達美樂 (DPZ) 2007 Q3 法說會逐字稿

Good morning.

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

At this time, I would like to welcome everyone to the 2007 third quarter earnings 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 session.

(OPERATOR INSTRUCTIONS)

I would now like to turn the call over to Ms.

Lynn Liddle, Executive Vice President of Communications and Investor Relations.

Ms.

Liddle, you may begin your conference.

Thanks, Jason.

Thank you everyone for joining us this morning.

With us today we have our Chairman and CEO, David Brandon, our Executive Vice President of distribution and procurement, David Mounts.

And as our former Chief Financial Officer, David will be covering this call as he passes the baton on to our acting CFO, Bill Kapp, who is also with us today.

We'll begin with an overview of the quarter from Dave Brandon, and followed up by David Mounts, and then open for Q&A.

A couple of points before we begin is we will ask the media to be in a listen-only mode, and I'll also refer you to our Safe Harbor Statement that is in our press release and in our [cue] in the event that any forward-looking statements are made.

And with that I would like to turn the call over to David Brandon.

Good morning, everyone, and thanks for participating in our review of the third quarter earnings.

Dave and I will likely both take a couple minutes more than we normally would to walk you through what we would expect to be a lot of areas of interest based on the environment that we're in and the results that we are announcing today.

Our earnings per share this quarter was $0.17, which is $0.17 less than adjusted EPS for the third quarter last year, but let me make sure I quantify this gap.

The vast majority of it, $0.13 of it, is due to the added interest expense from the change we made in our capital structure earlier this year, which we've covered on previous calls.

We've had very positive investor feedback regarding our more leveraged capital structure.

We actually, as we look back, believe our timing for this recap was very fortuitous, and we know that our shareholders appreciated the $13.50 dividend we paid in the second quarter.

So, my focus today is going to be on the remaining $0.04 of earnings per share decline.

This is primarily due to challenges that certainly aren't unique to our company or inconsistent with the many topics we've discussed, back as recently as our second quarter earnings call.

In fact, we have been discussing these trends and issues with you for quite some time.

We are managing in a very challenging domestic operating environment.

This is due to continued traffic declines in our category, which are clearly a result of continued softness in consumer demand.

And since most of you know how our business model works, you know that decreased traffic causes a reduction in our distribution volumes, which results in a reduction of efficiency and profitability in this segment of our business, as well.

We also continue to battle the cost pressures from commodities and labor that I described in a fair amount of detail during our last call.

In fact, these commodities were higher at the end of the third quarter than they were at the end of the second quarter.

Our operators continue to absorb very large increases in food, packaging and labor costs, which have pressured us during the entire year.

As I detailed during our last call, we are doing our very best to raise prices to reflect the impact of these historically high cost pressures.

At the same time, we're trying to stimulate traffic growth in our category.

It's not an easy task when consumers and particularly highly price-sensitive consumers are getting hit with food price increases at every turn and are clearly reacting by reducing their spending across many retail categories.

Thankfully, these challenges and shortfalls are somewhat mitigated by the stellar performance that we continue to get from our international group as evidenced by this quarter's results.

We continue to celebrate the growth and progress our brand is making in so many regions of the world.

Now, we've talked before how may segments--how there are many segments of the QSR industry that continue to experience reduced traffic.

And we see this from our third-party research sources, as well as our own internal data.

We really believe that consumers are reacting to their tighter financial situation.

Now, while our local store marketing efforts, our national marketing topics, and our store level execution were able to help us buck the traffic trend last quarter, our franchisees in the U.S.

didn't gain enough momentum to carry that into the third quarter.

We feel bad about that.

Our Team USA unit was able to lift their prices at a faster rate than our franchisees, while at the same time doing a better job of minimizing traffic loss.

Consequently, they were able to keep their overall same-store sales slightly positive for the quarter.

However, our franchisees were slower to raise prices and actually experienced a higher reduction in traffic.

So, we need--we know exactly what needs to happen.

We need to get our franchisees embracing the many initiatives that we have launched in our corporate-owned stores that will help them close the same-store sales gap that currently exists.

We're working very hard to communicate these best practices and proven techniques to our franchisees across our domestic system.

Now, in addition to the work that we are doing with our marketplace organization, we try to ignite the energy and power of our franchise system in the U.S.

I want to assure you we are not sitting idling by at our world resource center in Ann Arbor.

We have worked hard to earn our reputation as a very proactive management team, and we are all over these challenges.

I have recently announced changes that I believe will help bring even more focus and energy as we address our domestic sales situation.

we recently announced management changes, specifically the promotion of Patrick Doyle to President of Domino's USA, which puts a proven operator who turned around Team USA stores in the right place to positively impact our domestic franchisees and target our areas of weakness.

We also announced the transfer of David Mounts to lead our distribution and procurement business.

I believe this will be a great opportunity for David to make a positive impact on this important aspect of our business, particularly during this time of unprecedented cost inflation.

We've teamed up with a cutting-edge creative agency, Crispin Porter + Bogusky.

Their experience in targeting our key customer group and their spot-on assessment of our brand in the agency review process and their knowledge of how to leverage the value of brand equity is expected to result in some dynamic changes in our advertising, which you will begin to see early in the new year.

We also continue to leverage technology through our pulse point of sale platform, which has now been installed in approximately 60% of our domestic stores with new installations coming online every day.

