Denny's Corp (DENN) 2005 Q2 法說會逐字稿

Good afternoon. My name is Page and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Denny's second-quarter 2005 earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer period. (OPERATOR INSTRUCTIONS) Thank you. Mr. Lewis, you may begin your conference.

Thank you, Page. Good afternoon and thank you for joining us for Denny's second-quarter 2005 conference call. This call is being broadcast simultaneously over the Internet. With us today for management are Nelson Marchioli, Denny's President and Chief Executive Officer; and Andrew Green, Denny's Chief Financial Officer. We will begin with a brief overview from Nelson and Andrew will then provide a financial review of our second-quarter results. After that management will be available to answer questions.

One calendar note, we will be releasing our sales for the month ended July 27, aftermarket next Thursday August 4.

Before we begin, let me remind you that in accordance with the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, the Company knows that certain matters to be discussed by members of management during this call may constitute forward-looking statements. Such statements are subject to risks, uncertainties and other factors that may cause the actual performance of Denny's to be materially different from the performance indicated or implied by such statements.

Such risks and factors are set forth in the Company's annual report on Form 10-K for the year ended December 29, 2004, and in subsequent quarterly reports on Form 10-Q.

With that, I will now turn the call over to Nelson Marchioli, Denny's President and CEO.

Thank you, Alex, and good afternoon to everyone. Hopefully you've had a chance to read the earnings report that we put out after the market closed today. In that release I spoke of reaching two very important milestones during the quarter. The first was achieved in May with the relisting of Denny's stock on the NASDAQ. I said then that the listing affirms that the Denny's brand is strong and growing stronger each and every day.

The second milestone reached during the quarter certainly supports that sentiment as Denny's return to profitability after more than a decade of net losses arising from a combination of weak operational performance and a heavy interest burden. We have overcome those challenges in a quality way and while we still have a lot of hard work and additional investment in front of us, Denny's is well positioned and continues to gain share.

The performance improvements in our restaurants over the last few years combined with our financial recapitalization in the 2004 have Denny's reaching profitability. These are important milestones for Denny's and are the clear result of continued execution across our organization and I commend the entire Denny's team for their hard work and dedication.

Turning to our results, earlier this month we issued our same-store sales for the second quarter which showed continued positive trends as Company units generated a same-store sales increase of 4.1%, while our franchisee sales increased 6.1%. This sales growth was on top of strong comps last year for both Company and franchise restaurants. With franchise units making up two-thirds of the Denny's chain, we are particularly proud of the progress being made by our franchisees. It is encouraging for us, and I'm sure for our franchisees as well to see their efforts and investments paying off.

As in most good franchisee relationships, the Company units must lead the way with operational reforms in capital investments. Our franchisees embraced these initiatives and have come on strong in the past year which is reflected in these positive results.

We're also encouraged by the energy and commitment from our franchise community for growth and development. Our franchisees opened 12 new stores in the quarter which was the highest quarterly total in several years.

On the company side, we have broken ground on a new unit in Morgan Hill, California and we're in the permitting stage on a new unit in Hawaii. We are in the process of scraping and rebuilding a unit in Pensacola, Florida that was damaged by Hurricane Ivan last fall. While real estate costs are challenging, we do expect to grow our new Company units by a few each year. This will continue to be dependent on the cost and availability of good sites and flagship locations.

Moving back to sales, while our second-quarter same-store sales were quite strong we did experience some softening in desk counts. It does appear that macroeconomic conditions are impacting consumer spending in the restaurant sector. In particular, higher gas prices do reduce discretionary spending especially for the lower and middle income consumer that make up the core demographic for Denny's and other family dining restaurants.

In addition, our promotion for the quarter was priced at $5.99 compared with the $4.99 price point we promoted over the prior 18 months. I've said previously that Denny's can't get tied into a single price point again as it did with the $2.99 Grand Slam. We believe the breakfast bowls were perceived as good value at $5.99; however, we did see a great variation in sales across the country. In the Midwest particularly and in many areas and eastern half of the United States we saw more resistance to the higher price than on the West Coast. Other chains have expressed similar geographic difficulties which is likely due to greater macroeconomic pressures in those areas.

