Denny's (DENN) CEO John Miller on Q2 2014 Results - Earnings Call Transcript

Jul.28.14 | About: Denny's Corporation (DENN)

Denny's Corporation (NASDAQ:DENN)

Q2 2014 Earnings Conference Call

July 28, 2014, 04:30 PM ET

Executives

Whit Kincaid - Senior Director, Investor Relations and Financial Analysis

John Miller - President and Chief Executive Officer

Mark Wolfinger - Executive Vice President, Chief Administrative Officer and Chief Financial Officer

Analysts

Will Slabaugh - Stephens

Michael Gallo - CL King

Tony Brenner - ROTH Capital Partners

Nick Setyan - Wedbush Securities

Shawn Bitzan - Feltl and Company

Operator

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

Whit Kincaid

Thank you, Joshua. Good afternoon, and thank you for joining us for Denny's second quarter 2014 earnings conference call. With me today from management are John Miller, Denny's President and Chief Executive Officer; and Mark Wolfinger, Denny's Executive Vice President, Chief Administrative Officer and Chief Financial Officer.

Please refer to our website at investor.dennys.com to find our second quarter earnings press release along with any reconciliation of non-GAAP financial measures mentioned on the call with their corresponding GAAP measures. This call is being webcast and an archive of the webcast will be available on our website later today. Our 10-Q will be filed later today as well.

John will begin today's call with his introductory comments. Mark will then provide a recap of our second quarter results along with brief commentary on our annual guidance for this year. After that, we'll open it up for questions.

Before we begin, let me remind you that in accordance with the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, the company knows that certain matters to be discussed by members of management during this call may constitute forward-looking statements.

Management urges caution in considering its current trends and any outlook on earnings provided on this call. Such statements are subject to risks, uncertainties and other factors that may cause the actual performance of Denny's to be materially different from the performance indicated or implied by such statements. Such risks and factors are set forth in the company's most recent Annual Report on Form 10-K for the year ended December 25, 2013, and in any subsequent quarterly reports on Form 10-Q.

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

John Miller

Thank you, Whit, and good afternoon, everybody. We are pleased with our second quarter performance, which clearly demonstrates the success of our brand revitalization strategy. We generated yet another quarter of system-wide same-store sales growth highlighted by a strong quarter of same-store sales at company restaurants. In addition, we grew adjusted EBITDA and adjusted net income per share, while generating strong free cash flow.

As a result of our performance through the first half of the year, we are pleased to be raising our annual financial guidance and are on track to achieve the highest annual same-store sales growth for our company restaurants since 2005, primarily driven by our newly launched Heritage remodel program.

We have remodeled 33 of our company restaurants through the first half of this year, resulting in nearly 40% of our company restaurants showcasing the new Heritage image. We continue to work closely with our franchisees to develop remodel programs at an appropriate level of investment for a brand with an average annual sales of $1.5 million.

Due to Denny's diverse portfolio of restaurants with a wide variety of schemes, ages, geographies and sales volumes, we have seen a range of results with restaurants having the older schemes garnering the strongest results overall from remodels. Today, approximately 54% of the system is on the current pre-Heritage remodel scheme, with a much more relevant image than our older schemes. These include the 330 new restaurants that have opened since the beginning of 2008.

For these approximate 900 locations, either not due or yet to be revitalized. We continue to collaborate with our franchisees to finalize a more modest remodel investment. We expect to lower the cost program to generate a sales lift at the lower-end of the middle single-digit range that we are seeing today.

The great news is that the increases in the same-store guest traffic we are seeing at company locations are clear evidence of our success with the Heritage program, and further prove that our America's diner positioning resonates very well with our consumers. Our guests continue to guide us in our ongoing efforts to improve our menus, to meet the needs of an ever-changing marketplace.

Our revitalization efforts to improve our food, service and atmosphere, put for us further down the path to consistently growing restaurant sales and margins. Over the past year, we have made investments in our new restaurant opening and trainee teams to support our franchisees and their efforts to improve the overall guest experience.

We recently launched our Denny's Pride Restaurant Review program to improve restaurant operations and guest satisfaction. This is accomplished by assessing, measuring, coaching and continuously improving the consistency and the execution of both, our current brand standards as well as our new initiatives, everyday, every shift and every guest.

Our management team remains focused on finding ways to improve restaurant margins, including purchasing efficiencies, menu changes and other operational initiatives. Together, through the close partnership with our dedicated franchisees who have identified a unique opportunity in our franchise agreement to improve restaurant level margins.

