Papa John's International Inc (PZZA) 2007 Q2 法說會逐字稿

Good morning. My name is Ashley, and I will be your conference operator today. At this time I would like to welcome everyone to the Papa John's second 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.

Thank you, Ashley. Good morning. With me on the call today are: our CEO and President, Nigel Travis, President U.S.A., Bill Van Epps, President PJ Food Service and Preferred Marketing Services, Julie Larner and other members of our executive management team. After a brief financial update, Nigel will have comments about our business, the management team will then be available for Q&A. Our discussion today will contain forward-looking statements that involve 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 10Q and 10K. The call is being taped and a replay will be available for a limited time on our website and in downloadable podcast format.

We were very pleased with our second quarter results, especially given the tough environment that Nigel will talk more about shortly. Revenues were up six one -- 6.1% for the quarter and 6.8% for the first half of 2007 primarily as a result of our acquisition of 73 domestic restaurants from franchisees during the previous 18 months. The increase more than offset the impact of lower cheese costs on commissary sales to franchisees. We reported earnings per share, excluding the impact of the consolidation of the BIBP commodities cheese purchasing entity of $0.40 for the quarter as compared to $0.34 for the same quarter in the prior year, an increase of 17.6%. Earnings per share for the year to date excluding BIBP were $0.84 as compared to $0.71 for the prior year period, an increase of 18.3%. Worldwide system sales increased 2.1% for the quarter with new unit growth and international comparable sales increases more than offsetting the 1.1% decrease in domestic comparable sales.

Development activity was very solid during the quarter with 46 net unit openings worldwide. That gives us 75 net unit openings for the year to date and we are confident of a strong back half of the year where new unit openings are typically weighted. Nigel will discuss our unit growth progress further in his remarks. Operating income from key domestic business segments was lower for the quarter as compared to the prior year. Company owned restaurant income was $614,000 lower due to the 1.5% decrease in comparable sales coupled with labor cost increases. Commissary income was $595,000 lower due to increased labor, delivery and utility costs. And income for the domestic franchising segment was $672,000 lower due primarily to the previously noted acquisition of franchise restaurants by the company.

These declines in operating income were more than offset by improvements of $400,000 in the international segment and $500,000 in the all other segment, coupled with a $2.5 million reduction in corporate expenses. The international improvement was the result of management reorganization costs incurred in the prior year quarter, while additional commercial print business in our preferred marketing service group drove the improvement in the all other segment. The reduction in corporate expenses was primarily the result of reductions in projections for our performance based incentive and equity compensation programs driven in part by the transition of Founder, Chairman , John Schnatter to a nonemployee status. This decrease was partially offset by a $1.2 million increase in net interest expense for the quarter as a result of higher average outstanding debt balance due it to the ongoing share repurchase program and the cost of the franchise restaurant acquisitions noted previously.

Cash flow from continuing operations excluding BIBP increased $9.4 million in the first six months of 2007 as compared to the same period of the prior year. Weighted average diluted shares outstanding were 8.1% less in the current quarter than in the same quarter of the prior year. Based on the strong Q2 earnings results we are once again raising our earnings guidance for the year excluding BIBP from range of $1.52 to $1.58 per share to a range of $1.56 to $1.60 per share. At the same time, we are updating the key operating assumptions underlying this earnings guidance, the detail of which was included in the earnings release. Domestic comparable sales guidance for the year was revised from an increase of 1.5% to 2.5% to range of a 1% decrease to a 1% increase in the response to the actual decrease of .4% for the first half of 2007. The assumption for G&A expenses was reduced by approximately $15 million from the initial guidance due to the incentive and equity compensation decrease previously noted and concerted efforts to control costs given the tough operating environment.

The guidance for net interest expenses increased and the guidance for average diluted shares outstanding has decreased as a result of actual and projected share repurchase activity exceeding initial projections. Other assumptions were relatively consistent with the initial guidance. In addition to the reduced comparable sales assumption for 2007, there two are primary cost factors working to significantly pressure unit level margins. We estimate that the impact of recently enacted federal and state minimum wage increases will reduce company-owned restaurant margins by approximately 1% during the last half of 2007. We further estimate that anticipated increases in many of the commodity markets will reduce restaurant margins by approximately 50 basis points during the last half of 2007.