For the higher volume summer season, we've transitioned to a 4.99 message with our current promotion, Big and Bountiful Breakfasts. Our strategy is to work with multiple price points which offer comparable values to our customer but allow us to balance traffic gains and average check increases throughout the year. We will remain very watchful of economic trends and consumer sentiment and their impact on restaurant sales and customer traffic over the balance of 2005.

On the food front, we have been making steady progress in our efforts to increase sales of lunch and dinner entrees. I mentioned on our call in February that the Grilled Tilapia we introduced in the first quarter quickly became our best-selling dinner entree without the benefit of media support. We did feature it on freestanding menus and on our in-store marketing materials.

In the second quarter, we use the same support to introduce our steakhouse strip and shrimp dinner. The steakhouse strip is a new improved cut that replaced our sirloin. In the second quarter we sold 50% more of this product than we sold sirloins in the prior year quarter. We also invested in an improved shrimp that is seeing higher plate counts as well. And our current marketing module to freestanding menu features three dinner offerings, lemon pepper grilled tilapia, hickory grilled chicken and blackened steakhouse strip. These three items are new flavor offerings for current entrees and we are encouraged by their reception so far.

While lunch and dinner sales are a slow build, we are gaining momentum through new product offerings that are relevant to our customer and that maintain the value proposition expected at Denny's. We've seen strong sales growth over the past seven quarters. I believe Denny's can achieve continued sales growth over the next three to five years as we benefit from the additional investments we're making at the store level and leverage the excess capacity in our restaurants. We remain committed to driving our average unit volumes higher and expect that our margins will improve as we execute.

Though the current cost environment is challenging for us as well as other restaurant companies, we do see some softening on the horizon and expect to realize some relief in the coming quarters. We are very proud of the progress being made at Denny's but we feel there is additional opportunity to grow our business. Two of my goals coming into this year were returning to profitability and relisting on NASDAQ. With both of those accomplished in the first half of the year, we look forward to new goals and new heights for Denny's. A terrific brand.

As always, thank you for your interest in Denny's. I will now turn the phone over to Andrew Green, our CFO, who will take you through our financial review.

Thank you, Nelson, and good afternoon. This is Andrew Green. Let me start by reviewing our second-quarter same-store sales results which Nelson mentioned in his remarks. Our positive sales trends continued in the second quarter as our Company restaurant sales were up 4.1%. This increase was comprised of a 5.1% increase in average guest check and a 1% decrease in guest counts. The guest check rose due to the higher price point on our media promotion as well as price increases we have taken over the past year to cover cost pressures.

The traffic decline is attributable to the factors Nelson mentioned; macroeconomic factors especially in the middle and eastern parts of the United States and the higher promotional price point. Quantifying these factors individually is difficult.

Turning to the income statement, sales at Denny's Company-owned restaurants increased 2.8% in the second-quarter or $6 million to 224 million in total. Our strong same-store sales in the quarter offset an eight unit decline in Company restaurants since the same time last year.

Now similar to other restaurant companies, we continue to experience modest pressure on the cost side of the income statement. The margin analysis table in our press release summarizes these operating comparisons. Let me note first that our second-quarter Company restaurant operating margin was negatively impacted by a $1 million charge taken in the quarter to increase our legal settlement reserves. This charge relates to an ongoing case in California regarding vacation benefits. This charge is reported on our income statement in "other operating expenses".

Now if -- including this charge, Company-operating margin was 13.5% for the quarter; excluding the $1 million charge, store level margin of 13.9% equaled last year and was significantly better relative to our first-quarter margin of 12.4%.

Moving to the individual line items. Product costs decreased 0.6 percentage points in the second quarter due to the higher average guest check and relatively flat commodity costs year-over-year. Payroll and benefit costs were 41.5% of sales in the second quarter which was 0.2 percentage points higher than last year's quarter but 0.5 percentage points lower than we ran in the first quarter.

While we continue to invest in additional crew level staffing we are also experiencing some wage rate pressure in several states such as New York, Illinois and most recently Florida. This is due to minimum wage hikes. In these cases we pass through the increases on a dollar for dollar basis which protects our penny profit but negatively impacts percentage margins.

