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Sonic Corporation (NASDAQ:SONC)

Q3 2014 Earnings Conference Call

June 23, 2014 5:00 PM ET

Executives

Claudia San Pedro - VP of IR, Communications and Treasurer

Cliff Hudson - Chairman, CEO and President

Steve Vaughan - CFO and EVP

Analysts

Joseph Buckley - Bank of America Merrill Lynch

Mike Tamus - Oppenheimer & Company

Nicole Miller - Piper Jaffray

John Glass - Morgan Stanley

Jeffrey Bernstein - Barclays Capital

Will Slabaugh - Stephens

Matt DiFrisco - The Buckingham Research Group

Michael Gallo - CL King & Associates

Keith Siegner - UBS

Operator

Good afternoon and thank you for standing-by. Welcome to today's Sonic Corporation Third Quarter 2014 Earnings Conference Call. At this time all participants are in a listen-only mode. Following the formal remarks, we will conduct a question-and-answer session and instructions will be provided at that time for you to queue up for questions. As a reminder, today's conference is being recorded.

And now I would like to turn the conference over to Ms. Claudia San Pedro, Vice President of Investor Relations and Communications and Treasurer. Please go ahead.

Claudia San Pedro

Good afternoon, everyone. We are pleased to host this conference call regarding results issued this afternoon for the fiscal third quarter of 2014, which ended on May 31, 2014.

Before we begin, I would like to remind everyone that comments made during this conference call that are not based on historical facts are forward-looking statements. These statements are made in reliance on the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and are subject to uncertainties and risks. It should be noted that the Company's future results may differ materially from those anticipated and discussed in the forward-looking statements. Some of the factors that could cause or contribute to such differences have been described in the news release issued this afternoon and the Company's Annual Report on Form 10-K, quarterly reports on Form 10-Q and in other filings with the Securities and Exchange Commission. We refer you to these sources for more information.

Lastly, I would like to point out that remarks made during this conference call are based on time-sensitive information that is accurate only as of today's date, June 23, 2014. The archived replay of this conference call webcast will be available through July 23, 2014. This call is the property of Sonic Corp. Any distribution, transmission, broadcast or a rebroadcast of this call in any form without the expressed written consent of the Company is prohibited. We have posted our fiscal third quarter earnings slide show presentation on the Investors section of our Web site for your review, both during this conference call and after the conference call for up to 30 days. We have scheduled this call, which includes the Q&A portion, to last 1 hour. If we have not gotten to your question within that hour time slot, please contact me at area code 405-225-4846, and I will make the appropriate arrangements to answer your questions.

With that out of the way, I'll turn the call over to Cliff Hudson, the Company’s CEO.

Cliff Hudson

Thank you, Claudia and thanks to all of you for being here with us or participating with us this afternoon. We had a very good quarter for the quarter ended May and as you can see from the slide on the screen, a 15% increase in earnings per share. As to the health of the brand, a nice 5.3% same-store sales increase for the quarter. We did open 10 new drive-ins on the quarter which is a nice step-up over a year ago, we’ll talk about that more later in the presentation. And we continued with the implementation of our point-of-sales system in all of our company drive-ins and we do now have it in place in all the company drive-ins as of the third quarter. And we’ll continue also with our POS program that many of you all know about it now, and we got half of our company drive-ins and we will complete it during this fourth fiscal quarter, this summer here in our company drive-ins.

Also on the quarter we bought back about $11 million of stock, of Sonic Corp. stock, and so a nice use of that excess cash. So we felt very good about that in the quarter, and we will talk in another element as well with the nice same-store sales, good improvement in operating margins as well for our own stores and certainly our operators who are experiencing that as well.

Now, the contributors to that growth, almost all of you have been following the Company for some period of time, and you know there are a number of contributors in this multilayer growth strategy we have. Starting with same-store sales, so a nice contribution of course, this quarter with a 5.3% same-store sales growth but it did contributed into the operating leverage and as we continue with these over time in the last several years with the same-store sales, and operating leverage growth, and average store profitability, it has increased the unit growth rate and as we have their unit growth rate also contributes to our ascending royalty rates on an enterprise-wide basis. And the combination of these of course, a very nice contribution to available free cash flow for use and enhancing shareholder value there, so this multilayered growth strategy are now really kicking in.

Many of you can probably remember a year or two ago we were saying, look we are getting the same-store sales, we’re getting this piece over time we will get this piece. And now we’re moving to the point where we’re getting each of these layers working nicely to a contribution to earnings per share growth rate, so a nice movement of our business. There are a series of things that contributed to the same-store sales, and this flywheel you see pictured here, the framework we’ve used for the discussion to this for a number of years, continues working pretty well. So let me kind of dive into each of these elements that have been driving the business.

First, in the marketing focus, you’ve heard us talk for the last couple of years in particular about good media efficiencies in ’13 and ’14 and we have in fiscal year and calendar year ’14 continued to get a benefit of those media efficiencies, a reallocation of the dollars in ’13, the full year benefit in ’14, the additional talent inside and outside the company with the utilization of those, so ’14 too has been very nice transition for our Company from a media efficiency standpoint. That combined with the creative campaign we have in place really has put us in a very good position to continue to promote our innovative and distinctive food products that really provide a nice foundation for the existing health of the business and the business ongoing. These of course also cut across the variety of day-parts some products individually do, some products focus on a specific day-part but the strategy between lines of products and cutting across day-parts have been very helpful for our business. This summer - focusing on the summer shakes as we have in the past but also the Slush Headquarters, focused on 25 flavors of slush, a combination of these are very strong for our business from both the sales and profitability standpoint.

