Papa John's International Inc (PZZA) 2003 Q2 法說會逐字稿

Good morning. My name is Wes, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the Papa John's Second Quarter Earnings Release Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you.

I would now like to turn the conference over to Mr. David Flanery. Please go ahead, sir.

Thank you, Wes. Good morning. I'm David Flanery, Senior Vice President of Finance. And with me on the call today are John Schnatter, Founder and CEO; Robert Wadell, Papa John's Chief Operating Officer and President of [P.J. Foodservice][ph]; and several other members of our management team.

Our discussion today will contain forward-looking statements, which involve risks and uncertainties relating to future events. Actual events may differ materially from the projections discussed today. The call is being taped, and the replay will be available for a limited time on our website.

For the second quarter of 2003, we had revenues of $226.5m, a 4.3-percent decrease from the second quarter of 2002. Net income was $10.9m, as compared to $12.4m for the second quarter of 2002. And diluted earnings per share were 60 cents, a 1.7-percent increase over the 59 cents earned in the second quarter of last year.

For the first six months of 2003, revenues were $458.8m, representing a 4.9-percent decrease from the 2002 results. Net income was $21.8m, as compared to $25.3m for 2002, and diluted earnings per share were $1.21, a 1.7-percent increase over the $1.19 earned during the first six months of 2002.

System-wide domestic comparable sales decreased 4.8 percent for both the second quarter and first half of 2003, with relatively consistent results for both Company-owned and franchised restaurants. Reversing these recent sales trends continues to be challenging as July 2003 comparable sales decreased 4.7 percent, consisting of a 2.8-percent decrease at Company-owned restaurants and a 5.3-percent decrease at franchised units. Average weekly sales information for the comp and non-comp Company-owned and franchised restaurants is included in the earnings release, and I won't repeat those details here on the call.

During the second quarter, 22 restaurants were opened and 26 were closed. For the first half of the year, 48 restaurants were opened and 46 were closed. Net unit growth continues to be challenging due to overall economic conditions and the competitiveness of the pizza category.

At the end of the quarter, there were 2,797 Papa John's restaurants operating in 49 states and 11 international markets and an additional 141 Perfect Pizza restaurants in the United Kingdom. We just recently announced the opening of two new Papa John's restaurants in Seoul, South Korea, representing our 12th international market and our first presence in Asia.

The primary reasons for the year-over-year decrease in second quarter and year-to-date revenues were the decrease in unit sales for Company-owned and franchised restaurants due primarily to a reduction in transaction volume and reduced commissary sales due to a combination of lower commodity costs and lower sales volumes, which, of course, are directly related to restaurant sales volumes.

Restaurant operating margin at our domestic corporate restaurants was 17.6 percent in the second quarter and 17.7 percent for the first six months of 2003, compared to 21.8 percent for each of the same periods in 2002. Lower cheese and other commodity costs were more than offset by increased labor, advertising, and occupancy costs, resulting in the net margin reduction. All expense categories other than food were negatively impacted by the loss of leverage on fixed costs due to the decrease in sales. The labor increase reflected the across-the-board pay increase for General Managers and Assistant Managers in the third quarter of 2002, increased health insurance costs, and increased restaurant staffing levels and bonus opportunities in connection with the field management realignment announced in January that resulted in a shifting of G&A costs to restaurant labor.

Advertising reflected increased national television spending, partially offset by reduced local market coop spending, while occupancy costs reflected increased general insurance and utility costs.

Domestic commissary and other margin was 9.0 percent in the second quarter versus 10.4 percent for the same period in 2002. Cost of sales declined primarily due to lower cheese costs, which have a fixed dollar, as opposed to a fixed percentage markup and a shift from lower margin equipment sales to insurance services.

The cost of sales improvement was more than offset by an increase in other operating expenses due to a $2.4m increase in claims loss reserves related to the franchisee insurance program and the loss of fixed cost leverage at the commissary due to the decrease in sales.

