Dine Brands Global - Earnings Call - Q2 2017

Transcript

Speaker 0

Hello, and welcome to the Second Quarter twenty seventeen Dine Equity Earnings Conference Call. My name is Eric, and I'll 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 Diddy. Please go ahead, sir.

Speaker 1

Good morning, and welcome to Dine Equity's second quarter twenty seventeen conference call. I'm joined by Richard Dahl, Chairman and Interim CEO Greg Calvin, Interim CFO and Corporate Controller Darren Rebels, President of IHOP John Cywinski, President of Applebee's and Daniel Del Humo, President of our International division. Before I turn the call over to Greg, please remember our safe harbor regarding forward looking information. During the call, management may discuss information that is forward looking, involves known and unknown risks, uncertainties and other factors, which may cause the actual results to be substantially different than those expressed or implied. We caution you to evaluate such forward looking information in the context of these factors, which are detailed in today's press release and 10 Q filings.

The forward looking statements are made 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 from Dine Equity's Investor Relations website. With that, I'll now turn the call over to Richard.

Speaker 2

Okay. Thank you, Ken, and good morning, everyone. We have a lot to cover today, and I trust you all had the opportunity to review our press releases on earnings, the dividend and last but certainly not least, the appointment of our new Chief Executive Officer. We have searched long and hard for a new Chief Executive Officer for Dyne Equity. We have assessed talent both within the industry and outside of our industry.

It became quite clear as our process evolved that Steve's choice would be the best choice for the CEO of Dine. He is a doer. He is excellent with franchisees, turning around assets, building culture and catalyzing growth in the hospitality business. The restaurant and hospitality industries are similar in that loyalty and revenue increases are dependent upon providing a compelling product at a strong value. Steve will become CEO effective September 1237.

I've known Steve over the past several years as a fellow director. His clear vision and innovation make him the perfect leader for our company. His experiences in the restaurant and hospitality industry, both as a franchisor, operator and owner, make him uniquely qualified. And importantly, his skills in dealing with challenged businesses fits our current situation. Steve is on this call, and I will ask him to say a few words as we wrap up the discussions on our earnings and the presentations by the Division President.

I would like to focus on a few issues before I ask Greg Calvin, John Sawinski and Darren Rebelez to add their comments. For Applebee's, we have a great group of franchisees who are fully invested as is Dine in restoring guest confidence and financial health to our brand. Efforts to re empower the brands with necessary financial and human resources are well underway. John will discuss significant improvement in restaurant operations, work on our culinary pipeline and new advertising material. Also today, we'll discuss revised guidance on the closure of Applebee's restaurants.

We are long overdue in rationalizing the size of our system in closing poorly performing restaurants. Additionally, we will discuss a contribution by Dine to help shore up a shortfall in the Applebee's 2017 ad fund. This is clearly necessary at this time to produce new media material and get our message out. We will also bring you up to date on important curbside to go initiatives. The vitality of IHOP is tremendous.

Net development activity is robust along with remodels and new store concepts. While comp stores while comp sales have indeed suffered, Darren will address this as well as the fact that franchise revenues and overall guest satisfaction scores are both very positive. Also Darren will fill you in on our new packaging innovations and the launch of our initiatives in the to go and delivery business. This is a tough year, but a very exciting year. Before I turn the call over to John and Darren, I'll ask Greg to walk you through the relevant financial results of the quarter as well as our revised 2017 performance guidance.

Greg?

Speaker 3

Thank you, Richard. Good morning, everyone. For the second quarter, our adjusted EPS was $1.3 compared to $1.59 for the 2016. The variance was primarily driven by lower gross profit due to 6.2% decline in Applebee's comp sales, slower collection of Applebee's royalties and higher Applebee's restaurant closures. The impact of these declines on adjusted EPS was partially offset by fewer weighted average diluted shares outstanding.

Turning to G and A expenses, the slight increase in G and A for the 2017 compared to the same period of 2016 was mainly due to higher cost for professional services. The increase in professional services was primarily driven by investments in Applebee's stabilization initiatives, which include the utilization of third party consultants to assess the brand's performance and provide actionable recommendations. Regarding the $10,000,000 in costs associated with Applebee's stabilization initiatives we discussed last quarter, approximately $6,000,000 was incurred in the 2017. We now expect the remaining $4,000,000 will be incurred ratably over the second half of the year. As a reminder, we anticipate that a substantial amount of these costs will not recur in 2018.

