DineEquity, Inc. Q2 2008 Earnings Call Transcript

| About: DineEquity, Inc. (DIN)

DineEquity, Inc. (NYSE:DIN)

Q2 2008 Earnings Call Transcript

July 29, 2008 11:00 am ET

Executives

Stacy Roughan – Director, IR

Julia Stewart – Chairman and CEO

Tom Conforti – CFO

Analysts

Steven Rees – JPMorgan

Rachael Rothman – Merrill Lynch

Bryan Elliott – Raymond James

Tom Forte – Telsey Advisors

Robert Goch [ph] – MAC Capital

Clint Clark – Ironwood Equity

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2008 DineEquity Earnings Conference Call. My name is Grace Sand [ph] and I'll be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session toward the end of today's conference. (Operator instructions) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to Ms. Stacy Roughan. Please proceed.

Stacy Roughan

Good morning and thank you for participating on DineEquity's second quarter 2008 conference call. Today with us from management are Julia Stewart, Chairman and CEO, and Tom Conforti, CFO.

Before I turn the call over to Julia and Tom, let me remind you of our Safe Harbor regarding forward-looking information. Today, management may discuss information that is forward-looking and involves known and unknown risks, uncertainties and other factors, which may cause the actual results to be materially different than those expressed or implied in such statements. We caution you to evaluate such forward-looking information in the context of these factors, which are detailed in today's news release as well as in our most recent Form 10-Q filing with the Securities and Exchange Commission.

In addition, DineEquity disclaims any intent or obligation to update these forward-looking statements. In conjunction with our prepared remarks today, we have prepared or/and provided additional information on our IR Web site at dineequity.com for your viewing. The document can be found under the calls and presentation section of the IR site, which is posted as supporting material for today's webcast. If you haven't already done so, we encourage you to download the deck. Additionally, on this call we may refer to certain non-GAAP financial measures. These non-GAAP financial measures are described in our news release today, which is also available on our Web site. Now I would like to turn the call over to Julia Stewart.

Julia Stewart

Thanks, Stacy, and good morning everyone. Today, Tom and I will first walk through the details of our second quarter performance and update you on our strategies to revitalize and restructure the Applebee's business. We also intend to provide perspective on previously disclosed information concerning certain debt covenants. We've got a lot to cover today with regard to Applebee's, but I first want to start off with the continued strong results of the IHOP business.

IHOP performed well in this second quarter 2008 given a challenging consumer environment with system-wide same store sales growing in line with our expectations at 2.6% for the second quarter 2008 and a strong 3.2% performance year to date. The IHOP team is delivering on all fronts. Our strong limited time offers, continued strength of our Come Hungry, Leave Happy advertising campaign, new promotional events, and PR activities around IHOP's 50th birthday celebration have brought our marketing efforts to a whole new level this year. We are also focused on driving meaningful operational improvements system-wide as measured by IHOP's AB operator and restaurant rating systems.

Franchisees continue to execute their remodels in a timely manner. The system should be completely remodeled by the end of 2009. In addition, franchisees are developing new restaurants in the numbers and time frames expected. With 15 IHOPs open during the quarter, one of which was in Mexico City, representing IHOP's second restaurant opening in Mexico. Additionally, just last week, we appointed Des Hague as President of IHOP. With Des's leadership, we plan to build upon IHOP's strategy as we optimize the performance of our brand. IHOP's success is the result of the focused execution of our core marketing, operations, and development strategies.

I want to thank IHOP's management team, all of our employees, and each franchisee for their extraordinary efforts. We are going to celebrate our accomplishments at IHOP's upcoming National Franchise Conference in August. It really doesn't get much better. IHOP's 22 consecutive quarters of same store sales growth is indicative of the type of sustainable system momentum that we envision is possible at Applebee's. But it won't happen overnight. We have a lot of heavy lifting in front of us to get there. So, let's walk through where we are in the process.

Applebee's domestic, system-wide same store sales performance fell below our expectation, decreasing 1.7% for the second quarter 2008 and down 0.6% year to date. This compared unfavorably to positive growth in the prior quarter. We believe the reason for this sequential decline was primarily the result of advertised promotions that did not perform as well as expected in a value-oriented competitive environment. We began to see signs of traffic weakness worsening at the end of first quarter, which continued consistently through the second quarter and took immediate steps to create value offerings based on Applebee's guest favorites from our existing menu.

We tested these offerings with advertised support in several Company markets and the franchise market. The positive impact of same stores sales growth in these markets was significant, and we will roll out a value promotion system wide in late August. We believe a value message is critical for Applebee's to be successful given the challenging consumer and competitive environment at this time. We have now developed a line up of value-oriented sales driving offerings slated [ph] for the balance of the year and are optimistic about the results our value strategy should yield. With a successful value message, we expect Applebee's full year 2008 domestic system-wide same store sales growth to range between a positive 1% to a negative 1%.

Now, in the longer term, we believe that the key to turning around Applebee's business centers on improving our food. Using the framework of Applebee's new brand positioning and refined customer targets as our guide, during the first half of the year we developed a long-term menu plan designed to differentiate the brand. In 2008, our work primarily involved eliminating previously planned limited time offers in favor of increasing our operational focus around flawlessly executing our existing menu. This should benefit us greatly as our upcoming value offerings are based on existing items. Additionally, we are also focused on an operation simplification process designed to reduce preparation steps and eliminate single use ingredients to the greatest extent possible.

