Papa John's International Inc (PZZA) 2007 Q3 法說會逐字稿

Good morning. My name is Shasta, and I will be your conference operator today. At this time, I would like to welcome everyone to the Papa John's third quarter earnings 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. Flanery, you may begin your conference.

Thank you, Shasta. Good morning. With me on the call today are our CEO and President, Nigel Travis; President, USA, Bill Van Epps; President PJ Food Services 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 and 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 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. We were pleased with our third quarter results, especially given the increasingly tough cost environment that I'll talk more about shortly. Revenues were up 9.6% for the quarter and 7.7% for the first three quarters of 2007, as compared to the same period in 2006, primarily as a result of our acquisition of 115 domestic restaurants from franchisees during the previous 15 months. Comparable sales were relatively flat for both the quarter and year to date, although we were pleased to see the quarter results in slightly positive territory. We reported earnings per share, excluding both the impact of the consolidation of the BIBP's commodities cheese purchasing entity in all periods and certain tax benefits recognized in the third quarters of both years, of $0.31 for the quarter, as compared to $0.28 for the same quarter in the prior year, an increase of 10.7%. Earnings per share for the year to date excluding the noted items, were $1.15 as compared to $0.99 for the prior year, an increase of 16.2%. Worldwide system sales increased 4.3% for the quarter and 3.5% year to date, driven by worldwide net unit growth and international comparable sales increases. Development activity was very solid during the quarter, with 49 net unit openings worldwide. That gives us 124 net unit openings for the year to date, and we're confident of a strong fourth quarter, where new unit openings are typically more heavily weighted.

Nigel will discuss our unit growth progress further in his remarks. Operating income, excluding the impact of BIBP, increased 7.1% for the quarter and 12.4% for the year to date, as declines in our company-owned restaurant and franchising business units were more than offset by improvements in our domestic commissary business unit and reductions in corporate expenses not allocated to specific business units. The international and all others business units were relatively consistent between years for both the quarter and year to date. The overall 2007 operating margin for company-owned restaurants declined by 1.2% in the third quarter and 1.3% for the year to date as compared to the same prior year periods. Company-owned restaurants faced higher labor, advertising and occupancy and other operating costs in both the three and nine-month periods in 2007 as compared to the same periods in 2006. Cost of sales was relatively flat between years for both periods, as ticket average increases more than offset commodity cost increases. The increases in operating income for the domestic commissary business unit for the quarter and year to date were due primarily to increased sales volumes of higher margin fresh dough products and improved margins from other commodities.

The declines in the franchising business unit were principally due to costs associated with an increase in field support staff, while royalty revenues were flat as the impact of the company acquisition of franchise units was offset by new franchise unit openings and reduced royalty waivers. The reduction in corporate expenses was primarily the result of reductions in management incentives, health insurance and legal expenses. Total management incentive costs decreased $854,000 for the quarter and $4.4 million for the year to date, due in part to the impact of the change in status of our founder chairman to a nonemployee director of the company, as explained in our second and third quarter releases. Net interest expense increased $1 million for the quarter and $2.9 million for the year to date, as a result of higher average outstanding debt balances due to the ongoing share repurchase program and the cost of the franchise restaurant acquisitions noted previously. Cash flow from continuing operations, excluding BIBP, increased $15.7 million in the first nine months of 2007 as compared to the same period of the prior year.

Weighted average diluted shares outstanding were 7.8% less in the current quarter than in the same quarter of the prior year. Cash expended on the acquisition of franchised restaurants was $25 million for the first nine months of 2007, on top of $31.9 million expended on acquisitions during full year 2006. We believe we have accomplished our strategic objectives of stimulating unit growth in underpenetrated markets and in limited cases, protecting the brand image in the acquisitions we have completed during the previous two years. We do not expect to pursue any acquisitions of significance in the foreseeable future, although we may still pursue opportunistic acquisitions in existing company-owned markets, where operational and marketing synergies are available. In the longer-term, however, we expect that the combination of new unit development more heavily weighted to franchise units and the potential for strategic refranchising initiatives will lead to us a reduction in the domestic company-owned restaurant mix from its current 23.8% level. As a result of the solid Q3 earnings results, we are raising our earnings guidance for the year, excluding BIBP, from a range of $1.56 to $1.60 per share to a range of $1.64 to $1.68 per share, thus including the full impact of the third quarter tax benefit recognized. Key operating assumptions underlying this updated earnings guidance do not differ significantly from projections previously included in our second quarter earnings release, except for a modest increase in interest expense and a modest reduction in share count, as a result of share repurchase activity.

