Welcome to the second quarter 2016 DineEquity, Inc. earnings conference call. My name is Sylvia, and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session. Please note that this conference is being recorded. I will now turn the call over to Ken Diptee. Ken, you may begin.
Good morning, welcome to DineEquity's second quarter 2016 conference call. I am joined by Julia Stewart, Chairman and CEO, Tom Emrey, CFO, and Greg Kalvin, Corporate Controller. Before I turn the call over to Julia 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 substantially different than those expressed or implied. You are cautioned to evaluate such forward-looking information in the context of these factors for detail in today's press release and 10-Q filing. The forward-looking statements are as of today, assumes no obligation to update or supplement these statements. You 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 will now turn the call over to Julia.
Thanks, Ken, good morning, everyone. Thank you for being on the call today. Here are the headlines for the second quarter. We delivered year-over-year growth in second quarter adjusted EPS despite soft comparable sales at Applebee's and IHOP. We also generated free cash flow of $56 million in the first half of the year. IHOP's second quarter comp sales increased by 0.2% while lapping over the brand's highest quarterly sales increase in over a decade. At Applebee's, we saw a decline of 4.2% in comp sales for the quarter. I will elaborate on this shortly. As a result of the sales performance at Applebee's and IHOP during the first half of the year and our outlook for the back half, we are revising our 2016 comp sales guidance downward for each brand.
We will expect comp sales improvement in the second half, given the year-to-date results, we think it's prudent to reset the ranges. Tom Emrey will elaborate on these revisions in his remarks. Applebee's has been number one in casual dining for nine consecutive quarters as measured by total system sales. Our brand remains strong. We continue to drive brand differentiation for the long term while testing and implementing short-term traffic-driving initiatives. In May, we announced the nationwide launch of certified USDA Choice hand-cut steaks on a Wood-Fired Grill using real American Oak. Over 40% of our menu items are now being cooked on the Wood-Fired Grill, from steaks and chicken, salmon, pork chops, and vegetables, all now have that smoky flavor guests love. We're well aware of changing consumer needs and demands, we're testing several revitalization initiatives to address them.
To give you a sense, they include items such as value messaging, revitalizing the bar, Carside To-Go and delivery options, the remodel and new prototype programs, leveraging social and digital media to interact with guests in real time, and simplifying the menu, which includes the deletion of 22 menu items this year alone to make room for new menu innovation. In addition, with an average check of under $14, Applebee's is still near the low end of the scale for casual dining and provides guests with great value, which we define as more than just a price point. We've become more relevant to the younger generation, almost doubling the percentage of millennials in our restaurants in the last four years. As I've said before, changing perceptions of Applebee's and revitalizing the brand will not happen overnight. However, we are already beginning to see a change.
There's more good news. We conducted proprietary research after the launch of Hand-Cut, Wood-Fired platform and discovered that 95% of guests that purchased an entrée prepared on the Wood-Fired Grill said they would repurchase it again due to the overall taste and quality of the item. This is the start of changing the Applebee's story, which takes time. However, this quality improvement was met head-on by consumers looking for value. Based on what we've learned, our best hypothesis is that the platform's performance was impacted by not communicating its value proposition. We are currently working very closely with many of our franchisees to test and validate various value messages to help with short-term traffic. In addition to testing several different value messages with TV, we are also launching local promotional activity across the country to assist with short-term traffic needs. More good news.
While all of this additional traffic-generating work is underway, we have made real progress with improved service at Applebee's. Overall satisfaction scores have increased 500 basis points since the launch of Hand-Cut, Wood-Fired, and 64% of our restaurants are now ranked A or B operationally. To recap, we're changing the story at Applebee's and revitalizing the brand. This will not happen overnight. A major step in our journey was the introduction of the new wood-fired cooking platform, which, as I said earlier, impacts over 40% of our menu. It doesn't end there. We are testing and validating several revitalization initiatives while laser-focused on enhancing our service to the guests, a key component of price value. We're testing several value-related messages to give guests reasons to visit our restaurants and come back more frequently in the short term.
