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Denny’s Corporation (NASDAQ:DENN)

Q4 2009 Earnings Call

February 17, 2010 5:00 pm ET

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.

Brian Hunt – Wells Fargo Securities

Reza Vahab-Zadeh - Barclays Capital

Mark Smith – Feltl & Company

Tony Brenner – Roth Capital Partners

Jonathon [White] – No Company Listed

Jonathon [Desh] – No Company Listed

Operator

Welcome everyone to fourth quarter full-year 2009 earnings release conference call. (Operator Instructions) Mr. Enrique Mayor-Mora, you may begin your conference.

Enrique N. Mayor-Mora

Thank you. Good afternoon and thank you for joining us for Denny’s fourth 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 initiatives. After that, Mark will provide a financial review of our fourth quarter results. I will conclude the call with Denny’s 2010 full-year guidance.

As a reminder, we will be filing the 10-K by the due date, March 15, 2010.

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 urges caution in considering its considering its current trends and 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.

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

Nelson Marchioli

Thank you, Enrique. Good afternoon, everyone. I would like to start my comments by saying I am very proud of Denny’s ability to execute against the key strategic initiatives that underpin our business model transformation to 85% franchise. This despite the challenging business environment the industry has been operating in for almost two years.

Denny’s has materially and predictably increased adjusted income, organic cash flow, restaurant openings and net system growth. At the same time we have continued to pay down debt, primarily through proceed generated through the divestiture of company owned restaurants in our FGI program while generating commitments for future restaurant growth. The transformation of our business model to a cash flow generating and franchise focused operation has increased operating margins and earnings and lowered both our business and financial risk.

Key accomplishments in 2009 included 40 new restaurant openings, positive 10-system unit growth, total debt lowest in 25 years with a debt leverage ratio of 3.28, adjusted income before taxes of $30 million. I recognize we must improve our sales trends. I do firmly believe that we are beginning to position the brand for sustained sales improvement.

These challenges in 2009 can be broken down between industry specific and Denny’s specific. From an industry standpoint the existing consumer environment continues to be the most challenging. While the industry’s same store sales performance in the fourth quarter of 2009 was better than the 28-year low incurred in the second quarter it was still materially negative. This was despite the industry’s easier year-over-year sales comparables.

There are three main areas that have impacted Denny’s the most from a geographic and demographic perspective. First, our geographic concentration. 41% of our restaurants are located in California, Florida and Arizona, states that have been particularly hard hit by the economy. Second, our late night business which represents almost ¼ of our sales in which skews towards third-shift workers and a younger demographic. These are groups that have been particularly affected by the economy. Third, our target demographic household income level is the lowest in the family dining segment with 44% making a household income of less than $45,000 a year.

Based on the lessons we learned in 2009 we will make the following improvements that should result in our sales improving in 2010. A more focused value strategy. In 2010 we intend on introducing an everyday affordability approach to value. We are currently fine tuning our learnings from our test markets and anticipate a rollout in the second quarter. This value approach should also improve our late night trends where we compete directly with QSR.

Introduction of new products through limited time offers. In 2009 our new product strategy delivered many new craveable items such as our Grand Slamwich, Pancake Puppies and breakfast and dinner item extensions to our Skillet platform. In 2010 new products will be offered through an LTO platform to create a greater sense of urgency for our guests to visit our restaurants.

Reallocation of marketing dollars to media. We are focused on increasing our presence on media through the reallocation of funds within the market fund as well as building off of the success we had in establishing our local marketing cooperatives in 2009.

Facility refresh. Pending test market results we anticipate rolling out a system wide facilities refresh program by the fourth quarter of this year. This program would allow Denny’s to positive impact the look and feel of our units faster than our current 7-year model cycle.

Bigger and Better Super Bowl promotion. Last week we aggressively kicked off our year by having three separate commercials on the Super Bowl. This year’s Super Bowl was the highest rated U.S. TV show ever with an average audience of 107 million viewers, surpassing the final episode of Mash in 1983. Our objective was to build on the tremendous success of last year’s event while increasing the stickiness of the day. Said differently, extend the 4-6 week positive change in guest count trend we saw last year post giveaway.

