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Denny’s Corporation (NASDAQ:DENN)

Q2 2008 Earnings Call

July 29, 2008 5:00 pm ET

Executives

Alex Lewis - Vice President, Treasurer

Nelson J. Marchioli – President, Chief Executive Officer

F. Mark Wolfinger – Executive Vice President, Chief Administrative Officer, Chief Financial Officer

Analysts

[Unidentified Analyst] - Lehman Brothers

Bryan Hunt - Wachovia Securities

Michael Gallo - CLK

Brian Moore - Wedbush Morgan Securities

Steve Anderson - MKM Partners

Eric Wold - Merriman Curhan Ford & Co.

Sidoti & Company - Federal Inn Company

Anton Brenner - Roth Capital Partners

Operator

Welcome to Denny’s second quarter 2008 earnings release conference call. (Operator Instructions) I would now like to turn the conference over to Alex Lewis, Vice President and Treasurer of Denny’s Corporation.

Alex Lewis

With me today from management are Nelson Marchioli, Denny’s President and Chief Executive Officer and Mark Wolfinger, Denny’s Executive Vice President and Chief Administrative Officer and Chief Financial Officer.

Mark will begin today’s call with a financial review of our second quarter results. After that, Nelson will provide an overview of our business and our strategic initiatives. After our prepared remarks, management will be available to answer questions.

Before we begin, let me remind you, that in accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the company notes that certain matters to be discussed by members of management during this call may constitute forward-looking statements. Management urges caution in considering its current trends and in the outlook of earnings provided on this call. Such statements are subject to risks and uncertainties and other factors that may cause the actual performance of Denny’s to be materially different from the performance indicated or implied by such statements. Such risks and factors are set forth in the company’s annual report on Form 10-K for the year ended December 26, 2007 and in any subsequent quarterly reports on Form 10-Q.

With that, I’ll now turn the call over to Mark Wolfinger, Denny’s EVP, CAO, and CFO.

F. Mark Wolfinger

I’ll start my comments with a quick review of our second quarter sales performance. System-wide same-store sales decreased 2.8% on the second quarter comprised of a 0.7% decrease at our company’s restaurants and a 3.7% decrease at franchise restaurants. We believe part of the difference in the same-store sales between company and franchise restaurants is the timing of pricing actions and the rate of additional impact of geographic concentrations as well.

Looking at details for company sales performance, a 6.7% decline in guest counts was mostly offset by a 6.4% increase in average guest check. Most of the growth in guest check was contributable to pricing actions taken over the past year, then offset by minimum wage hikes and commodity cost pressures. The remaining growth in guest check was attributable to favorable menu mix compared with the prior year period.

Company restaurant sales for the second quarter reflect the continued impact of our franchise growth initiative or FGI. As sales decreased $55.1 million or 25%, due to 141 fewer equivalent company restaurants compared with the same period last year.

Since the beginning of 2007, we have sold 171 company restaurants for approximately one-third of the company base at that time. As a result, we have increased the mix of franchise restaurants in the dining system from 66% to 77% over the last 18 months.

As a successful execution of FGIs ongoing, the sequential decline in company units, company restaurant sales and company restaurant operating income is expected to continue while franchise revenue and franchise income are expected to increase.

Turning now to the quarterly operating margin table in our press release, our company restaurant operating margin in the second quarter was 12.5% of sales, an increase of 9/10ths of a point compared with the prior year period. We are very pleased to have generated margin improvement during the quarter as our primary costs, food and labor had been under pressure for more than a year from substantial commodities, inflation and minimum wage hikes.

The most significant change in our second quarter P&L was a 1.9 percentage point improvement in our food costs margins. In addition, a price increase was taken to help offset commodity inflation. We have been proactive in managing our menu mix in order to reduce our food costs per guest while still providing a compelling value offering to our customers.

Our primary product promotion in the second quarter was the Build Your Own Grand Slam. The Grand Slam is our most recognizable menu item. It is also one of our most profitable.

Payroll and benefit costs for the second quarter increased 2/10ths of a point to 42.3% of sales due primarily to higher group medical costs and increased restaurant management compensation partially offset by more efficient crew labor staffing and menu price increases intended to help offset minimum wage hikes.

Utility expense for the second quarter increased 3/10ths of a percentage point due primarily to higher natural gas prices.

On the franchise side of our business, we were experiencing offsetting positive impact from the FGI program, as equivalent franchise restaurants increased by 134 units in the second quarter compared to the prior year. This contributed to a $4.4 million or 20% increase in franchise revenue. This revenue growth was comprised of a $3 million increase in franchise rental income and a $1.6 million increase in franchise royalties partially offset by a $200,000 decrease in franchise fees.

Franchise operating margin increased by $2.8 million and higher revenue offsetting a $1.6 million increase in franchise cost primarily related to rail expense on properties subleased to franchisees.

