達美樂 (DPZ) 2006 Q3 法說會逐字稿

Good morning.

My name is Tamia and I will be your conference operator today.

At this time I would like to welcome everyone to the 2006 third quarter earnings 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]

I would now like to turn the call over to Lynn Liddle, Executive Vice President of Communications and Investor Relations.

Thank you, Ms. Liddle, you may begin.

Good morning, everybody and thanks a lot for joining us as we review the results of our third quarter.

With us today we have our CEO, David Brandon, and our CFO, David Mounts who will each make individual comments and then we'll open it up, as Tamia mentioned, to Q&A.

Just some housekeeping for you, though, we do not make a practice out of projections and forward-looking statements, but to the extent that something like that is mentioned on the call, I will refer all of you to our Safe Harbor statement which is both in our press release and in our 10-Q.

And we ask members of the media to be in a listen-only mode.

So with that, I will forward it over to Dave Brandon.

Good morning, everyone.

For anyone who wants to familiarize themselves with the strength of our business model, the third quarter of this year will provide a great lesson.

We continue to show an ability to cope with weak domestic sales cycle and still produce strong earnings and strong cash flow.

We think that's evidenced by the 30% EPS growth we achieved despite a 3% decline in our domestic sales.

We want to emphasize the fact that globally we're very proud of the same store sales record of our international business unit.

They had their 51st consecutive quarter of positive same store sales growth, and I want to, as I always try to do, give special recognition to our international master franchisees and our team members for their great work and outstanding results.

Our international unit remains both a stable and growing sector of our business and we're very proud of that.

Domestic and international new store growth remains healthy and positive and pretty much on track with our plans and projections.

I always try it focus you on our trailing four quarter net store growth performance which is just under 300 stores at the present, but I would also bring to your attention that we have always had a very strong fourth quarter in terms of store growth, particularly domestically.

It's just the way it happens, and so we believe that by the time the year is over, we will be right in line with the kind of rate and pace of growth we've experienced in the past.

During the quarter we also closed our previously announced sale of the corporate stores in the Netherlands and France to our Australian and New Zealand master franchisee who is one of the best operators we have within the Domino's worldwide system.

This transaction created a $0.04 per share gain and it show cases our commitment to continued international growth and our dedication to supporting and rewarding terrific master franchise partners like our friends in Australia.

Domestically we use our corporate portfolio in a similar way, and this quarter we sold 12 of our domestic stores to one of our great young franchisees, Jason Shifflet, who was both eager and ready for more stores and additional growth, and so we've provided him with that opportunity.

Now, back in the second quarter we touched briefly upon the negative traffic counts that we were experiencing and the general lack of momentum in the category, and with this trend continuing in the third quarter, I thought I should spend a little bit of time and give a little color on what we have been seeing as far as consumer spending trends in this quarter.

Given our reach, we deliver about a million pizzas a day, we do have a pretty rich database in terms of a sense for what's going on out there in various markets and regions, and we also, obviously, have access to a lot of third party research.

Now, as noted in our second quarter call, we sensed a general softness in consumer spending and that continued through the third quarter.

We are not sure how much these various factors played in terms of the impact, but the high gas prices that were certainly in place for a good part of the quarter and the impact that had on our core consumer, rising interest rates and variable loan mortgages and the burden that that puts on our core consumer, and just a general consumer sentiment and spending patterns that we were seeing, not only internally, but in the world around us, we felt all led to a continued softness in consumer spending in our channel.

For us, at Domino's and many others in the restaurant segment, traffic counts were down, and those with higher guest checks saw bigger declines than those with lower check, average checks, kind of at the bottom of the spectrum, and as we looked at the third party data, it really confirms that.

Generally speaking, fine dining saw traffic declines, casual dining saw traffic declines, and in our segment, pizza delivery, is always going to have the highest developed ticket.

And particularly our ticket, as a result of some of the activity that we had going on last year which really bumped our ticket higher than it even normally has been, created a situation where we were going to get a bigger brunt of consumer spending patterns out there than a lower ticket aspect of the channel like carryout.

