Papa John's International, Inc. (PZZA) Q1 2015 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Papa John’s First Quarter 2015 Conference Call and Webcast. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session with instructions following at that time. [Operator Instructions] As a reminder, this conference call is being recorded. Now, I'll turn the call over to Lance Tucker, Senior Vice President and Chief Financial Officer. Please begin.

Thank you, Tyrone. . Good morning, everyone. Joining me on the call today are our Founder, Chairman, President, and CEO, John Schnatter; COO, Steve Ritchie; and CMO, Bob Kraut, and other members of our senior management team. After the financial update, John and Steve 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 may involve risks relating to future events. Actual events may differ materially from the projections discussed today. All forward-looking statements should be considered in conjunction with the cautionary statements in our earnings press release and the risk factors included in our SEC filings. And all statements made on this call are as of today. Please refer to our earnings press release in the Investor Relations section of our website for a reconciliation and other disclosures related to our discussion of non-GAAP financial measures on this call. Unless otherwise noted, all comparisons are versus the comparable periods from a year ago. This call is being taped, and the replay will be available for a limited time on our website and in downloadable podcast format. Now onto a discussion of our first quarter operating results. EPS in the first quarter was $0.55, up 22% with strong domestic and international comp sales growth and favorable commodity trends. Our first quarter revenues increased nearly 8% versus the prior year, as we continued to see excellent comp sales driving our revenue growth, with first quarter comp increases of 6.5% for North America and 7.7% for international. Revenues also increased due to a 6% increase in the number of units operating globally on a year-over-year basis. These increases were somewhat offset by lower block cheese prices, which prices, which drove lower revenues in our PJ food service business since we have a constant dollar markup on cheese. We opened 36 net global units in the first quarter, with 35 net international openings, and one net North America opening. On a business segment basis, operating income for domestic company-owned restaurants increased $5.2 million in the first quarter, due primarily to 8.1% company-owned comp sales increases and lower commodity costs. Operating income for the North America franchising segment increased approximately $2.8 million in the first quarter, due primarily to the increase in comparable sales of 6% and reduced performance-based royalty incentives. Operating income for our domestic commissary segment increased by approximately $1.4 million in the first quarter due primarily to higher volumes that were partially offset by higher driver compensation and higher insurance costs. Operating results for our international segment increased approximately $600,000 in the first quarter, due primarily to 7.7% comps, and a higher number of units open on a year-over-year basis, partially offset by negative foreign currency exchange rates. Our China business showed a modest improvement versus the prior year. Our unallocated corporate expenses segment rose $4.7 million in the first quarter, due primarily to higher G&A costs, resulting mainly from higher incentive-based compensation, insurance, and legal costs. In addition, interest expense was up in Q1, as our expenses associated with the roll out of our focused POS system. Our effective tax rate was 33.5% in the first quarter, down 1.1% from 2014. Our 2015 full-year tax rate guidance has not changed this Q1 reduced rate is primarily timing so expect to higher rate in the second quarter. We repurchased approximately $25 million of stock during the first quarter and have approximately $96 million of remaining share repurchase authorization. Our free cash flow, a non-GAAP measure we define as cash flow from operations less capital expenditures, was approximately $33 million in the first quarter, up $17 million versus the prior year. Our net debt position defined as total debt less cash and cash equivalents, was approximately $207 million at end of the first quarter. We have now rolled out FOCUS, our new POS system to substantially all of our domestic restaurants domestic restaurants and I'd like to congratulate our entire technology and operations team on completing this huge task in only one year's time. As we noted in our press release, we have updated the following 2015 guidance items. EPS is projected to range from $2.00 to $2.08 from the previous range of $1.98 to $2.06, and we expect North America comps to increase 3% to 5%, up from the previous range of 2% to 4%. And now, I'd like to turn the call over to our Founder, Chairman, President and CEO, John Schnatter. John?

