Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Domino’s Pizza, Inc. (NYSE:DPZ)

F3Q08 Earnings Call

October 14, 2008, 11:00 am ET

Executives

Lynn M. Liddle – Executive Vice President of Communications and Investor Relations

Wendy A. Beck – Executive Vice President, Chief Financial Officer

David A. Brandon – Chief Executive Officer

Analysts

John Glass – Morgan Stanley

Jeffrey Bernstein – Barclays Capital

Joseph Buckley – Banc of America

Colin Guheen – Cowen and Company

Tom Forte – Telsey Advisory Group

Operator

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

Lynn M. Liddle

With me here today are Dave Brandon, our Chief Executive Officer, and Wendy Beck, our Chief Financial Officer.

We have some prepared remarks and then we’re going to follow that with Q&A. We are going to end on or before Noon, but before we begin I have a couple of brief comments.

One is to have you refer to our safe harbour statement in our press release and our 10Q so that in the event we make any forward-looking statements that you can take a look at that. And then also I would ask the media to be in a listen-only mode.

With that I’d like to start with Wendy Beck, Chief Financial Officer.

Wendy A. Beck

As you all know from our filings this morning, we once again experienced challenges this quarter in our domestic environment while continuing to generate strong international growth.

Starting with the top line, please remember that revenues are low and do not necessarily give you the complete picture of our top-line growth and instead consider global retail sales as a clearer gauge of overall sales and store growth performance.

Our global retails sales increased 2.4% during the third quarter. This was driven primarily by same-store sales growth in our international business and an increase in world-wide store counts of 55 net units during the third quarter and 216 net units over the trailing four quarters. Our international division now operates in 60 markets, including recently opened stores in Indonesia and Qatar.

Same-store sales. Domestically our sales decreased 6.1% for the quarter compared with a negative 1.6% comp in the third quarter of 2007. Company-owned stores decreased 3.4%, rolling over a positive 0.8% in the third quarter of 2007. While franchise same-store sales decreased 6.4% rolling over a negative 2% in the third quarter of 2007.

International same-store sales, however, increased 5.4% over last year’s comp of a very strong positive 8.3%. This marks the 59th consecutive quarter of international same-store sales growth. As a result, our total revenues for the third quarter were $323.6 million, a $13.7 million or 4.1% decrease from prior year.

Company-owned store revenues declined $11.5 million or 12.8% primarily due to a lower store count from store divestitures earlier this year, as well as lower same-store sales. The loss of sales from the store divestitures was approximately $9.4 million.

Domestic franchise revenues declined $1.1 million or 3.2% due to lower same-store sales and domestic supply chain revenues declined $5.9 million or 3.2% due to lower volume. This was offset in part by higher revenues due to higher pass through commodity costs.

Offsetting these declines was a $4.7 million or 16.5% increase in international revenue due to higher same-store sales and increased store counts.

Moving on to our operating margin. Our consolidated operating margin as a percentage of revenue decreased 0.6% in the third quarter versus the prior year period.

[Break in Recording]

There were essentially three main operating margin variances. First, our company-owned store operating margin declined 4.6% from the prior year period which accounted for 1.2% of the consolidated operating margin decline. Food, labour, and delivery costs accounted for over 60% of the decline with occupancy costs accounting for most of the remainder.

Second, our supply chain margin declined 0.2% from the prior year quarter which had a minimal impact on our consolidated operating margin. The supply chain margin decline was due primarily to the increase in pass through costs on other non-cheese commodities such as wheat, meats, and sauces. This had no impact on dollar margins. Dollar margin was negatively impacted due to reduced volume from lower same-store sales and traffic declines, as well as increased costs for fuel.

Third, a change in the blend of our revenue had a positive impact on our margin this quarter. We had a greater percent of our revenue from our international franchise business this year, which has a 100% gross margin, and a lower percent of our revenue from our company-owned stores. This change in blend improved our consolidated margin by 0.6%.

Now let’s look at our G&A expenses. G&A decreased $1.7 million or 4.2% in the quarter versus the prior year; $1.8 million of the decrease is non-recurring relating to the gain on the sale of three stores sold in California as part of our previously announced California store divestiture plan. Including the three stores sold during the third quarter we have sold 59 stores year to date. These details are also outlined in the items affecting comparability table in our earnings release. Excluding this non-recurring activity G&A would have been essentially flat.

While we did experience lower advertising expense due to the store divestitures and lower variable labour expense, our bad debt expense did increase in 2008. Having said that, the company continued to collect over 99% of domestic franchise royalty and domestic supply chain receivables during the third quarter and year to date. Believe me, we are all over aggressively managing our G&A in this challenging environment.

Now let’s look at our leverage. I’m thrilled to report that this quarter marks the first quarter that we do not have comparability issues with our debt structure. Given the uncertainty in today’s debt markets, we are very pleased to have a debt facility in place with a blended fixed cash interest rate of 6.06% through 2012 with two possible one-year extensions.

