbursement dropped with lower fuel prices, and utilities were down as a result of lower gas and electric rates. Offsetting these lower costs were higher labor expenses in the quarter resulting from another round of federal minimum wage rate increases. However, had we not had these rate increases, we would have seen a decline in our overall labor expenses. We continue to closely manage this line item.

Now looking at our G&A expenses, G&A increased $4.2 million in the quarter versus the prior year. Breaking down the increase, $1.8 million of the increase was from gains recorded in the third quarter of 2008 related to the sale of company-owned stores. Excluding this item, normalized G&A increased $2.4 million versus the prior year quarter, due primarily to targeted investments we have discussed over the year. Partially offsetting this increase in the quarter were lower bad debt expenses, which we see as a strong indicator of the strengthening of our franchise system.

As for our income taxes, the only item of note this quarter is that we recorded approximately $200,000 of tax reserve reversals related to certain state income tax matters. This had minimal impact on our effective rate for the quarter and is also outlined in the items affecting comparability table in the earnings release.

Next, our bottom line earnings -- our third quarter diluted EPS as reported on a GAAP basis was $0.31, or $0.17 when adjusted for items affecting comparability. The $0.17 as adjusted EPS figure is a $0.04 increase from the $0.13 in 2008.

Our improved operating results benefited us by $0.04 in the quarter, and our lower net interest expense as a result of our lower debt balance has also benefited us by $0.02 in the quarter. Foreign currency negatively impacted us by $0.02.

Now turning to our balance sheet, in the third quarter we repurchased at a discount $71.8 million of principal on our senior notes for a pretax gain of $14.3 million. Subsequent to the quarter, we repurchased an additional $20.9 million of principal on our senior notes for a pretax gain of $3.6 million in the fourth quarter. Year-to-date, including our fourth quarter purchases, we have nor repurchased $160.9 million of principal on our senior notes for $108.9 million, resulting in $52 million of pretax gains. These debt repurchases will save us an estimated $3.1 million of interest expense in the fourth quarter and $5.5 million in fiscal 2009.

As mentioned on our second quarter call, during the third quarter we entered into a new $50 million letter of credit facility, which allowed us to transfer our existing letters of credit and draw down an additional $35 million on the revolver that is currently at an interest rate of under 2%.

So we now have $33.5 million outstanding letters of credit under the new facility and $35.2 million of cash restricted on our balance sheet.

In closing, I hope this financial recap has been helpful in putting some additional context around the information we released this morning.

With that, I will turn it over to Dave.

David A. Brandon

Thanks, Wendy and good morning, everyone. First of all, we are very pleased over the fact that we are holding our own on the domestic sales front. It is still very difficult out there but we certainly feel like we are doing better than most and there are reasons why that is happening. We’ve driven positive traffic in the U.S. for the first three quarters of this year and that has been a very important focus of ours, to get more people involved with our brand and connected with our brand and we feel very good about that.

We’ve had slightly positive same-store sales through the first half of the year in our domestic business and again we think in the context of what’s happening out there, that’s a very positive sign. The third quarter was obviously flat but as we benchmark versus other players out there and look at the overall environment, we feel very good about this. And clearly as Wendy indicated, our profit picture continues to improve.

While a lot of other players out there in our industry are shrinking, we feel pretty good about the fact that we are both building and we are growing and it’s further indication in a clear way that in even the worst of times, our business model works well and we believe strongly that we should achieve even better results as the economy and the consumer spending environment improves.

Now our global retail sales grew steadily, thanks to another strong performance by our international business. We continue to be blessed by the fact that our diverse portfolio of businesses around the globe drive growth and it really minimizes risk because of the diversification that we have.

We are going to be celebrating our 49th anniversary in a few weeks and we will continue to celebrate that we have a very proven, easy-to-understand business model and how fortunate we are to have so many levers that we can pull to drive sales and profits during all kinds of economic cycles, particularly the difficult one that we are working through now.

I feel like we are very well-positioned for the future based on where the brand and the company sits today. We’ve done a lot of work in the area of cost-cutting and controls. I know everybody is talking about that right now because in many instances it’s out of necessity but we really started this process a few years ago and I really feel we got ahead of the curve. We sold off, as you’ll recall, some of our corporate stores in instances where we thought franchisees could run them better and our profit opportunities weren’t as great. We reduced headcount so that we could run lean overheads at our home office. We took some tough measures for a couple of years where we were paying very minimal salary increases. We had no bonus payments. It was tough but it was necessary based on what we needed to do to prepare for the current economic circumstance.

We did a lot of work in our supply chain area, cutting costs, moved to a twice-a-week delivery process which saved us a significant amount in fuel and mileage and created a lot of efficiencies. We worked on a special cheese contract that has added a lot of value. We’ve worked on our purchasing efficiencies and certainly have done a great job overall in our supply chain area.

So while others are hunkering down and cutting costs out of the necessities of the moment, we were able to be investing in and growing our business in really three key areas that I just want to briefly mention -- marketing, franchise operations, and technology.