Most of the remaining costs were comparable with the prior year with the exception of other operating expenses which were 0.8 percentage points higher this year. As I mentioned, this is due primarily to a legal settlement charge which accounted for 0.5 percentage points of the increase. The remaining 0.3 percentage points includes the cost of a new uniform roll-out during the quarter and increases in credit-card usage and their related fees.

Franchise and licensing revenue in the second quarter increased over 700,000 or 3.4%. Similar to the Company results, strong same-store sales offset a 23 unit decline in franchise restaurants since the same time last year. Franchise costs increased 400,000 over last year's quarter yielding a $300,000 increase in franchise operating income.

Now following on what Nelson said earlier, I do think it is important to note the especially strong sales of our franchise restaurants. With over 1000 franchise units compared to the 548 Company units, franchisees operate 65% of Denny's system. Same store sales at franchise units rose 6.6% in the first half of the year, or 1.4 percentage points higher than the company units. In the month at June, franchise sales rose 5.3%, a full 2 percentage points higher than the company units. We view this as a strong positive indicator of continued improvement in the Denny's brand.

While the Company's short-term benefit may only be the 4% royalty we earn on these increased sales, the long-term benefits of increased customer satisfaction and improved financial returns for our franchisees will lead to growth in average unit volumes of existing units of franchisees as well as in development of new units over time.

As Nelson mentioned, franchisees opened 12 new units in the second quarter. While I do not expect this pace to continue as part of it was due to -- the high number was due to timing, the opening of this number of units is indicative of the future growth potential for the brand.

Turning to G&A. Our second-quarter expense increased approximately 1.9 million from last year. This quarter, as in fact all year, we have two exceptional items impacting our year-over-year G&A comparison. First stock based incentive comp was 2 million in the second quarter compared with only 300,000 in the same period last year. Partially offsetting this increase was 600,000 of recapitalization related transaction costs incurred last year in the second quarter compared with none this year.

If you exclude these two items, G&A increased 800,000, due in part to investment and growth initiatives including increased staffing in our planning and development departments as we enhance the infrastructure necessary to grow. We have also incurred increased legal fees associated with the case I mentioned earlier.

Operating income in the second quarter declined $900,000 compared with the same period last year reflecting level Company restaurant margins if you exclude the $1 million legal charge as well as higher G&A expenses. Also operating income in the quarter was negatively impacted by a $600,000 increase in restructuring charges and exit costs resulting primarily from a benefit of 520,000 that was recorded last year in this quarter.

Operating income benefited from 900,000 in gains on the sale of assets primarily two surplus restaurant properties sold during the quarter yielding approximately 1.6 million in proceeds. We do anticipate the sale of additional surplus properties through year end that could generate proceeds of another 4 to $5 million.

Regarding the bottom line, we achieved our goal of profitability in the second quarter as we reported net income of 2.1 million compared with a net loss of 2.9 million in the same period last year. This quarter's net income benefited from a $5.8 million decrease in interest expense as a result of our recapitalization last year which significantly lowered our borrowing cost.

Moving on to capital expenditures. Our capital spending for the second quarter was approximately $9 million bringing the year-to-date total to 16 million. Our capital is ramping up through the year and the full year total should range between 55 and $65 million. The slower run rate in the first half is due primarily to timing as the bulk of our new point-of-sale system installations as well as our restaurant remodels are scheduled for the fall after our high-volume summer months.

With regard to our balance sheet, there were no significant changes during the second quarter. At quarter end our revolver had no outstanding balances and our surplus cash totaled 23.5 million. Early in the second quarter we made an $8.6 million coupon payment on or 10% senior notes and a 562,000 quarterly principal interest payment -- quarterly principal payment on our first lien term loans.

Based on our results through the end of June 2005 and management's expectations for the remainder of the year, we reiterate a previous guidance for 2005. When and if our guidance changes we will inform the market.

While year-to-date our same-store sales have exceeded the high end of our guidance range we have seen sales in particular traffic soften recently. In addition, our same-store sales results in the second half of last year were quite strong. In July we are rolling over same stores sales that were up 9% last year. And for the second half of 2004, same-store sales were up over 6%.

Given our concerns about the negative impact of gas prices and other economic trends impacting the restaurant sector, and the particular economic sensitivity of Denny's customer demographic that Nelson talked about, we expect same-store sales will soften in the second half of the year but to what degree is difficult to predict at this time.