An updated actuarial valuation for the franchisee insurance program completed during the second quarter reflected the substantial increase in estimated claims losses, primarily in the non-owned automobile and worker's compensation areas. These increases reflect both increases in general healthcare costs, as well as our specific claims loss history for the program. We believe that our current premium rates are sufficient to fund future claims losses at adequate levels.

The domestic commissary and other margin was 9.6 percent for the six-month period versus 9.9 percent in 2002, as the second quarter increase in insurance reserves had a reduced percentage impact on the full six-month period. Other factors impacting the six-month margin were similar to those for the second quarter.

International revenues and operating expenses were relatively flat for both the second quarter and six months, as compared to the prior-year periods. The 2003 revenues reflect a favorable exchange rate impact of $700,000 for the quarter and $1.5m for the year to date.

General and administrative expenses were $16.5m, or 7.3 percent of revenues, in the second quarter of 2003, as compared to $19m, or 8.0 percent of revenues in the same period of 2002. For the six months, G&A expenses were $33.1m, or 7.2 percent of revenues, as compared to $37.3m, 7.7 percent of revenues, in the same period for 2002. The decreases for both periods were primarily attributable to the previously noted restaurant field management realignment and units-level staffing decisions that resulted in a shifting of G&A costs to restaurant labor and reductions in corporate and restaurant field management bonuses.

The provision for uncollectible franchise notes receivable was $375,000 in the second quarter of 2003 and $801,000 for the six-month period, based upon an evaluation of our franchise loan portfolio. At the end of second quarter, $12.3m of notes receivable were outstanding, net of a $5.4m reserve for uncollectible amounts. Net principal payments of approximately $1m were received during the first half of 2003, and we continue to closely monitor certain workout loan situations.

Other general expenses were $1.1m in the second quarter of 2003, versus $1.4m for the comparable period last year. However, the 2003 costs were more than offset by $2m of income derived from the settlement of a litigation matter during the quarter. Other general expenses were $1.7m for the first six months of 2003, excluding the $2m legal settlement, versus $3.5m for the comparable period last year. The primary reasons for the reduction in the 2003 costs were lower disposition and valuation losses for restaurants and other assets and the inclusion of $500,000 of costs related to our heated delivery bag refurbishment program in the prior year.

Depreciation and amortization was relatively consistent year over year for both the second quarter and six months. Net interest expense was $200,000 lower in the second quarter than in the comparable period last year due to a March reduction in the effective interest rate on our debt and about flat for the six-month period as the second quarter reductions were offset by first quarter increases due to higher debt levels and reduced interest income on franchisee loans.

Cheese costs to the Papa John's system were substantially lower in the second quarter and first half of 2003 than for the same periods last year. A table comparing year-over-year equivalent-block prices by quarter is included in the earnings release. Additionally, the cheese-purchasing program initiated by the Papa John's Franchise Advisory Council has generated a cash surplus of approximately $18m as of the end of second quarter, which will reduce system-wide cheese costs relative to future actual block market prices. Company-owned units will receive approximately 25 percent of this future benefit, a portion of which is already being realized given the recent increase in the actual block market price.

We did not repurchase any stock during the second quarter or to date in July. Second quarter free cash flow was used to reduce outstanding debt by $14.6m during the quarter, resulting in a $105.3m debt balance at the end of second quarter. We currently have approximately $25m of remaining share purchase authorization through the end of 2003, and we will continue to evaluate the share repurchase alternative for use of our free cash flow based upon a variety of business, economic, and other factors.

New accounting guidance related to the consolidation of variable interest entities was issued earlier this year. We must adopt the provisions of FASB Interpretation No. 46, or FIN 46, as of the beginning of our third quarter. We had previously disclosed that FIN 46 might apply to BIBP Commodities, Inc., the franchisee-owned entity conducting the cheese-purchasing program for the Papa John's system. Evolving analysis and interpretation of FIN 46 appear to indicate that it may have additional applicability to Papa John's and many other franchisors based on certain franchisee relationships.

