Papa John's International Inc (PZZA) 2007 Q1 法說會逐字稿

Good morning. At this time, I would like to welcome everyone to the Papa John's first-quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (OPERATOR INSTRUCTIONS).

Thank you. Mr. David Flanery, you may begin your conference, sir.

Thank you. Good morning. With me on the call today are our CEO and President, Nigel Travis; President of USA, Bill Van Epps; President of International, Robb Chase; President of PJ Food Service, Julie Larner; and other members of our executive management team. After a brief financial update, Nigel will have comments about our business, and the management team will then be available for Q&A.

Our discussion today will contain forward-looking statements that involves risks and uncertainties relating to future events. Actual events may differ materially from the projections discussed today. Certain factors that can cause actual results to materially differ are outlined in our earnings release and in our Forms 10-Q and 10-K.

The call is being taped, and the replay will be available for a limited time on our website and in downloadable Podcast format.

Financial results for the first quarter were very solid, especially in light of the tough sales environment. Revenues were $260.6 million for the quarter or 7.5% higher than the first quarter of 2006, as the favorable impact of the acquisition of 54 franchise restaurants during the latter half of 2006 on company-owned restaurant sales more than offset the unfavorable impact of reduced cheese costs on Commissary sales. Worldwide systemwide sales increased 4.2% to $538.5 million, and we added 29 net new units for the quarter.

Operating income from continuing operations for the quarter, excluding the impact of the consolidation of the BIBP cheese purchasing entity, was $22.3 million, as compared to $19.5 million for the first quarter of 2006, a 14.4% increase. Income from continuing operations per share was $0.44, as compared to $0.36 for the first quarter of 2006, an increase of 22.2%. The continuation of our share repurchase program led to the enhanced EPS growth relative to our operating income growth, demonstrating the power of our cash flow and leverage capacity.

Net interest expense increased to $1.2 million for the first quarter of 2007, as compared to $400,000 for the first quarter of 2006, due to higher average outstanding debt levels. However, there were 10.1% fewer diluted weighted average shares outstanding in the first quarter of 2007 than in the same prior-year quarter.

On a business segment basis, pretax operating income increased nearly 9%, excluding the consolidation of BIBP as an increase in Commissary profitability, more than offset a reduction in results for company-owned restaurants. Commissary profitability was driven by a shift in product mix to higher-margin fresh dough products, as a result of the period one national restaurant promotion for free garlic Parmesan breadsticks. Restaurant profitability was negatively impacted by higher wage rates.

Other business segments were relatively flat on a year-over-year basis, including the International segment that incurred $2.3 million in operating losses in both periods. We continue to investment spend to build a strong International infrastructure in support of the substantial growth opportunities we believe exist, as Nigel will discuss in more detail. We also achieved about 25 basis points of G&A improvement during the quarter, due to leverage on the increased revenues.

Cash flow from continuing operations, excluding BIBP, exceeded $20 million in both the current and prior-year quarters, while capital expenditures were $9 million for the current quarter. Our strong free cash flow supported over $25 million of share repurchases during the quarter, with only $3 million of net new borrowings on our line of credit.

The spot and future market prices for cheese have increased recently, with the spot price hitting $1.70 and the 12-month futures prices averaging over $1.62 per pound. As a reminder, our restaurants do not immediately incur market increases in the cost of cheese, although we do pay average market prices over time. As indicated in our Form 10-Q filed yesterday, we expect the restaurant-level cheese price for full year 2007 to be approximately 5% less than the 2006 price.

We increased our earnings guidance on the strength of these first-quarter results from a previous range of $1.48 to $1.56 per share to a range of $1.52 to $1.58 per share, excluding BIBP. This guidance compares to 2006 comparable earnings of $1.40, and provides for continued significant investment in our International business unit.

I would now like to turn the call over to Nigel Travis, our CEO and President.

David, thank you and good morning, everyone. We are extremely pleased with our first-quarter performance that demonstrated the ability of our business model to produce excellent financial results in a very competitive sales environment. The growth in earnings per share from continuing operations of over 22% for the quarter was essentially double our stated earnings growth target range of 10% to 12%.