We are working to identify efficiency and productivity initiatives for our company-owned and franchise restaurants to help offset the increases in wages. Continuing to expand on our leadership position in on-line ordering may help reduce restaurant staffing levels at certain on-line volumes. Additionally, having a custom in-house distribution system provides us an opportunity to utilize distribution and transportation efficiencies to help offset a portion of the underlying commodity increases that are forecast. We have also recently taken some limited pricing increases in our company-owned restaurants in order to help counteract these cost pressures and we expect our franchisees may do the same. However, we are very sensitive to the overall customer value proposition and will be very careful about how any further price increases or discount reductions might be instituted. I'd now like to turn the call over to Nigel Travis, our CEO and President.

David, thank you very much, and good morning. It's been a very interesting three months since our first quarter conference call in early May. Consumer confidence and therefore consumer spending are under attacks on several fronts. We have upward pressures on interest rates that negatively impact adjustable rate mortgages and other consumer debt. We have weaknesses in the housing sector, and gasoline and energy costs have remained higher. Additionally, commodities have increased in nearly every category driven in large part by the diversion of feed corn into ethanol production.

And finally, federal minimum wage legislation was signed into law with the first of three scheduled $0.70 increases going into effect in late July. Yes this all sounds like the perfect storm. In the face of these tough environmental conditions in a very competitive category, we had a very strong second quarter. Although we're never satisfied with negative comparable sales results, our cumulative domestic comps for second quarter were an industry leading 3.6% for two years and 9.7% for three years. These results produced average weekly sales for the first six months of the year of nearly $15,800 for all company-owned restaurants and over $13,900 for all franchise units generating compelling unit economics.

We believe these unit economics will help us withstand the anticipated margin pressures from commodities and wages better than many other restaurant companies and our competitors in particular. We believe the numerous sales and margin pressures could lead to significant financial issues for many of the small and medium-size chains that make up over 50% of the pizza category. I do not want to sound complacent with these remarks as it is our goal to return to positive same-store sales on a current year basis, and I'm working very aggressively in this regard. With this in mind I'm excited about some of the new products and marketing programs in our pipeline, but obviously for competitive reasons will not say more at this time. We're very pleased with the second quarter financial results as David noted. The year over year increase in earnings per share excluding BIBP of 17.6% for the quarter and 18.3% year to date substantially exceeded our targeted 10% to 12% earnings growth goal and led to a second upward revision of earnings guidance for the year. I think this demonstrates the resilience of our substantially franchised business model and our ability to control administrative costs when faced with sales challenges.

Another indication of the strength of our business model, especially when combined with an aggressive share repurchase program that has returned over $650 million to shareholders since its inception in late 1999, is the fact that Papa John's was noted to have the highest return on invested capital of any restaurant company in 2006 by Banc of America Securities research report. Our industry leading ROIC for 2006 was 19.6%, and that included substantial investments in our international business in the form of an approximate $9 million operating loss. Although sales were somewhat soft during the second quarter, key elements of our strategy remain firmly on target. Quality ingredients and unit level execution are always the key components of our performance. We responded very effectively to Pizza Hut campaign directed at our signature fresh dough traditional crust products. Their hand-tossed style pizza is made from frozen dough, but we are totally convinced that consumers prefer fresh dough to frozen dough.

On another front we recognize that consumers want value and have made some adjustments to our model to accommodate this. Value is more than cheap pizza and there is more than one way to offset margin pressures than the increasing prices. It could include shifting menu mix and bundling offers. We think our quality positioning gives us added flexibility in this regard, allowing us to evolve our product mix to deliver value while also obtaining more ticket. On previous calls I've discussed our elaborate operational measurement systems that our Founder, John Schnatter, established in the company. In short we measure absolutely everything, and our measures tell us that the quality of our product we are serving our customers is amongst the best it it's ever been. We've also seen marked improvement in our service measures both in average delivery times and the percentage of deliveries for which we deem the delivery times unacceptable. Our internal quality measures continue to be validated externally, as during the quarter Papa John's was named the leading pizza company for the eighth consecutive year in the prestigious American Customer Satisfaction Index survey as conducted by the University of Michigan School of Business. We were also recently named the 2007 pizza chain of the year by "Pizza Today" magazine.

Another key component of our strategy for 2007 is the acceleration of net unit development worldwide. We're on pace to increase net unit openings, and I'll remind you that's total units opened, less units closed, and we've increased that from 89 in 2006 to a range of 2010 to 230 units in 2007. In fact, our trailing number is 130, so clearly this is trending in exactly the right direction. We are comfortable we can sustain this level of net unit development for the foreseeable future, although the mix of development will shift from being weighted more towards domestic to being weighted more towards international over time. Several factors have helped support this increase in net unit development, as strong domestic unit economics have led to a higher level of franchisee confidence in the Papa John's brand and system. Of the 136 new domestic traditional units signed to development agreements during the first six months 2007, 70% were signed by existing Papa John's franchisees. This excellent indication of franchisee confidence is support by our own internal franchisee surveys.

