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Dominos Pizza, Inc. (NYSE:DPZ)

Q1 2008 Earnings Call

April 29, 2008 11:00 am ET

Executives

Lynn M. Liddle - Executive Vice President, Communications & Investor Relations

David A. Brandon - Chairman & Chief Executive Officer & Domino’s Pizza LLC

William E. Kapp - Interim Chief Financial Officer

Analysts

John Glass – Morgan Stanley

Joseph Buckley – Bear Stearns

John Ivankoe – JP Morgan

Jeffrey Bernstein – Lehman Brothers

Colin Guheen – Cowen and Company

Chris Sipple – Blue Lion Capital

Operator

Welcome everyone to the 2008 first quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Lynn Liddle, Executive Vice President of Communications and Investor Relations.

Lynn M. Liddle

Wed like to take a few extra minutes today to review some franchise statistics that we think are going to be helpful in understanding our current environment. I’d like to note though that these are taken from a large sample of P&L’s that are reported to us by our franchisees. They’re not included in our DPZ financials that were published in the 10-Q and released this morning.

As always I’m going to reference our Safe Harbor statement in our release in the event that any forward-looking statements are made and of course my last bit of housekeeping I ask that the media remain in a listen only mode.

With that I’ll turn it over to Domino’s Chairman and CEO, David Brandon.

David A. Brandon

My objective for this particular quarterly conference call is to give you our assessment of the current state of our domestic business and most important plans and initiatives we have under way to get this part of our business turned around a growing again. Normally I offer brief remarks as it relates to the bigger picture and then I turn things over to Bill Kapp, our Interim CFO, for a more detailed presentation of the financials.

For today, I’m going to switch things up and ask Bill to briefly take you through the key financial measures for this first quarter and then following his remarks I will do my best to achieve my objective for the call. And following my comments obviously we’ll be prepared to take your questions.

So I’m going to introduce Bill Kapp, our Interim CFO.

William E. Kapp

As you will note from our earnings release we had several items that affected the comparability of our results to those of the first quarter last year. I’ll cover those shortly but first let’s start with the top line. We again ask that you remember revenues alone do not necessarily give you a complete picture and instead consider global retail sales as a clearer gauge of top line performance.

Our global retail sales increased 5.6% for the first quarter driven primarily by same store sales growth in our international business and an increase in worldwide store counts of 247 units over the trailing four quarters. Same store sales, domestically our sales decreased 5.2% for the quarter. Company owned stores decreased 2.4% versus a +0.006 in Q1 2007 while franchise same store sales decreased 5.5% versus a – 3.4 in Q1 07.

International same store sales however increased 8.8% over last year’s +3.8%. As a result of our global retail sales our total revenues for the first quarter were $339 million a $300,000 decrease from last year. Domestic supply chain revenues declined due to lower volumes offset in part by higher revenues due to higher pass through commodity costs. Our consolidated operating margin as a percent of revenues decreased 0.008 in the first quarter versus the prior year period 26% in Q1 08 versus 26.8 in Q1 ‘07.

I’ll now cover our three operating divisions. First, our international franchise business which has no cost of sales grew as a percent of revenues thus improving our overall consolidated margin in the quarter. Second, our company store operating margin declined 2% from the prior year period. Food costs accounted for about one third of the decline, labor costs accounted for another third of the decline and the loss of fixed cost leverage accounted for the final portion.

Third, our supply chain margins declined 1.5%. 0.007 of that decline was due to higher cheese prices in 2008 and had no impact on dollar margins. The other 0.008 of margin decline was due to pass through costs of other non-cheese commodities such as wheat, boxes and fuel. This also had no impact on dollar margins. The entire dollar margin decline was due to reduced volume from lower same store sales and traffic declines.

Turning to G&A, G&A expenses decreased $1.7 million in the quarter versus the prior year. G&A benefited by a net $2.8 million due to the gain recognized on the sale of 29 stores offset in part by the separation expenses from our restructuring plan. G&A would have been up $1.2 million excluding those non-recurring activities. We are continuing to aggressively manage G&A in this challenging environment. As we had previously announced we are planning to sell a total of approximately 60 company owned stores by the end of the second quarter. These sales will not have a material impact on ongoing net income.

Next, bottom line earnings, our diluted EPS as reported on a GAAP basis was $0.23 or $0.21 as adjusted for the first quarter. This is a $0.17 decrease from the as adjusted amount of $0.38 in 2007. Our recapitalization impacted the comparison by $0.14 due to increased interest expense. Our share repurchase program benefited us by $0.01. Our 40% tax rate hurt us by nearly $0.01 during the quarter. As previously indicated we anticipate a 39 to 40% rate in the foreseeable future. Our operating results impacted us by $0.04 for the quarter. This was all driven by lower domestic sales and traffic that we have experienced.

