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Sonic Corporation (NASDAQ:SONC)

F4Q10 (Qtr End 8/31/10) Earnings Call

October 19, 2010 5:00 p.m. ET

Executives

Pat Watson – Corporate Communications

Cliff Hudson – Chairman and CEO

Scott McLain

Steve Vaughan – EVP and CFO

Analysts

Jeffrey Bernstein – Barclays Capital

John Glass – Morgan Stanley

Steve West – Stifel Nicolaus

Matt DiFrisco – Oppenheimer & Co.

Keith Siegner – Credit Suisse

Brad Ludington – KeyBanc Capital Markets

Sharon Zafira – William Blair

Larry Miller - RBC

Chris O’Cull - SunTrust

Operator

Good day, everyone. And welcome to the Sonic Corp. Fourth Quarter Conference Call. Today’s call is being recorded. At this time for opening remarks and introductions, I’d like to turn the call over to Mr. Pat Watson. Please go ahead, Sir.

Pat Watson

Good afternoon, everyone. This is Pat Watson with Corporate Communications. Sonic is pleased to host this conference call regarding results issued this afternoon for the Fourth Quarter in fiscal year 2010, which ended on August 31, 2010. Today’s audio and slide presentation is available on the Internet. If you would like to view the slides during this presentation, please go to the investor section of the company’s website, www.sonicdrivein.com, and follow the link to events and presentations under Investor Info.

Before we begin, I would to remind everyone that management’s comments in this conference call that are not based on historical facts are forward-looking statements. The 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 10K, quarterly reports on Form 10Q, 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 management’s remarks during this conference call are based on time sensitive information that is accurate only as of today’s date, October 19th, 2010. For this reason and as a matter of policy, Sonic limits the archive replay of this conference call webcast to a period of 30 days. This call is the property of Sonic Corp; any distribution, transmission, broadcast, or rebroadcast of this call in any form without the express written consent of the company is prohibited.

With those announcements, I’ll turn the call over to Cliff Hudson, the company’s Chairman and Chief Executive Officer. Good afternoon, Cliff.

Cliff Hudson

Good afternoon, Pat. Thank you for the introduction and thank you to all of you all for joining us this afternoon.

In the call, we’re going to cover a number of topics this afternoon. An overview, this will include an overview of 2010, our fourth fiscal quarter, as well as the session about the fiscal year.

In addition the discussion about our fiscal 2011 focus and the progress we’ve seen in implementing some of the strategic initiatives that we announced earlier last fiscal year, announced in March, including product quality improvements and some of the early indications of those initiatives are having a positive effect on our sales momentum.

We’ll spend a little time giving you the development update in our business. And then also an update on our financial performance and capital structure for the fourth quarter, and expectations for the remainder of the fiscal year 2011.

As you know at this point, in our fourth quarter, and you’ve known, earlier release, our system-wide sales declined by 6.4%. Our company-owned stores had same-store sales slightly – our same store sales for the system down 6.4%, but our company-owned were slightly less negative than our franchise. This was the first quarter this had occurred in several years, and I think it’s indicative of some of the progress that we’re seeing with our company-owned stores that we’ll talk more about it today.

And one of the points that we do want to make clear as the months progress through the last fiscal quarter and then this year, in each of the months of the fiscal quarter, fourth fiscal quarter, our company-owned stores saw improvement in same-store sales versus prior month. And now as we look into this fiscal year, the improvement has continued into the first six weeks of this current quarter.

That last comment moving into this fiscal year, the first six weeks of current quarter, is true for the system as well, so we’re pleased with the transition of the business coming out of the quarter, moving into the fiscal year.

So let’s take a look at the 2011, Fiscal Year 2011 focus. Our focus as we look into the year, there’s some key drivers. But as a general comment, I’d say we expect to continue to see improved sales trends. And while we’re cognizant that there’s going to be external factors that could affect the pace of that improvement, we continue to be optimistic regarding the sales expectations for the year. We see that because of the continued refinement of initiatives we began implementing in the last year and more. And have a good degree of confidence that the strategy is the right one for the brand to move business forward.

The two main drivers we see looking into fiscal year in terms of driving better performance this year versus our company-owned drive-ins. Obviously, they’re an important contributor to our corporate earnings, and they’ve begun showing some progress both from a sales standpoint and also from a margin performance in our company stores.

I think it’s fair to say looking in the near term this fiscal year in particular, that one of the most meaningful kind of contributors to improvement this year to the corporate top and bottom line will come from company drivr-ins. So that’s a big part of what will be improving performance of our company this fiscal year.

Second point is our system, same-store sales performance. We believe we’ll continue to see improvement the first quarter versus the fourth. And in a more long term way, yes this fiscal year but beyond the system-wide same-store sales will have the most meaningful impact on stockholder value because of the ascending royalty rate. And once our sales and profitability right themselves, the system unit growth will be contributed to that as well.

The third point you see listed here related to the capital, in the past year, we’ve paid down more than $100 million of our debt. In the past fiscal year we ended the fiscal year with $86 million in cash. We have about $62 million in scheduled principal payments in fiscal year 2011. And as the year progresses we’ll become more opportunistic with the improvement of sales and performance, become more opportunistic of ways to deploy our cash.

Looking at our company-owned drive-ins and the improvement and performance there, the initiatives that we’ve had in place for some time now related to our company stores, the added emphasis on customer service; this includes skating, but it’s far beyond. In addition to the skating a number of initiatives in the last year and more that have begun paying off in terms of customer feedback on the level of service they’ve received. A reduction in the layers of management in that part of our business, and a new compensation structure, all these things seem to be playing and well in terms of reducing turnover, and impacting the customer feedback.

The result of these not only showing customer, different customer response, but narrowing the same-store sales gap with our franchisees, and with a reduced turnover, improved customer reaction, better same-store sales, we also expect to be seeing improved operative margins with SRI going forward.

The objectives that we’ve had with SRI when you think about the turn of it, as an example, the improved – so thinking about four different areas; improved customer service, closing the gap between the service and franchise drive-ins versus company-owned drive-ins, and striving really to, over time, to achieve a best in class service status. So that, and then also achieving same-store sales percentage in parody with franchisees.