Generally speaking in these kind of conditions, carryout being a few dollars less on a per-order basis, is going to do better and perform better, and we've seen that here at Domino's.

Our carryout mix has increased, and that just tells us that that shift occurred during this period of time and it's very indicative of the consumer attitude and spending patterns that we're experiencing.

Consumer sensitivity to higher price points during this quarter was a further impact on us because the major part of the quarter we had planned for and executed a promotion called "Super Six" which really required an $18 check minimum.

So in retrospect we were out there with a promotion that really was asking the consumer for a higher than average check, and during a time when the consumer was really resisting that type of an offer, and as a result of that, and all the other factors I mentioned, we continued to suffer from a quarter where traffic counts were just not where we had planned them to be.

During the latter part of the quarter we launched our oven-baked brownie squares as our national promotion, but it only happened at the very end of the period, and although the promotion got off to a very good start, it really didn't have enough impact on the quarter to make much of a difference.

So needless to say, we continue to work very hard to regain our sales momentum during a time when everyone's struggling to create sales momentum, and we're out there doing everything we know how to do based on our 46 years of experience and our track record of having 12 consecutive years of positive same store sales growth, we're pulling out every trick we know to try to fuel some momentum and create a more positive trajectory as we start thinking about 2007.

Stepping aside from that for a moment, I just want to say that we continue to fulfill our commitment to our shareholders by using our healthy free cash flows to do some things that we think are very shareholder friendly: We continue to pay an industry leading dividend, we paid out $7.5 million in dividends this quarter, we paid nearly $15 million in dividends to date.

We executed accretive share purchases when opportunities arise, and you saw that earlier this year, and we continue to opportunistically pay down our debt.

And with all that happening from a balance sheet perspective, and a dividending perspective, the most important thing is we continue to invest in our products, our operational execution, and the technology that we need and want to take us into the future.

With all of that, I'll wait to visit with you further during the Q&A period, and I'll turn things over to David Mounts, our Chief Financial Officer, for more insight on our financials.

Thanks, Dave, and good morning, everyone.

As Dave mentioned, the third quarter demonstrated one of the key attributes of our business model.

With continuing strong international performance we were able to post positive earnings growth in a weaker domestic sales environment.

Let's review what drove our net income growth starting with our top line.

Our global retail sales increased 3.1% during the quarter.

This was driven by same store sales growth in our international business and increases in our worldwide store counts of 293 units over the trailing four quarters.

As for the same store sales numbers, domestically our same store sales decreased 3.1% for the quarter, company-owned stores were down 2.3% rolling over a 4.2% increase in Q3 of 2005, and our franchise stores dropped 3.2%.

They were rolling over a .7% increase in Q3 of '05.

As for international, same store sales increased to 3.0%.

This is very impressive considering last year's positive 4.5% for the same period.

Driving global retail sales were our worldwide store accounts.

We added 48 net new stores to our portfolio during the quarter.

As I mentioned earlier, we had 293 units, 219 of these came from our international group.

Moving on to the income statement, our total revenues for the quarter were $326.7 million.

We remind you that the revenues are not the best gauge for our top line growth.

We prefer that you look at the global retail sales metric, and nearly $11 million decrease in our revenues, or 3.2% was driven by lower volumes in our distribution business, the sale of our corporate stores in the Netherlands, lower domestic same store sales and lower cheese prices, which accounted for $9.5 million of the decrease in revenues.

The average cheese block price in the third quarter was $1.19 a pound versus $1.48 last year, a nearly 20% decrease.

This benefited our team USA margins, but it lowered our distribution revenues.

We continue to believe that global retail sales which increased to 3.1%, versus the prior year that I mentioned earlier, is the best gauge of our top line performance.

Because of these other changes in store mix or commodity prices, our revenue line is sometimes skewed, and it also can have an affect of artificially spiking our margins from time to time.

We saw this again in the third quarter.

The decrease in cheese price lowered our year-over-year revenue comparison by $9.5 million, however, the cheese and other price changes didn't have any effect on our retail sales.

Next our bottom line earnings.