As for our tax rates, our effective rate was 30.7% in the third quarter. We recorded approximately $1.6 million of tax reserve reversals related to certain state income tax matters. This reduced our effective rate for the quarter and is also outlined in the items affecting comparability table in the earnings release. However, as previously indicated, we currently anticipate approximately a 40% normalized rate in the foreseeable future.

Now let’s look at bottom line earnings. Our third quarter diluted EPS as reported on a GAAP basis was $0.17 or $0.13 when adjusted for items affecting comparability. The $0.13 of adjusted EPS figure is a $0.04 decrease from the $0.17 in 2007. Our operating results negatively impacted us by $0.05 for the quarter. This was all driven by the lower domestic sales that we’ve experienced. Our EPS benefited $0.01 from the lower share count in the quarter versus 2007, primarily resulting from our share repurchases. Please note, our 2007 recap did not impact the comparison during the quarter.

As stated in our earnings release, we repurchased approximately $1.1 million shares of our common stock under the share repurchase program for $12.8 million during the quarter or $12 per share. Additionally, on a year-to-date basis, we have returned $41.1 million to our share holders and $95.5 million life-to-date under our share repurchase program. We have now completed 48% of our repurchase authorization. Due to the anticipated impact of recent events in the credit markets which we’ll discuss in a minute, we plan to build our cash reserves and will continue to evaluate the share repurchase program.

Now let’s look at our liquidity. As of the third quarter we had $20.1 million of unrestricted cash. Subsequent to the third quarter, Lehman Brothers, our primary provider of our revolver, declared bankruptcy. As a result, our ability to draw upon the $150 million revolver has likely been reduced, but we are actively monitoring the bankruptcy proceedings. Lehman’s share of the $150 million revolver was $90 million. If we cannot borrow under this agreement and we are unable to secure replacement financing from other parties for the $90 million our availability will be reduced to $60 million, of which approximately $38.3 million is already committed under letters of credit giving us a net availability of approximately $21.7 million. The company has historically not needed or used the revolver for working capital requirements. We believe that our current unrestricted cash balance, our expected ongoing free cash flow generation, and our estimated $21.7 million availability under the revolver is more than sufficient to fund our operations for the foreseeable future. However, as I mentioned earlier, we plan to build our cash reserves during these unprecedented times and we’ll be conservative and prudent with our cash.

In closing, despite a challenging year we continue to generate positive free cash flow of $25.8 million year to date and continue to grow our global system as we have great momentum within our international division with both strong sales and store growth. We have a proven business model that is resilient, even during these challenging times. We also have a long-term fixed rate favourably priced debt structure that has a [inaudible]. In addition, we are taking action to ensure we are well positioned for growth when the domestic environment stabilizes.

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

David A. Brandon

We entered the third quarter knowing it was going to be a difficult quarter for us. We had virtually no sales momentum going into the quarter. We had fewer national weeks on TV than we had a year ago by nearly 50% and this was at the same time it became very apparent to us that our national competitors were stepping up their spending considerably. Our main national topic was a movie property and something I would describe as more of a gimmick-limited, time-only pizza product for our national promotion. We had committed to that a year earlier and it clearly wasn’t a great fit for the sales environment that we face.

We experienced a peak in cheese costs. We incurred another increase in federal minimum wage. We saw tremendous volatility and spikes in fuel costs. And we knew the benefit we would get from our introduction of oven-baked sandwiches wasn’t going to begin until the fourth quarter. So it was a lousy quarter. In fact, it was a quarter that I can best describe as one of those that if it could go wrong it did go wrong. And I take full responsibility for it.

Now let me share with you what we’re doing to improve our outcomes in the fourth quarter. First off, I’d like to start with our new product platform introduction: oven-baked sandwiches. This is a big new product introduction for us and one of the quickest products to go from concept to test to national rollout in the history of our company.

While sandwiches are not a panacea for all of the problems that we face, they are a huge launch for our brand that has our franchisees national wide more excited about a new product line than they’ve been in years. And they’re doing a great job of really working this product hard with local store marketing, sampling programs, and a keen eye on operations. Our team members are very eager to sell these products because they’re great. And so far this launch has given us promising indications that we’re on the right track with this exciting new line of permanent products on the Domino’s menu.

In the first seven weeks of our rollout, when we had no national TV and we were still just ramping up to have the product available in all of our domestic stores, we sold nearly 5 million sandwiches. That’s already about $25 million in sandwich sales before we really got started. That was without any benefit of national TV support. We will likely sell a million sandwiches a week during our national promotion, and that’s in addition to the pizzas, chicken wings, and breadsticks we will also be selling.