We are number one in casual dining, we serve over 1.25 million people a day. We will not be deterred. Our franchisees are supportive and want to be part of the revitalization. Now let's switch gears to IHOP. Despite achieving its 13th consecutive quarter of positive comp sales, IHOP sales performance wasn't what we had hoped for either. It's worth noting that in the second quarter, we logged over the brand's strongest results in over 10 years, a 6.2% increase. We believe that consumer sentiment shifted during the quarter and caused guests to be more conservative and value-driven. On sustaining and building on IHOP's momentum, we're reinforcing our breakfast heritage and leadership position through everything that we do. We're testing additional platforms, there's more work to be done.
We're streamlining our menu to make it easier to execute in the back of the house, while continuing to build a pipeline of innovative and unique menu items. Evolving our breakfast strength to other day parts with IHOP's unique ability to provide a personalized offering to consumers will be a key aspect of these exciting changes. We're driving a significant and exciting remodel program, as we've said before, we're on track to have approximately 350 restaurants completed in 2016. The cost of the remodel ranges from approximately $100,000 to $175,000, depending on the extent of the remodel. We're placing a greater emphasis on our food, which is made fresh to order with the use of fresh ingredients, certainly differentiates us from fast food restaurants. As I said earlier, there are parallels with Applebee's.
IHOP also needs a compelling long-term value message, we are communicating an even more pointed value message going forward. One proven fact of how we'll accomplish this is by bringing back Kids Eat Free this month. This will be the centerpiece on our new value strategy, which we expect to drive traffic. How we communicate these initiatives in the coming months and years is just about as important as what we're communicating. We've a continued focus on the use of technology, including social and digital media, to engage with our consumers. To this end, one-on-one daily engagement is central to our social media strategy, we're capitalizing on real-time content opportunities to keep the brand relevant. We're also challenging ourselves to raise the bar and continually strive to take our advertising to the next level.
To achieve this, our new ad agency of record will assist with developing a new creative message. The new direction we've taken will be reflected in the campaign that kicks off at the end of September to support the introduction of new innovative seasonal items. Turning briefly to development, which is also a key part of our strategy. As you read earlier in our guidance, we're going to guide, excuse me, on the lower end and suggest that we may overall open five less restaurants. Our analysis suggests there is ample headroom to continue developing Applebee's and IHOP restaurants in the U.S. and internationally. We are working with our franchisees, both existing and new, to expand our footprint in rural, suburban, urban, and non-traditional locations. We're currently assessing our longer-term international development projections, will provide an update on our progress next quarter.
With that, I'll turn the call over to Tom to discuss briefly the quarterly results. Tom?
Thanks, Julia. Good morning, everyone. I'll provide a brief recap of the second quarter's financial results, starting with the income statement. Adjusted EPS in the second quarter was $1.59 compared to $1.53 in the same quarter of 2015. The increase was mainly due to fewer weighted average shares outstanding, lower income taxes, higher gross profit, and a decline in cash interest. These items were partially offset by higher G&A. Regarding gross profit for the second quarter, the slight year-over-year increase was mainly driven by development by IHOP franchisees over the last 12 months and favorability in IHOP royalties and dry mix. These were partially offset by lower Applebee's royalties and a decline in financing interest income. Turning to G&A, on an adjusted basis to exclude non-recurring consolidation charges, second quarter G&A was approximately $36 million compared to roughly $35 million in the same quarter of last year.
The increase was primarily due to higher personnel-related costs. When including roughly $500,000 of consolidation costs, G&A was $36.5 million. Please note that G&A for the second quarter also reflects lower incentive compensation accruals due to the comp sales performance of both brands in the first half of the year. As a reminder, there is some seasonality to our G&A in the back half of the year related to our annual franchise conferences, which are both scheduled for the third quarter this year compared to the fourth quarter in 2015. For the full year, we reaffirm our G&A guidance range of between $154 million and $158 million. Please note that this includes a total of approximately $4 million of non-recurring costs related to our restaurant support center consolidation, and I'd like to highlight that these costs do not have an impact on adjusted EPS.
