Sonic Corporation (NASDAQ:SONC)
Q3 2016 Earnings Conference Call
June 23, 2016 05:00 PM ET
Cliff Hudson - CEO
Claudia San Pedro - CFO
Brian Bittner - Oppenheimer & Co.
Will Slabaugh - Stephens Inc.
Matthew DiFrisco - Guggenheim Securities
John Glass - Morgan Stanley
Brett Levy - Deutsche Bank
Jeffrey Bernstein - Barclays
Dennis Geiger - UBS
Joshua Long - Piper Jaffray
Good afternoon and thank you for standing by. Welcome to the Sonic Corporation's Third Quarter Fiscal Year ‘16 Earnings Call. As a reminder, today's presentation is being recorded.
Before we begin, I would like to remind everyone that comments made during this conference call that are not based on historical facts and are forward-looking statements. These statements are made in reliance on the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, and are subject to uncertainties and risks. It should be noted that the company's future results may differ materially from those anticipated and discussed in the forward-looking statements. Some of the factors that could cause or contribute to such differences have been described in the news release issued this afternoon on the company's Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and in other filings with the Securities and Exchange Commission. The company would like to refer you to those sources for information.
Lastly, I would like to point out that the remarks during this conference call are based on time-sensitive information that is accurate only as of today's date, June 23, 2016. The archived replay of this conference call will be available through June 30, 2016. This call is the property of Sonic Corporation; any distribution, transmission, broadcast or rebroadcast of this call in any form without the expressed written consent of the company is prohibited. The company has posted their fiscal third quarter earnings slideshow presentation in the Investors section of their website for you to review both, during this conference call and after this conference call for up to 30 days. They have also scheduled this call, which includes the Q&A portion, to last about one hour. If they have not gotten to your question within that time slot, please contact Corey Horsch, at 405-225-4800, and he will make appropriate arrangements to answer your questions.
I would now like to turn the conference over to Mr. Cliff Hudson, Sonic Corporation's Chief Executive Officer. Mr. Hudson, you may begin.
Thank you and thank you to each of you for being with us to hear this afternoon. As you know now and you can see on the screen, our adjusted earnings per share grew 19% in the third quarter evidencing our multi-layered growth strategy, even as our same store sales momentum slowed a little bit in the latter half of the quarter.
System same store sales were up 2% versus 6.1% in the third quarter of last year. During the first half of the current fiscal year, comps were running along pretty good, round about 6% as well, and in this more recent period we have gone to somewhat more of a traffic decline and is more than offset by increase in average check.
The same store sales were negatively impacted during the quarter by what I think is pretty fair to describe as an industry wide slow-down in traffic in late April and May, and to a lesser extent, I think in our case it was also affected by unseasonably rainy and cool weather. I’ll talk about that a little later and give you some indication of what we see on that. But that too impacted both our traffic and it impacted some of the decisions we’ve made about how to move the business forward.
In the third quarter, we also closed on our additional debt securitization that really should help increase our balance sheet flexibility and allow us to continue to optimize our capital structure. The same flexibility will allow us to continue to return cash to the shareholders in a manner you’ve become accustomed. We’ve repurchased 39 million in stock during the quarter and approximately 111 million fiscal year-to-date. As of the end of May, we had approximately 170 million remaining on our share repurchase authorization.
Now, in conjunction with this earnings release today, we’re also outlining our plan to refranchise about 140 company owned drive-ins. We’ll be doing this throughout this fiscal year and next fiscal year, moving towards a 95% franchise system over that time. This will allow our company to improve assets efficiency and have some role in reducing some earnings volatility while at the same time enabling our franchises to optimize those same drive-ins performance.
We anticipate that the refranchising will be earning neutral in the first year, and we should say that we intend simultaneously to enter into additional development agreements for the same territories, as we refranchise the stores in select areas, and we’ll look forward to sharing more details with you as it progresses in the coming quarters.
Now you see here that the components of the multi-layered growth strategy that we’ve talked about in the past and still have such a role in our business, and given the recent debt transaction in our ongoing refranchising efforts the use of free cash flow is going to become increasingly important contributor to our earnings growth prospectively.
We also believe that the new unit development will play an even more prominent role going forward. We’re excited to update you on the progress in this area of our business later in the presentation. These two layers, the use of free cash and new unit development can and should offset somewhat lower benefit from operating leverage in company owned drive-ins over the next several years. We’ll update the components to our multi-layered growth strategy during our fourth quarter conference call in October, but we continue to target an annual EPS growth rate in the high-teens.
Now as we look at the transition of the business over time, you see depicted here the progress that we’ve made in building our average unit volume over the last several years. We continue to have confidence in that objective aiming towards a 1.5 million AUV by the end of the decade. It does require us to be looking towards a 3.7% average same store sales growth over that time and we will continue to move towards that with some confidence in spite of the immediate challenges.