Based upon our current analysis of FIN 46, we believe that we will be required to consolidate BIBP and additionally that we will be required to consolidate certain franchise entities to which we have extended loans and certain franchise entities in which members of our executive management or Board of Directors have a significant ownership interest. We believe that our existing $5.4m reserve appropriately reflects our estimate of the current economic exposure within our franchise loan portfolio. Additionally, we believe that we have no economic exposure related to the operations of franchise entities in which members of executive management or our Board of Directors have a significant ownership interest. However, we anticipate the adoption of FIN 46 will result in a cumulative-effect adjustment in the third quarter of 2003 related to the consolidation of these certain franchise entities and that such adjustment will reduce 2003 income. The calculations required to arrive at these conclusions are complex, and we are continuing to evaluate the applicability of FIN 46 provisions to our specific facts in order to determine the amount of the cumulative-effect adjustment and projected ongoing impact to our financial statements. No estimate of these amounts is currently available.

Finally, we are reducing our comparable sales guidance for full-year 2003 to a projected decrease of 4 to 6 percent based upon sales results and trends through July. Other guidance revisions are included in a table in the release, including a 1-percent decrease in projected restaurant margins, directly attributable to the reduced sales outlook. However, we are reaffirming previously announced 2003 earnings-per-share guidance of $2.20 to $2.26, excluding any cumulative effect or ongoing impact from the adoption of FIN 46. Favorable performance in the areas of G&A cost controls and commissary and other operating margin, coupled with reduced interest expense resulting from strong cash flows and declining debt balances, allow us to reaffirm earnings guidance even given the reduced sales outlook and the associated negative impact on restaurant operating margins.

That concludes the financial update, and now I'll turn the call over to John Schnatter, Founder and CEO. John?

Thanks, David.

The first half of 2003 continues to present Papa John's with a very challenging operating environment. According to CREST, the restaurant industry remains in its longer slump since CREST tracking began in 1975 with a record four consecutive quarters of traffic decline.

The pizza category remains extremely competitive, with the two largest chains offering buy-one-get-one-free or 99-cent second pizzas, DVDs, and continued mega-marketing spending. History shows that those operators who provide the best customer service produce the most customer -- most loyal customer base and are better able to weather the storm during tough times.

Last week, we received affirmation that our commitment to product quality in delivering a world-class customer experience is working. In 2003, QSR Consumer Commitment Study from [TNS Innersearch][ph], Papa John's was found to have the largest core of committed customers among all national pizza chains. As a quality provider in the pizza category, nothing is more important than having loyal customers, especially those who can tell the difference between average and superior quality ingredients and who over time are willing to pay for the difference.

To hold on to existing customers, our restaurant operators have to do a superb job with product quality and service. To encourage and reward this behavior, we have put our money where our mouth is over the last 20 months with several programs, including increased pay and bonus opportunities for the restaurant General Manager and Assistant GMs, resulting in 50 percent of our General Managers now being at or above the 75 percentile in total cash compensation in their peer group, half of whom are at or above the 90 percentile. Since implementing the pay increase, retention with our restaurant managers' ranks has improved, realigning our field management structure for our Company-owned restaurants with the entire $4.5m annual cost savings being invested back into the Company's restaurants in the form of increased labor for better staffing at our restaurants and greater bonus potential for our restaurant management team.

Most recently, we've implemented portion increases throughout the system on several of our core pizza products. The portion increases help affirm the purchase decision of our loyal customers who tell us they appreciate getting more, better ingredients on each pizza for their money. These investments have started to pay off in improved operational results, both in product and service, at our restaurants. They have not yet translated to positive comp sales.

When the category and economy turn, we think Papa John's will be positioned for continued success. Thanks, and we'd be happy to answer any questions.

[Caller instructions.]

Your first question comes from [Tim Rice][ph] of [Rice Volker][ph].

Good morning. I noticed in the press release that you had revised downward your revenue expectation for the second half but not the earnings expectation. Is it fair to characterize that as being due to the settlement of the lawsuit, or are there other operating efficiencies that you were able to employ to keep the net income at your previously expected level?

