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Wendy's International (WEN)

Q3 2006 Earnings Call

October 26, 2006 4:00 pm ET

Executives

Kerrii Anderson - Interim CEO

Brendan Foley - Controller

Dave Near - COO

Ian Rowden - CMO

John Barker - IR

Analysts

Jeffrey Berstein - Lehman Brothers

John Glass - CIBC World Markets

Glen Petraglia - Citigroup

Mark Rohaus -Morgan Stanley

Adrian Young - Credit Suisse First Boston

Joe Buckley - Bear Stearns

Martha Shelton - Jefferies & Co.

Rachael Rothman - Merrill Lynch

David Palmer - UBS

Andrew Barish - Banc of America Securities

Larry Miller - RBC Capital Markets

Steven Kron - Goldman Sachs

Presentation

Operator

At this time, I would like to welcome everyone to the Wendy's International third quarter earnings results conference call. (Operator Instructions) At this time, I would like to turn the call over to Mr. John Barker, Senior Vice President of Corporate Affairs and Investor Relations. Please go ahead, sir.

John Barker

Thanks, Lisa. Good afternoon, everyone. The purpose of our call and our webcast today is to talk about our third quarter business results for Wendy's and give you an update on some of our key initiatives. We published the third quarter results earlier today, and you can find the news release, all the financial statements and information on our web site, which is wendys-invest.com.

The agenda for today's call will begin with remarks from Wendy's Interim CEO and President, Kerrii Anderson. Kerrii is going to give you an update on the third quarter and some of our strategic initiatives. Then after that, Brendan Foley, our Senior Vice President and our Controller, will walk us through the financials for the quarter, and then we will take your questions.

Looking ahead, I would like you to note that we do plan to release our fourth quarter sales on January 5, that's a Friday, and our fourth quarter earnings are set for February 2 of 2007. Due to the fact that we are in the middle of a Dutch Auction tender offer, we are also planning to release our October same-store sales, and that will be coming up on November 9. For future reference, all the dates are on our web site for future releases.

As you may have seen in our news release today, the Board of Directors' search for a permanent CEO and President continues. Our Chairman, Jim Pickett, said that Kerrii continues to be a candidate for the permanent CEO position and that the Board continues to consider external candidates. The Company plans to issue a news release and other necessary disclosures at the appropriate time.

Now, I'd like to refer you for just a moment to the Safe Harbor statement that is attached to this news release today. Certain information that we may discuss regarding future performance, such as our financial goals and plans and development, is forward-looking. Various factors could affect the Company's results and cause those results to differ materially from those expressed in our forward-looking statements. Some of those factors are set forth in the Safe Harbor statement that is attached to the earnings release.

Some of our comments today may reference non-GAAP financial measures. In the event that we reference previously undisclosed non-GAAP information, we may post a reconciliation to the most directly comparable GAAP financial measure on our web site.

Now, let me turn it over to Kerrii.

Kerrii Anderson

Well, thanks, John, and good afternoon, everybody. I want to let you know that I am here with the management team today. Ian and Dave are both with me. We of course spent a significant amount of time with you on the 12th talking extensively about our business plan for improved performance and our focus on Wendy's. So today, what I am going to do is cover an overview of our release today, and then we're going to have Brendan take you through some of the detailed analysis of our numbers. With that, we will then open it up for questions and answers. Ian, Dave and I as well as Brendan and others are certainly here to take any questions that you might have.

So as we did discuss on October 12, our consolidated third quarter results are quite noisy and we've got discontinued operations, we've got charges and we've got an unusual item, as well as a report on continuing operations. Continuing operations consist of Wendy's and Cafe Express, as well as the discontinued operations include Tim Hortons and Baja Fresh. As all of you know, Tim Hortons was spun off on September 29, and we would expect Baja Fresh to be sold during the fourth quarter of this year. Therefore, they are being classified as discontinued operations as of the end of the third quarter.

Most importantly, our focus is certainly on the third quarter financial results that we released earlier today. It shows that we are in fact strengthening the Wendy's core business performance. It is improving, and it starts at the top line of sales. Our sales did strengthen during the quarter and our marketing is gaining traction as we introduce new products and the key commodity costs continue to decline for us.

As a result, our pretax profits at the company-operated restaurant level and royalty revenues were actually up about $9.8 million over last year. So that's where the core business is performing and I think that's the message, from our perspective today, that we think is most important. Having said that, we are reporting today of course revenues of about $623 million. That's only up about 2.5%. That's driven really by same-store sales, 4.1% at U.S. company and 3.9% at U.S. franchisees against some very negative numbers in the third quarter a year ago.

Our net income from continuing ops was $19.4 million, and that's down a little from $20 million a year ago. The net income from discontinued operations was roughly $52.5 million against $52.1 million a year ago. That rolls up to a final net income number of about $72 million against $72.1 million a year ago. Then of course, the EPS, and what's most important is continuing ops, is $0.16 compared to $0.17 a year ago, with discontinued ops being about $0.45 against $0.44 for a combined $0.61 in EPS against $0.61 a quarter a year ago.

From a development standpoint, we've talked to about slowing our development. We did have some stores in the pipeline and we opened about 34 new Wendy's restaurants during the quarter. That's really only three company-operated restaurants and 31 franchised stores. It is really important to note that we have about 42 fewer company-operated stores than we did this time a year ago due to the store closures and some of the sales of stores. We'd like you to keep in mind that this does have a negative impact when you look at our revenue growth, and we've also talked about this in giving guidance actually for 2007.

A number of unusual factors had a negative impact on our results from continuing operations, relative to those results for 2005. We'd discussed a number of these on October 12 but certainly we have more specifics today. We had other expense of about $6.2 million this quarter, compared to other income of $4.2 million in the third quarter of last year. That really includes the charges, impairment charges for Cafe Express, as well as some closing charges for closing Wendy's restaurants.

