Welcome to the Q3 2016 DineEquity Earnings Conference Call. My name is John, and I'll be your operator for today's call. At this time, all participants are in listen only mode. Later, we will conduct a question and answer session. Please note the conference is being recorded. Now I'll turn the call over to Ken Diptee.
Good morning, and welcome to DineEquity's third quarter 2016 conference call. I'm joined by Julie Stewart, Chairman and CEO, Tom Emrey, CFO, and Gregg Kalvin, Corporate Controller. Before I turn the call over to Julie and Tom, please remember our safe harbor regarding forward-looking information. During the call, management may discuss information that is forward-looking and involves known and unknown risks, uncertainties and other factors which may cause the actual results to be different than those expressed or implied. You are cautioned to evaluate such forward-looking information in the context of these factors, which are detailed in today's press release and 10-Q filing. The forward-looking statements are as of today and assumes no obligation to update or supplement these statements. We may also refer to certain non-GAAP financial measures, which are described in our press release and also available on DineEquity's Investor Relations website.
I'll now turn the call over to Julie.
Thanks, Ken. Good morning, everyone, and thank you for joining us today. I'll provide a business overview. Then I'll turn the call over to Tom for a recap of the financial results. We continued to deliver year-over-year growth in adjusted EPS and generated strong adjusted free cash flow despite ongoing challenges. Additionally, we continued to return the majority of our adjusted free cash flow to shareholders. In fact, we once again declared an increase in our quarterly dividend, raising it by 5.4% to $0.97 per common share from $0.92, effective with the next payment on January 6. We remain very confident in our two iconic brands, our brand strategies and franchise partners around the world. We have the best teams we've ever had in place at both DineEquity and the brands.
We've picked up the pace of innovation at both brands. We're taking the necessary steps to ensure their success. To this end, I'm pleased to say that we've completed the consolidation of our restaurant support centers. This plan has promoted greater cooperation, collaboration, and communication across the organization. The move has also enabled our team members to more effectively share ideas on how to make our brands more distinctive and relevant, which is just what we need right now. This is a very challenging time for our industry. Today, consumers are very sensitive to value stemming from tighter budgets. Slower growth in disposable personal income has influenced how much they spend on dining out. The already challenged restaurant industry has been hit with slowing overall economic growth and the gap between the cost of dining at home compared to dining out.
The result has been a high level of promotional activity in the marketplace competing for consumer attention. We're taking action to meet these challenges and emerge even stronger. At the heart of the steps we're taking is the continued strong collaboration with our IHOP and Applebee's franchisees. During our two successful franchise conferences in September, we laid out our plans to further differentiate ourselves from the competition and continually evolve at a fast pace. At the conclusion of both conferences, we aligned on the hard work needed from all parties to drive the brands forward. I'd like to thank all of our IHOP and Applebee's franchisees for their continued commitment and determination. Additionally, congratulations to the recipients of the Franchisee of the Year Award at both brands. Well deserved. I'll go into detail on each brand, starting with Applebee's.
Clearly, we're disappointed with Applebee's 5.2% decline in comp sales for the third quarter. Returning the brand to positive and sustainable sales and traffic is our top priority at DineEquity. Due to the environment and the emphasis being placed on value by consumers, it is essential that we reinforce our value proposition. Remember, value is not just about the price, but it's about what our guests pay for and receive across all dimensions of the guest experience. We believe that the need for stronger value messaging is a core factor impacting Applebee's. We are in the process of validating the best approach to use. We're also investing in the work necessary to create a more relevant Applebee's, particularly as it relates to our food, as well as improving the guest experience.
We are the largest casual dining chain in the industry. This means we must continue to innovate beyond value, differentiate and evolve the brand in ways our guests expect us to. This is absolutely critical. Building on the Wood-Fired Grill platform, which is part of our broader and bolder plan, we're laying the groundwork for growth by focusing on the key elements of our long-term strategy. Let me briefly provide some color on each of our four key initiatives. I'll start with operations. This is a greater focus for us. Our operations platform is gaining traction. More work needs to be done. To change perceptions of the brand, delivering a consistent guest experience is vital. We're collaborating with our franchisees to provide best practices in the areas of staffing and retention to build high-performance teams.