Tim, this is David. The settlement of the lawsuit was essentially offset by the increase in the insurance reserves, so that matter didn't really have that impact. However, we do have in a couple of operating areas better performance, one of which is the G&A area, where we're coming in so far at the lower end of our expected range due to some good cost controls. And then, also, in our commissary and other, unit margin is better or at the higher end of our range due to, again, some operational efficiencies and cost controls there. So those things, along with the fact that we've taken cash flow and had stronger cash flow this year than originally expected, some of our capital expenditures have been a little delayed, so we've had a little stronger cash flow, and that's allowed us to pay down some more of the debt, so the interest expense is a little lower. So the combination of those things are what helped offset the restaurant margin and sales declines and let us keep our earnings guidance at the same range it was previously.

Okay. And second question, on one of the earlier calls -- I'm not sure who it was, but one of the Company representatives made the comment in a response to a question I'd asked about negative comps, that -- I believe the quote was that, "Eighty percent of the franchisees actually had positive comps but that there were some troubled franchisees that probably needed to leave the system." Can you kind of update on that in terms of just in raw, rough numbers what percentage of the franchisees are still positive and maybe the health of the troubled ones?

I'll start out commenting about maybe the numbers part of it, and then someone else can -- you know, will jump in on the overall health. But we did update that information, and for the first six months of this year, where our franchisees overall were running near that 5-percent negative comp, 4.8 negative comp number, if you just look at the best-performing 80 percent, that number, while still negative, drops to about minus 2 percent. So, clearly, it's the bottom 20 percent that are, you know, continuing to drag that number down a little further. So that's the numbers part of it, and then I'll --

Tim, this is Robert Wadell. We have spent a tremendous amount of time out in our markets throughout this year, and between John Schnatter, Mike Cortino, and ourselves, have toured well over 300 restaurants. And our overall [indiscernible] core of our franchisees are strong and competitive, but we have had some areas that we've had some image and service and product quality, and we are taking steps to correct that. We have continued to struggle somewhat with the franchisees in the California area.

And one last question. I noticed in your projection for cheese prices the balance of the year, you obviously have them well under control from the commitments you've been able to garner, but I've heard two of your competitors in the last week say that they expect higher cheese prices in the second half. Is this a potential problem in '04? Or can you look out that far yet?

Tim, we really can't. Our crystal ball's not any better than anyone else's. I think it is safe to say that the expectation is that the actual block market price of cheese is currently certainly a lot higher, and the expectation is that it will be higher next year, on average, than this year. We do have a surplus that is there that will help keep our price lower than whatever the actual price is throughout, you know, a good part of next year, but we can't guess exactly what that might mean versus this year's price. So the only thing we can say with some confidence is that we will be better than the actual market. We don't know what the actual market's going to do probably better than anybody else.

Great. Thanks very much.

Sure.

Your next question comes from Barry Stouffer of BB&T Capital Markets.

Good morning. Could you comment specifically on what's happened to turnover trends among management and hourly?

Yes, Barry, this is Robert again. And as we've mentioned, we've made a commitment to increase our management pay and bonus opportunities in our restaurants and have streamlined our leadership for more effective management in those restaurants. And we've seen our GM management retention improve slightly over 12 percent. More importantly, we're seeing better staffing in our Assistant Manager level, and we've seen that improve upwards of 30, 30.5 percent.

Which would leave your GM turnover rate at what levels?

Through June, I believe, it was right around 41 percent.

And how about for hourly?

We're about 170 percent.

Okay. And can you comment on what kind of increase, if any, you saw in average hourly wage rates in the second quarter?

Barry, this is Mike Cortino. Average hourly wage rates have been fairly stable. We've seen turnover drop across all Assistant Managers, hourly and salaried folks. If you recall, about three years ago, we implemented three strategies -- neighborhood pizzeria, best place to work, and where we make money together -- and we focused on recruiting and selection, streamlined our training within our restaurants, and we're feeling we're getting stronger retention, and that's paying off in consistent execution in the restaurant and flat wage rates. We've not seen any pressure in that area.

