Denny's CEO Discusses Q1 2014 Results - Earnings Call Transcript

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 |  About: Denny's Corporation (DENN)
by: SA Transcripts

Operator

Good day, and welcome to the Denny's Corporation First Quarter 2014 Earnings Conference Call. Please note, today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Whit Kincaid, Senior Director of Investor Relations. Please go ahead, sir.

Whit Kincaid

Thank you, Joshua. Good afternoon and thank you for joining us for Denny's first quarter 2014 earnings conference call. This call is being broadcast simultaneously over the Internet.

With me today from management are John Miller, Denny's President and Chief Executive Officer; and Mark Wolfinger, Denny's Executive Vice President, Chief Administrative Officer and Chief Financial Officer. John will begin today's call with his introductory comments. After that, Mark will provide a financial review of our first quarter results. I will conclude the call with commentary on Denny's full year guidance for 2014.

As a reminder our 10-Q we will be filed later today.

Before we begin, let me remind you that in accordance with the Safe Harbor provisions of 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 current trends and any outlook on earnings provided on this call. Such statements are subject to risks, uncertainties and other factor 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 most recent Annual Report on Form 10-K for the year ended December 25, 2013, and in any subsequent quarterly reports on Form 10-Q.

With that, I will now turn the call over to John Miller, Denny's President and CEO.

John Miller

Well thank you Whit and good afternoon everybody. We are pleased to start-off the year with another quarter of system-wide same-store sales growth highlighted by our strongest quarter of same-store sales at company restaurants in over seven years. The strong performance of our company restaurants was driven by our newly launched Heritage remodel program w helped our company restaurants outperform the continuing momentum of our franchise locations. Enhancements and investments we’re making in our restaurant atmosphere reflecting more contemporary diner feel. This further reinforces our Americas diner positioning and strengthens the existing improvements we have made in our food and service. We’re focused on differentiating Denny's in a crowded marketplace by successfully executing our key objectives to further strengthen our position as America’s diner in 2014 and beyond, achieving consistent positive same-store sales performance through continued improvements in our food, service and atmosphere is one of our key objectives.

We have ongoing initiatives in place focused on improving all three of these critical elements. Of the 47 remodels completed in this quarter, 29 restaurants incorporated the Heritage image, including the all 16 company restaurants. The great news is that we are achieving positive same-store guest traffic at company locations. This is evidence of our success with the Heritage image upgrades, while we’re still early in the revitalization process. We look forward with optimism to the opportunities that remain in front of us.

Our franchisees have a seven year remodel requirement, which means approximately 70% of the system will be remodeled over the next five years. The Company will continue to lead the way by completing approximately 40 remodels this year, with the majority completed in the first half of the year. We also continue to make improvements to our food through both, menu and promotional changes. At the beginning of this year we launched redesigned menus, which further emphasize our diner heritage while decreasing our operational complexity and enhancing our breakfast-all-day and beyond breakfast offerings. Our first quarter limited-time-only menu featured the Build Your Own Skillet offering. In addition the menu highlighted our Fit Fare Build Your Own Grand Slam and the 2-4-6-8 everyday Value Menu.

Guests responded well to our Skillet offering and we were especially pleased to see our guests taking advantage of a high number of our add-on opportunities. In early April, we refreshed the limited-time-only menu with a Build Your Own French Toast offering, this menu also highlights the $4 Baja Quesadilla Burger on the 2-4-6-8 everyday Value Menu and a selection of avocado favorites.

Like the first quarter’s menu, there were numerous add-on opportunities in addition to showcasing our new coffee and milkshake flavors. These changes helped to increase our guest check average in the first quarter. We continue to balance compelling limited-time-only product offerings with our highly effective 2-4-6-8 Value Menu, which mixes in the 19% to 21% range. Over 20% of our guests say they visit Denny's specifically because of the 2-4-6-8 Value Menu and we have an even higher percentage for this menu from our Hispanic guests.