That wraps up my review of our financials for the second quarter. With that, I will now turn the call back to the operator to begin the question-and-answer portion of our program.

(OPERATOR INSTRUCTIONS) Eric Wold, Merriman Curhan.

A couple questions on the franchisee side. First of all, I know we are still only halfway through '05. But any early read or indication you can give us on what kind of interest you are getting from franchisees heading into '06 in terms of build? And then maybe not specific numbers, kind of interest levels? And then also what kind of franchisees you're attracting in terms of what kind of operators you are looking at currently?

Well, our greatest opportunity as with all franchises is with our existing portfolio of franchisees particularly with the energy and the enthusiasm for the business that they are currently enjoying. We see a robust activity for '06 at this particular time. I'm not concerned about meeting our objectives in '06 at this time. There is quite a bit of interest. There continues to be interest from new franchising also but the majority of franchising this year will be from our existing franchisee portfolio as will next year.

And then on the remodels, I know that franchisees were lagging a little bit behind you guys in remodeling the stores. Has that changed at all in terms of their interest levels in getting remodels done? And then give me numbers on how many remodels will be done this year both you guys and franchisees?

I don't have at my fingertips -- perhaps someone else does here as to how many franchised restaurants are going to be remodeled. We will stick with our guidance -- I think we provided guidance on remodels. Andrew?

I can give you some numbers. The company is now projecting 60 remodeled units for this year. We have shifted a little bit of capital into some of the new units that Nelson talked about. In addition we are doing some building expansions where we are taking an existing unit and bumping it out to add seats, if it is a high-volume unit with particularly long lines on the weekend. So we are putting some capital on a few of those this year as well. But 60 on the Company side. Franchisees, since we don't control doing the remodel ourselves, the guidance I would give you is I expect well over 100 this year.

I would expect based on earlier discussions with folks involved with our franchisees, we probably have another 1.5 years before we are current. And that is true on the Company side as well.

Okay. Perfect. I'll hop back in the queue and let others ask questions.

Thank you.

Tony Brenner, Roth Capital Partners.

Good afternoon. I'd like to pursue the same-store sales projection issue. I understand why you would choose to be cautious at this point in time. But 2.5 to a 3% increase given the 5.2% increase we saw in the first half implies essentially flat comps in the second half of the year of flat to up at the most 1%. I guess my question is, is that really your best guess as to where sales would be or is it more reflective of being prudent in terms of not ratcheting up a projection even as the numbers are softening until you get a better feel? Not to put words in your mouth.

Right. I think we are being prudent. We are in the high-volume period of the year for us, the summer. And as I said in the comments we, like other restaurant companies, have seen some softening in guest traffic in particular. And also the fact that we are rolling over such strong numbers from last year including the 9% in July. So I do believe that our same-store sales will be positive in the second half of the year. But don't really want to go beyond that projecting.

I understand. Just as a quick follow-up. What was the reason for the sequential increase in the second quarter of interest expense by about $400,000?

Our bank debt is tied to LIBOR, so it is increasing some as the interest rates have increased.

Okay. Thank you.

Dean Haskell, JMP Securities.

Yes, congratulations on a great second quarter, gentlemen.

Thank you, Dean.

My question comes back to the unit operating margins. It looks like occupancy per store is rising. To what do you attribute that?

Are you looking at the quarter year-over-year?

I'm looking at the quarter year-over-year and sequentially per quarter -- I'm sorry, yes, per quarter and per unit.

I mean year over year I do know that in the second quarter of last year we had an adjustment, a beneficial adjustment that lowered last year by about $0.5 million. So when you look at quarter-over-quarter, that is why on a percentage basis you are going to see some increase. The second quarter had occupancy of $13 million, is that right?

Last year it was 12.1 (inaudible), but it had a benefit of (multiple speakers).

Last year it was 12.1 but the benefit was 600. The first quarter was 13.1 million. So I don't think actually sequentially -- 13 is right about where it should run.

And you expect it to run that way the rest of the year?

I do.

Thank you very much. I'll get back in the queue.

Andrew Ebersole, KDP Investments.

Good afternoon. I was hoping you could talk a little bit more specifically about the performance of your lunch and dinner business maybe talking about traffic trends that you've experienced in the most recent quarter and year to date?