The net unit opening projection has also been reduced to a range of 180 to 200 net units for the year due to both a slight reduction in expected new unit openings and a slight increase in expected unit closings. This guidance considers the continued margin pressures on our company-owned restaurant business unit as a result of wage and commodity increases. Commodity pressures have continued since our second quarter comments, particularly in the wheat market, but we are comfortable we can overcome these rising costs to achieve the updated earnings guidance through continued focus on controlling G&A costs and various sales driving initiatives. Our preliminary October performance only supports our confidence with respect to our fourth quarter and full year expectations. We completed our current share repurchase authorization within the last two weeks and the board has historically approved subsequent increases in the authorization once a previously approved level has been achieved. The debt outstanding under our line of credit at the end of third quarter was $124.5 million, about 1.1 times our projected EBITDA for 2007, a level generally considered fairly conservative for a franchise-oriented restaurant company, as based on peer company comparisons.

Finally, we announced the initial rollout of a revised franchise agreement after nearly a year of negotiations with our franchisees. Key provisions of this new franchise agreement are outlined in the release and the expected financial ramifications are detailed in our Form 10-Q. I would now like to turn the call over to Nigel Travis, our CEO and President, who will provide additional comments regarding the cost environment all restaurant companies are facing, as well as comments related to our capital structure and leverage status, expected benefits of the revised franchise agreement, and a general business update. Nigel?

David, thank you, and good morning, everyone. Given the tough macroeconomic conditions and a very competitive category, our Q3 performance was good. Domestic comparable sales was slightly positive during the quarter, and it really is amazing the psychological difference to our system between running 0.2 positive compared to 0.2 negative. We continued to post industry-leading results for the last three years with cumulative comps of 8.6% for the third quarter during that timeframe.

I'm delighted to say we saw sales momentum grow throughout the quarter after a slow start in July. We're pleased that this sales momentum has continued into the fourth quarter as our period 10 Tuscan promotion was well received -- so much so that we're planning to add one of the two specialty pizzas featured in the promotion, the Six Cheese, as a permanent menu item next year. Last week we launched our period 11 promotion in partnership with Sony Home Entertainment surrounding the DVD release of Spider-Man 3. The promotion features the Superhero XL3 pizza, an extra large pizza with up to three toppings for only $12.99 and a $3 off coupon for the Spider-Man 3 DVD. Certainly great value. We kicked off the promotion of the event in Times Square with Spider-man himself and director Sam Raimi, followed by the NASDAQ market close, both events generating good exposure for our brand. Standing back from our sales, I was pleased with several elements of our business efforts in the third quarter.

Firstly, customers love their [LTO] pizzas in both September and October and we think it is because it gives us the opportunity to showcase the high quality ingredients in our pizzas. Secondly, our entire system -- both company and franchise -- executed the promotions both well and consistently, and thirdly, our industry-leading online ordering performance continued, and we believe that we're on course to achieve the 20% of sales target by the end of the year, as announced on the last call. To underline our strength as (inaudible) leader for online ordering, last week was a record, supported by great football on TV and Halloween. As we've noted in the past, while we always target positive comparable sales growth, an equal if not more important component of our overall growth strategy is net new developments activity. We were very pleased with our third quarter and year to date development results. As David noted, we achieved 49 net openings -- that's of course unit openings less unit closings for the quarter. And now we're split fairly evenly between domestic and international growth. We've opened 124 net new units during the first three quarters of the year, with 70 net units domestically and 54 net units internationally.

As always, the fourth quarter will be our strongest development quarter of the year, and we should approach 200 net new units for the year, which is nearly double the most net units we've added in any one year since 2000. We're really pleased with that statistic. We continue to lead our major national competitors in domestic unit growth, as our 70 net new units for the year to date compares very favorably to decreases in restaurant counts at our two main competitors. Given the strength of our domestic development pipeline, which stood at 335 units at the end of the third quarter, we expect we will continue to take market share by new unit growth for the next few years, as we continue to build out areas of the country where we are underpenetrated. During the last call, I said I expect we would also pick up market share from independents. This is already happening, based on third party information, and we expect the trend to continue. To ensure that we are able to keep our development engine in gear, as our efforts shift into more difficult regions of the country, and our franchisees face the same margin pressure that everyone in the industry is facing for the near term, we've instituted aggressive incentive programs. These include the waiver of the developments and franchise fees, and also reduced royalties for limited periods of time after new unit openings. We've focused these incentives on areas where our penetration is relatively low, with examples being New England and the West. So far, we're pleased with the early results these incentive programs have generated.