We continue to closely manage our G&A. Now I'd like to provide a brief update on the restaurant support center consolidation. The process is nearly complete and is going as planned. Year to date, we've taken approximately $5 million in charges. Of this, roughly $2.6 million hit G&A, primarily for relocation and recruiting related to the consolidation. We also incurred a charge of approximately $2.5 million in lease termination costs related to the facility in Kansas City, which were included in closure and impairment costs. We initially estimated that we would incur approximately $8 million in pre-tax consolidation costs solely related to the facility in Kansas City. Our original assumption was based on the entire facility being subleased. We now estimate that we'll incur a total of approximately $5 million as a result of terminating our lease on two floors of the Kansas City building.
Our team members will be moved to one floor that we will retain. On our tax rate, the tax provision in the second quarter of 2016 was lower due to our adjustment of state deferred taxes as a result of the restaurant support center consolidation. A few comments on the cash flow statement. Cash flows from operating activities were $54 million for the first six months of 2016, compared to $48 million for the same period last year. The increase in cash from ops was primarily due to favorable net changes in working capital due to having paid less interest on our long-term debt and an increase in advertising funds and marketing accrual. As a reminder, the initial interest payment on our securitized debt in the first quarter of 2015 represented five months of accrued interest through March of 2015.
All subsequent quarterly payments, including the payments made in the first and second quarters of this year, represented three months of accrued interest, respectively. The increase in cash from ops and the favorability in CapEx were partially offset by slightly lower net receipts from notes and equipment contracts receivable, resulting in free cash flow of approximately $56 million for the first six months of 2016, compared to nearly $50 million for the first six months of last year. In the second quarter, we returned a total of $32 million to shareholders, which included $17 million in cash dividends and $15 million to repurchase roughly 181,000 shares of our common stock. Turning to our performance guidance for fiscal 2016, I'd like to highlight a few revisions, but please see our press release for details on the complete guidance. We now expect Applebee's comps to range between negative 3% and negative 4.5%.
The previous range was between negative 2% and positive 2%. We currently expect IHOP comps to range between positive 0.5% and positive 2%. The previous range was between positive 1% and positive 4%. We are also making incremental investments over the next few months for testing additional marketing programs with Applebee's as part of our plan to generate traffic. We expect this to result in a decrease of approximately $2.5 million in Q3 franchise segment profit. Combined with the revised comp sales guidance, we now expect franchise segment profit to range between approximately $342 million and $352 million for the fiscal year. The original franchise segment profit guidance was between $345 million and $360 million. We will continue to review our performance guidance on an ongoing basis. With that, I'll now turn the call back over to Julia for her closing remarks. Thanks.
Thanks, Tom. To recap, we delivered growth in adjusted EPS despite comp sales being below our expectations. We also continue to generate strong free cash flow. A significant part of our story is that we have two iconic brands. IHOP is a leader in the industry's only growing day part, and we're in the early stages of revitalizing Applebee's, one of the world's largest casual dining chains. Getting both brands firmly back on track is our top priority. We're taking steps to drive positive and sustainable sales and traffic with a renewed focus on value at each brand. We also continue on thoughtfully exploring a strategic acquisition. Finally, the consolidation of our headquarters is nearly complete, and we're seeing the benefit of real synergies across the organization, which has facilitated more effective collaboration.
The consolidation resulted in approximately 100 new hires and has brought our two strong brands under one roof. In closing, we're confident in our plans and the strategic steps we're taking to drive the business forward. 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 you're using a speakerphone, you may need to pick up the handset first before pressing the numbers. Once again, if you have a question, please press star then one on your touch tone phone. The first question comes from David Carlson from KeyBanc.
Hi, I just had a really quick question. Is the thought process being that on the free cash flow that after paying dividend, that you still plan to spend the excess to repurchase shares? Then a follow-up to that being, given the same restaurant sales decline and the revised guidance, has it at all caused you to revisit your capital plan?
No, it hasn't. It hasn't made any real significant adjustments to our free cash flow when you look at it in totality. We've been doing what we've been doing for the last while, and we're not probably going to be making any changes to that.
Our following question comes from Brian Vaccaro from Raymond James.
Good morning, thanks for taking my questions. Julia, I wanted to just start out with the Wood-Fired Grill platform at Applebee's, appreciate some of the details around the initial guest response. Can you remind us sort of what's been done so far to build awareness around the platform and what the plan over the next several quarters would be to continue to drive awareness there?