Having said that, there is no doubt that in this third quarter our comps came in lower than we’ve forecast when we updated you with our guidance during our March conference call. This is driven by an estimated 200 basis points deceleration in the industry traffic as well as I mentioned a moment ago when we’ll talk about in a moment unfavorable weather in April and May.
The cause of the industry slowdown has really been difficult to pin point, as you look at more macro elements of the economy jobs have continued to grow though a little more slowly than they have earlier in the year. But also consumer discretionary income hasn’t deteriorated in recent months.
We’re watching some of the modest increases in gas prices and then the price competition in our grocery competitors and many are getting in to selling more prepared food. These are potential sources of demand volatility on our industry. But we’re not sure that the last couple of months represents anything more than a short term phenomenon. And it is clear though that the consumer has become more guarded this spring and the summer, and price sensitive than was the case just a few months ago.
Now I made reference a couple of times to some of the more challenging weather we’ve experienced in April and May, and it’s been particularly true where our core markets are. While the larger part of the slowdown that we experienced late in the quarter I think was due to these broader elements that are effecting the entire industry, here you can see a couple of maps depicting the unusual lows of precipitation particularly in April, the map on the left, and cooler temperatures than usual in May in the map on the right.
This is particularly true along the I-35 corridor in the middle of the country from South Texas all the way to Kansas City; you’re really talking about the heart of our core markets. As a matter of fact, the Houston market represents about 5% of our system sales and Houston in particular was hard hit with heavy rains and flooding. So with that sort of picking up in April and May, with the cool weather and slow start to the summer, these are the reasons why we shifted some of our promotional activity away from what has historically really much more drink and ice cream focused, but instead we’ve shifted to a food focused $5 Sonic Boom Box that features a signature premium 6 inch hot dog of beef and a junior deluxe cheese burger together with a side order and a drink.
So it is a shift away from what we’d ordinarily have more drinks and ice cream heavy calendar, and as a matter of fact we had started that in the spring and the wet and cool weather doesn’t play as well with drinks and ice creams. So the Boom Box here is more clearly value based less differentiated that we might ordinarily be promoting, but we felt in that April to May timeframe that we feel today that it is a strong tactical response to a more sluggish environment and we’re going to continue to assess that environment as the summer goes along and affect our promotions accordingly summer in to fall.
Now talking about those promotions of ours, the industry remains very value focused and intensely competitive, but it really isn’t any more so than it was earlier in the year, our primary peers continue to push pretty aggressive bundled value offerings, but they were doing that not only last winter but last fall as well. Overall, our plan is to continue to focus as we move to the summer in to the fall, kind of stay true to our long term promotional strategy of introducing higher quality premium priced products on the one hand, while communicating some targeted value with product and day part messaging unique to us on the other.
The intent of the Boom Box is to of course defend short term traffic challenges, while we continue to assess what’s going on in this broader environment. As we speak, we are in the process of amplifying the media around this promotion in ways that we believe will be very positive and we’re likely to continue that through a good part of the summer certainly July and even August.
And while June results have kind of stabilized versus May, we’re not where we want to be and this is reflected in the lower projection for full year same store sales of 2% to 4% versus what we might have indicated in March. We do expect our fourth quarter comps of summer quarter in to the August to be positive, and we feel comfortable in meeting full year consensus EPS expectations in the guidance range of 20% to 25% growth.
So as we look ahead to the fall, we anticipate executing against promotional calendar focused on food innovation and strong targeted value, but we are going to continue to watch this broader environment and we will adjust our course as permitted or as needed.
Now some of the initiatives we talked to you about over time, more specifically here is the rollout of our POS and POPS units. Last quarter, the quarter ended May we passed the halfway mark for our system, a significant milestone for us. It is very important because it lays the ground work for our ICE plans, our Integrated Consumer Engagement, and it also includes the national promotion of our new app which began in April and the app allows for gifting, paying at menu exploration, and is even usable in locations that don’t yet have POPS. We will increase the functionality of the app over time, as well as enhance its integration with the POP system as that gets rolled out market-by-market. So this aspect of our business continues to move forward and will become more robust over time.
Another area of our business that is moving very positively, switching gears to the development, our development activity, and we’re pleased to report on the significant progress and growing the new store development commitment pipeline as well as delivering on net new unit openings. You see pictured here our current geographic footprint as we continue to expand outside our core markets and the core markets in south central part of the country but additional unit growth outside of those areas.
We continue to sign new commitments for our future development with franchisees, and you see that increasing new store commitment pictured here. Year-to-date through the third quarter we’ve already secured more new commitments through the third quarter than we did all of last fiscal year, and we’ve surpassed what we set as a goal for ourselves on 2016 in just three quarters.