We also believe the very successful negotiations we had with our franchisees regarding revisions to the franchise agreement should help spur new unit development by removing uncertainties and clarifying expectations on both parties going forward. The diligence of the negotiating teams on behalf of the company and the franchise advisory council demonstrated the outstanding spirit of collaboration within our system. We greatly appreciate the efforts of these individuals in this important accomplishment. As you saw in our earnings release and in more detail in our Form 10-Q filing, there are several key provisions of the new franchise agreement that we want to point out to investors. First, we expect up to $2 million in incremental franchise agreement renewal income during the fourth quarter, as franchisees move to lock in the advantages of their new agreement. We plan to reinvest the portion of this incremental income primarily by reduced commissary margins to help mitigate the impact of commodity increases to the system. The royalty rate will increase to 4.25% for most franchisees at the beginning of 2008 and by an additional 0.25% at the beginning of 2009, 2010 and 2011. We expect to reinvest much of the incremental royalty income in 2008 back into the system in a variety of ways -- again, helping counteract the high cost environment we expect our system to face next year.

After 2008, assuming a more normalized cost environment, we would expect the royalty rate increases to ultimately produce annual incremental operating income at the rate of approximately $3.5 million to $4 million per quarter [point] increase of current sales and unit levels, most likely beginning in 2009. The new franchise agreement contains two additional key provisions that deal with required levels of [marked in expenditure] and the financial management of our online ordering system. The minimum contribution to the national marketing fund is established at 2.5% of sales and can be increased to 3% by the board that controls the fund. While total minimum marked in expenditures of all types effect 7% of sales, these represent increases from the current minimum spending requirements and we view this as important, as we continue to go up against a much larger marketing budget from our national competitors. We're also excited about the negotiated provisions relating to the online ordering system. Once we have recouped $6 million of our initial investment, remaining profits from online ordering will be available for system-wide marketing activities, further closing the gap in available funds with our competitors. We expect that beginning in 2009, sufficient monies will be available from the online business to fund incremental national advertising at significant upside since we currently only have seven two-week national flights per year.

I would now like to turn to a brief update on our international business. Our international system sales grew 25.3% for the quarter and 28.4% for the year to date and units have increased over 15% for the year to date, with development weighed heavily towards the fourth quarter, which of course is similar to our domestic business. Our losses for the quarter came in at prior year levels, as anticipated, and we remain very confident that we are quickly approaching the tipping point on leveraging our infrastructure. We're building our international business the right way and expect to achieve break-even results no later than 2010, representing $9 million of operating income improvement over 2007's expected results. Although we are pleased with our performance in many areas internationally, China continues to represent the country providing our most significant opportunities for growth. Systems sales in China have increased 85% year to date, supported by 60% unit growth, as we firmly establish ourselves as the second leading pizza brand behind Pizza Hut.

Now, I've said on several occasions that we're not likely to catch Pizza Hut, given their head start and substantial Yum! related infrastructure advantage. But having said that, we can be extremely successful as the second largest brand in the country with over four times the population of the United States. And as here in the United States, we will expect there to be individual markets where we are the dominant brand. We've only recently begun to move into second tier cities, where profitable growth opportunities abound. United Kingdom is another important international market that has substantial momentum. I just attended our annual UK franchisee conference last week, and the excitement and competence of our franchisees are at unprecedented levels. We're anxious to watch this excitement turn into continued same-store sales growth and unit development, especially with existing and new multi-unit franchisees. Additionally, we recently signed development agreements for two new countries, Turkey and Poland, totaling 90 units. This increases our international pipeline to nearly 900 units to be opened never the next nine years with substantial additional development activity in process.

Finally, with respect to the cost environment that David referred to, we are committed to facing these margin pressures head on. We did a very nice job controlling our G&A costs during the third quarter and we will continue our diligence in this area of the business during this challenging time.