Sure. In the middle of second quarter, we began the advertising that talked about the fact that we had this wood-fired platform and also that we were hand-cutting our new USDA Choice certified steak on the American Oak. That was the major thrust. For the balance of the year, you'll see more of it about both the value messaging, it also relates to other products that go on the wood-fired platform. The only thing we talked about in the initial launch was about steaks, over 40% of the menu at this point is affected by the wood-fired platform. The balance of the year, you'll see that. For instance, right now we're in the middle of salads, which many of them, the protein that's on the salad is on the wood-fired platform and also making dressing in-house.
It continues those quality cues, a lot of it related to wood-fire. The reason I mention the testing is we think there's an opportunity to bring in a stronger value message. That was the marketing, if you will, and then there was PR and there was additional in-store re-messaging that we did as well with the launch.
Okay. All right. That's helpful. Secondly, wanted to ask about your perspective sort of on the broader industry weakness and maybe from two angles. First, sort of the ongoing debate regarding the health of independents and their relative performance versus the chains. Could you share your perspective from what you're seeing on the ground or hearing from franchisees in that regard?
Yeah, it's very interesting. I think you've heard me say for some time that the consumer is lumpy and bumpy, and I would continue to say that. I think in general terms, there hasn't been a huge shift in market share. What you saw a couple of quarters ago in terms of independents versus chains is very similar. We are so big, to make a change in that category mix shift would take a lot. In general, you're seeing very much the same in terms of market share and so forth that we saw, I would say even three quarters ago. Not huge changes and shifts. I think if you're going to see that, it would reflect probably over several quarters.
All right. You mentioned your mix of millennials in terms of the consumer mix is up significantly over the past four years. Could you share where that percentage stands these days?
Sure. Millennials are now over 40% of the mix at Applebee's. That's significantly higher than many of our close-in chain competitors. I don't have the way to get at the independents, but that's through the work that we've been doing both in revitalizing the brand, and clearly, there's no question the social and digital strategy has made a significant inroad as well. The bar, that is one of the advantages we have at Applebee's. The bar does attract the millennial, and we have programs to enhance that. I think you heard in my prepared remarks about the revitalization of the bar.
Great. Thank you.
Our following question comes from John Ivankoe from JP Morgan.
Hi. I wanted to go two different places. First, just the overall attitude and willingness of not only the Applebee's franchise system to reinvest. Are you sensitive, Julia, you have some experience in this industry, are you worried about potential closures or non-renewals of the franchise system, especially as growth for the brand was so robust 20 years ago?
Well, I'll start by saying that we only have 32 franchisees in the Applebee's system who own almost 2,000 restaurants. This is a very well-heeled, sophisticated, thoughtful group of franchisees who have, over the years, invested millions and millions of dollars in this business. Just like our IHOP franchisees bleed blue, our Applebee's franchisees bleed Applebee's. They care deeply about it. It's their primary business, and they want to see it as successful as we do, if not more so. They are highly committed. As I said, they've been willing to test all along with us and continue to do so because they too believe that consumers' expectations and demands are changing. When you have 40% or more of your consumer base as millennials, their expectations are different than a baby boomer's, if you will. I'm grossly simplifying, but you get the gist.
The needs have shifted, the franchisees, I think, because they are so savvy, are willing to move with us. If that means a closure here and there, as it has over time, we figure it out and we work with our franchisees. I think you're also seeing more and more franchisees willing to realize if the shift of the trade area moves, they move with that new trade area. It's not just about closures, it's about moving to new areas of growth and development, and they're very focused on that. They've been terrific partners in that whole arena.
You made this comment in your prepared remarks about potential growth of Applebee's in the U.S. As you have conversations with these 32 franchisees and they have a sense of their pipeline, what may be closing, what may be moving, what might be opening, can the system sustain the number of units that it has today? What's kind of your view over the next couple of years in terms of the U.S. Applebee's store count?
As you know, we announced, gosh, it's probably been two years ago that we thought Applebee's could do a couple hundred more restaurants, and that was over the old modeling work that we've done.