So the comment I’d like to make there because one of the points of feedback we’ve gotten from some analysts and some stockholders over time is gee how long can you focus on limited time offers, your LTOs and get these kind of results, and one of the things perhaps we haven’t been as direct about in our promotions the last couple of years and more is not all of these promotions are LTOs, we are focusing on slush, we’ve had slush for years. We do have a flavor element here to drive that but our full expectation is when the summer is over and we’re not doing the same promotion we will just like with ice cream we’ll sell more slush than we were beforehand we’ll have the slush program in place as we have for 20 years almost and the effect of this will be we’ll have a sustained kind of a new level of sales or a new foundation for the business.

Same has been true with ice cream and its growth over the last several years, the same has been true for Entrées particularly chicken and I’ll talk more about that in few minutes. But it really has moved our business to a different foundation and maybe you see it depicted here a little better than with the prior slide that is that the lines of business that you see here the fountain with a variety of drinks, the slush included, chicken sales and it really is about a variety of chicken items and it was a very intentional approach several years ago. While the sales have grown from like 5% or 6% of sales to 9% plus now that is typically the time where we’ve grown our business nicely so as the system from an absolute standpoint we’ve roughly doubled the amount of chicken sales so it’s gone -- it’s been a very good effort on our part and not just an LTO on our part.

So you’ll continue to see this in terms of a variety of ways to focus on ice cream, you’ll see some different things in the coming months and how we will do that. The Slush Headquarters we’ll continue to focus on, Entrées we will and our belief is that by focusing on these foundational elements of the business sometimes in an LTO fashion, sometimes not we’ll continue to build the base of our business and with that be able to sustain it rather than simply being a single time promotion.

Now the POPS implementation you see depicted here we continue to focus on this. We expect very good results from this over the next several years. Right now it’s primarily in our company stores and it’s about half of those and as I said earlier this summer we will finish it in our company stores and then the fall begin offering it into markets where we have company stores to have the full brand effect in those markets and then roll it out in ’15, ’16 and we would hope to finish it ’16 into ’17. Initially the great thing about this thing connection with customers with a -- in a very targeted and personalized way 100% [inaudible] sale and then over time we are working now and will work -- continue to work on initiatives that will grow the use of this and in a very differentiated way much like our brand, work to increase traffic and check upfront but provide a personalized experience and use software and from a program standpoint on the POPS that we increase the targeted messaging over time and work to use the technology to differentiate the experience versus our competition.

Now I made reference earlier to the operating leverage that has occurred and we expect that to continue to occur. When you look at a variety of things positively impacting same-store sales clearly the -- impacting operating leverage clearly the same-store sales alone is the first thing that’s going to do that but the implementation of our point-of-sales system will help stores from a inventory and labor management standpoint for improving margins and then the same thing with our supply chain as we certainly particularly as we get these integrated -- roll that and integrate across the system. And all of our upcoming fiscal year ’15 SRI, our owned and operated group will get the benefit of each of these on a broader basis because it now has the point-of-sales system as of May as in all of its stores and as of this quarter at the end of the quarter we’ll have it, POPS in all the stores as well. So we’ll get the full integrated effect.

We anticipate over time a continuing improvement in profit margins and you see that depicted here, a nice continued improvement in margin performance with a goal over time of aiming that to 16% to 17% level. And so I think the sales that we anticipate and the tools that we will be putting in place should really very much help us get there. Another element that a couple of years ago missing from the multilayered growth strategy, was the development of ascending royalty rate and that new store development is now beginning to pick up as we grow sales and store level profitability over the last several years.

You can see here in the quarter we opened 10 stores in the quarter versus six the same quarter a year ago, fiscal year-to-date we’ve opened 23 through May versus 10 a year ago. Now we have a sufficient number of projects in the pipeline that we feel like we can hit that 40 to 50 range that we’ve talked about throughout the year. It is likely to be on the lower end of that range with a number of projects and variably things fall out and fall out is not the right word, but it gets some delays, regulatory and other ways. But we have sufficient number of sites under-construction to hit that 40, we have a sufficient number to go over the 40 but we’ll see how that goes as the summer progresses. Either way when you look at 27 last year and hitting roughly 40 this year, basically a 50% increase year-over-year in growth rate and our objective over time the market penetration you see here by state, lot’s of opportunity for growth 3,500 stores in 44 states, but national cable in all 50 states.

So we really got opportunity in our core developing and new markets for additional growth, our franchise sales folks are working to sell that to our existing franchisees and new franchisees in core, developing and new markets and we while this year are looking at something just north of a 1% growth rate we would aim over the next few years at building that to 2% and then 3% growth rate. This contributes to of course to our ascending royalty rate as we open the new stores under that more current license agreement. And the good news in the coming months is that in fiscal year 2015 we’ll have 850 stores convert to a new license agreement, September forward and then the consequence of this will be very positive from an income standpoint for us as a franchise org.

With that I am going to turn over to our Chief Financial Officer, Steve Vaughan.