These strong financial results provide an excellent backdrop for a quick review of our strategic direction and how our business model supports this strategic direction. The foundation of our strategy is our unwavering commitment to quality, as we continually strive to deliver upon our "Better Ingredients, Better Pizza" promise to our customers and enhance our already strong BIBP brand positioning. I'll have a lot more to say on quality a little later.

Our primary strategic objective in our domestic business is to improve our restaurant density from the 2,657 units operating at the end of 2006 to what we believe can be more than 4,000 restaurants, representing a full 50% increase in unit count. We would like to average opening 125 to 150 net new units per year, which would put us at 4,000 units in roughly the next 8 to 10 years, with about 80% to 90% of those units expected to be our traditional delivery/carryout model and about 10% to 20% nontraditional units such as airports, train stations, stadiums, concert venues, theme parks, et cetera. So we see an increase of some 1,000 stores on the traditional side and something like 500 on the non-traditional side.

This domestic growth will provide great value to us in several ways. Most obvious is the increased royalty revenue and Commissary profitability driven by the sales volume of these new units. Because our domestic infrastructure is solidly in place, there will be minimal new capital investment or G&A support costs required to service these incremental restaurants, thus creating operating margin improvement in addition to top-line revenue growth. Further, the sales generated by these new units will improve our leverage with suppliers, as we are able to negotiate pricing based upon steadily increasing volume requirements. Finally, these units will generate significant additional contributions to our national marketing fund and also to their respective local marketing advertising co-ops, allowing us to increase our national electronic advertising presence and to increase or perhaps to initiate a local electronic advertising presence in certain markets that are currently underpenetrated.

So how are we doing currently on this key strategic objective? Well, after several years of flat to declining unit growth, we opened a small number of net new domestic units in 2005 and 2006, and we are currently on track to achieve meaningful domestic development for 2007 with well in excess of 100 net new units.

We are also very excited about the progress that we are making in rebuilding our development pipeline in the US. In fact, first quarter was one of the best quarters ever in signing up new restaurant development. We signed 100 new units for development, of which 70% were to existing Papa John's franchisees. We believe this indicates the returns franchisees are achieving from their Papa John's investment and the confidence that they have in the momentum and direction of our brand and system.

The next strategic objective I'd like to review with you is our plan to shift our marketing portfolio to more efficient and effective channels over time. National television is important to build overall brand awareness and as a customer call to action on a promotional basis, and it will continue to be an important component of our overall marketing plan. Over the next two to three years, we believe we can increase our national spend by 20% to 30% as our increased scale kicks in.

However, given the size of our national marketing budget compared to our main competitors, we have to be more creative with how we spend our funds. We are a leader in the areas of direct-mail and database marketing, and we want to enhance our leadership position by continuing to implement programs that produce outstanding returns.

Our technology advantage, which most notably is evidenced by our leadership in online ordering capability, also provides us with marketing advantages, as several million customers have opted in to receive our e-mail marketing materials. We have numerous other technology initiatives underway which we believe will enhance both our ability to market to our customers and the ease with which customers have access to ordering from Papa John's. But we're not going to provide details today with respect to these initiatives, for competitive reasons.

One other strategic objective I'd like to review is our commitment to building a solid infrastructure and development pipeline to generate significant profitable growth in our International business unit over time. We're very pleased with the progress we're making in this area, and we're confident that the losses currently generated by this business will steadily decline, as new-unit development continues to ramp up. We believe International can achieve profitability around the 2010 timeframe, as compared to a budgeted 2007 loss of approximately $9 million.

We're on target to open 100 or more new units outside the US in 2007, with a continued focus on certain key countries -- notably, as we've said before, China, India, Korea, Russia, United Kingdom and Mexico. We also have a growing presence regionally in the Middle East, and celebrated an excellent opening of our first unit in Egypt during the quarter. Our total International development pipeline remains very strong, with approximately 900 units slated to open over the next nine years.