First of all in marketing, we are investing in our marketing in a number of ways, particularly in the new product innovation area. We’ve created several new product platforms, Domino's Legends Pizza, our bread bowl pasta products, lava cakes, and of course the one that I am going to highlight a little bit more specifically today is oven baked sandwiches.

If you dial back, it was only a few quarters ago that for just $250 per store to purchase a few small wares, we literally became the largest sandwich delivery company overnight. In the past year, sandwiches have become nearly a $200 million business for us. We’ve sold nearly 40 million sandwiches in 12 months and as you know, we are on air right now with four new varieties, a line extension of this platform and we expect that these will further extend our reach in the delivered and carry-out sandwich category.

We’ve also increased our marketing spend this year. We have more weeks on TV in a substantial way versus a year ago, which provides us with a more robust marketing plan overall and certainly allows us to get more heavily involved in online marketing, which continues to be a very important and growing segment of our marketing spend.

I am also pleased to announce that our franchisees have voted to increase the national ad spend for next year, which will put us in a position where in 2010 Domino's Pizza will have a record year as it relates to the number of weeks that we will be on television, as well as other important marketing initiatives.

Now something that we are very proud of, we continue to increase traffic at a time of consumer malaise, something that makes both our team and our franchisees very happy. And speaking of our franchisees and franchise operations, we believe that we’ve done a great job over the last year to 18 months in investing in the most important aspect of our business and that’s our franchisees. We are helping them to stay healthy and making sure that our good operators are rewarded with acceptable levels of profit.

Franchisees have always been and continue to be the key to the success of our brand and our company and I am pleased to state that our relationship with our franchise community is currently working as well as it has in my 10 plus years here at Domino's. We are just working together really, really well in the spirit of cooperation and getting things done and moving the business forward.

We’ve closed a few weak stores, and we’ve talked about that. We’ve exited some poor operators. We’ve talked about that in the past and the net of that is that it’s really created a stronger franchise base.

We’ve also invested in improving our auditing system to keep our store operations at the top of their game. And one of the indicators that that is working is that we were rated number one in the American Consumer Satisfaction Index this year. We led everyone in fast food, including Starbucks and Papa John’s. We improved from our first year score by 15% and being number one not just in the pizza category but in overall QSR we think says a lot about the work that we are doing at the retail level.

We are very focused on increasing our franchisee profits and getting them healthier and getting them better returns on their investment. It’s our number one corporate objective for 2009. We’ve been identifying areas of opportunity for profit enhancements and we’ve been promoting them heavily across the system and it’s important to note that our franchisees today are receiving profit sharing checks from our supply chain centers that are currently at record high levels, which just further adds to their profitability during the year.

We spoke a while back about our mandatory franchisee training program that was part of our commitment to strengthening the system. I am pleased to report that over 90% of our franchisees will have completed our high performance franchisee training program by the end of the year, which means we have put over 1,000 franchisees through this program since the beginning of the year, something we are very proud of. It was a big initiative and it is going extremely well.

Last I want to talk a little bit about technology -- a large part of our franchisee retraining includes a focus on technology and how our pulse system can be used to help them improve their business going forward.

The pulse system has excellent tools for efficient labor scheduling and theft prevention, features that our franchisees love because they improve their bottom lines. It also gives us a chance to promote online ordering nationwide and online ordering for us now is 19% of our sales on average. We have online order penetration as high as 45% in some of our stores. This affords us the ability to increase our ticket because the ticket is naturally higher with online orders and it’s important to note that we are now America’s fourth largest e-commerce site, just behind Amazon, Staples, and Office Depot in terms of the numbers of transactions that are taking place online.

According to NPV Crest, we have leap-frogged the competition by becoming the leader of online ordering market share. Our growth in online sales has outpaced the category in the last 12 months.

I just want to speak a minute about international. It’s been growing stores and posting positive results for 63 consecutive quarters. We’ve had yet another positive quarter in terms of same-store sales in the third quarter of this year. We are still on track for our long-term outlook for this business unit of sales comps of between 3% and 5%. Interestingly enough, the U.S. only has about 1,000 more stores presently than our international business as we expect to cut the ribbon on our 4,000th international store some time in the next few months.

And based on current store trends, our growth in international should put us in a position where our international store count would surpass our domestic store count in the next four to five years, something that is truly unbelievable based on how far we’ve come in the last 10 years or so.

International currently contributes nearly half of our global retail sales and 35% of our profits and Wendy mentioned the negative impact of currency exchange that has been hurting us during the first half of the year. That seems to be improving in our direction this quarter and as we project forward and we try to stay out of the business of projecting currencies but it looks like that’s an area where we potentially can have some better news in the quarters that come ahead.

This brings me to our last topic, and that is our balance sheet and a topic of overall importance and that’s our capital structure. To be clear, we are very -- and I want to underscore very -- comfortable with our current debt levels. We have a long history at this company now of levering up the balance sheet, rewarding our shareholders in tax efficient ways, delevering as a result of the cash flow that we generate and doing it all over again.