Steve Vaughan

Thank you, Cliff. I’d now like to spend a few minutes talking about our financial performance. We’re very pleased to report a system-wide same-store sales increase of 5.3% in the third quarter. These solid results reflect the sales driving initiatives Cliff described earlier. This sales growth resulted in strong operating income and earnings per share growth despite some cost pressures encountered during the quarter. Operating income improved 30 basis points from 20.5% in the third quarter of fiscal 2013 to 20.8% for the third quarter of fiscal ’14. Earnings per share increased 15% from $0.26 in the third quarter to $0.30 for the third quarter of 2014.

Turning to drive-in level operating margins, for the third fiscal quarter food and packaging costs were unfavorable by 60 basis points. As I mentioned earlier we did encounter some unexpected commodity cost pressures during the quarter. In particular lime prices hit a record high during the quarter more than four times their normal price. The good news is that lime prices have now returned to historical average levels. Beef, cheese and ice-cream mix continued to experience significant cost pressures. We have contracted for our ice-cream needs to the end of the quarter but continue to pay market prices for cheese and roughly one-half of our ground beef formula, so some uncertainty remains. The expected increases for these commodities will pressure our food and packaging costs in the fourth quarter. However we anticipate that we will begin seeing some benefit from the implementation of our new point-of-sales system and supply chain software during the quarter.

Further we took a 1% price increase around the beginning of May, with this increase we’re running approximately 3% of year-over-year pricing at our company drive-ins. These technology benefits combined with a favorable product mix shift driven by our Summer Slush promotion and our menu pricing should largely offset the commodity cost pressures. Accordingly we expect to experience flat to slightly unfavorable food and packaging costs in the fourth quarter.

Payroll and employee benefits were 100 basis points favorable during the quarter primarily as a result of leverage from positive same-store sales. As Cliff mentioned earlier, we completed the roll out of the new POS system to all company drive-ins during the quarter. To facilitate a successful roll out we encouraged some extra cost during the quarter for employee training, even with this investment for the future we saw a nice leverage during the quarter, we expect to continue to see leverage from positive same-store sales in the fourth quarter and also believe the labor scheduling tools that are now available in all of our company drive-ins will provide some additional efficiencies.

Other operating expenses were flat as a percentage of sales. We experienced some duplicate POS support costs during the quarter as we transitioned from our old POS system to our new POS system, which limited leverage and other operating expenses. With the new system now in place we believe our company drive-ins are poised for solid profit growth in the fourth quarter.

Looking to the fourth quarter the leverage from positive same-store sales combined with the benefits from the implementation of the new point-of-sales system and POPS give us confidence to expect 75 to 125 basis points of improvement in company drive-in margins in the fourth quarter. Brand-wide, we are very pleased with continued growth in profits that Sonic System has achieved over the past several months. These results provide our franchisees with increased optimism and confidence about the strength in future of their businesses and the brand.

Our SG&A expenses were $17.6 million during the quarter compared to $16.9 million in the same period last year. This increase reflects increases in headcount associated with the investment in talent we have been making to support the technology initiatives Cliff described earlier. We have invested in and we will continue to invest in additional resources to support the successful implementation of our technology initiatives over the coming months. While we will strive to pace our growth in SG&A to align with the performance of our business, we will appropriately staff these initiatives to ensure a successful outcome.

Our business is first and foremost a franchise business model as a result we generate significant amounts of stable and predictable cash flow with only moderate capital needs in a typical year. This model gives us the flexibility to invest in our brand when initiatives meet our return on investment criteria, repurchase shares and pay down debt. We ended the quarter with $34.8 million in unrestricted cash. As Cliff mentioned earlier, we repurchased approximately $69 million of stock during the first nine months of FY2014 and are on-track to complete the $80 million purchase authorization announced earlier in the year. We are continuing to make significant investments to drive sales and profits in our company drive-ins and expect to spend approximately $75 million to $80 million on capital expenditures, most of which will be spent to implement the new digital-point-of-personalized-service initiative and our new point-of-sales system in all of our company drive-ins in fiscal 2014.

Using free cash flow and cash on our balance sheet, we expect to continue repurchasing the remaining $11 million of stock authorized for repurchase through August 31st on a systematic basis during the fourth quarter. Because of our healthy cash flow, we believe we will be able to fund these additional share purchases and the investments in our business from cash on-hand and operating cash flows.

We are also pleased that our balance sheet remains solid with a net debt-to-EBITDA ratio of just over three times. We believe that a leverage ratio in the three times range is appropriate for our franchise business model. As our EBITDA continues to grow, we will continue to explore the best use of our balance sheet and cash flow to grow shareholder value. We continued to exceed our debt compliance covenants by a wide margin.

So, in summary same-store sales and margins are expected to continue to improve with the implementation of several key initiatives which Cliff outlined earlier. We expect these initiatives to drive 14% to 15% earnings per share growth in fiscal 2014. For our fourth quarter this expectation is based upon achieving positive same-store sales in the low single-digit range for the system, approximately 15 to 20 new drive-in openings, drive-in level margin improvement of 75 to 125 basis points, depending upon the degree of same-store sales growth at our company drive-ins, SG&A expenses of $17.5 million to $18.5 million, depreciation and amortization expense of $11 million to $11.5 million, net interest expense of approximately $6 million in the quarter and income tax rate of between 36.5% and 37.5%. However this rate may vary depending upon the reinstatement and employment tax credit programs that expired December 31, 2013 and pending resolution of certain tax uncertainty.