Summarizing these strategies from an investment perspective, we expect to generate operating income growth domestically from new unit development and from sufficient comparable sales growth to protect and even increase restaurant margins in normal cost environments. In the near term, we plan to also utilize strategic acquisitions of franchised Papa John's restaurants to drive incremental operating income, as well as stimulating more franchise growth. We also expect to generate growth in operating income from reduced International losses, driven by a combination of average unit volume increases and new unit development.

Our operating model provides that most of the new unit growth is funded with franchisee capital, both domestically and internationally. When coupled with what are effectively two royalty streams domestically -- on one hand, there's our royalty from franchise sales and, on the other, the profitability from sales of our Commissary business unit -- this model provides very strong and consistent cash flows, which provide further opportunities for us to create shareholder value, as evidenced by our long-standing and successful share repurchase program.

One last strategic observation before we turn to our first-quarter results. We are aware of the recent emphasis on increasing leverage through various types of recapitalization transactions throughout the restaurant category. At this time, we believe our efforts are best directed towards striving organic operating income growth while maintaining a relatively conservative balance sheet and capital structure to provide strategic flexibility.

We intend to explore every way to drive growth for the Papa John's system, including through using our own capital to stimulate franchise growth in markets around the world. A good example is our investment in co-branded stores with Blockbuster in Chicago is already leading to growth in the number of franchise stores in that market. But even with these targeted capital investments, returning excess free cash flow to our shareholders is expected to continue to be a valuable component of our overall growth strategy for the foreseeable future.

Returning to first-quarter results, the pizza category continued to be relatively soft to start the year. A potent combination of very mild weather early in the quarter, the transition to Daylight Savings Time three weeks earlier in March than in the prior year and a very aggressive competitive landscape provided a challenging sales environment. Our results continue to lead the other reported national brands, both in traffic and sales for the quarter, and our three-year cumulative domestic systemwide comps for the quarter were 8.2%, so our category-leading performance was not just a result of easy comparables.

In fact, I believe our sales results over the most recent two plus years are particularly impressive when viewed in the context of the overall pizza category performance. The category has produced a 4.7% decrease in traffic for the last five years, while total QSR traffic increased 7.7% during the same timeframe. We believe that creative marketing initiatives and the technological advantage I mentioned earlier are among the reasons we have outperformed the pizza category over this time period.

At this time, I would also like to mention that we're very pleased with the comps from both the UK and the International businesses. Total worldwide system sales increased 4.2% in the first quarter over the prior year, with total International system sales increasing nearly 30% during this time.

In addition to our fanatical emphasis on products and service quality, we have also had very compelling new product offerings during the past several years. The new product pipeline is strong, and we are confident we will continue to produce the kind of product quality and value perception that earned us numerous best-in-category awards.

In the last year alone, we have been recognized as the Chain of the Year by PizzaMarketplace.com. We have won the Restaurants & Institutions Choice in Chains Award for national takeout and delivery pizza chains, and for the unprecedented seventh year in a row, won the American Customer Satisfaction Index survey conducted by the University of Michigan Business School for the QSR category. We consistently lead all national takeout and delivery pizza chains in the quarterly RealPeopleRatings.com survey, a more frequent report on consumer preferences that we track closely.

As a result of those numerous independent views of our product quality and the relative value in the marketplace, we were somewhat surprised by the latest promotional campaign by Pizza Hut, in which they attempt to compare their new and improved hand-tossed style pizza to our traditional hand-tossed pizza. In its television advertisement, Pizza Hut includes an actor portraying a Papa John's delivery driver to make this comparison. We believe it's a difficult comparison for Pizza Hut to make, since its product is made with frozen dough versus Papa John's fresh dough product.

Fresh dough has always been the foundation of our traditional Papa John's pizza, and comprises an overwhelming percentage of our sales. Papa John's signature hand-tossed fresh dough is made with a proprietary blend of high-quality, high-protein wheat with all-natural ingredients -- no wheat gluten added and no trans fat. It is blended with clear filtered water and delivered twice weekly from the Company's regional quality control centers to each Papa John's traditional restaurant.