So this bodes well for aiming towards a 2%-3% net unit growth rate per annum over time. We got to get to the front end that is the pipeline. We got to get that filled and primed in order to get those stores opened over time. And that improved pipeline is starting to result in accelerated new store openings as you can see depicted here on this picture.
Over the last three years it’s been a nice progression, particularly when you combine new stores with our relocation rebuilds. You can see what our operators are investing in new stores, the combination of new sites as well as relocation and rebuilds of existing stores. We’re targeting 50 to 60 new units for this fiscal year ’16 and a combined 40 to 50 relocations and rebuilds are on track to achieve each of those.
The great thing is about these new units, as well as relo and rebuild may hit - they’ve been consistently hitting above system average unit volume and so they will be accretive in helping us reach our objective of growing system AUVs to 1.5 million. So this is the part of our business we are very pleased to see its progression and one significant and negative impacted by the recession several years ago, but we’ve got that good management group in place, we’ve got our average unit sales and profit, where the ROI is getting much more attractive and now you can see it starting to pop.
As a matter of fact when we look at this year, we see it hitting something of an inflexion point in terms of the net new units. You could see that here, year-over-year increase in net new units and in this quarter I think we’re looking at ’15 versus ’04 same period a year ago. Our commitment pipeline really began to accelerate meaningfully and that is just a commitment for future stores in that 2013-’14 timeframe. But as we continue to grow that pipeline, you can see now why there is this confidence in the net new unit openings trending upwards over the next several years because of the way we are now building our pipeline.
There’s an area in our business reflecting more store opening and reinvestment in existing sites along with fewer closings that should serve as one of the most significant indicators to you of our operators’ affirmation of the path our brand is on and their confidence in continuing to invest with us.
With that I’m going to turn it over to our Chief Financial Officer, Claudia San Pedro for her review and then we’ll come back for questions.
Claudia San Pedro
Thank you Cliff. System wide same store sales grew 2% and adjusted earnings per share grew 19% in the quarter. As Cliff mentioned previously, traffic was negative in the quarter, more than offset though by higher checks. Traffic was positive in the month of March and dropped off in April and May. Franchise royalties and fees increased by 6.8%. This increase was driven by same stores sales growth, increased franchise operated units, and the expiration of some development incentive.
Total company operating margins improved at 140 basis points to 23.5% in the quarter, driven primarily by SG&A leverage. In the third fiscal quarter, SG&A declined approximately 10 basis points as a percentage of sales versus an increase of 110 basis points in the first half of the year. The sequential improvement was driven by the timing of technology and headcount investments, higher capitalization of technology projects and lower incentive compensations.
Going forward, we are targeting SG&A growth more in line with revenue growth for fiscal year 2017 and subsequent years. If you go to the next slide and look at operating leverage from a drive-in level margin perspective. We see that company drive-in margins contracted by 40 basis points in the quarter. This was driven by food and packaging cost which were unfavorable by 30 basis points and this unfavorability was driven by slightly higher discounting and the establishment of the system brand technology fund.
We are also lapping over the benefits of our point-of-sale system, which drove significant efficiencies in our inventory control and in our food and packaging line items in the prior year of approximately 100 basis points.
With respect to commodity cost, we’ve locked in commodity cost for most of this fiscal year and anticipate commodity cost inflation to be approximately 1% for fiscal year ’16 as a total.
We are current running approximately 2.5% of year-over-year pricing at our company drive-ins, which is a modest step down from the recent 3% pricing we’d had in place over the past year. And this reflects part of the more competitive environment and deflation occurring in the grocery channels or for food at home.
With respect to labor expense, we de-levered by approximately 10 basis points in the quarter and that reflects lower same store sales than we had expected and ongoing labor investments that we have been making. We continue to proactively invest to ensure that we have the best work force possible as we drive our business towards our 2020 goals to get to an average unit volume of $1.5 million.
We believe these investments that are made across the board for our personnel, whether they are at the carhop level, our drive-in level management or pre-formulated compensation plans to align with improved door profitability at the [investor] level management piece position us well for being an employer of choice for prospective employees and we expect that to drive increases in sales and profits overtime.
Other operating expenses were flat as a percentage of sales during the quarter. Despite a technology fee that went in to affect March 1, which imposed an approximate 25 basis points fee in that other operating expense line, we were able to see flat margins year-over-year as a result of a reduction in repairs and maintenance cost at our drive-in level. In total we estimate that the new Brand Technology Fund will negatively impact company owned drive-in margins by approximately 50 basis points from the fiscal third quarter of 2016 through the first half of fiscal 2017.
If we move to the next slide to discuss our capital structure; again just to highlight during the third fiscal quarter we closed on the new $575 million debt securitization which includes 425 million in fixed rate notes and an undrawn variable funding note of $150 million of capacity. We ended the quarter with just under $100 million in unrestricted cash and we anticipate free cash flow of approximately $75 million to $80 million this year, with capital expenditures between $35 million to $40 million.