We also have a very strong leadership group within our franchise community and our relationship with these franchise leaders is outstanding. We spent the last several months working very closely with a task force of those franchise leaders on revisions to our standard domestic franchise agreement. The timing was right for this project as many of our 10-year franchise agreements are up for renewal in the next few years given our very strong unit growth in the late 1990s. We've completed our work with the task force and believe we have collaboratively made meaningful revisions to the franchise agreement, including provisions that establish guidelines for future royalty increases and allow for creative funding opportunities for the national marketing fund. I believe it is truly a win-win agreement for both the company and our franchisees.

I'm also really excited about our cost reduction program underway related to the buildout of a new Papa John's that should help spur unit growth. As you travel the country you never know where great ideas may come from within our franchise community, and this one came as of my visit earlier this year to our franchisees in Louisiana to review the post-Katrina development of the region. The franchisees I met with explained to me the dilemma they're facing. If business is weighted until the population returned before reopening, the lack of jobs would delay the rebuilding of the population for far too long. Our franchisees wanted to reopen units, provide jobs to spur the economic redevelopment of the area, but to build a full scale Papa John's was too costly given the currently reduced consumer base. Our development team attacked the need for a lower cost alternative, and they were able to identified opportunities to reduce the initial investment cost of a Papa John's restaurants by around $30,000, without negatively impacting our brand image or any areas of customer service.

This investment model will be valuable not only in Louisiana, but also in developing in smaller markets, including rural areas with lower population in the direct trade area, which have the potential for higher than normal levels of carry-out business. For instance, we recently opened a small town unit using this development model and the initial results have been extremely positive. As increasing sales volumes warrant, upgrades can be made to this lower initial investment model in a very cost effective manner. Our strategy to extend our technological advances is very much on track. Much has been discussed recently in the media regarding on-line ordering with a notable article, if you haven't seen it, been in the "New York Times" this past Sunday. We're pleased to lead the pizza industry in this important area. As many of you know we launched on-line ordering at Papa John's.com in 2001 at all of our traditional U.S. restaurants, well ahead of our larger competitors what have only recommend begun to offer this service and who still do not offer it at all the restaurants. A few fact worth noting about the volume of business transacted at www.papajohns.com. Customers have placed more than 38 million on-line orders representing sales of nearly $750 million, and during 2008, we expect the number to surpass $1 billion.

Secondly, Papa John's did more than $200 million in on-line sales in 2006 alone. And we're already approaching this number in 2007. Thirdly, on-line orders have increased by more than 50% each year since 2001. And finally, on average, each week we take roughly 280,000 orders on-line, and by year end we expect nearly 20% of our business will come via on-line at www.papajohns.com. We expect this ordering trend to continue and evolve into other forms of ordering technology. So we will continue to lead and innovate to make Papa John's available from wherever our customers want to order. We also continue to utilize a variety of alternative marketing and promotional opportunities to drive brand awareness and sales. During the second quarter we announced our partnership arrangement with Live Nation, the leading operator of concert venues in the United States. We have now opened 23 Papa John's nontraditional units in Live Nation venues with more to come in future years. In essence this arrangement is very similar to the Six Flags agreement that we signed last year and has been a success for both parties. I really like our opportunities with Live Nation, as it gives us access to the one area of the music industry that is growing, and that is live concerts.

The final area of extreme strategic importance that I'd like to update you on is our international business, which remains very much on target even with the departure of Rob Chase in June for an opportunity to return to his home town of Toronto. David Flanery has once again assumed charge of this business unit, and I believe we have a very strong team in place to meet the diverse needs of our international franchise base. We continue to build our infrastructure in key areas to support future unit growth such as the addition of Tim Scott as VP of International Marketing and Derek Walker as VP of Worldwide R&D and Quality Assurance. We remain on target to open well over 100 Papa John's restaurants outside of the United States in one year for the first time in 2007.

And our international development pipeline is very strong. We just signed a development agreement for El Salvador in Latin America and expect to sign a development agreement for a new country in eastern Europe, two regions we're very optimistic about our opportunities. We're also excited about the relaunch of our brand in Mexico with the opening of a first new restaurant by our Mexico City franchisee. China continues to remain a primary focus of our international development under the close supervision of VP of International Operations, Myles Felt. After acquiring the Beijing market from our franchisee late last year, we are now prepared to open several new company-owned units prior to year end. We've also been expanding company-owned units into certain second-tier cities near Beijing. Our franchisee in the Shanghai and south China regions have already begun expanding into second-tier cities such as Hangzhou, where we believe the return potential is even higher than in the major cities of Shanghai and Shenzhen due to the lower wage rates and rate.

