Denny's Corp (DENN) 2007 Q3 法說會逐字稿

Good afternoon. My name is Nicole, and I will be your conference operator today. At this time, I would like to welcome everyone to the Denny's third quarter earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. (Operator instructions)

Thank you. Mr. Lewis, you may begin your conference call.

Thank you, Nicole. Good afternoon, and thank you for joining us for Denny's third quarter 2007 investor conference call. This call is being broadcast simultaneously over the Internet.

With me today from management are Nelson Marchioli, Denny's President and Chief Executive Officer, and Mark Wolfinger, Denny's Executive Vice President Growth Initiatives and Chief Financial Officer. Mark will begin today's call with a financial review of our third quarter results. Nelson will then provide an overview of our business. After that, management will be available to answer questions.

But 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. Management urges caution in considering its current trends, and any outlook on earnings provided on this call.

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 27, 2006 and in any subsequent quarterly reports on form 10-Q. One note, we will file our 10-Q for the third quarter this evening, likely before this call concludes, so you'll have that additional information for review, along with our earnings release.

With that, I will now turn the call over to Mark Wolfinger, Denny's EVP and CFO.

Thank you, Alex, and good afternoon. I will start my comments with a quick review of our third quarter sales performance.

Company same store sales increased 1.3%, on top of the strong 4.2% increase in the prior year period. The sales increase in this year's third quarter was comprised of a 6% increase in average check, and a 4.5% decrease in guest count. Of the 6% guest check increase, four to five percentage points was attributable to price increases taken during the year to offset minimum wage hikes and commodity cost pressures. Average guest check also benefited 1% to 2% from higher menu mix as we reduced our emphasis on price point promotions. Partially offsetting the price and the menu mix increases were selected discounting efforts, which lowered the average check by approximately 0.5%.

Denny's franchise restaurants reported a 3.2% increase in same store sales in the third quarter. This, combined with the company performance, resulted in a 2.6% increase in same store sales across the Denny's system, which was a strong result for both our sector and the industry.

Like much of our industry, we are finding it challenging to drive positive guest traffic in the current environment. In the near term, we have chosen to focus on producing the most profitable sales mix of traffic and check. Nelson will talk more about our sales trends and expectations in his remarks.

Looking at revenues for the quarter, you can begin to see the impact of our Franchise Growth Initiative. Sales at Denny's company-owned restaurants decreased $17.9 million, or 7.6% from the prior year, due to 51 fewer equivalent units, or a 9.5% decline in company restaurants from the same period in the prior year. The decline in company units resulted primarily from the sale of 56 company restaurants to franchisees this year under the Franchise Growth Initiative, or FGI, and the closure of 16 underperforming company restaurants in the fourth quarter of last year.

The sequential decline in equivalent company units and company restaurant sales is expected to continue, and in fact, accelerate, as we sell additional company restaurants. The sales impact of the reduction in company restaurants was partially offset by a 1.3% increase in company same store sales.

Turning now to the quarterly operating margin table in our press release, our company restaurant operating margin in the third was 11.9%, a decline of 1.9 percentage points compared with the prior year period, while our primary cost lines, product and payroll, have been under pressure all year from minimum wage hikes and commodity inflation. We were able to hold them in check during the third quarter through tighter cost controls and higher average check.

Product costs increased by 0.2 percentage points, due primarily to increases in commodity costs. The third quarter year over year increase was the lowest of the year, as favorable menu mix shifts and pricing actions helped to offset food cost pressures.

Payroll and benefits costs for the third quarter were flat with the prior year period, at 40.7% of sales, as wage rate increases were offset by improving experience in workers' compensation costs and higher menu pricing.

Moving down the P&L, occupancy costs increased 0.6 percentage points for the third quarter, due primarily to an increase in general liability insurance expense in the quarter.

In aggregate, our other operating costs increased by 1.0 percentage points in the third quarter. Repairs and maintenance expenses increased 0.4 percentage points in the current period, due primarily to the timing of expenditures. Legal settlement expense of $1.6 million in the third quarter, compared with the prior year benefit of $0.8 million, resulted in a 1 percentage point margin decrease.

Partially offsetting the R&M and legal expenses was a $400,000 decrease in other operating expenses, due primarily to income related to the redevelopment of a company-owned restaurant on the Las Vegas strip. The developer is reimbursing Denny's for lost income, while rebuilding the location. Denny's will be a tenant in the new facility once it is reopened.

