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O'Charley's Inc. (NASDAQ:CHUX)

Q3 2010 Earnings Call

November 5, 2010 11:00 am ET

Executives

Gene Marbach - IR

Phil Hickey - Chairman

David Head - President and CEO

Larry Hyatt - CFO

Analysts

Jeff Omohundro - Wells Fargo Securities

Bryan Hunt - Wells Fargo Securities

Bryan Elliott - Raymond James

Robert Derrington - Morgan Keegan

Operator

Welcome to the O'Charley's Inc. Third Quarter 2010 Conference Call. (Operator Instructions) This conference is being recorded today Friday, November 05, 2010. I would now like the turn the conference over to Mr. Gene Marbach. Please go ahead sir.

Gene Marbach

Good morning all and thank you for joining O'Charley's fiscal 2010 third quarter conference call. On the call today are Phil Hickey, Chairman of the company’s Board of Directors; David Head, the company’s President and Chief Executive Officer; and Larry Hyatt, the company’s Chief Financial Officer.

The order of business this morning will be some brief remarks from Phil, David and Larry about the third quarter. We will then open the call to questions. In the time allotted we will take as many questions as possible.

Before we begin, I would like to note that certain statements made by O'Charley's management on this call may be deemed to constitute forward-looking statements made pursuant to the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements may be affected by certain risks and uncertainties including risks described in the company's filing with the Securities and Exchange Commission. In light of the significant uncertainties inherent in the forward-looking statements included in the company's comments, you should not regard the inclusion of such information as a representation that its objectives planned and projected results will be achieved and the company's actual results could differ materially from such forward-looking statements.

I would now like to turn the call over to Phil Hickey, Chairman of the Board of Directors of O'Charley's. Please go ahead.

Phil Hickey

Thanks Gene and good morning everyone. In our second quarter conference call back in August, I noted that Ninety Nine and Stoney River had experienced a positive shift in momentum. We are pleased to see this positive momentum continue in the third quarter as both concepts reported same-store sales increase for the first time in three years.

We are also pleased to see this momentum extend to the O'Charley's concept where quarterly guest counts increased for only the second time in five years. And same-store sales show substantial improvement versus recent trends.

While we are encouraged by progress of our efforts to drive guest counts and sales, we know that we have a lot more work to do translating this progress into long-term, sustainable growth in sales and profitability.

During the third quarter David Head joined us as President and CEO. I planned this transition so that future earnings calls will be handled by David.

I also plan to continue to work closely with him to find strategic direction of the company as its now Executive Chairman. I continue to believe in the potential of each of our three concepts and our company’s best days lie ahead of us.

Speaking of David Head, it’s my pleasure to introducing him to you. David joined the company in the beginning of September, as proven restaurant leader whom I have known for 15 years. He has substantial experience in both casual dining and as quick-service. I look forward to working with him as we continue our efforts to revitalize our company. David?

David Head

Phil, thanks for the introduction. Good morning everyone. Since joining the company in early September, I had been all around the country, spending a lot time in many of our restaurants, actually working in kitchens in all three of our concepts, sat down and met with many of our managers and team members and have a develop a clear understanding of what we do well and where we need to improve.

My initial focus is really the foundation of the turnaround plan. This is going to be on improving the execution of the basics, making sure that every guest experience is great food, great service, strong value, while we managed costs to improved profitability.

Although we clearly face many challenges in turning around our company’s performance, I strongly believe in the potential on each of our three concepts and absolutely share Phil’s belief that our company’s days lie ahead of us. I look forward to working closely with our management team and our Board.

So, let me begin my discussion of third quarter results with Ninety Nine where we continue to strengthen the concepts place to our core guests, who appreciate a friendly neighborhood environment that offers very generous portions of high-quality traditional fare at moderate prices.

Ninety Nine outperformed its relevant Knapp-Track averages in the quarter, and had its first quarter of same-stores sales growth in three years. We believe that this quarter’s growth in average check demonstrate that we can provide value for our guests without being overly aggressive with discounts or promotion. The Nine Real-Sized Entrees for $9.99 continues to prove very popular with our guest and profitable for us. We continuously refresh the nine items recently added eggplant [sauté] and Balsamic Chicken.

Our guests at Caption 99 continue to respond favorably to the opportunity to upgrade our Entrees into a full meal for an additional $3 and our Red Sox Win/Kids Eat Free promotion continue to be popular throughout the end of the season.

Now, during the quarter 99 improved its guest satisfaction scores by 200 basis points versus the prior year’s quarter. And through the first four weeks of the current quarter same-store sales and same-store guest counts were positive.