General and administrative expenses decreased $1.6 million from the prior year period due primarily to lower payroll and other compensation costs. Next, depreciation and amortization decreased $2.6 million from the prior year quarter due primarily to the sale of restaurant operations and real estate assets over the past year.

Operating gains, losses and other charges decreased $15.1 million from the prior year period due primarily to a $10.3 million decrease in asset gains compared with the prior year period. In addition, restructuring charges increased $4.5 million due primarily to severance costs related from the organizational changes we made in the second quarter, as we transition our company focus towards becoming a franchisor of choice in the restaurant industry. These changes included the elimination of approximately 50 field and corporate positions in June. Certain of these positions will serve out a transitional period so we don’t expect to realize the full $6 million-$8 million annualized G&A savings until 2009.

Operating income for the second quarter decreased $12.8 million due primarily to the reduction in asset sales gains and the additional restructuring charges. If you exclude these items from both periods, operating income increased $2.3 million despite a decrease in total revenue of $50.7 million.

Below operating income, interest expense decreased by $2.1 million or 19% to $8.9 million in the second quarter as a result of a $97 million reduction in debt from the prior year period.

Other non-operating income increased $1.4 million in the second quarter due primarily to changes in the fair value of our $100 million interest rate swap.

We reported net income in the second quarter of $3.2 million or $0.03 per diluted common share, a decrease of $7.5 million compared with the prior year period.

Because of the significant impact to our P&L from non-operating, non-recurring, or non-cash items, we give earnings guidance based on our internal profitability measure adjusted income before taxes. We believe this measure best reflects the ongoing earnings of our business.

Our adjusted income before taxes in the second quarter was $5.7 million, a $4.2 million or 280% increase over the prior year period.

We are very pleased that we were able to generate significant income growth despite the difficult sales and margin environment for the restaurant industry. We believe this is evidence of the progress we are making on our strategic initiatives, in particular the success of FGI as well as our debt reduction efforts.

To summarize our P&L for the second quarter for the sale of company restaurants to franchisees resulted in a $55.1 million decline in company restaurant sales and a $4.8 million decrease in company restaurant income. We more than offset this lost company restaurant income through the combination of a $2.8 million increase in franchise income, a $2.6 million decrease in depreciation and amortization expenses and a $2.1 million decrease in interest expense. We expect our P&L to continue to reflect these income and expense shifts as we transition to a more franchise driven business model.

To put this income shift in perspective, in 2007, our company operations generated 60% of our gross profit and our franchise operations contributed 40%. In the second quarter 2008, the contribution from our higher margin franchise operations had increased to 47%. We expect this to continue, this beneficial shift from company operations with margins of around 12%-13% to franchise operations with margins of 68%-70%. By the end of 2008, we expect franchise income will increase to 50% of our total gross profit.

Turning to activity in the Denny’s restaurant portfolio, the system decreased by net 5 units in the second quarter as four new restaurants opened while nine were closed. The net decline in units this quarter is expected to be offset by a strong schedule of new franchise restaurant openings in the second half of this year, as the impact of new store development from FGI begins to be realized. Our guidance for new franchise restaurant openings remains at 30-34 for the year which 11 had opened through the end of the second quarter.

Moving on to capital expenditures, our cash capital spending for the second quarter was $1.9 million, an increase of $1.5 million compared with the prior year period. Most of this increase was due to timing of expenditures as last year’s capital spend was heavily weighted towards the back half of the year and this year’s capital spend has been more even.

Turning to assets sales in the second quarter, we generated net proceeds of $7.1 million from the sale of 20 company restaurant operations and certain real estate. A big portion of these transactions was closed on the last day of the quarter. Approximately $3.2 million of the net proceeds were not received until after the quarter closed and are therefore shown in accounts receivable on our balance sheet.

On a year-to-date basis, we have generated net sale proceeds of $22 million on the sale of 41 restaurant operations and certain real estate. Excluding those receivables taken for $2.4 million of the sales proceeds and the $3.2 million of the proceeds received just after the second quarter ended, we took in $16.4 million in cash during the first half of the year. Most of these proceeds were used to reduce our off-standing debt by $15.4 million since the start of the year.

In these difficult economic times, we are very pleased to have reduced our debt by $214 million or 39% for the past two years.

That wraps up my review of our second quarter results. Before I discuss our revised guidance for the year, I would like to point out the short-term impact of the franchise growth initiative on our free cash flow. When you review our second quarter 10-Q which we filed this evening, you will see a noticeable decrease in cash flow from operations compared with the prior year, despite our increased adjusted income for the year. The primary reason for this decrease is a runoff of working capital resulting from the sale of company restaurants.