Here are some of the highlights of this year’s free Grand Slam day event. Denny’s served 2 million guests in our restaurants throughout the day including 7% more than last year during the 6 a.m. to 2 p.m. promotional hours. We reintroduced Denny’s Birthday Club with one of our spots. This is a 365 day per year traffic driving opportunity that offers guests a free Grand Slam on their birthday. 59 million hits on our website, more than 4,900 TV and radio airings and over 500 newspapers printed the story. Denny’s was the top ten trending topic on Twitter in the fourth quarter of the Super Bowl and on the day of the promotion.

From a financial perspective the total cost of the promotion was around $8 million, $2 million greater than last year. The increase was driven by having three commercials versus one last year. Of the total amount, approximately $5 million are part of the advertising fund to which the company and franchise restaurants contribute. Denny’s Corporate incurred approximately $3 million of additional costs. Half of this amount was for the cost of the food for the system and the other half for a partial contribution towards the media costs. It is our goal to minimize the net cost of this event by achieving improved guest counts and sales but that will be determined as the quarter and year unfold.

We firmly believe we are proactively and aggressively taking the right steps forward in terms of driving profitable guest count growth. These steps also include the increased weight to 75% of the same store sales component in both the corporate support center and field organization employee’s bonus plan. However, given the current unit visibility into the sales environment our stronger first half 2009 sales performance and due to the timing of some of the key initiatives listed above we anticipate our recovery will be a progressive build over the year with first and second quarter the most difficult.

The opportunity here at Denny’s excites us and 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 will now turn the call over to Mark Wolfinger, Denny’s Chief Administrative Officer and Chief Financial Officer.

Mark Wolfinger

Thank you Nelson. Good evening everyone. I will start my comments with a review of our fourth quarter sales performance.

System wide same store sales decreased 7% comprised of a 6.1% decrease in our company restaurants and a decrease of 7.2% at our franchise restaurants. Looking at the details for company sales performance, a 6.7% decline in guest count was partially offset by a 6/10 of a point increase in average guest check. Denny’s guest counts continue to be most negatively impacted by our late night business and in the areas of the country that have been hardest hit by the economic downturn, notably California, Florida and Arizona which account for 41% of our system units.

Most of the growth in guest check was attributable to pricing actions take in late 2008 and early in 2009 to help counterbalance commodity and labor cost pressures. Largely offsetting the increased pricing was the impact of a stronger, value oriented menu mix as well as an increase in discounts compared with the prior-year period.

The decline in total company restaurant sales in the fourth quarter largely reflects the continuing impact of our franchise growth initiative (NYSE:FGI) as sales decreased $43.5 million or 28% due to 73 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 4.5 percentage points in the fourth quarter for our company operated units was driven in part by favorable Workers Compensation claims development which drove 2.8 percentage points or $3 million over the overall margin improvement and a credit card settlement which drove 7/10 of a percentage point improvement. Excluding these benefits company unit margins would have increased by 1.1 percentage points.

Other notable margin improving actions include an efficiency gain in company operated units and increase in check average to selling of lower marg units through FGI and lower utility rates. These were partially offset by the de-leverage driven by negative same store sales and by the $900,000 corporate investment in media in the fourth quarter in addition to the costs associated with contributions to our local marketing coops.

Product costs for the fourth quarter decreased 7/10 of a point to 23.7% of sales primarily due to the impact of slightly higher average guest check, strong food waste management and flat commodity costs. This was partially offset by a higher mix of value priced menu items. Payroll and benefit costs decreased 2.5 percentage points to 38.6% of sales primarily due to favorable Workers Compensation claims development that drove 2.8 percentage points or a $3 million improvement. Without this benefit, payroll and benefits would have been 41.7% of sales.

The Workers Compensation benefit is the result of multiple years of increased focus on safety at the unit level through well designed and executed programs in addition to the benefit derived from selling company units through the FGI program. Selling lower performing units through FGI in addition to efficiency improvements in management and crew staffing levels also benefited payroll margin but were offset by the de-leveraging effect of lower sales.

Occupancy expense decreased 4/10 of a percentage point to 6.3% of sales primarily due to the negative development of general liability claims in the prior year quarter. This was partially offset by the de-leveraging effect of lower sales and the impact of the 53rd week in the prior-year quarter.

Utility costs decreased by 7/10 of a point to 4.3%. Denny’s is benefiting from natural gas and electric rates that have fallen considerably from the levels seen in 2008. Repairs and maintenance expense decreased 2/10 of a point due to a reduction in unit level painting. As Nelson mentioned this is being driven by the review of our remodel policy that currently requires a full facility remodel once every seven years. In test markets across the country we are currently testing a refresh approach that will result in more frequent updates to our facilities. This would have the dual benefit of keeping our facilities fresher and more contemporary as well as spreading out the lump sum remodel costs.