And finally as I mentioned earlier, capital expenditures of $75 million to $80 million for the year which included the implementation of a new point-of-sales system and digital-point-of-purchase technology in all company drive-ins during fiscal 2014.

I will now turn the call back over to Cliff for a few closing comments.

Cliff Hudson

We are very excited about the quarter. And we will now open it up for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And at this time we will move to take a question from Joseph Buckley with Bank of America Merrill Lynch.

Joseph Buckley - Bank of America Merrill Lynch

Thank you. A question on capital spending, looking ahead next year, there was a little bit of creep in the CapEx numbers for this year, it looked like the range was pumped up about $5 million and I guess I am curious if you are still thinking that next year you will be back in that $25 million to $30 million range or if there might be a little additional creep into fiscal ’15?

Steve Vaughan

Hi, Joe, yes, this is Steve. And we are working on our budget for fiscal 2015 right now, so we are still continuing to finalize those numbers. I can tell you that it will come down significantly from FY2014. It might end up at $35 million or it might be closer to $30 million. We are still kind of working through those investments that we feel like that we need to make to drive the business and really focused around the technology initiatives that we have in place. So, I think you will see it to be somewhere in that $30 million to $35 million range but we will be able to give you a more specific guidance in September.

Joseph Buckley - Bank of America Merrill Lynch

Okay and then just a question on the POS systems and really as the rollout we just completed last month but you made reference a couple of times to some of the margins benefits, are they coming through as much as you anticipated and as fast as you anticipated and maybe just review what the margin potential is from the POS systems again if you could please?

Cliff Hudson

Well, it’s -- so Joe, the, our Company stores did get them in, in the month of May, the final implementation in our owned stores. And so as an example with the labor piece, it takes some period to time to populate the system with not just information about people but patterns and the expectation would be given on that as it takes -- it’s going to take 60 to 90 days of operation at a given store, to be getting the benefit of that from a labor scheduling standpoint. So I think it’s in terms of looking at the thing that that would be the primary source of improvement in the quarter would be not accurate because we haven’t had sufficient time and sufficient number of stores. Probably the most consistent contributor in any quarter when you get the positive same-store sales like we have got that is probably the biggest contributor to margin improvement. So I think the margin improvement we anticipate getting, we’ll see more of over time rather than looking to this past quarter and saying that’s what occurred there.

Joseph Buckley - Bank of America Merrill Lynch

Okay, thank you.

Steve Vaughan

Thanks, Joe.

Operator

And at this time, we’ll take a question from Brian Bittner with Oppenheimer & Company.

Mike Tamus - Oppenheimer & Company

Great, thanks. This is Mike Tamus on for Brian. Can you talk about POPS system and the ability to do the targeted messaging the one-to-one marketing sort of where do you stand on that? And where do you see that going over the next year or two? Thank you.

Cliff Hudson

Well, this will be the ultimate objective of that. One of the things we’ve said very clearly is with the implementation of the system and having only 100% suggestive selling and order confirmation because that’s what the system has is it’s kind of first phase, yields a very sufficient return on investment, so we have said that, we’ll continue to say it with our operators because they’re first and foremost we will be concerned about insuring if they get an adequate return on investment.

Over time with various mechanisms and [app] [ph] offsite, mixed nature of payment methods on and offsite, loyalty programs et cetera we will have greater identification of the specific customer on premises in many cases before they pay for their food and certainly before the leave the lot. And this will put us in a position to have a one-to-one personalized marketing, we are not there yet, and even without that, I’ll repeat, the system has a very handsome return on investment that warrants installation. So it will be a progressive process as the system rolls out and we’ll share with you as we do.

Mike Tamus - Oppenheimer & Company

Good, and thanks, if I could just have one more on the restaurant margins, you talked about the other operating expenses being flat year-over-year because of duplicate POS expenses, do you have any idea ex those costs what that would have looked like?

Steve Vaughan

I don’t have an exact number for you Mike. I can tell you that we would have seen some leverage on other operating expenses. The other area that I didn’t call out that we did have during the third quarter was we in kind of in preparation for the POPS rollout we did what we call a refresh on our company drive-in, so we went in and did a lot of kind of sprucing up and most of that was capitalized. There was a little bit of expense associated with that as well and so I do anticipate during the fourth quarter we will see leverage on other operating expenses.

Mike Tamus - Oppenheimer & Company

Great. Thank you very much.

Steve Vaughan

Thank you.

Operator

And at this time, we’ll take a question from Nicole Miller with Piper Jaffray. Ms. Miller, we’re having trouble hearing you, please check your mute button.

Nicole Miller - Piper Jaffray

I apologize, thanks. Good afternoon.

Cliff Hudson

Hi, Nicole.

Nicole Miller - Piper Jaffray

Hi, can I ask you about the POPS and/or the comps, you talked about the benefit of fountain and chicken and ice-cream, I am wondering does that -- it couldn’t -- I don’t think grow all day-parts then in a similar fashion, so from a day-part perspective where are you seeing a breakout and is it a major shift one way or the other?

Cliff Hudson

Now your question is about POPS contributing to that or your question is about comps?

Nicole Miller - Piper Jaffray

And/or comp? Yes, I’m not sure how you want to frame it but I know you gave the color of the benefit for fountain, chicken and ice-cream from a promotion perspective, POPS obviously plays into that so I’m not sure…

Cliff Hudson

Well I think…

Nicole Miller - Piper Jaffray

But I am wondering if the day-parts are then shifting?