It is an advantage that we are proud to have as we fight for share in this highly competitive industry. This proven platform will continue to be a critical part of our strategy to increase guest counts, visit frequency and drive profitable traffic into our restaurants. We’ve worked closely with our franchisees to explore ways to leverage the high brand awareness of our 2-4-6-8 Value Menu, balancing its traffic driving appeal with the desire to grow profitability. As a result of our initial efforts we made some modifications to the 2-4-6-8 line-up with the clear objective of maximizing unit-level profitability. In April, we primarily focused on the $8 products by removing the free beverages with the exception of the Grand Slam Slugger. We also replaced a $6 endless soup and salad with the eggs in a basket, which is one of the successful products from our Hobbit movie promotions.

We expect these changes to improve the food cost percentage of the 2-4-6-8 Value Menu. We will continue to work closely with our franchisees in identifying opportunities to reinforce the traffic and frequency driving aspects of the 2-4-6-8 Value Menu, while continuing to look for ways to improve food cost margins, flow through and ultimately store level profits. Ultimately our guests will guide us in our ongoing efforts to improve our menus to meet the needs of an ever changing marketplace. In summary, our revitalization efforts to improve our food, service and atmosphere put us further down the path to achieving consistent positive same-store guest traffic and the recovery of lost transactions over recent years.

Another key objective is to increase the growth of the Denny’s brand, both domestically and internationally through traditional and non-traditional locations. In the first quarter, our franchisees opened four new restaurants including one international location. We expect to open between 45 and 50 franchise restaurants this year. Our newest international restaurant is located in Eastern Canada and opened by our largest international franchisee, Dencan restaurants, who is based in Vancouver, Canada. Dencan currently has over 50 Denny’s restaurants primarily in Western Canada with plans underway to continue their expansion. We continue to focus our efforts on finding the right, well capitalized franchisees to build our international pipeline and increase our global share. Our goal is to build on our momentum resulting in a growing net number of openings each year.

Our development pipeline currently stands at around 170 unopened restaurants, including almost 70 international locations. Interest in Denny’s from new franchisees continues to grow. Denny’s is ranked 8th in Entrepreneur’s 35th Annual Franchise 500 this year, marking the fourth in a row we have been ranked in the top-10. In addition to growing same-store sales and Denny’s net locations, we remain focused on our objective to grow profitability and free cash flow with a disciplined approach to operating cost, corporate G&A, expenses and capital allocation. During the first quarter, we generated almost 7 million in free cash flow after our investment in company remodels.

For the franchise focused business that generates significant free cash flow, we will balance our capital allocation between making investments to grow and to strengthen the Denny’s brand and returning cash to our shareholders. Given that we have a meaningful base of company restaurants, we will reinvest in those restaurants through our Heritage remodel program with a goal of having over 40% of the company restaurants remodeled by the end of the year. While these investments continue, we remain committed to growing earnings per share through our franchise focused business, which provides financial stability and flexibility. With the success of our America’s diner revitalization resonating with our guest, both our franchisees and our team continue to be energized and excited about the future of Denny’s.

With that, I’ll turn the call over to Mark Wolfinger, Denny’s Chief Financial Officer and Chief Administrative Officer.

Mark Wolfinger

Thank you, John and good afternoon everyone. Our first quarter results were highlighted by increasing domestic system-wide same-store sales by 1.8%, with company same-store sales growing by 3.2%, completing an additional 16 Heritage remodels of the company restaurants and generating $6.7 million of free cash flow after capital expenditures. During the quarter, Denny’s opened four franchise restaurants and closed eight system-wide restaurants, including two company restaurants. One is a temporary closure of our Las Vegas Casino Royale location and the other is the permanent closure of one of our restaurants located in Honolulu. As a result, we entered the quarter with 161 company restaurants and 1,535 franchise restaurants, bringing the total restaurant count of 1696.