We posted a $0.39 per diluted share number in the quarter, it's a 30% increase from year ago levels driven by strong performance in our international business, lower food prices, primarily cheese, which positively impacted our company-owned store margins, continuing to flex our spending in a soft domestic sales environment, and the gain on the sale of the company-owned operations in France and the Netherlands as well as a gain on the sales of the 11 team USA stores sold to the existing franchisee mentioned by Dave.

All of these contributed to the results.

Additionally, we benefited from share repurchases over the past year.

We lowered our weighted average share count to 63.4 million shares from the 68.2 million shares last year in quarter three.

Here's more information on the gains that I just mentioned.

First, as we reported in the second quarter we signed a stock purchase agreement to sell our company-owned operations in France and the Netherlands.

The sale closed in the third quarter on July 3, 2006.

During the second quarter we recognized the tax benefit of approximately $2.9 million from the realization of deferred tax assets relating to these operations.

We accounted for the remainder of the transaction during the third quarter and we recognized the gain of $2.8 million driven primarily by the recognition of foreign currency translation adjustments.

We also sold 11 team USA stores and this resulted in a pretax gain of $700,000.

Moving onto financial leverage.

Our total debt was $740.9 million, a $3.3 million increase from the end of the year.

This came from our additional borrowing of $100 million, that along with $45 million of cash from operations, was used to fund our share repurchase in Q1.

It was offset by $95 million of voluntary prepayments of our term loan through the third quarter.

The effective rate on our borrowing has gone from 6% in the Q3 of '05 to 6.6% this year.

That's due mostly to market interest rate changes.

Our interest expense was $1.9 million higher at $13.6 million for the quarter.

Our total leverage ratio stood at 3.0 times EBITDA down slightly from our 2005 year-end leverage ratio of 3.1 times.

For capital expenditures we incurred approximately $14.8 million of Cap Ex during the first three quarters.

This is down from the 20.7 we spent in the year ago period.

In last year's number we had included in there some Cap Ex related to our world resource center which is now complete.

The last item I'd like to mention is that despite our challenging quarter we continued to generate significant free cash flow, which we define as cash from operations less capital expenditures.

Free cash flow from the first three quarters of 2006 was $75.3 million versus $70.4 million for the prior year.

So far in 2006 we have produced a free cash flow yield of 7.5% versus 6.7% in the prior year.

This metric is sensitive to changes in revenues due to changes in food prices and distribution, so we look at it in terms of dollars of free cash flow per share as well.

We were at $1.16 year-to-date compared with $1.02 in 2005 against our diluted weighted average shares.

To further prove my point, in the slightly more than two years since our IPO in July of 2004, we used cash from operations to repay approximately $220 million of debt.

We used approximately $220 million to repurchase shares, and we paid dividends totaling over $52 million.

Again, as I mentioned earlier, we are in the business of putting dollars into shareholders hands, and our business delivers in soft or weak market environments.

For this reason we believe our model is less risky than many of our industry peers.

This concludes the financial update.

Once again, we want to thank you for your time today, and with that Dave and I would like to take your questions.

[OPERATOR INSTRUCTIONS] Your first question comes from the line of Mark Kalinowski with Buckingham Research.

Hi, everyone.

Just wanted to kind of revisit the sales trends so far that we've seen this year.

Certainly, part that far reflects the difficult comparisons both on a one-year and two-year basis.

Just want to get your sense as to how you can communicate, though, that that does not represent any slip in the operational execution of the Company.

Yeah, Mark, this is Dave.

We have a number of metrics to measure changes in our operational performance, and the ones that are most important to our customers are our out the door time measures, which really leads to our percent on-time delivery, as well as our product quality measures through our internal OER ratings process.

And I can tell you that, actually, if you look at where we are this year versus last year, we're actually better.

Now sadly, one of the reasons we're better is when you're not handling as much volume spike as we were last year, it puts less pressure on your operations.

So a year ago I would have told you that we really needed to do better than we were doing because we were really jamming big increases through our stores.

But where we are today operationally, we didn't wake up one morning and forget how to operate, in fact, I think we're a little better.

