Sonic Corp. (NASDAQ:SONC) Q1 2017 Results Earnings Conference Call January 4, 2017 5:00 PM ET
Cliff Hudson - CEO
Claudia San Pedro - CFO
Greg Francfort - Bank of America
Nicole Miller - Piper Jaffray
Andrew Charles - Cowen and Company
Sharon Zackfia - William Blair
John Glass - Morgan Stanley
Matthew DiFrisco - Guggenheim Securities
Brett Levy - Deutsche Bank
Will Slabaugh - Stephens
Alex Slagle - Jefferies
Michael Gallo - C.L. King
Good afternoon and thank you for standing by. Welcome to Sonic Corporation’s First Quarter Fiscal Year 2017 Earnings Call. As a reminder, today’s presentation is being recorded.
Before we begin, I would like to remind everyone that the comments made during this conference call are not based on historical facts and are forward-looking statements. These statements are made in reliance on the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, and are subject to uncertainties and risk. It should be noted that the Company’s future results may differ materially from those anticipated and discussed in the forward-looking statements. Some of the factors that could cause or contribute to such differences have been described in the news release issued this afternoon on the Company’s Annual Report, Form 10-K, Quarterly Reports on Form 10-Q and in other filings with the Securities and Exchange Commission. The Company would like to refer you to those sources for information.
Lastly, I’d like to point out that the remarks during this conference call are based on time sensitive information that is accurate only as of today’s date, January 4, 2017. The archived replay for this conference call will be available through January 11, 2017. This call is the property of Sonic Corporation; any distribution, transmission, broadcast or rebroadcast of this call in any form without the expressed written consent of the Company is prohibited.
The Company has posted their fiscal first quarter earnings slide show presentation in the Investors section of their website for you to review, both during this conference call and after this conference call for up to 30 days. They have also scheduled this call, which includes a question-and-answer portion, to last about one hour. If they have not gotten to your questions within this time slot, please contact Corey Horsch at 405-225-4800, and he will make the appropriate arrangements to answer your questions.
I would now like to turn the conference over to Mr. Cliff Hudson, Sonic Corporation’s Chief Executive Officer. Mr. Hudson, you may now begin.
Thank you, Bethany, and thank all of you all for joining us on this conference today. As you know now and as you can see on the screen here for our first fiscal quarter ended November, we reported flat earnings per share growth on a 2% decline in system same-store sales and this lapped a 5.3% positive comp in the first fiscal quarter of last year. The same-store sales consisted of about 2.5% menu pricing and some moderate positive mix shift, this has partially offsetted the negative traffic we experienced in the same quarter. The margins at our Company-owned drive-ins declined by 150 basis points and this is driven by the labor, investments and technology investments as well as some deleveraging from the negative same-store sales.
Also in the quarter, we continued to return cash to our shareholders. We repurchased over 500 million in stock during the quarter, about 4% of our shares outstanding. And year-over-year, the average diluted shares outstanding were down about 9% into this quarter now. And finally, we refranchised 56 drive-ins during the quarter. So, those are kind of the highlights. And then we’ll of course walk through details backing that in this presentation.
On that last point, the franchising, effective the end of December, we’ve now refranchised 104 stores since we announced our refranchising program and our negotiations are underway for the remaining 42 stores that were originally identified for disposition, and we expect to conclude those sales by the end of the third fiscal quarter of this fiscal year.
In most of these cases where we have refranchisees, we’re maintaining a small passive interest in the refranchised drive-ins and in most cases we’re also maintaining ownership in the real estate. What we would expect from these transactions, we have a history in all my time with our brand, a history in which our franchisees ultimately run these stores better than our Company stores. And so, we would expect over time near to midterm that the average unit volumes in these stores will improve and the customer experience will improve. In each of these cases, our franchisees who have acquired these stores, have also committed to new store development in those same markets. So, we as a franchisor, expect a growth in same-store sales from this growth in system sales, contribution to advertising, contribution to our royalty stream and a growth in system wide sales with the contribution of new stores over time. So, this effort is moving well. And as I said, we expect to wind it up by the end of the third fiscal quarter of this fiscal year.
Now, what you see here highlights some of our more recent product and promotional initiatives. I think as all of you are keenly aware, our industry has been and continues to be very competitive and it’s being fueled in part, no small part for the moment by moderating food costs. So, our ongoing objective is to leverage our core brand equities, historical innovation, differentiation, customization of products in an environment where there’s really heightened deal seeking by consumers and a proliferation of commoditized value promotions by our competitors. In our last call, last fall, we made some -- one of the things we talked about in that call was we made progress against the dinner and evening day parts during the quarter to increase focus on targeted value with such offers as the BOGO Wings on Monday to Thursday evenings and Two Can Eat for $9.99.