Our commissary business also gives us tremendous opportunity to identify operational efficiencies, especially as we continue to add net new units and therefore sales volumes in our procurement manufacturing and distribution activities. During this time of unprecedented increased commodity costs, we expect to use some portion of these efficiencies to reduce commissary growth margins in an effort to mitigate food cost increases at restaurant levels. That's protecting the health of the system while also protecting the profitability of the commissary unit. We recognize that we won't save our way to success in this period of rising costs, so we are aggressively pursuing a wide range of sales driving initiatives, one of which I'm very happy to share with you today. That is -- we are in the final testing phase with our beta users for SMS -- and for those who don't know what that means, that's short message system. You could also call it text ordering by cell phone and other devices. And other devices might be Blackberries or Palms. And we expect to make this exciting innovation available every one of our U.S. restaurants in the next few weeks.

As most of you know, Papa John's led the industry when we launched systemwide online ordering in 2001 and today we remain the only national pizza chain that offers online ordering at 100% of our U.S. restaurants. Leveraging our single platform PLS system takes ordering further, solidifies our leadership position in technology, and alternative channels of access -- that is, making the ordering of our product available wherever our customers may be when they want to order their pizza. Just to be clear, text ordering is very different than mobile web ordering, which one of our competitors recently announced. With mobile web ordering, customers have to access a webpage and navigate through a web browser which is a very cumbersome process, and in fact, only about 25% of mobile phones currently offer the technology needed for that kind of ordering.

With SMS text ordering, once customers set up their favorite order at papajohns.com, they can text their order over their cell phones with only a few easy clicks. And it shows up on the make line of our restaurant just like a typical online order. Industry research shows that there are currently 100 million active SMS users who send text messages on a monthly basis, which is more than three times the number of active mobile web users. So while we already have a large number of customers who order our product online, text ordering will allow us to reach a different group of customers who prefer text over online and email. And once again, Papa John's is pleased to lead the pizza category in innovation by introducing this new form of ordering technology. We also believe, as do our primary competitors based on their public comments, that there is room for actual or effective pricing increases, and we love the advantage we believe our Better Ingredients Better Pizza brand positioning gives us in this area. Cost pressures on discount oriented lower quality competitors should only ease the pricing landscape to our benefit, and we continue to believe that there could be some consolidation with the industry to the benefit of the national chains with this group's high levels of skill and efficiency.

Before we go to questions, I will briefly add to David's comments regarding our capital structure and leverage position. I will reiterate that we are committing to continuing to return our substantial free cash flow to our shareholders as we've demonstrated over the last eight years. Additionally, we expect that 2008 will be a healthy cash flow year as capital expenditures decline modestly and acquisition activity all but ceases and perhaps even turns to refranchising as David mentioned. We will provide more details relating to our 2008 earnings guidance, operational assumptions, and capital structure and leverage outlook in mid-December, as we typically do, after we present our plans and budget to our Board for approval. We are excited about the renewed momentum in our business, and with that, we'll open up the call for Q&A. David?

Thanks, Nigel. Shasta, if you'd go ahead and open the call for Q&A please?

(OPERATOR INSTRUCTIONS) Your first question comes from Mike Smith with Oppenheimer.

Hello, good morning.

Hi, Mike.

Hello, Mike.

You said that the the revisions to the franchise agreement was spurred due to development, and I've got the part where you are increasing the royalty payment from 4 to 5% over the next four years, but how does it spur new development?

Well, I'll start and Nigel can jump in. One of the things it does, Mike, is it guarantees that the royalty which could otherwise go to 5% immediately will only increase over the next four years for people who sign the new agreement, and in conjunction with that, as Nigel mentioned, we've put some other incentive plans in place. So it kind of takes some of that uncertainty out of the mind of -- some of our existing franchisees were kind of waiting to see what the final agreement would look like and now they're starting to initiate more development activity. Nigel?

Yes, I don't have anything to add. I think it's really the certainty, Mike, that's important for franchisees.

Okay, so let me make sure I understand this. Right now, they're paying 4%, next year for stores open next year they'll have a 20 year agreement at 4.25? Is that the incentive, that the sooner they open stores, the lower their royalty will be longer term or how does that work?

No, Mike. Let me try to clarify that. They will have 4.25% next year. It will be 4.5% the following year, 4.75 the following year and it won't reach 5% until 2011, while new franchisees or franchisees who elect to not sign this new Form of Agreement will go to 5% immediately in January of 2008. So, they get a basically a four year phase-in benefit relative to going to 5% immediately, and it's knowing that the certainty of what that environment looks like is now giving them the comfort level to say -- Oh, okay, I want to develop more units.