Denny’s total operating revenue including company restaurant sales and franchise and license revenue decreased $2.6 million to $111.9 million, driven by decreases in both company restaurant sales and franchise and license revenue. Same-store sales of domestic franchise restaurants increased 1.5%, primarily due to an increase in same-store guest check average given by both higher menu pricing and favorable product mix. Franchise and license revenue of $32.6 million decreased to $844,000, primarily due to a $1.1 million decrease in occupancy revenue, which was partially offset by a $454,000 increase in royalty revenues resulting from 10 additional equivalent franchise restaurants.

Franchise operating margin of $21.9 million decreased $139,000, primarily due to a $550,000 decrease in occupancy margin offset by the increase in royalties. Franchise operating margin as a percentage of franchise and license revenue increased 1.3 percentage points to 67.2% compared with the prior year quarter. This increase was due to both the increase in royalties and the decrease in occupancy dollar margin.

Same-store sales at company restaurants increased 3.2% due to both an increase in same-store guest check average and an increase in same-store guest traffic. The increase in same-store guest check average was driven by both higher menu pricing and favorable product mix, so the company restaurants decreased $1.7 million primarily due to five fewer equivalent company restaurants which was partially offset by the increase in same-store sales. First quarter sales were unfavorably impacted by a combined $2.7 million from the temporary closure of our Las Vegas restaurant and permanent closure of our Honolulu restaurant.

In addition, sales were unfavorably impacted by the refranchising of two restaurants in the third quarter of last year and the number of Heritage remodels completed during the quarter. As a reminder, our remodel restaurants typically closed for 5 to 7 days during the traditional training takes place.

Company restaurant operating margin of $9.1 million or 11.5% of company restaurant sales decreased $2.8 million or 3.2 percentage points compared to the prior year quarter. The decrease in Company margin included a $700,000 or 0.6 percentage point impact from the temporary closure of our Las Vegas Casino Royale restaurant. Excluding this impact, the decrease was primarily driven by increases in payroll and benefits cost and other operating costs. The increase in payroll and benefits cost as a percentage of restaurant sales was primarily driven a 1.4 percentage point increase in workers’ compensation cost and increase in group insurance benefits cost and higher incentive compensation.

The increase in workers’ compensation as due to $400,000 in unfavorable claims development during the current year period compared to $500,000 unfavorable claims development in the prior year quarter. The increase in other operating cost was primarily driven by higher utilities and repair and maintenance costs compared to the prior year quarter.

Total general and administrative expenses decreased $1 million from the prior year quarter, primarily due to reductions in payroll and benefits cost and incentive and deferred compensation expense. Interest expense for the fourth quarter decreased by $478,000 to $2.3 million resulting from an $11.4 million reduction in total debt over the last 12 months and lower interest rates under our refinanced credit facility.

In the first quarter our provision for income tax was $2.6 million, reflecting a 28.9% effective income tax rate. This is lower than our guidance range of 34% to 38% due to an $800,000 income tax benefit resulting from certain state jobs tax credits and other income tax adjustments relating to prior years. Due to the use of net operating loss and income tax credit carry forwards, we paid $820,000 in cash taxes during the quarter. At the end of the first quarter, the deferred tax asset on our balance sheet was $49.5 million. We will continue to utilize additional net operating loss and income tax credit carry forwards to eliminate the majority of our cash taxes for the next few years.

In the first quarter free cash flow after capital spending of $6.7 million decreased $5.9 million compared to the prior year quarter, primarily due to a $3.9 million increase in cash capital expenditures. We spent $6.9 million in capital expenditures in the first quarter, which included completing 16 Heritage remodels at company restaurants. In the first quarter, we allocated $9.1 million to repurchase 1.4 million shares. As of April 25th, we had repurchased a total of 18.1 million shares since we started our share repurchases program in November 2010. As a result, we have a total of 6.9 million shares authorized and remaining in our ongoing share repurchase program.

We ended the first quarter with $174.7 million in total debt outstanding with a total debt to adjusted EBITDA ratio of 2.3 times. As John mentioned, we will continue to use our free cash flow after capital expenditures, primarily towards share repurchases, while also making investments to grow and strengthen the brand.