Recently introduced a new franchise agreement with total royalty and marketing fees of 7.5% of gross sales, comprised of a 3% contribution to the Brand Building Fund and a 4.5% royalty, excluding any incentives. The old franchise agreement had total royalty and marketing fees of 8% of gross sales, comprised of a 4% contribution to the Brand Building Fund and 4% royalty, excluding any incentives.

Due to various incentive programs, the Brand Building Fund contribution rate currently averages 3% across the system, with most franchisee agreements providing a step up to the 4% contribution rate. The new fee structure lowers total fees to franchisees of 1.5% of gross sales.

The reduced total rates with the higher royalty rate will be offered to all franchisees that will move to the 4% Brand Building Fund contribution rate over the next decade. The new fees are more beneficial for all stakeholders and most importantly for our franchisees.

The total amount, which the Denny's system spends for advertising and promotion, will increase as we grow our footprint and restaurant-level sales, by retaining the current average contribution rate, the new fees eliminate a future step up in contributions to the Brand Building Fund.

To help the Brand Building Fund in this transition, if organic growth falls short of expectations, we have agreed to make an additional contribution to the fund through 2017, representing half of the incremental royalty up to $2 million per year. Although most of the eligible restaurants have switched to the new fee structure, today that represents only approximately 100 franchised restaurants.

It is critical to understand that due to the long-term migration of existing franchisees from older incentives and the Brand Building Fund, we won't see the full benefit from the higher royalty rate for than a decade. This is a great opportunity to enhance our existing and future franchisee profitability at a time when we are looking to grow our footprints across America.

With the franchise focused business that generate strong free cash flow, we will continue to balance our capital allocation between making investments to grow and strengthen the Denny's brand and returning cash to shareholders. During the second quarter, we generated almost $12 million in free cash flow after our investment in company remodels.

While these investments continue, we have remained committed to returning value to our shareholders through our share repurchase program. During the first half of the year, we allocated $24 million to repurchase 3.6 million shares, which is close to the 25 million we allocated for all of last year.

We are focused on growing earnings per share to our franchise focused business, which provides financial stability and flexibility. And although we are still early in the revitalization process, our America's diner revitalization is gaining momentum with our guest and our franchisees, and the Denny's team continues to be energized and excited about the future of the brand.

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

Mark Wolfinger

Thank you, John, and good afternoon, everyone. Our second quarter results were highlighted by growing franchise and company same-store sales, completing an additional 17 Heritage remodels at company restaurants, growing adjusted net income per share by 15.7% and generating $11.6 million of free cash flow after capital expenditures.

During the quarter, Denny's opened three franchise restaurants and closed six system-wide restaurants, including one company restaurant. As a result, we ended the quarter with 160 company restaurants and 1,533 franchise restaurants, bringing to a total restaurant count of 1,693.

Denny's total operating revenue, including company restaurant sales and franchise and license revenue, decreased $2 million to $114.6 million, due to fewer company restaurants and lower occupancy revenue, partially offset by higher same-store sales at company and franchise restaurants.

Same-store sales of domestic franchise restaurants increased 1.7%, primarily due to an increase in same-store guest check average, driven by both higher menu pricing and favorable product mix. Franchise and license revenue of $33.5 million decreased $254,000, primarily due to an $860,000 decreased in occupancy revenue. This decrease was partially offset by a $724,000 increase in royalty revenue, resulting from nine additional equivalent franchise restaurants.

Franchise operating margin of $22.8 million increased $698,000, primarily due to a $1 million decrease in occupancy and other direct costs. Franchise operating margin as a percentage of franchise and license revenue increased 2.5 percentage points to 68.2% compared with the prior-year quarter. This improvement was primarily due to the increase in royalties.

Same-store sales at company restaurants grew 3.7% due to both an increase in same-store guest check average and an increase in same-store guest traffic. The increase in same-store guest check average was driven by both higher menu pricing and favorable product mix.

Sales at company restaurants decreased $1.7 million, primarily due to five fewer equivalent company restaurants, which was partially offset by the increase in same-store sales. As a reminder, sales in this quarter were unfavorably impacted by the temporary closure of our Las Vegas restaurant and permanent closure of one of our Honolulu restaurants in the beginning of this year. In addition, sales were unfavorably impacted by the refranchising of two restaurants in the third quarter of last year and the temporary closures relating to completing 17 Heritage remodels during the quarter.

Company restaurant operating margin of $11.5 million or 14.2% of company sales increased by $101,000 or 0.5 percentage points compared to the prior-year quarter. The company margin was negatively impacted by the temporary closure our Las Vegas Casino Royale restaurant, which generated $800,000 of pre-tax operating income and $2.1 million of sales in the second quarter of the prior year.