Okay. And then, last, could you quantify perhaps the percentage increases you are seeing in utility costs, health insurance, and also property insurance?

Utilities was probably the one that had the biggest impact from a year-over-year basis, and, Barry, it was somewhere in the 50- to 60-basis-point range year over year. The general property insurance was much smaller, about 20 basis points or so, and -- I'm sorry, what was the third category?

Group health insurance?

I may have to get back to you on the health insurance. I don't think it was that significant. Here it is. Group -- yeah, group health insurance was about 40 basis points year over year.

And just help me with magnitude. Utility costs would be, what, around 200 basis -- 2 percent of sales in total?

That's correct.

And property taxes maybe 1 percent?

A little less than one.

And how about health insurance?

A little over one.

Okay. Thanks very much.

Your next question comes from Mike Smith of Fahnestock.

Good morning.

Good morning, Mike.

I guess of a -- you know, FIN 46 and the cheese company, if you are actually going to have to consolidate that, at the time you do that, won't you have to take in the $18m surplus? And will that mean that you're going to absorb all the cheese swings in Papa John's results before they're farmed out to the franchisees?

Good question, Mike. The first answer is no, we do not immediately -- and without getting too technical on FIN 46, the basics are, as long as the cheese company is in a surplus position, when we consolidate it, we will reflect -- you know, assets will get higher, our liability will get higher, but it essentially will have no P&L impact because we don't own it. So while it's in a surplus position, the Company -- Papa John's, the Company, will have no P&L impact.

If it were to go deficit, then in that case, Papa John's would have to record 100 percent of the deficit even though we only use 25 percent of the cheese. It is unlikely that we will let ourselves get in that position, and we are currently evaluating what alternatives we may have to address that.

Okay. And when you were talking about -- in the note that you gave as the press release, the commissary had -- you know, it seemed like the margin that you were getting on what you were selling your franchisees was kind of up 100 basis points except for cheese, but you explained that as to -- because there's a dollar margin. How does that work exactly?

Oh, okay. I understand the question. When we charge -- most of our products, we apply a percentage margin to, but because cheese can be volatile, we decided to charge a flat penny margin so that when the price of cheese is low, that flat penny margin represents a higher-percentage margin. When the price of cheese is high, that flat penny margin represents a lower percentage margin. However, that helps moderate the fluctuation in price. The last things that our system wanted, franchise and corporate stores together, was to have a margin that was higher just because it was a percentage of a higher number at a time when cheese price is high. So it actually helps moderate the range a little bit, but it does impact the reported percentage margin.

Got it. Capex for the year is budgeted now at what?

We lowered the guidance to, I think, 15 to 20 million. Originally, we were at 25 to 30, and the only real change there is just the practical matter of this refurbishment/renovation/relocation of a commissary that we're doing. It's just, you know, taking a little longer to get those costs starting to be incurred. That will flip over into 2004. We have not, you know, changed our mind on the project. It's a project we certainly need to do. It's just the timing is going to lag a little bit just for practical, you know, getting-it-done kind of issues.

Thanks.

Your next question comes from Dennis Joe of Sidoti & Company.

Good morning. I was wondering if 80 percent of the franchisees produce a negative 2-percent comp, does that imply the remaining 20 percent has negative double-digit comps? And if so, can you give us a sense of how many franchisees are not generating positive cash flow?

Dennis, this is David, and thanks for bringing that issue up again because I do -- I want to clarify something I said earlier. The 2-percent negative for the 80 percent, that was for corporate stores. I misspoke from my notes. Franchisee stores -- the best 80 percent of franchisee stores actually have a negative 1.4 percent. Not a big difference, but I just wanted to clarify that and make that accurate. The question is still the same. You are correct that the worst 20 percent would then have negative double-digit comps. That is true. And I don't know, Robert, if you want to take the issue on their cash position. We monitor the health of our franchisees. We don't exactly get all their financial statements, but we do monitor their health. I don't know if, Robert, you want to speak to that?