Marketing expenses increased 1.3 percentage points to 5.4% of sales primarily due to 9/10 of a point in incremental corporate investment in media and 2/10 of a point due to the establishment of local marketing advertising cooperatives with Denny’s franchisees. Legal settlements decreased ½ a point due to the minimal new case development in the fourth quarter. Additionally other costs decreased 9/10 of a point to 3.3% primarily due to a favorable credit card claim settlement. In addition the gross profit from our company operations was flat on a sales decline of $43.5 million.

For the fourth quarter of 2009 Denny’s reported franchise and license revenue of $29.2 million compared with $29.9 million in the prior year quarter. Excluding the prior year quarter’s impact of the 53rd week, revenues increased by $1.1 million. The growth in franchise revenue was driven by a $1.1 million increase in occupancy revenue. The increase from an additional 85 equivalent franchise restaurants compared with a prior year period was offset by the negative same store sales.

Franchise operating margin decreased $1.6 million to $18.8 million in the fourth quarter. Excluding the impact of the prior year quarter’s 53rd week, operating margin increased $200,000 from the prior year period. This increase was primarily driven by an increase of $1.2 million in royalties and a $400,000 increase in occupancy margins from the additional 85 equivalent units. These increases were offset by negative same store sales.

Franchise operating margin as a percentage of franchise and license revenue was 64.6%, a decrease of 3.7 percentage points compared with the same quarter last year. The franchise margin decrease was primarily due to the increasing contribution of lower margin occupancy revenue as leased company restaurants are in turn sub-leased to franchisees through FGI. Denny’s is on the primary lease and sub-leases these properties to the franchisee. We recognize our sub-lease income as franchise revenue but there is an offsetting cost in franchise expense for the primary lease. Therefore, the overall franchise margin as a percent will decline.

From a gross profit standpoint the franchise side of our business continues to contribute more than our company restaurants. This income shift allows us to reduce the risk and increase the predictability of our earnings.

General and administrative expenses for the fourth quarter decreased $1.7 million or 11.5% from the same period last year. This decrease resulted from Denny’s continued migration towards a more franchise based company, a $1.3 million reduction in incentive compensation and an $800,000 benefit from lower stock based compensation. This decrease was partially offset by $1.1 million increase in deferred compensation costs.

Next, depreciation and amortization expense declined by $1.9 million compared with the prior year period primarily as a result of the sale of restaurants and real estate over the past year. Operating gains, losses and other charges on a net basis which reflect restructuring charges, exit costs, impairment charges and gains or losses on the sale of assets increased $12 million in the quarter. This increase was primarily the result of an $11.8 million increase in gains on the sale of company restaurants and real estate.

Impairment loss was $2.4 million lower driven by losses in the prior year quarter while restructuring and exit costs were $2.2 million greater largely due to the departure of the Denny’s Chief Operating Officer and the Chief Marketing Officer in the fourth quarter.

Operating income for the fourth quarter increased $14 million from the prior year period to $24.4 million. Excluding gains and losses and other charges in both periods, operating income increased $2 million despite a $44.3 million decrease in total operating revenue attributable primarily to the sale of company restaurants. Close to $2 million increase in adjusted operating income despite a significant revenue decline is testimony to the efficiency of our transitioning business model.

Although operating income interest expense for the fourth quarter decreased $900,000 or 10% to $7.9 million as a result of a $49 million reduction in debt from the prior year period. Other non-operating income increased $6.3 million in the fourth quarter primarily due to the charges taken in the previous year for loss related to our interest rate swap and natural gas hedge.

Because of the significant impact to our P&L for 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 fourth quarter was $9.1 million, an increase of $2 million or 29% over the prior-year period. This increase in adjusted income occurred despite the estimated $3.1 million benefit in the same period last year due to the impact of the 53rd week.

We are pleased we were able to generate 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.

Turning to activity in the Denny’s restaurant portfolio during the fourth quarter the system increased by a net positive six units as 10 new restaurants opened while four closed. The 10 new openings were all franchise restaurants bringing the year-to-date franchise openings to 39 and year-to-date system openings to 40. These 40 units represent significant unit development products for the Denny’s brand and are also impressive in the context of an industry that is pulling back on growth. Denny’s year-ending net system growth a positive 10 units was its highest level since 2000.