Excluding this impact, the increase in company restaurant percentage margin was primarily driven by a reduction in payroll and benefits costs, as well as occupancy costs, which were partially offset by increases in product and utility costs. The increase in product costs was primarily due to the higher commodity costs and the impact of changes in the product mix in the quarter. Interest expense for the second quarter decreased by $274,000 to $2.3 million primarily, resulting from lower interest rates under our refinanced credit facility.

In the second quarter our provision for income taxes was $4.7 million, reflecting a 36.4% effective income tax rate. Due to the use of net operating loss and income tax credit carry forwards, we paid $820,000 in cash taxes during the quarter. At the end of the second quarter, the deferred tax asset on our balance sheet was $46.5 million. We will continue to utilize additional net operating loss and income tax credit carry forwards to eliminate the majority of our cash taxes for the next few years.

In the second quarter, free cash flow after capital spending increased $420,000 to $11.6 million. We spent $6.7 million on capital expenditures in the quarter, which included completing 17 Heritage remodels at company restaurants.

During the second quarter, we allocated $14.9 million to repurchase 2.3 million shares. As of July 25, we had repurchased a total of 20.3 million shares since we started our share repurchases program in November 2010. As a result, we have a total of 4.7 million shares authorized and remaining in our ongoing share repurchase program.

As John mentioned, returning value to our shareholders remains a very important part of our strategic plan, as evidenced by the 3.6 million shares repurchased in the first half of this year.

With our momentum growing to the first half of the year, we are well-positioned to raise the company's financial guidance for full year 2014. The company is increasing expectations for company same-store sales, adjusted EBITDA and free cash flow in addition to updating expectations for other selected components.

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

Question-and-Answer Session

Operator

(Operator Instructions) We'll take our first question from Will Slabaugh with Stephens.

Will Slabaugh - Stephens

Can you talk just a little bit of more about where you saw the strength? I think we have seen a lot of softness throughout family dining and all full-service dining in 2Q, and especially at the end of the quarter? So I don't know how much detail you'd be willing to get into in terms of geographic or progression throughout the quarter, sort of where you saw the strength within your business?

John Miller

It's John, happy to do so. 670 restaurants, we've shared in this past, so we have well-over 800, little less than 900 in six days. And if you look at Nevada, California, Arizona, Florida, 670 restaurants in the strongest performing state, so that certainly has a benefit to where we're geographically distributed.

So we're softer in Midwest, up Midwest. There are some areas, Middle-Atlantic, which just are still not responding like the stronger states, but I'd say that in general where you see the most employment, not necessarily in percent compared to pre-recession, but in just raw net numbers in new jobs created, you see the most sense of prosperity eating out again and innermost recovery in full service dine out occasions.

I think also the progression through the quarter in our calendar, Easter represented a little bit of a flip to our benefit. So the earlier part of the quarter benefited from that, the first month of the quarter. And then we had the World Cup that created a little bit of a headwind for us, that coming into, since we jumped out of the July quarter, we can return back to sort of more of a normal pattern pre-World Cup. So there was a softening during the best games.

And that's pretty much the story of the quarter. Strong regional performance, and especially Nevada and California, and then there's improving -- steadfast improvements in Florida, Arizona, and then benefit coming out of World Cup.

Will Slabaugh - Stephens

And then, wanted to ask just quickly as a follow-up to the cost that Mark walked through. So obviously labor came in nicely, 70 basis points below your year-over-year number. Can you talk about how you sort of see that going forward? I know that that's largely sales driven. And then combined that with the pressures you may see from a cost of good standpoint and what you're pricing stamps maybe going forward?

Mark Wolfinger

Well, from a pricing standpoint, well, I think we're looking at probably pricing for the year, I'll call it in the 1.5 sort of 2 range, depending upon franchise or company side. We really haven't talked specifically about all that components from a company margin standpoint, but clearly, I think as we commented after our first quarter call, where our first quarter company margins were lower than previous year, that we thought the margins would start to claw back, which they did. And just as a reminder, we had a workers comp charge that occurred in the last year same quarter, so that was part of the benefit unlike the year-over-year basis also in the quarter, but overall I think we were very pretty satisfied with the company margin side.

Will Slabaugh - Stephens

And last question if I could. Could you breakout traffic and check in terms of your company-owned stores?

Whit Kincaid

Will, this is Whit. So traffic was up 0.9% in the quarter and check would have been up 2.8% at the company stores in the quarter.

Operator

And we'll take our next question from Michael Gallo with CL King.