This has been our objective for some time. In addition, the stabilization in improving restaurant-level margins, and improving averaging of volume, so narrowing the gap between the franchise drive-ins and company-owned drive-ins over the next several years.

So you look back at those objectives, the first fiscal quarter of last year, 2010, the company-owned drive-ins achieved the first objective, and that is as it relates to customer service; closed the customer service gap that had remained, and have remained at parody with our franchisees. And at times, even slightly outperforming franchisees in terms of those customer measurements of service and the performance of our company-owned stores versus franchisees, so that was achieved in the last year, in the last fiscal year.

Looking at also in the last fiscal year, as a matter of fact the third fiscal – third quarter, third fiscal quarter of last year, our company-owned drive-ins achieved that second objective. And that is achieving the same-store sales percentage at parody with franchisees. It was at least then within three tenths of a percentage point. Then the trend continued into the fourth quarter with our company-owned stores slightly outperforming the system.

For the first half of this quarter, this present quarter, sales have continued to improve on a steady basis. And our company-owned stores, same-store sales performance is very much in line with that of franchisees.

So having achieved these first two objectives in fiscal 2011, we’re focusing on growing profits, which we are confident will happen as sales performance continues to improve. But also improving our average-unit volume, and over the next several years, narrowing that gap with our franchisees.

Now, as we think about how we’ve approached our business in the last, well you could say through this recession, thinking about it differently than we were prior to the recession, continue to focus on this issue of value and refining it in a way we were not before the recession. The value being the experience of the customers are having when they come to our restaurant; take that experience divided by the price they pay.

In fiscal 2009 as we talked to you about before, we really focused a lot more on the denominator, the price. We had rolled out initiatives to meet rapidly-shifting customer needs and expectations, including our everyday value menu. There was some different pricing strategies and promotional strategies. But at the same time, we also rolled out a new customer, or rather, well, consumer-feedback tool, customer-feedback tool that we had not had in place in the past.

As we moved into 2010, we really heightened the focus on the emphasis on the numerator, trying to heighten that difference in experience in coming to a Sonic versus our competition. Product quality initiatives, new product news, new messaging, but also skating carhops, so that we could provide a different experience to the customer when they come to Sonic.

As we look into this fiscal year, I think you could say we’ll be sustaining the emphasis on high quality distinctive food, which is where we’ve been moving into the year by focusing on new product news as the year progresses. But also focusing on the quality and consistency of the drive-in experience when customers do come to Sonic. And focusing on in fact improving the quality, but more so the experience, rather the consistency across the system.

Looking at sales-driving initiatives, before we implemented any other initiatives to improve traffic or check, we focused on improving the drive-in level execution. And we continue to see improved customer service scores from both company owned and franchised stores. We see the – we’ve improved our overall satisfaction rate, and this is one of the measurements you would expect to see from customers. But we’ve improved that overall customer satisfaction rate for company owned drive-ins. You go back to two years ago, the fall of ‘08, as a matter of fact of October of ’08, our drive-ins on that 100-point scale were 59%. We’ve moved it to 76% at the end of the fiscal year, this last fiscal year. So from 59 to 76 in terms of customer feedback. Our franchisees over that time period time have gone from 69% rating by consumers to 76%. And we’re pleased with the progress, but we know there’s still room for improvement, and particularly in terms from a standpoint of consistency across the system. And we’ll be focusing on that going forward.

As to the messaging and development of new messaging for our promotional activities with different messaging from promotional strategies, our new messaging has been design to emphasize what makes Sonic different from the typical quick-service restaurant. And the commercials not only call attention to what Sonic has and other don’t with respect to high-quality food, such as real ice cream that we had late spring and the summer, footlong quarter pound coneys in midsummer, late summer our burgers, and loaded burgers, and how they can all be customized, and so on. We’ve also worked to emphasize the fun aspect of the drive-in experience showing the skating carhops, and the personalized service that you get at a Sonic drive-in.

As we move into Fiscal ’11, you’re going to see that messaging continue to build on those themes and use a greater variety of medias to convey the messages about our brand to consumers in a variety of markets.

Now in the recent past, we’ve announced that we’re going to be going to a request for proposal process for specific parts of our marketing business; including the creative side, media purchasing, and media placement. This is a process. We’ve had questions from a few folks. This is a process internally that we began in the spring with the initiation of a media audit of our primary media partner. And that media audit was concluded in the early summer. And so we are using that to assist in this process. The fact is as you all know, the media world, the advertising world has changed dramatically. Over the time that we have used the same firm for 16-17 years. And our sense is that one of the things that we can do to help build our business to another level is that we should work to find the best firms in each marketing segment, you might say of services that can be provided to a brand like ours.

So one of the great things at this point and time in terms of focusing on this area of our business, is that Danielle Vona joined as Chief Marketing Officer in July. She came to us from PepsiCo, something you all know at this point. And we’re really excited about the depth of experience, and managing, and brand focus that Danielle brings to Sonic. And she’s going to oversee the process I just described in terms of selecting a new agency for various aspects of our marketing business just as you would expect. So we’re glad to have her onboard and believe she is going to make a very positive impact on our business.

In addition to the other initiatives I’ve described, we continue to focus on product quality and product quality improvements to raise the bar in terms of the experience that the customer has when they come to our drive-ins. This is included in the more recent past, as you know, the introduction of real ice cream in May, the quarter pound footlong chili-cheese coney in July, new bigger loaded burgers in September. And in each of these cases that we’ve rolled these out, we’ve seen incremental sales of the products. But the products aligned with the promotional period they’re attended to affect, the real ice cream, helping in the afternoon and evening day part, so also a little bit of dinner, but later in the day the ice cream helps more so. Coney sales are driving improvements to the dinner day part in particular. And so, as we move further into the year, we’re going to continue to incorporate new product news around these products that we’ve already rolled out, as well as some other new product news moving further into 2011.