As stated in our earnings release we repurchased approximately 1.4 million shares of our common stock under our OMR program for $18.4 million during the quarter. Our OMR program was implemented during the second quarter of 2007 and we will continue to be opportunistic buyers in the market. We have now completed 36% of our repurchase authorization.

Turning to leverage, during the quarter we repaid $15 million on our revolver and currently have no outstanding revolver borrowings. We continue to be very comfortable with our debt level which remains fixed for another four years.

This concludes the financial update. I’d now like to turn it over to Dave.

David A. Brandon

I want to thank Bill not only for that update but for his service as our Interim Chief Financial Officer over the past few months, post our decision to move David Mounts, our previous CFO into the position of Executive Vice President of our Supply Chain business and Bill has done a wonderful job.

I bring that up only to reinforce the fact that you will be hearing today an announcement that’s being made of the appointment of our new Executive Vice President and Chief Financial Officer and that individual’s name is Wendy Beck. Wendy is a 15 year veteran of the food service business. Her most recent position was that of Chief Financial Officer, Senior Vice President and Treasurer of Whataburger Restaurants located in Corpus Christi, Texas.

Wendy comes to us a result of a very, very careful and deliberate national search that has been under way for the past several months and I couldn’t be more pleased to announce her appointment. The Leadership Council and I here at Domino’s Pizza are thrilled to have Wendy be joining us. She’ll be starting officially on the 19 of May and we look forward to her and her family relocating here to Ann Arbor, joining the team and adding a lot of value to our growth and our future. There’ll be more details as it relates to Wendy’s background in the press announcement that is going out virtually as we speak.

What I’d like to do now is to provide a fairly detailed update as I promised I would on the state of our business and I really want to break that down into three key components. One is an assessment of our current views of economics of the domestic franchise stores and the overall financial strength of our system.

We get a lot of questions as it relates to how do the stores perform in the environment that we’re in and what is the financial stability of the system and I want to address that very specifically. Second is our domestic traffic problem and the aggressive plans we have in place to drive more traffic into our stores. That’s clearly our big issue right now and it’s one I want to address very specifically.

And then the third area I want to talk about is really a progress report on our efforts to upgrade our franchise system by identifying poor operators and facilitating their exit from the system and this is a topic that I brought up at our last call and I want to continue that conversation today. Let me summarize the situation regarding each of these areas of our business and provide you with some of the things we’re going to do to change the game for Domino’s Pizza.

First, an assessment of the current economics of our domestic franchise stores and the financial strength of the system. We have gone through a process where we’ve rated our franchise system according to several factors including operational execution, local store marketing performance, the store image, sales results and the franchisee’s specific leadership and involvement in the business.

In evaluating our 2007 year end P&L that we receive from our franchisees we have learned that our A franchisees, and these are the franchisees that we have identified as being the 143 best operators in our system and they happen to represent 21% of our stores. They reported for 2007 average store level EBITDA margins of approximately 11%.

Now based on their average sales per store, these franchisees are receiving cash-on-cash returns of approximately 40% on the average cost of a new Domino’s pizza store and clearly for those who purchase the store below the new build cost and turned it around, their cash-on-cash returns are even greater than the 40%. This group of franchisees prove the strength of the Domino’s unit economic model even during difficult times. Clearly these franchisees wish the economics were even better as they could be but their businesses are very viable and very profitable.

Our next segment of franchisees we call our B franchisees and this represents 830 good franchisees that represent 65% of our system and they’re working to get better. They reported store level EBITDA margins of approximately 9% in 2007. Now based on their average sales per store these franchisees reported receiving cash-on-cash returns of over 25% of the cost of the new store and like many of the A franchisees many of them paid less for a previously owned under performing store that they were able to turn around and the returns on those stores are clearly much higher.

Our B stores can greatly improve their returns by driving higher buying levels in their stores and we’re working with them to help make it happen. However, the cash-on-cash returns they are receiving are certainly strong enough to keep their businesses viable and keep them focused on getting better.

Now we have identified 246 franchisees in our system that represent about 14% of our stores that we categorize them as F franchisees. They are currently failing themselves and our brand and our system. Their average reported store level EBITDA margins in 2007 were approximately 6%. Based on their average reported sales per store this group of franchisees are still receiving over 15% cash-n-cash returns.

Now understanding these numbers are averages of those franchisees I can tell you that there are some franchisees in this category who are failing financially, there’s no question about that. But as I will cover in greater detail in a few minutes we believe that approximately 50% of these F franchisees are interested in recommitting to fixing their businesses and remaining Dominos franchisees and we intend to give them that opportunity. The other 50% will be attempting to sell their stores and they will be exiting the system, and again I’ll get into that in a little bit more detail later.