Significantly, sandwiches have increased our store traffic, which has been on a decline along with most of the rest of the industry, for a long period of time. Plus, we’ve expanded our lunch opportunity. Every Domino’s Pizza store in the US is now open for lunch, which is becoming an increasing valuable day part. The dinner day part has been suffering from recent consumer economic malaise, but the lunch day part has held up better. Sandwiches are a huge part of our lunch and, interestingly, our dinner sales as well. We’ll take all the incremental sales we can get at this particular time.

All that said, I would like to caution you to remember that there are no silver bullets in this business. As I stated at the outset, sandwiches are not a panacea to solve every ill of our current domestic environment. We have only been on national TV for two weeks and it’s still in its early days. But sandwiches, and it’s important for you to remember that sandwiches are a lower ticket item which will make it tough for them alone to drive enough business to overcome a string of negative comps. We have lots of work to do to get back to positive domestic sales comps and sandwiches are just one of the levers we’re using in that effort, but I want to emphasize it’s an important lever. Not the only lever, but a very important one.

So in addition to sandwiches our team is also filling our product pipeline with more new products than I’ve seen in years. These are not one-time, limited-time only type products that they’re developing and testing. These are products designed to become permanent menu layers that will improve our product variety, our brand quality, and our consumer brand impressions. We’re also developing and testing more value oriented promotions and products than we’ve ever had in our pipeline. And considering the current economic environment, we’re convinced this is the right path to follow.

To ensure that we have the ability to shout very loudly about upcoming product and promotion news we plan to have a much more significant presence on national TV in 2009. We plan to have a much greater share of voice in our category at the national level and we are going to launch our menu expansion with more weeks of television than we had in 2008. We know our franchisees agree that more television exposure, particularly for our new products and promotions, will be a good thing. Particularly in a year where we will likely be facing a continued difficult consumer environment.

We’re also continuing to develop our technological edge with on-line ordering now making up over 20% of our Team USA orders and with franchise stores not far behind. We expect this percentage to continue to grow, which is positive for our business.

My team and I believe that one of the most important tasks we’re undertaking is to revitalize our brands and refresh our franchise system, placing a strong focus on making sure our franchise base is where we need it to be for success going forward and that we have the right franchise partners in place, particularly in our domestic business.

Admittedly, a shakeout is happening right now and it’s a bit painful at the moment. Exiting ex-franchisees from the system is hard on everyone and with the credit markets where they are right now, getting stores turned over to new franchisees has become even more difficult. It’s paramount that we work hard with lenders to get credit lines opened up so that this turnover of the store base continues to move along at the rate and pace we need. It’s important that we recognize that all store operators, regardless of grade, are under pressure in today’s environment.

Being lower EBIDTA margins as franchise P&L gets squeezed by a touch sales environment and higher commodity and labour costs. We know from a recent rollup of the 2007 self reported franchise P&L that EBIDTA margins were down from traditional levels, putting additional strain on unit economics. Plugging in some projections for 2008, we expect this year will be worse. It’s hard on our operators out there right now, and we expect that and we’re doing everything we can to address the issue.

We’re working hard to assist ex-franchisees who want to stay in the system and improve to an A or a B. Our former interim CFO Bill Kapp, who is a very respected leader and a 20-year veteran of our company, is leading this most important project. He’s in the trenches working with banks and other lending institutions to get the sale of stores executed and to create workout plans so that those with marginal stores who need bank support to turn their stores around have the capital to do it.

I’ve promised you an update on a quarterly basis as to where we stand relative to those A, B, and F franchisees and here’s where we are as of the moment. Of the 247 original F rated franchisees we’re happy to report that 111 of them have recommitted to the brand and are doing everything they can do to earn their way back into the system as a permanent member, and many of them are making substantial progress. Right now 75 franchisees are in the process of selling their stores. Fourteen are still working out their options. We have removed 47 of those F franchisees from the system. Twenty-two of them left during the third quarter. The F franchisees who committed to stay are performing better overall, both operationally as well as their sales trends. We’re continuing our efforts to keep them moving along to a more positive outcome.

Our goal is to not allow marginal stores to be operated at sub-standard levels. Most of them are owned by F franchisees, but some are not. Even our strong franchisees are feeling the pressure of marginal stores. As we work through the tough market for selling stores it makes it difficult to project what our total number of US store closures will be this year. In Q2 we said that the US could be down by 50 to 75 net stores domestically. From where I sit today I hesitate to try to update that range except to say I expect it will be higher than that. We do expect to open approximately 100 new domestic stores during this year. However, market conditions will dictate what the final net domestic store growth number will be at year end.

All of that notwithstanding, we still expect our worldwide net store growth numbers to be very positive thanks to the continued strong store growth in our international markets. Unfortunately, our final net store growth for 2008 will be less than the 200 to 250 range we have established as normal annual net store growth for our system.