Thanks Lance, and good day to you everyone. We’re glad you’re able to be with us today on the call as we discuss our first quarter 2015 results. Thanks to our disciplined and focus on the fundamentals of what it takes to a successful global pizza restaurant, customers continue to reward us, not with just their samplings but more importantly, their loyalty. Following a great 2014, plus another strong start in 2015, with excellent first quarter results, our sales momentum continued in Q1 with North America comps at 6.5% on top of 2014’s 9.6%. Our two-year comp is over 16%. The reason is simple. Our unrelenting commitment to make the best pizzas and the most enjoyable buying experience possible. Our combination of the highest quality ingredients in pizza, along with great service, compelling offers, and ease of ordering via our digital platform, is clearly hitting home with consumers. And it's not only our sales results that tell us consumers are having a great experience at Papa John's, we were recently rated as the leader in the pizza category in two, in total of all, QSR in customer experience in the [indiscernible] experience ratings. Now, while these results are gratifying, they're not surprising. Management made a clear decision years ago that we would make the best pizza regardless of the cost, and that consumers would reward our efforts with their loyalty. That's exactly what we have done, and it's why consumers have responded so favorably. This does not happen by accident. Being the best is our mission and our commitment. Our success depends on a belief in better. From better ingredients to a better baking process and even a better box. We are prepared to pay more to deliver better, but instead of are hurting our bottom line, we have been rewarded for it. On the digital front, our sales mix averaged over 50% of the domestic sales in the first quarter, as we continue to set the pace in driving digital sales in this rapidly- expanding market. Also in Q1 we rolled out pay share across all digital channels. Pay share gives consumers a safe and secure way to split their bills while placing their order. Product innovation in the first quarter was headlined by our new brownie, which has been very well received. In addition, we added bacon to our popular double cheeseburger pizza which once again helped deliver a very solid Super Bowl. This year we delivered over 1 million in less than 24 hours. It's become our best day of the year. And we have found people who try during the big games come back to us again and again during the year. On the international side of our business, we continue to be pleased with our progress. Similar to North America, we continue to see sales [technical difficulties] comps for the first quarter. A two-year average of over 14%. Despite the foreign currency headwind's that you're all familiar with, we continue to make gains in operating income and the overall portfolio remains strong. As Lance noted, we also made modest improvements in China in the first quarter. Even though we may talk more about North America sales our intention will be increasingly global in scope and you will hear more about this over the coming year. Finally, I'd like to touch briefly on what matters most to me personally. Our constant efforts to deliver a better quality pizza. This is not some corporate social responsibility campaign or public relations stunt. Those of you who know me personally know that when it comes to quality, there is absolutely no compromise. Ever. I'm prepared to spend more money than the others in the category because I believe we will be rewarded for our commitment with unprecedented customer loyalty. For example, we have revamped our website to make it easier for customers to find nutritional details on their favorite Papa John's products, and to highlight why we believe Papa John's has one of the cleanest labels in all of QSR, you cannot make good wine from bad grapes. It's what our customers want and deserve and it's our responsibility to deliver it. We believe we will further solidify our reputation, our sales and our loyalty as customers better understand not only the quality that goes into our products, but that our products do not contain trans-fat, MSG, fillers in our meat, DHA, DHT, or partially hydrogenated oils, to name a few. I believe consumers can taste the difference and I believe this is a significant reason why we continue to outperform the category quarter after quarter. And with that, I'll turn it over to Steve Ritchie. Steve?