That wraps-up my review of our first quarter results. I will now turn the call over to Whit, who will comment on our annual guidance for 2014.

Whit Kincaid

Thank you, Mark and good afternoon everyone. I would like to take just a few minutes to expand upon the business outlook section in today’s press release. The following estimates for full year 2014 are based on first quarter results and management’s expectations at this time. We now expect full year company same-store sales to increase between 2% and 3% compared to our initial guidance range of 1.5% to 2.5%. We continue to anticipate that franchise same-store sales will increase between 1% and 2% for the year. We probably anticipate that commodity cost inflation will be between 1% and 2% this year, which is slightly higher than our previous expectations of flat to 1%. We’re currently locked into approximately 70% of our need for the year.

We continue to expect our full year company margin percentage to range between 13.5% and 14%. We expect the second half of the year to be stronger than the first half of the year, primarily due to the timing of our remodeling in company restaurants. We continue to expect our franchise margin percentage to be between 66% and 67%. In addition, we expect our occupancy dollar margin to be approximately $1 million lower than 2013. The decrease is driven by both a decrease in the number of subleased locations in 2013 and 2014 and the decrease in the number of subleases identified as capital leases. We continue to expect our annual affective income tax rate to be between 34% and 38% with tax taxes to be between $3.5 million and $4.5 million in 2014. This is slightly higher than our previous guidance of $3 million to $4 million.

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

Thank you, sir. (Operator Instructions) Our first question will come from Will Slabaugh with Stephens.

Will Slabaugh - Stephens

Excellent quarter, I wanted to ask you a little bit more about the cost side of the Company, sort of obviously the sales came in really strong there typically is there any reason to believe that we’ll see a continuation of some of these higher insurance cost or other claims that we saw? And then also just a little clarification on the incentive comp, I assume that was attributed to store and regional managers or was that the corporate level or where did that occur?

Mark Wolfinger

Well it’s Mark, how are you?

Will Slabaugh - Stephens

Doing well, thank you.

Mark Wolfinger

So very quickly on the workers’ comp, as we described before obviously a part of that is an issue relating to historical movement and outstanding claims and cases outstanding. I think the key overall focal point from a margin standpoint on the company side should be back to Whit’s comments on guidance and expectation for the second half of the year, I think that’s absolutely critical. And then important from the standpoint of I think what you talked about improvement in the second half of the year on the margin side. As it relates to the incentive comp, it would be basically at the store level and so yes it would basically be at the RM and GM level for store-base within the four walls as we’ve said.

Will Slabaugh - Stephens

Got you. And then also I wanted to ask you about the 2-4-6-8 Menu and I know that John you mentioned a lot of -- a few changes at least going on there in terms of sort of rejiggering how that menu looks or feels. Can you go into a little more detail about that? And then also mentioned the stat as far as the percentage of customers that come in just specifically for that 2-4-6-8, could you repeat that I didn’t get that down?

John Miller

I sure can, I think in my opening comments we were talking about 19% a little bit higher for Hispanic consumers who have a bit of higher preference for that when they bring larger groups. There is a higher percentage that come for the Value Menu, so about 20% it moves up and down as you know well we report each quarter where it’s been historically. So about over 20% or same they come for it and a little under 20% are actually buying at once they get inside the building because it’s not taken price since we rolled it out and we continue to evolve it and tweak it, some of the costs have moved up. So we did some value engineering exercises we took above 100 basis points annualized out of that menu and made that introduction recently.

And the biggest change is I think I highlighted one of those is to repeat there is an Endless Soup and Salad that has been traded for one of the Hobbit specials that we had during the last holiday season and that being a very popular dish, and a little bit friendlier on cost it substitutes it, and it keeps the viability of 2-4-6-8 really high. And then our $8 items we weren’t really getting credit for, but they included free beverage and so we just eliminated that except on the Grand Slam Slugger which was one of the more popular of our $8 items. So we kept it there again just to keep the satisfied guests coming back.

Will Slabaugh - Stephens

Thank you.

Operator

Thank you. And our next question comes from Michael Gallo with C.L. King.