We're also aggressively simplifying kitchen operations through strategic deletion of menu items and working on ongoing simplification to reduce complexity. Another aspect of our plan is to grow profitable sales by building our bar and beverage business and evaluating opportunities in off-premise channels. Think of these as revitalized Carside To-Go and delivery. Regarding brand relevance, as I mentioned earlier, we're taking a deeper dive to better understand when and why our core guests visit Applebee's. Secondly, you will see us extend offers and take an approach that is based on more effectively meeting our guests' expectations for value and innovation. Lastly, you can expect us to focus on continually evolving our quality food and beverages while consistently providing personalized service to fulfill our every guest, every time service promise.
Turning to technology, today's consumers use technology more than ever to help make a decision on where to dine, as well as to engage with the brands they love. The industry is evolving at a fast pace, and so must we. We have opportunities to create additional channels and add to the convenience of accessing Applebee's. One way is to expand and further enable meals to go. We see this providing an additional sales channel for our restaurants and expanding our guest pool. We are in active discussions with several third-party providers to offer Applebee's delivery to our guests, and we're getting ready to alpha test with three franchisees. Lastly, development. Given current conditions, Applebee's domestic restaurant development has slowed.
In the interim, we're doing the heavy lifting necessary, such that when the franchisees accelerate their development, we're going to move forward with a new restaurant prototype and small format design. Now, let's turn to IHOP. After 13 consecutive quarters of positive comp sales, IHOP's third quarter comps were essentially flat compared to one of the strongest quarters that we've ever had in over a decade. We are not satisfied with the results, which reflect that IHOP is not immune to the current environment. Alongside our franchisees, we are dedicated to maintaining and building IHOP's momentum through a committed focus on innovation and development. Ongoing brand innovation has been a central part of our approach to take IHOP to the next level and build sales momentum.
To this end, we have initiatives that are scheduled for beta testing next year. We'll come back to you with a progress update in 2017. Additionally, we launched an innovative e-learning training platform several months ago called DinePlate, which has yielded positive benefits to franchisees, such as a consistent training experience regardless of the franchisee. This helps to deliver an elevated guest experience across the system. We've received positive feedback from both franchisees and team members on this new interactive tool, which includes enhanced training on suggestive selling. The rollout was completed last month to hourly employees at all of our IHOP locations. Now we have nearly 99% of franchisees on the system and approximately 80,000 users. The knowledge gained has enabled us to start launching DinePlate seamlessly to our Applebee's franchisees shortly. Turning to the remodel program and development.
We know that the atmosphere in our restaurants is just as relevant to our guests as the service. The IHOP remodel, which is currently being rolled out, provides our restaurants with a fresh new look and feel that we believe will elevate the dining experience and differentiate us from our competitors. Our franchisees have completed nearly 200 remodels year-to-date, and we expect to have nearly 300 completed by the end of 2016. The cost of the remodel ranges from approximately $100,000 to $175,000, depending on the extent of the package. We are optimistic about the early traction we're seeing from the remodel. Additionally, the new restaurant image is appealing strongly to guests. Based on our proprietary consumer research, the feedback was very positive, with high scores received for likely to recommend, intent to revisit, and satisfaction.
Regarding development, we know this rejuvenates the brand and keeps it relevant. I'm pleased to say that we are tracking in line with our projections. Let's switch gears to talk about another important part of our growth strategy, international expansion. Based on the five-year plan, we believe we can double our international footprint to over 500 restaurants. We are confident we'll achieve this target, given that the new prototypes for each brand are being embraced by our international franchisees at a rapid pace. Our future looks bright, with nearly 80% of our franchise partners now developing restaurants and over 200 obligations in place. My sincere thanks to both our international team and franchise partners, who have driven some of the strongest growth we've ever had since forming DineEquity in 2008. Lastly, let's briefly turn to capital allocation.