The interesting thing is when we look at the products that we have rolled out to date and the improvements, the areas where we’ve had improvements in products, those products represent almost, I mean, it’s just right on the money, half of the sales at the average Sonic drive-in. So you’re talking about I think a real step up in terms of the quality of the food experience that a customer is having when they come to Sonic.

Each of the key product improvements was developed to target more of our core brand strengths, but also drive increased share and sales in that particular day part, something I alluded to a moment ago. And we consider our real ice cream to be really the best in class. I don’t know if you’ve had that ice cream. I’ve had it quite a few times, and it’s delicious. And it has helped us drive business, drive sales in the afternoon; evening and dinner day parts. As I mentioned, footlong chili cheese are really distinctive amongst our peers; also geared towards lunch and dinner, and it’s having that impact particularly on dinner. The same with our loaded burgers.

So these are intended to continue to distinguish Sonic as a premium player and provide an opportunity for increased flavor combinations in all of those cases. In all of those cases, the way to have increased flavor combination, and also use them as a platform for limited-time offers going forward. So nice improvement there and one that should continue to have improvement for our business.

As it relates to media impressions, some of the media strategies we have alluded to in the past have been helpful to our business as well, focusing somewhat more on impact in every trade area. We have moved to using a greater variety of different mediums from online advertising to outdoor billboards, and the sort. And the objective here is to focus on drive-in frequency for consumers living closer to a Sonic drive-in, as well as to optimize impressions to potential consumers in the most cost-effective manner we can. In different cases, different markets, different stores, provide the right message for each market or trade area. And do all that with a most effective medias that we can.

This initiative in terms of reallocation of some of these dollars was implemented system wide this past summer. And to date, it would appear that the effect of it has been to increase media impressions, increase impressions that the average customer sees, improve those slightly over the year before in spite of a decline in marketing dollars. So, an objective we had in reallocating these, and one that we believe is having a positive impact on the business.

Looking forward, or I should say in conclusion, maybe someone here is looking forward to my conclusion, but in either way, our internal focus in Fiscal 2011 remains on continued successful limitations and refinement of the strategic initiatives we began last year and all aimed at driving improved results. The initial results I think you can see and hear results in our first quarter indicate that we’re gaining momentum with the mini-o initiative, and we expect to see improved sales for the remainder of the year.

As we look at our business today, the next few years, we continue to be optimistic about these initiatives that we put in place. And with the other investments we’re making in management of our company, we expect to see improved performance of the near and long term.

The two main factors that have the most meaningful impact to our stockholders, the improvement of our company-owned drive-ins, and then system wide sales. So we stated earlier, this very much dictates for 2011, and it kind of evolved thereafter.

We’ve got a lot of room for growth, and it’s our view that once we work through some of the sales and profitability in the near-to-mid term, that unit growth is going to continue to play a role in the growth of our business for years to come, but more two and three years out from now.

We anticipate that development some 18 to 24 months down the road. Once we have a sustained period of increases in sales and profits, add about 18 months, and you’re going to see an improvement in development as well.

So in addition to these sales initiatives, we’ve strengthened our capital structure in the fiscal year with a pay down of debt, a reduction of debt more than $100 million, about $105 million of debt. And in Fiscal 2011, we’ll pay down another $62 million of debt, and look for ways to deploy excess cash. As that improves we’ll look to deploy it on an opportunistic basis.

In summary, our view is that the investments and initiatives we’ve implemented that we continue to refine are driving sales. They’re improving operations, optimizing our capital structure, and putting us and our company and our brand in a better position for the long term. They should do well in setting the stage for a solid reenergized growth, and do that in the near term and over the long term.

With that, I’d like to turn it over to Scott McLain for an update on development.

Scott McLain

Thank you Cliff. We finish the year with 80 franchise drive-ins openings, down from 130 the previous year, but in line with our revised expectations. The slowdown in our development activity is a direct result of the decline in sales and profits, which together with ongoing economic uncertainty have led to a more cautious approach by franchisees.

Because the development cycle is typically 12 to 18 months, development in the coming quarters will likely be even further constrained with 40 to 50 new drive-ins expected to open this year.

It has been encouraging to see our franchisees continue to invest in their existing assets, including rebuilding or relocating 23 drive-ins during the last fiscal year. We don’t count these as new store openings, but they do require a new drive-in to be built, and they’re probably our highest ROI activity, routinely generating sales increases of greater than 25%.

We put a strong emphasis on this type of investment since 2007, and since that time, our franchisees have relocated or rebuilt roughly 5% of their store base in addition to retrofitting a significant portion of their drive-ins.

As you may recall, we did offer some development incentives last year, which were designed to reward franchisees for multiple store openings, and encourage development in some of our more challenging markets. These incentives were well received and did have a positive impact on store openings.

This year we will again be offering development incentives, not only for our more challenged markets, but also targeted against markets that are close to achieving breakthrough media levels. And for a few of our franchise developers that have the financial and operational capacity for accelerated growth.

First year sales for new drive-ins are still strong, particularly in new markets with average opening volumes of $1.5 million. In fact, our new drive-in near Boston became the first drive-in to exceed $4 million in its first year of operation.

As the drive-ins in new markets enter their second and third years, we are seeing sales volumes decline fairly significantly from their opening levels. However on the whole, our volume in new markets continue to exceed the system average.

And as Cliff discussed, to help us improve retention of sales in new markets and as part of our refined media strategy, we’re employing new messaging targeted at the trade area designed to build brand awareness and usage for these drive-ins.

We ended the quarter with 3,572 total drive-ins, and we’re now operating in 43 states; making continued progress on our way to becoming a truly national brand by adding 14 new states in just the last four years.

Fifty-seven franchise drive-ins closed in Fiscal 2010, down from 72 the previous year. Given that we are a 50-plus-year-old brand with more than 3,500 stores, we believe that our rate of closings remains relatively low, especially given the current environment.

Although there are certainly some exceptions, which we are working through, the overall fiscal health of our franchisees remains sound. Despite the near-term challenges, our franchisees remain as passionate as ever about the Sonic brand and the strategic initiatives we have implemented. And we’re gratified by their continued commitment and investment in what we together believe is a bright future.