Michael Gallo - CL King

Again, congratulations, I think it was the best company comp, I can recall in a long, long, time. I just want to delve in couple of questions first for John. John, I noticed you made some changes around $2, $4, $6, $8, particularly on the $6 and $8 items. It look like you went more to some of the, I would say, more Denny's driven items. So you put the Hobbit-Hole at $6, and you made some changes with the Country-Fried Steak & Egg and some of the Skillets at $8 million.

My recollection was the $8 items historically didn't mix that well as a percentage. I was wondering within $2, $4, $6, $8, if you saw a push in the mix more towards $6 and $8 from what you have seen historically in say $2 and $4? And whether that helped average check in the quarter? And how we should think about that going forward?

John Miller

Yes. Those are great questions. The $8 category has always been the slightest, but nevertheless a solid category for us. It just doesn't compare to the $4 and $6. So I think the strength of $6 is really more around getting full for $6, and then you add the beverage. We started out the $8 category with beverage.

And then over a three-and-a-half, four year period without taking price in $2, $4, $6, $8, the effort to address margins that come under pressure through time with margin shifts, the menu had to shift. So we made the election to eliminate the free beverage with the $8 menu, all but one item, and so that puts more downward pressure on that mixing at the top of the four different priced options.

So our best performance group is the $4 and the $6 range. We expect that to continue. $2 is going to come under a little pressure near-term, because if we move that more into the dessert add-on strategy category than a full meal strategy, and that helps margin, but frankly, it's still just every bit as compelling as when we first launched it. Mix has moved up a little bit slightly over the same quarter last year.

Michael Gallo - CL King

And then just a question for Mark. I was wondering, just to kind of get into the details on how we should think about the change in the royalty fee as franchisee royalties roll over. So should we think about that as kind of $1 million or so positive tailwind to royalties per year, kind of as that rolls over and there will be some offsetting kind of expense. So how should we think about, I guess the financial impact to that?

Mark Wolfinger

So I'll look little bit, Mike, back to John's comments on that, and so to all the listeners, we talked about this new franchise agreement, John commented on that that includes total fees of 7.5%. So again that's a 3% contribution to the Brand Building Fund and a 4.5% royalty. John mentioned that that excludes incentives. We've had a lot of different incentives out there affecting certainly our royalty and also our brand building contribution. So again, that's sort of the standard agreement excluding those incentives.

So total fees of 7.5%, the old agreement was 8%, which was a 4% on 4%. And again, you had a sort of a series of migration, so both those numbers exclude incentives. John, also mentioned that there is, I think around a 100 units that basically are in that, sort of I'll call that 7.5% range, because of where they are timing-wise. But also mentioned the fact -- and this is really, I think to some degree, Mike, your question is modeling question that it will probably be up to a decade before the full benefit will be realized.

So I've given you a series of numbers, but without saying specifically what the short-term impact is, because there are so many different moving parts here. But overall, I think what John's point was that obviously from a fee standpoint, for our franchisees, that their overall fees long-term have been lowered by 50 basis points or 0.5 point of margin improvement basically. So a lot of moving parts and pieces, but clearly from a brand standpoint, I think we're certainly very, very positive on this change.

Operator

And we'll move on to Tony Brenner with ROTH Capital Partners.

Tony Brenner - ROTH Capital Partners

I had a question on the remodel or the timing of the company store remodels. I know that for this year your remodels have been first half loaded. I wonder if you could just update us on what the number of stores that might be remodeled in the second half? And then if you've got an early read on the number for 2015 company stores?

John Miller

Tony, this is John. So 17 were done in the quarter. I believe that's 33, year-to-date. And we had said in earlier guidance about 40 company stores on the full year.

Tony Brenner - ROTH Capital Partners

And then for next year any thought?

John Miller

Yes. So for next year, the 40 this year on top of 26 we did last year, so that's 66 of 160. So we certainly would continue. And I don't think we've guided longer-term. But again, I think if you look our habit would be to make sure that they are done when they're due and about a-seventh are due every year. We'll be a little bit ahead of that going into next year.

Tony Brenner - ROTH Capital Partners

And then what is the status now with your downtown Las Vegas store? I know a lot of people that I know have had to change their wedding plan. So just wondering where that store is at?

John Miller

Yes. It is fascinating to us as well, the number of people that make it a stop. I don't know the number of weddings we've done to date down there, but I'll have that for you here in just a second, 33 to date in a year-and-a-half or so. That's not too bad with no advertising other than the debut when the restaurant opened.

The store is doing well, along with that whole market has really gone through some increased tourism, and then also the state of Nevada is our leading state in comp performance year-over-year. Now, part of that is tourism is up, and no question when your have the store that's doing about $8 million a year, closed temporarily, the redistribution of that plays a role as well.