I think another area that’s important to focus on as it relates to the viability and the strength of our system even during these tough times is the area of store growth. As you all know in 2007 we were not able to drive strong domestic store growth as a result of the weaker returns across our system and the economic pressure that was a result of weak sales in a high cost environment. However it’s also important to consider the fact that we grew, and I want to underscore that, we grew our domestic system by a net of 12 stores during the year. In other words, despite the difficult times we opened a few more stores than were closed during the year.

Now in the first quarter of 2008 our domestic unit economic model continues to be under pressure, there’s no question about that. Our costs are actually higher than they were a year ago. However I believe the specific numbers I’ve shared with you today will bring comfort to anyone concerned about the viability of our franchise system or our franchising model and whether we have any material risk of a vast number of store closures in the current environment. We believe we do not. I plan to discuss the aggressive activities we have underway to address the F franchisees in our system. Suffice to say there will be some shirring over the next couple years as we facilitate changes in ownership of many stores and we have invite franchisees that are not doing an appropriate job of representing our brand to leave the system.

Let me shift over to the next point and that is our domestic traffic problem. We have a distinct advantage over other food retailers because we have a record of who our customers are. We know them by name, by address and their phone number. I recently appointed a cross functional team here at Dominos and tasked them with the duty of attempting to learn as much as we could about the traffic declines we’ve experienced over the past couple of years, not only just at our company but in the category overall.

We’ve also leveraged the experience and input of many of our A franchisees. We have consulted with important leaders from our franchise organization including those who sever on the advisory boards that we utilize to provide input and direction when we made decisions impacting the system overall. And we have a very important summit coming up in a couple of weeks as we will host a combined session of all of our advisory boards to further gain franchisee knowledge and input and although there have been no filter bullets coming out of any of the work we’ve done so far, nor did we expect any, we have confirmed some important factors and trends that will guide us as we continue to address the traffic problems facing our category and company.

We increased our delivery prices by nearly 10% in 2007. This dramatic price increase had the most detrimental impact on the purchasing habits of our single pie, low ticket delivery customers. We have chased many of them away and we need to get them back. We believe a value platform is now a requirement in our category and we will utilize our new 10 inch pizza product that’s currently being launched nationally with our $4 $4 $4 promotion that hopefully you have all seen on television to provide our value customers an alternative.

We also need to expand our growth into the lunch and late night day parts. We are not taking advantage of growth trends in these day parts and we need to do so if we want to grow sales in the current environment. We will be testing new products, new packaging and new price points to better position ourselves to pursue these opportunities. We will also be requiring all of our operators to adhere to expanded store hours to ensure that all of our stores are open for lunch and we will adjust the closing hours of stores where necessary to compete for customers interested in both delivery and carryout during these important parts of the day.

We also want to offer a value platform as I mentioned before but we also know that we have many customers who will pay for who enjoy a more premium priced pizza product so we’ll be exploring the possibility of launching a specialty line of higher end pizzas to complement our menu in the month ahead.

Team USA has out performed our franchise system over the past two years for a number of reasons. However one of the major reasons that we’ve identified has been their more disciplined approach to pricing our products. Our analysis team found many instances of franchisees offering prices to customers that were inconsistent including some selling policies that had the net effect of down selling and other pricing policies that severely penalized customers for paying menu prices for our products. We have developed a pricing model we will be sharing with our franchisees which is designed to help guide them to more rational sensible pricing that will maximize sales margin and overall customer satisfaction.

Finally we know that our A franchisees experienced positive same store sales growth in 2007. We know that our B franchisees experienced negative same store sales but their average unit sales were still high enough to create very acceptable financial returns. Our F franchisees reported their sales in 2007 as $4,300 lower per week than our A franchisees. As their same store sales were nearly 6% negative which is over three times more negative than the average of our entire domestic system in 2007. This demonstrates the opportunity for us to create a stronger organization and better results through better operators and better operations.

As we transition stores from F franchisees to A and B operators we expect to see positive change. We’ve launched an aggressive franchisee recruiting program designed to help us carefully select both internal and external franchise candidates. We’re hosting what we call Discovery Days every month here in Ann Arbor and we plan to create a strong pipeline of franchise candidates to help us replace some of those F’s with candidates who will bring new energy, new investment and new commitment to our brand and system.

The third area I want to touch upon as it relates to our domestic business is a progress report on our effort to upgrade our franchise system and I plan to be very specific. As I indicated earlier we have identified 246 F categorized franchisees in our system. We have had very direct discussions with all of these franchisees and we’ve reached agreements with 127 of them to sell their stores and leave the system.