We believe that this is a superior product to the frozen dough disc used as the basis for the Pizza Hut hand-tossed style pizza, and we welcome the brand exposure we're receiving from the current Pizza Hut campaign. We're comfortable letting customers see for themselves how our products stack up, and we're confident most customers trying both products will prefer ours.

While our first-quarter financial results were very strong, we're closely monitoring key macroeconomic conditions such as commodity price trends, federal and state minimum wage legislation and factors expected to directly impact consumer spending habits. We see these as gasoline and diesel prices, other energy costs and interest rates, especially in the adjustable-rate mortgage market. The commodity and wage-rate trends will put pressure on margins, although our restaurants are somewhat protected from the recent run-up in cheese costs, due to the BIBP cheese purchasing entity that is utilized to help moderate peaks and valleys in these costs. The overall pizza category has performed in a relatively stable manner in previous higher-cost environments, as there is a certain amount of trading up and down that occurs amongst consumers.

A couple of final notes before I turn it back to David for the Q&A, one sad one and one of which we're very proud. Firstly, on the sad note, our SVP and General Counsel, Rich Emmett, decided to leave us and take a similar position with Quiznos Subs. Rich was a key member of my senior management team, and amongst his substantial accomplishments during his long tenure with Papa John's was his management of our victorious litigation related to our iconic "Better Ingredients, Better Pizza" tagline. We will miss Rich greatly, and wish him much success in his new position. We're currently interviewing, and hope to bring in a General Counsel very shortly.

On a very proud note, our Founder and Executive Chairman, John Schnatter, was recently inducted into the National Junior Achievement Hall of Fame. He's the youngest business leader to be afforded this honor. John has built a great company, and has made us all proud with this accomplishment. Our 75,000 Papa John's team members worldwide strive every day to make him proud of our unwavering commitment to the quality principles upon which he built the Company.

Now, we would be pleased to take your questions, but first, back to David.

Thank you, Nigel. TJ, if you would like to open up the line for questions?

(OPERATOR INSTRUCTIONS). Barry Stouffer.

Was there less stock compensation expense in the quarter than there was last year?

Yes, I think there was slightly less -- not significant, but some less. Part of that is due to the timing of when our annual awards are made. So I don't think you'll see, necessarily, that trend continue. We could see a low bit of that the rest of the year.

I take it's worth saying that this is the final year of our three-year buildup of stock compensation. When we look forward, obviously we're not going to have to lap over such a large increase as we have from 2005, 2006, 2007.

Could you review again the increase in Commissary profits during the quarter? That went a little bit fast for me to grasp that.

The primary reason -- we ran, in January, a garlic Parmesan free breadstick giveaway. That's a fresh dough product, a manufactured product for PJ Food Service, which has a higher margin on it. So the mix of their sales was geared more toward the higher-margin product, so it increased their margins during the quarter.

So that's not expected to continue?

No, that would be a one-quarter situation.

This is going back a ways, but I seem to remember that in general, in the Commissary business, you were limited to a specific margin on an annual basis? Am I remembering correctly?

You are remembering correctly. That was somewhat of a voluntary policy in place. We have an agreement and an arrangement with the system, at this point, that we are encouraged for our Commissary business to continue to invest to try to keep food cost to the restaurants as low as possible, rather than focusing on exactly what their margin may be in any given quarter.

Dax Vlassis.

On the domestic strategy, I think about 22% currently of the domestic stores are company-owned. When you get to 4,000, what would you imagine the company-owned percentage to be?

That is looking 8, 9, 10 years down the road. It's tough to anticipate where we will be, and I think this question kind of came up last time. So I'll have a go and trying to answer it. We're very pleased with what we're doing. We're at 22%, as you rightly say. I think last time, I said we anticipate getting up to about 25%.

Then we will look at where we stand. One of the reasons we do this is, obviously, the additional operating profit. Another reason is to stimulate franchise growth. Possibly, when we get to 25% we will start refranchising, because we are primarily a franchise entity and we like using other people's capital. We have a franchise system that's very confident -- and very profitable, I should add. So we'd like to switch some of that back to the franchise side.