During the third quarter, for the first time, we rolled out online ordering messages in our TV and print ads, resulting in steady increases in online orders, which generally are more frequent purchasers and at a higher average ticket.

This was a distinct plus for our corporate Team USA stores since every one of those stores has pulse and offers online ordering in every store.

We've also added mobile phone ordering capability.

This increases access to our brand and targets our core customer, and how they prefer to order from our company.

We're also making progress towards rationalizing pricing.

As I said, our Team USA stores have worked hard to increase prices where there are opportunities, reducing unneeded discounts while optimizing coupons, purging underperforming products and underperforming promotions.

We have encouraged our franchisees to do the same thing.

As I said earlier, we know that prices must increase to cope with increasing commodity costs.

But we recognize that this must be done strategically when traffic issues continue to pressure the sector.

I brought this up the last quarter and likened it to dancing on the head of the pin.

Team USA has taken a very measured stance towards this delicate balance and has seen a minimal falloff in traffic as a result of careful and considered pricing increases.

But, so far, they are doing the best job of dancing, and we need to make sure our franchisees follow their lead.

Team USA stores also continue to be very active with their local store marketing, maintaining high levels, and this has continued to pay off.

We've shared their results from these elevated local store marketing efforts with franchisees, and we've encouraged them to participate in countrywide local store marketing blitzes.

There's no question about in today's environment, if you want to grow your traffic, you're going to steal share from somebody else.

And that's a war and battle that needs to be waged at the market and store level.

And that's what Team USA is doing very effectively, and we need to get our franchisees to do better.

Our primary focus in the fourth quarter of this year will be to more effectively get our domestic franchise system to grow their sales in the existing market conditions.

We cannot be successful unless our franchisees lead our success, and that's certainly been the history of this system.

Out of 10 of the last 13 years, franchise sales have exceeded corporate sales by an average of a 3% gap.

If they were currently beating Team USA by their traditional 3% spread, our quarterly results would be much improved.

It's important to note, though, that our franchise performance isn't the same for every store or in every market.

We're discussing averages here, and I want to make sure I send out a shout--I send a shout-out to those franchisees who have continued to outpace Team USA throughout this period.

We have some very successful operators out there who are doing a great job.

We're counting on them to help us lead the way to improve the performance of those who are lagging.

So, we're bringing heavy emphasis to close that gap and regain the historical momentum from our franchisees and our franchise system.

I want to close my remarks by, once again, pointing out that the big winner of this quarter was our international division, which did extremely well, posting a very strong 8.3% same-store sales comp, their highest in over two years.

This speaks loudly about the strength of our brand worldwide and strong engine of growth that our international division provides to this company.

Our international operators are a great example of executing the fundamentals of our business well every day, and I want to congratulate them on a great quarter.

Now, with that, let me turn things over to David Mounts who's going to take you through a more detailed look at our financial performance.

As Lynn mentioned, although David has officially transferred to his new position as the EVP of distribution and procurement, he is handling our call this quarter, which will be his last act before we pass the baton over to Bill Kapp as our acting CFO.

And Bill will execute the responsibilities of this important function until we complete our national search process and fill this position permanently.

David?

Thanks, Dave, and good morning, everyone.

As you will note from our earnings release, we had several items that affected the comparability of our results to those of the third quarter last year.

I'll cover those shortly, but first, let me start with the topline.

We ask you to remember that revenues can be misleading when analyzing Domino's financials and ask you always consider global retail sales as the key gauge of our topline performance.

Our global retail sales increased 7.2% during the quarter.

That was driven primarily by same-store sales growth in our international business and an increase in worldwide store counts of 272 units over the trailing four quarters.

Same-store sales domestically, our sales decreased 1.6% for the quarter.

As Dave mentioned, our company-owned stores increased 0.8%.

That was versus a down 2.3% in the Q3 2006, while our franchise same-store sales were a negative 2%.

This was versus a negative 3.2% in the third quarter of 2006.

International same-store sales increased 8.3% over last year's positive 3.0%.

This was the highest growth in nearly three years and marked the 55th consecutive quarter of international same-store sales growth.

Moving on to the income statement, our total revenues for the third quarter were $337.3 million, a $10.6 million or 3.3% increase from last year, was driven by higher distribution revenues that were caused by the elevated food prices, mostly cheese.

This benefited the DPD revenues, but it contributed to lower Team USA margins, which I'll discuss a little bit later.

Additionally, we had higher revenues from our international stores in the third quarter, which was driven by the increase in same-store sales and the store counts that I just mentioned.

Our consolidated operating margin as a percentage of revenues decreased only 1.4% in the third quarter versus the prior-year period.

We were at 24.9% in the third quarter of 2007 versus 26.3% last year.

There was a reduction of 1.6% based on the impact of increased cheese prices and its affect on the distribution percent margin.

The average cheese block price in the third quarter was $1.95 a pound versus $1.19 last year.

This is a 64% increase.

It's the widest spread we have seen in cheese prices between year-over-year quarters in three years.

Remember that the dollar value of margins does not change in our distribution business when cheese prices fluctuate.

Our international division's operating margins improved with the sale of our France and Netherlands operations, which was completed in the third quarter of 2006.

Also, our international franchise business which has no cost of sales gained as a percentage of total revenues.

This helped improve our overall consolidated margin.