Now I’ll turn the call over to Steve Vaughan, our Chief Financial Officer.

Steve Vaughan

Thank you, Scott. For the fourth quarter, our reported earnings were $.08 per share. Excluding the provision for impairment charge, our earnings totaled $.23 per share for the quarter.

Due to the challenging operating environment from both the sales and a margin prospective, we determined that the investment in several of our drive-ins have become impaired. These impairment charges were primarily attributable to company-owned drive-ins located in Florida, where the economy has been severely depressed, and south Texas where the economy has been more challenging recently. We believe that many of these locations will be viable over the longer term, and do not anticipate a significant number of drive-in closings in these areas.

For the fiscal year, our reported earnings per share was $0.34, reflecting a number of special items as well as the tough economy and sales environment. Excluding the special items, most notably the impairment charge in the fourth quarter, our earnings per share totaled $0.48.

For the fiscal year, our franchising revenues declined by $3.7 million, primarily caused by the decline in franchisee same- store sales for the year, as well as the decline in franchise fee revenue related to fewer openings. These declines were offset by increased rent from drive-ins refranchised during the second half of Fiscal 2009.

The effective royalty rate declined by five basis points to 3.82% for the fiscal year due to the decline in same-store sales.

Of the 80 new franchise drive-ins opened in Fiscal 2010, a total of ten met the criteria for the five-year royalty abatement program.

Our restaurant level margins declined 210 basis points during Fiscal 2010. However, the rate of decline slowed significantly in the fourth quarter. Overall, restaurant margins were only 70 basis points lower than in the same period of the previous year despite the impact of sales leveraging, the implementation of a new store-level compensation program, and investments in product quality.

Looking at each individual line item, food and packaging costs remain relatively flat reflecting denying commodity costs offset in part by a fourth-quarter increase in beef costs, and investments in product quality improvements.

Looking forward, the combination of increased costs related to our product quality improvements as well as a recent surge in several commodities will likely place upward pressure on our food and packaging costs, particularly over the next two to three quarters.

While we expect to benefit from lower plan discounting, beef costs are up over the prior year, and may remain higher for the next couple of quarters.

Most other commodities are either locked in, or are far enough along in the contract negotiation process to provide decent visibility into cost for the remainder of the fiscal year. We expect that commodity costs will be higher in the first through the third quarters, mainly due to higher beef costs, and product quality investments. These projections include the higher cost related to our product quality initiatives including the real ice cream introduction, the new footlong chili cheese coney, and our new improved burger that has 10% more beef than the previous version.

For Fiscal year 2010, we averaged a cumulative menu price increase at company owned drive-ins of approximately 1% to 1 ½% on a year-over-year basis.

Going forward, we remain sensitive to consumer environment, and we’ll be conservative when taking price increases. We anticipate taking a very small price increase in late November in our company owned drive-ins, which will result in a cumulative price increase of approximately 1% overall.

I would also like to point out that Omar and his team have made significant progress in implementing a comprehensive ideal food cost program, which has minimized waste at company owned drive-ins. This process has offset a portion of the investment in quality improvements, and we expect to continue to see benefit from this program over the coming quarters.

While pricing changes and improved controls will partially offset the investments in product quality initiatives and higher commodity costs, we now believe we will see increased food and packaging costs in the first ¾ of Fiscal 2011 in the range of 25 to 75 basis points year over year.

Payroll and employee benefits inclusive of non-controlling interest primarily reflect the shift in expenses from non-controlling interest to labor and benefits under the new Partner Compensation Program implemented in April of 2010. For the fiscal year, there was a 70 basis point deterioration in over labor margins resulting from incremental costs associated with the new partner program, and the final phase of the Fair Minimum Wage increase. This July is the first in three years that we did not have a Federal minimum wage increase, which will relieve some of the pressure on this line item for Fiscal 2011.

We believe more efficient labor practices combined with no Federal wage increase will result in slightly favorable labor costs as a percentage of sales during Fiscal 2011. However, since a greater portion of our manager’s compensation is now fixed, we will likely see unfavorable labor costs in lower volume months, our first and second quarters, and more favorable labor costs in higher volume months.

Other operating expenses were impacted by the decline in same store sales for the fourth quarter resulting in a 30 basis point deterioration, a marked improvement from the 140 basis point deterioration for the year. As same store sales improve in Fiscal 2011, we expect to see improvement in this item as well.

During the fourth quarter, SG&A increased by approximately $1.8 million. This increase reflected the investments we have made in strengthening our senior management team including significant relocation expenses encouraged in the quarter, as well as the incremental cost of new executive head count.

In addition, we continue to invest in resources assisting some of our franchisees with financial challenges.

Looking forward, we expect SG&A to be approximately $16.5 to $17 billion per quarter.

For the fiscal year, the depreciation and amortization declined by 11.3% primarily as a result of refranchising 205 partner drive-ins in Fiscal 2009. While we saw significant savings from the refranchising at partner drive-ins, we did reinvest a good portion of these savings in incremental resources and other areas of our business.

Because of the impairment charge taken during the fourth quarter, we have revised our expectation for Fiscal 2011 to depreciation amortization expense to approximately $10 to $10 1/2 million per quarter.

We continue to be pleased with our decision to move to a more franchised business model. This model allows us to maintain our capital expenditures at a reasonable level while also servicing our debt requirements comfortably.

As Cliff mentioned earlier, during Fiscal 2010, we made $50 million in mandatory principal payments, and purchased $58 million of our fixed rate notes at a slight discount.

At the end of the fiscal year, we have $187 billion in outstanding debt under our variable rate notes, with the interest rate on these notes averaging approximately 1.4%. Interest expense for this portion of our debt will depend on changes in LIBOR and commercial paper rates.

We also have approximately $400 million in outstanding debt under our fixed rate notes.

We completed the fiscal year with $86 million in unrestricted cash. This cash combined with our operating cash flow is expected to be sufficient to meet 2011 planned capital expenditures. And approximately $62 million in principal payments on our fixed rate notes.