That 3.5% to 5.5% leverage ratio is really our normal and it has been our normal for really the past 11 years. Our primarily franchise store model and the resulting free cash flow we generate makes increasing the leverage on our business the right corporate finance decision. It was back in 2007 when we refinanced our debt via a very attractive securitization method and it continues to be the right decision today.

Our asset-backed securitization facility is unique and we want to keep it as long as we can because we recognize we may not be able to duplicate it in the future. It has a 6% fixed interest rate with only one major covenant, and one that we’ve discussed in the past, the DSCR, or debt service coverage ratio. It is a five-year financing with interest only payments until 2012 and we have the option to extend this for two additional years and in fact we have the ability to automatically extend it if we reach a certain level with our debt service coverage ratio.

It has been our plan and our intention to extend this financing and take full advantage of it until 2014 when it will end.

I am pleased to report that based on our current EBITDA trends and projections, and our aggressive debt buy-back activity so far this year that Wendy reviewed with you, our current projections show that we will meet the necessary DSCR covenant levels to qualify for this extension. And that is even using our most pessimistic assumptions.

Our normal approach to managing our business, which we believe is prudent, is to model three different scenarios as we look out into the future. One is the worst-case, one is the expected case, and one is the optimistic case.

In the worst case, we assume that our sales comps are below our stated long-term outlook and in the optimistic case, we assume our sales comps are above that outlook. And I want to mention that even under our worst case scenario, we are able to comfortably meet the DSCR hurdle that would automatically extend the ABS financing for another two years. So we feel very confident we will be able to achieve this important objective not only for our company but as a significant benefit to our investors.

Now, once we start to approach the end of this financing, we plan to refinance this debt in whatever manner is most attractive at the time and based on our projections, this will not be a problem -- in fact, the leverage ratio that we’ll likely achieve in the next refinancing of our current debt will be lower than any of our past refinancing events. So we like where we are and we like where we are going as it relates to our capital structure and I wanted to make sure I emphasized this at the present time.

So in conclusion, I am as excited and as optimistic about the direction of our business as I have been in quite some time. It is still very challenging out there in terms of the overall environment but we are executing better in all phases of the business and I am particularly excited about some of our aggressive plans for driving growth in all of our operating units in the future.

So with that, I will turn things over to the operator and we’d love to entertain your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of John Glass with Morgan Stanley.

John Glass - Morgan Stanley

A couple of questions -- one is on the international comps and understanding they are still better than the U.S. but they have slowed sequentially, is there anything behind those numbers? In other words, are there markets that are significantly underperforming or outperforming that that would make the numbers slow sequentially?

David A. Brandon

Yeah, we had a couple of events in the quarter in a couple of our key markets that we would characterize, at least at this point, as more extraordinary than anything that we see as a pattern or a trend. And one of the reasons that I particularly emphasized the fact that we think that 3% to 5% growth rate in international continues to be a good kind of long-term expectation is for the fact that we still think that that’s a very good run-rate for that business. So it was a little softer than that by a small amount in this quarter but we don’t see that at -- at least at this stage, we don’t see that as any kind of a trend or problem.

John Glass - Morgan Stanley

What were those events or where did they occur? What was the nature of them, I guess?

David A. Brandon

That would be a much longer discussion than we should have -- we can have today and probably one that I would need some help from the team in terms of being as thorough and as specific as I would like to be.

John Glass - Morgan Stanley

Okay. You mentioned that the -- you’ve invested in marketing and franchisees and technology. I just want to clarify -- you talked about those investments as largely being in the past in the script but in the release, you talked about being prepared to invest in the future. Are there future investments that are material that we need to be aware of in any of those areas that might have an impact in either the capital spending or the margins of the business in the upcoming quarters?

David A. Brandon

Well, in the release when I talked about how we are now prepared to invest, it’s really an affirmation of the investments that we’ve already talked about, the fact that we have done a lot of work in retraining our franchisees, the whole initiatives around our F-rated franchisees and forcing some of those transactions, the new OER program that we’ve got out there that’s lifting the quality performance of our stores. What I am really relating to is the ongoing initiatives that we continue to invest in. I’m really not announcing anything new or different.

John Glass - Morgan Stanley

Okay, and then just last question -- can you clarify how many weeks you’ll be on TV in 2010 versus ’09 with the new franchisee vote?

David A. Brandon

Yeah, I could but I won't. That’s not something that we are going to advertise for reasons that I think are pretty obvious but I am comfortable in telling you that it will be more weeks than we’ve ever had in our history and we feel very good about that.

John Glass - Morgan Stanley

Okay. Thank you.

Operator

Your next question comes from the line of Jeffrey Bernstein with Barclays.

Jeffrey Bernstein - Barclays Capital

Great. Thank you. A couple of questions as well -- one, thinking about the broader category, the segment obviously faces the ongoing headwinds of the higher average check but it does seem like, and you mentioned that perhaps you are happy where you are relative to the broader category. I’m just wondering whether you could talk about kind of the lower priced items perhaps being -- countering that headwind, where you kind of see the category and where you are currently positioned versus perhaps some of your national and local competitors, perhaps what the broader industry is comping in the U.S. versus what you are doing at this point -- just some broader color on the category and how you are bucking that trend.