Going forward, our intention is to use platforms such as the recently launched Lil’ Grillers, and do this to meet the objectives of offering new and differentiated products which we have done over the years, promote products that include full margin items which these do, give the consumer compelling price point which this offer does and then drive relevance across multiple day parts which Lil’ Grillers also permit. These are essentially slider versions of a grilled cheese sandwich and are offered in a variety of forms with protein options, chicken burger -- chicken or burger; those are separate, chicken or burger, eggs or sausage and across a variety of price points with the basic version which is the plain cheese being offered at $0.79.
Our view is that this type of promotion is really highly relevant in the current environment. It allows customer to even add a Lil’ Griller to a meal you’re already ordering; you can attach it to as a snack in your happy hour drink, you can bundle several grillers together to make standalone order. So, it is a promotion that fits well from our brand in our view, the newness, the quality, attractive price for consumers but for our operators, pricing at full margin. And so, these are characteristics that dovetail nicely with our targeted value offerings, even at other day parts like the Morning Drink Stop. So, our view is, this is how we can differentiate and work to win as we set our heights on the spring and summer of 2017.
Now, while we are on this topic of differentiation, I want to talk for a minute about our ICE initiative. ICE is I am sure you recall is our Integrated Customer Engagement platform, and it leverages our point of sale system and in addition to point of sale system, our digital menu boards or POPS, our mobile payment processes, and then those with a guest smartphone or tablet which when these things are integrated, it creates the most personalized customer experience in QSR in our view. The bar chart that you see on the screen here is intended to provide our normal update on the progress of our POPS rollout. We have now surpassed the 70% mark for the system and we did achieve that in that first fiscal quarter.
And as we alluded to in our last report, we started testing limited enhanced ICE functionality, kind of the customization of product messaging shown on individual POPS unit based on the transaction or based on store level data. So, I think we have briefly outlined before two of our smart POP tools when we talked about last quarter, those two are store segmentation and a smart suggestive sale. The store segmentation allows us to show different POPS content to different store type, even within the same market. And the smart suggestive sale uses a rules engine to portray suggested and complimentary products as customers place their order. And these tools are under test in numerous markets right now. And as we commence rollout of these tools over the coming months, we will also expect to start testing order ahead, and we will be doing that in the spring or early summer timeframe. And where could we be by the end of the summer, well, let me kind of talk through what might be a little bit of preview of how we would see this coming together.
A customer has our app, let’s say, on their smartphone and they would receive from us a customized offer based on their order history and might also be that we are using some data to determine which offers are more likely to drive profitable incremental traffic at a time of day, day of week, time of the year, whatever. So, then that customer may choose to order off lot via their smartphone or tablet, and our view is that digital ordering can help customers and especially new customer unlock two of our biggest sources of competitive advantage, variety and customization, and they can do that in a way that an analog menu cannot. It’s one thing to say you have 1.3 million drink combinations and it’s another thing to guide them through a customization process on user-friendly customer interface that allows them to handle that however they would like.
Once the order is placed and paid for on their smartphone or tablet, the customer proceeds to the lot where they are recognized on the POPS screen as they pull into a stall. The screen will then tell them where their order is and in process and it will identify the carhop; it will be by name and he’s going to be bringing their food to them shortly. So from my perspective, the fact that the customer can do this in this way to that point, it may not necessarily be unique except that I think the technology plays very well with our menu and the whole customization piece. The fact is now when they pull on lot for as Sonic drive-in, they pull into one of 25 stalls, they literally are first in line every time they come to Sonic. Our competitors don’t have those 25 stalls; and with numerous people ordering at the same time, there is an immediate jam that occurs -- can be an immediate jam that occurs on lot, but in our case of 25 stalls, this is a technology and ordering process that does beautifully in our view with our business concept and our brand. So, this will be very exciting for us as we have this infrastructure in place and begin using it.
So, what’s also great about ICE is it can enhance our customer experience even without ordering ahead or even without the use of the app. Using store segmentation for example, a customer would pull into a drive-in stall and see a message unique to the characteristics of that store or market, and the example is shown here calling out a proprietary Sonic ocean water beverage in Dallas on a hot summer day.