Speaking of our international business, I continue to not only be impressed by the growth and drive of this division, but what I see on the ground when I visit these countries. I recently travelled in five countries from Turkey to France to the UK, Ireland, and Mexico, touring many stores and meeting with many franchisees. The most impressive thing that I observed was the energy in the stores. I saw franchisees and team members proudly growing their business by providing great products and services to their customers. I saw aggressive marketing both at the local level and the national level. I saw well located stores with strong brand imaging and strong operations. That’s the basic formula. It’s no wonder we’ve been enjoying consistent growth from our international division because in my opinion they are operating at a very high level.

Another strength of our international business model is what we truly refer to as our portfolio of countries. We tend to discuss international as if it’s one unified market. It’s not. It’s 60 different markets with 60 different market conditions. That means when one market is weak typically we can figure out a way to get another market to grow faster and offset it with strength.

We’ve been asked lately if we’re seeing a slowdown in our global business and the current answer to that question is best found in the outstanding results our international business achieved in the third quarter. However, we’ll continue to stay focused as we know global markets are being impacted more and more by the unstable financial markets, a higher commodity cost pressures, and in many cases reduced consumer confidence.

One thing that may work against us in many countries in the weeks or months ahead is the recent strengthening of the US dollar, which could impact our reported earnings going forward as we have benefited from a weaker dollar in past years. Despite whatever challenges we may need to confront in our international business we still expect robust sales and store growth going forward.

Before I go to questions I just want to say that despite the fact that commodities are high, consumers are scared, stores are battling tough trends, Domino’s Pizza is still producing ample free cash flow. Right now, as Wendy mentioned, I believe hanging on to that cash is the prudent decision. We will be building our cash reserves over the next several weeks until we feel the markets are more stable and the debt markets are becoming more receptive to the needs of our franchisees.

It will never be my preference to provide financing to our franchisees. We would rather keep our relationship with them focused on being the franchisor rather than their bank. However, we are wading through uncharted waters and we are not going to let our A and B franchisees fail if there are ways we can be helpful with some short-term financial support and solutions. We will be monitoring this situation carefully in the weeks ahead and invest capital, as always, that are in the best ways in the long-term interest of our shareholders.

And finally, an important reminder to you all. We’re working on some of our weaker franchisees. We’re working on some franchisees that are not operating at the level or the standard required in the environment that we’re in. I want to be sure to put on the record that we still have a talented, experienced core group of domestic franchisees and they have not only the talent but the experience and the passion to get their businesses turned around. And we’re working well together with them to make that happen.

With that, I’d like to open up the call for questions.

Question-and-Answer Session

Operator

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

John Glass – Morgan Stanley

David, first, can you just maybe provide a little colour on how bad the franchise financing environment is? Is it an absolute lack of access to capital or is it just an interest rate issue?

And you put a comment in there about now letting your franchisees fail. I mean, franchisees typically don’t need the capital to operate, I presume, it’s just getting the Fs out of the system or is there some working capital access to capital needs?

David A. Brandon

I think it’s this issue we’ve got with access to capital right now is the transactional activities. For the most part, because our franchise is based in small business operators, they have not gotten particularly leveraged in their balance sheet. It’s not a function of typically, and there’s exceptions to every rule, but typically we’re not dealing with a situation where people need necessarily short term borrowing. Often times what we’re running into problems with is we have an A or B operator that wants to buy stores, distressed stores from some of our F operators and right now it’s not an interest rate issue, there just doesn’t seem to be any capital availability to finance those transactions. So the ones that are happening are the ones that are financed from people who have cash flow substantial enough to fund it out of their own cash, but the bank credit market has been very touch and that’s gotten exceedingly worse during the third quarter and I would say right now has fundamentally shut down.

John Glass – Morgan Stanley

Okay. And Dave, you mentioned ad spending. There’s a national advertising presence in 2009 versus 2008. So are you spending more, are you increasing the percentage of advertising spend or is it just another year shifting from local to national?

David A. Brandon

It’s going to be a combination of both. The truth of the matter is it’s one of our problems thus far this year is we’re getting killed in terms of sheer voice. We’re not out there at a competitive level with our national competitors and what’s happened, and again this is one of those kind of timing is working against us, as you recall we went into 2008 with a plan to shift more of our dollars into the local level, less dollars at the national level, and what fundamentally has happened is with the inflationary pressures and with the margin squeeze some of those dollars that we hoped would be spent on marketing at the local level are not being spent. In essence what we’ve done is we’ve really trimmed back our voice as it relates to our overall marketing message. At the same time we’re teeing up a lot of new products and things that are going to require more education, more communication to the consumer. So as we go into 2009 we’ve already put the plan together. We will be on national TV a substantial number of weeks more than we had as part of our planned calendar for this year. That funding will come from a variety of sources, including a shift back to a higher percent funding at the national advertising fund level because that’s just an imperative as we launch these new product platforms to have the marketing bullets we need to get them communicated.

John Glass – Morgan Stanley

Are you preparing to talk about how much, though, and are you asking for incremental contributions in aggregate to that fund?