On the franchise side of our business, you can begin to see the offsetting impact of FGI taking shape. Franchise and license revenue increased $1.1 million in the third quarter, as a $1.1 million increase in royalties, and an $800,000 increase in initial fees offset an $800,000 decrease in franchise rental income. The higher royalties resulted primarily from a 3.2% increase in franchise same store sales, combined with a 29-unit increase in equivalent franchise units. The increase in initial fees resulted primarily from the purchase of 22 company restaurants during the quarter under FGI. The decrease in franchise rental income resulted primarily from last year's third quarter sale of real estate previously leased to franchisees.

Cost of franchise and license revenue increased by $100,000 in the third quarter, which partially offset the $1.1 million revenue increase, yielding a $1 million increase in our franchise operating margin for the third quarter.

As our FGI program progresses, we expect royalties and upfront fees to continue to increase. Franchise occupancy revenues should level off and begin to grow again, as we are rolling over the real estate sales from the prior year.

Moving further, general and administrative expenses decreased $400,000 from the prior year period, as share based compensation decreased $1 million, to offset a $600,000 increase in core G&A expenses, primarily staffing costs related to restaurant development and other strategic growth initiatives.

Next, depreciation and amortization decreased $1.7 million from the prior year quarter, due primarily to the sale of real estate assets over the past year.

The most significant line item impacting operating income is operating gains, losses, and other charges, which decreased $36 million over the prior year period, due primarily to $4.6 million in asset sale gains this quarter, compared with $39 million in the prior year period. In addition to lower gains, restructuring charges and exit costs increased $2.2 million, due to severance and other expenses associated with our operational realignment in the third quarter.

Operating income decreased by $39.3 million to $16.3 million in the third quarter. Excluding the lower gains and additional restructuring charges, operating income decreased $3.3 million on a $16.8 million decrease in total revenue.

Below operating income, interest expense decreased by $4.5 million, or approximately 30%, to $10.5 million in the third quarter. This included a $3.8 million decrease in cash interest expense as a result of lower debt balances and improved borrowing costs. In addition, non-cash interest expense decreased by $600,000, due to lower amortization of deferred financing costs.

Now to the bottom line. We reported net income in the third quarter of $5.3 million, or $0.05 per diluted common share, a decrease of $20.2 million compared with the prior year. Again, the primary driver of the income decrease was a $34 million decrease in asset sale gains.

Because of the significant impact to our P&L from non-operating, non-recurring or non-cash items, we have given earnings guidance based on our internal profitability measure, adjusted income before taxes, which excludes restructuring charges, exit costs, impairment charges, asset sale gains, share based compensation, other non-operating expenses, and income taxes. We believe this measure best reflects the ongoing earnings of our business.

For the third quarter, adjusted income increased approximately $200,000, to $5.8 million. Given a challenging operating environment and the reduction in company restaurants, we are pleased that our strategic initiatives succeeded in driving earnings growth during the quarter.

Regarding restaurant portfolio activity, the Denny's system leveled off at 1,539 restaurants during the third quarter, as four new restaurants were opened, while four were closed. The company restaurant portfolio declined by a net 20 restaurants in the third quarter, as two new company restaurants were opened and 22 were sold to franchisee operators.

The franchise restaurant portfolio increased by a net 20 restaurants in the third quarter, as franchisees opened two new restaurants, purchased 22 company restaurants, and closed four restaurants.

Moving on to capital expenditures. Our cash capital spending for the third quarter was approximately $7.8 million, bringing our year to date total to $21 million. We expect capital spending of $16 million to $18 million in the fourth quarter as we complete the construction of three new company restaurants.

Turning to our balance sheet, we continue to make substantial progress on our commitment to reduce debt and improve our financial flexibility. We generated net proceeds from asset sales of $9.1 million in the third quarter, primarily from the sale of 22 company restaurant operations and related real estate.

During the quarter, we paid down our debt balances by $26.6 million through asset sale proceeds and free cash flow. Our cash balance decreased by $18.2 million during the quarter, as second quarter asset sale proceeds were applied to pay down debt early in the third quarter.

Year to date, we have reduced our outstanding indebtedness by $45.2 million, or approximately 10%. If we look back over the last 21 months, since year-end 2005, we have reduced our total debt by approximately $146 million, or more than 26%.

That wraps up my review of our third quarter results. While our base business continues to progress in a difficult environment, we are most pleased with the advances we are making in our strategic initiatives to drive system growth, and optimize our company restaurant portfolio.

The reception among current and prospective franchisees to FGI has been encouraging, as the program is well ahead of our expectations. We closed on the sale of 22 company restaurants to franchisees in the third quarter, bringing the year to date total to 56. Of the total, 37 were sold to five new franchisees.