Lastly, would like to highlight that these costs are unrelated to the $8,000,000 committed to the Applebee's National Advertising Fund, which will not be included in our G and A. These costs will be recorded as an expense in our Franchise segment ratably over the 2017. Turning to our tax rate. Our GAAP effective tax rate for the 2017 was 46.5% compared to 32.5% for the same period last year. The variance was primarily due to an increase in our estimated unrecognized tax benefits in 2017 related to deductions associated with certain internally developed software and the adoption of new accounting guidance that addresses the treatment of certain assets of share based payments.

For adjusted earnings per share, we currently expect our effective tax rate for the full year 2017 will be approximately 40%. This compares to our previous guidance full year guidance of approximately 38%. Moving to the cash flow statement. Cash flows from operating activities for the first six months of twenty seventeen were approximately $21,000,000 compared to $54,000,000 for the same period of last year. The overall decline was mainly attributed to lower net income resulted from a decrease in gross profit from franchise operations and higher G and A.

The increase in G and A was primarily due to approximately $9,000,000 of non recurring cash severance and equity compensation charges incurred in the first quarter related to the separation of our previous CEO and the $6,000,000 incurred in the 2017 for the Applebee's stabilization initiatives. Cash from operations was additionally impacted by net changes in working capital, which used cash of approximately $25,000,000 for the 2017 compared to using cash of roughly $12,000,000 in the same period of 2016. The variance was primarily due to the timing of brand advertising payments. Adjusted free cash flow for the six months of twenty seventeen was approximately $19,000,000 compared to approximately $56,000,000 in the 2016. The decline was due to lower cash from operations as previously discussed and higher capital expenditures compared to the first six months of twenty sixteen.

The increase in capital expenditures was mainly due to Test Kitchen related construction costs at our corporate headquarters and additional investments in IT for consumer facing initiatives. Turning to an update on Applebee's franchisee financial health. We continue to partner with our franchisees and our financial advisor Trinity Capital. This is a very thorough and thoughtful process by which all franchisees may avail themselves to various financial assistance programs, including restaurant closures and direct financial support. Franchisee financial health matters are reviewed by both the brand and Trinity.

Direct financial support where necessary is progressing. Currently only a minority number of Applebee's franchisees have availed themselves to any direct financial assistance in this program. However, I'd like to point out that all but a few franchisees have participated in the improved closure process for underperforming restaurants. As we have discussed previously, not all Applebee's franchisees are in the same position and each case is being reviewed separately. With that said, there is a franchisee who accounts for approximately 5% of our domestic system wide sales that is exhibiting a higher level of financial difficulty.

We are actively working to address this franchisee specific situation. Regarding the sale of the remaining company operated IHOP restaurants, this past June we refranchised nine of the 10 restaurants in the Cincinnati market which were used mainly for test market purposes. The one restaurant that was not refranchised was closed. With the refranchising and sale of the related restaurant assets completed, we no longer operate any IHOP restaurants. Both brands are now 100% franchised.

Finally, I'll turn to our revised performance guidance for fiscal twenty seventeen. I'd like to provide a few highlights, so please see our press release issued today for complete details. We now expect Applebee's comp sales to range between negative 6% and negative 8%. Our guidance reflects the expected timeframe we believe it will take to implement sales and traffic driving initiatives to see meaningful results. At IHOP, we now expect comp sales to range between negative 1% and negative 3% reflecting the brand's performance in the 2017.

We now forecast Applebee's closures to range between approximately one hundred and five and one hundred and thirty five restaurants to reflect the ongoing franchisee financial health work discussed earlier. Our G and A is now expected to range between approximately $166,000,000 and $172,000,000 including non cash stock based compensation expense and depreciation of approximately $22,000,000 The revised range mainly reflects expectations for the timing of hiring for new positions and lower incentive compensation costs. As a reminder, G and A is inclusive of approximately $9,000,000 of non recurring cash severance and equity compensation charges in the first quarter of twenty seventeen, which was added back in our calculation of year to date adjusted EPS. Turning to adjusted free cash flow. Based on our revised guidance for segment profit, G and A expenses and taxes, we now expect a range of approximately $76,000,000 to $86,000,000 Lastly, capital expenditures are now estimated to be approximately $14,000,000 The projected small increase compared to 2016 is primarily due to IT related projects.

To close, we expect the business to generate substantial adjusted free cash flow this year despite the challenges facing our brands. We are committed to ensuring the financial health of our franchisees and making the necessary investments to further strengthen the business for the long term and drive shareholder value. And with that, I will turn the call over to Don.