David A. Brandon

I really don’t want to go into exactly how much that’s going to be because I think that’s very proprietary. But I’m happy to share with you the fact that we are putting together a much more aggressive national advertising plan for next year that will put us on TV at substantially higher levels.

John Glass – Morgan Stanley

Just one last question. Maybe for Wendy. Cash from operations this quarter appeared to be negative. In other words, you actually used cash in operations and it had to do with some of the other assets and liabilities in the current section. Is that bad debt? What was that? Is that recurring and is that related to bad debts in any way?

Wendy A. Beck

That’s a great question. It’s primarily two items. There’s an $11.7 million tax payment. Purely the timing that it fell into our third quarter, but it really was more for catch up of first and second quarter. And then $5 million was the legal settlement for California that’s now been paid.

John Glass – Morgan Stanley

Gotcha. So if you reverse those out you get, I don’t have the numbers in front of me, but how much would you have if you reversed those out would you get?

Wendy A. Beck

Right. You need to add back the $18 million to the $25.8 million. Those would be non-recurring.

John Glass – Morgan Stanley

Gotcha. Okay. Great. Thank you.

Operator

Your next question comes from Jeffrey Bernstein – Barclays Capital.

Jeffrey Bernstein – Barclays Capital

Great. Thank you. A couple of questions. First is on the follow up on the slowing credit implications. I was just wondering if you could talk a little bit about your share repurchase, perhaps, intentions for 2009 and whether that might be pared back as you look to kind of conserve cash.

And if you could also give us an update in terms of the turnover of the existing franchisees that you’re trying to move through the system. I know you said perhaps the rate and pace of the turnover has slowed. If you could just talk about perhaps where they are in the turnover versus where you perhaps were internally targeting them to be when we spoke about it a couple of quarters ago. And then I have a follow up.

David A. Brandon

Yes, I’ll handle the second part of that question first. The way that’s best for the brand and best for the system for us to remove F franchisees from our system is transactional. It’s not to close those stores either temporarily or permanently. It is to get those stores in the hands of quality operators who love buying those stores at distressed levels, they bring in their strong operational expertise, they execute a high level of the cash-on-cash returns from those investments can be very substantial. That’s the plan that we had and the plan that we have to kind of remove those F franchisees from the system and yet keep those stores open.

The difficulty we’ve run into is simply a function of the fact that many of our franchisees have had 20-year relationships with their local bank that has typically been available to them to extend credit to fund those kind of transactions and in the recent past those banks have not wanted to make commitments simply because they’re trying to figure out what’s going on in their industry. I think their credit committees have gotten very conservative as the overall banking industry has gone through their own form of hell.

So it has put a lot of our F franchisees in a situation where they want to transact their way out of the business, they don’t want to just close the store and not get any value, but transactions have been slow as a result of the credit markets. We’re hoping that situation relieves itself, but that’s a tough one to predict.

As it relates to our stock repurchase program, we just had a board meeting last week. It was a topic of considerable conversation. I can tell you that certainly where we were sitting last week looking at what was going on in the equity markets, looking at what was happening in the credit markets and the bank failures, our point of view was for the time being we were going to sit on the side lines, we were going to pile up more cash than we normally would think about piling up, until this situation sorted itself out. Once we knew where the credit markets were, where our revolver was, as we saw more trends develop in terms of what’s happening with the health and vitality of our franchise system, that we would make a better decisions as it relates to stock repurchases at some point in the future.

So right now we’re just going to carry a larger cash balance and we’re going to see how this all sorts out. Based on what’s happened in the last couple days we feel better than we did last week, but I think that’s an indication of how volatile the situation is and we’re going to watch it carefully and be patient.

Jeffrey Bernstein – Barclays Capital

Great. And then more on the operations side of the business. I know you’ve mentioned commodity cost pressures through the third quarter, and I guess your third quarter ended in early September, but I’m just wondering if you could give us an update in terms of the most recent using we’ve seen. It seems like cheese and wheat would be flat to favourable if you were kind of locked minimal over a quarterly basis. Maybe we’d see some favourability going forward. I’m just wondering what you see from here in terms of your kind of core commodities as you look out into the rest of this year and into next.

David A. Brandon

Yes, that’s a great question and again one that we spent a lot of time on last week. I can tell you in the third quarter we took a serious hit in terms of cost of our overall food basket. Cheese actually peaked at a higher level than it’s been in terms of the cheese factor in the third quarter. Our average cost was higher. It was a difficult quarter for us with cheese. But the reality is if there’s any good in what appears to be happening in the economy right now most of the smart people I talk to expect that we’re going to see some relief as it relates to some of these commodity pressures that we’ve been under. Fuel coming down helps us a lot. We’ve seen some relief in some of the meats and other areas of the food basket. Some of them are still very high. We continue to monitor them closely. The one that’s most important, as you know, to us is cheese. Cheese actually came down a little bit at the very end of the quarter and we thought that maybe we were going to get some significant relief. It frankly has gone back up to the point where I think it closed yesterday at $1.89. The cheese block, which is still very, very high. So we have not seen yet the cheese block come down at the rate and pace that we’d like to see and that we expect to see. Hopefully, as we get into 2009, sadly because of a lot of economic reasons that will be negative, but hopefully what we’re going to see is some relief on the commodities side.