Jeffrey Bernstein - Barclays Capital

Yeah, as we set the table for this year, we believed that it was going to be a very, very difficult year for our category and most categories, particularly at the dinner day part. And our whole strategy was to focus on traffic, with the notion being that during these difficult times, if we could hold traffic or even increase traffic in this environment, get more people involved with the brand, more phones ringing, more people visiting our stores, even if we were using some lower ticket items as ways to attract that consumer and getting into some day parts that have traditionally lower tickets associated with them, that overall we were going to be in a much stronger position not only for our performance this year but how that was going to set us up for growth when the consumer comes back and the dinner day part gets healthier.

And at least through the first three quarters, we are excited about the fact that we are traffic positive. I don’t think there’s a lot of people out there who are but we’ve got more people coming into the brand. We think that speaks highly to what we’ve done with expansion of our menu and working on day part with sandwiches and some of the other things that we’ve incorporated.

Since our sales are only slightly positive for the year year-to-date, you can see that we are trading off a little bit of ticket in terms of some of the menu variations that we put out there but we think it’s absolutely the right strategy because again, when the dinner day part starts to become healthier, we are going to be the beneficiary of that.

So the category is still tough, the dinner day part is still tough. We are glad that we are out there with a more diversified expanded menu. We think the players out there that don’t have those levers to pull and those things working on their behalf are probably going to take hits as a result. The more that they are a one-ball juggler at the dinner day part I think the more difficult it is going to be for them to grow traffic and ultimately grow sales. So I like where we are.

As it relates to the local and regional players, you know, that’s 150 different discussions and it’s really by market, by operator but all in all, we think our menu expansion has helped us because oftentimes those local competitors, one of the advantages they had was a broader menu offering and the fact that we now have sandwiches, we have pasta, we have dessert items, we have some of the things that traditionally we have not offered we think puts us in a better position where we can go toe-to-toe with those guys. So generally, we feel good about our positioning but again, that varies greatly as you go market to market.

I hope that answers your question.

Jeffrey Bernstein - Barclays Capital

Yeah, I’m just wondering versus your relatively flat U.S. comp, what you are hearing from your own industry sources as to what the category is growing at this point or what the category is shrinking, I should say, at this point.

David A. Brandon

The category generally is experiencing negative traffic and the only players that we can monitor with great specificity are the public companies who report and you know one of our major competitors has already reported and one hasn’t yet but that’s as specific a data as we can get in terms of individual brands and companies. But the industry data that we have overall shows that the dinner day part continues to be hurt and that the overall traffic continues to be negative.

Jeffrey Bernstein - Barclays Capital

Great, and then just talking about commodities, just wondering whether you can give us an update for perhaps the remainder of ’09 and whether you have any initial thoughts on ’10 based on what you are able to secure? I think you said after the second quarter that you thought your basket for ’09 would be down high-single-digits. Obviously we’ve seen further easing for most of the quarter on cheese. I’m just wondering whether we can get an update on that.

And then just as it relates to cheese, it seems like it’s down significantly year over year but rallied huge in recent weeks. Just wondering how that volatility changes your approach or perhaps that of the broader category when it comes to discounting.

David A. Brandon

I’ll defer to Wendy on that, only I’ll just caution you to say that after 49 years, we are not too proud to admit that we have no idea as to where commodities are going and how quickly they can move, particularly cheese, but we’ll tell you what we know at this point and most of that is based on what we are experiencing today.

Wendy A. Beck

So overall, we anticipate the majority of the commodities to be relatively flat in quarter four but down significantly year over year from the fourth quarter of ’08. Cheese, as you mentioned, is rising. Right now current forecasts show that it could be as much as $0.30 a pound rising in the fourth quarter but again, it’s hard for us to forecast that so we’re looking at that, at the time that it may be rising and yes relatively still gaining a benefit from the prior year.

Jeffrey Bernstein - Barclays Capital

And kind of an initial basket for 2010, if you were to just use current prices, obviously not being able to forecast much better than anybody, but how does that basket look for 2010?

David A. Brandon

Yeah, I’ve got all kinds of people in the room shaking their head at me that we don’t project baskets for 2010, so we’ll -- you know, we are obviously beginning to work on our budget for next year and we are starting to wrestle with some of those issues but we are not prepared to go public with any point of view.

Jeffrey Bernstein - Barclays Capital

Okay, and then just lastly, the shareholder value topic, I know you often mention $1 million a week in free cash so a healthy $50 million a year -- I’m just wondering the best approach to creating such value. I know you don’t currently have an ongoing dividend or any share repurchase activity going on. Just wondering whether we might see either of those increased or perhaps further debt pay-down, kind of what you are seeing as the best opportunity, especially if discounts on the debt you are buying back are more limited going forward?

David A. Brandon

Well, as we’ve shown and history is the best teacher, we’ve at various times thought that the right thing to do was deliver a very tax-efficient dividend. At other times, we’ve bought back stock at substantial levels and other times we’ve bought back debt to deleverage. That’s all based on a variety of assessments that we make in terms of what is in the best interest of our shareholders.