As the primary purpose of our FGI program is to facilitate growth in the Denny's system, we are pleased to report that the franchisees who purchased company restaurants this quarter also signed development agreements to build nine new franchise restaurants. This brings the year to date total for development commitments attributable to FGI to 35.

In addition to FGI, we are offering development agreements in areas that do not have company restaurants for sale, but have significant opportunity for growth. We call this program our Market Growth Incentive Plan, or MGIP. In the third quarter, we signed development agreements for 13 such restaurant locations, bringing the year to date MGIP development commitments to 36.

Through quarter end, we have now sold a total of 56 company restaurants and signed development agreements for 71 new franchise restaurants. The momentum behind our growth programs and the demand for the Denny's brand is proving very strong. As included in the business outlook section of today's earnings release, we expect to sell 40 to 50 additional company restaurants in the fourth quarter, which should bring us at or above 100 restaurants sold this year. That would equate to the sale of approximately 20% of the company restaurant base prior to the start of FGI earlier this year.

We are investing a lot of time and resources into this program in order to accelerate the transactional process, and the new unit growth that will follow. While we cannot yet determine the ultimate outcome of the program, we will continue to pursue the sale of company restaurants where it meets our objectives for unit growth, earnings accretion, and a tightened geographic span.

With regard to our outlook for the remainder of 2007, I am pleased to report that despite economic weakness and cost pressures, we remain on track to meet our full year earnings guidance. In fact, we expect to realize $8 million to $10 million in adjusted income for the year, which is at the upper end of our original guidance range.

We have tightened our same store sales estimate for the year, to 0% to 1%, based on our results to date. Our revenue assumptions will continue to be the hardest to project, based on the impact of restaurants potentially sold under FGI. Our 2007 company revenue projection has been lowered, to $840 million to $850 million, while our franchise revenue estimate has been increased to $93 million to $94 million.

We expect considerable new unit development in the fourth quarter, as we plan to open two to three new company restaurants, and 11 to 13 new franchise restaurants. Depending on the number of franchise closures, we should enjoy positive net unit growth in the fourth quarter, and should come close to flat unit growth for the year. While not yet positive for the year, after net unit declines of 33 and 25 the past two years, we are pleased with the progress of our development programs.

That wraps up my prepared remarks. I will now turn the call over to Nelson Marchioli, Denny's President and CEO.

Thank you, Mark, and good afternoon, everyone.

Our results so far this year have been impacted by the difficult consumer environment, and escalating cost pressures. Unfortunately, we do not see these negative economic factors improving in the near term.

However, I am encouraged that despite the current headwinds, we have been able to hold our own operationally, while executing successfully on many of our strategic initiatives.

In a difficult sales environment, we've chosen to manage our business with a balance between sales growth and margin protection. While our guest counts in the third quarter were soft, we were able to generate positive same store sales against a strong quarter in the prior year. We continue to proactively adjust our promotional activities so that we can maximize our sales, whether that is driven by guest counts, menu mix, or opportunistic pricing actions. We are currently working on our product lineup for next year.

One primary objective is to reengineer our value promotion, to ensure an attractive and profitable price point offering. Value is a core attribute of Denny's, and we remain confident in our relative value positioning.

The first -- as we work to get the most out of our base business, our management team is also working hard on many new initiatives, most of which are focused in some way on growth. Whether it's unit growth or sales growth or profit growth, our strategic focus is on building the Denny's brand.

As Mark mentioned in his remarks, we have closed the sale of 56 company restaurants through the third quarter, and expect that number to expand to approximately 100 by year-end. We have signed commitments for 71 new franchise units, and expect that number will also approach 100 by year-end.

When we revised our development programs coming into this year, we were hopeful for a positive reception. The interest level and energy for growth from our franchise community has clearly exceeded our expectations. While we are eager to move quickly on FGI, the Franchise Growth Initiative, we have put in place a disciplined process to ensure that we balance our objectives of timely execution, meaningful value creation, and growing the Denny's system.

We will continue to pursue Franchise Growth Initiative, FGI transactions, as long as we can meet these objectives. Notwithstanding the strong interest generated so far, we cannot confidently predict how far the demand will stretch. The optimal mix of company and franchise units will be determined over time.

Another growth opportunity we are excited about is the launch of a joint development program with Pilot Travel Centers. A relationship between Pilot, the largest operator of travel centers in the U.S., and Denny's, the largest full-service family dining chain in the U.S., seems to be an ideal fit. Denny's has a long heritage of operating along our nation's highways, and this agreement allows us to place restaurants at high profile, high traffic locations.