We had approximately $4 million less in pretax rental income in the quarter compared to a year ago. Again, that's due to the sale of the properties that we leased to franchisees that we closed on at the end of '05 and '06. That affects our franchise revenue line. We had no significant property sales this year in '06. That was compared to about a $4.7 million pretax gain that we had on the sale of some property in '05. We continued to have some consulting and professional fee expenses of about $3 million in the quarter.

Now, offsetting some of these negative factors was certainly a benefit we got from net interest income because of the cash on our balance sheet. Brendan is going to walk you through the treatment of those items.

At the Wendy's brand, we continue to see many good signs in the quarter. That gives us a lot of confidence that our turnaround is continuing to gain momentum. One-third of our same-store sales at U.S. company stores were the strongest since the second quarter of 2004 and we are excited about the new products and the marketing initiatives that we have in place for the rest of year and early 2007. I know that Ian talked to you about some of what we had going on the rest of this year.

The components of the U.S. third quarter same-store sales improvement really are in three areas. Checks was up about 0.9%, and that's really due to the introduction of the Frescata sandwiches in April and we've continued to see good product mix. We did take some price during this quarter, the third quarter, but it was really offset by key items such as our Super Value menu that we are now selling at $0.99 versus $1.29 the third quarter a year ago. Our transactions were up. Again, we are continuing to drive transactions. They were up about 3.2%, so that's really what's driving primarily your same-store sales numbers.

Before I turn it over to Brendan and look at the details for the quarter, I'd like to give you an update on several initiatives that we've been focused on over the past quarter. We are on track to achieve $100 million in G&A and overhead cost savings for 2007, as a run-rate relative to our 2006 corporate budget. We spent some time at our October 12 meeting talking about the areas in which you will see that reduction. About $50 million or $60 million comes from corporate G&A line; $20 million to $25 million comes from discontinued operations, really related primarily to Baja Fresh; and $20 million to $25 million comes from corporate restaurant operating costs, which is some of the reduction that we have experienced in the field. We've got a few million dollars from depreciation.

While I will tell you that the reorganization has been a difficult process, the reduction in costs were absolutely necessary for us to achieve our targeted savings and really to position us as a stronger company after the spin-off of Tim Hortons. We believe we will continue to operate as a more leaner and efficient company in the future as a result of this process.

From a corporate perspective, the past few months have certainly been busy. As you know, on September 29, we completed the spin-off of Tim Hortons. On October 12, we announced the agreement to sell Baja Fresh, and we plan to close that transaction in the fourth quarter. As a result of both of these transactions, we've now reported Tim's and Baja in the discontinued operations line of our income statement.

These transactions certainly closed the chapter on our business relationship with both of these organizations, and we wish their management teams and the employees of both companies the best in their future.

On October 12, we also announced that we received Board approval to repurchase up to 35.4 million shares over the next 18 to 24 months of our stock with the majority of this authorization being utilized in a modified dutch auction tender offer for up to $800 million worth. The tender offer was initiated on October 18 with a price range of $33 to $36, and is currently scheduled to expire on November 16.

So as we look ahead, we expect to realize positive same-store sales growth in the fourth quarter of 2006. Although we do acknowledge that our comparable sales comparisons in October and November of '05 were actually some of the strongest relative to the third quarter, much stronger than the third quarter of last year.

However, I'm really excited about the upcoming promotional calendar. Many of you ate our double-melt cheeseburgers in New York and we are launching that campaign in November. It features, of course, fresh ground beef patties layered with melted cheese, fresh toppings and other great flavors. We are also introducing our Wendy's gift card program, which positions us to really continue to sustain our momentum here for the rest of the year.

We do anticipate that our beef cost will be approximately 4% lower than in the fourth quarter of '05, and we also expect to realize $5 million or $6 million in incremental interest income relative to the fourth quarter of 2005.

In addition, we are going to incur some additional costs the fourth quarter, somewhere in the $4 million to $8 million range of pretax charges for the closure of Wendy's restaurants. Again, we foreshadowed a little bit of this in our October 12 meeting. As well, we will continue to incur some costs of around $3 million in the fourth quarter for our research and development efforts related towards breakfast. On the plus side, we expect some benefits from our cost-savings initiatives to actually begin; we will see the benefit of some of that here in the fourth quarter.

Finally, we are very much focused as a management team on executing our new, long-term strategic plan that we talked to you about in October. Many of you were in attendance and we want you to know and understand how focused we are on executing the recipe for our success to truly revitalize the Wendy's brand. Our management team is working on key initiatives to improve the store economics, which is the ultimate objective, enhance and improve our operations, and ignite our innovation engine as well as strengthen our creative. We have also developed a number of elements of our brand strategy for Wendy's to truly clarify our quality position with our customers. These initiatives have already started showing some results and our business indicators are headed in the right direction. We anticipate continued improvement in the fourth quarter, and we look certainly to close 2006 with positive momentum that will carry us into 2007.

In closing, I am extremely proud of the progress that the team has made to date, and I'm extremely optimistic about the future of this brand, both in the short-term and the long-term. So at this point, what I'd like to do, Brendan, is turn it over to you to walk us through some of the detail of our results.

Brendan Foley

Thanks, Kerrii. I will start by reviewing the Wendy's operating segment, and then we will walk through the income statement line by line to discuss some of the more significant items that affected the quarter. As Kerrii mentioned, we reported income from continuing operations and income from discontinued operations during this quarter. Please refer to the financial statements that we issued with today's press release for our year-to-year comparisons to third quarter 2005.