We are currently engaged in this process and we’ve already removed 22 of our F rated franchisees from our domestic system. This number will continuously grow as we move through the second half of 2008 and into 2009. The rest of the franchisees currently rated F have recommitted themselves both personally and financially to their business and we plan to watch them closely.

We hope many will move into the B level or better in the near future and those who can’t or won’t, will be added to the list of franchisees leaving our system. We will be compassionate with those who demonstrate a sincere desire to fix what is broken quickly and pull them out of the F category. We will not be patient with any of those who don’t make immediate improvements in their store operations.

I want to point out that our 830 B franchisees are a source of great opportunity. The more of them we can develop into A performers the stronger our system will be and the better we can withstand the economic pressures we are currently facing. We will be offering more training and development programs to this group than we ever have in an effort to better support them and help them perform at a higher level.

Before I end my remarks regarding the status of our domestic business, and I apologize this is taking longer than I normally do, but I think these points are very important, I want to make a couple of things very clear. With the advantage of 20/20 hindsight I want to openly admit to some mistakes that we have made that have contributed to the difficulties we have had during this period of surging costs, rising prices and consumers’ reluctance to spend particularly at the dinner day part.

First, we were slow to recognize the impact of our continuously increasing average ticket prices and the impact they were having on our traffic. We lost a lot of momentum in 2006 while we were still trying to push higher ticket growth when we should have been doing more to address the traffic issue. This caused us to enter the severe economic downturn in 2007 with no sales momentum and it made us even more vulnerable to continued traffic losses.

Second, as the value entry in the pizza delivery category we should not have pushed our prices as high and as fast as we did during 2007 and early 2008. We’re known for value and convenience and we lost many customers who felt we forgot them as we were adding delivery charges, menu price increases and higher promotional prices during a time when our customers were really being frustrated by higher gasoline and food prices.

Third, we allowed some of our franchisees to get complacent. After 12 consecutive years without a negative same store sales year we did not recognize and react as quickly as we should have to the number of franchisees who decided to put their businesses on auto pilot both in terms of their effort and their investment

Fourth, our company and truthfully the pizza category overall has in the recent past viewed menu innovations as primarily offering different topping combinations and catchy names on special pizzas but not really truly innovating. We need to take innovation to a higher level. We need product innovation that will broaden our menu, create more choices, penetrate more day parts and leverage technology in a way that is far more than just accepting orders online. You will see a vast number of new innovative products and initiatives from Dominos Pizza in the months and quarters ahead all intended to take a category that has been sleepy and wake it up.

Now I’ve given you a fairly in depth view of the domestic business. I want to just briefly switch gears and highlight our international business which continues to do an extraordinarily fine job. Retail sales in our international division has been growing overall at a 17% compound annual growth rate for the past four years. Our top 10 markets have grown at a rate almost equal to the overall with a 16% kegger during that time while our middle tier markets have seen growth of 27% during the same period. So while we still have significant growth left in our top 10 markets we have vast growth potential in those middle markets as demonstrated by our recent results.

The top 10 markets include those we’ve spoken a lot about in the past, the UK, Mexico and Australia but also include India, France and recently Turkey who has now made the top 10. The second tier markets include up and comers such as The Netherlands, Brazil, the Middle East and Malaysia markets we haven’t highlighted much but that have shown tremendous potential for the future of our business. Meanwhile we still have approximately 2,400 stores to build in just our top 10 markets alone with room to double or triple the store count potential in a number of those markets.

Store counts in international has grown at roughly an 8% compound growth rate over the past four years and same store sales have grown at a rate of 6% during the same period of time. The international division was only 18% of Dominos operating profits four years ago and by 2007 it was nearly 30% of our operating profit. Based on their continued growth trends the contribution of our international growth engine to our overall business results will continue to increase and we’re very pleased and proud with the work that they’re doing. And a reminder our model of growing through master franchise agreements enables us to attain great geographic expansion with very little investment again driving our pre-cash flow business model.

I’ve given you a lot of facts and figures to digest here and I understand that, but I hope it’s been helpful and what I’d like to do now is open up the call and take questions from any of you who may want to ask them.

Question-And-Answer Session

Operator

(Operator Instructions) Your first question comes from John Glass - Morgan Stanley.

John Glass – Morgan Stanley

David, first question is how do you facilitate the transition of the F stores to new ownership? Does the company need to be an intermediary or can you do that directly? I may have missed this but how many F stores are there? I think you said how many F franchisees there were but I didn’t catch how many actual stores this represents?

David A. Brandon

600 stores are total F’s, the F’s represent, as I recall, 14%. We’ll look that up to make sure we give you the right number. The situation is really the facilitating of the sale. Our franchise agreement affords the company the ability to have the first right of refusal on the sale of any store so we’re actively involved in those transactions, from the moment the operator decides to sell and until ultimately we decide whether we want to purchase the store. And we also have the right to approve whoever does purchase the store.