Guests will begin to see more submissive menu changes in 2009 as we work toward a systemic overhaul of Applebee's menu. We will improve the quality of ingredients. Our recipes will produce destination products and flavors that guests can only get at Applebee's and ease of preparation and delivery will also be a focus. We have renewed our relationship with Weight Watchers which will result in new health conscious offerings next year as well. To support our menu work during this second quarter, we completed a short-term marketing and media plan to drive the business over the next 18 months.

Applebee's advertising campaign is a whole new neighborhood, communicates change within our restaurant, and is an invitation to our guest to come and experience the new Applebee's. To build upon the campaign, we are making value the news of the neighborhood in conjunction with our planned offerings starting next month. Now for 2009, we are pursuing a variety of marketing strategies that will leverage our neighborhood position. The equity Applebee's possesses around the notion of neighborhood differentiates us from the competition, and we plan to take full advantage of it in our marketing approach.

Turning to Applebee's Company operations, operating margin improved 120 basis points to 12.7% compared to an 11.5% operating margin, excluding pre-opening expense in the second quarter of last year. The increase was primarily due to an approximate 170 basis point improvement in net depreciation and rental expense. This was the result of purchase price accounting allocations, which extended the usable lives of restaurant assets. This more than offset the higher lease expense associated with reestablishing leases.

As a percentage of sales, total food and beverage costs decreased by 30 basis points due primarily to the impact of menu price increases. Total labor costs increased by 60 basis points, primarily due to restaurant management retention bonuses and other factors partially offset by improving hourly labor management. These operating margin performance factors resulted in an 11.8% increase in segment profitability to $37.2 million in the second quarter 2008. We acknowledge to date that some of our operational improvements have not come to fruition because of a favorable mix shift to higher cost items, higher commodity costs in general and the continued effect of the field bonus and benefit programs. However, we are aggressively pursuing several new and existing operational improvements to ensure we meet our commitments for margin improvements for the full year.

The following are key improvements we are very focused on. Conceptual changes to the field benefits program in general, continued benefit of the revised manager bonus program implemented in the second quarter 2008, which should provide a greater benefit in the third and fourth quarter, easier comparisons against higher food cost items that were promoted in the second half of last year, and continued aggressive management of comps and discounts at the store level. So net-net, we are reiterating our expectation of producing 150 basis point to 200 basis point improvement in Applebee's Company operating margin for the full year 2008.

We expect operational improvements to drive approximately 30% of this improvement while accounting benefits will make up the balance of the gain.

During the quarter, we were pleased to announce the appointment of Mike Archer as President of Applebee's. Driving margin improvement will be Mike's number one focus. He possesses a keen understanding of the restaurant industry, particularly the grill and bar category and has immersed himself in the needs of our organization. Mike has the expertise in turning around brands and improving operational performance.

Now, turning to refranchising, the team is making good progress in its efforts to sell Company- operated Applebee's restaurants. We completed the sale of 26 Southern California restaurants in the third quarter 2008. We are on track with the sale of 15 Company Applebee's in Nevada and now expect to complete the transactions some time in the fourth quarter, as we work through a relatively complex process to transfer liquor licenses within the State of Nevada. Additionally, we signed an asset purchase agreement for the sale of three Company restaurants in Delaware to an existing franchisee during the second quarter 2008, and expect the deal to close some time during the third quarter this year.

Now, looking at our pipeline of interest, currently we are in various stages of negotiations that if successful would result in the sale of approximately 60 additional restaurants before year end. We are engaged with parties who believe in Applebee's future growth prospects based on the turn around strategies currently underway and the power of the Applebee's brand. We are reiterating our expectations of refranchising, a total of approximately 100 Company-operated Applebee's restaurants in 2008. It's our intention to announce deals only after definitive contracts have been signed and financing without contingencies has been secured by the buyers. So updates on deal activity could be backend loaded this year.

Our prior guidance of $90 million to $100 million of after tax cash proceeds for the sale of approximately 100 Company restaurants this year was based on an average profit margin across more than 475 restaurants. However, depending on which markets are sold, proceeds will vary based on the cash flow profile of the restaurants being sold. We now expect after tax cash proceeds from the sale of Company-operated restaurants to range between $70 million and $80 million this year. This decrease is based on the composition of restaurants which are expected to be sold in 2008, a number of which generate lower cash margins than is the case for the average Applebee's Company-operated restaurant.

In all, we are pleased with the refranchising efforts and are cautiously optimistic that deals should progress as planned. We are managing every aspect of the process within our control closely. Please continue to keep in mind that refranchising deals will vary in size, proceeds and timing, and not all the elements of timing are fully within our control. For example, the time it takes to obtain approvals of liquor license transfers varies significantly from state to state, and as we are selling whole markets and not one-off restaurants, deals can take time to consummate.

Turning to another aspect of our asset disposition strategy, we are pleased to completion for the sale-leaseback of 181 Company-owned Applebee's restaurant properties during this second quarter. Earlier this month, we also completed a transaction for the sale-leaseback of Applebee's corporate headquarters in Lenexa, Kansas. Between these two transactions and the sale of Applebee's Southern California, we were able to pay off $350 million of short-term funded debt in July and avoid triggering a make whole provision associated with this note.

With that, I would like to turn the call over to Tom Conforti.

Tom Conforti

Thanks, Julia, and good morning everyone. I would like to quickly walk through our financial performance for the second quarter 2008 focusing our discussion around the key performance measures of our business and touch on our debt covenants.