Turning to Stoney River, they had same-store sales growth for the first time in three years with guest count accelerating from the higher single-digits in the priors three quarters to over 15% in the third quarter. We believe that the repositioning of the Stoney River concept continues to show progress as we increase our relevance to a broader guest market.

Now, as previously noted we reduced the prices of certain menu items, added new menu items and more affordable choices to the wine list, while continuing to offer the Royal Stoney River guests the same wonderful service experience and all the signature favorites. We continue to focus on bringing Stoney River’s cost structure in line with the lower check average and this is the fifth concretive quarter in which we improved restaurant operating margin.

During the quarter Stoney River improved its guest satisfaction sores by 400 basis points versus the prior year quarter. And through the first four weeks of the current quarter Stoney River same-store sales and same-store guest counts continue their positive trends.

Now moving on to the O'Charley's concept; our guest counts increased in the quarter for the first time this year and our same-store sales showed substantial improvement versus recent trends, while clearly in its early stages. We believe that the turnaround of the O'Charley's concept is gaining traction.

The first step to improving sales and profits is attracting new guests, increasing the frequency among our recurring guests and providing everyone the great food and service that will make them want to return.

We believe that we started to accomplish this with the reintroduction of ‘2 Meals for $14.99’ in early August and guests responded favorably with the choice of seven proven favorites combine with value-priced beverage and appetizer choices, and then an opportunity to complete the meal with super salad and a dessert for $2.99.

In each of the 12 weeks, since we reintroduced ‘2 for $14.99’, guest counts at the O'Charley's concept outperform the relevant Knapp-Track index. With our culinary retraining and recertification program we believe that we are establishing the service and execution foundation to convert new and returning guests into loyal O'Charley's users.

Guest satisfaction scores in the quarter improved 100 basis points versus the prior year quarter was the highest level since we started measuring it six years ago.

Now as expected our emphasis was valued to induce trial contribute to a decline in average check and margin. Therefore, we believe that step two, in improving sales and profitability is to gradually increase the average check, while continuing to offer items of choices to value-oriented guests.

While we continue to offer enhanced “2 Meals for $14.99”, we recently introduced Classic Combos, which offers a combinations of steak, seafood and chicken at many prices between $12.99 and $15.99. In the two weeks since we introduced Classic Combos, O'Charley's same-store sales and same-store guests counts were both positive.

So we believe that our repositioning efforts for the O'Charley's concept require fresh thinking from an ad agency. As we announced in mid-September, through a review we selected Merkley+Partners of New York as the agency of record for the O'Charley's brand. Merkley is well known for its core competency in food and is considered one of the premier agencies in the country.

We look forward to combining their creative thinking with our great brand as we develop marketing strategies for 2011.

Before I turn the call over to Larry Hyatt for his comments, I just like to say how proud that I am to be part of O'Charley's team. I think this is a great time to join O'Charley's and we have a unique opportunity to build a special company.

I would also like to acknowledge the dedication of our 23,000 team members who are focused on delivering superb guest experiences. I just want to thank them for all that they do. Now, here is Larry to share with you the rest of the story.

Larry Hyatt

Good morning, everyone. And thank you, David. I would like to discuss our financial performance for the third quarter of 2010, some items that impacted that performance and our outlook for the current quarter. Additional information is available in our Form-10Q which we filed this morning with the SEC.

For the third quarter of 2010, revenue declined 1.2% to $191.7 million from $194.1 million in last year’s third quarter.

Loss from operations was $5.6 million or 2.9% of revenues, compared with the income from operations that was $0.3 million or 0.1% of revenue in the prior year quarter.

Results for the quarter include impairment and disposal charges of $2.5 million compared to $0.3 million in the prior year quarter.

Our adjusted EBITDA for the quarter was $7.6 million or 4% of revenues, compared to $13 million, or 6.7% of revenues in the prior quarter.

Reviewing our performance on a concept by concept basis; restaurant sales for company-operated O’Charley’s decreased by 2.5% to $120.2 million, compared to $123.3 in the prior year quarter. The closing of two O’Charley’s restaurants since the third quarter of 2009 accounted for $0.4 of this decline in sales.

Same-store sales at our company-operated O’Charley’s restaurant declined by 2.2% which was the result of an increase in guest count of 2.7% offset by a decline in average check of 4.8%.

Restaurant level margin which we define is restaurants sales minus cost of food & beverage, payroll and benefits costs, and restaurant operating costs at the O’Charley’s concept declined to 11.4% of restaurant sales from 15.1% in the prior year quarter.