You know, it will [see], depending on their location and their cost from regions and territories, so it would be difficult to say as far as their cash flow.

Okay, and then under our FIN 46, exactly how many units is affected under that? For instance, how many units does the Board and executive management have significant ownership position in, and then how many loans do you have out there exactly, and how many franchise units?

Dennis, we have about 40 restaurants that are owned by the various entities where we have loans outstanding that we believe FIN 46 will apply to. It's approximately 40. On the management board member side of the equation, it's about 50 that we believe the rule will apply to.

So it sounds like the magnitude, that FIN 46 will just be a minor impact?

At this point, I really can't really answer that. I just don't want to mislead. We're still doing the evaluation. I will say this, and I think this is a fair thing to say. The ongoing impact of it, I think, certainly is much less likely to be significant than the potential cumulative-effect adjustment. I think that is a fair statement without saying anything that we're not prepared to say yet.

Okay. And what point will you notify us about exactly how much FIN 46 will end up costing in the third quarter? Will it be on third quarter conference call of third quarter earnings release or before that?

If we have the information finalized before then, we will likely announce that prior to the end of the quarter.

Okay. Okay, thank you.

Your next question comes from [Jamie Wiggins][ph] of [Intrepid Capital Management][ph].

Good morning. If industry pizza sales are about flat and Papa John's comps have been negative for a while now, do you think it might be time for it to become more promotional? Or are you guys really convinced that you're spending money in the right places?

This is John Schnatter. I'll talk to that and then turn it over to Robert. The industry's minus two point two for the year, and I think we're negative four point four-and-a-half, so the category is negative, and we just happen to be more negative than the category. That being said, we're bringing in about 175,000 new households a week, so we're not having problems getting people in the door; we're just not doing as good a job as we'd like to do once we get the phone to ring and we do get their business.

Yeah, Jamie, this is Robert. Obviously, our goal is to stop the negative sales trends, and we continue to believe in better ingredients, better pizza, and we continue to win best pizza awards, as we -- the consumer commitment survey where Papa John's was number one as far as customer loyalty. That being said, we knew that we had some issues in our restaurants and that we weren't consistently providing a quality product with world-class customer service, and we have taken the steps to address those, and our internal measurements are showing improvement, and as we've already discussed, the increased pay for our Management retention and such. So we believe at the end of the day it's the ability to out-execute in the product quality and the service.

All right. Another question. Are you all intending to continue paying down debt? It seems to have been a trend in the last two quarters.

This is John again, Jamie. We will continue to pay down debt until we feel the business is trending in the right direction.

Okay, thank you.

Your next question comes from [Mark Calphin][ph] of [Dorsett Management][ph].

Good morning. I knew you'd spoken previously real briefly about the stock buyback, but how come specifically you're not buying back stock? And is the reason because you're restricted due to your loan covenants?

I'll answer the technical part of the question. We are not restricted relative to loan covenants. And then maybe refer back to what John said earlier, that it's something that we will address once we believe the business has turned.

Okay, thanks.

Your next question comes from [Charles Temmell][ph] of UBS.

Good morning. You've mentioned briefly the survey that you just got where Papa John's had the largest call of -- largest core of committed loyal customers, and I was wondering if you've gotten any insight, have you learned anything from that, and how that jives with the initiatives that you've put into place at the store level, and how you think that's going to translate into better results?

Charlie, this is John again. I'll kind of cover the top of that, and then maybe Robert might have some comments. What we think, we think there's going to be a lag between doing the right thing and positive comp sales. And we've been making good pizza and delivering good service now for about 75 to 90 days. We believe those initiatives will pay off; they just haven't yet. So there seems to be a lag, and there was probably a lag on the way down. We probably got away with doing some things as far as product and service that we shouldn't have and [indiscernible] get affected with sales, but the [demonstrative][ph] value part of our business we're going to continue to try to drive and then, hopefully, see some results on the top line.