Cliff Hudson

We would anticipate over time as we continue to build sales and we talk to our operators about how we’re going to build sales that we’ll do that across all day-parts. So it’s not a single day-part or with two or three day-part strategy, it’s a five day-part strategy. And because they’ve got 24 hour real-estate, and so we want to leverage that, but in terms of things driving that sales, it cuts across both day-parts and product lines and they -- so I think when we -- there is clearly an objective on our part to drive certain product lines, some disproportionate to the other in the near-term but the cause of that cuts across many lines including media and creative and nature of promotion and nature of things. We’re keeping on a menu in comparison to promotion, so when we promote a new chicken piece or we test a chicken piece it helps all chicken, as an example or we have a variety of ice-cream elements and we would expand it over time. We promote some ice-cream it helps all ice-cream. Ice-cream generally goes up. So it’s a combination of elements that helps drive this. And we don’t look to a single one to say here is what caused comps. And we don’t believe our business operates that way.

Nicole Miller - Piper Jaffray

Okay. And just a final question, I was thinking back to the days when your store count had a two in front of it, and a 3,500 plus stores knowing what you know today, what do you think is a good long-term estimate for what now seems to be, again back on pace development?

Cliff Hudson

Make sure I understand your question. Are you just…

Nicole Miller - Piper Jaffray

How many stores long-term I mean, I am just thinking back a decade plus over time, I mean it’s additional 1,000 stores I mean is it…

Cliff Hudson

Yes.

Nicole Miller - Piper Jaffray

…going to be another 1,000 or is it a double, what does it look like into the future, how big can this be?

Cliff Hudson

Well, our company stores, I mean as Steve made a comment about the royalty rate in his presentation we are first and foremost franchisor, really always have been. And at one point we did have as much as let’s say 15% or a little more in company stores, but -- and clearly the last several years we’ve brought that down. So it’s conceivable in the near-term that we could have company store growth keep pace with store growth generally, but we have no plans to have company stores grow at a rate that materially exceeds the rate of growth for the system.

Steve Vaughan

Well, Nichole you made - in terms of as a system we did put out a release, I guess a few months ago anticipating the opening of a 1,000 drive-in system-wide over the next 10 years. We feel like that is a pretty conservative number and in fact, if you kind of look at our target of 2% to 3% unit growth rate, I think you would get to a larger number over time. So we certainly feel like that as a system that that 1,000 new units over the next 10 years is very achievable and we can grow this brand beyond that.

Nicole Miller - Piper Jaffray

Thank you.

Cliff Hudson

Thank you.

Steve Vaughan

Thank you.

Operator

And at this time we’ll take a question from John Glass with Morgan Stanley.

John Glass - Morgan Stanley

Thank you. Just going back to the CapEx for a moment, you did raise it twice this year and so what was the driver of the overage and did that have, or was it just more expensive to put some of these to POPS and the POS then you thought or was it something else unique. And how does that enter to the conversation with franchisees when they think about the cost and the willingness to put the POPS system in themselves?

Steve Vaughan

John so a couple of things one, really the investment that the franchisees will be making the estimate hasn’t changed much from the beginning of the year. We did require a little more investment in developing the technology to basically get it ready to roll out and we thought we would need at the beginning of the year. So there’s been some kind of additional investment there over and above our budgeted amount. We’ve also got a couple of additional projects underway on the company side that we didn’t anticipate. We’ve got three relocations and rebuilds that we have completed and then a couple of more in the pipeline. So I think a minor increase in the investment but certainly within the range that we had expected longer term, again just a slight increase.

John Glass - Morgan Stanley

Okay. And then, can you just frame for us your perspective on what happened in the fourth quarter of last year, why comps were strong? I know there may be with a benefit of hindsight and time you have a better understanding of what were the key drivers and therefore the challenges and the opportunities for lapping that in the fourth quarter this year, since it’s the toughest lap you’ve had in several years?

Cliff Hudson

Well, the, I think I’d say John that the drivers it is our objective over time to grow our average unit volume for our operators and so we talk to them about that regularly. We’re talking about how we’re going to do that. And so the drivers are pretty much as we’ve already laid out, two years of no reallocation of media expenditures, the second year of that. A better and more efficient use of that, a full year affect, the better use of it, the return two years ago to the two guys, the product development pipeline today is much stronger than it was a year ago and ultimately stronger it was two or three years ago. And so it is a combination of initiatives like that that have yielded this, and this is kind of why we go back and say it’s not just a question of a single promotion or a single promotion by a month but rather product line strategy and day-part strategy that at this point we feel like we’re implementing pretty well and getting pretty good results.

Steve Vaughan

I would just build on that John, that Cliff’s earlier comments about our base business and really if you think about ice cream which is a big part of last summer, the fact that we’re continuing to promote summer shakes but layering on top of that the Slush Headquarters’ promotion, so again taking that base business and trying to build on it gives us confidence that we can comp nicely over the fourth quarter of last year.

Cliff Hudson

And so you might have the question when we saw last year and then we see this year, do we think, gee how are we going to do this again next year, I mean the answer is no, we’ve got very clear thoughts on how to do that and testing the products and compounding strategies and so on to continue to build that business. The fact is that people start coming to us and have better experience of food and service which I think we’ve done a better job, much better job with at this point kind of post recession versus going into the recession, we track and we see the usage and it’s less transactional; we do get people using us in a variety of ways at varying levels of expenditures by day-part and day a week, so it’s kind of building a, it’s like building the foundation of our business with the foundation, with the customer.