Our Team USA margins were negatively impacted by higher food costs and also higher labor costs, but not as severely as some in our industry, at only 2.3%.

This reduced our overall company margins by approximately 0.5%.

The resiliency of our model is clear when you consider that, if you factor out the increase in cheese cost impact on distribution, our operating margin was flat to slightly positive in this very tough cost environment.

As Dave mentioned, we are operating in an environment that is high cost, and we're working to manage those costs down on a number of fronts.

As I previously discussed, our Team USA food costs are net of the affect of our derivative milk contracts.

These contracts had a nonmaterial impact on our third quarter financial performance, and we're settled in the fourth quarter.

The settled contracts will not have a material impact in the fourth quarter.

This hedging strategy provided some benefit to our corporate stores in the rising cost environment we have seen over the past year, but the hedging is not a practical tool for the overwhelming majority of our franchisees.

Remember, our average domestic franchisee owns and operates three stores, so they're not inclined to want to get involved in market hedging activities.

However, in an effort to achieve the goal of lowering volatility and improving our operator's ability to plan and budget more effectively at the store level, we entered into a new multi-year purchasing arrangement during the third quarter with our primary cheese supplier.

We believe this contract will serve to more effectively smooth out our cheese cost volatility for both our company-owned and franchise stores.

Let me turn now to G&A expense.

Part of our cost containment effort is controlling G&A expenses, and we have been very disciplined about this during the quarter.

Excluding last quarter's $5 million legal reserve and expenses in connection with our recap, we saw total G&A trending down in the third quarter compared to levels experienced during the second quarter.

In case you're comparing to last year, last year's GA number includes gains from sales of our France and Netherlands operations and gains from the sale of our Memphis stores to a franchisee.

Our bottom-line earnings, our diluted EPS and reported on a GAAP basis were $0.17 in the third quarter.

This is a $0.22 decline as reported of $0.39 in the prior-year period.

In the third quarter of 2006, we benefited $0.04 from a $2.7 million after-tax gain on the sale of the company-owned operations in France and the Netherlands.

The company's recent recap had a significant impact on ongoing interest expense.

As a result of the higher debt levels, this resulted in a decrease in diluted EPS of $0.13, as Dave mentioned.

Our cash interest expense for the quarter was $23.5 million at a rate of 6.06%.

Our book interest expense related to our debt facility for the quarter was $25.6 million or a rate of 6.6%.

Our total interest expense for the quarter, including letters of credit, capital leases, and accrued interest on a FIN 48 tax liabilities is $26.5 million.

This was the first quarter with the full impact of our new capital structure.

This gives you a good picture of our ongoing interest costs for a 12-week quarter.

Keep in mind, though, that the fourth quarter has 16 weeks.

Including the affects of the items discussed above, the additional $0.04 decrease in diluted EPS was driven by lower Team USA margins, about $0.02, a decrease in distribution profits from lower volumes that was also worth about $0.02, and a gain from the 2006 sale of the 11 corporate stores in Memphis worth about $0.01.

This was offset in part by the continued strong performance in our international operations, which was a plus of a little more than $0.01.

Additionally, our effective tax rate was 39.8% in the third quarter.

This was because during the third quarter, we recorded a $300,000 net reserve related to ongoing state income tax matters.

2006 was positively impacted by a tax benefit associated with the sale of our company-owned operations in France and Netherlands.

We continue to anticipate that the normalized tax rate of 37 to 38% is still a good target over the foreseeable future.

As discussed in our earnings release, the company repurchased approximately 1.1 million shares of its common stock under the open market repurchase program.

This cost $18 million during the third quarter.

These shares repurchases on their own impacted diluted EPS less than $0.01 for the quarter.

Our OMR program was implemented, refined, and made fully operational last quarter, and we will continue to be opportunistic buyers in the market.

The purchases made during the quarter, when considered on an annual basis pro forma, would impact EPS positively by about $0.02.

Let me turn to leverage.

Our total debt was $1.7 billion, which represents $1.6 billion of AAA-rated notes and $100 million of subordinated notes.

I remind everyone that all of our currently funded debt is fixed rate for the next five years and that only our $150 million variable note program, our revolver, is a variable spread--is variable at a spread of 70 basis points to the commercial paper funding rate.

That has tended historically to be close to the LIBOR--30-day LIBOR rate.

We continue to be very comfortable with our new debt level, and we have seen no economic affects on our current financing or on our capital structure due to recent turbulence in the credit markets.

Since our rates and terms are fixed, we expect the same conditions during the balance of our five-year term.

In closing, despite a challenging quarter, we continue to generate positive free cash flow and have proven that we will utilize this in a manner that is most beneficial to our company and shareholders.

We remain focused on managing costs and creating shareholder value during these challenging times in our domestic operations.

This concludes the financial update, and, once again, we want to thank you for your time today.

We appreciate your support, and we'd like to answer your questions.

(OPERATOR INSTRUCTIONS) Your first question comes from John Glass with CIBC World Markets.

Jason, we can't hear John.

I don't know if you can.

Okay.

Give me just one moment.

Jason, are you still there?

Yes, sir.

Just one moment, please.

Your next question comes from John Ivankoe.

Hello?

John, we can hear you.

Okay.

Excellent.

Good.

Now we can't hear you.

Jason, we can't hear the question.

Jason, are you there?

Yes, sir.

We are experiencing some technical difficulties.