Restaurants typically operate in a negative working capital environment as sales are received in cash or through timely credit card receipts, while many of the costs associated with these sales are paid on delayed terms. Accordingly, we see a cash write-off from each restaurant sold of approximately $150,000 to cover the payroll and other lagging operating expenses. This results in the year-to-date use of cash of approximately $15 million based on 100 restaurants sold at the end of last year and so far this year.

Despite the effect on short-term cash flow, we are very pleased with our progress on FGI and the resulting optimization of our business model. We continue to see strong demand from potential and existing franchisees to purchase Denny’s company restaurants. The lack of liquidity and other challenges in the credit markets are making the process more difficult and more time-consuming but our pipeline and timeline for FGI transactions remains on track to meet our guidance of 75-100 restaurants to be sold this year.

Again, despite the effect on short-term cash flow from the working capital runoff, we continue to have a very strong liquidity position. With cash and revolver availability, we’re over $77 million at quarter-end. We also reduced our leverage in accordance to 3.8 times base on total debt to adjust EBITDA. I want to make sure that the message is clear that our cash flow is on plan and our financial position is as strong as it’s been in the last 20 years.

As for other guidance, we’ve updated certain metrics for the full year based on our positive year-to-date results and management’s expectations for the second half of the year. Our sales outlook remains cautious given the economic pressures that continue to impact our customers. However, the challenging sales environment has not kept us from making significant improvements in profitability during the year.

We now expect our core income metric adjusted income before taxes to range from $13 million-$17 million for the year. This is a substantial increase from our earlier guidance of $8 million-$14 million and a 25%-60% increase from our 2007 results at $10.5 million. In addition, our expectation for capital spending has been lowered from $35 million in our previous guidance to $29 million now. This change is due primarily to fewer company restaurant openings than previously estimated. One planned Pilot travel center location will now be opened by a franchisee and one traditional Denny’s opening was delayed until 2009. Most of the other guidance metrics provided in our press release have been updated moderately based on year-to-date trends and the impact of FGI transactions during the year.

That wraps up my commentary on guidance. I will now turn the call over to Nelson Marchioli, Denny’s President and CEO.

Nelson J. Marchioli

Thank you, Mark. Good afternoon, everyone.

Let me start by saying, I’m pleased with the progress we are making on our strategic initiatives, the most critical of which is our transition to a franchise-focused business model. It is through this change along with a commitment to improve our operating margins that we have been able to generate such strong earnings growth in the second quarter.

While improvement in the economic environment would certainly make our jobs easier, we don’t foresee any material lift in the second half of ’08 or into ’09. We don’t believe consumer spending is likely to pick up either. Inflationary pressures aren’t showing any signs of weakening.

We have chosen to develop a long-term, multi-faceted marketing strategy that addresses our guest count weakness without sacrificing profitability. We do not believe that there is an easy answer to attracting guests, particularly in this environment. We recognize the need for Denny’s to be more relevant, more convenient and more innovative in today’s highly competitive marketplace.

While we want to drive traffic across all of our four day parts, we are using our core attribute breakfast to connect with the consumer. In our research, participants selected Denny’s above all competitors when they thought of a real breakfast. We are using this connection as a foundation for our messaging and product innovation.

In May, we began an aggressive campaign to energize our late-night business. While almost half of our late-night customers were already in the 18-30 age group, we had not effectively targeted this important demographic. Through our Denny’s All-Nighter campaign we are using relationships with popular youth-oriented bands and targeted television and Internet media to build awareness for Denny’s late-night experience. While competition is strong at late-night, Denny’s can offer much more than a bag out of a drive-though window. Only at Denny’s can you choose from such a large variety of offerings including appetizers, sized per sharing, value-priced burgers and sandwiches, desserts to cure a sweet tooth, and of course, all your breakfast favorites. You can do it all when relaxing at a table rather than in the back of a car.

We know that it will take time and persistence to grow this business but we are encouraged by our early results. We have seen late-night traffic improve substantially but guest counts remain negative as we fight the economic headwinds affecting all of our day parts.

In late June, we launched our first comprehensive take-out sales initiative. While you’ve always been able to order food to go at Denny’s, we didn’t have a unified program to promote and execute it. It was more of an accommodation. Our customers told us that they wanted the convenience of having their real breakfast wherever they chose. The challenge was maintaining a quality breakfast in traditional packaging. Denny’s solved this problem with a revolutionary new packaging system called The Denny’s Dome. This proprietary packaging is designed to keep every part of your meal hot and fresh. While it is very early in the program, we have seen an increase in take-out sales and expect to see continued long-term sales growth as we build awareness for real breakfast-to-go.