In the most recent past, you can see that our primary objective has been to make sure that we positioned our company to take full advantage of the securitization and the way to do that is to extend it two years and the way to make sure that happens is to manage that debt service coverage ratio to a level where we can be assured that that’s going to happen.

The best way to make those numbers work is to make sure that our EBITDA continues to increase. At the same time, we reduce that debt by repurchase and certainly if you can go out there and repurchase that debt at a substantial discount, it has an even greater multiplier effect.

So in the recent past, we felt that the best way for us to deploy capital and the best interest of our shareholders long-term is through debt repurchase and although we never telegraph what we are going to do going forward, that certainly has been the most recent strategy that we’ve embarked upon and we think is yielding us significant benefits.

Jeffrey Bernstein - Barclays Capital

Even if a discount wasn’t perhaps available going forward, that would still be the preferred approach in the near-term?

David A. Brandon

Well, right now all things considered, we believe that deleveraging the company and creating the benefit that that achieves for our shareholders is a very intelligent thing to do and it is also important to note that current tax law is encouraging us to embark upon that strategy because we get a significant tax deferral benefit as we deleverage the company and that’s a new rule that has provided us a new incentive to make the economics of debt repurchase even stronger than they once were, so we’re going to take advantage of that and think about tax consequences as we think about extending the financing and as we think about what creates the greatest shareholder value.

Jeffrey Bernstein - Barclays Capital

Great. Appreciate the color.

Operator

Your next question comes from the line of Greg Badishkanian with Citi.

Greg Badishkanian - Citi

Just a little bit more color on the U.S. market -- obviously same-store sales were pretty decent relative to the industry and you didn’t see the deterioration that some of your other competitors have seen. How much of that is due to new product versus promotions and how -- you know, with the industry kind of slowing down and you have low commodities, what’s the level of promotions that you are seeing from your competitors, both the chains as well as the mom and pops?

David A. Brandon

It’s hard to separate new products from promotions because sometimes they overlap. You know, we promote new products and sometimes we put new products in combination with existing products so [I think more a basket] under the umbrella of marketing, I think our marketing right now is in a very good place. Our advertising is scoring well and working well. Our new products are doing well. We are achieving our mix objectives. Our promotions seem to be driving consumer behavior and providing us some benefit in terms of lift and overall I am extremely pleased with what our marketing group is doing in combination with our franchise partners because national marketing is really important but also equally important is the local store marketing and the marketing that we are doing at the market level.

So I feel really good about how that’s working and I see it building momentum and one of the reasons I said I’m as excited as I’ve been in a while is it really feels like we are starting to see some of these things really catch hold and they will make even a bigger difference as we move forward.

What was the back half of your question? I’m sorry.

Greg Badishkanian - Citi

Sure, just the level of promotions coming out of mom and pops as well as the chains.

David A. Brandon

We are not seeing what I would characterize as unusual behavior out there in terms of kind of crazy discounting or people using price as a lever in desperation to try to gain some share. And that’s a comment in terms of the national outlook. Now I can tell you about a couple of markets, and I think it’s more prevalent in markets that were substantial growth markets -- you take a market where there was huge growth, real estate inflation, back three or four years ago, you know, tracks of homes were being built by the day and so retailers went out and in some cases built spec stores based on anticipated growth. And then all of a sudden these markets hit the skids and real estate goes to hell in a hand basket and at the same time, these homes don’t get built and you’ve now got a situation where you are overbuilt with the number of stores and everybody is trying to keep those stores alive and you discount as a strategy to try and build some share and support your infrastructure.

That type of scenario is pretty limited. It’s only occurring in a handful of markets where you could probably guess where those markets are, where the growth trajectory went from extreme meteoric rise in growth to substantial reductions in growth.

Other than that though, other than those specific kind of sunbelt markets, I would tell you that on a national basis, the pricing has been fairly disciplined and I don’t see it as a threat to what we are doing with our marketing or our margins.

Greg Badishkanian - Citi

Good. Very helpful, thank you.

Operator

Your next question comes from the line of John Ivankoe with J.P. Morgan.

John Ivankoe - J.P. Morgan

Sorry if I missed this point -- what is the shift in national advertising from ’09 to ’10 as a percentage of sales? Have you quantified that?

David A. Brandon

No, we haven’t really released that. What we -- and we’ll talk about that. That’s maybe something we’ll go into more detail in the future. It’s a relatively recent event and it was something that we worked out with our franchisees. We got 100% participation and support that affords us the ability to really have a larger, more robust national advertising fund for next year that will afford us the ability to do some pretty exciting things. But in terms of how that mechanism works, I’m not sure what we’ve said and what we can say at this point and so we’ll come back to you later.

John Ivankoe - J.P. Morgan

In the past it’s come out of regional co-op -- I mean, should we think about something similar in this case or it’s an actual increase in spend?