Earlier today, Standard and Poor’s downgraded the rating on our certain securitization debt from triple B minus to double B plus. Moody’s rating of our debt remains investment grade. However, under the terms of our debt agreement, if either the S&P or Moody’s rating falls below investment grade, we are required to pay an additional 50 basis points to the monoline insurer. We expect this ratings action to result in incremental interest costs of approximately $2.5 million in Fiscal 2011. This ratings action was partially reflective of the financial condition of the monoline insurer as our condition remains very solid. We can continue to exceed our debt compliance covenants and we anticipate this compliance will continue into the foreseeable future.

As Cliff mentioned earlier, we are pleased with the sales improvements we have seen recently. These improvements are consistent with the expectations we outlined last month.

To reiterate, in 2011 we expect improving sales throughout the fiscal year. And as a reminder, each 1% change in same store sales has a $0.03 impact on earnings per share for the year; 40 to 50 new franchise drive-in openings, roughly flat restaurant level margins reflecting improving sales trends, and some efficiencies from labor costs offset by threshold commodity costs and investments for higher quality products. SG&A expenses in the range of $67 to $68 million. Depreciation and amortization expense of $41 to $42 million. Net interest expense of $34 to $35 million. And capital expenditures of $20 to $25 million.

So in summary, we are pleased with the progress of the strategic initiatives we have implemented, and the sales improvements we are experiencing. External variables such as the economy will continue to pose some challenges in Fiscal 2011, But we believe our corporate strategic focus including focusing on improving sales and margins at company-owned drive-ins, continued focus on system wide sales drive-in initiatives, and identifying strategic uses of excess cash will yield the best returns for our shareholders.

As evidence of our financial strength, we expect our cash flow generated from operations will be sufficient to fund capital expenditures and debt payments with minimal uses of existing cash. This should provide us with ample flexibility in utilizing our excess cash for shareholder value driving initiatives going forward.

This concludes our prepared remarks, and we would be happy to accept your questions.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll take our first question today from Jeffrey Bernstein with Barclays Capital.

Jeffrey Bernstein – Barclays Capital

Great. Thank you very much. A couple of questions. One just on the broader unit-growth outlook as we look at 2011 and beyond. It seems like you pointed out, the growth rate has kind of been cut in half from a franchise-unit opening perspective and in terms of the expectation for ’11. And I think you mentioned 18 to 24 months before you would likely feel reacceleration. I’m just wondering whether you can give your thoughts on kind of the longer-term outlook there, whether you still feel the same way in terms of, you know, the meaning unit growth opportunity in the Northern states making it worthwhile for the reacceleration? I think you mentioned kind of the volumes in those stores are really slowing down significantly in the second and third year.

Just what are your broad thoughts on the franchise growth algorithm and whether you think it’s prudent to really reaccelerate that growth over the next few years based on what you’re seeing now. And I'm going to have a follow-up questions.

Scott McLain

Okay, Jeffery, this is Scott. I’ll take a shot at answering your question. I think we – we still remain very bullish about the process of our brand, and growing our brand, and becoming an actual brand. We have yet to find a place, whether it’s in Boson, which is our first $4 million drive-in, or Spokane, Washington, or San Diego, that our brand doesn’t seem to resonate with folks. And so our view and our historic experience is that when sales and profits stabilize we will see an uptick in our development. And as Cliff mentioned, there’s normally a 12-to-18 month lag after that.

You know, we also are working with our new messaging strategy to retain sales and work within those trade areas. And even though our sales have come off from those really high opening volumes on the whole, our volumes in new markets still exceed our volumes – our average volumes overall.

So we believe, you know, our brand is relevant with customers everywhere and we believe that over time, particularly as our sales and profits and believe we will see our growth rates pick up significantly.

Cliff Hudson

And Jeffrey, we saw – we have seen the same thing in the past in prior recessions, a slowing of development and then as the economy returns and sales and profits pick back you, you add 12-18 months and development picks up too. This is true in the early part of last decade through the 90s.

Jeffrey Bernstein – Barclays Capital

Just as a follow up to that, I know you mentioned the second and third year, a decline, but still slightly above the system average. Is there any – is there a reasonable base of stores that are now in the fourth year? I mean, does the decline continue or do you see it really stabilizing?

Cliff Hudson

We’ve got stores that are probably as old as four years since we started really entering new markets in a meaningful way. And like I say, you know, on the average, our stores in new markets are exceeded the average for the system. So we don’t see any evidence that our brand is not resonating with people everywhere. And we are very confident given our experience in the past that once we see sales and profits improve, we’ll see our growth rate pick up as well.

Jeffrey Bernstein – Barclays Capital

Got it. And then just separately on – you didn’t really give any color I guess on earnings, specifically. I know you gave a lot of the line-item components, but is there kind of a – without giving specific earnings guidance, is there a range of comp and a range of earnings that you’d guide to with a comp point worth $0.03? I mean, ballpark, it looks like the street is looking for up to 10% in fiscal ’11. I didn’t know if you had any broader thoughts on whether that seems reasonable based on your comp and opening assumptions? Thank you.

Cliff Hudson

Yeah, Jeffrey. I would just say we did not give specific com guidance. We do expect to see our comp source sales continue to improve as we progress through the year. However, just based on the external environment, we did not feel like it made sense to give a specific comp guidance at this time.

Jeffrey Bernstein – Barclays Capital

Thank you.

Operator

Ladies and Gentlemen, in order to give everyone a chance to ask their question, we do ask that you limit yourself to one question each. We’ll take our next question from John Glass with Morgan Stanley.

John Glass – Morgan Stanley

Thanks. I am wondering if you would be willing to talk a little bit more specifically about the magnitude that you are seeing given that everyone’s lapping kind of the worst of the discounting last year and you’re comparison get increasingly easier the next two quarters. Would it be reasonable to assume comps can turn positive or have turned positive during this period or is that too aggressive of an assumption?