Jim has been with us for a year and has done even new and more sophisticated modeling, and that number is still very relevant. That work is in progress. The mapping that he does individually by DMA, and with each franchisee is a very thoughtful review of where they are, where they could grow, and what the map suggests as either trade areas develop or grow or move. That work is going to be in progress, well, really, the end of this year and the beginning of next year, to really hone in on that sophisticated level of development and where we might be able to go.
What will be interesting in that work, I've really never talked about this before, much similarly to the work we're doing at IHOP, is whether there are fill-in opportunities in existing markets where you use a smaller footprint or you look at different ways to outlay that marketplace. That's the work that Jim and his team actually have been working on. We'll be finalizing and then literally sitting down with each individual franchisee. All of these franchisees are sophisticated developers, but they want that additional mapping work, which we are in the process of finalizing. That will be an opportunity for them to really stretch their wings and look at the growth potentials by DMA. Some have more potential than others.
Can you give us color to the extent that it's appropriate about kind of the state of those 32 franchisees? Should we expect to see more consolidation? Maybe there could be some fragmentation, maybe there are some generational issues amongst what I think some of these are family-owned businesses that may be transitioning. How do you anticipate that franchise community changing, and can that be to a benefit to you in the next few years?
I think you'll always, I've been saying this for years on both businesses, there's always buyers and sellers. That's no different this year than it's been any other year. You'll always see a couple of transactions from an existing franchisee to a new franchisee, whether they're in the system today or not. Our recruiting efforts this year, just like any other year, have produced a handful of interested parties who'd like to become a franchisee. I think that buying and selling, if you look over the last, gosh, I'll say five years, in any given year, you've had a handful of franchisees sell and handful of either new franchisees or existing franchisees buy. I don't see that as any different this year.
Okay. Thank you. Let me change directions for a second. It looks like your net debt to adjusted EBITDA is around four and a quarter, I think. Is that what you guys calculate?
Yes.
More or less.
Yeah.
A little higher than that. Mid-fours.
Okay. Mid-fours. What is the appropriate target leverage ratio for the company at this point? Just remind us what kind of either refinancing opportunity or, I guess probably better said at this point, tack-on ability that you have to the current facility, that if you wanted to put more leverage, half a turn or a turn or whatever, could you and would you, I guess is the question.
Let me start off with saying, we've said for several quarters when asked that question, that we are very comfortable with where our leverage ratio is today. We feel very good about it, but I'll let Tom answer in terms of the refi specifics.
No, I think that's fair. We can't really refinance the securitization for a while anyway, it runs out, the total period of it is 7 years. It runs through 2021. There's no urgency to do that. We feel pretty good about where we are, and as it stands now, don't propose to make any significant changes to it. There is some room to borrow more under the securitization, potentially. We'll also evaluate that as needs arise.
And then just to refresh your memory, we do have the revolver, which is $100 million. We have that revolver as well. And what was drawn against the revolver? Like five?
Yeah, about five. Yeah.
Yeah, about five. Yeah.
It's tied up in the letters of credit.
Yeah, it's really tied up in the letters of credit, but we always have the revolver as well. Sorry, I didn't mean to interrupt.
Oh, please. In addition to that revolver, you're carrying $118 million of cash. How much of that can be returned to shareholders? How much of that do you want to perpetually hold back versus could be used for other purposes?
Well, a fair bit of that money is advertising and gift card related and all that. What you should look at is the metric that we talk about when we talk about our annual free cash flow and the amount we return to shareholders, and that's been pretty consistent over the last couple of years, and that's sort of the way to kind of look at it.
Okay, thanks.
Our following question comes from Michael Gallo from C.L. King.
Hi, good morning.
Good morning.
One question and one follow-up. First on Wood-Fired Grill, Julia, I know you noted very strong purchase intent, and customers seem to really like the product. I was wondering whether with some of the changes, whether perhaps some of the core price points might be too high for where the customer is today. I know you're addressing it a little bit here on air with the $8.99 salads, can you speak to whether some of these changes and improvements might have priced it a little above your core customer? Also, I have a follow-up question. Thanks.