Moving onto capital expenditures, our cash capital spending for the fourth quarter was $5.9 million, a decrease of $800,000 compared with the prior year period. For the year cash capital was $18.4 million, a decrease of $9.5 million. As we reduce our company restaurant portfolio and remain selective in our new restaurant investments we expect capital to decrease year-over-year.

Turning to asset sales in the fourth quarter we generated cash proceeds of $14.4 million from the sale of 22 company restaurant operations, an additional $5.5 million from the sale of five real estate sites including three that were previously part of an FGI transaction. Net cash proceeds were $19 million when factoring in working capital runoff we experience when a unit is sold.

For the year we generated cash proceeds of $26.7 million from the sale of 81 restaurant operations and $14 million from the sale of certain real estate. Net cash proceeds were $29 million when factoring in the working capital runoff we experience when a unit is sold. We have used these proceeds towards the reduction of $49 million of outstanding debt over the past year including a $26.9 million reduction in the fourth quarter. We will continue to balance our debt reduction goals and our commitment to maintain ample liquidity cushion.

Our cash balance combined with access to our credit facility at the end of 2009 provided us with ample liquidity of approximately $76 million. Given the challenges facing our national economy and our industry we are very pleased to have reduced our debt by $272 million or 49% since mid-2006. This has driven our debt leverage ratio to 3.28 times as compared to 5.18 times at the beginning of 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.

In respect to FGI, program to date to the fourth quarter of 2009 we have sold 290 company restaurants or 56% of the prior company store base. This includes 22 sold in the fourth quarter of 2009. As a result we have increased the mix of franchise restaurants in the Denny’s system from 66% to 85%. Additionally, since the first quarter of 2007 Denny’s has signed development agreements including those through FGI for 185 new restaurants, 58 which have opened yielding a current development pipeline of 127 new restaurants.

Denny’s targeted portfolio mix is 90% franchise and 10% company units. We anticipate achieving this goal through a combination of new franchise unit growth and select FGI transactions over the next couple of years. This wraps up my review of our fourth quarter results.

Before I let Enrique walk you through our specific financial guidance I will caution that visibility into 2010 continues to be muted for both the industry and Denny’s. So while we are encouraged by a stronger sales driving plan for 2010 we do remain cautious until we deliver improved sales trends on a sustained basis. Our ongoing transition to a franchise focused business model has been driving margin and earnings growth but the impact of further sales declines could lessen these benefits in the near-term. We will continue to manage our expenses and capital spending to protect liquidity, reduce our debt and further strengthen our balance sheet.

Our 2010 guidance assumptions include top line sales reflecting a sequential improvement to our recent trends, the continued expansion of unit development and system growth primarily through our franchisees and the ongoing focus on the generation of cash with the objective of paying down debt and strengthening the balance sheet.

With that I will turn the call over to Enrique.

Enrique N. Mayor-Mora

Thank you Mark and good afternoon everyone. I would like to take a few minutes to expand upon the business outlook section in today’s press release. As has been the case in the past three years projecting our financial guidance during the FGI process is particularly difficult. The variation in equivalent units based on restaurants sold in the prior and current year results in a wide revenue change. Comparable sales uncertainly only adds to that challenge.

The estimates provided today are a most likely combination of the impacting factors. The following estimates for full-year 2010 are based on 2009 results and management’s expectations at this time. We expect full-year franchise restaurant sales to improve sequentially from our fourth quarter 2009 results but to remain negative in a range of negative 5 to negative 3%.

For company restaurants we are expecting sales to perform approximately 1 percentage point better than our franchise units, between negative 4% to negative 2%. Underlying this assumption we anticipate little reliance on guest check increases but rather sequential improvements in guest traffic trends; meaning less negative than in 2009.

We expect that our sales performance will get stronger as the year progresses. This is due to the current muted visibility into the sales environment, the relatively stronger sales performance we delivered in the first half of last year and due to the timing of key initiatives this year.

Moving onto equivalent units. We expect equivalent company units to decrease between 30-40 units for full-year 2010 due to the FGI transactions in 2009. Our franchise equivalent units should increase by a similar amount depending on the number of franchise restaurant openings and closures and the number of FGIs in 2010. We expect to open approximately 6 new company restaurants in 2010 and for franchisees to open approximately 35. Based our analysis of potential closures we anticipate the system will increase by 5 units in 2010.