Our late night and take-out initiatives were internally the first two parts of our three-part summer sales program we called Triple Play. The third component of this program is the introduction of a brand-new product line, Sizzlin’ Breakfast Skillets. We are currently offering two variations, a Southwestern Sizzlin’ Skillet and a FlapJack Sizzlin’ Skillet. The Southwestern comes to your table fajita-style, sizzling on a hot cast-iron skillet. On the side are warm tortillas ready to be loaded up with scrambled eggs, fire-roasted peppers and onions, hash browns, bacon and sausage. Fresh pica de gallo and sour cream are perfect on top. The FlapJack Skillet also sizzles with traditional breakfast ingredients of scrambled eggs, bacon, sausage, and hash browns, ready to be rolled up in sweet, thin pancakes and perfect with syrup on top.

We are very excited about the launch of these innovative new menu items and we’ll begin an immediate pizza campaign this week and a full commercial schedule next week to support them.

We are confident that we are building a foundation for marketing and product development that can meet our goals of sustainable relevance, convenience and innovation. With that said, we are also aware of how difficult it is to drive positive traffic in today’s environment. Our revised sales guidance for the year anticipates continued negative guest count despite our enthusiasm for our new sales initiatives.

We all recognize that the U.S. economy continues to experience significant negative pressures. Nevertheless, we are confident about our strategic initiatives and believe that our current actions create long-term shareholder value.

This quarter’s results are evidence of that success as we continue to optimize our business model, increase our profitability and strengthen our financial position. We have completed our organizational changes and are now focused on meeting our strategic goals while insuring and improving day-to-day execution in all of our restaurants.

I want to thank our employees, our franchisees for all their hard work to grow and energize the Denny’s brand. I’d also like to thank our shareholders for their ongoing support. We’re pleased with our progress but we believe the opportunities ahead are far greater.

As always, thank you for your interest in Denny’s. I’ll now turn the call back over to Alex.

Alex Lewis

We are ready for the question-and-answer session.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from [Unidentified Analyst] from Lehman Brothers.

[Unidentified Analyst] - Lehman Brothers

The cost of sales as you mentioned was significantly lower than prior year as well as the preceding quarter as a percentage of restaurant sales. Can you talk about that?

F. Mark Wolfinger

Rayfer, its Mark. I briefly talked about it in my comments but it’s primarily driven by the success of Building Your Own Grand Slam. Obviously, it is a popular brand per se, as the Denny’s brand. That’s sort of what we’re known for, the Grand Slam. It’s also a very, very attractive food cost structure to it. So we were very pleased with the kind of mix we saw in that product line during the second quarter and that was the key contributor to that movement.

[Unidentified Analyst] - Lehman Brothers

Are you actually experiencing food costs inflation or just offsetting it with the menu types?

F. Mark Wolfinger

Yes, we are experiencing definitely food cost inflation on the commodity side and again, we don’t see that changing whatsoever. I mean, if anything, I think the inflationary factors will continue to build. I also mentioned in my comments, obviously, we have taken pricing actions over the last 12 months as well. At the same time, when you look at our product cost line-up and if you go to our menu items, the Grand Slam is a very attractive food cost structure which is out of the gate to begin with.

[Unidentified Analyst] - Lehman Brothers

As far as your re-franchising activities, are you encountering any slowness in terms of financing availability to your re-franchising activities?

F. Mark Wolfinger

This is Mark again. It is getting tougher, no doubt about it. I would say the word slow is probably the way to put it. I think that there are a number of transactions out there that we’re very positive and optimistic about but it is definitely a slower process when you go through the finance and metrics now. Again, I think there’s a stronger selectivity there on the part of the third-party financing entities. Right fully so, in the given credit market situation out there. As I mentioned in my comments as well, we remain on target to our original guidance of 75-100 company stores to be sold during 2008 and obviously we have 41 under our belt the first half of the year.

Operator

Your next question comes from Bryan Hunt with Wachovia Securities.

Bryan Hunt - Wachovia Securities

I was wondering if you could talk about the movement in your EBITDA guidance. You hit the lower end of $3 million. Was that because of confidence in some of your activities that you put in place during the cost-savings or sales side or did you just outperform what you anticipated to do in Q2 on an EBITDA basis?

Alex Lewis

Bryan, hi this is Alex. It’s a combination of the fact that we’ve seen already this year, certainly the product cost line was a benefit but it is one that we certainly modeled coming into the year. We’re well aware of how profitable the grand plan is that we need to get into the year and see what the mix is going to be on the Build Your Own and those things. There certainly is upside there and the other piece of it is the FGI. We sold a considerable number of restaurants literally at the very end of last year which is really sort of in front of our planning, after our planning period.

We needed to see the impact of those roll through and I think you’re seeing it in our P&L. You’re seeing that transition of the business model really come through. Those transactions are very accretive. We do accretion tests on every transaction that we complete and you’re seeing exactly what we expect to have happen. You’re seeing interest come down, you’re seeing depreciation come down, you’re seeing the transition. While you lose a little income certainly from the switch from company to franchise, you got a nice consistent, very high-margin business on the franchise side. We just had to get into the year and continue the realization of our initiatives and I think that’s what we seen so far.