Our second quarter results reflect the strong performance of our core IHOP franchising business and the addition of Applebee's franchising businesses. This produced $39.5 million increase in franchise operations profitability, primarily due to a full quarter's recognition of Applebee's franchise operations process and 9.1% increase in IHOP franchise operations product.

EPS for the quarter was impacted by a one time non-cash impairment charge of $41.1 million associated with the sale-leaseback of Applebee's Company-owned restaurant properties. All of the parcels involves in the transaction were assigned an estimated fair value as part of the purchase price allocation at the time of our acquisition of Applebee's. Since that time, we noted deterioration in the real estate and credit markets between the date of the purchase price allocation, which was November 29, 2007, and the June 17, 2008 sale-leaseback transaction date.

We ultimately concluded that the estimated fair value of the real estate determined in the purchase price allocation was reasonable and appropriate as of the time of the acquisition, and that the decline in value related to market events subsequent to the acquisition date. This decision resulted in an impairment charge as opposed to an adjustment to the allocated purchase price. Again, this was a non-cash charge. Our decline in EPS exclusive of one time charges was impacted by an increase in interest expense to $51.6 million during the quarter, primarily due to Applebee's debt. Approximately $9.8 million of this interest expense was non-cash, primarily associated with financing related costs.

Going forward, we will also be recognizing the expense associated with the sale-leaseback transactions for Applebee's restaurant real estate and Applebee's Lenexa headquarters building in our consolidated interest expense line. The accounting treatment for the restaurant sale-leaseback reflects that we will have an ongoing economic involvement with the restaurant properties until we can assign the leases to franchisees. Because of the fact that we expect to sub-lease, we will also have an ongoing economic involvement with the Applebee's Lenexa headquarters. As a result, the transactions are accounted for as corporate borrowings with the related interest expense hitting our corporate interest expense line.

For 2008, the restaurant property and headquarters transactions will result in approximately $15 million of interest expense. Accordingly, we increased our interest expense guidance for the full year to approximately $203 million at the time of our completion of the restaurant real estate transaction in mid-June. Approximately $40 million of this is non-cash interest expense, as previously disclosed.

Turning to an important operating lever in our business, G&A. Consolidated G&A increased to $49.2 million, reflecting a full quarter of overhead expense at Applebee's. G&A was $25.2 million at Applebee's, $9.4 million at IHOP and $14.6 million at the corporate level during the quarter. Consolidated G&A included $4 million in non-cash stock compensation expense and $2.4 million worth of primarily retention and related expenses for the quarter. We are pleased with our G&A management progress year to date and are on track to meet our full year consolidated spending expectation between $196 million – $186 million and $199 million.

Looking at income taxes, our effective tax rate for the second quarter 2008 was 35.8%. This is higher than the first quarter level of 9.9% which reflected the benefit of compensation related tax credits associated with the Applebee's Company-owned restaurant operations on a lower net income base. Our tax rate will be highly variable depending on extraordinary activities like franchising Company-owned Applebee's.

Now, I would like to provide a brief update on purchase price accounting. As you know, our fair value estimates for the purchase price allocation may change during the allowable allocation period, which is up to one year from the acquisition date, if additional information becomes available. A significant portion of the fair value assigned to property and equipment in the preliminary purchase price allocation was related to 511 Applebee's operated restaurants owned at the time of the acquisition. Initially, we used global assumptions as to rental rates and capitalization rates. We now have analyzed this information on a restaurant specific versus a global basis, as well as updated certain capitalization rates.

As a result of further review, the estimated fair value allocated to property and equipment was revised downward by approximately $146 million. Accordingly, we have revised our depreciation and amortization expectations to range between $105 million and $115 million in fiscal 2008. This compares to our prior expectations of depreciation and amortization ranging between $115 million and $125 million this year. We have included purchase price accounting information in the supplemental materials we have provided on our IR Web site in conjunction with today's webcast.

Turning to our cash performance, consolidated cash from operating activities was $56.8 million for the first six months ended June 30th, 2008, a 141% increase from the first six months of 2007. The growth in cash from operations was driven by higher cash earnings as a result of the acquisition of Applebee's. The IHOP business also generated $7.9 million of cash from the structural run off of principal payments related to its long-term notes receivable for the first six months of 2008.

During the same period, consolidated capital expenditures increased to $23.2 million due to the capital needs of Applebee's Company-operated restaurants and final construction expenditures on Applebee's corporate headquarters in Lenexa, Kansas. Displaces consolidate free cash flow, which we define at this point as cash from operations plus the receivable run off, less CapEx at $41.5 million for the first six months of 2008. This is a 37% increase versus the same period last year. Uses of this cash primarily included the payment of our common dividend as well as $21.5 million in unpaid transaction related expenses associated with the acquisition of Applebee's.

Now, I would like to take time to discuss some of the debt covenants in our securitizations. As a reminder, all of the covenants that govern our securitizations are disclosed in securitization documents filed as an exhibit to our 2007 10-K. There are two specific covenants that have become the source of recent investor inquiry, which I would like to cover with you today. The first covenant I would like to cover appears in both the Applebee's and IHOP's securitizations and measures Company-wide adjusted debt to EBTIDAR calculated on the same basis. The targeted ratios differ in each securitization and the ratios reduce over time.

The IHOP securitization calls for adjusted debt to EBITDAR to be maintained below 7.75 times through November 28, 2008, below 7.5 times through November 28, 2009, and below 7 times thereafter. The Applebee's securitization calls for adjusted debt to EBITDAR to be maintained below 8 times through November 28, 2008, below 7.75 times through November 28, 2009, and below 7.25 times thereafter. At the end of June, our Company-wide ratio measured 7.35 times, satisfying both the IHOP and Applebee's leverage test thresholds. A description of how to calculate our adjusted debt to EBITDAR ratio is provided in supplemental materials posted on our IR Web site in conjunction with today's webcast on this call.