John Glass - Morgan Stanley

Yes great, no that was the question I was asking, thank you.

Steve Vaughan

Thanks John.

Operator

At this time we’ll hear from Jeffrey Bernstein with Barclays.

Jeffrey Bernstein - Barclays Capital

Great, thank you very much, two questions, one just a follow-up on the unit growth topic, it seems like this year you said the 40 unit plus which I guess is roughly 1% net growth, just wondering you’ve mentioned a couple of times getting to 2% to 3%, I am wondering, obviously you haven’t laid out plans for next year yet but should we see, should we expect a sharp acceleration in fiscal ’15, getting more at least to the 2% of the 2 to 3 or is this still going to take a couple of years to get to that 2 to 3 longer term run rate?

Cliff Hudson

This is something that, it is a good question, and understandable focused on your part and it’s understandable because it is a sign of confidence in the brand by operators but also contributor to growth of the brand and the profitability of our business. It is -- this is in some ways one of the most challenging aspects of the business, we are in the franchise business and so you’re not just talking about how do you drive, a test a product and attempt to promote it in a system. You’re talking about how do you convince somebody to put significant portion of their net worth into this physical asset and then take the risk of operating it but you’re also doing that in the context of regulators by market that can provide assistance or provide incredible resistance to process, so it’s the least controllable from our standpoint and thus the ambiguity in turning to you or any other investor and saying here’s the predictive rate at which we’re going to do this, if these are all company stores and we had two huge development department driving it, it would give you a different kind of predictability.

So you’re right, there is a big spread going from 1% to 2% to 3%, it is our belief that we can reach that. We’ll do it in a stair step fashion over time, we will want to be selective with the folks that we do it from an operating standpoint, but also a net worth and liquidity standpoint and so this will be a progressive thing, stair step over time, it won’t be a, you’re not going to find next year a big spike that these things have a long runway to them in terms of getting property acquired and buildings built and moving to either coast into newer markets will take us longer than the experiences we have had in core markets, interior of the country and in particularly small towns. So we’re entering to a phase of development, maturity of our brand where though there’s enormous amounts of room left from a geographic standpoint and throughput capacity and so and so forth, we are moving into markets that are more challenging from a due dil standpoint and it will take us longer.

Jeffrey Bernstein - Barclays Capital

I got it, but you don’t yet have the visibility because we’re only a couple of months left this year, you don’t yet have this contracts in hand or construction begun to have a ballpark for what the openings might be?

Cliff Hudson

I think we will be sharing our fiscal year 2015 projection in August…

Steve Vaughan

September.

Cliff Hudson

Yes, September.

Jeffrey Bernstein - Barclays Capital

Got it, and the other follow-up was just on the comp side of things with the company staying ahead of the curve with the POS and POPS and the franchisees to follow over the next few years. Is it reasonable to assume we will see the company operated comp start to outpace franchisees, I know the past four quarters the franchisees continue to outpace and I would have thought at some point we’ll see a reversion, so I am wondering if that’s what you’re expecting as well or is there certain reason why the franchisees should continue to outpace even though you’re rolling out the comps driving technology that they’re not yet doing?

Cliff Hudson

Yes with the early implementation of POPS for the company stores versus the system we would expect for our owned stores to get a top-line improvement and margin improvement disproportionately great to the comparable stores. Now in some ways, in a discussion over time in what that means for you and for the market might be a little problematic. And why do I say that? Because in the last year and two, the markets that have benefited the most from this reallocation of media dollars that we did in 2012 nice benefit for the whole system in ’13 and ’14. But our so-called developing markets that we started moving into more in the 90s, but didn’t ever have -- they are not mature by any means from a market penetration standpoint, never had big media support.

In the last two years, so the Carolinas, Florida, Virginia, California and Nevada, so on, the last two years these types of markets have just gotten enormous benefit from this. So if you were to look at what’s happening with our owned stores with some of these initiatives, you might look at it and say, gee, you guys aren’t getting as much as California or the Carolinas and so on. And the answer is, that’s right because they are in a different cycle from a maturing standpoint and this benefit from the national cable. A Dallas may get a 20% spike in gross rating points from the media, but Carolinas may get 75% spike. So there’s a big difference going on there.

So we do - so there is two answers to your question. We do expect to get top and bottom-line improvement that is disproportionately great versus comparable stores that have not yet implemented POPS and POS, their challenge is going to be how do we convey that to you over time because we will be comparing it to an indirect system where other things are going on to drive the business in less mature markets. So we will attempt to decide for that for you over time as we roll it out, but you are correct in assuming that company stores should get some disproportionate benefit of that first.

Jeffrey Bernstein - Barclays Capital

I assume it’s a good problem to have if your company and franchise comp are both 5%, that’s pretty good.

Cliff Hudson

Yes. You’re right. It is a good problem to have, and it would be easy for a person to say well because you’re slightly behind, well. One is good, the other one is better. And they are both good. And so a person could slice and dice it and say, oh my god, you didn’t do as well, yes but they are both better and we’re stealing share from competitors everywhere. Yes, so I think you’re exactly right. It’s a nice “problem” to have deciphering that for you over the coming months.

Jeffrey Bernstein - Barclays Capital

Great, thank you.

Steve Vaughan

Thank you.