Jeffrey Bernstein – Barclays Capital

If I could just throw in one last question, I guess for Wendy. You mentioned the FX head winds, which have been a favourable tailwind for a while, but it looks like beginning 4Q should we expect a headwind? I’m just wondering whether or not you have any hedging in place or if the dollar were to stay at these levels what you’d expect your 2009 hit to earnings per share to be or perhaps what it was in 2008, just to kind of get some perspective.

Wendy A. Beck

Sure. Well, we can’t foretell the future. Right now we are braced for a hit for $1 million in the fourth quarter. Again, we would have no way of knowing if in fact that happens.

Jeffrey Bernstein – Barclays Capital

Thank you very much.

Operator

Your next question comes from Joe Buckley – Banc of America.

Joseph Buckley – Banc of America

Thank you. Couple questions. First on the oven-baked sandwiches. Thanks for sharing as much insight into it as you did. And I know you said this was the product to move very quickly from test markets to roll out, but I’m curious in the test markets how incremental those product sales proved to be versus cannibalizing your pizza sales.

David A. Brandon

Well, Joe, what we’ve learned thus far about the sandwich business is, first of all, it’s brought in some new customers. That’s always great. It’s accelerated our traffic appreciably. It’s been the biggest traffic mover we’ve seen in my 10 years. So we’re getting velocity out of it. Some of it’s from new customers, but the other thing that we’re learning about the sandwich business is that the repeat customers is really a phenomenal number, unlike pizza where we’re used to people kind of cycling. The heavy user might buy pizza once a week and the typical user might be every three weeks. We’re in a situation with sandwiches where we have evidence that people are buying multiple sandwich orders from us per week. So one of the things we’re learning and we like about sandwiches is that we’re getting a more loyal, repeat order customer, which is having a significant impact on our traffic.

So we saw that in our test markets. We’ve seen a continuation of that as we’ve gotten into the initial stages of our rollout. Obviously it’s far from the mature product platform for us, so we’re still learning and we’re still just a couple weeks into national TV. So we’re still educating people. But right now we’re excited about what it’s doing for our traffic. It’s making the phones ring, it’s getting us more engaged at different parts of the day, and we’re excited about it.

Joseph Buckley – Banc of America

And how do you deal with the price point? Is there a minimum check that’s required to deliver the product? Is that one of the issues with a lower ticketed product?

David A. Brandon

It is one of the issues. We leave that up to the local operator. You see a little bit of everything out there. Some of them will require a minimum of two sandwiches, some will have a minimum total dollar amount for the order, you know, $8 or greater. Other people it’s part of the trial experience. They’re willing to take the hit and they’ll deliver whatever you want to order to get the trial. We really leave that up to the local operator and we’re all still learning as to what’s kind of the best answer. But right now I would say we’re being very aggressive. I’m very proud of my franchisees. They’ve really embraced this. This is teach an old dog new tricks in terms of a whole new platform operationally in the store. But also the marketing. This is a product that sets itself up very well for sampling and our franchisees have done a phenomenal job of getting out there and getting people to get this product in their mouths and when they do they buy it.

Joseph Buckley – Banc of America

I’d really like to [inaudible] for a moment. Are the implications of the revolver, are there any day-to-day implications of the revolver being so modest? How concerning is the situation or is it just something that prudence would suggest you need to raise cash and find some replacement for that $90 million of short term credit?

David A. Brandon

Joe, I’m going to soon be celebrating my 10th anniversary at this company and, as you know, from day one we’ve been a levered balance sheet because we should be. In my 10 years we have never used the revolver for anything material. The only time we’ve accessed it is to either put LCs against it or, in very odd circumstances, we’ve accessed it because we’ve gone out and done a big block trade or we bought some additional incremental shares since we’ve become a public company. I think the most we ever got into it was $15 million. So we are losing no sleep, have no concern about our liquidity, we have significant cash balances. We still have two components of the original revolver that are in place and available to us if we need them. We don’t plan to use it but it’s there if we need it. The only disappointment of the $90 million Lehman piece is that when the stock market does what the stock market does and drives our stock down to irrationally low levels, you know, that big revolver was there and we always had the opportunity of thinking about accessing it to a more material degree to take advantage of buying opportunities. In the case of those large block trades and big open market share repurchase plans we’re going to have to be a little bit more conservative than we otherwise would have been because we lost $90 million of our capacity. But from a day-to-day operations perspective I think that event means nothing.