Cliff Hudson

Well, a couple of things, John. One, they kind of silver lining the improvement of sales is so it’s understandable that you had raised the question, well, it’s an easier comp period. And so I’ve got a couple of things. One is that I think to get better, it’s got to stop getting worse first and that – and in this period of time as we described, particular our company stores, July better than June; August better than July; September better than August, October better than September.

So we’ve seen those – an improving trend. Now to your question about well, isn’t it an easier period? Aside the fact that it’s not getting negative, it’s getting positive versus where we’ve been. We’ve also seen the initiatives that we’ve put in place as I mentioned, ice cream – food products, Chili-Chees and Footlong Coney. These things are having a positive impact on the day part that they’re intended to impact. So the later part of the day in particularly, one of the most hardest parts of our day during this recession has been the evening business.

So we’re also seeing with the promotion of ice cream, we’re seeing a disproportionally positive impact on the evening business. So I say that to remedy the concern that this is simply a general market condition, or general response, or general condition cutting off of negative sales. In fact, it aligns with the initiatives that we’re pursuing.

Specifically to the question of can you infer a level of sales, that’s a question we’ll answer when the quarter is over. We felt given the performance of the fourth quarter that it made tend to give trend information about what was occurring as the initiatives came into play. So that’s the reason for our statement about the positive trend. The improving trend occurring or moving into this first fiscal quarter, first six weeks of the year, and if you intend us to give you a specific number, we’re not going to do that.

John Glass – Morgan Stanley

And then just as a follow up, where do you stand on the price promotions that you’ve done in the past, either the dollar menus, which you have worked with, or the happy hours? Do those all stay in place when you’re adding layers on top of that with the food improvement, or is there a point in time either now or in the near future when you eliminate those promotions in search of sort of a higher check average?

Cliff Hudson

Well, the menu that we put in place during – when the recession came on that had those items on it, the low-value menu, continues to be our menu now system wide.

John Glass – Morgan Stanley

Without plans to take it away?

Cliff Hudson

Well, what we will do from a promotional standpoint in the future, we will disclose that to you as we do it rather than before we do it.

John Glass – Morgan Stanley

Thank you.

Operator

We’ll take or next question from Steve West with Stifel Nicolaus.

Steve West [Matt] – Stifel Nicolaus

Yes, thanks. Matt on here for Steve. I guess one more, not to beat this into the ground, but on a three-year basis on the same sort of sales I guess, I think that’s what John was trying to get at, is improving compared to the declines you have last year? I guess improving doesn’t really clarify much to us. Is there anything else you can provide on a two-year basis that would give us, you know, maybe a magnitude of direction whether it’s, you know, a 4% spread or a 1% spread? I know you don’t want to get too specific but can we get a little more detail there if possible?

Cliff Hudson

Yeah. No, we’re not providing any more detail on that today. We’ll give you more – we’ll give you guidance of what occurred in the quarter at the end of the quarter.

Steve West[Matt] – Stifel Nicolaus

Okay. And the following up on the current beef trends, where are you in terms of possibly locking up some beef to give yourself some further clarity here to see if you’re 1% price increase you’re expecting to take is going to be enough? Have you locked in anything, and how far out, if possible?

Cliff Hudson

Well, if your question relates to commodity costs, where we’re at, if you just kind of take our largest items, we’re on the long-term contract of our [inaudible] and we will have a – probably a low single-digit increase in that come January 1st. Beef is the next largest item and that is still on a month-to-month contract. And that guidance that I gave including packaging costs outlook, that assumes that we continue to have some pressure in that area. So we – we do not have that locked in. If the timing become right, we would like to lock that in longer term, but it’s not currently a good time to do that.

We are – we’ve locked in about half of our cheese costs and we expect that to be up slightly the first half of the year and then down a little bit the second half of the year. So that will be pretty flat. Chicken is locked in through February and it gets a little bit favorably year over year. That’s our fourth largest item and then, you know, it goes down from there.

But overall, right now we’re seeing some pressure in the commodity items that are treated with the protein because of the increases in corn and wheat prices, that is having come impact, but we are trying to lock in most of the items that we can.

Steve West [Matt]– Stifel Nicolaus

Great. Thank you.

Operator

(Operator instructions) We’ll go next to Matt DiFrisco with Oppenheimer & Co.

Matt DiFrisco – Oppenheimer & Co.

Thank you. Just looking at the closings in the quarter, on the franchise side 19 stores. I think that’s the highest in a quarter. How should we look at that going forward in the context of your 40-to-50 store openings? Is that – that’s a gross number sale, correct?

Cliff Hudson

Yeah, 40-50 is a gross number. But Matt, we closed, as I mentioned, we closed 57 stores last year, which is actually down from the year before. We closed I think 72 the year before that. So I guess our view is, you know, given the age of our concept, you know, and the fact we have 3,500-plus stores that 57 stores is not a number that’s out of line.

Matt DiFrisco – Oppenheimer & Co.

But what about the 19 specific to this quarter? I mean, that seems to be ramping up, not a slowing down. So how can we look at the next couple –

Scott McLain

Yeah. I wouldn’t overrate that.

Matt DiFrisco – Oppenheimer & Co.

Okay.

Scott McLain

I don’t think there’s a lot of significance to the fact that there happened to be 19 in the fourth quarter. I would look at the results for the year as more indicative.

Matt DiFrisco – Oppenheimer & Co.

Okay. And then just on that line, on that further, are you starting to see – is that store that closed in – on the Jersey Shore in Cape Mae, is that sort of a one-off situation or are we potentially going to see some of the newer markets maybe reorder some of their stores into some trade centers that might be stronger? I’m just curious if you have any comments on some of those closings in the new markets?

Scott McLain

Well, I think that particular circumstance is more of just a one-off circumstance.

Matt DiFrisco – Oppenheimer & Co.

Okay. All right. And then just clarification, flat restaurant margins for the guidance but absent any same-store sales, does that infer flat same-store sales – flat sales levels or comparable sales levels, what you’re seeing now would infer flat restaurant margins?