Speaker 2

Thanks, Greg, and good morning, everyone. Over my first one hundred and twenty days or so with the brand, I've spent considerable time with our 33 franchise partners to truly understand their perspective on our recent past and to gain alignment on our path forward. While the past twenty four plus months have been extraordinarily difficult, our partnership and commitment to one another is strong, as is our understanding that our turnaround won't happen overnight. Together, we've concluded the initial assessment stage of the plan and we have a firm grasp on where things went wrong, as well as a detailed action plan to enhance Applebee's relevance and performance moving forward. Now I'd like to frame my remarks this morning around the following components of the business: Restaurant Operations, our Guests, culinary innovation, and brand marketing.

So starting with operations. We've had too much restaurant variability across our system as well as a rather high percentage of guests not satisfied with their experience. Franchisees, however, have shown significant improvement on this front over the past few quarters, with the percentage of poorly operated restaurants narrowing from a high of 16% down to about 4% where we currently stand. Our focus moving forward is simplifying our operation while elevating the guest experience across all 33 franchise groups. As part of this initiative, we have retained PricewaterhouseCoopers to help us unlock between one hundred and two hundred basis points of restaurant level profitability over the next couple of years, which can be redeployed as necessary to labor and food investment.

Now as Greg outlined, we'll be aggressive on restaurant closures this year. These closures typically fall into one of two categories. The first consists of older locations in lapsed trade areas where once vibrant retail, residential and traffic characteristics are just no longer present, often where the desirable trade area within a town has simply moved over time. The second category consists of underperforming and perhaps even brand damaging restaurants with unsustainable unit economics. These are typically well below average unit volumes where the franchisee portfolio benefits financially from the closure and the brand benefits because we are no longer experiencing our guests are no longer experiencing a substandard Applebee's.

Again, the resulting sales impact is perhaps less than expected as these are very low volume restaurants. In either case, these restaurants need to close and perhaps should have closed long ago. Of course, these are complex, requiring exit negotiation of the remaining lease obligations. This removal of nonviable restaurants is an important tool to stabilize the financial health of franchisees, and I anticipate it continuing to a lesser extent in 2018. It's also possible that we experienced the consolidation of an existing franchise entity or the addition of a new franchisee before the end of this year as part of our ongoing optimization.

Again, this is all part of our long overdue portfolio rationalization that should have taken place probably in the normal course of business. Now, let's shift attention to our guests and perhaps one of the brand's strategic missteps. Over the past few years, the brand set out to reposition or reinvent Applebee's as a modern bar and grill, an overt pursuit of a more youthful and affluent demographic with a more independent or even sophisticated dining mindset, including a clear pendulum swing towards millennials. From my perspective, this pursuit led to decisions that created confusion among core guests as Applebee's intentionally drifted from its, what I'll call, its Middle America roots and its abundant value positioning. While we certainly hope to extend our reach, we can't alienate boomers or Gen Xers in the process.

Much of what we are currently unwinding at the moment is related to this attempted repositioning. Now, directionally speaking, the Applebee's guest is more middle income than upper income. Our age demographics remain broad, and we over index with families. Moving forward, we'll primarily focus on two target segments. The first we categorize as routine traditionalists.

They like CDR chain restaurants. That's important. They skew a bit older. They don't mind spending more for good food. And they tend to be creatures of habit, ordering familiar favorites more often than not.

The other equally important group is value seekers, not surprisingly. These folks also like CDR chain restaurants. However, they tend to be brand switchers, searching for the best deal rather than a specific menu item. Together, segments are predisposed to like Applebee's a lot and they make up a meaningful percentage of our core guests and revenue. From a culinary perspective, we recently hired, and I'm pleased to announce, Chef Stephen Baldorelli as our new Chief Culinary Officer.

Steven is a CDR veteran and has been leading Chili's culinary efforts over the past five or so years. While Steven brings deep experience commercializing menu initiatives across large scale brands, what I value most is his clear guest orientation, his passion for ops driven innovation without unnecessary complexity and his commitment to franchisee collaboration. These traits will certainly serve Stephen well here at Applebee's. And as he steps into his role, we have three immediate culinary priorities. Number one, reestablish a relevant innovation pipeline with a new disciplined validation process.

Much of our twenty sixteen innovation work was focused on hand cut wood fired steak, so the broader pipeline requires replenishment. The good news is our testing process is now in place in partnership with our marketing and insights team and we'll begin to see tested propositions beginning early in Q1 twenty eighteen. Number two, address the quality and value gaps that have emerged from our core menu satisfaction study. Our action steps are clear. The work is underway with an emphasis on abundant value, presentation and taste, including the possible reintroduction of a few guest favorites that were removed as part of the earlier referenced repositioning effort.

Again, with proper testing and supply chain lead time, these initiatives will impact our menu also beginning next year in Q1. Number three on culinary, assess whether the brand gets credit truly gets credit for hand cutting steaks in restaurant and whether we should continue with this approach. A tested guest and ops driven decision will be reached with franchisees over the next few months. Now on the marketing front. We have near term challenges as our national ad fund is reduced from a year ago.