We define free cash flow as net income, depreciation, amortization expense and stock compensation expense less capital expenditures.
Upon the completion of our issuance, we increased our share repurchase authorization by $155 million through the end of fiscal year 2017. Through the end of the third quarter, we repurchased approximately $111 million of stock. We are underway with our newly announced refranchising initiative as we look towards having an approximately 95% franchise system by the end of fiscal year 2017.
We are in active negotiations in select markets, and we are in early discussions on other markets. We expect to achieve this percentage mix primarily refranchising select markets, but also through new franchising growth. Our intent is to make the transaction earnings neutral as Cliff mentioned previously in the first year after completion by using the proceeds from the sale for additional share repurchases. We will provide updates on our progress in subsequent conference calls.
Finally, with respect to our outlook for the fiscal year, we are reducing our same store sales projection from 4% to 6% to 2% to 4% reflecting a decline in consumer traffic that began in April. We do expect fiscal fourth quarter comps to be positive, however due to a more volatile consumer environment, we believe providing a wider range in same store sales growth for the fiscal year is prudent.
Despite the reduction to our comp forecast, we are maintaining our projection for 20% to 25% adjusted earnings per share growth along with SG&A controlled including lower incentive comp making up for the lower sales. As it relates to company drive-ins, we now expect flat to 40 basis points of margin expansion versus prior expectations of 50 to 60 basis points set on our March conference call. The change in our annual outlook is predominantly driven by lower leverage on reduced same store sales expectations, as well as modestly higher promotional activity as we put added emphasis on value during the summer quarter.
With that we will open the call up for questions.
[Operator Instructions] We’ll take our first question comes from Brian Bittner with Oppenheimer & Co.
I think the main question here is on the comp guidance, Cliff and Claudia you both said in your prepared remarks that you expect 4Q comps to be positive. But the 2% to 4% full year guide implies a range of negative 4 to plus 3 for the fourth quarter that’s what the math suggests. So the fact that due to the flat comp in the fourth quarter I think the full year comp will be near 3.5%. So can you just clarify the implied 4Q range from the math versus your comments about fourth quarter expected to be positive.
Claudia San Pedro
Absolutely Brian, it really just reflects the acknowledgment that we are in a more volatile consumer environment, and we have less visibility. As we started to go in to - as we saw the slowdown in April and as we started to go into May, our sense was that it was really more weather driven and it might have just been a one month issue on the consumer, as we completed May and went into June, I think from our perspective what we’re seeing now is that it is more of an industry slowdown feature and we just have less visibility. And at this point, we thought it would be more prudent to provide a wider range on that.
We typically make sure that we set ourselves up to meet or exceed. So at this point, we believe we’re going to have positive comps, but it is an acknowledgment of that the consumer environment is a little more volatile.
Okay, but is you confidence about positive comps for the quarter have to do with the way things have trended so far this quarter, or is it based on things improving as we go through the summer.
So in a way it’s both, because once we implemented new initiatives we saw improved performance, no return to where we were, but we saw improved performance, but we want more. So we’ve pursued some other refinement of those promotions and related both in terms of quickly creating appropriate television creative that fits this. I mean this is a creative that didn’t exist 30 days ago, and so it’s a quick creation of creative. It is a reallocation of media dollars and it is the complementary promotional activity as the summer goes along.
So we saw with what we did at the end of May, 1 of June as being helpful. It’s seems to have been helpful from a traffic standpoint as well as check. It is not what we want from a blatant reversal standpoint, but it is an improvement, and so we are refining promotional, creative and media strategies as we speak to work to improve July and August. And in some of those strategies just so you know, in terms of pulling the trigger some of them are already pulling the trigger on now. So this isn’t give us six week sort of thing.
And just a non-timed question, just the refranchising strategy, how long have you been thinking about doing this, and what ultimately was the main driver of you deciding to go through with it. Thanks.
Well, it is a question as you would expect, that has been asked of us for a good while. A number of our owned stores have suffered quite a bit of damage at the low point of the recession and we’re going through a process of rebuilding there. And so it is a question we have asked ourselves over time.
One and two years ago as we started moving towards implementation of some of our 2020 initiatives, we did not feel like we could turn to our operators and say, here are some underperforming stores, why don’t you buy them and you make the investment and we needed to for general purposes, for franchise growth we needed to move AUV and profitability to a point where it would help new store development and we needed to do that even more so with our owned stores.