Restaurant sales for Ninety Nine decreased by 0.2% to $63.9 million compared to $64 million in the prior year quarter. The closing of 3 Ninety-Nine restaurants in the third quarter of 2009, reduced year-over-year sales by $0.9 million.

Same-store sales increased by 1.2% in the quarter and a 1.8% increase in average check was partially offset by 0.6% decline in guest count.

Restaurant level margin in Ninety-Nine declined to 12.1% of restaurant sales from 12.4% in the prior year quarter.

Restaurant sales for Stoney River increased 10.9% to $7.3 million compared to $6.6 million in the prior year quarter. The opening of one Stoney River restaurant since the third quarter 2009 accounted for $0.6 million of the increase.

Same-store sales increased by 1.7% in the quarter at a 15.4% increase in guest count, talent was partially offset by a 11.9% decline in average check.

Restaurant level margin in Stoney River improved by 190 basis points in the quarter compared to the prior year quarter.

On a consolidated basis restaurant operating margin was $22.6 million or 11.8% of restaurant sales in the quarter compared to $27.5 million or 14.2% of restaurant sales in the prior year quarter. A number of factors contributed to year-over-year change.

Our cost of food and beverage in the quarter was $58 million or 30.3% of restaurant sales compared with $56.5 million or 29.1% of restaurant sales in the prior year quarter. Lower commodity cost was offset by the impact of our effort to improve food quality and provide better value to our guests. Food and beverage cost per guest increased by 1.5% on a consolidated basis while our restaurant sales per guest declined by 2.5%

Our payroll and benefit cost declined to $68.5 million or 35.8% of restaurant sales from $70.5 million or 36.3% of restaurant sales in the prior year quarter. During the quarter the company recognized the year to-date benefit of the hire act which reduced payroll tax expense by $0.8 million. Workers compensation and health insurance expenses were $1.7 million lower in the quarter compared to the prior year quarter, while training expenses were $0.5 million higher reflecting our current cost culinary, retraining and recertification effort.

Restaurant operating costs in the quarter were $42.4 million or 22.1% of restaurant sales compared to $39.5 million or 20.4% of restaurant sales in the prior year quarter.

Utility expenses was $0.7 million higher, reflecting higher electricity usages during the unusually hot summer. Supplies and replacements were $0.7 million higher, repairs and maintenance expense was $0.6 million higher and the property taxes were $0.6 million higher reflecting the true-up of property tax approval in the prior year quarter.

Advertising and marketing expense was $8 million or 4.2% of revenue in the quarter compared with 7.6 million or 3.9% of revenue in the prior year quarter.

Our general and administrative expenses were $8.3 million or 4.3% of revenue in the third quarter compared to $80.7 million or 4.5% of revenue in the prior year quarter. The $0.4 million year-over-year reduction in G&A expenses is due primarily to changes in the value of deferred compensation balances, which is offset by an increase in interest expense. Our interest expense for the third quarter was $2.5 million compared with $2.3 million in the third quarter of 2009.

On a year-over-year basis, the impact of reduced debt level was more than offset by the $0.4 million impact from changes in the value of deferred compensation balances.

At the end of the quarter, we had $115.2 million of senior subordinated notes outstanding, a cash balance of $22.7 million, and $32.4 million of availability on our revolving line of credit.

Our capital expenditures in the quarter were $3.2 million compared to $4.5 million in the prior year quarter. Our results for the quarter include an income tax benefit of $0.6 million compared to an income tax expense of $0.1 million in the prior year quarter. Our net loss in the quarter was $7.4 million was $0.35 per diluted share compared to a net loss of $2.1 million or $0.10 per diluted share in the prior year quarter.

For the fourth quarter of 2010, we forecast total revenue of between $184 million and $190 million. A loss from operation between $3 million and $6 million and adjusted EBITDA between $5 million and $8 million. This forecast reflects the impact of closing of two restaurant at the end of the third quarter of 2010. But does not reflect the impact of any impairment or severance charges that the company may recognize in the fourth quarter.

And, with that, I will turn the conference call back over to the operator, so that we can answer your questions. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) And, our first question is from the line of Jeff Omohundro with Wells Fargo Securities.

Jeff Omohundro - Wells Fargo Securities

Thanks. I guess my first question relates to the operating costs left in the third quarter. It does sound like some of these items might be ongoing. Should we assume that your operating costs will be a bit higher on a go-forward basis, may be closer to this 22% level relative to sale?