Give me just one moment, please.

Okay.

Hello?

John, is that you?

It's John Glass.

Can you hear me?

Yes, we can hear you now.

Wonderful.

Okay.

Sorry about that to John Ivankoe.

Could you help put the quarter in context of the industry in the U.S.?

Did you feel like you outperformed the pizza category, underperformed it, or is this sort of what everyone else has been doing, as well?

You know, It's the obvious question.

We subscribe to the CREF data, and it's the best data that we have, and it's certainly--I think it's good directional data.

Our sense is that the category was totally negative as it relates to traffic growth.

Everybody was trying to inch ticket up in light of the cost situation, but we can't see anything in the data that leads us to believe that there's been anything other than a significant reduction in consumer spending in the category and that traffic is down across the board.

Okay.

You talked about the--getting the franchisee's traffic better.

You talked about that last quarter.

Is there anything different in what you've seen them doing this quarter versus last quarter, or is there anything new or different in how you're going to help them going forward, drive their traffic stronger?

Well, listen, the status quo isn't working.

I think some of the things we're doing with leadership changes and some of the internal programs that we've launched and trying to excite the franchise body with some new brand positioning and the new energy that's going to come from advertising agency, all those things in their own way are a function of trying to shake things up a little bit and create some back pressure on our franchise group.

These are unprecedented times for us, both in terms of cost inflation and the fact that we're having a hard time growing our sales.

As you know, for many, many years, it wasn't a function of whether we were [having] positive sales.

It was a function of how positive they were going to be.

And one of the things we're really trying to coach this system through is how do you react to this adversity and not do things that are detrimental to the growth of the business?

This is not a time to be cutting back on marketing activities or cutting back on marketing spend or cutting back on technology spend.

This is the time you have to invest because it's war out there.

And whoever gets ahead of the curve is going to be the one that's going to get the benefit.

So, again, as I said in my kind of prepared remarks, we've got a lot of franchisees who are getting it right.

They're growing their sales in this period, and they're doing well.

We just don't have enough of them.

And that gap that exists between the franchisees and Team USA right now is the elephant in the room, and we're going about the business in every way we know how in getting that fixed.

Gotcha.

Then there's one last question.

David Mounts, you had mentioned a cheese contract.

Can you talk about any details?

Is it an absolute price, or is it [a collar]?

How much volatility should we still expect in cheese prices with this contract in place?

Yes, we think the volatility--the only way I can really answer that, because the nature of that contract is that it's confidential, John, but I can give you a sense for volatility.

We think that volatility will be down about a third.

Okay.

Thank you.

Your next question comes from John Ivankoe.

John, can you hear us?

I can hear you fine, yes.

Okay.

We can hear you now.

Fire away, John.

That's great news.

What has been the hesitation of franchisees to reduce discounting or take pricing in the third quarter?

It would seem like it would be a fairly simple action.

So, what has really been their pushback from their perspective, or why do you think they haven't done it as quickly as Team USA has?

Well, I got 1,275 answers to that question.

Okay.

Again, there are people who have done it well.

There are people who have done it better than Team USA.

But we have a lot of smaller operators out there who have kind of a historical reflex and have been in a pattern of behavior.

And what we're finding in these highly unprecedented time, it's more difficult than I thought it was going to be to get them to understand that they have to really significantly change the direction of how they're marketing in their local market areas.

Okay.

And so, it's taken longer than I thought it was going to take.

It's a bigger challenge than I thought it was going to be, and, truthfully, the target keeps moving because it seems like the cost pressures continue to spiral in an upward direction.

Frankly, at the end of the second quarter, I didn't believe it could get any worse.

Yes.

When I look at the commodity charts, and it's gotten worse.

So, there's a fear factor out there, too.

So, if you kind of get in the bunker, and you believe that the thing to do is to just really, really carefully control your resources and underinvest and pull back, that somehow the storm cloud will pass and life will be better again.

And we've really got to teach our franchisees that this is the time to be aggressive and go out there and make something happen.

Right.

Okay.

Speaking of commodities, as everyone knows, wheat is up very significantly.

I know you addressed it in the last quarter in terms of something that's causing you pressure, but not very significant.

Is there a way for you to quantify it for us in terms of--we've talked about cheese a lot in the past--how meaningful wheat is and flour more specifically is to your P&L today?

Yes.

Let me talk about just wheat as a category, and then David will explain to you, as a great example of the forces that are in play right now and how it's impacting us here at the corporate level.

For 10 years, if you look at the wheat commodity price on a price per bushel basis, you will see a tighter range than anything you can imagine.

We were buying wheat typically in the $3 per bushel area, up to $3.50.

A spike that occurred in 2002 took it up to just about $5, quickly corrected back to that $3 to $ range.

And so, we had a method of setting pricing on our dough ball, implementing that pricing through our distribution center, setting expectations for our operators.

And that was virtually a eight, nine, ten-year practice that everybody was very comfortable with.

At the end of the third quarter, wheat was--we were buying wheat at over $9 a bushel.

So, literally an increase from $3 to $3.50 a bushel to $9.

And it happened remarkably fast in a period of a short number of months.

Now, I'll turn things over the David, and he can tell you what the implications of that have been to our distribution centers and, in fact, our operators.

Yes, John, we have been on a cycle where we have set pricing on our wheat on an annual basis historically because it hasn't--there hasn't been much variability.