As the guest begins to place that order, the order is cross-referenced with similar orders in our database that generate add-on suggestion with a good degree of relevance for whatever it might be, that day part that time of the year et cetera. In this case, POPS might suggest adding a Jr. Breakfast Burrito to a Morning Drink Stop order. So, this gives you a sense I think of a quick review of how our ICE program, where it’s headed for 2017, how it can work with the broader technology points of engagement meaning a tablet, a smartphone, the app off premises but also how it can aid, check store level profitability even when those elements aren’t utilized. The activation of these tools will be it will evolve over time. And in our view, as it evolves, we will learn more about it and we will achieve greater success with it, but we’ll also look forward to sharing with you our learnings as we move forward with this.
Now, shifting gears to development, what you see here depicts our updated footprint. At quarter-end, the system included 3,559 drive-ins across 45 states. And you can see the improved rate of development activity over the past rate several years. As of the end of first quarter 2017, the number of drive-ins under contract lease --- under contract, lease or under construction grew more than 75% versus the same time last year. So, we’re really getting good head of steam here. Relocations and rebuilds more than doubled and this quarter one, the total of 25. And to answer our comment and anticipated investor question, the sluggish sales environment of 2016 has not negatively impacted the development to-date.
Now, the aggregate investment picture is shown here is perhaps the best reflection of the confidence shown by our franchisees in the current health and future prospects of our Sonic brand. Franchisee capital investment in POPS and POS implementation climbed significantly in fiscal 2016 as rebuilds and new store development also grew. You can see that depiction here. And as we anticipate store investment to climb again in 2017 with franchisee investment in the brand reaching nearly two times a level, what it was for 2015 and the 2017 estimates exclude investments related to the refranchising initiatives, we feel really fortunate our franchisees willing to invest in the long-term growth of our brand and we’re grateful of their continued confidence and support of our business. In this fiscal year, we anticipate 40 to 50 net new drive-in openings as we progress toward our longer term goal of 2% to 3% annual net new unit growth.
So with that, I’m going to turn it over to our Chief Financial Officer, Claudia San Pedro, who is going to walk through the financial performance of the quarter and our prospective guidance. Claudia?
Claudia San Pedro
Thank you, Cliff.
For the quarter, system-wide same-store sales declined 2% and adjusted earnings per share were flat. Traffic was negative partially offset by higher checks. And franchise royalties and fees increased by 50 basis points, reflecting an increased number of franchise operated drive-ins offset by same-store sales decline. Total Company adjusted operating margin improved 80 basis points to 18.7% in the quarter, driven primarily by lower SG&A and the higher mix of franchise stores. SG&A expense came in modestly low budget primarily due to the timing of technology and headcount investment and strong cost control. As a reminder, SG&A spend was front-end loaded in 2016 during the first fiscal quarter, so we were lapping an 11.5% increase in SG&A this quarter, making for an easier comparison.
Company drive-in margins contracted by 150 basis points in the quarter. Food and packaging costs were favorable by 20 basis points as a result of commodity cost improvement offset by higher discounting and the impact of the establishment of the Brand Technology Fund. We have locked in a majority of our commodity costs through the third quarter of fiscal 2017 and anticipate our commodity basket inflation to be flat for the full year, with the first half of the year more favorable than the second half.
We are currently running pricing of about 2.25% of our company drive-ins and then approximately that level for our franchise drive-ins as well. Labor expense was unfavorable by approximately 140 basis points in the quarter. Of this amount, 70 basis points is attributable to labor investments we made in the prior year to assistant manager wages and bonus, as well as employee meals; 40 basis points of unfavorability is attributable to increased healthcare costs, which is partially as a result of the timing of refranchising transactions and some other timing issues, and we at this point do not expect that to be a permanent feature for the fiscal year. And then another 30 basis points of the unfavorability is attributable to the deleveraging impact of same-store sales decline.
We instituted a change to the drive-in manager incentive compensation program as of December 1, which we believe will result in an approximate 20 basis-point headwind for labor for the remainder of 2017. However, we anniversaried the impact of the free meals and the change to the system manager compensation program during the quarter. So, the overall drag from labor investments should begin to moderate going forward.
We remain committed to our goal of investing in our people to ensure that we remain an employer of choice within the QSR industry with the long-term goal of reducing employee turnover, maintaining high levels of customer service and increasing our average unit volumes and profits.
Other operating expenses deleveraged by 30 basis points in the quarter, reflecting the payment of the brand technology fees as well as sales deleverage. Recall that as of March 1, 2016, all drive-ins now pay a technology fee into the system Brand Technology Fund which equates to approximately 25 basis points of sales. This fee runs through the other operating expense line.