Michael Gallo - C.L. King & Associates

Hi. Good afternoon. Congratulations on a good quarter. My question is on the GAAP that’s developed over the last couple of quarters between company unit and franchise same-store sales. Obviously probably the majority of that is attributable to the impact of the Heritage program, but I was wondering what you’re seeing in terms of franchise interest as the franchisees started to see some of this significantly improved performance in company store, same-store sales and traffic as a result of the Heritage remodel obviously the pretty old asset base there that hasn’t been a whole lot of significant refranchise -- remodeling activity over the last four or five years. And then also whether you might provide any incentive plans to try to accelerate the potential reimaging or rollout of the Heritage? Thank you.

John Miller

Yes, so those are some great questions and there is a number of things put in there, let’s just talk about the program itself. We completed 47 remodels in the first quarter, 29 Heritage remodels and in all 16 -- I am sorry all 16 company and 31 franchise stores were remodeled. So because that 31 as a percentage of the total franchise base compared to the 16 plus those we completed the tailwind fourth quarter of last year. So combined we have a higher percentage base which creates a little bit of a separation. We also have 36% or a little bit of north of the third of our locations in California where you’re seeing more of the growth in transactions and so there is an economic recovery. So it’s created a bit of a tailwind for the Company’s performance over franchise, but our franchisees are doing a great job adopting, implementing and rolling out this program as one would expect.

Overall the whole system is about 25% older image, so the desire to move quickly through those is a priority for the Company and then for our franchisees is what we’ve been focusing on and we’ve been able to take that part of our portfolio folks on the older ones first which also perhaps in the range of performance we have -- we’re still sort of mid single-digit reporting on our overall remodel program but it is a range and so with the priority for company on the older schemes it creates a little bit of a separation in our performance there as well. So I think that answers your question. We think clearly with about a quarter of the restaurants being in that older scheme it’s the priority to move our image forward the Company is putting its best foot forward and I would say our franchisees small and large are following suit as their do and as the opportunity presents itself.

Michael Gallo - C.L. King & Associates

And John just a follow-up to that I was wondering as you see the Heritage image is much more contemporary. I was wondering if that drives the higher incidence of lunch and dinner and that’s where you see the biggest pickup whether the pickup is in same-store sales pretty even throughout the day? Thank you.

John Miller

And most of the lift is traffic which is pretty consistent with normal remodel impact the consumers are curious and/or if they’ve been a frequent consumer and they create a little bit higher frequency for us the most dramatic change has been at dinner traffic so your instincts are right on that here on the question.

Michael Gallo - C.L. King & Associates

Great, thank you.

Operator

And our next question comes from Tony Brenner with ROTH Capital Partners.

Tony Brenner - ROTH Capital Partners

Thank you. Can you breakout for company stores the increase in guest traffic versus average ticket and related to that I wonder if there was a sharp pick up in March compared to January-February or just was it sort of even throughout the quarter?

John Miller

Even throughout the quarter, yes. So, it’s hard to answer it Tony on that one because of the disparity between weather patterns across the country, so clearly where the weather was toughest there it was the toughest period for us but that varies by what week it was and in what part of the country. And I’m sorry back to the other question a little bit about traffic.

Tony Brenner - ROTH Capital Partners

So wait a minute, assuming the worst weather was in January and February, I mean are you saying there was a bigger gain in March?

John Miller

No clearly March performed the bad weather months, yes.

Tony Brenner - ROTH Capital Partners

Okay. And then just traffic?

John Miller

Yes, so on traffic, the company positive in the quarter was going over the easiest quarter of last year, right. But your question is specifically about traffic we were up about 0.4 in the quarter on company traffic.

Tony Brenner - ROTH Capital Partners

Okay. And then you alluded to this in the previous question, I wonder if you could quantify what sort of sales lift you’re getting in the remodeled stores and why aren’t older remodeled Heritage stores out of curiosity?