It is important to consider that the average sales volume on a unit closed in 2009 was $1.1 million while the average sales volume for an opening was projected at $1.6 million or 45% higher. Due primarily to the impact of FGI, we expect company restaurant sales to decline by approximately $75 million to between $410-420 million. Conversely, the midpoint for franchise revenue is expected to increase by approximately $1 million to between $118-122 million. This will be driven by the increase in franchise units offset by lower same store sales.

At this time we expect company operating margin will be 1-2 percentage points below 2009. This is due in part to the sales de-leveraging from our expected negative same store sales which could have an impact from a percentage margin standpoint on the fixed cost components of our P&L. We are also taking into account the year-over-year material benefits we experienced in 2009 from favorable Workers Compensation claim development of approximately 1.1 percentage points of $5 million as well as a favorable credit card claim settlement of approximately $800,000.

Offsetting a portion of these margin pressures is the margin lift provided to our restaurant portfolio by the sale of lower volume units. We anticipate flat to slight increase in product costs for the year. At this time we expect our underlying commodity basket to range from flat to an increase of 2% in 2010 with pressures increasing in the back half. Our focus on value for 2010 will also contribute to higher food costs.

For payroll and benefits we are expecting a de-leverage due to same store sales declines and as we lap last year’s material Workers Compensation benefit. We do anticipate the continued benefits from a soft labor pool. The other line items in our P&L such as rent, insurance, utilities and repairs are more fixed in nature and therefore more vulnerable to further sales declines. One note related to rent, for those of you that model the company from a credit standpoint and choose to capitalize operating rent our operating rent expense in 2008 was approximately $50 million. It was approximately $49 million in 2009 and will likely be the same in 2010.

When we FGI a leased property we remain on the head lease until the term expires and receive sub-lease income from the franchisee. Therefore the lease expense shifts from the company portion of our P&L to the franchise portion but does not go away. What does change is the amount of sub-lease income we receive to offset the $50 million in rent. In 2008 sub-lease income was approximately $32 million. In 2009 it was approximately $38 million. I cannot project 2010 sub-lease income without knowing the number of FGI transactions but it will certainly continue to rise. We suggest modeling our operating rent expense on a net basis to better reflect the impact of our new business model.

Turing to our general and administrative expense for 2010, we expect to see a reported G&A decrease by approximately $2-4 million from 2009. Our income guidance is presented based on two metrics which we detail on all of our earnings releases. Adjusted income before taxes and adjusted EBITDA. Adjusted income before taxes is our internal profitability metric which we believe most closely represents our ongoing business income. We also utilize adjusted EBITDA as it is the metric used to determine covenant compliance under our credit facility. Please refer to the historical reconciliation of these metrics to net income in today’s press release.

Our adjusted income before tax estimate for 2010 of $23-28 million is $2-7 million below our 2009 results. Excluding the materiality of the Workers Compensation and credit card claims settlement benefit in 2009 we anticipate adjusted income will be up $1-6 million in 2010 on an approximate $70 million decrease in revenue. Our adjusted EBITDA estimate for 2010 is $71-75 million. Compared with 2009 we expect depreciation and amortization will decrease by approximately $5 million, cash restructuring and exist costs will decrease by approximately $4 million and cash payments for share based compensation will decrease approximately $1 million.

Two other items of note for 2010 are cash interest expense and cash capital spending. We expect cash interest expense to decrease approximately $6 million in 2010 to $23 million. This reduction is based on the modest debt pay down and due to our December 2009 buyout of our debt swap which was paying approximately 6.89% on our term loan versus the LIBOR plus 200 point rate we will pay in 2010. Non-cash interest expense should be similar to 2009 at approximately $3 million.

Turning to capital expenditures we completed 2009 with capital spending of approximately $18 million. Our estimate for 2010 is $1 million lower at $17 million. This decrease is attributable to a reduction in maintenance capital requirements as we reduce our company restaurant portfolio. This is being partially offset in 2010 with the anticipated opening of six company operated units and the anticipated rollout of a new remodel or refresh program.

Four of the new company restaurant openings will be conversion sites at Flying J travel centers and will have capital expenditures of approximately $500,000 per unit. The company will take the leadership position to test the success of these sites prior to potentially opening the opportunity to our franchisees.

That wraps up our guidance commentary. I will now turn the call over to the operator to begin the Q&A portion of our call.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Michael Gallo – C.L. King & Associates, Inc.