Yes, we remain very confident about China. We now have 58 franchise units in addition to the five company-owned units we acquired in late 2006. They're in 15 different cities, and we're pleased to say that all our franchise units open for more than one year are cash flowing at store level. The turnaround plan developed for the United Kingdom last year under the leadership of Managing Director, Ian Saunders, is on target, as we recently announced the signing of a 10-unit development agreement and actual growth of 15 units and it's going to be based in the [M-4] region. Probably most of you don't know where that is but it's the area of the motorway that goes from the west side of London right out to areas like Bristol. Shifting development to multi-unit operators is a key strategic objective in the U.K. and we're in discussions with several other groups at this time.

A couple of final notes before I turn the call back to David for Q&A. First, Tim O'Hern, Senior Vice President of Development, recently left the company to focus on operating and growing Capital Pizza, a Papa John's franchisee, in which he's been a principal since 1993. Capital Pizza owns and operates 20 Papa John's restaurants in Indiana, Illinois, and Kentucky. With Tim's departure, Bill Van Epps, President of U.S.A., will lead the company's development efforts with Tim acting as a consultant through the end of the year. We really do appreciate Tim's years of service to Papa John's and are delighted he will stay actively involved in our brand as a franchisee.

Next, we're pleased to welcome Lou Jones as our new SVP and General Counsel. Lou comes to us from Blockbuster where she spent the last nine years of her career most recently as SVP, corporate and international law. She has over 24 years of legal experience including domestic and international franchise law, transaction and general corporate law, as well as real estate. Welcome, Lou. We'd also like to welcome Alex Smith to our board of directors. Alex is President, CEO and a member of the board of directors of Pier One imports and has over 30 years of experience in the retail industry. His retail expertise and significant international management experience will be a valued addition to the outstanding talents of our board. In closing, we remain very excited about the future and feel that the programs that we're working on will help us to overcome the avalanche of cost pressures that the industry is facing. Most of all we fully intend to protect our quality and on-line leadership position. And now will be pleased to take your questions. David.

Ashley, if you would like to open the lines up for questions now, please.

Yes, sir. (OPERATOR INSTRUCTIONS) We'll pause for just a moment to compile the Q&A roster. Your first question comes from the line of Adam [Hammel] with Gates Capital Management.

Yes. Hi. I was wondering if could you talk about the pricing environment. Dominos mentioned they think they're probably going to raise prices to keep margins steady. Wanted to see what your thoughts were on that.

Okay, I'll kick off. Obviously, you've got two or three factors going on out there. You've obviously got the commodity increases that we have to take into account from a margin perspective. We've also got the desire by consumers that they want greater value, and we're trying to balance all this, and as I said in my remarks, it's not really just about increasing prices across the board. I think one has to be a little bit more sophisticated than that. And we've been working extensively on looking at our products, looking at where our greater margin opportunities are, and trying to change our mix. So our approach to this is to work on our mix to focus very much on our higher margin product, look at increasing prices there, while at the same time making sure that we communicate value in the many communications that go out in this industry, be they e-mails, be they direct mail, be they leaflets, be they door hangers, because customers obviously want to see that value, but as I say we have to balance that against making sure we maintain our margins. I think we've tried to do that very sensitively, and as we move forward we will continue to look for more opportunities to increase margin through that philosophy.

Okay. And then you mentioned that you think these pressures are going to hit the small and medium chains. Have you guys seen any or -- any concrete indication of that so far?

We have. We've seen some impact through numbers we receive in the industry based on the very -- we've seen some closures in the mom's and pop's and the regional chains, and I think the number that's worth quoting to you, and this is our latest numbers, is if you look at the number of independent out there, there's actually, according to our numbers, 23,250 stores, and if you take the regional and small chains, 22,965, so you've got something like 46,000 small operations out there. So we think they're going to really feel the pressure. That may see some of the consolidation that's on us in our industry is different from most retail industries, where there's been extensive consolidation over the last 20 years. To have less than 50% share for the major chains is unusual in a retail or food industry. So we've seen the trends going in that direction, and I think it will continue as long as these cost pressures are maintained.

And then last question, how aggressive do you guys plan on being in the repurchase program? There doesn't seem like there's that much left on your authorization.