The first Denny's under this program will be a company-operated restaurant in a new Pilot facility under construction in Mt. Vernon, Illinois. Development of additional company-operated locations will begin early next year. After we open and operate a few locations, we will be better able to judge the magnitude of this exciting opportunity for future company and franchise development.

While all of these commitments are filling out our future growth plans, this fourth quarter will be marked by a significant number of new restaurant openings. In fact, our biggest challenge in the fourth quarter may well be the smooth transition of 40 to 50 restaurants from the company to franchisees, while at the same time opening 13 combined company and franchise restaurants. This is clearly a good problem to have, and one that is long overdue here at Denny's.

Another emerging growth initiative is the launch of several test programs for new products and new facility innovations. We're testing a lineup of portable products in a number of our existing restaurants, to evaluate our opportunity for greater off-premise consumption.

Also, just this week, we reopened a Denny's location as a new restaurant and a restaurant concept. One half of the restaurant remains Denny's current full service prototype. The other half is a new concept we are calling Denny's Fresh Express. The Fresh Express concept leverages Denny's breakfast heritage in a more contemporary setting, that offers high quality ingredients, portable products, and a convenience-driven service model.

These are the first of many tests we'll be undertaking over the next year. For the first time, Denny's is administering a dynamic research and development process. While it will be some time before we will be able to discuss our findings and our ultimate plans for these terrific innovations, we are all excited about the possibilities. We are discovering for the Denny's brand, and see considerable opportunity ahead of us.

I want to thank our employees for all their efforts to grow this great brand, our franchisees, and our shareholders for their ongoing support.

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

Thank you, Nelson. Before we move on to the Q&A, I'd like to take a few minutes to talk about the financial impacts we are seeing from FGI. The numbers I am about to discuss are based on the 100 or so restaurants we expect to sell through year-end. There have been a lot of questions regarding the numbers involved in FGI, and we wanted to have a significant sample size before we discussed the financial specifics.

As we've said from the beginning of this process, we have targeted the sale of lower volume, lower performing restaurants from the company portfolio, that totaled more than 500 units at the start of this year. We often show a chart in our investor presentations that breaks down these 500 restaurants into quintiles, of approximately 100 units each. The top 100 volume restaurants are in quintile one, the next 100 volume are in quintile two, all the way down to the bottom 100 volume restaurants in quintile five.

Through the first 100 units sold, or planned to be sold, we are averaging around at quintile four. We have sold close to equal numbers of quintile three, four and five units, so we're meeting our goal of trying to target the lower end of our portfolio. These 100 restaurants have an average sales volume of approximately $1.5 million, and an average four-wall operating margin of around 9.5% to 10%. This yields an average operating cash flow of about $145,000.

Now that the restaurant is operated by a franchisee, we were in a 4% royalty, which on 100 -- a $1.5 million restaurant is about $60,000. So on an operating cash flow basis, we give up $145,000 in company cash flow, and get back $60,000 in franchise cash flow, thus lowering operating cash flow by $85,000.

We then have cash savings from field overhead, capital expenditures and interest that's combined to make the transactions both accretive, and cash flow positive. And those are the two metrics that we use when we analyze each transaction as we go through the process.

From a field overhead basis, we expect to see $15,000 or so reduction per unit. Obviously, this doesn't happen on a pro rata basis, but as a certain number of restaurants are sold, then a field management reduction is required. This is not G&A -- this is purely in the field. We are not factoring G&A into this analysis at this point.

From a capital standpoint, we incur approximately $25,000 per unit in ongoing maintenance capital expenditures. We also factor in the amortized savings of a $210,000 remodel every seven years, or another $30,000 annually. So we project, combined, a $55,000 capital savings for each unit.

As for interest, we are receiving an average purchase price of approximately $500,000 per unit for the business value of each restaurant. Any real estate that may be included in the transaction is eliminated from this analysis. We apply the net proceeds after costs and fees are taken out, to reduce interest costs by approximately $40,000.

So if we net all of this together, we have operating cash flow down $85,000. We have field overhead savings of $15,000. We have capital savings of $55,000, and interest savings of $40,000. And we end up with an ongoing, on average, cash benefit of around $25,000 per unit.

I caution you that this analysis is based on averages for transactions that can vary greatly, and also, the pool of units we've sold to date may not reflect any units we sell going forward.

Regarding the sales multiples we are receiving, I think it's important to remember that these transactions are priced on the cash flow of the buyer -- in this case, the franchisee -- and not the cash flow of the seller -- in this case, the company.