Bryan Hunt - Wachovia Securities

The follow-up on your FGI initiatives. It appears that the cash proceeds per unit has come down in the most recent quarter and additionally, it doesn’t look like you signed any new franchise agreements along with the most recent transaction. I was wondering if you could describe what’s going on in those two instances.

Alex Lewis

I think the proceeds are always going to move around. Again, this is Alex. If you take the total dollars that we took in this year divided by 41, you get a little over $500,000 and that is what our proceeds have been through the whole program on average. Now, each quarter is going to be a little different but what we’ve seen now after 171 now it will probably go back to being around $500,00 a piece on a net proceeds basis. It’s challenging to look at the quarters because we got proceeds in on the second quarter that were related to first quarter transactions. We haven’t gotten all the proceeds from the second quarter because some of those were on accounts receivable balance for one day at the end of the quarter. It’s hard to look at all that but as we gave in the script, if you take the $22 million and divide it by 41 units, you’re at about the right number. I’m sorry, what was the other part of your question.

Bryan Hunt - Wachovia Securities

The other part of the question was at the end of last quarter, you had an agreement from franchisees to open 135 locations as of the last conference call. Now, it’s only 136 and you’ve sold an additional 20 locations. What’s going on that front?

F. Mark Wolfinger

Well, that too has been very dramatic. We had three new contracts for three units in the second quarter and that again is going to vary greatly. In some areas of the country, we are not going to get any development agreements. We’ve been saying this all along. Other areas of the country we can get very strong development agreements. Again, you got to go back to the averages as we work our way through this and we’re ahead of where we’d thought we be on the development standpoint so we’re pretty pleased.

Operator

Your next question comes from Michael Gallo from CLK.

Michael Gallo - CLK

A couple questions. I was wondering, you’ve obviously done a very good job of managing the food costs this year. Certainly the Grand Slam promotion worked very well. I was wondering if you expect to have similar food costs on the skillet promotion or whether you expect the mix to be not quite as favorable in the second half.

F. Mark Wolfinger

Well, I don’t know if I want to get real specific because we are still going to be running the Grand Slam. That’s one thing to know. The Build Your Own Grand Slam will still be available in the restaurants. It may not be the focus of our TV advertising at certain times but it is still going to be a promotion that will run all year and we expect to have a strong mix all year. The skillet is kind of good, the food cost is nothing like the Grand Slam but we’re very comfortable with the skillet’s food costs.

Michael Gallo – CLK

Second question, I have, I just wanted to drill down on to-go. I know it’s only been in the system for about a month but I just wanted to get a feel for what kinds of things you’re seeing whether you’re seeing it help the mid-week business, whether it’s helping on the weekend where there’s a long wait on a Sunday for breakfast, or what your expectations are over a longer period of time, whether you think that can be a 2%, 3%, 4% add-on to sales. Certainly breakfast is more difficult to do, but I was wondering what kind of customer feedback you’re getting on the new packaging, keeping the product fresh and whether you’re starting to get some repeat business either during the week or people just coming on the weekends?

Nelson J. Marchioli

It’s Nelson. Where we’re seeing the greatest increase is in late-night or take-out. Most folks in this industry do about 5%-15% in take-out. We are now in that range of about 5%. Prior to starting, over the last several years we’ve been between 3.4%-3.6% so we’re seeing a nice lift. At least we are at the industry average. My comments are it is pretty much an accommodation at Denny’s. We are building that business. We haven’t seen the benefit in some of the other day parts, even though we thought we would. We knew from the start it would be a slow grow. We’re seeing nice growth. We’re pleased with where we are so far.

Michael Gallo – CLK

It seems like it is actually ramping faster than I would have thought given it’s only been in the system for a few weeks.

Nelson J. Marchioli

It’s amazing when you talk about something, look what happens. Internally, our employees are excited about it. They see it as a unique offering and it’s something that they can do. It’s not a new product; it’s just a new offering. It gives them an opportunity to go out into the marketplace, into the neighborhoods where they do business and demonstrate their pride in the brand.

Michael Gallo – CLK

Final question, you talked about Pilot over the last couple quarters. The initial units were exceeding expectations. As I recall, you were going to be evaluating Pilot, or the Pilot test in Pilot later this summer for potentially expanded rollout or retrofit. I was wondering if you could give us an update on where you stand with that, whether you plan to obviously you started to open it up to franchisees but just kind of what you see the longer term opportunity there and when you expect to make a decision on a more expanded rollout?