From a marketing standpoint, again, I think we're doing all the things that we know how to do.

We're just in an environment right now where traffic is very, very hard to come by for everybody, and sadly, at least year-to-date, we're being impacted by that, and we're working hard to try to overcome it.

Thank you.

Your next question comes from the line of John Ivankoe with JPMorgan.

Hi.

Thanks.

A couple questions if I may.

First, obviously, you experienced some weakness in consumer traffic in the first quarter, second quarter, and into the third, and the product that we currently see advertised is without a price point, it's with the purchase of a, and it's free with the purchase of a full-price pizza, and most consumers know that the pizzas that they're used to buying it's somewhat of a price or somewhat of a discount, a promotional effort.

So I mean, I guess could you frame to us just in terms of like what kind of message you're trying it get through with the consumer today and if we should expect perhaps a change at some point in the fourth quarter to maybe bring back some of that traffic that you've described as being elusive?

I don't want to comment on current promotions, and I'm not going to certainly comment on what our plans are going forward other than to say that what we have been working on and what we will continue to work on is delivering our very, very best tested products to our national rollout windows that show the greatest promise of generating traffic.

So the promotion you alluded to, the brownie promotion, if that had not shown an ability to drive traffic in our test market experience, we would not have rolled it out.

Okay.

And actually that's actually very good because it's very good color.

It may be what is seen that that could have been an average check-driving promotion, not necessarily a traffic driving promotion but you, in fact, are describing it as a traffic driving promotion.

Yes, and it's a great question because over time our strategies adapt to whatever's happening in the marketplace.

Once in a while you'll hit a promotion that gets both traffic and ticket growth, and we had a promotion last year that did that and drove extraordinary sales results driving up our ticket at the same time it created a lot of traffic.

Where we are today is that we clearly understand the need for trying to accelerate the number of calls we're getting to our stores, so everything you see us doing is going to be targeted towards that in an effort to make that happen.

Could you -- for the third quarter and if you feel comfortable in the fourth quarter talk about your advertising weights year-over-year, if they had changed?

No appreciable -- I think I said this before, there's been no appreciable level of front loading or back loading.

A lot of what drives that question is GRPs specific to TV, and weeks on TV.

We obviously took a step forward in that regard this year by being up on TV a little bit more as a result of the rollout that we described earlier.

But having said that, we're also doing a lot of other things with print and technology to, hopefully, do a good job of rounding out our calendar and our promotional events.

So I would tell you there's no anomalies in our performance that relate to anything that we're doing differently in the weights and the investments that we're making in marketing.

We're just still having a hard time exciting enough consumers to stay as busy as we want to stay in our stores.

And one more question if I may, and this is on a completely different topic, maybe it's for David Brandon or David Mounts.

You know, you kind of described being at a debt to EBITDA ratio of three times, and you've obviously reported what your Cap Ex requirements were for 2006.

I guess especially where the stock is today and your intent of returning cash to shareholders, what is your future attitude towards increased leverage or paying off debt?

You know, it's in terms of you're going through a very tough time.

What type of capital structure are you comfortable with going forward as an ongoing business that doesn't want to feel any constraints through its balance sheet?

Well, one of the best ways to answer that question is to refer to history, and you can see a couple of examples, in my nearly eight-year experience here at Domino's where we have, in fact, ramped up, you know, to nearly six times, and we've been very comfortable, and you can go back and see how quickly we have been able to deleverage the Company in that environment and how comfortable we are doing that.

I think another thing for you to focus on is when you look at this year from a sales -- from a domestic sales perspective, this is the toughest year we've had in a long, long time.

Yet if you look at how we're performing, and the numbers David shared with you in terms of our earning and our cash flow, anybody interested in looking at the debt worthiness of this company will tell you that if in a year like the one we're having, with our domestic engine sputtering a little bit, we can still produce the kind of cash flows and be as stable as we are, I think is another vote in favor of the fact that this is a company that can handle a significant amount of leverage.

So with those two data points, I'm not going to predict the future, and I'm not going to signal anything we may or may not do, but I will tell you that this management team is very comfortable operating in an environment where this company has a significant amount of more leverage on the business than we currently do.