David A. Brandon

Yeah, it’s more of a shift but time will tell whether it’s an increase in spend because the shift is occurring to national but then the co-ops have the ability to replace with additional spend at the local level and oftentimes history has shown us that that’s what happened, so time will tell in terms of how this all works its way out but under any of the scenarios that we can imagine, it’s an extreme positive for the brand for us to have the kind of leverage that we are going to have in our national advertising fund.

John Ivankoe - J.P. Morgan

You know, you’ve obviously outperformed significantly in 2009 -- could you put that in the context of -- you know, I just remember a few years ago where you guys really had to firm up your new product testing, market testing in terms of properly predicting the success rate of your products. I mean, do you feel that you are in the right place at this point or are you continuing to fix what you’ve done in terms of your capabilities in predicting future success?

David A. Brandon

I really like where we are, John. I think the platforms that we’ve chosen have all been good ones. They’ve all proven they resonate with consumers. They are all great products. They are lifting the quality image of our brand. The oven baked sandwiches when we have a two-to-one preference over the leader in the category, that’s huge and it lifts the overall brand. You know, when we’re out there with lava cake dessert products and legend high-end pieces, these are things that are having more of just an impact on mix and some incremental sales -- they are really lifting the quality image of our brand and we think that’s extremely important.

I really like where we are. We are going to market faster than we ever have. It used to take us too long once we had an idea that we felt was a good one to be able to get it to market. We are getting to market really quickly. We are able to react and move fast and we have a pipeline now where once upon a time we might have a meeting and we decide which one of our two choices we would use to fill a marketing window -- now we have a list of choices and depending on the scenarios that we are looking at, we have the ability to be flexible and move in one direction or another.

So I like where we are, I like what our marketing team is doing and I feel some momentum that we didn’t have before and it feels pretty good.

John Ivankoe - J.P. Morgan

And one last thing for me -- a lot of companies have obviously flexed down their cost structures, given what is a challenging top line environment. Is there anything that you foresee, assuming the top line environment improves, that you may need to flex back? In other words, increase your cost structure or do you think you can accept any increases in revenue, whether same-store or new store growth, you know on the cost structure that you’ve managed your business down to?

David A. Brandon

It’s a great question. We’ve made those investments. I mean, the training investment has been made and it’s in the plan and it’s part of our performance this year. The OER and the more careful oversight of what’s going on at the retail level, that’s been made. The technology investments for the most part have been made and anything that we have to make will have pay-backs associated with it that will be attractive.

We feel really good about the investment that we made in the thin crust plant that affords us the ability to do a vertical integration play that allows us to be manufacturing a product that we were paying a significant margin to have somebody else manufacture for us. That plan is up and operating. I visited it, it looks great. It’s doing a terrific job and the pay-back on that CapEx project is going to be extraordinarily fast.

So we have made a lot of the investments, we are well-positioned, there’s no big needs out there -- just big opportunities. And so the only thing we’ll be talking about in terms of net investment would be something that comes along that we believe can give us a great pay-back and really jump-start the business.

John Ivankoe - J.P. Morgan

Okay, great. Thank you.

Operator

Your next question comes from the line Joe Buckley with Merrill Lynch.

Joe Buckley - Merrill Lynch

A couple of questions -- the company store performance lagging the franchisees, is that still a function of geography more than anything else in your view?

David A. Brandon

You bet. Interestingly enough, Joe, we have corporate markets where we are dramatically outperforming our franchisees and doing a terrific job. But as I think I’ve mentioned on past calls, we have certain strategic concentrations in terms of market positions in places like Las Vegas and Phoenix and Southern Florida that are having a significant impact currently on the overall performance of Team USA. Those are just very, very tough markets and I think they are for everybody in the retail industry.

Joe Buckley - Merrill Lynch

And then a question on the extension to 2014 on the debt -- EBITDA is still down year over year. It was down last year as well. In that worst case scenario, can you give us some sense of what EBITDA has to do sort of worst case that you would still qualify for the extensions?

David A. Brandon

Joe, our worst-case scenario is very pessimistic. We really create a situation where we close a bunch of stores that we don’t ever believe would be closed. We have significant negative sales. We stress test this pretty well in terms of how we look at the negative scenario and when you look at the impact of that on our EBITDA, I mean, it really creates a situation where our EBITDA does not grow a substantial amount. It maintains a pretty flat posture when you stress test the model at that level. And what I am here to report is even at that what I consider to be overly pessimistic approach to stress testing the model, when you combine that EBITDA and that free cash production with the continued deleveraging of the company, we get there. And to me, that’s a very important significant outcome. It’s a very -- and that’s the reason we’re highlighting it today because we have reached a point in terms of our debt repurchase and what we consider to be reasonable EBITDA trend assumptions where we feel comfortable that that’s a scenario that is going to live its way out.

Joe Buckley - Merrill Lynch

Okay, and then last question, the product pipeline, from what you described, can we assume that there’s a pretty robust product pipeline for 2010 that might include some new introductions? And I guess I’d ask whether or not there might even be new categories as there were in the past 12 months?