Slide 19 provides a bridge from reported 2016 Company operated drive-in margins to our guidance of 16% to 17% for fiscal 2017 which is unchanged. The pro forma bar in green shows that our company owned margins would have been in 2016 excluding the stores targeted in the refranchising initiative. In other words, all else equal, on an annualized basis, the drive-ins targeted for refranchising were 240 basis-point drag margins in 2016. So, then, starting from a pro forma basis of approximately 18.6% in 2016, we subtract 70 to 100 basis points to reflect the fact that the drive-ins were not refranchised on day one of fiscal 2017; in essence, this is the deferred benefit in store margins we should realize in fiscal 2018.
We then subtract another 30 to 40 basis points to reflect our labor investments on an annualized basis including investments in employee meal, assistant manager comp and general manager incentive compensation including the original guidelines issued by the Department of Labor earlier this fall. We subtract another 25 to 30 basis points to reflect the impact of the Brand Technology Fund which is a drag on food and paper and other expenses in the first half of the year. Finally, we anticipate about 35 to 75 basis points of underlying margin contraction as a result of operating deleverage on negative same-store sales.
All-in, the sale of the lower margin drive-ins should benefit company owned margins by 140 to 170 basis points for fiscal 2017. We estimate that the drive-ins targeted for refranchising generated a $153 million in sales and around $19 million in store level profit in fiscal 2016. This income puts [ph] approximately $7 million in depreciation expense will go away replaced by an approximate 4% royalty stream and a couple million in income related to franchisee lease payments and income from minority investments
Slide 20 is unchanged from last quarter. We have a $122 million remaining on this $173 million in share repurchase authorization for 2017 and we expect to pay a dividend of $0.14 per share. We ended the quarter with $41 million in unrestricted free cash. We anticipate free cash flow of approximately $60 million this year with CapEx of between $40 million and $45 million. We define free cash flow as net income, depreciation, amortization expense, and stock compensation expense, less capital expenditures.
Moving on to our fiscal 2017 outlook, we continue to expect same-store sales to be flat to down 2% and adjusted EPS to be flat to down 7%. The same-store sales forecast assumes continued negative traffic for the industry and positive checks. I would note that the current Q2 is the smallest and most volatile weather quarter of the year, making it a poor barometer, good or bad of the underlying business. This is exacerbated this year given the multiyear comparison and the inclusion of [indiscernible] last year which added 1.3 percentage points to a system same-store sales in the second quarter. Our guidance assumes an acceleration in same-store sales in the second half of the year as comparisons ease and we lap the onset of significant food cost deflation in the grocery channel, in addition to the introduction of new product news and the implementation of technology initiatives that we expect will drive improved same-store sales.
As previously discussed, our assumptions for negative same-store sales will likely drive operating deleverage for Company drive-ins, particularly in the first half of the year with significant pressure on labor. We have moderated our projection for SG&A expense to approximately $84 million from $85 million to $86 million. This primarily reflects the timing of investments in headcount technology, which benefited the first fiscal quarter as well as modest savings related to refranchising transactions that have been completed to-date, and ongoing cost control efforts. Although visibility is low in the immediate term, our current projections for SG&A and CapEx assume that we will not pull back on ongoing or future investments and relocations rebuild, information technology or ICE, so we have maintained flexibility to adjust spending levels, should our outlook change.
A note on our refranchising initiatives, as we have refranchised markets, we have sold 75% of the operating assets of the drive-ins and provided franchisees the option to buy the land and building at various states. We have retained an investment in the operating assets because we believe drive-in performance will improve and maintaining an interest allows us to sharing the improvement. You will note that we’ve realized the $3.8 million gain on the sale of an investment this fiscal quarter; this reflects the 25% minority investment we have retained as part of a refranchising transaction in 2009. This past fiscal quarter, franchisee had the option to buy out half of that 25% minority interest and they exercised that option resulting in a $3.8 million gain. AUVs with these drive-ins have increased 38% over the term of our investment in this transaction. In addition to royalty revenue, we will be receiving monthly lease payments from franchisees for the land and its building unless the franchisee exercises the option to buy. Subsequent to the end of the quarter, we also closed on another refranchising transaction for 19 drive-ins. This brings our total refranchised drive-ins since announcing the initiative in June, to a 104 and we expect to be complete with remaining markets by the end of the third fiscal quarter as Cliff previously mentioned.
As we provided in our prior conference call, we expect the refranchising fees slightly dilutive to EPS and EBITDA, and we will offset the EPS solutions by using proceeds to repurchase shares. We have been extremely pleased with the level of interest and number of existing and new franchisees buying these drive-ins. They’re continuing investment in not only these drive-ins but in the unit growth, relocations and rebuilds, and technology initiatives reflect their confidence in the brand’s health and success. We consider our franchisees to be among the best in the industry and truly appreciate their partnership.