Thanks, John, and I'd like to add my thanks as well to our franchisees and operators around the world for continuing to deliver on our brand promise. 2015 has gotten off to a great start with strong performance across the entire business. And we look for more of the same as we move further into the year. As I stated before, the fundamental principles of the Papa John's brand are the key components of our success and will continue to be the catalyst of our future growth. There's little new news to report relative to the competitive environment as pricing and deals across the category generally remain consistent. The Papa John's system once again responded well with excellent comps driven by strong operational execution, product innovation, digital initiatives, and partnerships and creative branding. John noted our strong two-year comps and I think those figures bear repeating. We're very proud of our Q1 performance and that is our two-year comps exceeded over 16%. Our continued top line sales growth is producing strong profitability gains in our franchise and corporate units. Our franchise system has been very pleased with the strong economics and the brand continues to have broad appeal from both existing and prospective franchisees. With that said, there is obvious strength in our category and we know we need to keep our foot on the gas to sustain our momentum. That momentum will be sustained with a continued focus on the customer experience strategically executed through our core brand pillars of quality, branding, and technology. On the technology front, John discussed our digital performance for the quarter, and we will continue to focus on and leverage our technology advantage to drive our digital sales mix steadily higher. The roll out of our new FOCUS point of sale system has been substantially completed. Over time we expect the new system to have a very positive impact on system-wide store level operations and to drive multiple store level efficiencies. We have only had the system in place for a short time, but many stores have already experienced improvement in order speed, accuracy, delivery service, and team member training. These improvements will contribute to the enhancing of the customer experience, which in turn support further top line sales growth. We will keep you updated on efficiencies as we get further down the road. On the development front, almost all of those coming from the international side of the business. Turning to our international business, our strong Q1 comps represent our 21 consecutive quarter of positive comp sales. Performance across the board remains strong. And we had particular success in the UK, which ran a double-digit comp sales performance driven by operational execution, strong digital initiatives, and a successful launch of our largest national TV campaign in the UK to date. We are fast approaching 300 stores in the UK, and the brand strength is growing stronger each and every year. Beijing remains a priority and a work in progress. But as noted, made modest margin gains in the first quarter. We are evaluating various aspects of this business as we discussed in previous calls, but it remains too early in the process for us to have made decisions or any significant changes. So bear with us as we look to work through this process and expect an update later in 2015. In closing, we are focusing on delivering another great year in 2015. While laying the foundation for continued gains in the future. As John spoke to, our commitment to delivering on our better ingredients, better pizza, brand promise, has never been stronger, and we will continue to leverage our quality position as we continue to grow the Papa John's brand around the world. And with that, I'll turn it back over to Lance for questions. Lance?

I think we're ready for questions.

Thank you. [Operator Instructions] First question is from Alton Stump of Longbow Research. Your line is open.

Yes, thank you, good morning and great jobs, guys, on the quarter.

Thanks Alton.

Thank you.

Just on the brownie, it looks like it had a very nice benefit, it would appear, to cost first quarter, actually, the chocolate chip cookie was a big success as well. As you look at your menu, you've always had a much more focused menu on a core pizza line versus some of your major competitors, I would guess you probably want to stay that way. But has the success of either the brownie or the cookie, made you think about would it make sense to add some more if were not pizza items to the menu in coming years?

Yes, Alton, it's Steve. Good question. And obviously as we've spoken to, it has been one of the key drivers and catalysts of some of the growth. I'll reiterate and I know we've said this before, our brand and our model is one of quality, consistency, and simplicity. We'll continue to play that play. Pizza will be our focus. However, when we look through the lens of quality, consistency and simplicity, the two desserts that we have added over the year kind of meet within those guardrails. It is adding additional product mix, which is supporting the overall ticket, which obviously is also supporting the profitability growth. But I would not expect ever to see at Papa John's an extensive development of sandwiches and an array of side items that would create any kind of complexity within our operations model.

Yes, this is John. To Steve's point, on a Friday night we have stores literally doing 400 or 500 pizzas an hour, and so from a tactical point of view, you've got to make sure if you do implement something strategic, that it doesn't in anyway hurt the efficiency and the productivity of that make line because then your service goes bad.

Right. Makes sense, and then as you look at comps here, you know, on a franchise versus company-owned side company obviously has outperforming. How much of that do you think over the last couple quarters has been due to timing of the FOCUS roll out perhaps going on in the company-owned stores, or is there some other factor that you can point to as to, both are very strong, but even stronger comps coming out of company owned restaurants?

This is John again, Alton and I'll let Edmond jump in here because he does this every day, but we basically outperformed the franchisees in every single measure. Now, with that being said, there are some franchisees out there that actually do a better job executing than we do and we love that. But on average, we just out execute our franchisees.