As you saw in our press release issued today, we increased our quarterly cash dividend, reflecting the confidence we have in our 99% franchise business model to sustain strong and stable adjusted free cash flow. We remain committed to returning a majority of adjusted free cash flow to shareholders through the combination of quarterly cash dividends and share repurchases. Since we announced our plans to return cash to shareholders in the first quarter of 2013, we've returned a combined total of over $390 million. With that, I'll turn the call over to Tom to review the third quarter's financial results. Tom?
Thanks, Julie. Good morning, everyone. I'll provide a brief summary of the third quarter's financial results, starting with the income statement. Adjusted EPS in the third quarter was $1.46 compared to $1.43 in the same quarter 2015. The increase was mainly due to lower weighted average shares outstanding, lower income taxes, and a decline in G&A, mainly driven by significantly lower incentive compensation costs compared to the third quarter of 2015. These items were partially offset by lower gross profit. The year-over-year decrease in gross profit was mainly driven by a 5.2% decline in Applebee's comps and incremental investments to test additional Applebee's marketing programs, which we discussed with you last quarter. Development by IHOP franchisees over the last 12 months and favorability in dry mix partially offset these factors. Switching gears to G&A.
G&A for the third quarter of 2016 declined by $5.6 million to $36 million compared to the same period last year, mainly due to significantly lower non-recurring costs associated with our restaurant support center consolidation and lower incentive compensation accruals due to the comp sales performance at both brands in the first nine months of the year. Regarding our tax rate, the tax provision in the third quarter of 2016 was lower compared to the same period last year due to favorable foreign return-to-provision adjustments that lowered the effective rate and an unfavorable adjustment to tax reserves recorded in the third quarter of 2015 that raised the effective rate for that quarter. Turning to the cash flow statement. Cash flows from operating activities were approximately $62 million for the first nine months of 2016 compared to $71 million for the same period last year.
The decrease in cash from ops was mainly due to net changes in working capital, which used cash of approximately $36 million in the first nine months of 2016 compared to cash used of $28 million in the same period of 2015. The unfavorable variance in working capital was mainly due to less cash collected from gift card receivables. The decrease in cash from ops and the decline in receipts from notes and equipment contracts receivable were partially offset by favorability in CapEx, resulting in adjusted free cash flow of approximately $66 million for the first nine months of 2016 compared to nearly $76 million for the comparable period of 2015. For a brief recap on returning cash to shareholders.
In the third quarter, we returned a total of approximately $27 million to shareholders, which included $17 million in cash dividends and $10 million to repurchase roughly 130,000 shares of our common stock. Regarding our quarterly cash dividend, I am pleased to say that we increased the dividend by 5.4%, reflecting our commitment to return the majority of adjusted free cash flow to shareholders, as well as the ability of our business model to generate strong and stable free cash flow. Turning to our performance guidance for fiscal 2016, I would like to highlight a few revisions, please see our press release for details on complete guidance. We now expect Applebee's comps to range between -4% and -5%. The previous range was between -3% and -4.5%.
We still expect IHOP comps to range between +0.5% and +2%, the low end of the range is most likely. Given Applebee's lower comp sales in Q3, we now expect segment profit range to range between $340 million and $345 million, compared to the previous range of $342 million to $352 million. For the full year, we now expect G&A to range between $150 million and $154 million, reflecting an improvement from the previous range of between $154 million and $158 million. This includes a total of approximately $4 million of non-recurring costs related to our restaurant support center consolidation. I would like to highlight that these costs do not have an impact on adjusted EPS. With that, I will now turn the call back over to Julie for her closing comments. Thanks.
Thanks, Tom. To summarize, we again delivered growth in adjusted EPS despite a difficult environment and soft comp sales. We also continued to generate strong adjusted free cash flow. We completed the consolidation of our headquarters and were enthusiastic about having the teams for both brands under one roof. At both brands, we're adapting to a challenging environment by relentlessly reinforcing our value proposition and having an even sharper focus on operations to continuously improve the guest experience. We're acting on our comprehensive plan to restore positive comp sales and traffic at Applebee's, and we're executing against our strategy at IHOP to build on the brand's momentum. We're taking action to drive positive and sustainable sales and traffic with a renewed focus on value.