Okay, thank you.

Thanks, Mike.

(OPERATOR INSTRUCTIONS) Your next question comes from the line of Michael Wolleben with Sidoti & Company.

Hi, Michael.

Hi, guys. I just want to go back to that royalty rate increase. Have you guys -- what's the reception from the franchisees? Are you guys, I know in your filing you expected a majority of the franchisees to sign up for the 4.25 increase. What's kind of the feedback from them?

Okay, good question. Obviously, no one likes price increases. If we increase a pizza from $11.99 to $12.99, people wouldn't like that and franchisees don't like any increase. I think though, the reason that we had a successful negotiation is as both David and I said in answer to the previous question, it gives them certainty. It also, if you like, diverts more money to the marketing funds which both our franchisees and us believe is very important. I think the fact that we've if you like removed the increase to 5%, it's seen as very important. So franchisees basically feel a lot better about the next three to four years. Now, what I would add is no one wants to see any increases, particularly in the current cost environment. But we've indicated to our franchisees that we're very conscious of that and that both David and I said in our remarks, we've got various ways that we hope to mitigate those cost increases, certainly next year, to help them along. We're very conscious of the environment, we're very conscious of cost increases and we believe through the very strong collaborative partnership we have with our franchisees, we have an excellent opportunity to build on that partnership by helping them next year.

And Michael, the only thing I'll add to that is when you compare our rate to the rate of our competitors, we still, even with these planned increases, will have a lower royalty rate than either Domino's and Pizza Hut. And on average we're very comfortable that our unit economics stack up or are even better than the competitors. So from that point of view, we think we still offer an advantage from a franchising perspective.

Mike, just one last comment I'll make is -- we can say all we like. It's going to be the results that count. And based on our initial results coming in with people signing up or not signing up, we expect a very large majority to sign up.

All right, great. Thank you.

Your next question comes from the line of Mark Smith with Feltl.

Hi, guys. I just want to clarify one thing on the franchise renewal fee and the royalty impact going forward. Now the $3.5 million to $4.5 million or excuse me, $3.5 million to $4 million increase in the royalty fee income -- is that an annual number, is that correct?

Yes, Mark. What we tried to do is if you took 0.25% on our existing royalty base, then annually that would represent somewhere in the $3.5 million to $4 million incremental royalty range. And then obviously what we said for 2008 is don't necessarily expect all of that to fall through to our operating income because we want to be very sensitive to the cost environment that our whole system is facing for 2008.

Okay, great. And then you will be looking at a little bit more of an impact from the franchise renewal fees here in the fourth quarter, but your same type of thing you'll be passing on some of that benefit on to the franchisees?

That is correct.

Yes, I think it's important to say, Mark, that we're conscious that it's not just commodities that are going up. It's also national minimum wage, there's state minimum wage, all kinds of legislation out there talking about healthcare, talking about mandatory sickness. So we're taking all of that into the account. And also because we're a marketing company as well, we spend a lot of money on media and media costs are expected to go up significantly next year. We could argue that that actually gives us a smaller advantage over our major competitors because they are going to have a much higher cost because they do on spots here on the TV and radio a lot more than we are.

All right, and let's talk about the favorite subject for everybody. Cheese prices. With the way the futures market looks here, I guess I'm a little surprised that for fourth quarter we're not seeing that BIBP block price come up a little more than the $1.57. Is there any reason there?

It's basically the way the model works and luckily, our deficit at the time we set pricing which we set in mid August for fourth quarter -- because the whole point is to give our system the opportunity to know what their margins will be so they can set their promotional offerings and so on. So the good news is the deficit wasn't that large in August. The historical cheese market and the futures market, the way those things averaged out there was a slight increase. S we're still at $1.57 for fourth quarter. Certainly, those numbers as you saw in our Q are expected to increase going on into 2008.

And then it looks like you maintained for the most part everything in your guidance. Just one clarification on G&A expense. Are you still kind of expecting that $1.02 to $1.04 range?

It could possibly be a little lower than that, but it was close enough that we didn't feel the need to specifically call that out from a guidance change, but obviously in this environment, we're trying to do everything we can do to control that particular cost.

Okay, and part of that could come down as that due to kind of John's new status now?

Yes. That is correct, and the overall impact of the various compensation programs, yes.