That's great.

Thanks so much.

Your next question comes from the line of Joe Buckley with Bear Stearns.

Hi.

This is actually Joe Fisher sitting in for Mr. Buckley.

One question, or a couple questions.

With gas prices falling, is there risk that the delivery surcharge is going to be removed?

The delivery surcharge that we're -- that the industry has embraced, I think we've commented when this was kind of a newer phenomenon in the industry a couple years ago was basically a strategy that we were a follower as opposed to a leader.

So our response was if everybody in the market is offering one, or putting on one of these delivery charges and putting us in a position where they can advertise more aggressive price points than we can because of the subsidization they're getting through this delivery charge, then that's a problem for us and we're going to have to match them, and we have.

So it's built in now to the equation in terms of the financial model of the average delivery store in the U.S.

I think the vast majority of stores and markets have a delivery charge.

As best I can tell, it is afforded the industry the ability to promote more aggressively and it's been kind of baked into the P&L.

I don't see it going away, but I also think that the industry is, in light of our current traffic situation, is going to have to be very, very judicious about whether that is a charge that they increase or see as a way to increase price in the business.

I think that's one of those things to watch, but my personal prediction would be that it's highly unlikely, despite the fact that in the near-term or in the recent past, fuel prices have declined.

It's hard for me to imagine a world where the delivery charge goes away.

Okay.

Great.

Thank you.

And you mentioned that the brownie promotion looked good, got off to a good start, I believe you said, but was too late to have a real impact.

Is it still going pretty well?

Is it driving traffic like you had wanted in the test markets?

Yes.

We don't comment on the performance of promotions ever because not that we wouldn't love to talk to you about what's going right and what's going wrong, but just because we think that that's proprietary, and I would love for our competitors to give detailed accountings of what's working and not working with their promotional topics.

We just can't answer that question.

I did comment that we did rollout a new national window at the very end of the quarter, and what's most important is that, at least initially, the promotion performed very similar to what we experienced in tests, but it was only at the very end of the quarter.

Okay.

Great.

Any updated thoughts on the Bain stock?

No updated thoughts on the Bain stock.

Okay.

Great.

Thank you.

You bet.

[OPERATOR INSTRUCTIONS] Your next question comes from the line of John Ivankoe with JPMorgan.

While I have you on the line, do you have any intelligent view on cheese costs for 2007 in terms of which way the market might go?

John, I love the way you framed that.

I quite frankly don't have one myself, which is why I ask.

John, I was teasing because I love the way you framed that because we have a view, it just isn't intelligent.

We have no idea.

Our view is that this year on average, the average price per pound of cheese has been lower than what we would call normative levels but we wouldn't call it low.

I mean we've experienced much lower in periods of time in terms of cost of cheese.

When we think about next year, all we do is kind of plan and budget around normative levels.

It's all we can do and we figure if we just take that historical average and we use it in putting our plan together, at times we'll be the beneficiary of lower prices, and at other times we'll be the victim of higher prices.

But that's kind of how we think about next year.

And how important is the actual flour cost to you all?

Wheat is obviously getting a lot of press right now.

Is that something that's important to the system?

It's a very low percent of the cost of the pizza.

Cheese is 35% of the cost, and depending on the topping combinations, the impact of flour and sugar and some of those ingredients is very, very small.

Probably packaging would be a bigger impact to us than specifically flour.

Thanks very much.

Yes so not something that, you know, it's some we watch and it's something we try to buy prudently, but it's not what I would consider to be a material issue.

Your next question comes from the line of Joe Buckley with Bear Stearns.

Great.

Hey, it is Joe Fisher again.

One more for you.

Regarding the national ad fund contribution, the increase for 2006, are you all committed to spend that in 2006?

The way that works is that the money is accrued during 2006, and we have policies and programs as it relates to what we call cushions that we carry over from year-to-year, just to protect ourselves and make sure that there's ample resources there so that isn't is a zero-sum game.

We manage it prudently depending on what our needs and our opportunities are in the fourth quarter.