I will focus my comments on the results from continuing operations. The reported enterprise operating margin was 3.1%, compared to the prior year's margin of 7.2%. The decrease was primarily the result of a number of charges related to our previously announced strategic initiatives.

Wendy's segment operating income was $26.5 million compared to $45.2 million last year. Our reported operating margins were 4.3% compared to 7.5% last year. These Wendy's segment operating margins are based on the fact that Tim Hortons and Baja Fresh are no longer included in our reportable operating segments because they are classified as discontinued operations. As a result, the majority of the amounts previously classified as corporate charges in our reportable operating segment is now included in the Wendy's segment.

Although operating income in the Wendy's segment declined, the results included an improvement in the Wendy's company store operations and royalties of about $10 million, as Kerrii mentioned. These operating improvements were offset by the timing of management bonus accruals, which negatively impacted operating income by $7 million as we expect to pay partial bonuses commensurate with stronger second-half 2006 operating results relative to 2005.

2006 includes $5.5 million in store-closure charges in the third quarter, compared to about $4.7 million in gains on the sale of properties leased to franchisees in the third quarter of 2005. 2006 reflects lost rental income of $4.3 million due to the sale of sites previously leased to franchisees. 2006 also includes $3 million in higher consulting and professional fees and about $2 million in restructuring charges.

Now, let's look more closely at the income statement. I will take you through each line and point out the significant items in each. Starting with the top line, total revenues increased 2.5% from $608.8 million in the third quarter of 2005 to $623.8 million in the third quarter of 2006. Total Wendy's segment revenue increased 2% from $601 million to $615 million. Total retail sales, which come from company-operated stores, were up 3.6% at $541.9 million, reflecting the average same-store sales increases, partly offset by the impact of restaurant closures in late 2005.

Wendy's segment franchises revenues were down 5.4% at $73.4 million as a result of lower rent revenues from franchisees due to the 2005 sale of 171 sites previously leased to franchisees. The absence of gains on sales of properties leased to franchisees in 2005 is partly offset by higher royalty revenues of $5 million.

Now, let's take a look at the costs line. Cost of sales improved 140 basis points as a percentage of retail sales versus 2005 at $336 million and 61.1%. This compares with $332 million and 62.5% of retail sales last year. Wendy's U.S. company-operated restaurant food costs improved by 110 basis points and 30.2% of Wendy's retail sales in the third quarter a year ago to 29.1%. Improvement was due primarily to lower beef costs and improved menu management with the introduction of higher-margin products such as the Vanilla Frosty, Crispy Chicken Sandwiches, and Frescata deli sandwiches.

Wendy's U.S. company-operated restaurant labor costs also improved by 70 basis points, 28.3% in the third quarter a year ago to 27.6%, primarily due to leverage from improved same-store sales. These improvements were slightly offset by other cost increases, especially paper costs and higher store-level bonuses, reflecting the improved results.

Company restaurant operating costs were $158.5 million or 28.8% of retail sales. This compares to $146.9 million or 27.7% a year ago. The percentage increase relates primarily to higher bonus costs of about $2 million, higher utility costs of about $2 million, and higher insurance costs of about $1 million, all within the Wendy's segment.

Operating costs were $8.3 million compared to $4.7 million in the third quarter last year. The increase includes payments related to distributor commitments and franchise remodel incentive payments. Depreciation was $31.9 million versus $33 million a year ago.

General and administrative expenses were $63.4 million or 10.3% of revenue, compared to $52.3 million or 8.6% of revenue in the third quarter of 2005. The increase includes approximately $3 million in consulting and professional fees, the timing of accruals for management bonuses of about $7 million due to improved performance at the Wendy's brand, and R&D-related breakfast costs of about $1 million.

On the other expense line, we incurred $6.2 million of expense compared to other income of $4.2 million in the third quarter of 2005. This variance relates primarily to $5.8 million in pretax fixed and intangible asset impairment charges for Baja Fresh that were recorded in 2006 and $5.5 million of pretax charges related to the closure of 20 Wendy's restaurant company-operated restaurants. We plan to close a total of 30 to 40 restaurants in the next six months. The other expense line also included $2 million in corporate restructuring charges in 2006, offset by favorable lease reserves.

Our results were also impacted by items below the operating income line. Net interest was a $15.8 million benefit in the third quarter. This favorable variance, relative to the third quarter of 2005, resulted from higher interest income of $13.5 million, primarily on funds received from Tim Hortons after its IPO in late March. The net interest improvement also includes a decrease in interest expense due to the December 2005 repayment of $100 million of 6.35% notes. Finally, the effective tax rate from continuing operations in 2006 is 22.8% and reflects approximately $4 million in lower tax reserves and additional tax credits in 2006.

Regarding our financial position at the end of the third quarter, we ended the quarter with $1.2 billion in cash compared to $233 million at the end of the year. This primarily reflects funds received from Tim Hortons after its IPO. You'll note that our third quarter balance sheet includes line items labeled as amounts from discontinued operations. The amounts for 2006 represent balances from Baja Fresh. The amounts for 2005 include both Baja Fresh and Tim Hortons.

One last item before I turn it over to John. Many if you have asked about the differences between our 2007 guidance and our 2005 reported operating income plus depreciation of property and equipment that's included in the Company's October 5, 2006 Form 8-K, which excluded the impact of Tim Hortons as a discontinued operation. I will take a minute now to identify the major differences.

The starting point, some of you used from the Form 8-K filing for the 2005 fiscal year is that 2005 operating income of $135 million, plus depreciation of $141 million, which totals $276 million. The reconciliation sum of that forward is between the $276 million and the Company's 2007 guidance of $330 million EBITDA. The 2005 $276 million amount contains a number of non-operating gains, charges and other amounts that occurred during 2005 that are not expected to recur.