All right, and then last question, I think from me. Cut a little bit on the unit growth here in the fourth quarter. Are some of those units that the we may have been looking for kind of gone or are we going to see some rollover into first quarter of '08?

I think, the fourth quarter is always an interesting period in this business because we seem to focus all of our biggest quarter of openings in the fourth quarter. And obviously, they're planned. Some of those will get pushed as you said into next year. Some of them will disappear because obviously, we've had some cost pressures like everyone else. As I said in my remarks, we're very pleased with where we stand in terms of openings for the year. But obviously with very high costs, a few people have decided to defer their openings. But basically, everyone is on track. We follow the openings every week. But because we did lose some of these openings and had one or two more closings than we expected, that's why we bought the top level of guidance down a little bit for openings. So basically, we're on track.

And what I'd add to that is that number includes international also, and we've had a couple of international markets, I'll give you one example of India that would have had a certain development schedule throughout '07. We actually changed our franchise partner in India much for the better. Our initial partner only got four or five units open and really wasn't taking the brand anywhere. We've now brought in a franchisee for India that has had success in our Middle East market. And to demonstrate, they actually opened three stores on one day in the Mumbai region earlier in the quarter. So, that delayed some of the opening in India, but it's certainly not going to go away. It's just a timing issue and we're pretty excited about the new franchisee coming in. That's something that needed to happen.

Okay, and it sounds like the pipeline is very strong with it looks like about [900] now international. So there's no cause for concern that we're losing restaurants from these pipelines; is that correct?

That is correct.

Okay. Let me just sneak in one last one. The the $500,000 loss to sell some Company owned units -- so is that something that we may look for? Is that kind of a refranchise project we may look for here in the fourth quarter?

Yes, this particular market, I'll go ahead and mention it, it is the Chicago area. We said all along we were going into Chicago to help spur the kind of the redevelopment of that market. As you may recall in 2004, we kind of had a market meltdown with a franchisee partner that we parted ways with. We thought it was important to show corporate support for that market and we're very pleased to see the unit count and the development pipeline specifically as related to Chicago is now trending on its way back up. So we kind of feel like we've done our duty there, but we don't think long term, we want that to be a corporate market. So we've just acknowledged that we're effectively planning to refranchise. So I think Chicago is a little unique situation.

Okay, and then I promise this will be the last one. You haven't had any pushback previously from the the Board on reauthorization for share repurchases as I understand it, and at this point you feel comfortable with taking on a little more leverage to buyback stock?

I think what I said on that is we continue to look at the situation. And as I said, we've had support from the Board over the last few years but no reason to believe that the bull run continues to be supported. But I've been wrong before, so I'm not going to second guess the Board. I'm going to let them sit down and look at all of the facts and make the decision at the appropriate time.

Great. Thank you.

Thanks, Mark.

Your next question comes from the line of Mike Smith with Oppenheimer.

Well, we talked a little bit about International. What is the pipeline of domestic restaurants?

I think we said 335, I believe, and that pipeline has actually been growing. And as we've mentioned, we just put in this fairly aggressive incentive program. I think we actually expect that pipeline to continue to increase.

Yes, Mike, the challenge is we're going into areas where our brand isn't well known. So obviously, we've got to support these franchisees as best we can. That's something we're very focused on and something we spent actually a lot of time talking about in recent times. But what is encouraging, we want to, well, New York was one of those markets which you probably know hasn't been well served. And New York's turning around pretty dramatically. We've got a lot of growth. They've set up a new co-op in New York. We're excited about all of the things they're doing. If we can replicate the success of New York on the West Coast in certain markets, certainly L.A. is in the the process of going down the same way. They've got an L.A. co-op for instance. New England is another market that we need to develop and Michigan again which is a bit like Chicago. And as I think we talked a couple quarters ago, we've got a brand new franchise there that's very focused on the African American community which obviously is important in Detroit.

So we're taking a different strategy for each market, but we recognize the hurdles we have to overcome. And I think we have good strategies for each of those markets, but I don't want to mislead anyone. Some of these markets with low awareness are going to be tough and we recognize they're tough and I think we're up to the challenge.

And the other question I had concerns your media buy. You said you have seven two-week national flights, with your increase in the contribution to the marketing fund. How could we expect that to change and could you give us dollars as opposed to percentages on how much you spend on media?