So we have made those investments in all of our owned stores now. We’ve also moved sales to different level, profitability to a different level in the more recent past after a periodic review of that with our Board of Directors, how do these assets look and how we are moving etcetera, etcetera, with a periodic review of that in the more recent past our review was we can now sell these our improved assets versus several years ago, number one. Number two, we can package it with new store development commitments in those same markets and in all cases that is the case with these stores we’re looking at, the markets we’re looking at. So the intersection of these elements, improvement in these stores, having something better to sell, showing our operators that we will make that investment in 2020, get the profitability to a point where it’s a better product to sell and franchisees not only very desirous of buying, but willing to commit to new store development.
So we’ve kind of hit that intersection in this fiscal year that made it a better point in time go ahead and do that.
And our next question comes from Will Slabaugh with Stephens.
This is actually Billy on for Will right now. Just one quick one to start, would you be willing to break out the traffic and check breakdown during the quarter, and kind of as a follow-up to that with respect to the traffic decline that you guys did see. Would you say that you saw it deteriorate from April into May as well, or would you say both of those months were kind of equally slow?
Claudia San Pedro
What I can tell you is in March we had positive traffic, very strong same store sales growth in that month. In April, we saw the slowdown and we saw some deterioration in traffic. We saw further deterioration in May; however that portion was really due to as we discussed, weather. And particularly as you look at it, when you look at our summer promotions, what we have been very successful at is driving in specialty product categories like slush, like ice cream.
We have those promotions again this year, they are more weather sensitive. So while we were ready for spring and summer to come, come May, we weren’t seeing that. We saw wetter weather in April and then cooler weather in May, so that disproportionately impacted our drinks and ice cream business and that associated checks with that. So does that answer your question?
Yes, that’s helpful. And actually as a follow-up to that, you talked about kind of refining your promotional strategy in response to what you’re seeing in the industry right now. Can you talk through how you’re thinking about that and will it be focused more on traditional media outlets like TV and radio or is there a different strategy there as you move into the fourth quarter?
I’ll give you some element from a general standpoint that I think won’t surprise you. Some of the specifics that you might like I probably won’t go to different forms of media and so on, and I’m not sure that that makes sense for me to go that level. But what we’ve done with the migration here, May into June, we’re seeing what we’re seeing from a traffic standpoint and understanding some broad elements here, some broad meeting. We didn’t have the view that this is just about our business that something odd was going on here from a consumer orientation. So we already made a point to you about some sluggishness generally but also with the cold and wet weather and here we would be moving into things like slush and ice cream. If it’s cold and wet, people don’t go out much and they are not as inclined to do drinks or ice creams, when it’s 82 degrees or 78 degrees versus 95 degrees or 93 degrees.
So to drive traffic and drive it across multiple day parts, we pursued the strategy we did that included a bundle of items and food, and it had its intended effect and we’re confident that it drove some traffic we would not have seen otherwise from a general trend standpoint. Now the objective - we have that in place and in a period of time in which it’s very clear that consumer has some kind of attitudinal shift, and there is not a macroeconomic piece. But we’ve got that in place and we don’t have a desire to pull it. But what we do have a desire to do now that that colder, wetter weather has moved out of our core markets and we’re into summer now. We have a desire to augment it with more traditional summer promotions for us. And so you could expect immediately to see some diversification of promotional activity that involves more traditional summer activities for us without dropping that Boom Box.
And next we’ll hear from Matthew DiFrisco with Guggenheim Securities.
Cliff, I wanted to learn a little bit more about the promotional environment. I know last time you guys talked, it appeared as though the promotional environment hasn't changed that much as far as a lot of your peers doing meals and other things for 4.99 and 5.99, bundling offerings and those don't seem to really impair you guys as bad as maybe dollar offerings and some lower price points on individual items. Are we missing something competitively that maybe promotionally is out there now that has emerged in the last two or three months that has changed the promotional environment out they directly towards the Sonic brand?
I think that the activity that we’re seeing both retail - we’re seeing at our competition is seeing it, people outside the industry in other words other industries are seeing this would indicate that the there’s something more fundamental going on than just Sonic versus somebody or somebody versus Sonic. That being said, its 10 to 3 from a competitive standpoint and somebody is always trying to pick-off the stuff we’re doing, somebody is, and we’ve had pretty good run and people do try to mimic what you’re doing. But the problem with trying to pin on that too much is that some other folks have experienced some similar challenges including businesses outside of our industry.
And then Claudia I have a question with respect to the guidance here. You gave cash flow guidance and uses of proceeds out to ‘17. In one of the slides, I think it says about 155 million for share repurchase. Is there any ability or do you have the financial flexibility to potentially do that repurchase that might have been initially slated for ‘17 in ‘16 or earlier in the fourth quarter?
Claudia San Pedro
We do have that flexibility Matt.