To arrive at a comparable operating number in 2005, we need to net those gains, charges and amounts against the reported number of $276 million. The $276 million in reported 2005 operating income plus depreciation includes a $36 million net gain from Wendy's facility actions, including $63 million in gains on real estate, offset by a $27 million loss on restaurant closures. The $276 million number also includes a $20 million loss from developing brands which are not included in the Company's guidance for 2005.

Also included in the $276 million amount are two other items that will not recur in future years. They are an adjustment for rental income that the Company recorded in 2005 and will not recur in future years due to the sale of properties previously leased to franchisees. This will have an ongoing negative impact of about $15 million on all subsequent years relative to 2005.

We also need to account for the expected loss of about $15 million in income from our combo store Canadian joint venture with Tim Hortons. Because of the accounting rules regarding discontinued operations, the joint venture was not accounted for as a discontinued operation in the Company's Form 8-K filing because the Company will have an ongoing and financial interest in this joint venture. Instead, it was included in continuing operations in the 8-K filing and needs to be adjusted by the $15 million.

So for the purpose of comparing future years to 2005, a total of $46 million should be removed from the 2005 reported number, which represents the total impact of these four items that I just mentioned. Beginning with the $276 million amount and subtracting the $46 million, the comparable $276 million amount is $230 million. So this $230 million adjusted number should be the base for the addition of expected incremental benefits and the costs to arrive at an estimate for the 2007 EBITDA.

The next step is to adjust for all the factors that we expect to impact 2005 to 2007 comparability. The first factor is our publicly stated goal of $100 million in gross cost savings during 2007. This $100 million will be netted against the $20 million of G&A savings that were associated with the developing brands, which we will no longer own in 2007, so a total of $80 million in net G&A savings is expected.

Remember that this $80 million savings is off the 2006 budget, which already incorporates inflationary G&A growth for 2005. Also remember that the expected inflationary G&A growth during 2007 will impact compatibility to 2005. But because we are reconciling from reported 2005 results to expected 2007 results, we must build in two full years of inflationary growth. The total expected inflationary G&A growth for 2006 and 2007 of approximately 3% to 4% equates to $15 million to $20 million and needs to be factored in when comparing to the 2005 results.

The next gap between 2005 and 2007 is our expected management bonus payment. 2005 management bonuses were very low due to the worse than expected 2005 operating performance at Wendy's. We would anticipate about $15 million to $20 million in higher incentive compensation in 2007 versus what we paid in 2005, assuming that we achieve our financial goals for the 2007 year.

We also expect a total of about $2 million to $4 million in incremental stock expense for 2007 compared to 2005. This reflects two additional years of equity award grants made since 2005. The Company began expensing restricted stock and restricted stock unit equity award grants with its 2004 grant.

As we mentioned on October 12, we are anticipating about $25 million in annual incentive payments to our franchisees beginning in 2007. That amounts also needs to be factored into the 2005 and 2007 compatibility.

Most importantly, the Company is focused on improving its operating results at Wendy's. The 2007 guidance includes $80 million to $90 million of operating results improvement. Based on the 2005 adjusted $230 million amount I mentioned just a few minutes ago, this represents an approximate 35% increase over our 2005 results.

So, let me just briefly summarize that last set of adjustments. We started with $100 million of targeted G&A savings, less $20 million related to the developing brands. We identified inflationary growth of $15 million to $20 million for 2006 and 2007. There are higher expected bonuses of $15 million to $20 million; incremental stock of approximately $2 million to $4 million; franchisee incentives of $25 million; and again, most importantly, the improvement in Wendy's operations of $80 million to $90 million.

Adjusting for all of these factors brings you within our guidance range of $330 million to $340 million in estimated EBITDA for 2007.

Now, I will turn it back over to John.

John Barker

Thanks, Brendan. One last note before we open up the phone lines for your questions. From a dividend perspective, the Board approved the 115th consecutive quarterly dividend, which will be paid on November 20, and that will be to shareholders of record as of November 6. The quarterly payment will be $0.085 per share. When we adjust it for the value of the Tim Hortons dividend, which was $0.25 per share, times the spin-off distribution ratio, which was 1.35, our dividend rate is equivalent to what we were paying prior to the spin-off of Tim Hortons.

As we announced at our October 12 analyst meeting, our Board will continue to review the dividend policy going forward. Because the record date for the dividend payment is before the expiration date of the dutch auction tender offer, shareholders of record on November 6 who tender their shares in the tender offer will be entitled to this dividend payment.

We are now ready to begin the Q&A session. To allow everyone the opportunity to ask questions, we ask that you try to limit yourself to one question per caller. I also want to mention again that on the line with us here today is Ian Rowden. Many of you met Ian in New York, our Chief Marketing Officer. Also with us today is Dave Near, our Chief Operations Officer. Both of them look forward to your questions.

Operator, we'd now like to begin queuing up for Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jeffrey Bernstein - Lehman Brothers.

Jeffrey Berstein - Lehman Brothers

Thank you very much. I just had a couple of questions. You talked about the tender offer and share repurchase. First, I'm wondering if you could just talk about the method or the approach utilized to determine the tender offer price range?

Secondly, what are your thoughts, should the shares rise above the upper end of that range by the mid-November deadline is that something that you would consider, increasing that range? I'm just wondering on the broad thoughts and how the range was determined and the ability to take that higher.

Kerrii Anderson

Jeffrey, it's Kerrii. First of all, the approach that we took in our pricing the dutch tender auction was to certainly consult with our investment bankers, both JP Morgan and Goldman Sachs. I think we also spent quite a bit of time with our finance advisory committee along with our Board of Directors to really discuss the pricing of the offer. Given the advice of our experts and our outlook that we have shared now with The Street, we felt that was a reasonable range and indicative of the value.