So we’re in the middle of those transactions and we can make sure that we’re facilitating the ownership of that store to the appropriate new owner who will hopefully take it and operate it at a higher level. The number of F franchisees that we have is 246, we indicated that that’s 14% of our stores which is 633 stores. About half of those F franchisees we’ve identified as people that we truly believe can get things turned around. The other half are the ones that will be exiting.

John Glass – Morgan Stanley

Just to clarify does facilitate mean you buy and resell or are you a broker?

David A. Brandon

It is not our intention to purchase these stores, it is our intention to broker these to A and B franchisees and any of our new external franchisee candidates that we feel are capable of taking those stores over and investing in them appropriately and operating them appropriately.

John Glass – Morgan Stanley

One more, in you’re talking about value, can you provide some context about what has happened to your average check over the last couple of years and you said the delivery costs, but could you run that and how have you worked up the average check over the last few years? When you think about value are you going to do a high-low approach to hope to keep the average check about steady but provide a value alternative or are you actually thinking that you need to lower your average check?

David A. Brandon

In the delivery customer which is our most important customer obviously 15 to 20% of our business is carry out and it’s a little bit of a different scenario but as we focus on our delivery customer the ticket increased approximately 10% in 2007. If you were to go back and include 2006 and before the advent of delivery charges and some increased inflationary pressure you would see that over the past two to three years that ticket has probably gone up more to the tune of 15 to 20% and that’s including the delivery charge as part of what’s happened in our business.

We believe that the barbell strategy is an appropriate one for us. The launching of the 10 inch pizza, if you will, the $4 pizza which is currently being launched as the $4 $4 $4 promotion affords us the ability to truly provide alternatives to those customers much like you’ve seen in other categories who are looking for a much smaller ticket opportunity to participate in the brands. And we also believe as I indicated that parallel with that to continue to be out there developing a more premium line, premium price pizza line is a good strategy for us because we know based on our analysis there are many of our customers who enjoy that product and they’re certainly not as price sensitive.

John Glass – Morgan Stanley

But you’re doing the value promotion now and I presume it will take some time to develop those premium products? Or are they closer in?

David A. Brandon

That’s exactly right. We have two or three of those product platforms already built as a result of limited time only promotions that we’ve had that have done very well and so you may see some of those resurrected as part of the premium platform line but we also have others that will be going into test that will round out that line. When and how that all evolves it’s to be determined but we’re pretty excited about the prospects.

Operator

Your next question comes from Joe Buckley - Bear Stearns.

Joseph Buckley – Bear Stearns

You ran through the cash-on-cash returns that franchisees are getting but how leveraged are the franchisees? What coverage ratios are those groups of stores showing?

David A. Brandon

Joe, when you understand the composition of our franchise system is that the average operator owns three to three and a half stores. That’s the average and we only have a handful of franchisees that own over 50 stores as opposed to having major corporations who are going out and doing refinancing deals with high levels of leverage we’re dealing with a lot of owners who own their businesses outright, many of whom have long since paid for their stores. So we do not believe that we are in a situation where we have a lot of exposure to highly leveraged franchisees.

The diversification of our portfolio of franchisees, if you will, really reduces that risk. Do we have certain franchisees out there that have run up their borrowings and they’re more at risk? Certainly we do in this environment but not to a material degree.

Joseph Buckley – Bear Stearns

A number of this season’s conference calls people have talked about how hard it is to sell restaurants and get financing for restaurant deals, are you helping the buyers of some of those F stores in any way to raise cash for the deals?

David A. Brandon

We have relationships that are long standing with financing organizations that we certainly enjoy working with and have the ability to facilitate their involvement in some of these transactions. We don’t like to be the bank in these transactions so it’s rare for us to get involved in any a financing way but we’re certainly helpful in helping put the transaction together to bring financing to the table.

Joe, you’re absolutely right in today’s environment, it’s tougher than it’s been in a long, long time so we have to work a little harder and in some cases there’s probably more of a premium paid for some of the financing. But one of the advantages that we have versus a lot of people you’re talking to is that the average new store build for us is $175,000. When some of these failing stores are sold in a failing mode, the price tags for these stores can be less than $100,000.

So the financing challenge is very different than if you’re out there talking about a burger concept or something where the original store cost is $1.5 million and there’s big real estate and big leverage on the property.

Joseph Buckley – Bear Stearns

Just one more, the extended hour opportunity, how significant is that? Can you give us some sense of what percent of the system might not be open for lunch currently or maybe the late night opportunity?