We had initially planned for the entire monthly lease payments from franchisees for real estate to be classified as operating lease revenue. Due to the limited life of the assets and lease terms, the portion of the monthly lease payments from the franchisees that are related to building an improvement are accounted for as capital leases. From a balance sheet perspective, the value of these assets moved from PP&E to direct financing leases. A portion of the monthly lease payments from franchisee will be considered principal payments and reduce this amount on the balance sheet.
There are two impacts of this accounting treatment to the income statement. First, this results in a significant reduction in our expected depreciation expense of approximately $5 million since we will no longer be depreciating these assets. As an offset, we will no longer recognize incremental lease revenue and the monthly payments from franchisees are now classified as interest income or a reduction of principal. The cash flows are the same. However, the proceeds are recognized differently on our financial statement. To summarize, depreciation will be lower than expected, we will recognize lower incremental lease revenue than we had originally anticipated and interest income will be $1 million to $2 million higher. Net, the cash flows remain unchanged.
We now expect free cash flow to be at the lower end of our original $60 million to $65 million range. As we mentioned, we have greater clarity on the timing of our franchisees exercising their buyout options and the accounting treatment of these refranchising transactions on the monthly lease payments. A portion of this impact will flow through the income statement but a portion will not, which impacts how we calculate free cash flow and define it. In addition, share repurchase can offset those items.
To conclude, while the first half of fiscal year 2017 is proving to be as challenging as we had anticipated, we are performing well against our refranchising and technology initiatives and remain confident in our prospects for improved sales and earnings performance in the second half of the year.
With that, we will open the call for questions.
Thank you. [Operator Instruction] And we will take our first question from Greg Francfort of Bank of America.
Can you just talk a little bit more about the 2Q laps? And just sort of I think part of the reason you guys have done so well the last couple of second quarters is because you have done a solid job with the food and growing the food at the winter slower seasonal timeframe, can you talk about that business and how that factors into sort of the second quarter and your thinking about the laps?
Claudia San Pedro
So, I think you are referring to our prior year comps that were hurdling at this point; is that correct, Greg?
Claudia San Pedro
Okay. So, as we think about and as Cliff has discussed, over the past few years, we’ve really been focused on growing more food sales during that second fiscal quarter to reduce some of the volatility we see, and what we have seen is on an absolute basis amount our monthly unit volumes during the winter quarters have increased dramatically, so much so that as we talk about believe our monthly unit volume for February of 2016 was the equivalent to our monthly unit volume of August…
Claudia San Pedro
For 2012; so, as we look at comping over, it’s not just a matter of comping over, so it’s high hurdle from percentage basis that we look at these high unit volumes that we have and we feel very good about how we are growing the business, but it does present a little bit of a challenge as we enter this quarter, given not only some potentially weather challenges but also the moderating commodity costs and what that’s done too.
We also were filling -- so, I’m saying a little bit of same thing Claudia said with a little bit different twist that is probably in ‘12, ‘13, ‘14, ‘15, we were filling a little bit of a gap where we didn’t have the same -- historically some of the same food offerings, particular emphasis the last several years on chicken. And so, in the fall or the winter month, as we shifted to national media and to more chicken promotions to just kind of fill the gap there in those fall and winter months on food sales. So, this was part of the very nice run in ‘13, ‘14, or ‘15 and ‘16, first two quarters. And so, these were the historical dynamics there versus this year.
That’s helpful. And then just on the refranchising, can you talk a little bit about the franchisees who are buying these properties? Do you have any sort of restrictions on the debt that they put in or how much debt they are putting in versus equity? Just anything on sort of the restrictions or the profile for how they are raising the money, I think would be helpful.
I’ll give you the profile of the franchisees and Claudia can speak to any concerns about capital et cetera. The transactions that we have consummated to-date are with -- in most cases, with existing franchisees, I’d say for the majority of the stores we have refranchised -- for a majority of the stores we’ve refranchised -- majority of the stores we’ve refranchised, they are with existing franchisees and long-standing, I mean you are talking 20 and 30 years, 30 years in the business. And in the case of one market is that franchisee new to the system but one that has decades of operating experience, very successful operating experiences with multiple brands. So, these are -- in each case, these are well-capitalized franchisees with lots of experience. And the case with existing franchisees, they have existing operations in those states where we’ve -- where we sold them store. The stores for which we are still negotiating with franchisees for potential sale, it is a blend of folks with decades of experience in our system. We are also utilizing these relationships with new franchisees, just because it’s good to have kind of the new blood into the system. So, it’s good to have some of each.