From our perspective, our focus here is the fact that we have a lot of cash on our balance sheet and we wanted to most effectively return that to shareholders in the best way. So therefore, we've got the $800 million out there. It is currently our plan for it to expire on November 16.

Jeffrey Berstein - Lehman Brothers

Actually, as a follow-up question more on the operations front, can you just talk in a little bit more detail on the very favorable food and labor cost you experienced in the burger business? Do you expect those favorable trends to continue at the same rate for the rest of this year and into '07? How low would you ultimately expect each of those could fall as a percentage of retail sales?

Kerrii Anderson

I will start and then Dave will take it over. I think we had said, as a management team, we absolutely have to continue to drive improved profitability and margins in our business. While we had a good experience both in food and labor, we had a little bit of offset, so that we had about 100 basis points improvement net.

So we have to continue to drive performance. It starts with sales at the top level. We of course have indicated that beef is going to be down in the fourth quarter about 4% compared to where it was a year ago, so I think we have commodities in our favor at this point. But we have to continue to drive operations improvement also. So with that, I will turn it over to you, Dave.

Dave Near

Yes, I think that's exactly right, Kerrii. I think sales is the big factor there. We've got to get that going in the right direction. I think we would expect to see continued improvement on the food and labor side, compared to last year. I think with our menu management that we've got in place now, some of the products that we will be rolling in November and December, I think food should come in line. Again on the labor side, when we hit our sales projections, that should help leverage the labor percent as well.

Operator

Your next question comes from John Glass - CIBC.

John Glass - CIBC World Markets

I'm just trying to reconcile the $26.5 million segment income that you referenced with this $10 million improvement year-over-year. Firstly, how much corporate expenses are now allocated up into that line?

Brendan Foley

Probably the best way to get to that number is take a look at the reported Wendy's operating segment from last year that we had reported for 2005 and compare it to what we have now. The difference would be those corporate charges. I don't have the exact number, but it is the significant majority of them, where those corporate charges are now in the Wendy's segment.

John Glass - CIBC World Markets

Okay. Then how about the extraordinary charges that you listed, $11 million in the other line, and $3 million in G&A excluding the incentive comp? Are those all up in the segment income as well?

Brendan Foley

Yes, they are.

John Glass - CIBC World Markets

Then since you started to talk a little bit about restaurant margins, at least food and labor, can you talk about what restaurant-level margins are at Wendy's now and maybe what your goal is for restaurant-level margins specifically?

Dave Near

I think the Company discontinued giving that out a little while ago. I don't think we disclose that these days. It's something we could take a look at going forward but it's not something we give out right now.

Kerrii Anderson

We have talked about, Dave, you disclosed I think we are trying to continue to get another 200 to 300 basis points over the next two to three years.

Dave Near

That's exactly right.

Kerrii Anderson

You can see the impact of sales, John, as you well know. When we draw top line sales as we did this quarter, 4.1%, and with food cost commodities positive for us, I mean, we had a 100 basis point improvement in one quarter, so the key is sales.

Operator

Your next question comes from Glen Petraglia - Citigroup.

Glen Petraglia - Citigroup

Good afternoon. I was hoping, first, that you could maybe share what your outlook at this point is for beef costs in 2007? And then if you could give us a status as to where you are in terms of searching presumably for a buyer for Cafe Express, I would appreciate it.

Kerrii Anderson

Yes, Glen. As we look out for 2007 beef costs, we think overall we will have favorable pricing on beef, compared to '06. I think on average for the entire year we are expecting '06 to be down from '05 about 8% to 10% I think is the overall number in '06 compared to '05. We are expecting to drive that down further in '07, probably in the 3% to 5% range. You know, it certainly will fluctuate by quarter, as it always does with some seasonality. But we should be going into next year with a very positive outlook for beef.

The second question you asked us was Cafe. I will be candid and just tell you that we continue to seek strategic alternatives for Cafe but we don't have any further announcements today.

Glen Petraglia - Citigroup

Thank you.

Operator

Your next question comes from Mark Rohaus -Morgan Stanley.

Mark Rohaus -Morgan Stanley

My question is on the breakfast. It seems like that could be a major swing factor to the operating earnings story you've mapped out. You've talked about $75 million to $95 million that could come from breakfast. Is that with breakfast at full speed, or is that including a ramp-up phase? At what point do you think you'll be making a decision on actually starting the breakfast?

Kerrii Anderson

Yes, from $75 million to $95 million, it is absolutely full-speed. You are in full launch nationally, and you've got all the bugs worked out from that perspective. I think it is a tremendous opportunity for us. As far as a decision point, what we said in New York and we continue to say is that we have a number of decision points through '07, really by quarter, as to the progress we're making and the results we see in test. At this point, we have not made a definite decision. I don't know, Ian, if there's something you would like to maybe add?

Ian Rowden

No. It's just what we reiterated in New York, which is we are on track with our testing. We will report back on our testing to our franchise community. We will take it one step at a time in the process as we said we would as we go through the next 12 months or so.

Mark Rohaus -Morgan Stanley

If all goes well, how would the $75 million to $95 million number look like in that first year of transition?

Kerrii Anderson

Yes, the one thing we said is the $75 million to $95 million does not include an initial $30 million advertising investment that the Company is committed to if and when a decision would be made to go forward with breakfast. So that very first launch year, that $75 million to $95 million would be reduced by $30 million. After that, it's a run-rate.

Operator

Your next question comes from Adrian Young - Credit Suisse.