If we use the numbers I just went through, the company sold an average of $145,000 or so in cash flow for an average price of about $500,000, or about a 3.5 multiple of cash flow. The franchisee has to then pay a royalty back to the company, which reduces their cash flow to approximately $85,000. This, in turn, raises the buyer's purchase price multiple -- and that's how these transactions are negotiated -- to an average of about six times franchise cash flow.

I would also point out that the purchase price could be affected by many factors. That includes geographical demand, the capital requirements of the restaurant -- is it due for a remodel? If so, that certainly factors in. The growth commitment by the franchisees -- how much growth is in that area, and how much they're willing to sign up for ahead of time, commit to. And these are contracted -- contractual commitments that they're making. They have incentives to continue, and also penalties if they don't.

So all those factors go together -- okay. So due to these factors, and the variability of the company cash flows, we've sold units for a wide range of cash flow multiples, but are comfortable with the accretion and the ultimate cash flow contribution on both an aggregate and a standalone basis from these transactions.

It is important to note that the financial analysis I just went through does not incorporate, in any way, the growth potential of FGI. So far this year, we have signed commitments for 71 new Denny's. Thirty-five of those are directly attributable to FGI transactions. So the incremental royalty income from these units is all upside to what is already an accretive model.

I know I just gave you a lot of numbers, and hopefully the transcript should be available from the various commercial outlets. The replay of this call will be available both on phone and on our website. Also, early next week, we'll try and get a slide posted onto the website that runs through these summary numbers. And as always, I am available both this evening and tomorrow to answer any questions about that.

Hopefully, we won't run through a lot of the numbers in our Q&A now -- let's try and hold that offline. But we will certainly try to answer them if we can.

And with that, let's move to the Q&A.

(Operator instructions).

Your first question comes from the line of Reza Vahabzadeh, with Lehman Brothers.

Good afternoon.

Hi, Reza. How are you?

Good. Your traffic trends were weaker than preceding quarters, and obviously, your price was also stronger. Was that in line with your expectations? And did that traffic trend sort of stay relatively stable during the quarter? Can you talk about that, please?

Reza, it's Mark. As far as expectations on the traffic side, I think -- as I said in my remarks, and Nelson emphasized as well -- you know, it's a tough environment out there. So clearly, we anticipated that traffic would be negative in the quarter. It's just a very challenging operating environment. I think, as we mentioned, we focused obviously very much on the menu mix side, and also on margins, to make sure that we obviously flowed as much profit through the P&L as we possibly could.

I guess the critical element here is that we did have positive same store sales, but it is a difficult traffic environment.

Would you say the traffic trends, as challenging as the environment was, was it -- did it worsen, or stay about the same during the quarter?

Really, throughout the quarter, I think it was relatively -- sort of in that camp, as one might say.

The one thing I'd add to that, Mark, is -- you know, we do have different promotional activities that go on, and they're certainly not tied to the quarter, so they run across quarters and in between quarters. So that can vary, if we're doing -- again, going back to our point about, we do have some promotional activities that are traffic-driven, and we have other activities that we're doing that are more check-driven. And we're trying to solve for the best outcome of both.

It is definitely a difficult environment to drive traffic, and we're trying to make sure we do what is the proper outcome from sales as a whole.

Right.

Reza, it's Nelson. I would say that the decrease in guest counts of 4.5%, as Mark indicated, certainly was disappointing, but not a surprise.

Got it. And then, can you comment on the competitive environments from peers that you compete directly with, and other chains that you compete indirectly with, if it got more competitive, or is everybody just raising prices and so it's a stable competitive environment?

I would go with your latter example. I think everyone is trying to figure out what to do, but the competition really hasn't changed. All of us are taking price, some more than others, and we continue to operate in a difficult environment.

Okay. My last question is that your food costs and payroll cost ratios were relatively flat year over year. I assume that's because of pricing. But then your occupancy and other operating expense ratios worsened, year over year. Can you just comment on that?

Sure. As we said in our script and in the release, the occupancy was general liability expense. So we had some unfavorable cases that developed there. Frankly, GL has been a positive for a couple of years, and we certainly hope that it will continue to be a positive to our results going forward, but there were some unfavorable developments in this quarter.

And the same thing really is true on the legal side, which hits in the other/other. And you can see the breakout of that in the back of our press release.

Yes, you provided a lot of information, but just -- sometimes it's hard for us to get through all of it. But thank you very much.

I understand. Thanks, Reza.