Nelson J. Marchioli

We have a meeting with Pilot in the fall as we had promised last year we would, with management there. We have been very pleased with our relationship. It is my understanding they are very pleased as well. I would tell you that in my mind, it’s no longer a test. We have already opened it up to two franchisees. We clearly will have somewhere between 2-4 franchise units opened this year with Pilot and based on the locations, we’re very excited about it. I think we’re off and running. I think it’s been a good partnership and we’re going to continue to make that work. I’m going to be meeting with their CEO along with our CFO and our Chief Operating Officer in the fall as I said to bring some clarity as to what all of our expectations are. I think there will be more rather than less.

Operator

Your next question comes from Brian Moore from Wedbush Morgan Securities.

Brian Moore - Wedbush Morgan Securities

I guess I will try my interquarter monthly same-store sales question. Really, I am trying to understand this from a macro view, you know, the impact of trade-down, tax rebate checks and gas prices. If you want to, you can address how the industry had a pretty good April, a really good May and a somewhat disappointing June.

Alex Lewis

I don’t know if we buy off any of those numbers, Brian. We got our guidance. Our guidance is flat to down for the rest of the year based where we are right now. I think we take a very conservative look at the marketplace for sales right now. We’re not seeing any improvement. We put that, Mark spoke to that as did Nelson. We’re very pleased with some of the opportunities that we were able to create with some of our new programs but the headwinds aren’t getting any easier particularly in some of those really challenging areas of the country. I’ll see if Nelson has anything else.

Nelson J. Marchioli

I really can’t add much, Brian. It’s still a really tough trending environment. The trends, I would tell you from where I sit, the trends in June continue and that’s probably all I’m going to say about that.

Brian Moore - Wedbush Morgan Securities

I guess I’ll just ask the question though. Is it fair to say that you didn’t see benefit in May from tax rebate checks?

Nelson J. Marchioli

No, people talk about that. As we were recently at the Oppenheimer Conference and there was quite a bit of conversation about it. We haven’t seen it.

Brian Moore - Wedbush Morgan Securities

I guess a question for Mark, thank you for that Nelson. If I look at the G&A, $6 million-$8 million in manual savings, how do I figure out the base year, is that 2007 as the base year or from ’08?

F. Mark Wolfinger

It’s sort of a run rate from where we were at that point in time, Brian. We were still ramping up in hiring. Frankly, we’re still hiring. We got some positions that we think could help build our franchise business and we have been working on that regards so it’s really at that point in time. Our biggest focus is you’ll start to see the impact won’t be necessarily in the third quarter, it will be more in the fourth quarter and more in the beginning of next year. We’re not giving guidance for next year’s G&A number.

Brian Moore - Wedbush Morgan Securities

One final question. I guess we’re going back, way back, to the five quintiles and the spread in terms of profitability. Is there an opportunity to provide an update in this environment as to how the top two quintiles have performed versus the bottom three?

F. Mark Wolfinger

I don’t have any exact numbers in front of me, Brian. Clearly, all units are struggling with margins. We are very pleased with what we did in the second quarter without having a margin list across our business in this environment. We have certainly impacted the high stores and have impacted the low stores. What we have completely did was we have been able to execute our quintiles strategy, if you will, we were able to sell a considerable number of stores out of the quintile 5 which we consider the low quintile or 3. Those are in our target areas and that’s what we’ve been able to do. We’re continuing to optimize our business model but it is a challenging environment to do that because all units are under pressure. All of our units have wage issues, all of our units have commodity issues, it really doesn’t change. They’re very successful in terms of trying to overcome that.

Nelson J. Marchioli

I would give you this, Brian. Those restaurants that are located around theme parks, Hawaii, Vegas, Disney, major attractions, our restaurants continue to do well. It’s a mixed bag after you leave those particular venues. It appears that the American consumer that planned on going to Disney or the Alamo or to Hawaii or to Vegas, they’re still going and they’re going to Denny’s for value. When you get away from those central locations, it turns out to be a mixed bag.

Operator

Your next question comes from Steve Anderson with MKM Partners.

Steve Anderson - MKM Partners

Very quick question. What can we assume for the average sales price of each individual restaurant, for franchisees in the first half? I think you have it a little north of $500,000.

F. Mark Wolfinger

I think we said year-to-date it was $22 million for 41 sold so it’s about $500,000.

Steve Anderson - MKM Partners

Okay, so running about that rate. Is there any progress on Fresh Express at all?

Nelson J. Marchioli

We continue to look at Fresh Express as our area for research and development to find more relevant portable products. The sizzling offerings that we’re introducing, that we introduced last week and we’re beginning to go on air with them this week, that actually came from our team that works in Fresh Express. We continue to work on non-traditional units as it relates to Fresh Express. We still have work to do before we would roll that out over than in a non-traditional situation. We see it as a great avenue or laboratory for us to develop new and relevant and exciting new products and pull it into the base brand where we get the most benefit.

Operator

Your next question comes from Eric Wold - Merriman Curhan Ford & Co..