Larry Hyatt

Jeff. Let me talk about each of the three categories that were the cause of major variances. But, the results of our property tax expenses in the third quarter of 2009 which create that negative year-over-year comparison.

Utilities expenses were largely the result of the unusually warm summer, and repairs and maintenance is probably reasonable to think that we may have somewhat higher repair and maintenance expense going forward than we had in the past.

Jeff Omohundro

Okay, that’s helpful. And relating to the Classic Combos relative to the ‘2 for $14.99” promo. I wonder if you can maybe show us some of your efforts to move mix towards this Classic Combos and how you might achieve that?

David Head

Jeff this is David, that is promoted at the table. It’s inserted in the menu and it’s spoken to by the server as folks sit down and so the 2 for $14.99 the value promotion that we are using on television to be able to talk about the strong value message and then the trade-off offering is focused on at the table, where the server points out to these brand new offerings that we have and how compelling there are the life that we have experienced successful transitioning to those.

Operator

And our next question is from the line of Bryan Hunt with Wells Fargo Securities

Bryan Hunt - Wells Fargo Securities

Thanks you and good morning. I was wondering if you could tell then to your hedging position for Q4 and in to 2011 considering the commodity inflation which we’ve seen particularly since June and I got a follow up.

Larry Hyatt

Bryan, sure. For the balance of the current fiscal year in that sense for the rest of the fourth quarter we locked in substantially all of our pricing for the center of the plate commodities. Based on that locked in pricing and the current forecast the we are working at, we expect to continue to see a decline in cost in the fourth quarter of this year versus forth quarter last year in the low single digit for food, while we continue to expect to see an increase and in our alcoholic beverage cost in the range of low to mid single-digit.

As far as the 2011 fiscal year as you have probably heard from a number of restaurant companies it does appear as if our commodity cost are likely to be higher in 2011 then they were in the current fiscal year. As of right now we have locked half of our estimated sea food and pork, approximately half of our poultry requirements but because of the current uncertainties in the market we have not yet contracted for beef.

We are continuing to watch the beef market and all of the commodity market closely but we are yet, comfortable that we are in a position to offer a more specific forecast for 2011.

Bryan Hunt - Wells Fargo Securities

Based on what you’re looking at so far do you have any type of guidance for inflation at this point on your centre of the plate?

Larry Hyatt

Its abating, it will be somewhere in the low single digit, Bryan.

Operator

Thank you. And our next question is from the line of Bryan Elliott with Raymond James.

Bryan Elliott – Raymond James

Thanks. Good morning. Kind of, following that question. The transition that you referenced minutes ago, a successful transition to moving some mix towards the Classic Combo on the $14.99. Just wondered if you could give us a sense of the gross margin pick up that occurs with that transition?

Larry Hyatt

Bryan, we managed our menu mix, so should I say seek to manage our menu mix to maximized gross margin dollars, not gross margin percentages, and without getting very specific, the Classic Combos from a gross margin dollar standpoint have a very attractive margin. And so, when we get guest trading from other menu items into Classic Combo that is a generally accretive to gross margin.

Bryan Elliott – Raymond James

If maybe this process continues that we might begin to see the average check above offer I guess what maybe more broadly ask the question of what sort of your short to intermediate term due on the potential for some average check rebound at O'Charley’s?

Larry Hyatt

One of the things that you hopefully heard David say a couple of moments ago was that we feel the turnaround particularly at the O'Charley’s that as being a three or fourth step process where the first step was to provide compelling value to get last users and new users back.

Step two is to gradually migrate them positive with respect to the average check and then the third step is to drive margin. We believe that we made significant traction with respect to that first step. We think with Classic Combos we are beginning to see the second step.

Operator

(Operator Instructions) And our next question is from the line of Robert Derrington with Morgan Keegan.

Robert Derrington - Morgan Keegan

Thank you. A couple of questions. Larry looking at this past quarter or maybe David you might be better I am not sure who would assistant who.

During this third quarter, there were some costs associated with the retraining of personal within the restaurants. Do you consider some of that and I am just trying figure out how much of that may be one more one-time in nature. Is there is someway to kind of think about that?

Larry Hyatt

We will probably will continue with that on retraining, certification both in the back of the house and in front of the house for a number of quarters going forward. And at this point in time as we are continuing to finalize the plan for the next fiscal year and in a position to be a lot more specific about that but I think its reasonable to say that we are going to continue those efforts beyond the third quarter.