And it's worked out well for everybody.

We buy about 5.5 million bushels of wheat a year.

So, every time the price changes $1 on a bushel, we're going to feel a $5.5 million impact, both us and our franchisees and our distribution system, the way it works because of the profit share.

So, when you start to compare those price changes, you see a large impact.

One of the things that we will have to implement next year is we will have to go to more frequent pricing during the year.

We think that quarterly pricing makes the most sense at this stage, but we're going to continue to evalute all our options.

For sure we will not be going with annual pricing in distribution.

So, we won't be in a situation where we were this year where we had pricing in place for the year.

We made the decision, given all the other price changes that are impacting our franchisees, not to go in and amend prices mid-year because our franchisees had built their budgets and their plans based on what we told them pricing was going to be on dough balls for the year.

So, we're taking, especially in this last quarter, we're taking an impact here that we didn't anticipate and wasn't planned.

And, of course, some of that impact is also absorbed by our franchisees and their rebate payments, but we clearly have to get--in an environment like this, we have to get to a more frequent adjustment of pricing and let these costs more flow through like we do with our other commodities.

Okay.

I definitely did notice the distribution income was absolutely lower than what we thought it was going to be.

Was wheat a primary contributor to that?

Wheat was a primary contributor to that.

Okay.

All right, then.

We're going to see that again, John, and probably even more--a little more exaggerated than even the third quarter because we had some forward purchases that shielded us from part of the third quarter.

And we're not going to have as much coverage in the fourth quarter, so we're going to see an even more exaggerated impact.

And then when it comes to reprice at the beginning of the year, we should be able to reset most of those back into what's being customary.

I guess it's kind of a bigger question, but we talk about dough balls and cheese.

The franchisees really are feeling a lot of pressure.

Have they really begun to push back on you, saying, "You know what, we know we're sharing half of the distribution's profitability.

We think that number should be greater." In other words, are the franchisees trying to take from the corporate now versus just trying to make money from the customer?

John, that's never the case.

We have--our distribution business is managed, and the structure is set up where there's absolute alignment between us and the franchisees.

We have franchisees that serve on our distribution advisory board.

They're involved in, and they nderstand the realities of the business and how they're affecting us.

And they're part of that decision-making process, and it has been historically and will continue to be a very collaborative process with both sides incentivized to try to grow distribution EBITDA in ways that manage the supply chain more efficiently.

Okay.

Very good.

And a final unrelated question for me.

The cash balance is, from my opinion, high given what your free cash flow yield.

Could you explain why that is?

Was that for your credit agreements?

And is it possible to assume that all of your free cash flow in the future will be used to buy back stock, or is there a necessity to put aside more funds for the debt holders?

You're certainly seeing an abnormally high value.

It's a very good question, John.

We're sitting with $115 million in cash.

The way that breaks down, about $100 million of it is tied just into the ABS in terms of reserves and really timing of the interest payment.

Let me walk you through a breakdown of the core of that $115 million.

$15 million had to be set aside as a capitalized in the new franchise or entity to qualify for the uniform franchise exemption.

So, in other words that we can continue to franchise throughout the company as a well-capitalized franchisor.

So, that is a one-time increase in capital and in cash that is, at this point, appears to be permanent, but we're going to evaluate that over time and see if other assets also could qualify for that exemption.

But right now we think it's mostly cash.

We have $55.2 million that's set aside right now for our interest payment that we're going to make on October 25.

Remember that the ABS interest payments are quarterly based on a calendar basis, and, as you know, we have 12, 12, 12 and 16 in terms of our quarters.

So, you end up with a little bit of a timing difference, and, on October 25, we're going to write a $55.2 million check to our noteholders for all the interest that was due them for the prorated second quarter and all of the first quarter.

We also have $26.9 million that's set aside in interest reserve, basically the equivalent of a little more than one quarter's payment to the noteholders.

And that was really kind of a cushion setup in the structure that was to be evaluated after the first two quarters of interest payments.

And the way that reserve works is it's measured against the debt service coverage ratio, and we compare where we are in actuality to the DSCR measurements.

And as long as we are over 2.7, which we fully anticipate that we will be in terms of that calculation, then two-thirds of that cash will be freed up, and we'll only have to keep one month's interest reserve on file.

So, part of this is just timing in terms of getting through the first quarter and getting the first payment made.

It's part of its timing and a new structure where everybody wants to make sure after it's implemented that all the pieces fell into place like everybody thought they would, and that will get reserve--that reserve will be reduced appropriately after the new year.

And so, those are the two main things and then this new franchise unit.

So, when you take those into account, you've really only got about a little over $15 million left, which is probably more typical, and you should expect to see us use that cash when it becomes available from the reserve mechanism, and you should expect to see us continue to use cash flow to pay down or to buy back our stock, rather.

Okay.

All right.

That's a great answer.

Thank you so much for that.

Your next question comes from Jeffrey Bernstein.

Jeff, are you there?

Yes.

Can you hear me?

We can.

Go ahead.

Hello?

Hello?

Just first a kind of bigger-picture industry question.

You mentioned the CREF data and the impact on consumer spending.

Just wondering how you believe the pizza category is positioned relative to some of your other QSR peers.

And you had mentioned that the pizza category, in another comment, you said it's more across the board including the more traditional QSR peers.