Your next question comes from the line of Mike Gallo with CL King.

Hi, good afternoon. Congratulations on a good quarter in a tough environment.

Thanks, Mike.

A couple of questions that are really -- I guess, a two-part question. Obviously, you gave a lot of detail on the FGI, which we certainly appreciate. One or two areas that I didn't hear you hit on the FGI -- perhaps I missed it -- is one, whether you've determined at this point how many company units that you need to operate to have kind of skin in the game. Obviously, some of your closest peers operate as few as six company restaurants.

And two, I was wondering, on a longer term basis, as you start to see 100 unit type transfers from company to franchisees via refranchising, what kind of G&A savings that you would expect those kind of reductions should ultimately generate?

Thank you.

Well, I think -- no, we don't know, and we tried to say that again. We don't know the ultimate outcome yet, and I don't think we will. As we go through the process, we'll learn more -- we'll learn more about the demand. I can tell you, I don't see it being six units, back to your point on that one.

And we've said it a lot. There are -- we have units that -- going back to my quintile discussion, in my remarks. We have -- the top two quintiles make a whole lot of money. And it is going to be very challenging to sell those units. That is not what our franchisees have typically wanted to buy. They have typically wanted to buy the lower cost of entry, the lower risk units, which are at the other end of the spectrum.

So we don't know how far that demand will stretch yet, as Nelson said in his remarks. We're very encouraged by what we've done so far, and we're going to keep moving forward. But we don't know what that ultimate outcome will be.

And Mike, I forgot what the second part was.

The second part was, as you start to really peel off chunks of these units, as you're now doing, what kind of -- is there a G&A per unit, or per 25, or per 50 unit type reduction that we should think about, on a company unit basis?

Well, there were -- again, back to my remarks, there's -- we're putting $15,000 as a placeholder for field management structure. That's more -- that actually primarily hits the cost of goods sold, or in the payroll line.

I think what I'd like to do, from my standpoint, and I'll let Mark jump in, is go back to the realignment that we did. I mean, that, in some ways, began to deal with this changing of our business model. And we have expanded some spans of control, and changed the way we managed the business through the realignment.

There were some savings in G&A there as well, but the one thing to keep in mind is one of the things that Nelson talked about, is the growth initiatives that we're working on require G&A. We are making an investment in new concept innovation and franchise development that does require some additional G&A.

So we certainly expect G&A savings down the road, but -- and probably, even some savings in the near term. But that may not show up as much due to the investments we're having to put into new concept innovation.

Mark, do you --?

And Mike, I think we also spoke about the fact that we've also invested back on the training side. So again, I think that with growth comes additional G&A investment in the appropriate areas, clearly like in the new store development piece, with the type of the development agreements we're signing with the franchise community. That obviously will require additional resources in our development team internally here.

So there's some tradeoffs there, but again, the whole model is around growth, profitable growth.

And Mike, it's Nelson. As with all the information that we're trying to share with everyone today, everyone wants to know what is the optimal mix. And as I said in my remarks, we've really put in place a disciplined process to ensure that we really balance our objectives of timely execution, meaningful value creation, and growing the Denny's system.

And we're -- we'll continue to pursue those FGI transactions as long as we can meet those objectives. That's the key. And that's why -- we're not trying to be vague. We're trying to be as candid and upfront as we can. But I don't know that we know the answer yet.

And as we know it, we always address these kinds of things on a quarterly basis. And I think you need to understand, from a G&A standpoint, we're still a publicly traded company, we still have to meet audit requirements. The legal department's not going away, the finance department's not going away. It's about processing -- you know, we may sell 100 restaurants this year, but really, the processing of invoices and receivables and the like really doesn't change that much, even with 100 stores, when you're working on a base of 1,500. There's a basic minimum that we have to have.

So I would let you know that we are going to be as aggressive as we can on G&A, but I think Alex has really provided you with some excellent direction today.

And we appreciate the direction on that very much, and also appreciate your candor. And again, congratulations, and good to see Denny's in a growth mode again.

I couldn't agree with you more. Thank you.

Thanks, Mike.

Your next question comes from the line of Dean Haskell.

Hey, Dean.

Thank you. Congratulations, gentlemen.

Thank you.

My questions go more towards the -- can you break out the fee (technical difficulty) of the franchise royalties in the quarter? By the way, the Q is just now up on the SEC website.

Yes, and that will have it in there for you, Dean. But I think it was about $1.2 million, if I remember right. [Jay], have you found it quicker than me? Yes, about $1 million -- yes, okay, I got it. About -- in the quarter, the fees were $1.2 million, the initial fees in the quarter. That's compared to $300,000 last year. And so that was the $800,000 increase we talked about.