Operator

And moving forward we will hear from Will Slabaugh with Stephens.

Will Slabaugh - Stephens

Yes, thanks guys and congrats on a great quarter. Could you give a little bit more detail on the POPS rollout? Could you speak to what type of traffic and checklist have you been saying in those that you have rolled out so far? And I know it’s early there, so whatever type of commentary you could offer there. And then what that cadence may look like, rolling out to company stores throughout the quarter?

Steve Vaughan

Yes, well so we have not quantified the POPS rollout. We did rough test this in about 65 company drive-ins that have actually now been in place a little over a year. We began kind of [inaudible] consider the actual rollout, so the test is over, rolling out POPS to company drive-ins, that really started in late April and at a slow pace, and then it has kind of ramped up as we have gotten into May and June. We are now, I figure roughly half of our company drive-ins have that. We expect to be completed by the end of the fourth quarter with the rollout of POPS. And then we will start that rollout to our franchisees in mid-September. And the franchisee rollout will likely be a 2 to 3 year process. It will take some time, but, again that’s really a layer of our technology initiative that gives us confidence on this ability to hit on a consistent basis, this low single-digit comp as we roll this out to the system.

Will Slabaugh - Stephens

Got you, and also are there any closure days to think about as those retrofits happen, as you install POPS?

Steve Vaughan

Any I am sorry…

Will Slabaugh - Stephens

Closed days.

Steve Vaughan

We have been doing this at night and have not really had to have any closures, we might have lost a couple of hours although close down maybe at 10 O’clock, with the goal of being back open by 6 AM the next morning, and depending on how that process goes we have might have lost three or four hours of sales, but definitely not anything in a significant way.

Will Slabaugh - Stephens

Got it. And one more follow-up if I could on sales and promotions. So thinking about the strength that you have seen in your summer promotions this year and then last year as well, and then about the promotions coming up this summer as we think about those promotions on a year-over-year basis, should there be any margin difference in terms of the half price shakes after 8:00, I know you have the full priced slush running alongside that, should we think about -- given what you have mentioned in the commodity basket movements, anything else happening from a promotional standpoint that might move the cost of goods numbers one way or the other?

Steve Vaughan

Well, that’s one of the benefits that we have this summer, is this slush promotion which is one of our most profitable products. And as you mentioned, selling it at full price except or during happy hour, that is going to be a tailwind in terms of our food and packaging costs. We do have these continued commodity cost pressures, but I think that’s one of the reasons, the lime price is coming down combined with this favorable product mix shift in the fourth quarter compared to last year we should see those food and packaging costs flatten out to be maybe slightly unfavorable as opposed to the 60 basis points of unfavorability we saw in the third quarter.

Will Slabaugh - Stephens

Got it, thanks guys.

Steve Vaughan

Thanks Will.

Operator

Matt DiFrisco with Buckingham Research has the next question.

Matt DiFrisco - The Buckingham Research Group

Thank you. Just have a couple of quick questions here, just one follow-up on that actually where I think you just said you expect to have half of the company owned done by the end of the fourth quarter?

Steve Vaughan

No. No, Matt, if you’re talking about the POPS rollout, we are currently at about half of our company drive-ins have POPS and then we’ll have the remaining one half done, so all POPS will be in all company drive-ins by the end of the fourth quarter.

Matt DiFrisco - The Buckingham Research Group

All company, okay. So there is no, that just closes the loop on any CapEx associated with the point-of-sale or POPS or any incremental CapEx leading into FY15, would that be correct?

Steve Vaughan

It will in terms of the hardware, there may continue to be some development costs CapEx in 2015 not anything near the extent to what we incurred in 2014.

Matt DiFrisco - The Buckingham Research Group

Okay, great. Just trying to understand also the free cash flow guidance; it seems like you raised the CapEx by 5 million on the range yet you’re to-date it looks like the earnings have risen 19% I don’t think you’re guiding for a contraction in the fourth quarter by any means. So I am just curious why would you -- you almost have flat operating cash flow on a year-over-year basis to generate sort of that 10 million or so 10 million to 15 million free cash flow assumption implies flat operating cash flow. What are we missing that the operating cash flow wouldn’t grow as much as the earnings?

Steve Vaughan

Well, I am not sure I am following your numbers. We may want to take that offline and try to figure out where you’re coming up with that. Because I think we’re anticipating operating cash to increase, operating cash flow will increase so…

Matt DiFrisco - The Buckingham Research Group

Right, you had 87.8 last year that’s what I was just using and if you’re implying 90 million this year, if you are…

Steve Vaughan

Well I guess, yes, 75 to 80 and then we said 10 million to 15 million of free cash I mean that’s a if you take the two ranges it could be as high as I guess if you took the more aggressive end of that as high as 95, so 85 to 95, is that am I thinking about that right, 75 to 80 plus 10 to 15?

Matt DiFrisco - The Buckingham Research Group

Correct, in relation to the 87.8 in operating cash flow year ago, so that’s where I am just saying I would have thought there would have been closer to a 100, but okay we could talk further about that offline. And then lastly if you can just look at the royalty rate I think this is one of the highest increases you’ve had year-over-year in a while the 5 basis points I know there is a couple of driving forces obviously the better than expected comp at the franchise side pushed volumes higher. How much of the 5 basis points is higher AUVs and comp driven versus anniversarying and maybe rolling off some of the teaser or incentive fees that were done - begun two to three years ago?