Just a follow-up to that if I'm looking at the comments that you guys made as far as the high-teens EPS growth longer term, and I look at that free cash flow slide, obviously in the flywheel and the components of that flywheel of getting to that high-teens EPS growth rate, presumably ‘17 is going to get a much bigger lift from the share repurchase portion and the cash flow portion that's being used in ‘16 as well as in ‘17 to repurchase shares and reduce your share count out there. Is that enough to offset what presumably is a challenging earnings environment, as far as we're six weeks away entering FY ’17?
If we look at FY ‘17 as far as the other parts of the flywheel, if you're not getting the operating earnings growth contribution, would you be able to offset that more so with the capital structure activities you're doing now and plan to do in ‘17 to support that high-teens earnings growth rate.
Claudia San Pedro
Sure. So I think if you look at the past few years in how we been able to grow really solid earnings over the past few years, there’ve been really three major layers of that multi-layer growth strategy has been consistently evident, and that’s been same store sales, operating leverage and use of free cash. Most recently in fiscal year ’15 and to some extent this year in fiscal year ’16, you’ve seen the ascending royalty rate come in to play.
Going forward, what you will see and I think you start to see that inflexion point. We are very excited to see is the development story, which is part of one of the layers that has not been a meaningful contributor. So as we go forward, what I would tell you Matt is, we believe that through same store sales growth, development, use of free cash and to your earlier point we do think that use of free cash will play a little bit more of a meaningful contribution in fiscal year ’17.
We can still achieve our long term target to get to between 14% to 20% earnings per share growth.
[Operator Instructions] And next we’ll go to John Glass with Morgan Stanley.
Can you talk about the profitability profile of the stores you're going to sell? We assume that they're average relative to the company margin today or some store - some chains have disproportionately profitable sort of last 5% of stores. How do your stores fit in that distribution?
Claudia San Pedro
That is a good question John. So what I would tell you is that the stores that we are targeting or the markets we’re targeting have a little bit less AUV than our company drive-in average, however, but we expect to see upon selling these market is a significant improvement in our drive-in level margins, because the profitability is pretty low for these drive-ins in these markets.
Would you describe in selling this next 5% or 6% of stores, would you go far to say it's EBITDA neutral to the business or is it dilutive still?
Claudia San Pedro
I would tell you there would be a small decline in EBITDA, when we look at those target markets, a small, small.
When you think about being a 95% franchise versus 89% or whatever it is today, does that materially change leverage targets or do you still think the current 3.5 range is appropriate for a 95% franchise business?
Claudia San Pedro
As we just completed the debt transaction we’re very comfortable at this leverage ratio that we have. We certainly have a lot of flexibility and as you know, we are consistently talking about this with our Board. But at this point, I think we feel comfortable with where we are as we progress along the refranchising initiative and as we access the environment we’ll continue to evaluate our options then.
And just lastly are you willing to at least say your comps positive now or do they need to become positive to get to positive in the fourth quarter, or the remainder of the quarter?
Generally we do not comment on comps in the current quarter. What we want to give you a sense of is that one, what had driven our not only the performance on the third quarter, but what drove our promotional shift and what are our tactical activities to some degree laying that out here in this summer quarter, but not abandoning our broader strategy. So want to give you that sense of improving what we’ve experience April in to May and how we intend to work to improve that still. Though we generally do not comment upon intra-quarter comps and do not intend to today.
And next we have Brett Levy with Deutsche.
How should we be thinking about 2017 net unit growth, now that you're asking the franchisees to spend a lot more money to buy into the new units and also to refranchise? And are we still thinking that you can get to 2% to 3% gross type number in ‘17 and still maybe a net number in ‘18, or is that more of a ‘19 kind of thing? And does this change in direction lead you to possibly update the franchise agreement, potentially raising the floor while still keeping the escalating rate?
Well so several things there, one, will - I think I hear you asking, will the sale of these stores and the assumption of responsibility negatively impact the new store growth rate in ’17, and I am firm in saying no it will not. There’s a widespread base of existing franchisees and new franchisees that have commitment to create that pipeline that exist currently, and so the parties with whom we are talking, either negotiating or talking to about these other stores they will sign new commitment agreement, but that should not affect and probably will not affect the pace of ’17.
Now in terms of rates of growth and you’ve raised the prospect of ’17 being gross and then in to the net concept. I suspect I’m going to look to Claudia here, I suspect that it will be as the new year begins that you will want to give guidance on what we expect ’17-’18 from a growth rate standpoint.
Having said that, clearly it’s our objective, you saw the slide that shows the commitments climbing and those commitments are incremental as shown on our charts there not cumulative there, incremental year-by-year. Though the pipeline is getting heavier, pipeline is getting stronger and the objective very much as the decade progresses is to get that to 2-2.5 and then 3 by the end of the decade 3% net. So that is the objective, and we are on that path.
With respect to who you're targeting, how much of the base are you looking to sell to existing franchisees versus new franchisees? And then if you could just update us on what you're seeing on labor wage rate inflation.