Well, obviously we do have the remaining authorization, and I think the best thing I can say is that if you look at our track record, the board has been very supportive when we've gotten to the end of an authorization to increase that authorization. Obviously, we can't commit to that at this point, but I think if you look at our track record you'd say that we are committed to returning our free cash flow to shareholders, and we tend to do that somewhat opportunistically. So --

Okay. Great. Thanks.

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

Good morning.

Hey, Barry.

Wonder if you would comment on the franchise acquisitions you announced in the press release. Specifically what I'm looking for is what motivated Papa John's as a buyer and what motivated the franchisee, the sellers.

I'll start out, Barry. The largest one in there was the recent Kansas City area, and I think we saw a nice midwestern market. We grew up in Louisville, Nashville, southeast, midwest, and Kansas City, certainly, fits that mold. We look at the pricing of the market relative to what we believe we can perform like in that market, and so I think that gives us our indication there. The other one was in Georgia, which fits very, very nicely with where we already after very strong corporate presence out of Atlanta. So those are the two larger ones.

I don't think, Barry, I'd add anything other than we really think that they're great markets. They're very synergistic with other operations that we have, and it seems to be a great opportunity, and we're excited about both of them.

What prompted the franchisees to sell?

One gentleman particularly was just looking to retire, I think, and leave active business. And you'd have to ask the other franchisees their specific motivation, but that's going to happen from time to time.

I think, Barry, if your question is were there negative reasons for them selling, I think that in any franchise system you go through turnover where people get to a certain age they want to retire, move on, they want to do other things. And this happens as all chains become more mature. I mean, I remain encouraged, as I said in my remarks, by the fact that 70% of our development comes from our existing franchisees. We're encouraged also by the quality of the new franchisees that we've brought in, and I think franchise confidence is as high as it's ever been, despite a very challenging environment.

Are there any valuation metrics you could share with us on the acquisitions, like multiples of net cash flow to you?

Barry, the best thing I can tell you is that we have certain hurdle rates that we look at that obviously take into account the net impact of the acquisition, the lost royalty verses gained operating income, and these all met our hurdle rate thresholds very firmly.

Okay. Thank you.

Thanks, Barry.

Your next question comes from Stewart Solberg of Somerset Capital.

Good morning, guys. I apologize if you've gone through this already, but I wanted to get a better nothing, as far as variable interest entity. What will your cheese rates be going forward for the next quarter to your franchisees, and how does that compare to the first quarter -- to the second quarter? And -- well, let's go through that first.

All right, Stewart. And we try to put a detail of that in our 10Q. So I'll hit some of the highlights, but if you want more details you can actually go to the 10Q. If you look at that price that our franchisees were paying during the second quarter of last year, and this will be their base price, the kind of the block market equivalent price, it was actually a little over $1.48 second quarter of last year, where as this year it was approximately $1.38. So contrary to the trend in the actual cheese market, our franchisees actually -- and corporate stores paid a lower price. Based on the futures market information, well, actually third quarter is already established, third quarter was $1.525 last year and will be $1.497 this year. So about flat. Then in fourth quarter that will flip a little bit where it was $1.447 last year it will be $1.57 this year. That, of course, is a projected number because the mark could change between now and when that price is established.

Right. And are you maintaining the spread between futures market and what you're charging your franchisees, or are you changing the spread at all?

We are not changing the formula at all. It's a very consistent formula. It worked very well back in 2004, when the actual block market price of cheese got up to $2.20. What happens is you will see the deficit in this separate entity grow. It grew to about $24 million in 2004. We think it will be in low $20 million this time. And then that deficit will start going away and reducing as the price of cheese, under the formula, comes up some.

And if cheese is sustained here at these prices for longer than you expect, is there a point there at which you have to change this formula, or you think that there's -- you can't take any more pain from the rising losses?

It -- Stewart, that's good question. It basically is a self-correcting formula. So what will happen, if cheese were to remain high, the price we charge the stores very quickly comes right up to that level, so that the deficit doesn't get any larger. So it is a self-correcting type of formula.

Okay. So if cheese prices remain high here, your franchisees are going to experience higher cheese costs. Right now they're "subsidized," but as we go forward we'll continue to see them maybe -- if cheese prices were to stay at these levels, you'd see them paying higher prices for cheese.

That is correct.

Okay. Thanks, guys.

Sure.

(OPERATOR INSTRUCTIONS) There are are no further questions.

Okay. Well, I'd like the to thank everyone for their continued interest in Papa John's, and we look forward to talking to you again in three months' time. Thanks for your attendance.

This concludes today's conference call. You may now disconnect.