It seems like that the pizza category is kind of attracting more with casual dining, whereas some of your quick-service peers are performing better.

Just wondering how you think about pizza versus the more traditional fast food in this environment.

Yes, Jeffrey, it's a great question, and we've spent a lot of time looking at that.

There's no question about the fact that there has been, at least if you look at the CREF data, that there's been somewhat of a deceleration in traffic across QSR.

But overall QSR is still growing at a 1 to 2% rate in terms of transactions.

Most of the growth is coming from party check.

But our assessment of the situation is a lot of what you outlined.

When you look across total QSR, which includes the lunch day part, the breakfast day part, sandwi guys, people who seem to be operating in the party check mode of $6, $7, $8, which is kind of the overall average for QSR, the ones that are at the low end of that average check range seem to be doing better-- the lunch guys, the burger guys, the breakfast folks.

And those of us who are operating at the $16, $17, $18 average checkout, we seem to be having the most difficulty in this environment.

And that's pretty intuitive when you consider how the consumer is behaving and what their grocery bill is now when they're going off and buying groceries in the grocery store and situation where there are (inaudible) loans and all the other things that we're reading about.

Those folks who are operating at the higher end of the ticket range are probably going to be more impacted than the guys who are offering value menus at lunch at very low tickets.

It seems pretty obvious that your $16 to $18 is feeding a few people whereas $6 to $8 is probably feeding one.

I don't know whether there's a way to somehow reposition in a tougher environment and focus more on individual servings for whatever that's worth to kind of bring someone in that might not be looking to feed three or four but rather just one.

Well, listen, value--we still have a great value message.

Let's face it.

For less than $20, you can feed a family of five oftentimes with some of our bundled deals.

It's still a great value message.

We typically do reasonably well during these times.

But in the past, when we've had these kinds of traffic slowdown, one of the tools that we reach to very quickly is to stimulate consumption, stimulate trial by going out and shouting value in a very, very bold way.

That's difficult to do when virtually every commodity that you're buying is a 10-year historical high.

So, part one of the conundrums that we have right now is that the easiest lever for us to pull is a difficult one for many of our operators to pull to stimulate traffic because we're in a very, very unusual, unprecedented cost environment.

So, dancing on the head of the pin part of it, how do we shout value, and how do we get the attention and stimulate some activity in terms of traffic in an environment where we're getting bombarded with cost increases?

This, too, will pass.

I don't think there's any element of this that we can't work our way through, and that we're not working our way through.

But it's a tricky set of issues.

Yes.

And specific to those cost pressures, just a clarification.

You mentioned the multi-year purchasing agreements specific to the cheese, and I think you guys have noticed, I guess, volatility would be a third of what it has been.

Is that--just trying to figure out when you say a third, does that mean if cheese prices are up 50%, year over year, that you can kind of mitigate that to the point that it's really only up a third of that when your franchisees have to go do purchasing?

Or how do you-- what does that really mean, a third?

Without getting into details and violating our agreements with our supplier, I would just tell you that the whole objective of that was to put ourselves in a position when cheese prices spike high, as they've shown a propensity to do in the most recent past, we're not going to experience as high a ride.

And then when cheese prices settle back, which they will because they always do, obviously at that point we'll be paying a premium to what we did in the past, but we've eliminated about a third of that roller-coaster ride that could be very difficult for our operators to plan around.

You eliminated a third, or you got it down to a third?

Eliminated a third.

Got it.

There will still be volatility.

There's no way to avoid that.

Yes.

Okay.

Then just--actually, one other thing.

In terms of--you mentioned, obviously, the franchise disparity.

I'm just wondering what the commonalities are, if any, in terms of why some are performing better than others.

Is there--do you see having one geographic strength or weakness in any areas, or is it--and that it's working for some, but isn't working for others?

No, we really don't, and we've looked all of those correlations.

It's not geographic.

It's not urban versus rural.

It's not large operator versus small operator.

It's all based on, frankly, the passion and the execution at the store level.

And our job--and we understand it, it's been our job for 45 years--is to get our franchisees all on the same page with the tools in their hand that allow them to be successful and keep them passionately moving in the direction of growing their business.

It is not enough just to give them a store concept and a list of operating guidelines and a brand and some advertising support.

We've got to get them waking up every morning and going to the stores that they own and putting the teams in place and engaging with their customers and executing against the business model at a level that supercedes what their competitors do in that market.

It's hand-to-hand combat particularly in this environment.

And our job is to make that happen, and, obvioulsy, in the environment we're in, that's one of says-easy-does-hard kind of things, but it's something that we're good at.

We've shown ability during the past, and we'll get it fixed.

And you had mentioned the new ad agency and whether they gave you an early diagnostic to say, "This is the direction we might take in that's different from what you have been doing."

Yes, you're going to see a remarkable change in our brand focus starting the beginning of the year.

Obviously, we're not going to telegraph that at this particular time.

It's still a work in process, but can I tell you that if you really sit back and look at where the category's been operating, we've all been launching our limited-time-only offers and putting spins behind this product and price focus.

If you really look at how that's performing, and certainly the environment we're in right now, nobody is using that to really drive traffic and sustain any growth.

And so, we're looking at something that we can own and execute against and sustain at a higher level than just the in-and-out item kind of habit that everybody's developed, and we're kind of anxious to get that moving and more to come early next year.

Great.

Thanks very much.