Adrian Young - CSFB

Hi, Kerrii. Congratulations, first of all, great quarter. I'm trying to get at a lease-adjusted leverage and coverage ratio. Can you confirm for me last quarter's stand-alone rent expense? Also, I'm looking for other off balance sheet items that maybe should be factored in, the guarantees and what not.

Brendan Foley

I'm certain we don't have that right here with us, but Dave and I, if you are okay with that, would follow up with you offline.

Adrian Young - CSFB

Sure.

Dave Near

I might refer you to the 10-K. It will probably give you some pretty good information in the release footnote. We break that out between segments historically, so. Also in the footnotes, we disclose commitments, the contingencies as we are required to do. So you might want to check there.

Operator

Your next question comes from Joe Buckley - Bear Stearns.

Joe Buckley - Bear Stearns

Thank you, a couple of questions. The R&D number on breakfast, the $1 million in the third quarter and the $3 million in the fourth quarter, it sounded like that is in G&A. So is that actually R&D spending as opposed to the operating losses of the tests?

Dave Near

I'm sorry, the question was--?

Kerrii Anderson

Is it in G&A?

Dave Near

Is it in G&A? Yes.

Joe Buckley - Bear Stearns

It is in G&A?

Kerrii Anderson

It is in G&A. It's not operating losses. You certainly have some start-up, Joe, when you begin to roll breakfast out. But this is primarily in the R&D area.

Ian Rowden

That's correct.

Joe Buckley - Bear Stearns

Going from $1 million to $3 million, does it signify a broadening of the test or just more products being tested at the corporate level?

Ian Rowden

Actually, it's an indication of both, Joe. We are broadening the test, as you know, as we expanded to full tests in some markets, and we're still working and developing additional breakfast items as part of the menu.

Dave Near

We are going to additional stores, Joe. Additional markets.

Joe Buckley - Bear Stearns

All right. A question on the beef costs. If they are down 3% to 5% in '07, what kind of impact would that have on your overall food cost margin?

Kerrii Anderson

What we've talked about before is a $0.10 decrease per pound is about, from a store operating perspective, 50 basis points in margin, Joe.

Joe Buckley - Bear Stearns

Okay, that's helpful. Then lastly, with the headcount reductions at the corporate level, have there been any areas that you've noticed significant strain in the organization as a result of all the streamlining?

Kerrii Anderson

I'm sorry, Joe. We kind of got an interruption on the call. Have we noticed significant what?

Joe Buckley - Bear Stearns

From all the headcount reductions that have been implemented are there parts of the organization that are feeling strained from the streamlining?

Kerrii Anderson

Everybody here looks well-rested. Seriously, there's no question, Joe, that, given headcount reductions, the majority of the headcount departed corporate at the end of September, first of October, really. There are a few less, just maybe 30 to 40 people that will actually depart in December. So from that perspective, there's no question, given all the activity that's going on, working on sales, the discontinued ops, the spin of Tim's, all of that has been taking place at a rapid pace.

What affects us most is to see that positive same-store sales number. So from that perspective, that's what we are all focused on, is the future of Wendy's, and really being able to get through some of these initiatives to allow us to get to the real target.

Joe Buckley - Bear Stearns

Okay, thank you.

Operator

Your next question comes from Martha Shelton - Jefferies & Company.

Martha Shelton - Jefferies & Co.

A quick question for you. Insofar as beef is a percentage of cost of goods sold, do you all give that figure out?

Kerrii Anderson

Generally, Martha, we have not. You know, certainly, because of our product mix, we talked about hamburger being about a third of our product mix historically. You can kind of get an idea from that perspective. That has a pretty significant impact on us.

Martha Shelton - Jefferies & Co.

Insofar as your contract situation for beef, for ground beef, is that something that you all talk about?

Kerrii Anderson

Yes, Martha, from that perspective, we've talked a lot about it. The way our pricing for beef works, and this is consistent with the way it has been for the last couple of years, is we actually get quarterly pricing because we use fresh ground beef. We can't hedge or lock in long-term contracts, but we do get pricing that is generally a quarter lag for us. In other words, the pricing we had in the fourth quarter will be dependent upon a formula that is determined by the market in the third quarter. So, that's most of the information I think we'd normally share with you on a contract perspective.

Martha Shelton - Jefferies & Co.

Got it. Then, are they are several suppliers or is it just one or two that you're looking towards?

Kerrii Anderson

Yes, we try to provide a choice of suppliers, three or four or five key suppliers, just because you want to make sure you keep people competitive. There are certain plants that are located in areas that make more sense to utilize from a freight perspective.

Martha Shelton - Jefferies & Co.

Got it. Thank you very much.

Operator

Your next question comes from Rachael Rothman - Merrill Lynch.

Rachael Rothman - Merrill Lynch

Can you give us an update on what the appetite has been for the remodels once you guys launch the franchisee incentive program?

Dave Near

Rachel, this is Dave. We haven't launched it yet; we've targeted a November 1 date to come out to introduce it and come out with the specifics and details regarding it. But we've had a lot of excitement in the franchise community in regard to it. I think they are anxiously awaiting what the standards and what the details are around that.

Kerrii Anderson

Right, and we will be sharing that detail with our franchisees on November 1. They will have a clear understanding of what they need to do to qualify for getting a $25,000 remodel incentive.

Rachael Rothman - Merrill Lynch

Could you give some sense for how many units you would target annually?

Dave Near

I don't think we have a target at this point. I mean, I think we will just have to wait and see and see what the reaction is to the incentive. But I don't think, at this time, we can give you an estimate as to what that would be.

Rachael Rothman - Merrill Lynch

Okay. Then on the $100 million in savings in G&A, I know there are a bunch of moving parts. Can you kind of give us an update? Is that still $100 million? Is that still appropriate, or is a portion of that going to go away because of Baja Fresh and a portion of it maybe goes away because of higher bonus payments or is that what we should be looking for?