Lastly, our business model is more scalable than ever, and we continue to thoughtfully explore a strategic acquisition to leverage our shared services platform and superior franchise partners. In closing, we're motivated to meet and adapt to industry challenges. We're building a solid foundation for future growth, and we will continue to return cash to shareholders through dividends and share repurchases. Now, Tom and I would be pleased to answer your questions. Operator?
Thank you. We will now begin the question and answer session. If you have a question, please press star then one on your touch tone phone. If you wish to be removed from the queue, please press the pound sign or the hash key. If using a speakerphone, you may need to pick up the handset first before pressing the numbers. Once again, if you have a question, press star then one on your touch tone phone.
Our first question is from Michael Gallo from C.L. King.
Hi, good morning.
Morning.
Good morning.
Good morning. Just a question on wood-fired grill. Obviously, it's been out there now, call it six months. You haven't really seen traffic improve. Obviously, the industry is a big part of that. I was wondering if we speak to how you balance what you're doing in terms of improving product quality, which was, I think, a big part of wood-fired grill, but also still delivering value that your customers are clearly looking for right now. How you dovetail those two together, how you evolve wood-fired grill in order to be a better traffic driver? Thanks.
Yeah, I think that's a great question. I think there's lots of lessons learned. I think at the core, the whole notion of wood-fired grill is impacting over 40% of the actual menu items in terms of taste and profile. It's also improving the quality of the steak. Those perceptions don't happen overnight. As you know, in casual dining, it's not as if people are coming in four times a month. It takes a while to enhance and change perceptions. We're comfortable and confident that the feedback we're getting in our proprietary research, we know that our consumers really do feel differently about our product quality, but that takes time.
We recognize that in the interim, as I said, we have to do a better job of communicating that value message, obviously with our operations improvement and our brand relevance improvement, making that value proposition a much stronger communication vehicle. We have to do that work, but we know that Hand-Cut Wood-Fired was absolutely the right thing to do for the long-term perception change. It just takes time.
Our next question is from Chris O'Cull from KeyBanc.
Thanks. Good morning, guys.
Morning.
On the last call, you indicated the lack of a strong value message was really the primary reason for the mid-single-digit comp declines. I think you guys made some adjustments this quarter, yet the relative performance to the industry deteriorated. What do you think you missed on the value message that you ran during the third quarter? Why do you think it didn't resonate?
I think, as I said in my prepared remarks, we've got to validate the best approach to use in terms of the stronger value messaging. We do believe that's a core factor, we think there's an opportunity to improve both that messaging and how it comes to life in the restaurant. That's the work that we are currently doing. I think this whole operations piece, which I spoke of earlier, is an important piece. The consumer has very high expectations of what they want, not just in terms of consistently a great experience, the real value for the money, that is work we are both looking at and validating as we speak.
I noticed some of your competitors were running lunch offers that were lower priced. Has Applebee's considered anything similar? A similar kind of program?
We've been looking at lunch. I know it's not our number one priority. I think our number one priority is getting at this stronger value messaging and validating it. I think lunch is something we can do. Clearly, if we were to do a different lunch strategy, it's got to be a smaller menu. You just simply can't serve all 80-some dinner items at lunch, we recognize that. It isn't our number one priority right now. Our number one priority is to get us back on track at dinner.
Okay. Tom, this year there were some timing mismatches from the extra operating week when you project free cash flow. Are there any adjustments we should be considering for next year when projecting free cash flow?
No, not that we're aware of right now. We're still working through 2017 as part of our planning process right now. We'll be getting back about that.
Okay. Lastly, given you guys just had your conference with Applebee's, Julie, can you talk a little bit about agreements that these guys have for renewal? I know that many of them were opening restaurants in the mid-'90s, and they signed 20-year agreements. Can you speak about franchise willingness to renew agreements, and have there been any renewals that's happened here recently?
What you're referring to is the big renewal push, which is in 2020, 2021, 2022. That's a ways out. I think I've mentioned that a couple times before. We have our ongoing normal renewals that happen in the course of a year at both brands. Nothing extraordinary or exceptional in terms of numbers.
Okay. Okay, great. Thanks.
Our next question is from Brian Vaccaro from Raymond James.