I’ll turn to Claudia and let her address the issue about any capital structure concerns.
Claudia San Pedro
We do not provide any restrictions on the way they structure their transactions; what we do is work very closely with them on the economics of what the cash flow is going to be of that service and looking at it, we typically look at what they are looking to do is about 20% down and then a big portion financed with moderate leverage.
[Operator Instructions] We will move next to Nicole Miller of Piper Jaffray.
I just wanted to potentially understand the magnitude of the store level margin restaurant profit line as we go through the year with the significant amount of remodels that have happened to-date. So, could you just help us maybe put some guidelines around 2Q as an example should be down 150 basis points that 1Q was, maybe you get back to flat in 3Q and it’s up in 4Q. Is that the right way to think about that line item please?
Claudia San Pedro
Nicole, the perspective I would give you is the second fiscal quarter again is always somewhat volatile. And so, that one, I would tell you is a little bit more unpredictable because of the seasonality of our business and the results that could be associated with that. To your point though, our expectation is with the refranchising transactions complete and with improved same-store sales, we do anticipate that drive-in level margins should improve as we go out throughout the year. And just as an example for instance, in the first fiscal quarter, we had 70 basis points of unfavorability related to labor investments. We’re lapping over that. So that will not continue as we proceed in the remaining part of the year, even though now we’ve just got about 20 basis-point drag from the impact of the new drive-in partner compensation package. So, it will moderate and it should improve throughout the year.
And we will take our next question from Andrew Charles from Cowen and Company.
Great. Claudia, just a quick book keeping question, till we get the 10-Q. What were the proceeds from sales of assets in first quarter?
Claudia San Pedro
It was about nearly $11 million from the proceeds related to the refranchising transactions and then there is another $7 million that’s related to the buy-outs of the portion of the minority interest.
And then, your comps and EPS were little better than expected in the first quarter, and obviously there is some accounting differences around the lower D&A but G&A as well. So, I’m just kind of curious though just what drove the decision not to increase the full year EPS guidance and now just emphasize on the low-end of the free cash flow range?
Claudia San Pedro
Well, I think primarily, because we just completed our first fiscal year, we’re entering our most volatile and weakest time of the season. I think our perspective is, until we finish the second fiscal quarter, we won’t have any additional clarity into same-store sales and its potential impact on EPS.
Okay. And for comps as well?
Claudia San Pedro
For comps as well. Again, the second fiscal quarter can be the most volatile, and depending on what happens with weather, and unfortunately I cannot predict whether. So for that reason, I think we made a decision and it’s really more prudent to wait until the second fiscal quarter to really give a full update on what we’re seeing with respect to both same-store sales trends, underlying same-store sales trend that may or may not be impacted by weather and their corresponding impact on EPS results for the year.
And we will take our next question from Sharon Zackfia of William Blair.
Hi. Good afternoon. Just a quick question on the royalty rate, it looks like the imputed royalty rate went down a little bit year-over-year. And I don’t know if that has something to do with the refranchising. But if you could talk about what your expectations are for that as this year progresses?
Claudia San Pedro
Sure. So, what I am showing Sharon is that our effective royalty rate was about 4.08% in the first fiscal quarter of 2017 compared to about 4.07% in prior year first fiscal quarter, so just a slight increase. What I would tell you is, we would expect to see, given same store sales declines, some modest decline in the effective royalty rate, that will be partially offset by new drive-ins that are opening at a higher royalty rate in addition to the relocations and rebuilds that are producing anywhere from 28% to 40% sales bump and that would be in at an incremental royalty revenue - or an incremental royalty rate.
Can I just sneak in one other clarifying question? The new D&A guidance, does that assume all of the refranchising is done or does that just assume what you’ve done so far?
Claudia San Pedro
That assumes all of it at this point.
And we’ll move to John Glass of Morgan Stanley.
First, if I could just follow-up on an earlier question, was the first quarter in line with your expectations from a sales and earnings standpoint? I’m just trying to understand how you’re thinking about the year now versus prior.
Claudia San Pedro
Yes, I think it was pretty consistent. I mean, we would have liked to of course have seen better same-store sales but pretty much in line with what we had expected.
And then, I guess just more broadly on sales, last quarter there was some discussion about food deflation, but you also talked about ice cream sales, in particular that was an important quarter for deserts and now, you moved out of that. So, has there been a broadening -- comps are sort of similar to last quarter [indiscernible] basis. So, is that still a drag? I presume it hasn’t been because it’s seasonally less important this quarter. So, has there been a different change in the underlying mix in your business? What did you see in your underlying day parts for example or regional may have changed this quarter versus last quarter, if anything?