As Greg referenced, due to negative sales, restaurant closures and some franchisees experiencing financial difficulty. As mentioned earlier, the $8,000,000 Dine equity contribution will partially offset this erosion. In addition to the ad fund decline, our biggest marketing constraints have been the absence of tested proven propositions as well as the absence, frankly, of lead time. This has led to a compromised plan with few alternatives and poor execution. The good news is that's behind us.

Our Marketing and Culinary teams have developed a fully integrated 2018 brand marketing plan, which has the enthusiastic endorsement of our Franchise Business Council. Additionally, we refined our national media strategy for greater impact beginning right now as we approach Q4 of this year. So our marketing priorities moving forward are clear. Number one, become more relevant from a price value perspective. Affordability has always been a cornerstone of the Applebee's brand, and it's essential to our guests now more than ever.

Bottom line, we've taken our eye off the ball here and we have work to do. Number two, better leverage guest insights and ensure a strong correlation between test results and end market performance. We've addressed both of these with an entirely different and disciplined process, which will pay dividends in 2018. Number three, we established our off premise business as a growth engine under the leadership of Scott Gladstone, our new Vice President of Strategy and a former BCG consultant. Applebee's led the CDR category of CarSide to go in the early 2000s and then allowed that leadership position to drift over time.

While it's been a priority for our convenience driven guests, it simply hasn't been a priority for the brand. We have work to do here from a guest perspective as our to go experience is highly variable from one restaurant to the next. Our website will be redesigned for enhanced branding, functionality and personalization effective early Q4, not far away of this year. You'll hear more as we progress, particularly around operating standards, online ordering and payment, packaging, marketing as well as our very encouraging delivery test initiatives. Number four on the marketing front.

Reignite Beverage innovation is a driver of incremental check-in revenue. In particular, Bar is a latent brand equity in a highly profitable 14% of our sales mix. We're excited about this initiative under the leadership of our Vice President of Beverage Innovation, Patrick Kirk, who came to us last year from Buffalo Wild Wings. Finally, we plan to reestablish Eaten Good in the neighborhood as our core brand and advertising platform right out of the gate in 2018. There's equity and differentiation here, and we plan to leverage it moving forward.

From a marketing perspective, we're fixated on core guest insights, discipline and developing relevant content. We'll simply marry the right target with the right programming and the right message, something that frankly we haven't done well of late. In summary, we're back to basics in virtually every respect as we view 2017 as a transitional year for the brand. Our optimization and turnaround is underway, but it will take time to restore Applebee's to financial health. And I don't expect a trajectory change in our performance until we begin to implement our initiatives in early twenty eighteen.

We remain committed to our franchise partners, and they, in turn, are aligned and enthusiastic around our vision for the future. With that, I'll turn it to Darren. All right. Thanks, John, and good morning, everyone. We ended the second quarter as well as the 2017 on slightly positive franchise restaurant sales, which consisted of 1% growth over the respective periods in the prior year.

This was offset by a 2.6% decline in second quarter comp sales. Although we downwardly revised comp sales guidance as a result, we upwardly revised expectations for franchisees to develop between eighty and ninety five restaurants globally this year, the majority of which are domestic openings. The solid pace of development by franchisees in the 2017 led to 33% growth in new restaurant openings over the first six months of last year. We're clearly disappointed in IHOP's comp sales declines. This was mainly due to softness in the dinner daypart as a result of promotions that did not have the impact on sales and traffic as expected.

The family dining category remained highly competitive as guests continue to focus on value and convenience. But IHOP remains on solid ground as we continue to execute our strategy, developing off premise occasions, enhancing the guest experience through remodeling restaurants and technology and expanding our innovative culinary pipeline. Our plan focuses on also improving the guest experience outside of the restaurants. Consumers desire speed, quality, portability of food and affordability. They also utilize online ordering and apps to reduce their wait time.

To further build on our revitalized IHOP and GO platform, which is designed to grow off premise sales and meet the convenience needs of our guests, we completed the rollout of our proprietary new packaging. This ensures that IHOP's food will be just as delicious when taken off premise. Additionally, we began the rollout of our online ordering platform in the second quarter. We anticipate completing the deployment system wide by the end of Q3. Although it's early, I'm pleased to say that we're seeing average guest check growth from the online ordering platform versus phone orders.

We're very optimistic about the potential impact of online ordering on our to go sales, which today accounts for approximately 5% of our sales mix. Another opportunity for us to create an additional revenue channel is through delivery. We're currently in discussions with Amazon and other potential partners regarding the limited delivery tests. We'll share more information with you as this progresses. Turning to the remodel program.