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

I have a question as to whether you can give us any initial feedback on what kind of results you are seeing from the test of the more value oriented, I guess the Right on the Money Menu as it is called. I know it is early but I was wondering if you could share with us any feedback from that?

Nelson Marchioli

We are encouraged by the results but it is too early to make that call. We certainly would hope we could give you some more information on our next call.

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

I was wondering if you have started to see any regional differences emerge? As some of your peers have indicated Florida has gotten a little better. California has obviously been one of the more challenging areas for some time. I was wondering if you could talk regionally about what you have seen in some areas starting to show some improvement?

Nelson Marchioli

I would echo what you have said. California continues to be most challenging. There has been some improvement in Florida in the southern part. Elsewhere it is about the same.

Operator

The next question comes from the line of Brian Hunt – Wells Fargo Securities.

Brian Hunt – Wells Fargo Securities

I was wondering if you could talk about the pace of FGI related openings in 2009 relative to the contractual agreements you have established over the years when you sold the company owned units?

Mark Wolfinger

If I understand your question you are asking about the development agreements and how those openings have occurred once those agreements have been signed?

Brian Hunt – Wells Fargo Securities

Right, relative to the expectations.

Mark Wolfinger

I guess I would start first with the 40 new store openings we had in 2009 of which 39 were franchise. A considerable number of the 39 came out of those development agreements we started back in 2007. On average if you look at the number of stores that have been agreed to in the development agreements it probably would suggest they are going to open over a five year timeframe. So we continue at this point to be on target to what those development agreements call for and our opening targets. Again, there are really two types of development agreements we sign. One is through FGI. Then separate from that we have something called, and pardon the acronym here, an MGIP which is a market growth incentive plan that does not relate to FGI and we also have developed agreements in place for those. The numbers I gave in my script tie to the overall number of development agreements we have in place.

Brian Hunt – Wells Fargo Securities

My follow-up question has to do with the executives that departed during Q4. Are there any plans to replace those individuals in the short-term or what type of timeline do you have for replacing them?

Nelson Marchioli

We absolutely do plan on replacing those individuals. We have initiated a search some time ago with a specific executive search firm. We are looking for just the right fit. Our officer group which we are very proud of has stepped up and we haven’t missed a beat. We are providing an opportunity for them to be developed and for them to get more deeply involved in the business. So we feel we are in a pretty good place right now looking for just the right candidates. As far as a timeline is concerned I would suggest we will get it done this year.

Operator

The next question comes from the line of Reza Vahab-Zadeh - Barclays Capital.

Reza Vahab-Zadeh - Barclays Capital

The value marketing plan for this year I guess why not focus on value earlier such as 2009 because you did have a value message a couple of years back and it seems to have worked out well. So I am curious why you have decided the value message is the right way to go?

Nelson Marchioli

What we did last year we had a lot of promotional items that actually provided a significant discount with a lot of visibility through various advertising methods, the national media fund as well as coops be that on electronic media as well as in FSI’s and we just didn’t get the traction using that particular discount method that many people did in the industry. We felt a better approach this year to look at an overall value menu and that is in fact what we have in test at this point in time in six markets. We actually started those tests the first of the year.

So we did address value last year but we addressed it on a one-off promotional basis. Candidly we didn’t see that work. We are looking at more of a roll back strategy. As I said earlier on the call I am encouraged. It is about everyday, 24/7 and it is about affordability. I think that is where the difference is and where I think we can take credit for it particularly with our blue collar customer base.

Reza Vahab-Zadeh - Barclays Capital

Do you feel like you may have lost some of your value perception among consumers in 2009 that you had gained perhaps previously?

Nelson Marchioli

The good news is no. We still get high value marks in our research but the reality is I think we are getting that because of the halo effect to your point from earlier years. The good news is we still have that value perception. It is still in our top five that I talk about often. I am convinced with this strategy assuming it works based on the encouraging results thus far that we will take the value position in the minds of the consumer in our segment.

Reza Vahab-Zadeh - Barclays Capital

To the extent you may have lost some sales do you think the sales loss was to eat at home or quick service or other venues?

Nelson Marchioli

I think it was too quick service in particular and at home. But I would say quick service as consumers look for value particularly at lunch and at breakfast. People are trying to figure it out in this economy. I think grocery stores have eaten into our business as well as the quick service to your point, not just a breakfast but late night and dinner as well.