But that will be in the Q, broken out for you.

Right, and I'll get that. The legal settlement in the quarter, that was about a net -- I think it was a net $1 million between this year and last year. Can you talk further about that, both last year and this year, a $2.4 million swing?

Last year, we actually -- I think, if I remember right, in the second quarter, we had some expense that later turned out we were able to take back. So we had a benefit in the third quarter last year.

This year, we did have two cases that developed unfavorably, and that cost some charge in the quarter. So it was really exacerbated by the benefit last year.

So they were all related to workers' comp issues?

No. No, they weren't.

Okay, so that's what I'm asking. What are these legal settlements? What are they pertaining to?

Well, last year -- Dean, it's Nelson. Last year, we had reserved for a wage and hour lawsuit, and we had a favorable settlement to our reserve, which amounted to -- I think, about $800,000, as I recall.

This year, however -- and I know at least one of them made AP, on the press -- it had -- one had to do with workplace environment, and the other one had to do with alleged discrimination, and we received an unfavorable ruling from the jury. Those were the two issues, as I recall, and they were split evenly, pretty much, on the settlement costs, of that $1 million odd that you just mentioned.

Okay, that's right. I do remember the alleged racial incident. Are you taking any of these to further court, or are these done?

Well, one of them, we are not. The one that occurred, that alleged racial discrimination, we have filed with the judge. The judge has not yet ruled on what the ultimate settlement will be. However, we did take the charge, and financially assuming we don't get the benefit of his ruling.

Okay. My last question, taxes dropped off pretty dramatically as a rate of -- net of pretax income. Can you give us some guidance on why that happened, and then into the fourth quarter?

Dean, you've been around long enough to know, watching our taxes will just drive you nuts. It is -- it's going to continue to be -- it's not that it dropped off. Last year was primarily related to the asset sales last year, so I don't think this year's number is that outside of what we've typically been expensing. Last year's number clearly had the impact of all those capital gains in the asset sales.

Right, I know --.

But no, I can't give you any guidance for the fourth quarter.

Okay. I've been running around 20% for the year to date after second quarter, and now we're below 10% in the third quarter.

I mean, again, when you're talking about how small our tax numbers are against these big numbers, it's going to be very variable.

Thanks, okay.

Maybe solve for the year to date effective rate, I guess, would be the best case.

Your next question comes from the line of Steve Anderson with MKM Partners.

Hello, just a couple of quick questions. With regard to the liability insurance, do you see that as a recurring expense? Or is that just a -- limited to what you saw in 3Q?

Well, we certainly will have ongoing expense there, but we do feel like this quarter did have -- was an anomaly. We've -- again, as we've said before, we've had fairly favorable, both on a workers' comp and GL, our trends have been very -- have been improving for a couple of years now, so we've been very proud of that.

So yes, we had a few cases this quarter that had -- cases that had been existing that had unfortunate developments, so we had to take more reserve. But I think -- we don't expect that to be continuing at that rate.

Okay. And my next question concerns what we saw with the wildfires in Southern California. Have you seen any business disruption, either with regard to restaurant openings and closings, and supply distribution?

I don't think we've seen -- the restaurant openings and closings, actually something we talked about today, that has evidently had a labor impact in that regard. Let me go back to just impact overall. We've not seen a material impact from the fires to our business.

Denny's traditionally does very well in these types of environments, post -- post issue. Yes, we have sales up, and if you go back to the hurricanes or other issues, we're a place that people can go to when they're displaced, and we get a lot of traffic that way. We get Red Cross traffic, we get our National Guard traffic, so we tend to offset any lost sales with higher sales while we're open. So I don't think that's been an impact.

We have heard about, on some of the openings and those things, maybe there's some labor impact. I don't know about distribution. Nelson, have you heard anything with that regard?

We haven't had any distribution issues. Our distribution provider has done an outstanding job in making sure, candidly, with these increased volumes that we experience, as Alex pointed out, has actually provided us with additional deliveries to keep us in product.

So we haven't had distribution issues. My understanding, up until this point, and this obviously is subject to change -- we're not out there. So but what we understand is, it's only been seven stores that have had to go through closings and openings, and somewhat repeatedly. Some closings have been as short as a few hours. Others, on the company side, were, I think, almost three days. We only have one restaurant that we're aware of -- currently a franchise restaurant, in Ramona, California, where water is not available, because for the firefighters, they had to drain the reservoir, literally. And they are having to work through -- and, they didn't have power.