The second covenant I would like to discuss is the Debt-Service Coverage Ratio or DSCR, a requirement that is independent for each of the securitizations. The securitizations call for the respective DSCR to be maintained above specified levels. At the end of June, IHOP's three- month DSCR was 3.15 times, comfortably above the applicable DSCR threshold detailed in the IHOP securitization documents. Applebee's covenant is based on the three months adjusted DSCR that incorporates a cash residual it receives from the IHOP securitization.

The cash residual is a portion of IHOP's cash after payment of expenses specified in the IHOP securitization that is redirected to the Applebee's securitization. The three-month adjusted DSCR for Applebee's at the end of June was 2.63 times, again comfortably above the applicable DSCR threshold detailed in Applebee's securitization. The consequences of each securitization DSCR falling below certain levels is summarized in the supplemental materials available on our website. Several components which are used to calculate the DSCRs are generated through cash based accounting and are not publicly available.

In summary, we are comfortably in compliance with our current consolidated leverage and DSCR tests.

With that, I would like to now turn the call back to Julia.

Julia Stewart

Thanks, Tom. So I want to say clearly that based on our current plans, we fully expect to remain in compliance with these debt covenants. As Tom noted, we are meeting our current consolidated leverage and DSCR test, and expect that will continue to be the case as the consolidated leverage test covenant for the IHOP securitization reduces to 7.5 times this November.

Looking ahead, the consolidated leverage ratio covenant and the IHOP securitization reduces to 7 times in November 2009. Based on current plans related to refranchising and the performance of Applebee's Company restaurant business, which are the key drivers of this leverage ratio, we expect to remain in compliance. Our base plan calls for refranchising approximately 190 Applebee's restaurants in 2009. Prospective buyers have expressed interest in every Company market and we are in various stages of negotiation for each of these markets.

In addition, we expect to deliver modest same store sales growth next year, which will enable us to improve the performance of Company-operated Applebee's. However, our margin of error to be below this 7 times level in November 2009 is tighter than we might like. As a result, we have already begun the process to increase our financial flexibility. There are several steps we are currently evaluating. First, there are opportunities to enhance our EBITDA performance, including cost reductions that are within our control. To size it for you, each $7 million of increased EBITDA represents an approximate 10 basis points improvement in our leverage test.

Secondly, we might seek a covenant amendment to provide us with more financial flexibility. And third, under the documents for both of the securitization transactions, we have the option, but not the obligation to use free cash flow to make capital contribution to the securitization subsidiaries, which we could use to reduce the amount of securitization debt. So I hope this provides you with a clearer perspective on our debt covenants and the steps we are considering to increase our financial flexibility.

Lastly, I want to express my confidence in our plans to revitalize Applebee's brand and transform the business model to a highly franchised one. Our marketing and operations initiatives for Applebee's are strategically aligned with our business objectives. Our refranchising pipeline is solid, with interest from new and existing franchisees. In the last seven months, we've put in place the right building blocks to drive sustainable system momentum over time. But Applebee's turnaround won't happen overnight. And as I said earlier, IHOP's success and track record of 22 consecutive quarters of same store sales growth is the result of the focused execution of our core marketing, operations, and development strategies. This is exactly what we plan to do with Applebee's. We are focused on those things within our control that enable us to manage our business as effectively as possible, and we have a solid plan to drive both the near and the long- term performance of our Company.

Now, Tom and I would be happy to answer any questions you have. Operator?

Question-and-Answer Session

Operator

(Operator instructions) And your first question comes from the line of Steven Rees of JPMorgan.

Steven Rees – JPMorgan

Hi, thanks. Just on the restaurant level margin performance in the quarter and the expectations going forward, the actual food and labor components were less than I would have thought given all the initiatives you are working on. Can you just talk about what opportunities you see in the second half of this year to drive food and labor improvement, and then tie that to some of the recent changes you made in your bonus program, how you expect that to help going forward?

Julia Stewart

Sure, I'm going to answer the last part first, which is the change in the bonus program happened at the end of first quarter. And so as I said in my prepared comments, I think – in third and fourth quarter you'll see the impact of that. So, for the full year we believe that will make a difference in our Company-operated margin. So, that's on the whole full year basis of the whole issue with the bonus. The change in hourly benefits would be effective quarter four and the two quarters impact of the manager bonus programs really are sort of a full year offset. The biggest other changes that we are looking at is in the managing of comps and discounts, continues to be an area of opportunity for us, and that's the plan. And then if you think about the full year, clearly one of the issues we described is that we are promoting value-oriented messages on television, which has the opportunity to raise our food costs slightly, but of course you are banking on increased traffic and sales. So, it's a bit of a mix, if you will, and that's what we're looking for, for the full year. So, I would say managing comp and benefits, also the hourly labor piece. We think we've got an opportunity in hourly labor and I think that has a lot to do with bringing people in at a lower level, so the full year mix has an opportunity for increase. And then Tom, did you want to add anything on the –?

Tom Conforti

Just a couple of items, Steve, that we are taking on the food side related to chicken and the preparation of some of our ribs and how they're cooked. And so that we think that will have appositive impact on food costs. One other things that you should bear in mind is you are doing quarter-to-quarter comparisons for the rest of the year, there will be no preopening expense this year. That was included in the Company as we're not opening additional Company stores, and as Julia said in her prepared comments, last year's third and fourth quarter at Applebee's, the promoted items had very high food cost components to it. And so we think the comps will improve in the third and fourth quarter as well.