Reza Vahab-Zadeh - Barclays Capital

On the product costs are you largely hedged or how much visibility do you have on that?

Mark Wolfinger

We are about 50% hedged at this point for 2010.

Operator

The next question comes from the line of Mark Smith – Feltl & Company.

Mark Smith – Feltl & Company

I first off wanted to ask your outlook on FGI and I know this is always tough but getting down to a 10% goal, is this something you had hoped by the end of 2010 or is this going to continue to be a longer process?

Mark Wolfinger

I would tell you that it is going to be a more gradual process that will be a combination of selected refranchising. Also again a majority of our new unit growth will be franchise growth. So obviously we have moved very rapidly from that 65% to that 85% and again we view the progress we made in FGI as terrific, very positive and it has obviously added a lot of new franchisees to our system as well. I think we will gradually get to that 90% but we also felt as a management team we had to give a sense of direction of where we were headed.

Mark Smith – Feltl & Company

Looking at your cash flow and your use of cash, you guidance on interest expense what kind of a rate does that look for on paying down your debt? Now that your swaps have expired will you still aggressively knock down your debt there or are you tempted to hold onto cash and look at your notes come late in 2010?

Enrique N. Mayor-Mora

The only portion of our debt that we can’t pay down is the term loan and that is what we have been paying down the past couple of years and that is what we will continue to pay down. The notes we mentioned don’t come due for a couple of years. So we will continue as we have to pay down our term loans.

Mark Wolfinger

The other piece is when you look at the year-end cash I think we are around $26 million on the balance sheet. That is a little bit higher than last year. There is no message or signal there. Again we have always talked about a liquidity range of about $70 million including the availability on the revolver. Obviously we are focused on that 2012 date and we know we are headed towards a capital structure decision we will make that at the appropriate point in time. Obviously we have also been very focused on de-leveraging our balance sheet and that is why we are obviously very pleased it is sitting below 3.3 times levered and almost two full turns in leverage down since 2006.

Mark Smith – Feltl & Company

Looking at the food costs on this year’s free Grand Slam promotion I believe that came down from last year. Is that just a function of commodities being lower?

Enrique N. Mayor-Mora

Exactly right. It is a function of the commodities being lower.

Mark Smith – Feltl & Company

On that same note, on your other promotions from free refills on pancakes to the free burger giveaway coming up, are you doing any subsidies for your franchisees on these other promotions?

Nelson Marchioli

No we are not.

Operator

The next question comes from the line of Tony Brenner – Roth Capital Partners.

Tony Brenner – Roth Capital Partners

[inaudible] next line item is helpful. My question pertains to your top line guidance and specifically same store sales for 2010. I assume you are not attempting to forecast things like changes in unemployment rates by state and that sort of thing but it sounds like you are simply penciling in roughly a 1% sequential improvement quarter by quarter and you will adjust that as you go along. Is that fair?

Enrique N. Mayor-Mora

I think it is a little bit more than a point.

Tony Brenner – Roth Capital Partners

But it still leaves you with negative comps for all four quarters of the year. Is that right?

Enrique N. Mayor-Mora

Our guidance is for the entire year. What we did say is we do expect for the reasons I mentioned sequential improvement throughout the year. Said another way, improvement throughout the year but still negative, yes.

Operator

The next question comes from the line of Jonathon White.

Jonathon White

A question for you on the consumer spending and your mix shift of late and I wonder if you could maybe sparse out the weather impact and talk about if you have seen any positive signs of the consumer and how they are spending? Do they still need the big carrot to get in the door or are you seeing any signs of hope of late?

Nelson Marchioli

I can’t really point to anything in particular that is improving consumer confidence from our perspective. I think all of us in this industry are fighting for every customer and working very hard to get them to come back. That is our focus. To talk about value, hospitality and execute it consistently. I am not seeing anything in the economy that indicates an overall improvement.

Jonathon White

The incentive comp, stock comp in the quarter was there any reversal in those numbers or was that just kind of accruing at a lower rate? What is the story there?

Mark Wolfinger

That is more of accruing at a lower rate.

Jonathon White

I didn’t catch that the story was on the Workers Comp benefit.

Nelson Marchioli

We saw it this year in the third quarter and we saw it again in the fourth quarter which is a benefit to our liability on the balance sheet we have a liability for Workers Compensation. We saw in the third and fourth quarter again a material benefit based on the actuarial reports we get back that are done at every quarter end. It doesn’t necessarily change what we accrue at a monthly level in terms of an expense. So when looking forward I think it is a question for folks what does the Workers Compensation for Denny’s look like moving forward.