So we've still got one restaurant in Ramona, I understand, that is down. I spoke -- actually, I met with the franchisee day before yesterday, and the last information that he had, he felt that he would be up and running again, from what he's being told by local authorities, by the weekend.

Okay, thank you very much.

You're welcome.

Thanks, Steve.

Your last question comes from the line of Tony Brenner with Roth Capital Partners.

Thank you.

Hey, Tony.

I'm just kind of curious. Denny's is probably impacted in the current environment more than many of your competitors, partly because of the profile of your demographic, but also partly because so many of your stores are located on interstate highways. And that has historically been a strategy, to place stores in those locations.

A lot of people think that energy costs are high permanently, that they're not going to come down meaningfully, and might even continue to go up.

I'm wondering if, strategically, you've thought about pursuing the same strategy -- locating half of your stores on interstates going forward, or if you might change that mix somehow? Or if even, on depressed sales, highway stores are economically still more attractive than other stores?

I would suggest -- it's Nelson, Tony. From what I can tell currently, although gas is about $0.50 higher than it was, let's say a year ago, I really don't -- that's just one more thing. I don't think it is the thing. I think what we're seeing, particularly in Florida and California, is a reaction to the housing market slump, and the subprime loans.

I think we're certainly holding our own, if not better than many of our competitors in casual dining, I think we are competing. And I -- with the fast food side, the QSRs providing that level of value, and that's why we're looking at these other strategic initiatives that we mentioned earlier in the call to address.

But are we avoiding interstate locations? Honestly, no. Are we looking more at residential? When it makes sense in tourist locations or in neighborhoods where we're well established, we still are seeing our franchisees as well as ourselves building in those markets.

So strategically, I haven't seen a lot of change in that -- in site selection.

Are the AUVs and store margins larger on -- you know, on average, in the interstate highway stores than in the town centers?

No, I wouldn't split it that way. I look more at East and West, and Midwest, and South, and Southwest. That's where you'll see the profitability breaks.

And Tony, it's Mark. I think the other aspect of where we have stores is, when we are in key tourist locations, whether that's Las Vegas, or around Disney, and Orlando, etc., obviously those stores do extremely well from a business standpoint.

Sure.

And I think that the other follow-up point I'd make, as far as the question on interstate locations, as Nelson mentioned in his comments, the growth opportunity that we have with Pilot, and Pilot being just an excellent partner for us. And obviously, they're developed heavily on interstate locations, and actually are true destination points.

So we're obviously very excited about that kind of strategy.

Thank you.

Thanks, Tony.

Mr. Lewis, I am showing that it is approximately three minutes until the hour. Would you like to continue taking questions, or begin your closing remarks?

Yes, we'll take one more.

Your next question comes from the line of Karen Eltrich with Goldman Sachs.

Hi, guys. Congratulations on the Pilot Travel arrangement. That does sound like a perfect fit for you. I'm curious though, on how the economics work. Do you guys pay them for the construction? Do you pay a rent to them?

And also, how large is this growth opportunity? In the press release, it says that they hope to open 20 to 25 per year. In addition, is there any potential for existing units to have conversions to Denny's restaurants?

Karen, this is Alex. Well, we don't know yet. As we said in the release, we've got one that's being built right now. We hope to get it open by year-end or soon thereafter. We've got a few more that are going to be -- and it is a mix of new locations and some of their existing locations, so we're trying both.

I don't think we know exactly what the outcome will be, and how many of those 25 or so they're going to build a year, they will choose to put full service in. I think that a lot depends on how well it goes.

Certainly playing any role in that will be very additive to our growth profile, and I think there will be opportunities inside of their existing to convert as well, assuming things go as well as we hope they do.

And at this time, Karen -- it's Nelson -- they are, in fact, our landlord. It is a traditional lease relationship, with the appropriate requirements. So at this point, they're acting as a landlord for either us, or selected franchisees.

And do you fund the construction of the units?

I'm sorry?

The interior -- the build out interior. They sort of provide the shell, and we [bed] out the interior, as we would in any strip center or any of those kind of developments.

And so, what is the cost per unit for that?

Well, we haven't done one yet.

Okay.

We'll give you that.

We're in process, but it pencils very nicely.

Okay, I would figure. Thank you very much.

Thank you, Karen. Take care.

I think that's the last question, so we appreciate everyone's being here tonight. Again, I'm happy to try and answer any questions, and we look forward to talking to you next quarter.

This concludes today's conference. You may now disconnect.