Generally speaking, we try to deploy most of the money that come in in a given year against the marketing opportunities in that year, and with a reasonable cushion that transitions over into the new year, that's kind of how that thing perpetuates itself.

Okay.

So there's a bit of flexibility.

Yes.

There is a bit of flexibility.

We certainly don't spend money just because it's there.

We spend money when we feel like we have a [medium] buy opportunity and we always leave some in reserve for those opportunistic buys.

Okay.

Great.

Thank you.

You're welcome.

Your next question comes from the line of Steve Loeb with Yellowfan Capital.

Hello.

Hello.

Two questions.

The first is, in terms of the domestic same store sales, you talked about the consumer environment, gasoline prices, interest rates, et cetera.

How much of it do you attribute to competitive impacts because at least some of your competitors actually seem to have been doing okay as far as same store sales growth in the states?

Well, when you say some, that's not the data that we have.

When we look at the major players across the category we see everybody in a negative traffic mode, some more than others, but everybody's negative in traffic, and we do have a couple of players who were better positioned to take advantage of ticket growth, and if we had a lower ticket this year coming into the year, if we'd have had a different strategy last year, we would have had more upside.

But those players in the delivery segment that had a lower developed ticket can continue to show some same store sales growth this year by simply employing strategies that get the ticket up despite the fact that traffic is hard to come by, that's harder for us.

Generally speaking, we think what we're experiencing is pretty much across the channel just different players or different, are either better or worse, are either more positively or more negatively positioned to deal with the environment that we're in.

Okay.

So you would not see any of the diminished performance as an instance where a competitor or a couple of competitors were taking market share away from you guys even though, of course, within the broad category they would be the exceptions to, you know, a slow traffic environment?

Well, the market share data that we're able to really able to focus on are the national players in the deliver segment.

So it's Domino's and it's Pizza Hut and it's Papa John's.

And what we can tell you is that Pizza Hut has struggled far more than we have in this environment.

They've been negative against negative a year ago and their traffic counts are down larger than ours based on the third party data that we're looking at, and they've lost more market share than we have.

We, to a lesser degree, have negative sales problems domestically as a result of the issues that I have already conveyed.

Papa John's, being the third player, is the one that we think has done a good job of getting growth through ticket.

I would be surprised based on the third party data we're looking at if Papa John's traffic situation is any more robust than the rest of us, but you'd have to ask them.

They're doing a good job in this environment getting more from ticket, and some of this has to do with, if you look at two and three year comps, some brands are better positioned than others as well.

So there's a lot of factors there.

But Papa John's is doing the best job and was positioned best to continue to stay positive sales in this environment even though I think we're all dealing with very, very slow traffic counts.

The second question was you mentioned that the fudge-ins promotion kicked in at the very end of the quarter.

I thought actually it was rolled out nationwide August 21st, which would suggest it was intact for six out of thirteen weeks unless there was some kind of a delay in getting it rolling from the nationwide rollout date that was advertised.

There is two things.

I think one, we need to go back and check the start date which we'll do now, but remember that we're on twelve-week quarters, so in the third quarter for Domino's you're in the 36th week of the year ending.

September 10th would be the end of the quarter that we're reporting.

Right.

And we had a soft opening with some print the first week, and then we hit TV and my recollection was we were only on TV two weeks of the quarter.

Okay.

So it only goes to the period September 10th, that would explain the disconnect.

Yes.

That I was seeing.

Okay.

Thank you.

You're welcome.

At this time there are no further questions.

Well then let me close things off this morning by thanking you all for joining us and even though our sales growth was less than robust domestically during the quarter, our track record is still what it is, and we believe that the strength of our business model is there for the world to see, and the management team of this company continues to work really hard to use all of our experience and all of our resources to get out there and continue to create as much momentum as we can in the domestic business despite a bit of a downturn that we're working our way through as it relates to the category and the overall economies in our business.

We thank you for your time today, and we'll look forward to speaking with you at the end of the fourth quarter.

Thank you for participating in today's 2006 third quarter earnings conference call.

You may now disconnect.