David A. Brandon

I’ll just say this is a tough area for me because I’m excited and I would love to yap on about some of the things I’m most excited about. We have a very busy marketing calendar for 2010 -- very busy and it will include a number of different topics that I think will resonate with the consumer and will create news and I really better shut up beyond that, other than that’s kind of where we are and that feels pretty good to me.

Joe Buckley - Merrill Lynch

Okay. Thank you.

Operator

Your next question comes from the line of Mark Smith with [Felt] & Company.

Mark Smith - Felt & Company

A couple of questions for you -- first can you give us any insight on comp trends during the quarter and if there was any impact from Labor Day and some of the back-to-school shopping pushed back a little bit?

David A. Brandon

Yeah, I think one of the things that really is difficult right now is that patterns are really difficult to establish. We see gyrations of consumer behavior out there that’s unlike anything we’ve ever seen. You know, normally you get in a certain track and that track is kind of consistent and if it’s a track, positive track it stays positive and if it’s a negative track, it stays negative.

We are seeing much more volatility from week to week, weekend to weekend, topic to topic. So my general response to your question is that as opposed to a lot of times in my past where it feels like you can say gee, the back half of the quarter was stronger than the first half or visa versa, it’s really kind of all over the place and it makes it very difficult for us to forecast.

And I think it’s just a sign of the times. The consumer changes and reacts very quickly to whatever the news of the moment is and it does have an impact on their behavior.

So no real pattern of -- no real trend or pattern of behavior in the quarter that I think would be material or useful as it relates to projecting that forward.

Mark Smith - Felt & Company

Okay, and to follow-up on some questions from earlier, you talked a bit about product mix and some of your new products and the impact on check -- can you talk at all about the profitability as you’ve seen a shift in some of this mix, especially for your franchisees?

David A. Brandon

Yeah, certainly our margins at the store level will be up this year and as a result of the fact that not only have commodities but as traffic has improved, it certainly has a significant impact. You’d have to go into each one of these products one by one and talk about their food costs and their margin but we won't do that anymore than our competitors will do that, other than I can tell you that the food costs and the margin opportunities associated with these products that we have launched and that we are launching, are all within the band of what’s acceptable in terms of our operating model. We can’t sell our franchisees to get excited about a product that they don’t make money on.

Now in some cases, we do a lot of coaching about penny profit versus margin because you don’t take percentages to the bank but when you combine the impact of commodities and the fact that we are traffic positive and the fact that our sales are trending better, the combination of that is improving unit economics at the retail level substantially and everybody views that as a good thing.

For instance, we wouldn’t be rolling out four new variations of our sandwich line if we weren’t very pleased with the profitability of that product. And we wouldn’t be devoting entire windows to bread bowl pasta and sandwiches if we didn’t really like what that was doing for our profit at the store level.

Mark Smith - Felt & Company

And last question, can you talk at all about your franchisees’ health, especially regarding kind of changes in the credit markets and opportunities to increase some growth, and also again looking at their profitability and any significant increase in cheese prices and how that may affect them?

David A. Brandon

Our franchisees are healthier than they’ve been in quite some time. Obviously if margins are increasing and sales are better, they are going to feel that. When their profit-sharing checks are at record levels from the supply chain center, they are going to feel that. We’ve gotten rid of some of our poorest performers in some of our stores around the edge and frankly we’ve closed some stores that were not particularly buyable based on who owned them and where they were positioned. So we’ve done a lot of that work and by far and away our franchise system is stronger and more secure today than it was a year ago, or even earlier this year.

So we feel very, very good about that and we continue to monitor that closely and work hard at trying to get those margins at the retail level up to the point where our franchisees are really getting the kinds of returns that they like to have.

The financing market is improving a bit, still tough. There’s some transactions happening out there. There will probably be some more. We’ve got some of our healthier franchisees who are generating enough cash now that they are looking opportunistically at investments so we are still putting together our plan for 2010 but I think generally we feel that it’s going to be a much more positive plan in terms of net store growth in our domestic business than what we’ve seen in the last couple of years and that feels pretty good to us.

Mark Smith - Felt & Company

Excellent. Thank you.

Operator

Your next question comes from the line of Tom Forte with Telsey Advisory Group.

Tom Forte - Telsey Advisory Group

Thank you. Two questions and one to some degree was just answered -- on store closures, it looks like you had a comparable number to last quarter. If you had a continued challenging sales environment and a tight credit market, do you feel any differently today about purchasing stores versus letting the stores close? And then second, real quick, I think you made a comment earlier about seeing encouraging data points regarding economic -- the economic behavior. Are there any around the dinner day part that you could share?

David A. Brandon

Yeah, as it relates to the whole store growth situation, as the unit economics improve at the store level, you are just going to see less closures because some of the more marginal franchisees and you always have the bottom 20%, particularly in a system as large as ours, you are always going to have those around the bubble. Well, when those margins start to improve, they kind of come off the bubble and they become more encouraged. And you also see your stronger franchisees start to invest in growth.