Kerrii Anderson

I will let Brendan walk you through that because I know you might have come in late on the call but he actually did kind of walk us through that. I don't know, Brendan.

Brendan Foley

It was announced at the analyst meeting, there's about $20 million of that that relates to developing brands. Then I don't know if you were part of the call but offsetting that a little bit are some inflationary increases that are going to happen from 2005-2007 as we walked through that reconciliation. Again, the $100 million is based off of the 2006 budget that the Company has.

Rachael Rothman - Merrill Lynch

Okay. The bonuses are already factored into that? The higher bonus level?

Brendan Foley

Yes. Again, those are savings off of the 2006 budget.

Rachael Rothman - Merrill Lynch

Okay, thank you.

Kerrii Anderson

Thanks, Rachel, and hopefully the reconciliation was helpful. I know it was important to try to get some clarity to that and we appreciate your inquiry.

Operator

Your next question comes from David Palmer - UBS.

David Palmer - UBS

Thanks for that reconciliation between '05 and '07. That explanation which of course compares your profitability against yourselves two years ago, it definitely seems to make sense that you're not egregiously lowballing here. But I'm taking a step back again and I'm thinking, even if I bridge up to a pretty good margin increase in your company stores, you're operating margin is still going to something like a 7% margin in '07 on EBIT. That looks still well below peers.

I'm wondering if you've thought about it that way, even after making some significant progress halfway, two-thirds of the way there and you're still 400, 500, 600 basis points behind peers when you're having pretty good sales per unit. Have you thought about it in that respect?

Kerrii Anderson

I think, David, there's no question we have opportunity to improve. What we are fighting here is a situation which for two years we've had negative transactions and negative sales and increased commodity costs. So while our peers, God bless McDonald's, have been putting up 9s and 7s and 10s, we were negative. So from that perspective, you're exactly right; we have a lot of work to do and a lot of opportunity, and we have to continue to do it in all of the areas.

When we talk about sales, we have to have new products; we've got to have better menu management; we've got to bring out products at lower food costs to help our food costs get down. I mean, all of the things we chatted about continue to bode well for the opportunities for us to improve the results.

Dave Near

Yes. Just to tag on that, David, I think as we've talked about, we still feel like when we first announced the 500 basis points that we were going after, we are still, like you said, we are about halfway there. Once we can get another 250 or 300, we will then evaluate where we are at and continue to make improvements to see if we can go further.

David Palmer - UBS

Thanks. I would second John Glass' motion for company restaurant margin disclosure. That would be fantastic. Thanks very much.

Kerrii Anderson

We would have to acknowledge that we are evolving as a brand, you know, in the sense that we are now Wendy's and we don't have Tim's and we don't have some of these other things, so we will continue to review what is best disclosure for everybody.

Operator

Your next question comes from Andrew Barish - Banc of America Securities.

Andrew Barish - Banc of America Securities

It's good to be talking about the business again. A couple of quick questions on that front for Dave and Ian. If you can sort of address what you think the best opportunities or the area you're going after most, first from ops?

Secondly on the marketing, it looks like some of the language and things you're talking about is moving the marketing much younger to the kind of core male heavy fast-food user. Does that risk alienating some of the broad audience you've historically attracted at Wendy's? Ian, if you can touch on that front.

Dave Near

You know, Andrew, I think the big thing from an operations perspective is what we are focused on right now is really returning our focus as an organization back to the customer, which we really haven't been focused on as much as we've needed to be over the past couple of years. There are several things we're working on. The first thing is we're really going back and trying to motivate and inspire our folks to get back in front of the customer and run the stores the right way. We are looking at operational efficiencies, everything from how we operate our stores from a systems perspective, how our managers manage the stores. We're looking at the store reinvestment piece obviously, which I think is very important as we move forward.

We are continuing to look at service times and accuracy and courtesy and all those programs that we were very dominant in, in the late '90s and turn of the century. We need to get back and really get focused on the basics again to make sure we're driving the things that we need to, to improve the business.

Kerrii Anderson

I might just add to Dave's point on operations. I mean, the inspection services which we have said help us really calibrate where our restaurants are operating -- I think Dave, you said you've already done 260 or 270 at this point in time, of these inspections.

Dave Near

We have. You know, we hired 31 QSC managers that will do one SOE and SFE in all company stores and franchised stores in 2007. We have done a little over 260 audits so far this year, and it's really helping us recalibrate where we are from an operational perspective, which is the first thing that we need to do to level-set as to where we truly are and then we can start to make progress going forward.

But that so far has been very well received in our company and franchise stores, and I think we'll start to see some real improvement from an operational perspective as a result of that.

Kerrii Anderson

Ian, you might comment on the marketing.

Ian Rowden

We have been, for the last year or so and will continue to restage our brand with a younger consumer target. We've been very, I think, transparent in our conversations on that and the need for that. We know and we've communicated that we lost transactions with that audience in recent years, and a part of our strategy is to restage ourselves with greater currency and greater relevance so that we can bring transactions amongst that consumer group back into our business.

As Kerrii said, in the third quarter results, you can see our transaction growth that we've had, and we are seeing the merits of the shift we're making begin to pay off for us as we do restage ourselves.

But I will tell you we're doing that in a manner that isn't designed to alienate us from the broader consumer group. And in fact, our menu-management process and the way we've outlined our strategy, thinking about focusing on our core hamburger business and the core Gen N target by ensuring that we have a product portfolio and a menu-management process that has a broader menu set, that is built out of the quality and freshness that makes our brand unique and different is key to what is driving Dave and I as we look at the business going forward.

So our intention is to continue to focus, to make sure that we restage ourselves but that we do that in a way that continues to provide choice and variety across a broad range of quality products to a broad consumer group.