This is an important part of our strategy to drive sales and traffic as well as enhance the guest experience inside our restaurants. The Rise and Shine remodel program continued at a healthy pace with 79 remodels completed in the second quarter. Through the end of Q2, our franchisees have completed 136 remodels this year. We are again targeting a total of 300 completions by the 2017, reflecting a total investment by franchisees of approximately $38,000,000 this year. The IHOP remodel provides our restaurants with a fresh new look and feel, which we believe will elevate the dining experience and further differentiate us from competition.

Regarding new restaurant openings, our franchisees opened 17 restaurants in the second quarter also with the Rise and Shine image. IHOP's innovation not only influences our culinary efforts, but also our development strategy. In addition to our non traditional restaurants, I'm pleased to say that we have opened two prototype small format traditional restaurants this year. The restaurants are located in Rowland, Missouri and Chester, Maryland. The small format units are approximately 3,500 square feet and have a seating capacity of 140.

This concept gives our franchise developers a format that can work in more rural areas as well as help them penetrate more concentrated urban areas where real estate is at a premium. We also believe that these restaurants are ideally suited for a consumer environment where carryout and delivery have the potential to play a larger role in the overall sales mix of our business. Also as Greg mentioned earlier, during the quarter and as part of our plan to maximize the resources dedicated to supporting the brand and our franchisees, we refranchised the remaining company operated restaurants in the Cincinnati area, completing Dine Equity's transition to a 100% franchised restaurant system. We remain confident that our testing needs will continue to be eagerly met by our franchisees as they are today. Continuing to elevate the guest experience through improved operations is core to our strategy.

We successfully collaborated with our franchisees to complete a series of meetings across the country to focus on operations excellence and restaurant execution. As a result, we're seeing some positive momentum and achieved the highest overall guest satisfaction scores this quarter since the program began in the 2016. This is a testament to the hard work and dedication of our franchisees and teams to provide best in class service to our guests. Turning to marketing. Being nimble and bringing fresh new thinking to our business is paramount in this changing environment.

Therefore, I'm excited to announce that we've hired a new Chief Marketing Officer to lead the Marketing and Culinary functions at IHOP. Brad Haley brings to the IHOP brand over twenty five years of restaurant marketing experience, most recently as the CMO for CKE Restaurants for the last six years. Brad was instrumental in the turnaround of the Hardee's brand where he leveraged their significant breakfast equity into broader daypart appeal. He also has a wealth of experience in collaborating with franchisees to bring compelling programs to life. I look forward to Brad's leadership of the IHOP marketing team.

At IHOP, culinary innovation is at the core of everything we do. Consumers told us that they want fresh quality products and we responded. We introduced our all new fresh market offering, pairing our made to order signature breakfast items with seasonally fresh fruits. Starting at only $4.99 the offering provided guests with a compelling and customizable value proposition. Following up on this promotion, we took creativity to the next level.

We're very excited about our recently launched all new French toasted doughnuts. These are unique items that you can only find at IHOP. Donuts are a product category that are on trend, but we're meeting that guest need in a unique way that only IHOP can deliver. The launch has been extremely popular and has garnered a lot of attention in the media, resulting in over two fifty stories and generating more than three fifty seven million earned media impressions. With that said, we're very optimistic about the potential for these new items.

Lastly, IHOP recently celebrated its fifty ninth anniversary on July 18 by offering guests short sets of our world famous Buttermilk pancakes for only $0.59 from seven a. M. To seven p. M. At participating restaurants.

We aggressively promoted the anniversary to drive even more traffic into our restaurants through increased and advanced publicity, marketing and advertising. Our efforts included traditional media as well as digital and social media. The event was a success as we saw a 59% increase in sales on that day. To wrap up, I'm confident that our strategy will change the trajectory at IHOP sales over time. We're taking the right steps to drive sustainable positive sales and traffic, expand IHOP's appeal across dayparts and create additional channels to access the brand.

With that, I'll now turn the call back to Richard for his closing comments. Thanks, Darren. I'd like to add a few comments about our International division, which represents both Applebee's and IHOP. Over the past five years, our international restaurant development has a compound annual growth rate of over 8%. We should be up to approximately two ninety restaurants by year end 2017.

Currently IHOP development is outpacing Applebee's and the key markets are Mexico, Canada and The Middle East. Many opportunities exist throughout the Far East and Latin America as well. Daniel DiLomo, President of this division, is with us today should you have any current questions. In the future, we'll have Daniel comment on the progress of this important growth opportunity. In closing, I'm optimistic about the future of Dine.