I don't have traffic trends that I'll be able to talk to you about lunch and dinner by day part. We are on media as we've stated and have been for some time with a breakfast message. So the lunch and dinner day parts are a slow build. We are introducing some great new products and Nelson mentioned them in his comments. But it is a slow build and I don't want to imply that it's a rapid story. We need to bring in new products, improve the customer perception and over time think that we'll be rewarded.

You guys, I know I guess it was maybe a little more than 12 months or so ago that you went out there and tried to actively market that business. Are you guys just taking a more conservative approach and you are looking to up the product before you start marketing it? Basically are you suggesting you are not happy with the menu as it stands now and before you start to get behind that menu and those day parts you went to make additional investments?

No, I wouldn't say that at all. I think it was two years ago I think actually that you are referring to in the second quarter of 2003 when we last advertised dinner. And we are focused on breakfast; it is still a core equity for our Company. And we will put some effort in store behind dinner and our menu really, I don't know when you were last in our restaurants -- but the dinner and lunch lineup really has improved. But it takes time to get the customer to recognize that and keep coming back. But we fully intend to stay on breakfast.

Okay. Thank you.

(OPERATOR INSTRUCTIONS) Reza Vahabzadeh, Lehman Brothers.

Good afternoon. On the outlook for the second half, what type of assumption are you making on the commodity product cost outlook?

I would advise you that we see it as a flat.

Okay. And then secondly, as far as your menu price focus going to the 4.99 from the 5.99 abundant breakfast price point, would that have much of an impact on your gross margins?

It's going to change your margins because when you go to a higher price point on your advertised item, you're going to pick up some margin. And it is a trade-off, and I think Nelson alluded to this in his comments; it's a trade-off between check, average guest check, and traffic count. And we don't want to get tied to any one direction. So we are going to go back and forth between different price points. We don't want to get stuck on any one price point. Like frankly we used to be with Grand Slam.

So there is a trade-off to your point between the two. We try to look at it over the balance of the year as opposed to any one month or quarter.

So the trade-off that your strategy is adopting is let's get more traffic in, leverage the fixed cost and not necessarily give up a little bit on the gross margin per customer? Because of the environment?

Yes, it's back and forth. It's back and forth. At times I'll be going for more check, and at times I'll be going for more traffic.

I would add that the 4.99 and the 5.99 both provide us with terrific margins. So it isn't a question that we are sacrificing all that much here.

I understand. We're talking just tweaks.

Yes.

Ken Bann, Jefferies & Co.

Could you talk about your outlook for utility cost with this unusually hot weather? Are you experiencing somewhat higher utilities and do you expect that to continue through the summer?

Well, utility costs in the quarter were 4.3% of sales, the same as last year. It was about 300,000 more in dollars. You do see seasonally typically in the summer -- you are going to see some increase because of the hotter weather. I don't view it as a major impact. But we will probably see an uptick in the third quarter.

Also on product cost, earlier in the year you were expecting product cost as a percent of revenues to be basically flat. You have seen a fair improvement in that. Is there upside -- you are saying it's going to be flat in the second half again -- but is there some possibility of upside to that that product cost will come in a little bit lower than what you are expecting?

I don't see it. I see it being relatively flat. We may get some benefit into the next calendar year. But at this point I would stick with our flat position.

Yes, I mean --.

What was the major improvement over what your expectations were through the first half of this year? I mean again, you were expecting flat to the first half and you were improved by 0.6 of a percent. What came in lower?

Well, really overall commodities, as Nelson was saying, were about flat year-over-year. But you get the benefit of the higher average guest check with that. So on a percentage basis, you actually show a decline, an improvement. So it's that combination of the two, the higher check with flat food costs that will lower the percentage. So to that extent that is frankly I'm pleased to have commodity costs flat after the last couple of years of continual increases. With the higher guest check, that will improve on a percentage basis even though commodities overall may not be down.

Thanks.

Thank you.

At this time, there are no further questions. Mr. Lewis, do have any closing remarks?

No, we don't. Thank everyone for joining us and we will talk to you next quarter.

Thank you.

Thank you. This concludes today's Denny's second-quarter 2005 earnings release conference. You may now disconnect.