So until we reopen at our flagships location, affectionately known as unit number 141, at Casino Royale, we don't know the overall weight between the market being up and the redistribution of sales, but that downtown store is doing quite well.

Tony Brenner - ROTH Capital Partners

All these construction that was going on in that area is now complete. It's been a while since I've been downtown.

John Miller

No, actually it's not. At our end of that little area, it's still little messy, frankly.

Tony Brenner - ROTH Capital Partners

But the comps in that store are positive?

John Miller

Yes. Traffic's up, comp's up. Good numbers.

Operator

And we'll take our next question from Nick Setyan with Wedbush Securities.

Nick Setyan - Wedbush Securities

Let me ask that royalty question a different way. Maybe just kind of number of franchise stores, I know you guys said, 100 are currently on that new sort of model. I mean, let's say, a year from now we're standing next Q2, when you're talking about how many stores have gone on that number. How should we think about that? Is it maybe 100 stores a year? Is it maybe a little bit less than that, a little bit more than that?

Mark Wolfinger

It's Mark. I think what we can say on that is that -- again, so I'll mention what John mentioned, which was the 100 that are currently on that, I think we're are anticipating probably by the end of next fiscal, it will probably be, I'll call it several hundred restaurants will probably be on that kind of structure.

Again, they qualify for that fee structure. They obviously have to amend their franchise agreement to signup for this new arrangement. So again, you've got this transformation that's taking place. But I think probably by the end of 2015, there will be, call it, several hundred, I'll call it 300 to 400 that will probably -- again, if everything works normal fashion, it would be at that type of arrangement. So is that helpful?

Nick Setyan - Wedbush Securities

Yes, it's very helpful. And is there I think anything else in terms of commitments, that go into the restructured commitment there in terms of maybe development agreements, maybe up the number of units you have to build per year, anything like that?

John Miller

Nick, this is John. There is no development related tagalongs with this fee change.

Nick Setyan - Wedbush Securities

And the other question I have is, it's around the 14th week of Q4, do you guys know how much in terms of EBITDA that 14 week is worth?

Whit Kincaid

Nick, this is Whit. It's about kind of call it, $3 million, $3.5 million. And so most of that flow through its coming in on the franchise side on the royalty piece, but you do see an impact on the company margin as well, call it around 30 basis points, maybe 40 basis points in the fourth quarter. And that's a tax number on a $3 million to $3.5 million.

Nick Setyan - Wedbush Securities

When's the next menu change coming? Are we going to see a little bit more pricing in Q3 with the minimum wage headwind in California?

John Miller

Yes. So Q1, you remember, we talked about slightly under 1%. And then we took a menu price increase in July, second half of the year slightly higher in California to cover, call it 30 basis points hit from California wage inflation, and call it 30 basis points on ACA. So the franchisees are in, call it, the 2% range on the year is how we're guiding for price in the company a little -- about 1.6% on a year.

Nick Setyan - Wedbush Securities

And you guys said that the average check in the quarter was at 2.8%. What was the breakout between menu price and mix?

John Miller

About 1.5% price so far and about 1% mix for the 2.5% total check change.

Nick Setyan - Wedbush Securities

And then just last question, kind of longer-term. Would you guys consider maybe buying a second brands as maybe a growth vehicle or are we kind of just looking at continued share repurchases going forward in terms of the use of cash?

John Miller

I think the best way to answer that is we're committed to the current course. We want to optimize the value of Denny's. We think we have a great brand with tremendous global expansion potential. And so any of those kinds of conversations, of course, like any good management team, we consider all kinds of options for cash use, but our focus right now is share repurchase.

Operator

And we'll take our last question from Mark Smith with Feltl and Company.

Shawn Bitzan - Feltl and Company

This is Shawn Bitzan sitting in for Mark Smith. One quick question, can you just talk a little bit about how much the limited time offers drove comps in the quarter?

Whit Kincaid

Can you repeat the question please?

Shawn Bitzan - Feltl and Company

Sure. Can you talk a little bit of about how much limited time offers drove the comps?

John Miller

That's a great question, because answering with precision is a little difficult. I can tell you that our LTOs run pretty consistently around 10% of product mix, because that's consistent quarter in and quarter out, where this impact on comps is sometimes hard to tease out. And so we use traditional methodology and asking what consumers thought of the media and their favorability to brand, but that doesn't necessarily translate certainty. So I'd tell you that without sales it wouldn't be as strong, and with it we have brand momentum, but to say precisely what the advertising does is pretty tough to answer.

Operator

And that will conclude today's question-and-answer session. At this time, I would like to turn the conference back over to our speakers for any additional or closing remarks.

Whit Kincaid

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

Operator

And this concludes today's conference. We thank you for your participation.

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