I believe that we have the right people, resources and strategy in place to position the company, our franchisees and our brands for long term success. Finally, I would like to congratulate and thank our team members and our franchisees for their hard work and dedication. I also wish to thank the Board of Directors for their support of me. They are 110% engaged in the success of this business. We know we have a lot more work to do, but I'm confident that we are up to the challenge.

With that, I'd like to ask Steve Joyce to say a few words. Steve may be familiar to many of you as the CEO of Choice Hotels. And prior to that, Marriott has indicated he has a tremendous amount of experience I could not in the Board. I hope you all feel the same way. Could not be more pleased with him stepping into the role as permanent CEO.

He will have a few comments. He will not be available to answer questions as you'll have plenty of time to do that with him once he sits in the chair. Steve, if I could turn this over to you for a few minutes and then back to me.

Speaker 4

Thanks, Richard. So first of all, I'd like to thank you for your service in stepping into a difficult situation and really providing tremendous leadership over the last eight or nine months in a very difficult situation. I think the board is very appreciative, and I know I am. Secondly, I'm very appreciative of the confidence the board has shown in me. And third, I'd just like to say this is exactly the type of opportunity I was looking for post choice.

It is a tremendous company with tremendous assets that obviously needs some adjustments, but I think we've got good leadership. I think we'll be able to add some talent to the team. I think we're going to do a lot of different things that I think will add value as a longtime leader of choice in other public companies. My first priority is and always will be return to shareholders. That is the priority.

And I think we've got a tremendous opportunity in this situation to drive real value for the shareholders to create a company that is a long term viable opportunity with strong growth potential and a capitalization on two of the most iconic brands in the business. I have had some significant exposure to the restaurant business. I'm incredibly excited to be back in it full time. Obviously my background is a strong, and consistent leadership of franchise systems. I know many of the franchisees here already, so I'm excited to spend more time with them and talk about what we're gonna do together.

We've obviously, as you heard on this call, have strong leadership of not only the financial aspects of the company but also of the brands. So I'm very, interested in learning from the folks that are running those brands at this point, and also helping support them in the efforts they were describing. And I'm also very interested in working with Richard in his new role as chairman of the company. And I am ready, willing, and excited about starting on the twelfth. You will hear from me, in the not too distant future.

I'll work with senior leadership and the board to develop a comprehensive plan, which I would expect to deliver within the next sixty, ninety days. And then you can hold us accountable to that plan, because that's where we will be holding ourselves. So I couldn't be more excited about the opportunity. I think this is a tremendous company with tremendous potential. And I think we've got the leadership team and the Board to make that happen.

So with that, let me turn it

Speaker 2

back over to you, Richard. Great. Thank you, Steve. And again, congratulations and look forward to your leadership. And with that, operator, what I'd like to do now is open the call for questions.

Speaker 0

Thank you. We will now begin the question and answer session. And our first question comes from Brian Vaccaro from Raymond James. Brian, your line is now open.

Speaker 5

Thank you and good morning. Just had a couple of questions on the Applebee's side and starting with the closures. I was curious, was the increase in the closures for the year primarily related to the franchisee that you mentioned on the call? Or does it reflect more of the sort of the broader review of the system?

Speaker 2

Brian, this is John. It's a fairly complex process. Really, change in guidance around closures reflects the fact that we tackle these one at a time, and each one requires a substantial negotiation, unless it's at lease end with a landlord. And so we just have greater visibility another quarter into this as to where we stand. And so again, I personally view this number and this range as necessary.

I do not anticipate the same extent of closures next year, although there certainly will be some. And this is part of reestablishing financial health. But again, the change in guidance is just because we have more visibility now to reality. Further to your Richard here, further to your question, the referenced franchisee while there were store closures is not all due to that particular franchisee. It's a widespread of pruning the stores across a wide range of franchisees.

As Greg indicated, just about every franchisee with few exceptions has indeed used this opportunity to close source, prune the system to rationalize it and improve it.

Speaker 5

Understood. Okay. Thank you. And now that you're a little bit further down the road on the financial health review, I'm not asking for individual franchisee profitability, but can you comment on the system average overall of the franchisee profitability? And also how much leverage the average franchisee has on their balance sheet?

Speaker 3

This is Greg. We don't comment on individual franchisees or their leverage. What we do what we have done, as I said, is had a thorough and thoughtful process reviewing every franchisee's particular situation. And everybody's unique, Brian, because for obvious reasons they different businesses even in addition to Applebee's. But we look at those on an individual basis and to date we focused on store closures as we previously said.