Our total production fund has about $50 million budget, Mike, and obviously some of that is for different purposes. Not all of that is just buying. Each campaign costs about $5 million, and the problem is next year is the Olympics and a Presidential election year, so everybody fully expects that advertising rates will go up.

And Mike, I wouldn't make the assumption that all of our money is just going to national TV media. We've got other things that have been very successful -- by supported our online programs is a good example -- and so it may be that we just boost those, so don't make the assumption that TV is the only place that we will go.

And the last question that I have, at least I think it's the last question. Concerns -- you mentioned pricing, and you have some pricing power which in the pizza market I kind of thought was a pretty bold statement. Have you tested that or how do you, why do you say to that?

We constantly survey pricing out in various marketplaces around the country and that gives us some idea of what the competition is doing. To be frank, we're kind of surprised how well -- well, in certain markets we're surprised just how far some of our competitors, not necessarily our major competitors have gone. We think and -- you may say it's slightly arrogant of us -- but we've got the best product out there. People will pay for quality. That's certainly been the case in the past. So we feel that our competitors have gone up strongly. That sometimes gives us the opportunity. Sometimes, by the way we haven't gone up as far as they have. So this is based on empirical evidence that we continually research around the country. And I'm not saying that it's enormous but we think there is some out there. And probably, we start it from the same place as you, being skeptical about how much pricing is there.

So certainly given the cost environment, our small and large competitors have obviously sat back and looked at where they stand and then decided that the only way to overcome the the cost increases that they've been faced with is to go out and increase prices. Now, pricing doesn't just mean increasing prices. It means shadowing some of our discounts, it means changing our mix. And to answer your question very directly, we've seen some very good results as we've changed some of our mix. I'm not going to go into exactly what we did, because it's competitively sensitive, but we're excited about some of the things we've done and the response of consumers to the kind of products we've offered at a higher price and how they've reacted to it.

And Mike, we've typically not been the highest price player in our markets and we don't expect to change that. It's just as our competitors take pricing up, we think that would give us room to also follow.

Thank you.

Your next question comes from the line of Fitzhugh Taylor with Banc of America Securities.

Hi, guys. Just quickly on the franchising, on the agreements, for an existing franchisee, does the new agreement have any changes in kind of the specific new unit opening requirements versus the existing agreements?

This is a franchise agreement, Fitzhugh, not their development agreement. So they're two separate things. So this just deals with their currently open restaurants and kind of the rules of engagement around their existing restaurants.

Okay, so you just, they aren't, you believe that these changes will kind of help spur --

Yes.

Growth as opposed to forcing it basically?

Correct, exactly.

Okay. And just real quick remind us what wheat is as a percentage of your overall cost of sales?

It's relatively small. It's a lot smaller than cheese, and a doughball is roughly maybe 20% of the cost of a pizza, but the raw material of wheat is only a small part of the cost of a doughball, so it's going up obviously but it's a relatively small item.

Okay, thank you a lot.

Your next question comes from the line of Stuart Goldberg with Somerset Capital.

Sorry, we can't hear you very well. We can hear everyone, if you could just repeat what you said, please?

Or maybe not? Okay, go ahead with the question, please?

(inaudible)

Hello?

Hello?

Mr. Goldberg? Your line is open.

Yes, sorry about that, guys. I just had a quick question and I apologize if you've gone through this already, the tax rate. Can you walk through what the credit is for and how we came about that?

Yes. This is and we had discussed this in the past and I think all companies are facing this. This is a new accounting rule that require you to recognize changes in your tax reserves for potential tax issues when either you settle the issue or the statute runs. So instead of being able as companies did in the the past maybe rightly or wrongly smooth those things out, they now have to be recognized in the exact quarter when that event occurs. And third quarter of every year seems to be when a lot of statutes usually run when you file prior year returns. So we had a $2.4 million benefit related to certain tax issues that we were reserved for effectively going away. So, our base rate is still the 36.5% that we would expect in normal situations, and then in third quarter we had the added benefit of a $2.4 million reduction in our tax reserves.

Okay, thanks.

(OPERATOR INSTRUCTIONS) You have a question from the line of Kyle Kliegerman with EnTrust Capital.

Yes, hi, guys. I had a quick question related to guidance on that tax rate. What is your ongoing tax rate sort of in a normalized environment?