Good morning.
Good morning.
Just I wanted to follow up on Chris' question on lunch versus dinner. Did you see a noticeable difference in daypart trends in the third quarter that you could provide color on?
No. There really weren't any major changes either by daypart or by area of the country. Nothing really that stood out.
Okay. All right. Then shifting gears to the broader guest satisfaction scores. I think on the last quarter, you had mentioned a pretty meaningful improvement in guest sat at Applebee's. Did that improvement continue in the third quarter? Where specifically are you seeing the improvement?
Yeah, I would say in third quarter it was more stable. We didn't see any kind of hockey stick in third quarter. It was pretty much level set. We know there's an opportunity there, and that's a real drive and focus for us operationally. We can and will do better.
All right. One more on Applebee's, if I could. What's the average pricing that's running through the franchise system overall? I know it probably varies by region. Then also, could you give an early read on your commodity and labor cost inflation expectations that the average franchisee could experience in 2017?
You're asking about the average check? Is that what you're asking? Across the country?
Yeah, check or pricing. Yeah. However you'd like to address it. Yep.
The average check is $13.75 across the country. However, the coasts, I think I've said this before, are substantially higher than $13.75. It's a little bit of a mix, right? The middle of the country is slightly under $13.75, and the coasts are slightly higher. That's a little bit of the nature of the beast and the cost of labor. From a standpoint of forecasting where we are from a co-op perspective for 2017, we don't have a forecast yet, but at least preliminarily, it would be down. It looks very good in 2016, and again, it looks very good in 2017. I'll have a final number for you on our guidance, but at least preliminarily, it would be, once again, very favorable for the franchisees.
Okay, a similar sort of backdrop from a labor cost inflation perspective in 2017 versus 2016? Is that your sort of the early thoughts on the labor front?
It really depends on the state you're in and whether or not.
Yeah
there's obviously the federal changes and there's the state changes. It varies dramatically. Right. The one thing I haven't seen a huge change in, although there's a lot of state legislation and infighting, I'm not seeing a huge change in our, still we have eight or nine tip credit states. That looks like that stays in play. I'm sorry, eight or nine states that do not have a tip credit. In general, boy, if nothing, it will be more aggressive, not less aggressive. I mean, labor is an ongoing issue.
Sure. All right, just one last one for Tom Emrey. On the networking capital use of cash you called out in the quarter, did that include the $10 million one-time tax payment?
This is Gregg Kalvin. Yeah, it did. It's in the press release, Brian Vaccaro. We paid $7 million of the $10 million and revised the guidance for the difference of the three.
Right
essentially, until we settle that.
Okay.
All in Q3.
All in Q3. All right, great. Thank you.
Our next question is from John Ivankoe from J.P. Morgan.
Hi, thank you. Just a few, if I may. Julie, I think it was also to Chris' question earlier about franchise renewals from 20 years ago. My question is more around closures. One of the leading indicators of closures that we've seen in the industry in the past couple of decades is when franchisees slow down new unit expansion, which is something that you've called out. Just hoping that you can kind of help us think in the next couple of years that there's any kind of natural contraction of the system in the U.S. that may happen. If not, if there's something that you're doing with financial incentives or what have you, that could potentially prevent some closures given some recent results.
Yeah. No. I'd say over the last four years, we've run an average of about 25 closures a year at Applebee's. That's pretty much standard. I don't see any huge change. We run slightly less than that at IHOP. Those are just natural, either attrition of flowing or the trade area's moved away. I don't necessarily see anything extraordinary. In any given year, you can float between 25 and 35, but there's nothing in the next couple of years that I would see on the horizon that's dramatic. As I said before, a lot of the renewals that you all are talking about with the aggressive expansion of Applebee's in the '90s, those come a calling in 2020, 2021, 2022. By the way, that's the same exact scenario on the IHOP side. There is no distinction. They both had huge development in the '90s.
That's when you'll see that changeover. We'll certainly give you plenty of forewarning as to what that looks like and what that potentially entails when we get closer. It's just too far away.