But we consider all options open and there are a lot of vehicles we can use to help our franchisees under direct financial assistance. To date, it's been mostly on the closure side. But again, we look at their individual situation all separately and they're all unique.

Speaker 5

Okay. And then just two one more for me, if I could. You mentioned the improvement in some of the poorly operated units on the Applebee's side going from 16% to 4%. I guess, what have been some of the primary areas in which that improvement occurred? Are we talking about reinvesting in labor to elevate services?

Is it cleanly is there a few can you just give us some color on that?

Speaker 2

Sure, Brian. This is John. Some of those look, we have an internal set of metrics. Some of those are

Speaker 3

kinda

Speaker 2

internal looking components of this formula around cleanliness and quality and safety. Most of what we're talking about is guest facing. And specific improvements have been around guest satisfaction in particular. And we've seen a significant tightening of our what was pretty good variability previously. And again, of that around guest satisfaction, the interaction between our servers and guests.

I won't speak specifically to investments in labor. That's been a challenge at the restaurant level. And we're taking steps in the future to ensure that we can deploy labor more properly moving forward. But we're pleased with the progress and we're hearing that from our guests.

Speaker 5

All right. I'll pass it along and get back in the queue. Thank you.

Speaker 0

And our next question comes from Michael Gallo from CL King. Michael, your line is now open.

Speaker 6

Hi. Good morning. Couple of questions, if I may. First question, when we look at some of the costs you had this year for a onetime or perhaps ongoing, obviously, there's the $10,000,000 diagnostic. Should we think about the $8,000,000 investment in advertising as something that's going to be ongoing to some degree?

Is that something you're just doing this year and you'll see how it works and reevaluate? Because obviously, as you're looking at more closures, the it will likely put pressure on the advertising budget going forward. So I was wondering how we should think about the $8,000,000 Michael,

Speaker 2

this is John. Look, the 8,000,000 as we speak is a necessary initiative. It is addressing some of that shortfall that we have in the ad fund. The shortfall is certainly larger than the $8,000,000 reference. As to whether that would continue in the future, I don't know.

We don't know. We are committed to reestablishing financial health and sustained growth. This is a year over year challenge, 17 versus 16 at the moment, and it's fairly substantial. We'll be in a better position, and we certainly expect performance to improve across the system early part of next year and continuing. So it's the best I can do at the moment as to whether there would be steps next year.

It's very much contingent upon our performance, and we'll keep you posted.

Speaker 6

Okay. That's very helpful. And second question I have, just in looking at the overall SG and A structure structure now, obviously, you're rationalizing the remaining IHOP stores and you're 100% franchised. I was wondering whether you plan to look comprehensively at the SG and A structure? And what do you think as you move the company in a little different direction, whether you think there might be some opportunities?

Thanks.

Speaker 3

This is Greg. I think the way to think about it initially is we've got the cost that we believe will not recur next year which is the $10,000,000 We've also got in the G and A this year the severance cost. So that's 19,000,000 off the top if you will as a starting point. We consistently evaluate our internal structure with regard to people, third party spend and all of the components in G and A. And we will be taking a hard look at that as we always do on a go forward basis for the remainder of 2017, which is currently built into our guidance and then into 2018 and thereafter.

Speaker 2

Michael, Richard here. I'd like to add a little bit to that. As you may recall from our earlier calls, we really shifted our focus from a heavy shared service model to re empowering the brands and putting a lot of that talent down into directly into the brands themselves to speed up our decision making and so on. So 2017 will establish a very good baseline for where we really need to be on SG and A. Think there are certainly opportunities there.

And 2017 will be that base year for us to go forward into 2018. But think strongly that getting these resources, both dollars and human resources into these brands will empower these brands to success.

Speaker 1

Okay. Thank you.

Speaker 0

And our next question comes from John Ivankoe from JPMorgan. John, your line is now open.

Speaker 7

Hi, thank you. Two questions if I may. The first is I think related to just the prior question. Dollars 10,000,000 of nonrecurring stabilization initiatives in 'seventeen is worth around $5,000 a store. So you think about it in that context, it's not a lot of money.

That $8,000,000 of advertising is worth around $4,000 a store. I mean those don't sound like big numbers. Mean if there's going to be real financial and advertising support given to the stores, one would probably guess the multiple many, many times, something like 4,000 or $5,000 a store for each of the different programs. Could you help me think about whether it's is that the right way to think about it, the wrong way to think about it when the franchisees are just kind of thinking about, hey, need this much money on a per store basis to really reinvigorate things, how much might that spend per store be?

Speaker 2

John, this is good morning. This is John. And I look, we're taking a comprehensive view to the business. The $10,000,000 was very much around assessing state of the business with an independent third party across virtually all components. The 8,000,000 is a very specific need to address the advertising fund.