Steven Rees – JPMorgan

Okay. And then just on the proceed assumptions, I realize the change for this year, but how should we be thinking about it for 2009? Should we still assume $900,000 to $1 million per unit, which I think was the original plan? Or should we assume lower proceeds closer to what you're selling now in the second half of this year?

Julia Stewart

We are currently evaluating our total refranchising proceeds expectations and we'll give you the update as soon as it's prudent. I would suggest closer to the end of the year when we are in a better position, but our 190 is currently the plan for 2009. As I said earlier, it really depends on where you sell which market, and that I think we’ll be in a much better position to share that with you towards the end of the year. It really has everything to do about which market you sell, as you saw from the prepared comments today, right, with the markets we're looking to sell this year.

Steven Rees – JPMorgan

And then just finally you had mentioned, I guess, the lack of a value message in the second quarter for the traffic declines, but yet it was – the three-course combo, which I think is a good value. So, how are you thinking about value going forward? Does it need to be a national price point? Does it have to be All You Can Eat? Does it need to be discounted? So, what changes are we going to see in value in the second half?

Julia Stewart

So, that's really a good comment. So, I think there's three components. I think from a marketing perspective in this kind of a environment, the one thing you need to be sensitive about is continuing to repeat an existing message. And although three-course combos is a great idea, we've done it before, and so I think in this environment, repeating existing promotions is tenuous at best, and I think that's a learning we had out of three-course combos. So, that's one lesson. And I think the second and third lesson is making it as aggressive and as big and bold as you can, which without giving away competitive information, that's what we are aiming to do. And I think giving the maximum value that you can to a consumer, which remember isn't just about price point, it's about service platform as well. So, all those things combined is what we are looking at. As I said in my prepared remarks, really for the first time since I can remember, one of the great things about what we have coming up is we actually tested it with television in some of these Company markets and one franchise market. So, it gives me a bit of insurance if you will, that we are doing the right thing.

Steven Rees – JPMorgan

Yes. Thank you very much.

Julia Stewart

Thank you.

Operator

The next question comes from the line of Rachael Rothman of Merrill Lynch.

Rachael Rothman – Merrill Lynch

Hi, guys.

Tom Conforti

Hi.

Julia Stewart

Good morning, Rachael.

Rachael Rothman – Merrill Lynch

Can you talk a little bit about, you mentioned the controllables and taking a look at the controllables in an effort maybe to get some more wiggle in your covenants. Are you talking specifically about G&A or can you talk a little bit about what you are thinking in terms of where you could save?

Tom Conforti

Yes. I think the term Julia used was, we are going to focus on items that we can control, and so that's going to be mostly in the area of G&A. We are looking at different potential areas of cost reductions. That's going to be the primary focus of our EBITDA improvements.

Rachael Rothman – Merrill Lynch

Great. And then just to follow up, I know you guys are reducing the targeted proceeds this year for the refranchising. When we think about the full three years, is this just a timing issue in terms of the units that you are selling? – Or should we think about the total proceeds being reduced commensurate with your reduction in your '08 outlook?

Julia Stewart

Yes, it's a great question, Rachael. As I said, I think we will be in a much better position to give you the total franchising proceeds expectations and an update later this year when we are in a better position and we have taken a full view of what we have got, and what we have sold and what we haven't sold. So, I think it's a timing issue and you've got to give us a little bit of time and I think we will be in a much better position to give you a full look at all the restaurants that we are selling. As I think about what we are selling the balance of the year, it's lowering the number, right? So, then we have to look at the balance of our portfolio and where we will be. And again, it's really a timing issue in terms of, I'll feel a lot better and I think all of us will and by giving you all a number once we have gotten through this year.

Tom Conforti

Rachael, and just to add on to Julia's comments. The reduction this year in proceeds guidance is totally market specific, and so it should not be reflective of a larger comment on proceeds over the three years. However, there is work to be done as Julia said.

Rachael Rothman – Merrill Lynch

Great. And then –

Julia Stewart

If you ask me that question at the end of the year, I will be in a much better position.

Rachael Rothman – Merrill Lynch

Okay, thanks. The lower cash flow from operations guidance, I think you guys gave a comment about increased tax obligations. Can you just clarify for us what that means a little bit?

Tom Conforti

Sure. Rachael, when we – there are three items that are driving that tax impact on cash from operations. Number one, the gain on the sale-leaseback, we are going to have to pay those tax obligations over the next couple of quarters. Of course, we are not going to be able to recognize them on our books until all the transactions are done. Second, impact is the impairment effect and the $40 million impairment effect increases our deferreds another $16 million as well. Now, offsetting some of that is an item that we raised when we announced the sale-leaseback transaction, and that is because we were able to retire $350 million worth of the funded debt, we were able to recognize on a tax basis, a benefit of around, I think it was around $12 million. And so when you add up all of those numbers, the impact on cash from operations was negative by some $40 million plus. However, offsetting that is higher cash earnings than previous forecasts that we had. I also want to point out one other thing as it relates, Rachael, to lowering our cash from operations. I think it's important that everyone understand this, that is, while we have lowered our cash from operations guidance for the year by about $10 million, one of the effects that's taking place is taking place within cash from financing activities. And that is that the money that is earmarked for the payment of those taxes on sale-leaseback are already captured in our restricted cash number. And so that restricted cash number is coming down by a considerable amount of money. So, the net-net effect of all of those factors, cash from operations being lowered for the factors that I identified by $10 million, the guidance. But when you consider the fact that restricted cash is being freed up to the tune of about, I think $25 million to $30 million so the net-net cash available is not being impacted in a negative way. And I'm not sure that I just didn't add a whole bunch of complexity to it, but I thought it was important to mention, we are going to talk increasingly about the release of restricted cash as we transform this business as a source of cash flow for the Company.