Would just ask for your color, just in terms of franchisees kind of talking about their store profitability or their organization profitability. 2016, was it really a surprise to them in terms of what happened to comps? If you can speak generally or specifically, are most franchisees in a financially strong position to kind of withstand this?
I've mentioned this before. We have a robust process for evaluating franchisee financial health. Our franchisees are smart. They're resilient business people. They've got experience in navigating ongoing industry headwinds. I think from time to time, we have over the last 15 years, we've always seen from time to time a franchisee here or a franchisee there that's got subpar financials. They're weathering the storm, and we're working with them closely.
Okay. Thank you. That's very helpful. There was a previous question about if there was anything unusual in the cash flow statement in 2017. I would like to ask the question in the context of deferred tax liabilities, which actually has been a use of cash for the past couple of years. Since 2013, 2014, it's actually been a fairly significant use of cash as that account has been drawn down. Is there a reason that that may change in 2017? At least, will it continue to be a use of cash, or could that potentially start to become neutral?
This is Gregg again. It shouldn't change substantially in 2017.
It's the same process at play.
It's pretty fixed as to what there's tax differences between the book and the tax. A lot of it has to do with the old IHOP sales of the old business model that'll continue to draw down. We pay taxes on the money we collect off those notes, if you will, where we recognize them for book purposes years ago. That'll continue to come down in similar amounts as it has in previous years.
Thank you for the color. Finally, could you remind us that you've had on-balance sheet cash, non-restricted of $107.8. Is that all unencumbered cash? I guess, what is the unencumbered cash, if it's not that, at the end of the third quarter that you could use for buyback or acquisition or dividend, what have you?
Well, let me say, a lot of that is Applebee's gift cards.
Yeah. That's the important thing to remember is that a significant chunk of that is related to the gift cards.
advertising. Yeah.
We spell out the amounts that are related to the securitization.
Okay. Is there a number that you could say in terms of what the unencumbered cash is of that $107.8? Or is that an exact thank you.
A little less than half.
Yeah. I'd say it's Yeah.
Okay.
It's reasonably significant.
All right. Thanks for that. Thank you.
You bet.
Our next question is from Stephen Anderson from Maxim Group.
Yes. Good morning. Just calling to ask about the SG&A. With your support center consolidation now complete, have you pinpointed any opportunities for further SG&A efficiencies?
We always look at SG&A on an ongoing basis, and it's obviously a big priority. We want to make sure that we balance our being conservative with SG&A, with investing properly in the business at the same time. Both of those are important considerations, but nothing dramatically significant in terms of that right now. We're always looking for opportunities to economize.
Thank you.
We have a question from Chris O'Cull from KeyBanc.
Thanks. I just had a couple of follow-ups. I wanted to follow up on the research process at Applebee's that you're conducting. When do you think we'll start to see changes to the sales plan based on that research?
Yeah, it's not necessarily research, it's a validation process, and boy, I wish I could silver bullet that, but I can't. I think the most important thing is we take the time to really validate how do we maximize our message going forward and make certain that we're meeting and exceeding consumers' expectations. That process is going to take a while, but we'll certainly keep you updated.
Just ballpark, do you think this is something we could see the beginning of next year or the middle of next year, or?
Yeah. Certainly ask me the same question on our earnings call on March 1st, we'll provide you as much of an update as possible.
Okay. Do you guys have a large project plan for the fourth quarter, Tom, that would cause a meaningful acceleration in the CapEx? I think year-to-date, it's like three and a half million, the guidance is $8 million.
Well, you've got IT in there, you've got.
Yeah, it depends on the timing when IT projects close and things like that. We'll keep looking at that on an ongoing basis. CapEx stays at a relatively low level for our business as you know, on an ongoing basis.
Okay. Thanks, guys.
I'll now turn the call back over to Julie for closing remarks.
Thanks, operator. Thank you all again for joining us on the call. We're scheduled to report results for the fourth quarter and the full year of fiscal 2016 on March 1st, 2017, as I mentioned before. If you have any questions in the interim, I want you to feel free to call myself or Ken or Tom. Thanks much.
Thank you, ladies and gentlemen. That concludes today's conference. Thank you for participating, and you may now disconnect.