Claudia San Pedro
I think a couple of factors; one, you want to look at our prior year comps that we were comping over when you look at it two or three year basis were pretty challenging. I think the other piece is that what we’ve noted and Cliff made mention of this as we look at our promotions is that while we’ve seen good, and continue to see some improvement in our chicken sales, if you look at the overall base business that we have, other food items continue to see a decline from those items.
So specifically, you mean like add-on items or core burger sales or what…
Claudia San Pedro
Our core entrée sales, so with the exception of chicken, our core burger sales and our core entrée sales have declined.
Versus last quarter?
Claudia San Pedro
And we’ll take our next question from Matthew DiFrisco of Guggenheim Securities.
Question here with respect to -- two questions actually, just follow-up on the refranchising. Can you talk about how many stores maybe you’ve added to your pipeline? If we look at the growth rate for 2017, how could maybe the refranchising help us envision how much more you could possibly get in development as soon as maybe 2018 or is that not practical and you’re thinking maybe a couple of years out the refranchise stores can start to impact the net development?
Well, in each case as we do refranchise these stores, as I mentioned earlier, in each case, we do have varied development agreements that are entered into then simultaneously. What this does do of course is then help the pipeline that results from the overall pipeline of new store development over time. What it does not do by and large is affect that in the immediate term. In other words, we entered into these in 2017; it doesn’t mean, we get stores opened in 2018 as a result of that. So, it’ll positively impact the pipeline. It’ll not -- the likelihood of it positively impact in certainly in any material way but I’m not sure would at all impacting the openings in 2018 and so it’s pretty slim.
And then just looking at the much discussed about gasoline prices sort of rolled over themselves and now are up for the first time in over two years on a year-over-year basis. To the consumer, have you seen a correlation with perhaps traffic trends, maybe the two-year traffic trend, has there been any sort of response or slowdown correlated with late November changeover where gasoline became a headwind rather than a tailwind to your consumer?
We’ve seen no indication of a correlation between those elements.
Okay. And then, just a last question here, can you give us some data maybe on -- with all the investment you’ve made on the POPS and the digital, a percentage of sales perhaps that are done on a digital app now and how you look at that growing? I mean, you’ve got 71% of your base now of your system out there.
Yes. So, keep in mind, the 71% does relate to the POP being on the screen at the store level. It does not relate to -- I mean the rate of download and usage of the app is a completely independent and separate element for the time being. In the spring and summer, we will begin experimenting with offsite ordering and offsite payments. So, until that occurs, I think what you’ve got right now is a customer can download the app, they can load the app with funding but they have to pay for it on premises with that mechanism. So, the dynamic that we’re describing of off premises order, off premises payment and facilitating customization off premises and speed of process on lot, speed and convenience will occur once you have those elements in place, they’re not in place right now, so the percentage of sales that are coming through the app right now is nominal.
So, the percentage of sales being paid on lot with the app is low single digits or nominal, okay.
Yes. I think you could say very low single digits.
And we will take our next question from Brett Levy of Deutsche Bank.
If you could do me a favor and share with us, you used to give us number of commitments you have out there. Obviously, it’s clouded right now with all of the refranchising; if you’d be willing to share that and also what you’re seeing in terms of wage rate inflation and also unit level turnover? Thank you.
I don’t have the pipeline of commitments for you off the top of my head. We have seen increases each year for the last several years. And so, it has gotten pretty healthy. I’m trying to think about recent -- I think the last year, it was -- Claudia?
Claudia San Pedro
150 I think.
Anyway, we’re seeing improvement in that pipeline year by year. Now, your second part of your question related to the health of what?
Wages, what you’re seeing in terms of inflation, turnover outside of the 20 basis points for the managerial changeover.
Claudia San Pedro
We are continuing to see some wage inflation. We think that’s been occurring over the past 12 months as the labor market’s been tightening up. So, as you know, we’ve talked about our perspective is that we continue -- we’ve made a good portion of our labor investments over the past two or three years; we feel good about them. And I think at this point, we will continue now to focus on leadership and on meeting our multiyear AUV goals and our profitability goals. Is there something else you wanted some other context on wages?
Well, just if you had what the level of wage rate inflation was and if you are seeing any incremental turnover?
Claudia San Pedro
Sure. So, from a wage rate perspective, we are continuing to see maybe 1.5% to 2% wage inflation, which is pretty consistent with what we’ve seen in the past. As we look at turn over, our turn over numbers have declined in double digits, as a result of these initiatives, and so that continues to be a positive sign in our mind of building more effective crew teams at the drive-in level.