Rachael Rothman – Merrill Lynch

Okay, great, and then just a bigger picture question on the franchised unit growth at Applebee's. I guess that would indicate that the franchisees are still fairly optimistic about the longer-term outlook of the brand. Can you talk about maybe what the pipeline of unit openings looks like for '09, and whether or not people are still committed to growth within the Applebee's brand?

Julia Stewart

Well, two things. The short answer is, I'll be in a better position to answer that, again, toward the end of '09, I mean, excuse me, end of '08, the end of this year. We have certain people who have development agreements and they are meeting those development agreements, but we said at the beginning of the year or I said that I knew that the development would slow a little bit, and that was okay. I anticipated that. I think we knew that was going to be the case. I'm all right with that because I think it's more important that we reenergize the brand and get our foot in. So, we said from the very beginning that I think half our growth right now is coming from international in Applebee's, half our growth is coming domestically. I'm okay with that. I think as we start to turn the brand, you will see the growth gear backup again, and we have talked about that very openly with the franchisees. But the actual numbers for '09, Rachael, again ask that question at the end of the year as we do the whole guidance issue and we will bring that to the forefront. But we knew going in that there would be a slowing this year, and we predicted that, and we managed accordingly.

Rachael Rothman – Merrill Lynch

Perfect. Thank you very much.

Operator

Your next question comes from the line of Bryan Elliott of Raymond James.

Bryan Elliott – Raymond James

Good morning, couple of questions. One, first, let me follow up with Tom on the discussion on the cash flow from ops. Maybe it would be helpful to talk about the changes, the deltas in the context of the publicly available components of cash flow from ops. And it sounds like the public statement format, and it sounds like there's been a significant swing in deferred taxes and on the quarter to date cash flow, I guess second quarter deferred taxes was the use of cash north of $30 million. So, maybe what is a decent range for that full year deferred tax change as a use of cash and we all can plug that into our models. And also if you could give us an update of what you are thinking about, the net working capital requirement on a full year basis within that cash flow from ops umbrella?

Tom Conforti

Bryan, I would be glad to give directional guidance on the questions. I think what I did on Rachael's question is lay out what the components are and I talked about $40 million to $50 million increase in deferred taxes for the year. Offsetting that in part is higher cash earnings associated with the timing of our refranchising because the more – the longer we keep restaurants, the more cash earnings we generate on an operating basis. So, that's working in our favor. I mentioned the point that happens in financing that increasingly and I'm going to introduce this over the next two quarters. Increasingly we need to keep an eye on restricted cash, and as we transform the business and refranchise the business, increasingly that restricted cash becomes a source of cash flow. It doesn't happen in cash from operations. It's down to cash in financing, but as time goes on, Bryan, we will begin to cultivate that source of cash. On working capital assumptions, there are two or three – two areas of leakage and working capital this year. One we have described previously, which was accounts payable. At the end of 2007, Applebee's had built up a big payables level as we were entering a new year. Some of that stuff was one time, and then another item that is leakage on working capital is other accrued expenses, and what's driving that largely is that the deferred comp program that existed earlier at Applebee's has gone away. And so those are two of the areas of leakage on the plus side. Prepaid expenses are a source as are tax receivable – the cash inflow on tax refunds has been stronger this year. So, some of this stuff is situational, Bryan, and it doesn't lead to a rule of thumb that one might employ going forward. But I guess those are some of the major contributors to overall cash from operations or leakage from cash from operations this year.

Bryan Elliott – Raymond James

So, if I heard you right, did you say that the deferred tax number would be a $40 million use of cash for the full year?

Tom Conforti

That I said $40 million to $50 million.

Bryan Elliott – Raymond James

Okay, okay. All right. And with respect to the refranchisings that are expected over the balance of the year –?

Tom Conforti

Yes.

Bryan Elliott – Raymond James

It’s – I just wondered there's 74 stores essentially given the 26 that were already closed. Of those 74, you've mentioned their lower cash flow margin. I wondered if that's because they're disproportionately recent sale-leasebacks or if they're – I guess the question is how many of those 70 stores roughly are in the 180 store sale-leaseback you just did and therefore carry a really high rent burden?

Tom Conforti

Bryan, let me just try to recalibrate. The 70, 80 stores include the 41 stores we announced from California and Nevada, the three stores for Delaware and then some 30 to 40 stores that we contemplate closing by the end of the year. Okay?

Bryan Elliott – Raymond James

Got it.

Julia Stewart

Not closing, selling.

Tom Conforti

Selling.

Bryan Elliott – Raymond James

Right.

Tom Conforti

Yes, selling. Of course. And so –

Bryan Elliott – Raymond James

Placing on the sale up [ph].

Tom Conforti

The answer to your – I think you asked me two questions. One, you had asked how many of them are sale-leaseback properties, and we think the number is around 20 units to 30 of the units will be sale-leaseback properties. But I think the real question you were asking us was, is that the reason why proceeds are coming down? And the answer to that is no.