David A. Brandon

I can tell you that we have been a concept that for a long time has really been focused on the dinner day part almost obsessively and up until the not too recent past we’ve had a significant number of stores that weren’t even open until the middle of the afternoon. We’ve worked on that hard. We’re to a point now where about 85% of the domestic system is open for lunch but I will tell you that in some cases that’s a relatively recent development. We still have many stores to get open for lunch.

We also have the same issue with the late night. We’re traditionally known as a food alternative that stays open really late on the weekends but in many cases we’re been closing down too early during the week. We know that 40% of America is working less than what would be considered to be traditional hours and so we see that in all of the different concepts where for instance the burger guys who are staying open for 24 hours a day, people who are extending their hours, there’s benefit from that because there are people who want to eat at those times that previously were considered fringe, now they’re becoming more mainstream.

We want to get in that game both in terms of hours of operation and in terms of menu and price point and packaging because those are all related and that’s a big commitment that we’re making and it’s something that the system will be getting benefit from in the months and years ahead.

Operator

Your next question comes from John Ivankoe - JP Morgan.

John Ivankoe – JP Morgan

One thing that I noticed in the release was that company store margins were actually higher than I expected given the comp and the higher cheese prices and distribution revenue was actually a lot lower. Was any of that a function of the cheese hedges that you had in place or perhaps had in place in the first quarter?

David A. Brandon

No. No. There was no cheese hedge year-over-year in place at all.

John Ivankoe – JP Morgan

Moving on from that and again given the distribution revenue, was there any forgiveness or perhaps price control that was given to the franchisees in the distribution segment that was unusual in the first quarter relative to previous quarters?

David A. Brandon

No. The revenue declines in distribution were simply volume offset by higher commodity pricing. The cheese contract that we put in mid-year, John, mitigated a little bit of that cheese difference, $1.33 block a year ago versus a $1.93 block this year. We didn’t see that entire amount due to the new pricing on the cheese but there was nothing going on. Our distribution model stayed true to what it has always been.

John Ivankoe – JP Morgan

Am I right that this is the quarter, the first quarter that you passed on the higher wheat prices, the flour prices, to the franchisees through the distribution segment?

David A. Brandon

Yes, we did and we stepped that up actually. We took a significant jump right at the beginning of the year and then we stepped it up during the quarter again. We blended that increase so that it didn’t happen all at once. But yes, this is the quarter where we basically passed on the impact of the wheat increases on our dough prices.

John Ivankoe – JP Morgan

Continuing on this line of questioning, obviously company store economics are challenged, franchise store economics are challenged. Of course I understand that half of the distribution segment profit is given back to the franchisees in terms of the rebate, but are franchisees really calling for more at this point? Are they calling for better pricing terms in 2008 and 2009 and if so is that something that you would consider?

David A. Brandon

No. We’re constantly through our distribution advisory board and our general communications with our franchisees, we’re constantly benchmarking our distribution prices against the other concepts out there. It’s not hard for us to find out what the other people in the pizza delivery business are charging their franchisees and operators at the store level.

So we’re benchmarking against that and we have specific objectives in terms of the competitiveness of our pricing and the fact that we have the profit sharing agreements that affords our operators to participate in the efficiencies and success of those organizations is helping us a great deal because as we’ve looked at things about product engineering, as we’ve looked at delivery frequency, some of the efficiency initiatives that David Mounts has put in place with our supply chain business our franchises have been very receptive because obviously it helps their economics and it makes their profit sharing checks larger.

John Ivankoe – JP Morgan

One thing that you’ve identified in terms of call it the difference between the A, B and the F franchisees is pricing, its menu pricing and how they have managed their menu in terms of what’s being offered to customers at what price. Is there anything else, any specific or even very few factors that you can point to that can say if the F franchisee can, whether it’s delivery times or answering the phones or it’s cleanliness of the restaurant, what have you.

Are there a few factors that you can focus on or that you can identify that can make an F franchisee perform in line with the average or is it just an overall things need to be better across the board effort?

David A. Brandon

I think you’ve highlighted a lot of the key factors, John. It’s really a situation of whether you’re in the game or not and frankly we have some franchisees who are a victim of their own success. Over the past many years they’ve done very well, they’ve very good money, good returns, they become more distanced from their business and one thing I can tell you is we’re in an environment right now where if you want to be successful you have to work harder and operate better and bring more leadership focus to your business than ever before.

There is nothing about the business right now that comes easy either on the sales side or the cost management side and if you delegate to people who you either cannot trust or people who are not prepared for the challenge of that, you’re going to pay the price. Generally speaking if you want to come up with one characterization of our F franchisees, they’re not engaged in their business at the level they need to be to afford those stores the ability to be successful.

It manifests itself in stores that are below image standards, that are operating and providing poor service to customers, that are providing inconsistent products, all the things that are detrimental to your business and it shows up in their sales results, it shows up in their margins and it shows up in their cash-on-cash returns.