Steve Vaughan

Yes, it’s really probably about 80% of that’s being driven by the strong comps that we had. We aren’t really getting a lot of benefit from those incentives rolling off yet; that will come into play more in ’15 and ’16.

Matt DiFrisco - The Buckingham Research Group

Excellent, okay. Thank you.

Steve Vaughan

Thanks Matt.

Operator

At this time we’ll take a question from Michael Gallo with CL King.

Michael Gallo - CL King

Hi. Good afternoon and congratulations on the good results.

Cliff Hudson

Thank you.

Michael Gallo - CL King

I just want to delve in on the -- what you’re seeing in the new prototype you had obviously a number of units opened on that. I was wondering what you see in terms of units that have indoor seating as well as the drive through how that gets utilized and how you think about how that changes the landscape of units going forward? And then also what you see in terms of volumes in those units versus what you see in traditional units and how much of the volumes you see going through drive through and dine in versus more traditional? Thank you.

Steve Vaughan

Okay. Michael, I’ll try to answer this generally and then maybe we can get into a little bit of specifics. But our new stores are continuing to open at very strong volumes, in many cases 30% to 40% above the system average. We attribute some of that to this change in media strategy. As Cliff mentioned newer and developing markets got a disproportionate lift from that. Now we are continuing to see well a couple of developments, one, all new Drive-Ins virtually are being opened with a drive through and we’re seeing a lot of business particularly in those newer markets go through the drive through. So we feel like that that’s a critical part of the experience. We are continuing to kind of expand this test of inside seating and are seeing some pretty nice results from that. I think it’s too early to say that’s going to be a part of all new Drive-Ins we’ll continue to kind of monitor the results.

We will open a handful of those this fiscal year and that does add some cost and that’s why we’re being fairly cautious about weaving that in. The small building prototype we continue to see nice cost savings from that but particularly we’re seeing that utilized more in the small market - small town markets and it’s really making it more affordable to get into those small markets. So I think on a new store front we feel very good with where we’re at. As Cliff mentioned earlier we were seeing that momentum continuing to build, it’s difficult to point to an exact number on what the impact would be for the next fiscal year. But I do think overall we’re feeling very good about new unit growth and the returns on those new units, is there any…

Michael Gallo - CL King

Okay, I was just going to say I had a follow-up to that, are POPS a requirement now in all new drive-ins?

Steve Vaughan

It is, yes, so all new drive-ins that open up are required to have the POPS system.

Michael Gallo - CL King

Okay, thank you.

Steve Vaughan

You are welcome.

Cliff Hudson

Thank you.

Operator

And at this time we’ll take a question from Keith Siegner with UBS.

Keith Siegner - UBS

Thank you and very nice comp. I have a question about the media efficiencies that Cliff highlighted earlier on about one of the contributors to same-store sales. And Cliff said your Analyst Day last year and some other times you have kind of quantified some of these either in terms of growth in impressions or other benefits that you have gotten. Now that we’re in year two of this, just do the same, update us maybe a little bit on what are those media efficiencies, maybe quantify it a little bit and how are you coming across those, that would be very helpful? Thank you.

Steve Vaughan

Yes, so Keith let me just make sure I understand it. You are asking for the contributors to same-store sales growth that we - I guess in this past quarter?

Keith Siegner - UBS

No, I am talking about media efficiencies were highlighted as one of the drivers. Of those media efficiencies can you quantify maybe for us what the efficiency gains are and where you are getting those efficiency gains, similar to what you have done in the past?

Cliff Hudson

Yes, I think what we have done in the past is lay out the kind of the layers that contribute to growth and how we saw over the coming years if we’re growing we have said 14% to 20% EPS growth rate. Here are five elements that will contribute to that and here is a range of single-digit contributions that we’ll each make to that 14% to 20% growth rate. Until we’ve done that by going through a series of the same-store sales operating leverage, new store development, ascending royalty rates and use of free cash flow to help drive earnings per share to that 14% to 20%. I think that’s so far we’ve gone through. Now perhaps what you’re asking is just to go through, today and maybe saying are we pegging in those ranges. I don’t know if that’s what you’re asking?

Keith Siegner - UBS

No, I am just asking about the media efficiencies, how do you quantify media efficiencies?

Cliff Hudson

Well, that is, no, I cannot quantify that for you, I mean so that’s the short answer. I can’t quantify it.

Keith Siegner - UBS

Okay, that’s fine. Thank you.

Operator

At this time there are no further questions, I will turn the call back over to Mr. Hudson for any additional or closing remarks.

Cliff Hudson

Thank you. I appreciate that, and appreciate all your participation. To reiterate there are a number of things that will drive the business and this is what gives us confidence going forward and continue to build the business. So I want to just walk through in that last question from Keith. There is no single element that we will look to and that’s one of the strengths of our business, has been historically and as we have kind of rebuilt the foundation, one of the strengths that the business offers now and that is there are a number of levers that we can pull, that we do pull and we will pull over time that continues to drive earnings per share and the growth of our brand. So this past quarter in many ways was perfect reflection of those elements coming together very positively and will be in this fourth quarter and next year and beyond, so high confidence level with us and where our business is today and the growth of it over the next several years so we continue to appreciate your engagement with us and Steve and Claudia would be available for questions hereafter as you have them. Thanks very much.

Operator

Ladies and gentlemen, this does conclude today's conference call. Thank you for your participation.

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