And we will take our next question from Will Slabaugh of Stephens.
I wanted to talk a little bit more about price points and how we should expect Sonic to commenting those in this environment? So, if I can go back, you said couple of quarters where you brought out your own value bundle at the $5 level at the Boom Box to help combat pure discounting and then since then you have moved toward that Two Can Eat for $9.99. So, I am curious if we should assume the guest is more positively responding to that higher price bundle for your brand or is the launch of the Lil’ Grillers a sign that maybe more entry level price points are needed here? And I guess just sort of how we think about your pricing expectation to a new offer?
Well, the environment and the receptiveness of consumers to one promotion versus other, as you point out, will affect how we go about this ongoing. So, price sensitivity is there and there is no doubt it will continue to be there. As the calendar year progressed, it was our objective first to drive trial or to drive traffic I should say and use more aggressive promotion to do that and work to evolve our promotions to where they can be brand, even unique drivers, traffic drivers that have price sensitivity and yet not the same margin impact as a $5 deal for our -- the same margin impact for operators. So, this is the evolution. You are seeing the evolution of the thinking coming out of the significant shift in that April, May timeframe that the consumer went through and consumer still on that mindset.
So, really you are just witnessing our evolution of how we talk about value, how we talk about price and what our preference is, and how we talk about that with the consumer. Our preference being if we talk about it with unique product, they can protect margin from the operators view point.
And we’ll hear from Alex Slagle of Jefferies.
I just want to see if you could provide some more commentary around the success you are seeing with the testing of the enhanced ICE functionality, just typically the two tools, the suggestive sale and the store segmentation work. I mean any metrics you could share with us, now what you are seeing there that’s actually moving the needle as you rollout the new market?
Well, in terms of giving you quantitative read on what’s occurring, the answer is we don’t intend to. So, this is going to be an evolution, I mean you think of it as plumbing that will continue to work over time, with evolution of content, so that it is not a onetime deal. And as we learn what works, we’ll do more of what works and less of what doesn’t work. From a qualitative standpoint, I’ll say to you that it shouldn’t be a surprise to you that things we put on to screen were more likely to sell. And so, this is why we are trying to refine data that first has to do with what’s appropriate for a trade area, those promotions; those screens maybe different by store within the same market. But then also the evolution of that particularly once we start getting the download and usage of the app, the evolution of that promotion to where it moves from store level segmentation, store level promotion to customer level segmentation and customer promotion. And as we evolve to that point, which also is the progressive build, but as we evolve to that point, the whole engine becomes far more powerful. But it’s not our intention really as to any of these to say to the marketplace when we do this we get X, but when we do the other we get Y because there is really no benefit to our doing that particularly as it relates to competitors.
Understood, is it expanding to initial markets beyond from the fourth quarter?
We are in the process now of refining the takeaway from our first round with these things and taking it to additional markets for expansion. And so, this will be an ongoing process for us.
[Operator Instructions] And we will move to Michael Gallo of C.L. King.
My question is just on the commentary about weaker sales of entrées other than chicken. I was wondering if you can parse out, what are you doing to address that and then also from the standpoint of obviously chickens, grown a lot over the last few years, so whether you see a lot of room for that to continue to grow or whether you expect that to a level off and whether you will need some of the other areas to pick things up starting in the second half? Thanks.
Well, in the last over of years, chicken has grown disproportionate -- I mean, there are really kind of two things ‘13, ‘14 and ‘15, chicken and ice cream grew disproportionate to other product areas in our business. As part of an objective to grow sales generally, meaning positive same-store sales, our anticipation would be that we would grow across product lines and across day parts. That is our business objective. And so, our promotional activity is geared in that direction, within a given three or four months period and varying like order. In other words, spring and summer more likely to be more heavily focused on treats, and in the following winter a little bit more likely to be focused on foods and heavier foods. So, they’ve grown disproportionately, chicken in particular because of new offerings and building that is up as part of our business has not been a significant portion historically. And so, it’s got disproportionate attention from us but our expectation going forward is that we grow a variety of -- growth would come from a variety of sources over the next several years.
And ladies and gentlemen, this does conclude today’s question-and-answer session. I would like to now turn the call back over to today’s management.
We appreciate your participation today. And as we said at the outset, if you have additional questions, Corey Horsch is available to deal with them after the call. We appreciate your interest in the Company and your participation in the conference today and we’ll look forward to seeing you along the way. Happy New Year.
And ladies and gentlemen, this does conclude today’s conference. Thank you for your participation. 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: email@example.com. Thank you!