In addition, Charles, the survey just came out at the end of last week, and we got it in detail the first of this week, so we're digging into it and seeing what we can learn from that.

Your next question comes from [Jill Delosa][ph] of [Arden Capital][ph].

Hi, thank you. I just had two questions. The first is, if you are going to start favoring paying down debt versus repurchasing shares? I was just wondering if you had a target debt-to-cap ratio?

And then, secondly, on -- with regard to the FIN 46 consolidation, on the restaurants that you'll have to consolidate, I was just wondering if I would understand it correctly in that you would lose the royalty sales but you'd actually have the sales of the restaurants and then you'd have to apply some kind of margin to those sales to get what the earnings would be? Is that the right way to look at that?

Jill, this is David. On the debt question, I'm not sure we exactly said we would favor paying down debt, but I understand your question. And, no, we don't have a specific debt target. What we've said in the past is we're certainly comfortable at, you know, 1 to 1.5 times EBITDA of debt, so that's not really a constraint.

The second thing, on FIN 46, is once you make a determination to consolidate these entities, in effect, the way it will impact our financial statements, it will tend to gross up our entire income statement. Sales will go up, food costs -- I mean it will be as if we owned those restaurants on every single line item. But then when you get down to the bottom, if those restaurants had made money during the quarter because we don't own them, we don't get to count the earnings. We have to call that -- what's called a minority interest, more than you want to know -- but it's -- in other words, another expense. So the best we can come out when we can consolidate these is zero. We can't have any up side, but all of our individual line items end up getting grossed up in a full line-item consolidation, and we are certainly currently working internally and with Ernst and Young on, you know, the best way to do that so that it is understandable to the investment community.

Okay. So you would lose the royalties from those restaurants, is that right?

In effect, you would eliminate the impact of the royalty because it's us, so you can't pay a royalty to yourself. But that won't have an impact overall because when you consolidate, it basically gets down to whether that company made money or lost money during the quarter.

So if the restaurant made money, the best effect is zero. What if it loses money?

If their shareholders' equity is in a deficit position, we pick up 100 percent of the loss.

And can you tell us what percent of those restaurants have positive shareholders' equity right now?

Not at this point.

Okay.

We're not prepared to talk numbers.

Okay, thank you.

You're welcome.

[Caller instructions.]

Your next question comes from [Jim Dormer][ph] of [Satellite Asset Management][ph].

Good morning.

Hi, Jim.

Just to follow up on that FIN 46 question, while you would consolidate the loss if the equity position was in negative territory, on your cash flow statement, there would be a reversal. So from a cash impact, it would be zero, correct?

Jim, you raise an excellent point, and I'll go even a step further. It is true it would have no cash impact.

And, secondly, our concern is that it doesn't truly reflect the economic reality. And certainly we've discussed this with Ernst and Young. They have had discussions with the FASB. And at this point, there is no indication that there are any changes in the offing for this rule. So your point is a good one. We are afraid that it creates financial results that are not economic reality, which will cause us a significant challenge in trying to explain that to the investment community. But you're right; it will not have a cash flow statement impact.

And will you have any greater ability to control the sales levels of those non-owned units than you do today, meaning that you're not going to have any control over the sales and, therefore, their operations but will have to incur the pain if they do record these losses?

That is correct.

Thank you very much.

Your next question comes from [Steve Cosbell][ph] of Raymond James.

Good morning, guys. How're you doing?

Fine, thank you.

Good. If you look at the success that McDonald's and Wendy's have had with healthier offerings, salads and things, have you guys considered testing a healthier pizza with low-fat mozzarella and maybe turkey sausage or things like that?

Yes, of course, at this time, we are exploring options. Oh, I'm sorry. This is Mary Ann Palmer.

Okay.

And I am the head of marketing, and we are looking at exploring a number of different options. We have several items in test at this time, and we are exploring options in terms of things that have light cheese, which we always have available, and we are looking at different options that would offer our consumers a variety of things.