The lion share of who we would target for these, which when I say target it’s really fair to say, people with whom we have already conservations. And so these run the spectrum of people with whom we are currently negotiating actively for a specific type of stores in markets and the other in the spectrum is, people with whom we’ve spoken but are not actively negotiating right now, not because they are out, but just we’re staging this, we’re going to be staging this overtime by market. And most of the lion share of them are existing franchisees.
Claudia San Pedro
With respect to wage growth Brett on that front we are actually not seeing any significant increases. The increases we are seeing are what I would tell you are intentional initiatives that we’re putting in to place to be proactive on building a strong workforce at our drive-in levels. To make sure that we’re ready to operate at that 1.5 million average unit volume level.
[Operator Instructions] and next from Barclays we’ll hear from Jeffrey Bernstein
Couple of questions, just one, maybe a clarification on that last one. The pipeline chart you showed was impressive in terms of that new unit growth trajectory. But I just wanted to clarify, that pipeline, that is strengthening and yet separately you have franchisees who are keen to buy these - whatever, an incremental 5% of your system. You have two different tracks, but enough demand to satisfy both of those? That was just a clarification.
Yeah, the clarification, one should not dilute the other and should not and will not. So that’s just it, I mean the folks that are talking to us about buying stores are going to be making incremental commitments and the folks making commitments to build new stores there’s a widespread base that makes that up. So much smaller that we’re talking to about, much smaller we’re talking to about stores.
Understood, and then just follow-ups on the comp side of things, the $5 Boom Box, I think I heard you speaking recently at conferences where you were talking maybe about how it helped traffic, had a perhaps modest negative impact on margin. I'm wondering if you can give any incident to that it seems like maybe this Boom Box is here now to stay. I think you said July and even into August. So I'm wondering if you could give a little more context in terms of what is helping, what's hurting the mix shift to more value.
Well first of all as whether it’s here to stay, we’re not indicating that. One way or the other it is a response to a intensely competitive circumstance we’re going off for a number of months and we worried until we saw some of these other consumer behavioral shifts. So what we do with that even in the near term, I mean near term as in 60 to 90 days were fluid and you’ll learn as we move along. But the conduct that’s occurred in terms of some qualitative feedback about quantitative impact I suppose in getting the word out about the Boom Box, we are confident that it be - that it reverse some trends in traffic.
There’s no doubt in terms of margin impact it is a good deal for the customers. So to the extent they might have - to the extent that you’ve been able to maintain business with other products and it can have negative impact on margins, but to the extent that you’d be losing that customer it is profitable and we’d rather have those customers online buying that and other goods and having people in the car buying other goods. They may not be buying the Boom Box.
We are confident that it is driving traffic, we are confident we are getting some business there that we wouldn’t be getting if we didn’t have it, and so it seems to be doing its job in terms of driving that traffic and then we will evolve with parallel promotional activity some of which price sensitive that will pull the customer towards more what we would say, for us a more traditionally differentiated product with better margins and so on, as the summer progresses. I’m not talking over a longer period of time; I’m talking about from this weekend forward. We’re already pulling the trigger on the revisions of this promotional strategy.
Understood, and lastly, just one other clarification. I think you mentioned that May deteriorated from April, but that you attributed that to weather and then perhaps now June has improved from May, once again attributed to help from weather. So would you say based on the numbers you're seeing that April, May and June ex the weather were pretty stable or you highlighted Houston as that one market that took a big hit. But if you just looked at the markets other than those that were hit by weather, is it fair to say April, May and June were stable and that would be obviously a good indicator?
Therefore giving you the sense that the swing was largely weather driven that would be an incorrect impression. There’s no doubt that the shift in consumer behavior picked up well as they progressed and went through the first week as real through the last week, and then it was through all of May. I think we had no doubt ours was somewhat exacerbated by the weather piece and so want to lay that out, but we also - the purpose showing the weather thing in part was to say, this no small part why we shifted promotional activity was because, you will think, make hay while the sun shines. You know the sun is not shining, you better figure out something else to make.
So with it being cold and wet, we said lets quite trying to put ice creams, let’s get something that can drive some traffic and give a jolt out there, get some traffic, get the business charged again. And then we can refine that, even in the immediate term that we got to do something different to drive things. So now it’s not just weather and I don’t want you to - I think even if you take out the weather you still have the patter. I don’t want you think that okay things were more at level, but constant.
I think we’re seeing trending as we described deteriorated in to May, and we’ve got a reversal of that in to June and we’re going to try to refine that still with our promotional activity now moving in to July. When I say moving in to July I want to be clear, we’re on this, we’re revising promotional activity, we’re revising creative, we’re revising media allocation by product and media type meaning I wanted to say product, I mean what we’re promoting in that media. And it’s not a, “we will till August”. This is occurring this weekend that refined strategy.