Cliff Hudson

It assume that if we have improving trends that we expect relative to where we were at in the fourth quarter, that we would expect to see our labor improve and offset the pressure on the food and packaging costs over all flat margins.

Matt DiFrisco – Oppenheimer & Co.

Okay. I guess I’m – so you’re saying in that flat margin assumption, there is a certain amount of improvement meaning positive comps implied for the flat margins to incur?

Cliff Hudson

Meaning improvement from our – like the negative 6 that we had in the fourth quarter. I don’t think it implies the positive comps, but we do thing we can see continued improvement from what we reported in the fourth quarter and we’ll just continue to update that as the year progresses.

Matt DiFrisco – Oppenheimer & Co.

Okay. So a less-bad comp environment can produce a flat smart of restaurant margins?

Cliff Hudson

That’s correct.

Matt DiFrisco – Oppenheimer & Co.

Thank you. Okay.

Operator

Well go next to Keith Siegner with Credit Suisse

Keith Siegner – Credit Suisse

Thanks. First question is on the ascending royalty rate, now assuming we continue along this path, less bad and maybe we get to positives as the year progresses, have we passed the trough on the ascending royalty rates? Should we start to think about that effective royalty rate picking back up maybe next year?

Cliff Hudson

Well, I think we had a slight decrease on about a 80 percent comp decline and so I certainly think as we see an improvement, particularly from our fourth quarter trends, that you would see that flatten out and potentially start to go back up. We do have our new stores opening up at a higher rate and then we also continue to have some conversions of sort that go to a more current form of our agreement. So there will be kind of natural tendency for that rate to rise over time so you don’t have to give back the positive same-store sales that have a positive royalty rate. But we would expect, again, as the year progresses, to see that flatten out and potentially turn positive.

Keith Siegner – Credit Suisse

Okay. One other quick question. It looks like there was a change in the cost allocation between other ops and labor this quarter. Is that part, you know, I understand the previous one where we’re taking non-controlling interest and moving them to labor, but what happened with that reallocation and can we possibly get from like restated quarters?

Scott McLain

I will – let me get back with you on that. Are you talking about non-controlling interest?

Keith Siegner – Credit Suisse

No. If you look, there was a change in treatment – or I can talk to Claudia about this off line, but the other op and labor, it looks like there’s a shift out of other op and into labor for how that’s being reported. And I’m just wondering if that was part of that change or if that was something else?

Scott McLain

Okay. Let’s – yeah, we’ll visit about that. I’m not sure, we’ll need to get more specifics on your question.

Keith Siegner – Credit Suisse

Okay.

Operator

We’ll take our next question from Brad Ludington with KeyBanc Capital Markets.

Brad Ludington – KeyBanc Capital Markets

Thank you. I had a question on the traffic improvement you talk about with the product rollout. I believe previously you said that once the promotion period for those new products roll outs ended the traffic sell back op. Is it maintaining beyond that at this point? And following up to that, does the guidance that you put out imply that if same-store sales are flat or worse, we’d probably pack out flat to down EPS year over year?

Cliff Hudson

Well, why don’t I handle the first part of that and Steve can handle the second part. As to the first part, I don’t think we’ve said that after a promotion ended we saw sales average trends fall back to where they were, whatever term you used. I don’t think we said that previously and so it kind of – if I go back that is – as we’ve focused on – so we rolled out ice cream in May/June and then as the summer progressed we had had promotions come in our out on a shake or another ice cream product and we saw it – the promotion of one ice cream product upped all ice cream generally and in all specific day parts in particular.

So our objective, just so you want me to broaden that a little bit more, our objective is to not just drive product, it’s also to state to the customer that we’ve got an improved quality product and in turn then drive traffic more generally. And there’s some indications and some of our customer information that in fact with existing customers – it takes a while to get the customers, on a broad basis, or consumers on a broad basis to have a shift in the perception of quality. With our existing customers, we already have some indication that they see these quality improvements affecting their view of the food and their view of the brand with the food.

So it’s not a – it’s not just a purely transactional piece as you might have perceived, and I want to make it clear, we did not say that when we stopped the promotion we said it recedes to where it was.

Steve Vaughan

Yeah, and the second part of your question, Brad, I would just say that we gave a fairly specific outlook for each line item of our income statement. I think the thing that remains very uncertain is the economy and the consumer environment and so we have specifically not gotten, you know, given specifics on our outlook for the earnings for the year. And so I don’t believe we’re going to give any more details on that out. I think what was your question.

Brad Ludington – KeyBanc Capital Markets

Okay. Thank you. Yeah, I didn’t mean to imply at all it was way off. I thought it was kind of a lift and pull back a little bit. I doing my best to help you on the ice cream day down here in Texas.

Steve Vaughan

Thank you very much. We appreciate that.

Brad Ludington – KeyBanc Capital Markets

You bet.

Operator

Well go next to Sharon Zafira with William Blair

Sharon Zafira – William Blair

Hi. Good afternoon. Most of my questions were answered, so I guess I have a pretty simple one. I know you had some issues with average track over the past years and it seems like that flattened in the third quarter. So I’m just curious on the average check trends in the fourth quarter and what you expect for that going forward?

Cliff Hudson

Yeah, sorry. In the fourth quarter our average check was basically flat, so the decline in same-store sales was attributable to traffic. I think we’re seeing that trend continue into the first half of the current quarter in terms of average check.

So the change year over year is traffic driven, not check driven.

Sharon Zafira – William Blair

Are there – I believe there are initiatives in place to drive up average check? Is that something were you expect it to inflate in a positive territory at some point during the year?

Cliff Hudson

Well, I’m not sure what conditions specifically you’re referring to. We continue to see very strong reception of our happy hour promotion in the afternoon. And you may recall, that has the lowest average check of any day part that we have. And so that will continue to have some slight down pressure on our checks. I think that is being offset by less discounting. We’ve been doing less discounting than we had in the prior year. So overall, we’re seeing a pretty stable average check, which we’re very pleased with, by the way.

Sharon Zafira – William Blair

Okay. Thank you.

Operator

We’ll go next to Larry Miller with RBC.