So I think, if we look way down to where we get 4,000 stores, I think you'll see a situation where obviously the non-traditional units will be primarily franchise, so that will skew the percentage some. We probably will be more franchised than we are now, I would anticipate. So it wouldn't surprise me if right down to that time, we were down to something like 10%, 15%, something in that range.

So I want to emphasize once again the caveat I made at the start, that that is so far in advance -- we tend to do our long-range plans over three to five years, not eight to nine.

Yes, I was just looking for kind of a direction. I understand what you're saying.

My next question is respect with international infrastructure. I think you said it was going to be about $9 million of losses internationally. What was it in 2006?

It was almost exactly the same; I think it was $8.9 million. What we basically said is we expect that to be relatively flat between the two years.

I think it's worth reiterating the change in strategy we've made in the last two years is we believe that to build International to the kind of opportunity that we believe it will be, we needed to invest in significant resources, and that meant we had to take short-term losses.

I believe we not only are on track, we're probably ahead of where I expected us to be. We're pleased, as I said earlier, with our International comps. We're pleased with the overall revenue growth, which is both comps and new stores. We're upgrading our infrastructure. Last year, we brought in Robb Chase to run international the Business. We brought in Ian Saunders in the UK to run the UK business. We've brought in others more recently. We have repositioned some people in the business on the International side. A gentleman called Joe Smith is one of our major finance players, is now very involved with International.

So we feel we have had a significant talent upgrade, and obviously that costs money. But taking that short-term pain, in our view, is exactly the right thing for what is a phenomenal opportunity down the road. If you ask me the same question about International eight, nine years down the road, I think we'll have a very profitable and a very successful business.

What do you think the total dollar value of spending -- I understand what you're saying and agree with it. What do you think the total infrastructure spending is needed in dollar terms?

What we have said is that if you look at it from a business segment point of view, we would expect that $9 million loss to steadily work its way down to around the breakeven level in 2010. That's not because we're necessarily going to be spending less. We will probably be spending more, but the revenues will then start catching up and put us into profitability at that point forward.

One other strategic type of question -- what sort of leverage are you comfortable in this business, maybe as a debt-to-EBITDA type of number? Would you consider, with all the opportunities that you have right now, something outside of pizza as far as an acquisition goes, or some other sort of quick-service category?

David and I will do a tag team on this. David will answer what kind of leverage we are comfortable with, because he's better then I am with numbers.

I think the first we say -- as I said in my remarks, we're very conscious of what's going on out there. Clearly, Domino's have demonstrated in our segment what one can do. They've got a clear strategy, and they seem to have executed that very well.

That's not our approach. We think that we have the opportunity to significantly grow this business. We want to invest when we see opportunities. We see opportunities all the time. We believe there are not only opportunities to invest in stores, as we have done by buying back franchisees, but also invest in technology, where we're very proud of our technological leadership.

Internationally, it may be that Robb comes up with more opportunities. Let's face it -- last year, we took the opportunity to buy Beijing back. We're delighted with that acquisition. I think it's going to give us a lot more control and understanding of the China market, and you may well see us spend more money internationally. Who knows? We've got no specific plans, just to be clear. But we'd like to have the money available to take advantage of those opportunities.

In terms of leverage, we don't feel we have to actually follow the fashion. I think it was interesting this morning -- there was a discussion on CNBC about Disney, which from my prior life, I've got some understanding of that Company. A lot of people were saying they were under-leveraged compared with the rest of the media segment. They must have a strategy similar to ours that you don't have to follow the fashion.

So we are aware of what's happening. We will continue to look at it. That doesn't mean that we're going to change our strategy, and it's one we obviously talk to our Board about on a regular basis.

So David, do you want to talk about --?

Yes, right now, we're about 1x EBITDA ratio. If you look back in history, probably the highest we have been is about 1.5x. Our current financing arrangements clearly support us going up to 2x without having to take any action. So I think if you used history as a guide, our comfort level is probably in the 1x to 1.5x range, absent some opportunity arising that Nigel mentioned. (multiple speakers).

Would you consider something outside of pizza?