Yes, our normalized, Kyle, and we would expect to flow into fourth quarter, would be that 36.5% rate. So that's why when we changed our guidance for the full year, we basically went up the the $0.08 of the one-time benefit that we received in third quarter. So we went from the $1.56 to $1.60 to now $1.64 to $1.68, basically letting that $0.08 flow through. But it doesn't change our normalized tax rate.

Okay, so then just stop me if I'm off at all here. The one thing I'm trying to understand, if I just sort of look at what your number this year was for continuing operations, I guess it was $3.8 million just sort of looking in the Q, and I add back the loss from the cheese purchasing of $7.85 million. If I were to tax that at a normalized rate, wouldn't that be sort of even below that kind of $0.31 number when you add back the $0.08? Am I doing something wrong? I'm just trying to understand that better.

I think the difference, Kyle, is make sure you're adding back the right number for the cheese company because it can be a little confusing. It's not just the $7 million plus number on the income statement. It is the full impact of the cheese company which is about $10 million for the quarter. So when you add that back to operating income and then tax effect that at 36.5, you should get about a $9.4 million net income number, which is what gives you the $0.31. And that's the consistent methodology that we always use on that.

Okay, great. That's very helpful, thank you.

Thank you.

(OPERATOR INSTRUCTIONS) We'll pause for just a moment. You do have a question from the line of John Curti with Principal Global.

Good morning. I have two questions. First off on the domestic side of the business, could you go over again what you're doing in terms of incentives to spur development and for how long a period that will last in terms of reduced royalties and I guess elimination of I guess franchise fee per unit development fees, etc?

Well, thanks for the question. Yes, this is a program we're kind of excited about because we think it's important to spur development. And in fact, this was an idea that came out of one of our Board meetings that the we should really be aggressive to try and stimulate development in the underpenetrated areas. So we identified certain markets around the country. Parts of it was designed to attract franchisees from other parts of the country to go to newer territories, also to attract new franchisees. The programs differ from place to place, so I'm not going to give you a generalized number. Basically, they last for a year. It's to try and incent people to move fairly quickly, and the programs have a mixture of total royalty relief, semi-royalty relief. In some cases, we've got royalty relief for existing franchisees to actually change the development plans and put more stores in quickly. I remember in one meeting I was in fairly recently in Las Vegas, one senior franchisee said this is just a no-brainer. I'm going to sign up for a couple of stores now. So that's the kind of reaction we're getting. So I wouldn't like to give you -- this is what the program is because the program varies around the country.

But it is a combination of royalty relief as well as waiving of the fees per unit?

Yes.

Okay. And then on the international side, with the expectation of moving towards kind of a break even point by 2010, at that point, your best guess as to how many international units you would have in operation at that time? To reach that kind of break even point?

It would probably be around 800 or 900 units if you looked at that growth rate.

Okay, and then based on the development program that you see coming for the next three or four years in international, what kind of an increase should we be seeing on the infrastructure side? Obviously, you've put in a big infrastructure and you're growing into it, but there will still be additions along the way, but will those amounts be relatively small?

Yes, I think what we've said and you'll see more as we announce our 2008 guidance in December. But we are getting very comfortable that we're building an infrastructure that's now ready to be leveraged as we get the additional units going forward. So without giving you specifics, I'd say absolutely you should see a slowing in the increase of any infrastructure building in international. And then the unit growth will overtake that which gives us that leverage and that improvement in operating income.

And that's primarily because of the development being confined more or less to the existing territories which you're now in rather than adding a whole bunch of new geographic locations where additional infrastructure would have to be built?

No, I would say that's not correct. What I would say is basically, an increasing of expertise and the ability to share best practices are around the world. For instance, when I was in the UK last week, I was working with our supply chain people and they see opportunities for working together, the Middle East, and some of our Europe operations. So it's really gaining the experience. It's really seeing what's worked in one part of the world and taking it to another part of the world and then leveraging a supply chain, leveraging the marketing idea, leveraging, if you like operations. And we have two real big senses of G&A and International in the UK and U.S. We're trying to leverage those. We are putting some more people on the ground but as David said, there should not be a significant increase in the G&A going forward because I think we're getting a lot more sophisticated and a lot more knowledgeable about how to pass good practice around the world.

Great. Thank you very much.

Sure thing.

At this time there are no further questions.

Thank you.

Thank you very much, and can I thank everyone for their continued interest in Papa John's. We look forward to speaking on our next conference call. Thank you.

Thank you for participating in today's conference call. You may disconnect at this time.