So comparing quarter to quarter on store closings I think can probably mislead you as much as it can help you because some of those are timing issues and some of them are planned and the point is in the big picture, we see a deceleration of closings, the potential for an acceleration of openings. We’ll have more opportunities for franchisees to buy some of these failing stores as opposed to having them either close permanently or temporarily close -- that’s a positive thing. Whether we as a corporation are a buyer or a seller really depends on a number of opportunistic factors that we can consider and we will continue to do that as we move forward.

I just think the big picture here is that we’ve got a lot of the heavy lifting behind us in terms of closures and the exiting of poor performing franchisees and as I look forward, I think that’s going to be a much better, stronger picture in terms of our domestic business.

As it relates to economic indicators out there, I hopefully didn’t mis-communicate or mislead anybody -- I think generally speaking the dinner day part continues to be under substantial pressure. I think it’s getting tougher out there. I don’t think it’s getting a lot easier. I don’t see any indications that there’s a significant releasing of discretionary spending on behalf of consumers at the dinner day part. I still think consumers are pretty much in the bunker and being very careful and that’s one of the areas they can save the most money. So I think the industry generally is continuing to experience a reduction in the out-of-home meals at the dinner day part and that’s probably going to continue for a little while and that’s why I am glad we don’t have all our eggs in that basket anymore because we’ve now diversified the menu to the point where we can play in some of these other day parts and we have the benefit -- and this should never be overlooked -- I mean, we had the benefit when that dinner day part gets under pressure, in some cases we become a beneficiary because we do get trading down opportunities and we are certainly less volatile than most other dinner day part players, simply because we do get that trade-down effect.

Tom Forte - Telsey Advisory Group

Thank you.

Operator

Your next question comes from the line of Michael [Wallowman] with Sidoti & Company.

Michael Wallowman - Sidoti & Company

Just two quick questions here -- can you guys give us a kind of an indication here of what the FX impact would be here in the fourth quarter if currency kind of stays flat to where it is now? Would you actually be seeing a benefit or would it be really more of a neutral compared to fourth quarter last year?

David A. Brandon

I’ll pass that over to Wendy.

Wendy A. Beck

Okay, so for fourth quarter last year, that was where it significantly took a turn and we had a negative impact of $3.6 million in the prior year same quarter, or $0.04 EPS so what we are anticipating this year is that we will be relatively flat year over year and possibly with a small benefit. But that’s based on the latest consensus report that we’ve received and that can change drastically.

Michael Wallowman - Sidoti & Company

Okay, and then the last thing here, positive traffic through the first three quarters here, can you guys give us any kind of an idea of the breakdown how much of that traffic is stemming from being open now for the lunch day part and what traffic looks like at the dinner day part compared to that?

David A. Brandon

You know, a quick answer, no. We start to get into some details that again we think are a bit proprietary and would be helpful for our competitors and we never like to do that.

But what we will tell you is that getting the stores open and having a lunch business is an ongoing opportunity for us because it’s building and it’s growing and having the stores open and getting people out there detailing local companies and people and saying hey, we’re open for business, and oh by the way, here’s our menu and we’ve got a lot of things for you to choose from -- we like where we are today and we think there’s a lot of upside there.

We are also pleased over the fact that sandwiches, by way of example, there’s a significant number of our pizza orders at the dinner day part that go out with sandwiches and that shows us that that’s a product category that is not just about lunch but also has helped kind of create a greater level of interest in the brand, even at the dinner day part.

And furthermore, we’ve been delightfully surprised at how many sandwiches we sell at late night. It seems like there’s a lot of people that enjoy that opportunity at the later day part than just ordering pizza.

So the platform is working for us across a number of dimensions and we feel really good about that but to quantify that and give that specific information is probably more than we want to talk about.

Michael Wallowman - Sidoti & Company

All right, thanks.

Operator

And your last question comes from the line of Colin Guheen with Cowen.

Colin Guheen - Cowen & Company

Most of my questions have been answered but I guess just stemming from the last question, as you look at the lunch platform, is there real opportunity looking into 2010 and 11 to start putting products that have shorter cook times at lunch into the units and/or some [sort of] merchandising strategy that we might be seeing?

David A. Brandon

Yeah, there may be opportunities for either shorter cook times or products that will hold heat and still perform at a high level in terms of the taste and quality, so we are experimenting with a lot of different things that would afford us to be a little bit more of a player in the quick serve area where people don’t have to wait 10 minutes for something to bake. We think there’s some opportunities there and there’s some people out there that have proven there are opportunities there and that’s certainly not an area of the business that we are afraid of pursuing, so we’ve got some interesting thoughts in mind [inaudible] some of these products that might work in that environment.

Colin Guheen - Cowen & Company

Thanks a lot.

Operator

There are no further questions. Do you have closing remarks?

David A. Brandon

My only closing remark is to thank you all for participating in our call today. We had some great questions and I hope this has been helpful and we are pleased and proud of what we did in the third quarter and we are already fast at work at trying to make the fourth quarter equally as successful and we will look forward to reporting that to you in the early part of next year. Thank you very much.

Operator

Thank you for participating in today’s conference. You may now disconnect.

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Source: Domino's Pizza Q3 2009 Earnings Call Transcript
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