This is something that obviously is a question which in many ways is an obvious strategic option for us to look at, and it's one we've actually discussed at Board level. I think, in the short term, our view is we have so many opportunities with this great brand that we're responsible for that we don't see ourselves doing anything in the next two, three years. We believe, if we did do anything, we have got great leverageable assets like our capability of understanding delivery, our technology leadership, our sometimes undervalued Commissary network, our print capability as well. There's all kinds of things that, if we did ever do anything, we can leverage.

I think probably sometime down the track that may happen, but not in the near future. We're very busy and excited about what we're doing. I think I said when I first did my first conference call, I came here over other companies because I was excited about our opportunities. I can tell you, I'm even more excited about the Papa John's opportunities now than I was at that time.

Mike Smith.

As you go forward internationally, what percentage of the stores internationally do you expected to be company-owned? In which countries are you most comfortable investing?

Rather than me go on, I'm going to pass it over to the person who knows it much better, Robb Chase.

I think it's fair to say that we will be predominantly franchised internationally. We are looking at -- we've made the investment in North China, which was partly to get hands-on experience operating in that country. But we also got back significant territory, which I think in the long run we will look to commingle franchising and company operations.

In terms of where we are comfortable investing, we're looking at places where we can invest where we've got proven unit economics, and where we think the competitive set is such that we're starting closer to number one and with a less-developed competitive set but an established pizza category. So we are evaluating places like Russia. It's premature today, but as that business develops, that's one that we are continuing to explore and look at. China is clearly one that -- and really, all of Asia, including Southeast Asia, is markets that we are thinking of and exploring for possible additional investments.

But having said all of that, I think franchising is predominantly the way we're going to grow, as Nigel said in his opening remarks. We think that on-the-ground franchisees just bring that kind of capability and knowledge of local markets that's difficult to establish as a pure company operation. It also leads us to think of JVs in certain places where we can combine both our expertise as franchisor and running a system, as well as the local operating expertise of franchisees.

For somebody who has followed you guys for quite a while, I remember back in the mid-90s when franchisees were opening stores more rapidly than the Company could imagine. I wonder whether -- could this possibly happen internationally, that the returns are high enough that the franchisees are more interested in getting new stores opened more rapidly?

That's a very optimistic view, which we would like to share. I think it's too early to say whether that could be the case.

But I think you have to look at some of the problems we have at the moment to take an optimistic view, as you expressed. We are lacking in scale in just about every market, and I really mean by critical mass, we probably need 50 stores per major city, as we tend to look at it, certainly, in China. If you take the Middle East, as a good example, I think we've got 60-odd stores in the Middle East. We probably need to get it up to 100 before we can get on things like satellite TV. Once you get to that scale, the brand becomes better known. They leverage their own capability. They are encouraged to invest to make their own co-ops.

So it could happen, but I think we need to go through this initial stage first before we get to a sort of breakout type strategy. But as Robb said, we're very excited about Asia, the Middle East -- and that's why we put it in the remarks today -- is exciting. I think Latin America -- we have got some nice markets building steadily.

We've steered clear of, if you like, the normal places that companies go when they first develop in Europe, such as France, Germany, Italy, Spain, all of which Robb and I have got a lot of experience of. But I think we are smart to stay away from those very competitive markets, and we're excited about others.

So it could well happen. Rob, have you got any more comments on that?

No. I think that's exactly right. We're looking for the places where it would be easier to get the critical mass in a reasonable timeframe, and in Western Europe and countries like that it's tough to do.

I think it's also interesting, in some of these markets, competition doesn't really exist, full stop. It's not just a question of just no competition from pizza; there isn't a lot of fast food, for instance. So you've got a broader market to go after, and I think certainly in places like Russia and China, we have done a pretty good job of capitalizing on that.

The only thing I would add is we already have a 900-store contractual development commitment out there across International over the next nine years. So we've certainly got some opportunity for that scale to come, as those development commitments are executed.

There are no further questions at this time, sir.

Thank you. I'd like to thank everyone for their interest in Papa John's, and we look forward to talking to you again next quarter. Thank you.

Thank you. Have a great day. This concludes today's conference call. You may now disconnect.