Your next question comes from Glen Petraglia with Citigroup.

Glen, go ahead.

Great.

Dave, I was hoping you could--and I know this is a question that's come up on past calls, but clearly your franchisees have scaled back their local marketing initiatives.

And I'm wondering if you need to change the breakout of the ad dollars in terms of how much are allocated to local versus national marketing.

Well, we have.

I don't know when we last talked about this, but as you recall, we got into a--I think we got into a bit of a trap where we believed the more money we had in Ann Arbor to spend at the national level, the better that was going to be.

We found that there's probably, like everything else, a point where too much is too much, and I think what we did is we began to bring too much of the accountability and too much of the marketing focus in a centralized environment in Ann Arbor, and that's not good.

So, as we go into 2008, there's going to be more balance in the marketing budgets, and there will be more dollars available at the local market level to give resources to the franchisees around their local market to be able to engage in things that they think will be more applicable to their business and their competitive set.

And I actually think that's a positive thing.

So, 2008, the media calendar will still be filled with many, many weeks of national television and national offers and in support of some of the things that Crispin's working on.

But Crispin will also be developing tools that will be administered at the local level in a marketing way to allow our franchisees to do things that they think will work in their business, and that's a good thing.

Okay.

And David Mounts, in terms of your new role, given your background at UPS and knowing that everybody there has quite an operations focus, what sort of efficiencies do you think you can bring or that you've seen thus far that would be able to maybe enable you to squeeze the stone a little bit more?

It's a great question, and it's one that I'm looking forward to getting in and digging in and finding opportunities.

As you probably appreciate, I've got one foot as we wrap up this quarter in finance and one foot into my new job.

My focus right now is on meeting my team and understanding the challenges that they have and where I can be helpful to them.

And I haven't come to any conclusions at this point, but really doing a lot of listening and learning.

And I think that will be the focus for a while.

As we find opportunities, we'll communicate those to you, and Dave will communicate those to you on subsequent discussions.

Okay.

And just lastly, most of my other questions have been asked already.

What sort of--what percentage of your orders are coming online now and how have you seen that change over the course of the last several months since you've begun to comment on online ordering opportunities?

Yes.

I want to be responsive without giving anybody the keys to the kingdom.

I would just tell you that the stores that have had online ordering the longest are showing a proensity for getting that mix into the double digits, which we think is meaningful and important.

And there's a fair amount of variability depending on the demographics of that store, its location, but what we see is that this is a material channel for many of our customers who enjoy ordering that way.

And if and when we get to that double-digit mix mode, it does very good things for our business.

And Team USA, being further down that track, certainly some of the benefits that we're seeing in terms of their execution and their sales growth, we believe, is attributable to that.

We also have seen that in some cases there are tactics we could use to drive that number, and we're having some interesting--we're doing some interesting testing and getting some interesting results from that, as well.

But beyond that, we just as soon not talk about what we're doing there because some of it we're pretty excited about and none of it we want to share with our competitors.

Fair enough.

Thanks.

Your next question comes from Ashley Woodruff with Friedman, Billings, Ramsey.

Go ahead, Ashley.

Hi.

Can you hear me?

Yes.

Okay.

Could you talk about--I guess the transition you've seen throughout the year where you ended the first quarter with positive traffic, second quarter, positive, and then, obviously, things dramatcially slowed down in the third quarter.

Can you tie that--did it really trend exactly with what the overall pizza or fast food data that you have for CREF showed, or did you see a real change based on what your current promotion was?

And kind of a follow up on that, can you talk about how you feel about the pipeline and really how you feel about the promotional pipeline has been over the past 12 to 18 months in general?

Yes.

First of all, we did not have positive traffic in the first quarter this year.

We had negative sales--domestic was negative 2.9 and it was negative traffic in the environment for us.

In the second quarter, we had positive sales, primarily ticket, just a little bit of traffic but mostly ticket.

And you obviously know the situation in the third quarter.

The CREF data would lead us to believe that if you go back to basically the middle part of 2005 that the vast majority of the growth that has occurred in the category has been ticket.

In fact, CREF would tell you there's only been two quarters since the middle of 2005 where there has been traffic growth--one was 1% growth and one was 2% growth.

Now, again, CREF can only do what CREF can do.

This is a big category, and we've seen 8,000 pizza shops, and CREF is not in a position to be able to really have their finger on the pulse of what exactly's going on.

But directionally, I think it's good guidance, and it ells me that the whole traffic growth situation has been one that's been somewhat structural in the recent past in the category and everybody's been kind of living off ticket.

So, when you keep moving the ticket up on your customer, and then your customer starts cutting back in their spending as a result of some of these most recent factors, and you've got the cost pressures which will make it difficult to go more value than you're already at, you kind of see the world that we're navigating through.

CREF would show that the party check average, if you go back, and you take a look at really the last five years, that the guest check average in the pizza category has increased about $2.50.

And if you go back, and you look, that's the implementation of delivery charges.

And that's growing the business through check as opposed to traffic.

I think what's happening is the consumer has to catch up with these new price points.

Price points will continue to move, but we've got to be creative enough in the context of all that to figure out a way to continue to generate some new interest in the brand and some traffic in our store and probably in the current environment.

As I said earlier, that's going to come from taking share from somebody else and winning the battle at the local level than it is anything that's going to dramatically change the current status of the category.