And we don't look at that on a kind of the way you framed it on a per restaurant basis. And we'll have some visibility to performance once we turn the corner on the year. So these are need based specific to quarter by quarter business requirements. And in the aggregate, they are substantial. But they're addressing specific needs.

So we're kind of more need based than we are let's direct a specific dollar figure per restaurant to the system. We will do what is necessary and required. And I should not be remiss if I don't emphasize that our partnership with franchisees perhaps stronger than it's been in years. And don't take my word for that. There is a very cautious optimism but tremendous enthusiasm about our strategy and our alignment and much of what we do, if not everything we do, is in concert with our franchisee leadership.

So more to come as we look at 2018 in terms of whether there are incremental investments or not.

Speaker 7

That's great. And whenever you guys are ready to put one of the big franchisees or someone from the franchisee advisory council on one of these calls, I'm sure it's something that everyone would benefit a lot from. I understand it's not today, but perhaps in the future understanding the business from their perspective would be very, very valuable. I've got a little free advice there. And then secondly, I'm going to see if I can answer this question in the correct way.

The current run rate of comps, the current visibility of costs, outside of the stores that you've announced the closure, do you have a sense of how many stores at the store level, not at the organization level, but at the store level, are kind of nearing cash flow breakeven? I understand, I mean, you don't want to close a store for cash flow breakeven if you think results are going to get better in a couple of years. But what percentage of the system again just kind of taking the current run rate of results are kind of nearing that point of marginal profitability at the store level?

Speaker 3

This is Greg, John. What we said previously is that we've got we've analyzed each of these on a case by case basis. Obviously, if these stores are close to breakeven or having cash flow issues, that's a pretty strong indicator that it's up for closure and it is built into the closures that we've estimated for this year. So that's the first cut we take at it. And then other areas around that we consider, but the cash flow is obviously the main point that we look at.

We don't disclose how many stores that we that are cash flowing or not cash flowing, but we built that into our analysis and how we evaluate each franchisee and all of their stores during this process. There's a lot of work that goes into it and we're thoughtful about each store before we decide to close it.

Speaker 7

Okay. All right. Think I heard that. Then in the release, and I'm sorry if I missed this, there was kind of a mention of uncollectible royalties. I mean, is how big and I think there was some in the first quarter that began to peak up if I'm remembering that correctly.

Mean how big might that number be in 2017 and at least at this point do you think that number grows into 2018?

Speaker 3

So right now the guidance that we've just issued that number if you think about franchise revenues on a gross basis for Applebee's which we break out in our public 10 Q documents, it's running for the rest we expect it right now to run for the rest of the year about 7% to 8% of that number. And that's where we currently believe we're headed as far as collectability of royalties is what we're talking about here. So that's what it amounts to.

Speaker 7

Okay. Thank you.

Speaker 0

And our next question comes from Steven Anderson from Maxim Group. Steven, your line is now open.

Speaker 7

Yes. Thank you. And taking a look at your reduced free cash flow expectations for 2017, I wanted to ask about your ability to continue paying the dividend and what the outlook for that will be going into 2018? Thank you.

Speaker 2

Richard here. Clearly, dividend, but all capital allocation issues are aggressively studied by the Board at each meeting. And obviously, with the announcement of the dividend that came out today has confirmed that the ability to pay the dividend is there and desire to do so. As I say, this is looked at steadily, but we certainly understand the interest of shareholders of the stability of the dividend and so on. And we look at that every time we meet.

Speaker 7

Some of the debt service covenant ratios and I know you've published that with the 10 ks. Can you provide a little bit of color into that?

Speaker 3

Well, is Greg. We have a coverage ratio that we leverage ratio that we publish, if you will, in our 10 Q and that is the ratio that we focus on the most. There's a debt service coverage ratio that isn't in the discussion really because it's so the cushion is so large. But we have a leverage ratio that we publish every quarter and it's about five times right now is what it's at. And that's where it stands at the end of the second quarter.

Speaker 6

All right. Thank you.

Speaker 2

And Steve just to add to that, this

Speaker 1

is Ken. With regards to the DSCR, we're about 300 basis points above

Speaker 6

where any cash trap event might occur.

Speaker 0

I'm showing no additional questions at this time, and I would like to turn it back over to speakers for closing remarks.

Speaker 2

Okay. Well, thank you again for joining us on the call today. We're scheduled to report the results of the third quarter in November, I believe November 1. And we look forward to speaking to you then or perhaps even earlier as Steve gets into the chair. And again, I want to thank Steve for joining us today as well as all of you.

Thank you.

Speaker 0

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.