Joseph Buckley – Banc of America

Okay. And then the conditions under which you would extend credit to your franchisees are you indicating would only be to facilitate transactions of A and B franchisees buying F rated stores?

David A. Brandon

I think the situation that we’re in right now is it’s a very one-off consideration. Bill Kapp and his team are looking at these things very carefully. If we can help facilitate a transaction that we know is going to be a winner and we can provide some very non-material level of bridge financing, we will consider that. If we’ve got a franchisee who’s moving into a bunch of new stores and is going to be in a turnaround mode and it’s sensible for us to provide some deferrals of costs, deferrals of royalties, deferrals of other payments, we will look at that simply as a way to work with that franchisee and help facilitate something that’s overall good for the brand and the system. So we’re going to be creative and we’re not opposed to helping out our best franchisees become bigger and better, but it’s going to be done in a very careful, I would say targeted way, with limited exposure to our shareholders because, frankly, I don’t want to be a bank. It’s never been our plan or our interest. So whatever we do, in my opinion, will be done at a very low level and will not be material to our financials.

Joseph Buckley – Banc of America

Okay. And the domestic store closures we’re seeing, are they related to the F program, for lack of a better term?

David A. Brandon

Absolutely. They’re related to two factors. Actually, three factors. One is, we’re putting enormous pressure on people who are not operating stores at acceptable levels. We’re putting a lot of pressure on them. We’re making their life miserable because they’re hurting the whole system. They’re not just hurting us at the corporate level; they’re hurting our entire system of franchisees. So we’re putting a lot of pressure.

The second thing that we’re doing is, as we’re putting that pressure on them, if you’re a weak operator with low volumes and you’re not doing a great job, in this environment you’re margins are going to disappear. This is a time and place where operators have to be great to be successful. And by definition, if you’re an F franchisee and you’re not getting the job done your bank and your income statement every period is encouraging you to consider getting out of the business.

And then the third component is, whereas normally we would have big appetites around the system to buy up these stores, as I mentioned earlier, the credit markets being what they are and just the overall fear factor that exists in small business today is such that we’ve seen people that would traditionally be stepping up and wanting to buy these stores being far more hesitant until there’s a little bit more stability in the financial markets and the overall business conditions.

Joseph Buckley – Banc of America

Okay. And then the last question, when do you telegraph the possible effects impacting the fourth quarter? What’s been the positive EPS impact from foreign exchange in the first three quarters?

David A. Brandon

Yes, let us look that up. We’ll get it to you, Joe.

Joseph Buckley – Banc of America

Okay. Very good then. That’s all I have. Thank you.

David A. Brandon

Yes. Thank you. If we get it before the end of the call we’ll shout it out here.

Joseph Buckley – Banc of America

Sounds good.

Wendy A. Beck

Yes, the total effect was $1.7 million positive, $0.9 million in Q1, $0.6 million in Q2, and then $200,000 in this quarter.

David A. Brandon

Did you get that, Joe?

Wendy A. Beck

Hello?

Operator

Your next question comes from Colin Guheen – Cowen and Company

Colin Guheen – Cowen and Company

Hi, there. Just a couple of questions that haven’t been asked. I just been focusing back into the company store margins talking a little bit about food. What about labour during the quarter? What is some of the variability in the comp or the declining comps ended up in some inefficient labouring schedule that might be better planned in the fourth quarter. Maybe parse out that other 60% of a margin decline.

David A. Brandon

Yes, I would say Team USA had a very poor quarter. We did not manage labour well. We got hit particularly hard with the next tranche of the minimum wage increase, which puts pressure on labour. I think we had the right intentions. In many cases we were bringing on incremental labour to go out and do door hanging and try to do more local store marketing. We were trying to improve our service. But at the same time we were bringing on all that labour our sales were dramatically less than what we’ve grown to expect from Team USA. So lower sales and higher investment in labour and higher fundamental minimum wage labour costs, you know, the combination of those factors created a very lousy outcome in terms of Team USA’s performance. We’ve addressed those issues in a number of ways and, again, we don’t do go forward things, but I can tell you that trend is moving the other direction and that’s a good thing in terms of our tight management of labour costs at Team USA.

Colin Guheen – Cowen and Company

And then just, we’ve talked a lot about providing some small financing of the franchisees. What about buying franchise stores? Is that on the table at all or is that something that left kind of to the A franchisees?

David A. Brandon

It’s always on the table, but what we’re committed to is being very, very disciplined about where we buy stores. Meaning, if we have infrastructure in place and we have a good team and a solid business and a market and there are stores that are contiguous to that that we can buy at levels we think are attractive, that will always be an option that we’ll look at and certainly carefully consider. What we’re not going to do is become kind of the port of last resort for three stores here and four stores there that will cost us more to supervise and integrate into our system than we’ll ever hope to make. Those are the stores and frankly that’s more of the situation that we’re dealing with today with these F franchisees sprinkled around the country. We really need our A and B franchisees to step up and take over ownership of those stores. It’s hard for us to step in those shoes.