And our next question is from Dennis Geiger with UBS
I know you that talked about G&A growth being in line with revenue growth in ‘17 and beyond. But is there may be an opportunity to adjust the G&A base in conjunction with the refranchising initiative?
Claudia San Pedro
Well I think what you need to note is that unlike many restaurant companies, most of are above store level management cost are included in our drive-in level margins. We do not include that as SG&A, one. Two, as you look at our SG&A growth as a percentage of system wide sales, we have historically been and continue to be at the low end of our peer competitive set. So what I would tell you is what you would typically see as saving from above store level management, that’s pretty much captured in the drive-in level margins. We will as we progress and it depends as we make progress on those markets, we’ll evaluate that piece, but it’s not going to be a significant driver for us, because we already account for that differently.
Right, that makes sense. And just a second question, with the app advertising nationally for the first time at the end of April and recognizing that functionality will grow over time, anything you can share on download, usage data, any other data, maybe how you've gotten to know the customer better? Anything along those lines would be great.
So we have started seeing a much more rapid download of that, almost immediately from the time that we’ve been putting on the television in early April. We now had in that period of time about 1.4 million downloads and I have no doubt as the functionality becomes greater and we get different types of communication meaning in essence almost two way going with that, with the customer more active utilization of it, that that will become more robust in terms of rate of download. But it has picked up quite dramatically and we will in a steady fashion make it more robust with these incremental elements in the near term.
And next we’ll hear from Joshua Long with Piper Jaffray.
I wanted to see if you might be able to elaborate on the investments in the labor force that you've mentioned a couple times on the call, just a little more clarity on programs or platforms that you’re looking to invest in to improve the quality of work, differentiate your work experience for your team members. And then separately, as we think about the pricing outlook for the year, should we look for something to maintain or pretend to maintain pricing at this level or would you expect pricing to continue to roll off in the back of the year, just given the backdrop and kind of your initiatives on promoting value?
Claudia San Pedro
Josh, I will go back to fiscal year ’15, when we made our first investment from a work force perspective and that is typically because of the seasonality of our business. We contract a little bit or you see a little bit of a decline in our direct labor when we go in to that winter season. We made the conscious decision based on our same store sales momentum and our long term growth targets to keep staff on during that winter quarter and then reason we did that was to say, we want to make sure that people can see this not as a seasonal business that you may or may not have, you can’t rely on, but a business that you can rely on and potentially have a career path.
So we did that first in fiscal year ’15 I believe, and then most recently one of the changes we made in fiscal year ’16 is that we added and what we heard based on employee engagement surveys is, one for our carhop hourly paid employees an expansion of our employee new program. So instead of offering a portion of a discount, just offering free meals in general that was viewed vary favorably.
And then the second component is, this past year as we increased assistant manager hourly wages and we also supplemented that with a bonus program, specifically targeted with aligning them towards providing improved customer service at the drive-in level. At the same time, with over this past year, we’ve reformulated our compensation plans for our director of operations and our multi-unit partners to really hone in on what we think are important metrics to a successful drive-in, which is not only improve customer service, but also improve crew retention.
So the bonus is tied to how well they can improve crew retention in addition to achieving improved sales and profitability. So we think all of those components combined will help us overtime. We still have - we’re looking to see what other adjustments we may need to make over the next couple of years. But those are the things that we believe we needed to make early on so that we could have a firm footing as we knew the labor market, we anticipate the labor market will tighten and as we grow to a larger unit volume.
And then on your pricing question, I think that’s something we are evaluating right now. And so dependent on our perspective is as you know, we’ve employed a much more strategic pricing model in the past few years and one that’s focused on consumers’ willingness to pay and being sensitive to elasticity. So we will look at these two things somewhat separately, but what I would tell you is, if we see a consumer environment where we need to be a little bit more conservative on price because of what we see the consumer doing, then that will be our direction.
We will not take the approach that we’re just going to get aggressive on pricing to meet our cost. We’ll just work on balance and those issues as we plan for 2017.
And there are no further questions; we’ll turn it back over to Mr. Hudson.
We appreciate your participation today, and we know that this more challenging time on a broad basis, but more challenging time for our business. So, we hope that the feedback and the explanation we’ve given today have been helpful. If you still need more additional feedback, please do call Corey Horsch here at our offices and we’ll tend to describe whatever clarification or additional information necessary.
We’ll look forward to visiting with your as the summer progresses, particularly in the fall to give you a sense of how this quarter has progressed, and we remain optimistic about the business and like where we are and we will continue to give you updates on what occurs as time is appropriate.
So have a good summer and we look forward to seeing you along the way. Bye, bye.
And that concludes today’s conference call. We thank you for joining.