I think if you go back to 2008 and look at a percent of sales roughly 1.3-1.5% for Workers Comp percent of sales is what you can expect to see. However, at the end of every quarter there is an actuarial report that comes back looking at all the historical claims and adjusts potentially either positively or negatively our liability on the balance sheet. That is what you saw in the third and fourth quarter in terms of a positive benefit to Denny’s.

Jonathon White

Did that benefit put you at the 1.3-1.5 range for 2009?

Nelson Marchioli

No those are independent. One is related to the balance sheet accrual and the second is an ongoing rate in which we…

Jonathon White

So what did you end up being in 2009 on full year Workers Comp?

Nelson Marchioli

What we said was there was about a $5 million benefit for the entire year, year-over-year which is about 1.1 points, 110 basis points.

Operator

The next question comes from the line of Mark Smith – Feltl & Company.

Mark Smith – Feltl & Company

A couple of quick follow-ups. First, Nelson can you comment on your initiative on continuing to offer new items? Will we look for this primarily in late night or will this be spread throughout the day parts?

Nelson Marchioli

It will be spread throughout the day parts and it will be focused on value.

Mark Smith – Feltl & Company

Secondly, the Flying J units you are doing are all of these conversions you are looking at right now? Secondly how big of an opportunity is this if these workout for you?

Nelson Marchioli

They are conversions to answer your first question. I will also tell you they are pre-existing restaurants. The four we have done that we are looking at as a test actually have a pre-volume performance rate of $1.5 million each. We like the travel center business as we have talked about. A franchisor has to take the lead. There is a real demand for this brand as an expansion vehicle. This is just one of those things we felt as a franchisor we needed to take the risk and demonstrate to our franchisees that it makes sense. But at this point it is too early to talk about the size of the opportunity until we get some more results.

Mark Smith – Feltl & Company

But at least on these initial ones it looks like a $500,000 investment on units that are in their steady state running about $1.5 million average unit volume?

Nelson Marchioli

Yes. So obviously that is a very good return and we expect to do better than that.

Operator

The next question comes from the line of Jonathon [Desh].

Jonathon [Desh]

Why do you think the sales and guest traffic have been down over the past year? Is it more the economy or was it because of the operations and marketing?

Nelson Marchioli

I would tell you it is probably over the last three years it is a combination of the three things you mentioned. We are far more focused this year however on executing against operations. Marketing with a specific objective and focus. So I am confident we are going to reverse that.

Jonathon [Desh]

The Super Bowl ad, in regard to last year’s Super Bowl ad you said you also indirectly got about $50 million in indirect marketing through the buzz it created. Is that correct?

Nelson Marchioli

That was last year. That is correct.

Jonathon [Desh]

Then last year even with that $50 million in marketing buzz you got the trends and the traffic were still pretty bad throughout the year right after that quarter. I was just thinking even with that extra $50 million in indirect buzz on top of your $60 million in total marketing spend in the year that if we got those types of results then why would we triple down on that again this year?

Nelson Marchioli

Well you have to look at this as getting the stickiness. It is about brand awareness. We clearly got a lot of, to use your term, buzz in the media and it certainly put us in the forefront in our segment in the minds of the consumer. Our responsibility and where I feel we dropped the ball last year is we didn’t continue to focus on the opportunity that the Super Bowl provided us. We can’t expect the Super Bowl to carry us the entire year. It carried us the first quarter. We have a responsibility as management to take care of the second, third and fourth quarter accordingly and we were not strong enough in providing that stickiness we talked about to get consumers to come back over and over again throughout the year and that is where our focus is now.

Jonathon [Desh]

So once we get the results from this year’s Super Bowl ad if it carries us through that quarter does that mean next year we are going to triple or quadruple down on it again?

Nelson Marchioli

I wouldn’t think so. But I think we will make that decision in the fourth quarter of next year once we see the overall benefit and determine whether or not the Super Bowl makes sense. We think it was absolutely the right thing to do last year and this year as well. It may be time to do something different or it may be time to do the same thing.

Enrique N. Mayor-Mora

That concludes our call for today. I would like thank everyone for tuning in. We will talk you again next quarter on May 4th is our tentative date. Thank you and have a great evening.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Denny’s Corporation Q4 2009 Earnings Call Transcript
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