Yes, Alton, this is Edmond. We perform at such a high level inside the restaurant, we just continue to deliver on the BIBP promise. The measurable of hospitality and product quality and customer service just continue to go off the charts, so hopefully you're going to see that gap decrease a little as the franchisees continue to execute better but we're just really good at executing right now.

Alton, it's Steve, I'll just add a little color onto the comment around the FOCUS POS system. There was an earlier roll out that hit the corporate restaurants but as you've seen and John kind of alluded to, the last four years the corporate restaurants have outpaced the franchise side of the business and that really is by design. We use our corporate restaurants to lead and drive best practices to influence the franchise system. Our corporate restaurants now average over a $1 million restaurant and our franchisees, many of them fast approaching those same targets.

That's great. And then if I could slip in one last model question and I'll back in the queue for Lance. With the almost $5 million higher cost, unallocated higher costs, if you could break out if you could or just color on the insurance piece of that and more importantly, how much of that have been one time in nature versus if it will show up at the same amount here over the rest of the year?

Thanks, Alton. I'll give you a little bit of color. So G&A certainly in the first quarter was up for several reasons. Two of the most significant items were increases in performance-based incentive comps and operations don’t at the supervision level, both of which were driven by our strong performance so actually we kind of like to see that. We did have legal and insurance expenses that were higher than what we saw in the first quarter of last year. And we did also make a marketing investment into our international franchise business. So there's actually kind of four or five key items that are driving that G&A up. Moving forward, our guidance does include G&A at modestly higher levels as a percent of the sales than we saw in 2014, so I would continue to expect that number to be a little elevated over last year. And, you know, we'll just continue to balance driving good increases and profitability while making the resource investments we need to make and, you know, on that G&A side.

Alton, this is John again. I want to come back to the franchise versus corporate because we actually, Simon Smith franchise and Edmond runs corporate. They have a little bit of friendly competition every morning on who's does better. Simon and his team is doing a great job with the franchisees. Our franchisees are in fact getting better. They're just not getting better as quick as the corporate restaurants.

Gotcha. Makes sense. Thanks so much for all your time, guys.

The next question is from Alex Slagle of Jeffries. Your line is open.

Thanks. Really solid quarter here all the way around, you know, my question is just on the international franchise development with 50 opening in the first quarter. That's about double what I had and double what you usually have in the first quarter historically. Is that, you know, is that something you expected internally or the franchisees projects moving along ahead of schedule?

Alex, this is Lance. I'll start with that one. So we opened 35 international units in the first quarter, and we did plan to be a little higher than in the first quarter, I believe, because we did some conversions on the franchise side in India. So, you know, we've given the full year guidance at 220 to 250. We've reaffirmed that guidance. So I would expect throughout the year it ought to shake out pretty similar to what it's looked like in past years other than we did have some early conversions in the first quarter in India.

Alex, this is John. The development's just one discipline that's actually in our proactive position. To my delight, probably the last 24 months, 30 months, every single discipline that we have is getting better, from Shane and his team in distribution, Tim O'Hern, as you mentioned, in development, Edmond and Simon with operations, our marketing with Bob Kraut and his team, every single discipline is getting better every day.

Alex, its Steve. I'll just add as well because I think this is a key piece. As you think about the future growth opportunities for the Company, international as you well know has become a significant focus and opportunity for the brand. You think about the international growth numbers that we have targeted for this year, but you look five years out, and as we talked about, we're not in countries like Brazil, we're not in countries like South Africa or Australia, a number of large opportunistic countries throughout Western Europe. So a lot of excitement about the possibilities for the growth and potential for the brand given how much success we have had year after year in terms of the sales growth throughout the vast majority of our international markets.

That's great. That's very helpful. And then switching over to the North American franchise revenue, you had 12% growth there, and got a modest tail wind from the reduced royalty incentives in the quarter. Is that something you expect to continue through the year?

Alex this is Lance. In general I would say obviously you've got our comp guidance so we're going to continue to drive comps on the franchise side. Some of the royalty incentives we've actually replaced in some ways with some other marketing initiatives that we occasionally do to help some of the franchisees out. So I would expect any tail wind from that to be very modest overall impact on the P&L.