Robert Derrington - Morgan Keegan

David when we look at the margin trends at the other brands other the O'Charley's brand, for example Stoney River has certainly seem some nice gradual improvement there, Ninety-Nine looks like it is clearly making some progress, are there any learnings that we can take away or we could think in terms of extrapolating ultimately to the O'Charley's brand?

David Head

Bob I think when you look at those brands and most notably Stoney River they are really further ahead in the comeback process than O'Charley's but the same approach that Larry detailed before totally apply. That’s s compelling value offering.

And in this case the “2 for 14.99” do get folks and then put the pressure on us to deliver a superbly executed experience and the thing I’ve learned in the last nine weeks, I have been with the company and I have been all over the US, that when we deliver we can compete with anyone. That gets me very excited and then the ability to transition to higher margin items and still have great guest satisfaction are our compelling value to where our attentions are going to be focused.

Operator

(Operator Instructions) And our next question is a follow up from the line of Bryan Hunt.

Bryan Hunt - Wells Fargo Securities

Thank you. David, I was wondering if you could talk about store conditions. I mean, the company’s CapEx has been down back or at least the last couple of years. It wasn’t a major remodel phase at O'Charley's.

Could you just talk about store conditions relative to your expectations and whether you think a heightened level of repair and maintenance was required into our remodeling program, could begin the re-phase in one store as economic stabilizes?

David Head

Bryan. Our focus is clearly on putting our dollars, our energies, our attention what’s on the plate and the method in which its delivered via our servers and bartenders, hostesses and all.

And our plan for our facilities were to make sure that there are kept in competitive very good repair and that the buildings are fresh and clean and well maintained and our capital budget which is still under development will reflect that for clearly 2011 and at some point we will look at a fresh face the O'Charley's brand to go forward on.

But all of the data and anything you see quantitatively and qualitatively speak to the fact that the guest is going to reward us if we offer great value, great execution and deliver that on a consistent basis.

Bryan Hunt - Wells Fargo Securities

Okay, my follow-up is, just wondered if you could just talk about employee turnover in light of the historical experience and light of where unemployment is. And does that become a benefit of some point in time over the next year.

David Head

Our turnover levels at both the manager and team member levels are at a historical norm really in the last data seen for the last two years I believe. And at the ninety-nine brand we are famous for best in class stability at the team member level, at the manager level and O'Charley is brand is comfortable with the rest of the industry at this point.

Operator

Thank you, and our next is a follow-up from the line of Robert Derrington at Morgan Keegan & Company.

Robert Derrington - Morgan Keegan & Company

Yes, this is more a housekeeping. Looking at your 10-Q it talks about your tax rate in the fourth quarter or excuse me for the year I think it implies a tax rate of around a negative 4.4%, which I guess if you extrapolate, implies the fourth quarter is going to be a negative roughly 25%, 27%. Any kind of color you can give us there.

David Head

Sure Bob, again to just to refresh everybody’s memory, the I tax situation gets extremely complicated, we generate substantial tax and that most of which are a function of our labor expanses, not of our profitability as you also may recall in the third to fourth quarters of 2008 we recorded a evaluation allowance of almost roam a $62 million against our deferred.

As a result of ongoing changes in the evaluation reserves, variability of our actual and projective pretax profit or ability or lack thereof of utilization of tax credits, the vision is very valid or difficult to predict on a quartet-by-quarter bases`

Having said that let me talk a little bit about the tax provision and our anticipated tax provision for the current fiscal year. We expect a f full year tax benefit of the $0.4 million to $0.6 million change. Because of the prefix loss, the tax credit and reserves against our deferred tax assets, we don’t expect any federal income tax expense in the current fiscal year.

We expected a saving some income tax expense to approximately $0.3 million and expense related to a increase in deferred tax liabilities of $0.7 million, both of which will more than offset by a benefit of approximately $1.4 million related to the reduction of a prior year tax obligation.

And so what you are seeing in the third quarter is the adjustment of everything to be appropriate on year-to-date amount.

Operator

Thank you, I am showing no further questions at this time I would now like to turn the call back over to management for closing remarks.

David Head

Thank you very much. We would like to thank everyone who participated on today's conference call. We greatly appreciate your interest in O'Charley's. If you have any additional questions, Larry Hyatt and I stand ready to answer them and we look forward to speaking with everyone in the future. Again, thank you very much.

Operator

Thank you. Ladies and gentlemen, this concludes the O'Charley's Inc third second quarter 2010 conference call. If you would like to listen to a replay of today’s conference, please dial 1-800-406-7325, or 303-590-3030 with the access code of 4374099. ATT would like to thank you for your participation. You may now disconnect.

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