Eric Wold - Merriman Curhan Ford & Co.

A couple of follow-up questions from the earlier questions. One, you did a great job controlling cost on the food cost line in this environment with the rising commodity cost. Talk about where you guys stand with what’s contracted and how much is contracted, take the view that obviously you guys will start renegotiating those contracts towards the end of this year, assuming prices for the contracted items shift to more current levels, what kind of impact would that have?

Alex Lewis

We’re done for this year. We’re into ’09 at this point and trying to be opportunistic. However, this time isn’t about how low you can buy that but how realistically and how quickly we have to make decisions to make sure we understand what we will have to be dealing with. Grains are the most difficult and we’re making partial-year commitments at this point for ’09. We received advice. We moved early this year in our contracts for grains and other commodities and at the time, boy, it didn’t seem like a value but in retrospect, we made some incredible buys although it has escalated from the prior year. I think that’s what we’re dealing with in’09 as well. People ask me, particularly at the Oppenheimer Conference recently in Boston, they asked, gosh, what do you think food inflation is going to be? I think it’s going to be in a range of 4%-16% and it really depends on a lot of things. It’s not an easy one to predict.

F. Mark Wolfinger

There’s still a ways to go in this year before we start doing too much guidance on next year and most of our buying has typically been toward the end of the year, first of next year, locked in for the year. I don’t think we’re ready yet to give any guidance for next year on that.

Eric Wold - Merriman Curhan Ford & Co.

Last question. On the refranchising, obviously 75-100 is a wide range. 75 is probably my guess to what you got pretty fairly locked up with current discussions and things that are kind of in place. What needs to happen to get to that 100? Are there discussions of going to the banks to get to that 100 or is that more of a stretch or is that a realistic possibility at this point?

F. Mark Wolfinger

Eric, hi, it’s Mark. The way I look at this is a net point between the 75-100 is sort of high 80s and we’ve done 41 after the first half of the year so we’re sort of targeted if you just annualize that. To answer your question, it’s still a wide range because some of these transactions are one or two stores but some of these transactions are 10, 12, 14 stores. If one of those larger transactions moves the wrong way and it moves into the next fiscal year, obviously that can influence the number substantially. We got a number of discussions underway but again, there’s approximately 5 months left in the fiscal year so there’s still a ways to go here. What you’re hearing here is normal conservatism from a CFO having sold as many in the last 18 months, but as I made my earlier comments, we are still in that range, 75-100, and clearly, when you look at that guidance that was put out there in February and you look at where we are today, I have to say the environment has gotten a lot tougher in the last five months. Obviously, we’re satisfied that we’re still in that annual guidance range and we’ll continue to push hard, but it’s definitely a tougher environment that we’re dealing with, obviously when you look at the consumer situation but also the credit markets. Again, it’s not that the deals can’t get done. It’s slower, it’s tougher, with tougher terms and conditions on those transactions.

Nelson J. Marchioli

It’s Nelson here. I would add to Mark’s comments. There’s still an incredible interest in behalf of the new and existing franchisees to purchase these restaurants and commit the growth but the lending market is much an earlier slope. So how much we get done this year is kind of up for grabs at this point. We are comfortable with the guidance. I know it’s a wide range but we are comfortable with it and in the third quarter, we’ll give you a better idea although I will tell you, last year, it really didn’t get interesting for us until October-early November to make our fourth quarter more than we ever anticipated. We’ll give you an update on our third quarter call.

Eric Wold - Merriman Curhan Ford & Co.

One quick follow-up. On the last call, with FGI, with the difficulty being across the board, you guys are looking to do one or two units or 12 to 14, is it more difficult for the much smaller transactions or is it more difficult for the larger transactions or doesn’t it make a difference?

F. Mark Wolfinger

The only way I can answer that question, this is Mark again, Eric. I would go back and look at the 171 we have done. It really didn’t come down to the size of the transaction as far as degree of difficulty. It comes down to where in the country is the success of those stores, the type of franchisee, is it a new franchisee or an existing franchisee in our system, and again, we’ve been ecstatic for both our existing franchise base and the stores they purchased and the new franchisees that we brought in. It can come down to the financing entity. Some of the third-party financing entities are, I don’t want to say more challenging, but they have a different type of parameters and metrics and depending upon how they move through internally, that can actually move a transaction faster through the pipeline or it can slow it down. It ranges broadly and again, I think we’ve got a very strong, systematic method in which we do these transactions from start to finish and I’d like to say that we’ll continue to have the success factor that we had.

Operator

Your next question comes from Sidoti & Company with Federal Inn Company.

Sidoti & Company - Federal Inn Company

Just a couple questions. Sorry if they’re repeats, as I have been bounced around on calls. First, the company-operated restaurant data, it was 3 total for the year, is that correct?

Alex Lewis

That’s right and we’ve done those three.