The promotions that you've done, have you seen a similar kind of mix in terms of order incidence to what you saw, say, several years ago with some of your stronger promotions, or--yes, basically.

Interestingly enough.

The limited-time-only promotions that we've put out there this year have for the most part achieved mixed levels that were very typical with objectives, very typical with test-market experience.

And so, we don't think the products were bad or poorly accepted or didn't have good repurchase.

In fact, they did exactly what they did in test in terms of achieving mix.

People saw the commercials, they reacted to them, they tried the products, they repurchased the products.

All that's fine, but what isn't not fine is it isn't driving traffic.

It isn't bringing people into the category that weren't there before.

And that's the remarkable change, I think, over the last year, year-and-a-half with a lot of the limited time onlys.

And when I see what the folks are doing at Pizza Hut and Papa Johns, I get the impression that they're in the same situation.

We're all inventing the latest twist of pizza toppings or the latest brand name to put on a limited-time-only offer.

But it sure doesn't seem to be driving category growth for any of us.

Okay.

Then shifting to the franchisees, I think you used to say, and maybe this goes back a couple of years, that the average EBITDA margin for a franchisee is after royalties ran around 10, 11%.

Where is that trending on average now given all the cost pressures that we're seeing this year?

Well, we've rolled up all the P&Ls from 2006 because obviously we won't know this year's results until we roll them all up several months into next year.

But as we look at the impact of 2006 and the fact that it was a negative sales year for us, the first one in 13 years, the average franchise store incurred 0.5 point EBITDA margin hit.

So, that's negative.

That's bad.

That's inconsistent with our objective, but it still puts our operators in a cash-on-cash return mode that explains why people are still out there building stores and why people are still committed to the business.

It's still a great business.

It's still a great business model, but obviously we want margins to expand.

We don't want them to contract, and the way to do that is to get more traffic and sales through the front door.

Okay.

Then just one last question on use of cash for share repurchase versus debt paydown.

I think your inclination originally was to buy stock at least in the first couple of years of this new facility, but given the market's pretty significant sentiment shift against companies of a significant amount of debt, has that changed at all your thoughts in terms of the timing of paying down your debt?

No, no.

We're very comfortable with our capital structure, extremely comfortable.

And we purposely left room, and we got an authorization to repurchase stock.

And we said all along we're going to be opportunistic.

And based on what I'm seeing on my screen today, there's plenty of opportunity to take advantage of people who don't get the long-term view.

Okay.

Thank you.

Your next question comes from Joseph Buckley with Bear Stearns.

Could you quantify the pricing you've taken at the company stores and maybe talk about how much you've taken versus what you think the franchisees have done so far?

Yes, Joe.

As you know, we've been very reluctant, and I think for good reasons to not get into specifics about ticket versus traffic and what those numbers are, because frankly I would love to have that from my competitors and follow those trends.

I would just tell you that the phenomenon that we're dealing with, which is just inconsistent with historical norms, is that in the third quarter, Team USA took prices up higher than our franchisees and had a lower reduction of traffic growth.

Now, make no mistake about it.

Team USA had negative traffic, as did our franchisees, but to a lesser degree, and their ability to raise increases faster than the amount of negative traffic they experienced was what allowed them to be positive for the quarter.

Our franchisees did not take as ambitious and as aggressive and what I would consider as strategic and tactical approach to raising prices.

And in fact, their traffic fell further.

Now, that gives us a great story to tell when we go out to our franchisees and say, let us show you how we got more price in the business which is exactly what this current situation calls for.

At the same time, it doesn't have to be detrimental to your traffic.

And so, that's what we're fast at work doing.

Patrick Doyle is on the road right now meeting with franchisees, sharing that information.

So, we feel like there's a way to get there, and we've demonstrated that.

We've got to communicate it.

We've got to implement it and execute against it.

But again, we view this as a short-term challenge that we're working our way through that will have a good long-term result.

Okay.

A question on the global retail sales number.

How much was that influenced by currency during the quarter?

Yes, for the total company, it's about 2% overall.

There's about a $25 million affect in terms of the currency.

Okay.

Then lastly, this may be kind of a moot question with the new cheese contract, but will you be hedging again in the future, or will the new cheese contract kind of negate the need to do that?

The lower volatility in the new contract will negate a lot of the need to do it.

I wouldn't say we would never hedge again.

We always like to keep a toolbox open and put all the tools in there we can, but clearly with this new structure, there's a lot less need for that.

Okay.

Very good.

Thank you.

At this time there are no further questions.

Are there any closing remarks?

My only closing remarks are to make sure I emphasize during these challenging times that I want to emphasize the strength of our business model.

If Lynn would have let me, I would have put a headline on our press release that said, "Takes a beating and keeps on ticking." Because we continue to generate cash, and we continue to do very well in a very, very difficult environment.

And I think it does speak to the strength of the business model.

Our total operating margins remained relatively stable at about $84 million, which is only down 2% from last year's level.

And in the environment we're in, we just think it speaks very, very hard and fast to the strength of our model and in fact why this business has prevailed and succeeded over such a long period of time.

So, we continue to be very committed to fix what's broken and get momentum back in our domestic sales and get our franchise business ignited, and I'll look forward to giving you an update at the end of our fourth quarter.

Thank you all for your time and interest in Domino's Pizza.

Ladies and gentlemen, this does conclude today's conference call.

You may now disconnect.