Yeah. Great question. Really good question. I think there's two things to remember. In the casual dining space, you have a lot of light user base. We recognize, and we've said this repeatedly, that it takes time for people to try the item, come in and actually do it. As in all of casual dining, there is a huge light user base, it does take time. I don't want to underestimate the importance of people making clear when they're ready to go in, they'll try it, and they can't wait, that type of thing. We know that. The other thing I mentioned is, it's less about the price that actually franchisees are charging for it. It was the fact that we didn't put a price point on television.
Our hypothesis is some people may have thought, "Gosh, this is going to be expensive." We have a way to counter that with the work that we're doing for the balance of the year. I think those two things combined are an important factor to remember.
Okay, thank you. Just to follow up on IHOP. It's really outperformed for a long period of time, and you've done a great job with the brand. I was wondering this quarter whether you really saw anything shifting, either competitively or otherwise, or was it just more a function of Paradise Pancakes perhaps not being as strong a promotion as Summer Stacks was last year? Thanks.
Yeah. Great question. We continue to do well. The brand is, as you might well imagine, iconic in so many ways. I think as I said in my prepared remarks, we recognize there's probably an opportunity as we think about messaging the brand to consumers, to be a little stronger in terms of reminding people what we do differently and better than everyone else. Thus the notion of the new ad agency, thus the notion of being a lot more focused on, I wouldn't say aggressive, that's probably not a fair word, but being a lot more targeted in our approach about the things we do that virtually no one else can do, and talking about them in a more meaningful way.
I think I've sort of tongue in cheek talked about the fact that we've been serving breakfast all day for 57 years, and we've been scratch cooking for forever and the like. There's probably a little bit more of a targeted approach we can do to the messaging that we think we need to get after. The brand is certainly solid and iconic and brings back memories for anybody and everybody. I think there's an opportunity in the messaging, and that's really the focus that I was trying to get across in my prepared remarks.
Just as a follow-up to that, am I hearing you right that you don't really see much changing in the dynamic around competitive or geographic or otherwise? It's just from a standpoint of IHOP controlling what it can control. Is that fair?
I think that's fair, I would also say, and I think I mentioned this a couple of quarters ago, there is no question, you have significantly more people in the breakfast space today than you did five years ago.
Yeah.
That's why it becomes so important how you message what we do differently than everybody else. We just have to be more laser-like in that communication.
Okay, thank you.
The following question comes from Alton Stump from Longbow Research.
Hey, guys. It's actually Brittany Whitman on for Alton this morning.
Hi, Brittany.
Hi.
Hi. How's it going? On the wood-fired cooking platform, I wanted to ask about the guest traffic that's driving. Is it mostly just new customers, or is it more regular customers coming in more often, or what's that dynamic?
I think the dynamic is that you have existing guests who know and love us coming in a lot more frequently. The opportunity is to get that infrequent and light user to come in. Thus, everything I talked about today about really focusing on the value piece of it and driving it home to that light or infrequent user that may be either shopping or just needs to be reminded of what we've got that's new and different.
Is there anything in the platform that maybe you could talk about to sort of keep that going?
Well, there's lots of things. I mentioned it early on that over 40% of the menu now being impacted by Wood-Fired Grill, we have a real opportunity to talk about some of those other items. It's not just about steak. I challenge you to go have that pork chop and tell me that's not the best pork chop in America. The salmon or the grilled vegetables. They're really fabulous products, thus this notion of now what we've got on air talking about salads. We have a real opportunity not just to talk about the platform, the innovation doesn't stop there.
All the things I mentioned to you early on about all the new initiatives that really are focused on the revitalization, it's not just that Wood-Fired platform, it's a great beginning. There's a lot more to talk about related to that and this value messaging. I always have to remind people, we play at the low end of casual dining. There's a real opportunity there to take advantage and optimize that.
Okay, great. Thanks, Julia.
We have no further questions at this time. I'd like to turn the call back over to Julia Stewart for closing remarks.
Well, thank you all again for joining us on the call today. We are scheduled to report results for the third quarter on November 1st. If you have any questions in the interim, as always, feel free to contact Ken or Tom or myself, thanks again.
Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.