Sidoti & Company - Federal Inn Company

So you’ve done those three and no more. Is that part of the new strategy as you turn to a higher franchise base to kind of pull back on those company-operated openings?

Alex Lewis

It certainly is. We said the growth out of this brand is really going to come through franchising but we did decide, we had one other Pilot unit as we said in Mark’s script and we decided to offer it to a franchisee and they jumped on it very quickly. We had another unit, more of a traditional unit that shifted and pushed back to early ’09. So it was kind of a little bit there, that was five and we sort of came into the year thinking 4, 5 or 6 so that’s how we got back to 3. I think we’ve been pretty uniformed in saying we’re going to new units that help build new development programs for us, things like Pilot and other avenues where we can build something new for franchisees to use and help them grow. We’re probably going to continue to look at the high-volume flagship locations, Vegas, Hawaii, Orlando, places like that we’ll continue to look at as well.

Sidoti & Company - Federal Inn Company

Second can you just talk about if you received any pushback from consumers on some of the menu price increases?

Nelson J. Marchioli

No, we really haven’t because our menu starts around, you can get a complete breakfast for about $4.39 and you can get appetizers for less than that. So there is a wide range of value options for our consumers. We’re very careful when we review where our competitors are. Generally speaking, we’re priced below our national competitors and our regional competitors we are at parity or below even with the price increases that we’ve taken.

Sidoti & Company - Federal Inn Company

Last question. Can you just talk a little bit about the health of your franchisees, you maintained your guidance for new openings and what you expect to be sold to franchisees but can you talk about any attrition with franchisees especially as we see other chains closing up shop these days?

Alex Lewis

I don’t think we have any real news there. We’re pretty pleased with where we’ve been the past couple of years. I think the new development agreements that we’ve gotten out of our franchisees, the fact that we’re going to open 30-34 new franchisees this year and we’re still on pace for that. We feel very good about that. It’s considerably more than we’ve done the past couple of years. We continue to get a lot of demand to buy company restaurants. Again, the financing sources are a little challenging but the demand isn’t the issue on FGI right now, for sure. I think we feel pretty good about it. Things like Grand Slam put more cash in their pockets as well. We’re doing better on a margin basis and they’re probably doing better on a margin basis as well. We have 250+ franchisees so I’m sure there’s some that are more challenging than others. I’m sure as a whole we’re very pleased where the brand is right now.

Nelson J. Marchioli

We work closely with our franchise association. We work hand in hand on the purchasing side and we all obviously are working together to drive more sales. They were very much in support of our new Sizzler rollout as well as the take-out rollout and the late-night. It’s been a tough environment but a lot of harmony and working together more than we’ve done in years. Our relationship with our franchisees, I would tell you, it’s the best it’s been in a long time. It’s been that way for awhile and we are always concerned about the profitability of restaurants, both the company’s and the franchised. I would tell you, we have a healthy system. We have almost no accounts receivable at this point in time. Every brand has a handful of franchisees that struggle, in my experience, but nothing that I could suggest that would be out of the ordinary.

Sidoti & Company - Federal Inn Company

I’ll sneak in one more question. What happened in California today, any initial feedback on any damage or any closure there since you have so many company restaurants in greater California.

Alex Lewis

Nothing that we’re aware of.

Operator

Mr. Lewis, would you like to take any other questions?

Alex Lewis

Yeah, let’s try to squeeze one or two more in quickly.

Operator

Okay, your next question comes from Anton Brenner from Roth Capital Partners.

Anton Brenner - Roth Capital Partners

I’m curious regarding gas prices, given with the large number of highway locations and especially with the summer driving season being an ideal period for Denny’s, when you have abrupt changes in the price of gas as we had in both June and July, whether that has a noticeable effect on customer accounts?

Nelson J. Marchioli

I think it does. Tony, its Nelson. I think consumer confidence as it relates to gasoline prices is probably more important than the price itself. I think the energy policy which will be forthcoming from whoever becomes President will be critical and how the consumer looks forward, both short-term and long-term. I do think that the gas price went up early in June and again in July, and it had negative effect on all retail. I think that’s coming out in all of these earning reports and the media was anxious to talk about yesterday about how it had dropped to $3.95. Nobody really pays attention to those kinds of drops, unfortunately.

Anton Brenner - Roth Capital Partners

You can tell your original caller that most structures in California remain standing.

Operator

We have no other questions at this time.

Alex Lewis

Thanks everyone. If you have an analyst on the phone, if you have reports or questions that need to be answered, I am actually going to be out of the office tomorrow so if you can stick around and call me tonight, send me an e-mail, leave me a voice mail of whatever it is, I will try and get back to you. I hope you get those reports out. Thanks to everyone and please call us if you have questions.

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Source: Denny’s Corporation Q2 2008 Earnings Call Transcript
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