Bryan Elliott – Raymond James

Now and that’s the reason why they are articulated as below average profit margin?

Tom Conforti

That's correct.

Bryan Elliott – Raymond James

They are below average profit margin on an EBITDAR basis at the restaurant level?

Tom Conforti

No, the reason that we have characterized them as such is because they are lower sales levels than the average Applebee's Company-store sales level.

Bryan Elliott – Raymond James

Got it. Okay, very good. Thank you.

Operator

Your next question comes from the line of Tom Forte of Telsey Advisors.

Tom Forte – Telsey Advisors

Julie, hi. From a competitive landscape point of view, I wanted to know, you touched on this earlier but I wanted to do a bit of a compare and contrast [ph]. When you think of the promotional environment for both Applebee's and for IHOP and emphasis on value, are you seeing a big difference in how your competitors are behaving?

Julia Stewart

So, at IHOP if you think about it, it really is a value message, right? We give people a reason to visit with a special item that is, may be some part of our existing menu with a twist or a spin. So, the Discover America Pancakes for the summer, probably one of the more difficult promotions we have ever done at IHOP creating nine new pancakes, but it's existing pancakes with a little bit of a twist, right. And so when you think about the competitive landscape at IHOP, many folks now because we have been so successful at IHOP are trying to steal shamelessly for us, coming up with some version of something similar. And so you are seeing that a lot more deeper discount if you might say in the competitive landscape at IHOP, but I think that's because you've got inherent value played into IHOP every day. So, you might see more aggressive competitive landscape on the IHOP side just when you think about where IHOP is today with its value message. On the Applebee's side, you are seeing a lot of aggressive value messaging for the competitors both nationally and regionally, and I think that has a lot more to do with the dinner gate park and trying to make certain they expose as much aggressive valuing as humanly possible. And although I didn't mention it very much, this whole notion of car side to go has been interesting because it's the one area of the business where we are seeing people maybe either leave us to go to fast food or see us in the fast food arena because it's not so much the price point, it's the occasion, right? If you are not picking it up at Applebee's at car side, you may be going through the drive through. So, that's been an interesting thing we are looking at and how do we combat that. So, I think in both the family dining arena and the casual dining arena, you are seeing aggressive value messaging, but it's different depending on the brand, and the need, and where the brand is. I have said all along that I think Applebee's because they haven't been the last three or four years cultivating their remodel, cultivating new menu advertising, new menu, new advertising, I think it puts us behind the (inaudible). So, what we've got to do is get in front of it. I think if IHOP had not spent the last four years doing what it's been doing, we'd never be where we are today. So, I use that analogy a lot because I think once we have done that with Applebee's, we will be in a very different position. But there's a little bit of catch up, and what that means is you've just got to play in that arena until you've done some of those other things. But I think it's a tough marketplace from an aggressive value messaging right now.

Tom Forte – Telsey Advisors

Great, thank you very much.

Operator

Your next question comes from the line of Robert Goch [ph] of MAC Capital.

Robert Goch – MAC Capital

Hi, good morning.

Tom Conforti

Hi.

Julia Stewart

Hi, Robert.

Robert Goch – MAC Capital

Just a question on the margin improvement at Applebee's, keeping the range of 150 to 200 BIPS. But if I heard it right, 70% of that is from both the depreciation and the accounting issue surrounding the rental expense. Is it fair to assume that there's going to be 30% of that is only going to be cash improvement on the margin?

Tom Conforti

Yes. That's correct, Robert.

Robert Goch – MAC Capital

Right. So, I believe that when you laid out a strategy to improve the performance in these units it was able to sell them at a higher price to franchisees especially given the market conditions. And I was just wondering how does that cash margin improvement change the 30% of the 150 to 200 cash margin improvement change that? And just as a follow up on that, Julia you just mentioned capital spending and perhaps that Applebee's maybe has been under spending on CapEx. When franchisees are looking at the economics of purchasing one or more restaurants, how does that enter into the calculus?

Julia Stewart

So, at the beginning – so, let me try to answer. I think that's a two part question. So, at the beginning of the year we said we were slowing down refranchising because we wanted to give Company operations a bit of an opportunity to improve their sales and profit, which in turn we might take some of that benefit, apply it to refranchising. I think as the year has progressed, some of that has come to fruition, some of that hasn't. We continue to refranchise. We continue to believe that's the right thing to do, and if you think about refranchising, it's existing franchisees or new franchisees who are buying into the whole notion that we are going to reenergize this brand and this business, and that absolutely positively the future is bright. That's why they are buying in because it's the opportunity on the backend to make those improvements. So, I would say it's steady as she goes with what we said we were going to do. We did slow it down at the very beginning, but I think we have been very clear on this call. We are currently going to guide to 100 restaurants will be sold this year, 190 in '09, and business as usual. If we can get some of that profit and bring that to the bottom line, terrific, but we are going to continue as business as usual. So, I think that's the point. As it relates to CapEx, I don't think I made a mention of capital. So, if you can repeat your question that might be helpful to me.

Robert Goch – MAC Capital

No. I'm sorry, I thought to the previous question you mentioned Cap – I guess I misheard it. I apologize. I thought you mentioned capital necessary going forward, capital spending or implied something to that effect. Just one more, on the cash flow from financing on both the headquarter sale-leaseback as well as the unit sale-leaseback, how much of the total rent expense you are actually seeing flowing through cash flow from financing due to the accounting treatment?

Tom Conforti

No, no, Robert, give me a second. I just need to consult with someone.