Operator

Your next question comes from Jeffrey Bernstein – Lehman Brothers.

Jeffrey Bernstein – Lehman Brothers

Just a follow up on the day part expansion, I know you said late night and lunch. I’m just curious whether this is focused on the traditional pizza product or can you give any type of more qualitative color in terms of other products that might be tested during either of those day parts?

David A. Brandon

We think that our pizza product works really well in both day parts particularly when we start coming up with a smaller portion size at a lower price point. We plan on selling a lot of pizza at lunch and we plan on selling a lot of pizza at late night day parts. I will also tell you that we have test platforms in place for other products other than pizza which we think will complement pizza and afford us the ability to be offering more choice in both of those day parts to customers who are looking for choice.

Jeffrey Bernstein – Lehman Brothers

In the stores that have done this expanded hours, the stores in test, can you give some color in terms of the incremental traffic or some of the benefits that they’re seeing?

David A. Brandon

I think the best illustration is Team USA. They got on the lunch bandwagon quicker and faster than we were able to coax our franchisees in many cases and one of the reasons that we would attribute their out-performance of the franchise system would be their commitment to lunch. It’s one of those day parts where when you haven’t been in lunch in many cases for years and years when you first put that Open sign out, you’re not going to get an avalanche of business because it takes a while to create awareness that you’re in that day part and that you’re open.

What we found is if you have the perseverance to stick in there and market hard and commit to lunch and make sure your customers know you’re committed to lunch, then over time we can build a very, very significant business. That’s what we’ve done with Team USA and that’s what we plan on leading with the rest of the system.

Jeffrey Bernstein – Lehman Brothers

You mentioned more the value focus, I know you have the three pies for $4 each, just wondering in terms of profitability if some of these promotions and targeting that lower end consumer, obviously you’ve increased delivery charges and prices to offset margin pressures at least in this high cost environment the profitability at the expense of driving higher traffic and comps?

David A. Brandon

Without question the food costs of an offer like a $4 $4 $4 is higher than other promotional offers we may have launched in the recent past, it’s still within an acceptable range. Our operators still enjoy selling that three 10 inch pizza, one toppings because it provides us great opportunity to up sell. Every topping that we can add to one of those pizzas becomes an up sell opportunity. There’s a lot of other things that we can do to try to take that core $12 ticket and move it up.

It’s a platform that works well for us and frankly our focus right now is and has to be traffic. I suppose in an ideal world we’d have one customer a week or one customer a year that we’d sell a $1 million pizza to but the reality is we need to get into the business of driving traffic, creating trial and getting momentum in our store and to the extent the value platform will help us do that we think overall that’s going to be to the benefit of our operators both in terms of traffic and sales but also in terms of profitability.

Jeffrey Bernstein – Lehman Brothers

I believe I’ve heard you make comment or perhaps it was last quarter in terms of strategies on leverage and why you don’t think it’s a near term concern in terms of the interest only payments, you would potentially willing to pay down some debt earlier if the opportunity presented itself. I’m just wondering if you can give an update on that? Is that something you are perhaps pursuing?

David A. Brandon

We continue to evaluate our capital structure and the capital markets and we continue to look at our stock price and we continue to look at the free cash that’s coming out of the business and the Board of Directors and those of us in leadership roles at the company will continue to watch that very carefully and make prudent decisions for the betterment of our shareholders.

As it stands today based on the 6% fixed debt that we have and the runway that we have ahead and the amount of cash that the business is still generating obviously we still believe the best deployment of that capital is in the form of stock repurchase and we’re pleased to do that. If we get to a point where we feel differently we obviously have the flexibility of making that shift. For right now we think that’s the best value in town. We’re going to continue to use our free cash in that way.

Operator

Your next question comes from Colin Guheen – Cowen and Company.

Colin Guheen – Cowen and Company

My first question is given an outlook where you’re rebuilding perception around value but also building awareness around the specialty products and extended hours of operation, what’s the forward marketing strategy going to look like?

David A. Brandon

The core marketing strategy?

Colin Guheen – Cowen and Company

The forward marketing strategy it seems to be that you’d be changing some of the way you market to your customers and who you market to.

David A. Brandon

I think that you’ll see a lot of news being generated as a result of the things that I’m talking about, new product platforms, new things on the menu that will not only add value to some of the day part expansion but will also be exciting to some of our regular customers at dinnertime. I think to launch a value platform concurrently with the fact that we’re working on a premium pizza line affords us a lot of news generation and in the low traffic world that we’re in right now news is important.

Anything that cuts through and allows the customer to reconsider you as an alternative, I think is a positive thing. So our marketing calendar will be busy with news, new topics, new products and a lot of things that we hope will generate some excitement not only for the brand, but for the category.