Colin Guheen – Cowen and Company

Okay. And there’s no material change in the $25 million of CapEx expected as kind of a run rate number?

David A. Brandon

No, other than as we look at a world where business is tough and we’re still in the process of getting things turned around we will be even more conservative and careful in the way that we allocate and spend that capital. So $25 million is still a very good number to use, but under there’s flexibility in that number if things continue to stay very tight we’ll see if we can reduce it.

Colin Guheen – Cowen and Company

And assuming you are going out and looking to extend the revolver back to the $150 million if that would be available. What’s kind of the process given the bankruptcy?

David A. Brandon

Yes, that would take about an hour and half. There’s ongoing discussions with Lehman and certainly this involves now Barclays and how they want to manage their client relationships and how they want to pick up the pieces with some of their existing clients. So there’s conversations going on on that end. There’s other relationships we have that are very close and very important and those people may have an opportunity to step up and fill that void. We’re having those conversations. Obviously everybody’s playing their cards very close to the vest, particularly in the last week or two weeks. It was kind of hard to get people to answer their phone in light of what was going on, but we’re having good conversations with people that we have good relationships with and certainly we’ll put that $90 million back in place if there’s a way for us to do that on an economic basis that’s attractive and consistent with what our needs are.

Colin Guheen – Cowen and Company

Thank you very much.

Operator

Your next question comes from Tom Forte – Telsey Advisory Group.

Tom Forte – Telsey Advisory Group

Great. Hi. I wanted to talk about the quarter and my first question was, when you look back and think about some of the activities, the Olympics, some of the other good television, what if any was the benefit to sales from those activities?

David A. Brandon

Very little from the standpoint of the fact that we weren’t really involved in the Olympics in terms of any kind of advertising or brand presence. The Olympics does put people in front of TVs, admittedly, but based on the time differences and other factors we didn’t feel any kind of material impact from the Olympics, nor do we normally see that as a big business boon opportunity for us. The key thing for us was that our competitors, and God love them, they’ve fired a lot of media bullets during the quarter, launching platforms and supporting them with high levels of TV and we got caught in a quarter where we had a major reduction. So I think it was really more a share of voice issue than it was anything else in terms of what was going on in the marketplace.

Tom Forte – Telsey Advisory Group

And then in that regard, can you talk about some of the promotions that you’ve talked about. You said you’ve had more promotion in the pipeline than you’ve ever had. Is there something, lower price points, what sort of considerations do you have?

David A. Brandon

Yes. And listen, I hate talking about this because I don’t like to make it easy for anybody to figure out what we’re up to, but I can tell you that first of all we’re excited about Russell Weiner, our new chief marketing officer, who is now on board in the saddle. A very talented marketing executive that is going to bring a fresh perspective and new energy and we’re excited about having Russell on board. I’m excited about the fact that we’re working hard to get a greater share of voice and get out there and really be able to shout from the roof tops on some of our new platforms. We have test markets that are out and going that have a new pizza product that I think are the best food that we’ve ever made in terms of pizza products. We’re testing pasta products because obviously that’s a category that’s generated some interest and we want to participate. We’ve got an approach to that that we’re very excited about with some initial good results. We’ve got some pricing and value promotions that I won’t go into specifics on only because I think that would damage our competitive situation. We’re looking at a value menu, opportunity value offering that we think will balance out what we’re doing at the premium end with some of our new line of pizzas that we’re very excited about. We think commodities are going to be coming our way and we’ll see some relief in that regard. We’ve already seen some in some areas. We hope to see more.

So the combination of all those factors put us in a position where we’re optimistic about the way we’re going to be moving into 2009 and the kind of momentum that we can create. We’re disappointed with the fact that we’ve created a low base for ourselves with the problems that we’ve weighted throughout the last couple of years, but we’re optimistic about where we think we can go and there’s a lot of energy throughout the company and the system in that regard.

Tom Forte – Telsey Advisory Group

Great. Thank you very much.

David A. Brandon

You’re welcome.

Operator

There are no further questions at this time. I would like to turn the call back over to Mr. Dave Brandon.

David A. Brandon

Listen, very briefly I just want to point out the obvious, and that is that there is no doubt we’re living through unprecedented times. We’ve seen shakeouts in a number of industries of late and we’re likely to see shakeouts in our industry as well. I’m just here to assure you that Domino’s Pizza will not only be one of the survivors, but we’re going to be one the brands and companies that will be stronger as a result of the challenges that we’re working through today. We appreciate your patience, we appreciate your commitment, and I look forward to reporting to you on our fourth quarter results in a few months. Thank you.

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!

Source: Domino’s Pizza, Inc. F3Q08 Earnings Call Transcript
This Transcript
All Transcripts