John Miller

Yes. So if you had a long permitting process then you’d probably got a permit we wouldn’t change the scheme on you, but basically everything going now if it’s of an older scheme it’s going to the latest scheme which is the Heritage remodel so effectively it’s headed that direction at this point.

Tony Brenner - ROTH Capital Partners

And the lift from the remodeled stores versus the base in terms of same-store sales?

John Miller

Yes, we continue to have a range of performance on these depending on if they are older scheme, newer scheme and the average of the range is still mid single-digit.

Tony Brenner - ROTH Capital Partners

Mid single-digit sales increase or the difference between what their base is doing and what the remodels are doing?

John Miller

Mid single-digit increase.

Tony Brenner - ROTH Capital Partners

Okay, thank you.

Operator

Thank you. And our next question comes from Mark Smith with Feltl and Company.

Mark Smith - Feltl and Company

Hi. Good afternoon guys. Most of these have been hit, but I did want to check just on average ticket and any pushback in the January’s menu price increase that you took I want to see if it was less than 1%?

John Miller

Yes, given the quarterly results we haven’t seen all the competitive numbers come in, but I would say that it was in that range sort of expected range in that modest pricing range and so the consumer I think responded more favorably that that when you take aggressive pricing. We do have the California wage, ACA, other impact, 14 states taking with wage initiatives, California being one of the more aggressive with the dollar increase in July, so we expect to take more price then as well. On how the consumer responds to that, you can’t know for sure, but again we’re trying to keep it in the most modest range possible which is consistent with our strategy over the past few years.

Mark Smith - Feltl and Company

And that was really my next question, I was just looking at commodity price increases, labor expense, all the different issues that you face, how much opportunity you have to pick above and beyond then what you’ve historically done here in July or whenever this next menu kind of rolls out?

John Miller

You know it’s -- we engage, we go through quite a process comparing competitive prices, price elasticity, studies of sorts, and we’re highly sensitive to it, because if you take it too faster there’s no question of a traffic consequence. That said, we’re now sort of baking in that positive traffic range, we have strong performance in California, Texas, Arizona and New Mexico. Florida has turned to the bright side, a lots of sun shining on the state there and the Denny’s performance in that state, so we see actually the consumer behaving a little differently. We have got the 2-4-6-8 Value Menu, thank you very much. But the add-on sales, and how consumers are responding to it, our Skillet promotion it is sort of giving a tale of a different story that if I want what I want and we’re going to pay for it if the value is there and how it’s merchandized and how it’s offered. So we’re starting to see less reluctance, and absolute prices as well there, there is no question value is still a big part of winning in the marketplace today.

Mark Smith - Feltl and Company

Last question from me, can you just give us a little more of an update on international development, what you have assigned to-date, and where you’re seeing opportunities and I guess how pleased you are with where you stand today on international?

John Miller

Sure, well we’ve got as mentioned in our notes about 170 locations in the pipeline, 100ish or so for domestic, 70 in the international pipeline. Our international franchisees are growing at or ahead of their development agreement schedules, which is a good sign, we’re pleased with returns and the demand there shows the competent inspection of our concept. Our largest franchisee has really stepped up for expansion recently, our Canadian franchisee with more growth and then Dominican Republic is new, the Central American franchises are, we all know they were off to a good start a few years ago but already on their fourth restaurant with continuing development plans, our first restaurant in South America opened earlier in the year performing quite well, so we think we’ll see more of that. And then of course we have the 30 unit deal we signed in Middle East those restaurants is expected to open over the next two years. Not a location, there’s not a restaurant announcement yet we have the first restaurant but to begin I think all this represents momentum overall for international development for Denny’s.

Mark Smith - Feltl and Company

Great, thank you.

Operator

And it appears there are no further questions at this time. I would like to turn the conference back over to our speakers’ for any additional or closing remarks.

John Miller

Thank you, Joshua. I’d like to thank everyone for joining us on today’s call. We look forward to our next earnings conference call to discuss our second quarter 2014 results in late July. Thank you and have a great evening.

Operator

This concludes today’s conference. We appreciate your participation.

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