Colin Guheen – Cowen and Company

So we can expect to see some of the specialty platform integrate into the marketing strategy sooner than later?

David A. Brandon

Yes. We have a lot of test markets that are under way and obviously we’ll be setting priorities for national windows based on the results of those tests. But we have a lot of things in the hopper right now that I think you‘re going to be seeing a lot of in our commercials as we go into the latter part of this year and certainly into 2009.

Colin Guheen – Cowen and Company

Will you look to offset value messages with specialty product messages or rotate them or how do you envision that working?

David A. Brandon

We think the people who have done this the best are out there with concurrent messages that are really appealing to a broader section of customers. We don’t want to just be the value pizza, we also want to take care of those customers who are less price sensitive and more into premium products. To do that you’re going to have to balance that spend and that marketing message both with your television and your print and your menus to communicate to both those customer segments that we’ve got something that’s attractive to them.

Colin Guheen – Cowen and Company

And when from an hours of operation standpoint do you think you’ll be able to start marketing system wide late night and lunch?

David A. Brandon

Our hope would be that if a couple of the test platforms that we’ve got under way right now work out as well as preliminarily they seem to be working we’ll be able to put a major marketing push behind lunch, and I don’t want to tip our hand here but, in the fairly near future.

We think one of the ways to get all of our stores open and to really get a lot of energy behind that is not only the introduction of our 10 inch pizza product which is a really nice platform for lunch, but also to launch that concurrent with other entrees and products that will create even more excitement around that day part. I really don’t want to go any further other than that to let you know that’s one of those things that we’re working on long and fast.

Colin Guheen – Cowen and Company

Just one other financial question, the $8.2 million that showed up on the cash flow statement, was that the total proceeds from the company owned store sales?

William E. Kapp

A portion of it was that and a portion of it was due to selling of pulse systems during the first quarter as well.

Colin Guheen – Cowen and Company

Can you give us the number that was actually the proceeds from the sale of the stores?

William E. Kapp

$6.4 million were the cash proceeds from the sale of the stores in Q1.

Colin Guheen – Cowen and Company

From 29 stores?

William E. Kapp

Yes.

Colin Guheen – Cowen and Company

That’s the total amount that you’re going to receive for the sale of those stores or is there some deferred payment or something?

William E. Kapp

That’s pretty much all of it.

Operator

Your last question comes from Chris Sipple – Blue Lion Capital.

Chris Sipple – Blue Lion Capital

Can you talk about the 41 franchise stores that close din the quarter and were those part of the F group or were they parts of other groups?

David A. Brandon

The 41 stores that closed a high percentage of those would have been F operators, some of those stores will be permanently closed but some of those stores will likely be re-opened by other operators.

Chris Sipple – Blue Lion Capital

In the future as you cull the F portion of the herd, if you want to use those terms, how many stores will be closed versus successfully sold to better operators?

David A. Brandon

That’s a really tough number to give you specifically. I would tell you that last year we began this process although not as vigorously as we are currently engaged and as I already reported to you we were able to open a few more stores than we closed. I think in the environment we’re operating in in 2008 if we were to get to the end of the year and be anywhere near close to break even in terms of having the number of closures equal the number of opens I would view that in the current environment as a pretty successful outcome.

There’s always a chance that we could end up with 20 or 30 net closes in an environment that we’re in. We could always catch a break depending on sales trends and activity in the second half where maybe we could get a more robust growth plan put together so I want to give myself some wiggle room there but we do not see any material impact in terms of store closures in 2008 versus what you’ve grown to expect from us.

Chris Sipple – Blue Lion Capital

What was the foreign exchange gain in the quarter?

William E. Kapp

The foreign exchange gain for the quarter for royalty income was about $850,000.

Chris Sipple – Blue Lion Capital

And there was none for the company owned stores internationally?

David A. Brandon

We don’t have any company owned stores internationally.

Chris Sipple – Blue Lion Capital

They’re all franchise?

David A. Brandon

Correct.

Operator

There are no further questions at this time.

David A. Brandon

I just want to quickly summarize I hope today has been able to demonstrate to you the strength of our franchise model particularly during times of challenge and duress, but we know full well the real proof is in the free cash flow that this business continues to generate. Despite the tough times as you all know we generated nearly $17 million of free cash flow during the quarter.

We deployed it continuously into our share repurchase program. We’re at about 36% of our open market authorization that we’ve received from our Board and we continue to operate against that authorization. I like the things that are happening in our business in terms of change. We continue to operate in a pretty ugly environment but nevertheless we continue to keep our feet moving and I’ll look forward to telling you more about how we’re progressing in a few months. Thank you all for your time and attention today.

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Source: Dominos Pizza, Inc. Q1 2008 Earnings Call Transcript
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