Julia Stewart

And Robert, while he's doing that, I think what you were referring to in my last comment was about development and the franchisees developing. I think that's what you were referring to, and the franchisees have the wherewithal. As you recall, these are 42 franchisees who are – have large business, and so they have always been developing historically at a rate closer to 70 to 100 a year. So that rate has somewhat slowed, but they absolutely have the wherewithal to continue the development. I think they just want to make certain it's the right box and in the right environment. But I don't think that will be an issue once the reenergizing takes place. I think that may be what you were referring to.

Robert Goch – MAC Capital

Thank you.

Julia Stewart

Sorry, Tom?

Tom Conforti

Yes, Robert, let us get back to that specific question. We think that the number, that's interest expense, right. So, Robert let us get back to you on the number because obviously it'll be variable over time. So, let us get back to you on the numbers. Stacy do you have his contact information? Okay. We may have to issue an (inaudible) make it available to everyone. Okay. Good question, Robert.

Operator

Your next question comes from the line of Bryan Elliott of Raymond James.

Bryan Elliott – Raymond James

Just a quick clarification and then a question. In my earlier question we talked about the break out of the stores that you've identified that will be refranchised, and I think the residual after the closure in California, the pending closures in California and Nevada, three in Delaware was like 30 to 40 roughly over the balance of this year. Is that correct?

Julia Stewart

It's 60 stores, Bryan.

Tom Conforti

Now what's your question?

Bryan Elliott – Raymond James

The question relates to how many are going to be sale-leaseback? You said 20 to 30 would be stores that will just say are sale-leasebacks, and that's 20 to 30 of that 30 to 40, correct? In other words, not California and not Nevada, those were not sale-leaseback?

Julia Stewart

That is correct. You're absolutely correct.

Bryan Elliott – Raymond James

Okay, okay. All right, and then also a question, the news is just hitting –

Tom Conforti

Hey, Bryan, let me pull you back. I didn't answer the question appropriately. The 23 of the 60, right, because the number of units we are shooting for are 100 units. We currently have around 44 with the markets we have identified. So, 23 units of the 60 or so units that we expect to refranchise in the balance of the year, 23 of the 60 are anticipated to be fortress properties, 20 to 25.

Julia Stewart

Right, so none of the California or Nevada have any sale-leaseback.

Tom Conforti

And neither are the Delaware.

Julia Stewart

We're all on the same page.

Bryan Elliott – Raymond James

Okay, very good. And apparently it's just hitting the wires that Bennigan's has shut down. I believe it's as much as an 800 store chain. I haven't verified that yet. I wondered if you might have with you any competitive set information or trade area information, and wondering how many of those Bennigan's stores might be within a three-mile radius of Applebee's. And I guess IHOP would benefit as well.

Julia Stewart

I don't have that information at my fingertips, but we do have that information and I can absolutely get that to you.

Bryan Elliott – Raymond James

Yes. Apparently, they're just not opening the doors this morning.

Julia Stewart

We just saw the same thing.

Bryan Elliott – Raymond James

All right. Thank you.

Julia Stewart

Thank you.

Operator

Your next question comes from the line of Clint Clark of Ironwood Equity.

Clint Clark – Ironwood Equity

Yes. Thank you, Julia. I have two questions. First of all, would you comment on July comps for both concepts and would you also comment on what you all are doing with provisioning regarding commodities over the next six months plus '09? Thank you.

Julia Stewart

Sure. We do not comment inner-quarter, so I can't comment on July comps, but I can tell you in terms of commodities. So let's talk about the fact that Applebee's has about 90% of its products under contract, the big items, beef, pork, poultry, seafood, dairy, soybean oil, and IHOP has about 65% to 70% of its large items similar under a pricing arrangement. And in particular where IHOP's got contracts is about 25% of the business in eggs and pancake mix, which is critical. So, if you think about it, most of those contracts will be coming up, or those pricing arrangements for both brands will be coming up in the next 6 to 12 months. And so our thought process is to work hard for those that are coming up this year to put as long a term a contract as we can in place. However, as I’ve mentioned in previous calls, we are working very hard with the team from IHOP's franchise community and a team from Applebee's franchise community to put together a procurement coop. And so the thought process is, those contracts, those arrangements would be transferred over to the coop in early '09 as they format that, which hopefully shall give them even longer-term cover if you will, as exposed to – as opposed to exposure. So, the intention is to keep the large majority of those contracts in place, right. So, the large majority of the business is under contract. Many of them come up in the fall or early '09 and our thought process is to keep those under contract and then as they switch over, they would go over to the coop. So, currently we feel pretty good about where we are. Certainly they're seeing some contracts that are either monthly or quarterly where we've had to take an increase. And the big issue, really, is on fuel escalators, right, which is common in the distribution agreements. That's the area where people are looking for, the distributors are looking for relief because of fuel costs. That's been an ongoing issue that we have been dealing with throughout the year. But I feel good about where we are and the fact that we are going under – we are under contract for most of it and then clearly working those contracts through for '09 and transferring those to the procurement coop which is currently slated to be live and doing all the work in January of '09.

Clint Clark – Ironwood Equity

Terrific. Thank you.

Operator

And this ends the Q&A session of today's conference. I will now turn the call back over to Ms. Julia Steward for closing remarks.

Julia Stewart

So, thank you all very much for today. Hopefully the call helped clarify, and if you have any questions or concerns, be sure and give Tom, or I, or Stacy a call. Thanks so much for joining us.

Operator

Thank you for participation in today's conference. This concludes the presentation and you may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!