Andrew Barish - Banc of America Securities

Thank you.

Operator

Your next question comes from Larry Miller - RBC.

Larry Miller - RBC Capital Markets

It sounded like your response to an earlier question about recapturing or closing the gap on the margins between you and your peers, there might have been a structural difference. Aside from the 1%, it looks like you're going to give away in franchise incentives. Is that correct? I mean, is it an issue of real estate ownership or something like that, or can you really narrow that gap over time?

Kerrii Anderson

I think we absolutely can narrow the gap over time. I mean, one of the things we talked about earlier here today was breakfast. Our average unit volumes compared to at least McDonald's, we are significantly less. They are at 1.9 million; we are 1.350 million. There's a lot of margin that comes to the bottom line when you grow top line sales.

Along with that is we're not in the breakfast business and we know it is the lowest food cost. So again, you know, if you can position yourself to be successful in that business, you are lowering your food cost while you're growing your top line and leveraging that building. So I think it's a significant improvement.

So there are some real differences today from us and our competitors. I think we're really about the only one in QSR that's not in the breakfast industry, you know, or in that day part. We talked about the fact that it's a $30 billion business and it's 15% of QSR revenues, and we're not there. So I think we can continue to leverage what we have and improve as well as our new menu-management. We've not been so good about taking things off the menu when they weren't working. So I don't know if, Dave, you or Ian want to comment on that.

Dave Near

From a menu-management perspective, and I think we've talked a lot about how we need to get a lot more involved in the drinks and desserts segment, which we're working on as we speak, and I think that will start to make a big difference from a margin perspective as we continue to develop and evolve our menu.

Larry Miller - RBC Capital Markets

The beverages was in the guidance though, I believe, isn't that correct?

Kerrii Anderson

Right. I mean, we gave overall same-store sales guidance of 3% to 4% if we can continue to drive beverages. I think we all have upside. We want to be reasonable but conservative.

Larry Miller - RBC Capital Markets

Yes, I was just trying to reconcile what Brendan was saying, which again I appreciate the reconciliation with the fact that you guys are significantly below your peer group and maybe it is just understated. I just don't understand that, that's all. Thanks.

Kerrii Anderson

Some of it, to your point, actually, Larry, might be some people do hold their real estate. Certainly McDonald's does and leases it to their franchisees, and as they improve sales, they therefore improve rent royalty. So that is not a model we've of course followed. We also recognize that, to some degree, we are more heavily company-store operated. That's one of the things that we are focusing on getting down, because sometimes franchisees can actually run stores more efficiently and effectively than we can. So those are all elements I think that drive upside for us.

Larry Miller - RBC Capital Markets

Yes, that might be the difference between you guys and Sonic, who have a higher margin and a lower volume.

Kerrii Anderson

You've got it.

Operator

Your next question comes from Glen Petraglia - Citigroup.

Glen Petraglia - Citigroup

Actually, I have no further questions. Thanks.

Operator

Your next question comes from Steven Kron - Goldman Sachs.

Steven Kron - Goldman Sachs

Thanks. I actually just had a couple. I wanted to follow up on the last topic of product innovation. Ian, at the analyst day a few weeks ago, you talked about new product innovation process and using outside consultants to take a look at that. I think you made the comment that you have more product in the pipeline than you have testing capabilities for.

But recognizing you went through a period not too long ago with some innovation or lack of new product news, I guess as we look out to '07, do you guys have a targeted platform launch goal or targeted new product introduction goal? How are you going to ensure that you have the new product news necessary to maintain those comps?

Just on a related topic, more in the near term, just the language in your press release talking about positive same-store sales in the fourth quarter but recognizing that you are lapping some more difficult things, giving that we are most of the way through October, is there any subtle message you're trying to send there? Have you seen comps soften in October? Thanks.

Kerrii Anderson

I will just address the comp issue real quick. As you might guess, Steven, we're not going to give guidance or give any kind of indication on October sales at this point. What I think we're trying to bring to everyone's attention is the fact that, if you look at our monthly comps last year in the month in the fourth quarter, we came off of the third quarter being like negative 5 got basically, and then in October we experienced negative 2.1 last year, and I think for November negative 2.4. So all we're trying to acknowledge there is that the comps were going up again. While they are negative, they actually were the strongest negatives we had last year. So that's just what we're trying to acknowledge, that's all. We will of course share with you same-store sales in around November 8 or 9.

Ian Rowden

Steven, just to answer your question on the product pipeline, you're absolutely right. We talked about how we had, for a number of years, not had sufficient new product innovation in our pipeline, that we fell behind. It was another one of the reasons why our brand fell out of step with consumers in some regards.

We have a process in place. I talked to you about that, that some folks helped design an innovation process with us which we are deep into the process of implementing and generating new products from.

This year, we will have introduced, I think, somewhere around 13 to 16 new product ideas to our business. We see that number abating for the obvious reasons, but we know that new product innovation is important to driving new news and traffic in our business.

So I see a range of six to eight products a year going forward. We may do a little more than that next year, but we see a range like that that's sustainable and replicable and that the process will generate the news for us that we expect will support the direction and the strategy we have in place and the results accordingly.

Steven Kron - Goldman Sachs

Great, thanks.

John Barker

We will take one more question and then wrap up the call for today.

Operator

That was the last question, sir.

John Barker

We thank you all for listening in on the conference today and webcast. If you have follow-up questions, please reach out to myself or Dave Poplar. Thanks.

Kerrii Anderson

Thank you so much.

Dave Near

Thanks.

Operator

This concludes today's conference. You may now disconnect.

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Source: Wendy's Q3 2006 Earnings Call Transcript
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