Larry Miller - RBC

Hey guys. I had a question on the SG&A. Can you guys help me understand why it’s so high, especially since you’ve been, you know, you undertook a refresh program a couple years ago – in dollars I’m talking.

Cliff Hudson

Well, okay. A couple of things, Larry. We made, and as we’ve talked about some of the investments that we’ve made back into the brand, in particular we have made some investments at the senior executive level that have paid dividends already, we think will continue to pay some significant dividends. We have made some appropriate adjustments that we talked about in terms of – specifically related to the refranchising the company-owned drive-ins. But I think that we’ve chosen to reinvest some of those savings back into the business because we do believe long term that we’ll grow our business by investing a little.

Larry Miller - RBC

Okay. Should we expect that the SG&A over the longer term should come down then?

Cliff Hudson

Well, we gave pretty specific guidance, we do expect it to grow in Fiscal 2011, and it’s $67 to $68 million. And you know, that’s a pretty modest growth rate, but again, we will continue to invest in the business and try to make sure that we got the infrastructure to support the growth that we expect.

Larry Miller - RBC

Okay thanks.

Operator

And we’ll take our next question from Chris O-Cull with SunTrust Bank.

Chris O’Cull - SunTrust

Thanks. Good afternoon. How has the company’s advertising expend been affected by the negative franchise comps the past several quarters? And by that I mean, has the ad contribution been down, at about the same rate as the system comp support?

Cliff Hudson

The ad – the percentage contribution has remained relatively constant and so they ride, you know, fairly nice. You’ve got vendor dollars and other things that don’t make it exactly the same as the comp, but they have gone to similar patterns in the last 12 to 24 months in terms of marketing dollar declines.

The offset of that is some of the reallocation of dollars in terms of medias in an attempt to increase the exposures that a consumer can get, impressions. And so use of some medias that were using as heavily two and three years ago, a greater diversification versus simply television time.

Chris O’Cull - SunTrust

Has the company considered subsidizing that media fund in order to try to reverse some momentum that’s occurring right now?

Cliff Hudson

Chris, are you thinking of becoming a franchisee?

Chris O’Cull - SunTrust

So I take it there are no subsidies right now?

Cliff Hudson

Yeah. That’s not said. It’s not on the drawing board. I mean, in a way the company has spent quite a bit on marketing; one, through the stores we own, they’re contribution, but also an underwriting staff for that purpose in terms of direct contribution to the system fund, that is not something we pursue.

Chris O’Cull - SunTrust

Okay. And then one last question. Just quick, you know that the guest satisfaction scores and the comps for the company stores have improved relative to the franchise, how much of that is due to the refranchising that’s occurred over the last 12 months?

Cliff Hudson

Well, the refranchising occurred before the fiscal year began. And so the period of time that we talked about an improvement in the last 12 months, it’s been an operational, it’s been the actual experience in that same group of stores.

Now, the figures from the fall of ’08 that are more dramatic – I mean, the stores that we’ve sold, I mean, just so you know, and we’ve probably talked about this before probably, were a blend of underperforming, but also very profitable stores. That’s the way we had to package those to sell them. So it’s not as though they were strictly damaged stores that were sold, they’re underperforming stores.

But regardless, in the last year they’ve gone through, on a same-store basis, serious improvements in customer feedback.

Chris O’Cull - SunTrust

Okay. Great. Thanks.

Operator

And we’ll go next to Matt DiFrisco with Oppenheimer & Co.

Matt DiFrisco – Oppenheimer & Co.

Thanks. I just had a follow-up question on the – or clarification with the interest expense guidance. I understand with the credit change or the rating change, 50 basis points more on your interest expense and then you concluded with the full year will be up $2 million or incremental $2 million expense. I would think though that on a year-over-year basis given what you’ve paid over the last 12 months in interest expense, having a lower debt balance, your forecast for interest expense is going to be lower in dollar terms but you’re saying $2 million incremental versus what you had prior expected before this, correct?

Cliff Hudson

That’s correct, Matt. It’s about 2 ½ million more than we – the guidance we have just last month.

Matt DiFrisco – Oppenheimer & Co.

Okay. Thank you. That’s all.

Operator

And Ladies and Gentlemen, we have time for one more question and that will come from Keith Siegner with Credit Suisse.

Keith Siegner – Credit Suisse

Just a quick follow up kind of along those lines. The tax rate, I didn’t catch it, and I apologize if you did give this. Did you update the tax rate guide to say with the other items and if it’s still 37 to 38, can you help us walk through why so much higher in ’11 versus ’10?

Cliff Hudson

Sure. Keith, we – the tax guidance, tax rate guidance or outlook is still the same as what we put out last month. I would just note that last year we did have the option exchange, which had a pretty significant tax benefit associated with it. I think we had about a $1.8 million one-time benefit, tax benefit from that for GAAP accounting purposes and so that did really skew down the rate last year. But the 37 to 38 percent is more in line with our historical tax rates and what we expect in the coming year.

Keith Siegner – Credit Suisse

And then one last quick one. We heard a lot about all these new initiatives around product quality ranging from coneys to ice cream, to the loaded burger. We haven’t heard as much lately about beverages and around that platform. Is there anything like exciting and new or newsworthy that you want to call out for the coming year around quality and beverages?

Cliff Hudson

That answer is, we will have some initiatives in the coming months, both less exciting from a flavor standpoint, but operationally impactful within the store. But then also from a flavor standpoint both in terms of variety of flavors, I mean, it will have the effect of variety of flavors over time, not all up front from a marketing standpoint. But then also new flavors as it relates to shakes, etcetera. So we’ll continue to focus on the drink side, including shakes in that, shakes and carbonated beverages in the coming months, new flavors with a wider variety.

Keith Siegner – Credit Suisse

Thanks.

Cliff Hudson

Thank you. We appreciate your participation today and our Chief Financial Officer and Treasurer will stand by if you have additional input that you need. We appreciate the engagement with the company and we’ll look forward to visiting with you in the future.

Thank you very much.

Operator

And this does conclude our conference. We appreciate your participation.

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