Okay.

And we don't like to say exactly what we have in test.

Okay. What markets are those in test in?

We don't like to say where we --

Okay.

-- [inaudible] test either.

Okay. All right. Thank you.

Okay.

Thank you.

Your next question comes from [John Engel][ph] of [Terradotta][ph].

Good morning, gentlemen. With regards to the store opening versus closing rates for the year and the quarter, notice it's basically a flat growth. Two-part question. First, do you see that extending itself further to a growth position? And then with regards to those that you close, could you provide some color around why they closed and what impact that had on the comps?

This is Chuck Schnatter. I'll take the first part of that and maybe let Robert address some of the things that I may touch on, some of the reasons why we're having some closings.

On the development side, we've done a couple of things. About a year-and-a-half ago, we brought on Bill Van Epps, who's here with us today, to head up our international group, and we've made a lot of progress on the development side there. And I think that we're planting a lot of seeds that will generate some growth down the road.

On the domestic side at the end of the -- or the beginning of the second quarter, we brought on a gentleman for the domestic franchising by the name of [John Campbell][ph]. He has done some reorganization and is starting to fill up our domestic pipelines. So we're starting to see some positive results on that front. So my goal on those two things is to get our pipeline built back up to where we have a net increase in openings.

As far as the closings go, in a general sense, I can tell you that we have -- I mean it's been a tough economy, tough segment, and we've seen some cost increases on the insurance and utilities, that kind of thing. And lenders are just not as aggressive as they used to be.

On the operational side, I'll let Robert address that.

You know, John, when Papa John's was growing four or five hundred restaurants a year, we probably opened a few that we shouldn't have. Had some locations that we've had to go back and relocate. And some folks that just weren't long for our system. One third of those closings have taken place in primarily Northern California, and it's a small number with relatively low per-store -- or per-sale averages, so it really didn't have a significant impact on the comps.

What percentage of those would be relocations?

Generally, the way we define a relocation is something that moves in a set period of time, so none of those would be relocations. A closing is a closing.

Gotcha. Okay, thank you, gentlemen.

Your next question comes from Dennis Joe of Sidoti & Company.

Yes, just one quick follow-up question. I was wondering if there's any similarities in the bottom 20 percent that's having these poor -- extremely poor [comps][ph], maybe perhaps with regard to a geographic location? And is there something you could specifically do to address the problem?

I'll kind of take the similarities and then let Robert address the program to get them fixed.

On the objective side, we are seeing that when a franchisee gets strung out too far, there's too much distance between the stores; they seem to lose the span of control. So Chuck and his team are trying to get their arms around that and not make the particular franchisee drive so far between restaurants.

The second part of that is we've done analysis on the folks that are winners and the folks that are not winning, and we're seeing huge differences in the personality traits. The winners believe in the system. The winners are competitive. The winners are aggressive. The losers tend to whine and point fingers. And in my opinion, the psychological make-up is a bigger part of this than the demographics or particular geographic region. That being said, some markets start off a little stronger than others and they take a little -- the lower ones take a little longer to get built up. But with the right operator, even the low start-ups seem to become winners sooner or later.

You know, [and this and that][ph], Dennis, our franchise performance team goes and does an analysis on the restaurants, the franchisees and such, and offers additional training support. Mary Ann and her team offer additional marketing support. And some of those comps are -- negative comps are due to the fact that some of the base closings and such will be -- had access to deliver pizzas to the troops and so forth, such as in San Diego.

Okay, thank you.

Your next question comes from Mike Smith of Fahnestock.

Just real quick, you seem to identify California as being sort of a problem area. How many different franchisee groups are we talking about in that particular market?

Mike, John Schnatter. Approximately 10.

Thanks.

At this time, I'm showing no further questions.

Thank you, Wes.

Thank you, Wes. Good day.

That concludes the Papa John's Second Quarter Earnings Release Conference Call. You may now disconnect.