Alex this is John, getting back to getting better, I would be remiss if I didn't mention our culture. We just got rated as one of the best places to work in Kentucky, that's a couple years in a row, and I think that permeates throughout the rest of the organization. But Bob Smith has just really embraced the culture and people really like coming to work.

Great. Thank you.

Our next question is from David Carson of KeyBanc. Your line is open.

Thank you, guys I have a couple questions. I hope everyone is well. Lance, labor was a head wind during the first quarter, given the comp trend and the completion of FOCUS. I thought maybe it could potentially be a tail wind. So could you kind of speak to what is driving the labor increases at the company-owned stores and if this trend is expected to continue?

I'll start with that one, certainly, David and then I'll pitch it over to Mr. Ritchie. You know the biggest reason it was up, and it was up about 50 basis points, is a reason that we like, and that's variable incentive comps, so bonuses out at the store level was the biggest driver of that increase. Steve, what would you add to that?

Yes, I’d just add a little more color to that David. I think the key thing as you see, as we just spoke to, the success we've had in our corporate restaurants in terms of the sales performance, the same store sales growth of 8% for the quarter. If you look at the two and the three-year comps on the corporate side of the business, they're significantly even more than the overall. That's going to be the key focus as we've talked about, leveraging our labor investments to enhance the customer experience, which in turn is going to continue to drive that sales growth. We know we will eventually get the leverage that we need, but not by sacrificing the customer experience.

And, David, this is John. To keep this sustainable, we cannot turn people over. And we don't like turning over, especially at the General Manager which we call the center of the universe. But Steve and I did an analysis last week. Our average TGM this year will be over $80,000 bucks. That means half are making $90,000 and half are making $70,000 and everything in between. We'll never lose a TGM if we're paying that kind of money and that's why we're having such fantastic sales results.

That's good. One other also concerning the comp momentum. John or Lance, would you say that 2015 is an exception when it comes to G&A de-leverage as a percentage of sales? And I'd also like to get one in on the international segment after this if possible.

Sure, David, this is Lance and I'll start with this one. You would certainly hope that the 2015 would be an exception relative to G&A de-leveraging a little bit. The comparison and our revenues just aren't going to grow as quickly as they typically would because the commissary is such a big piece of our revenue number and the cheese number is bringing the commissary revenue number down and actually keeping it flat so you don't get some of the typical revenue growth you'd see that would keep you from de-levering on G&A. But the thing I do want to say is, our G&A includes international infrastructure to manage the operation, the franchise side of the operation on the international side. It includes a big piece of our technology infrastructure. So while certainly we're going to do everything we can to spend responsibly and to not grow G&A, we do have a lot of business driving assets that live within that G&A line and we're going to make the long-term investments we need to make over time while balancing that with good profitability.

And so that kind of moves me to my next question, the international segment. The profit improved by, I think, over 80% in the first quarter and you kind of alluded to some investments here a there in G&A, but would you guys say overall the international division has reached tipping point with respect to profitability? And, you just alluded to some G&A investments that may remain, but anything meaningful from an investment standpoint or would you expect to continue seeing more of the revenue fall through the bottom line moving forward the way that it has in the last couple quarters?

David, its Lance I'll start again and I'll let Steve or John add anything they'd like. I think our expectation is certainly we've reached a tipping point where you're going to see growth. You know, certainly annually on the international side. Now, things can jump around a little bit within quarters even now. So I'm not going to promise we'd go forward every quarter internationally, but I certainly feel like we've hit that tipping point for the most part. As far as major investments go, we're going to continue to invest in personnel as we need to make sure that the business is being driven. We're going to continue to invest on the technology side on international. And in this quarter as an example, we made a marketing investment in one of our franchise markets that drove pretty good results and so you will see some occasional investments that may make the number jump around, but by and large I guess to answer your question, I would tell you I do expect international to remain profitable, certainly.

Yes, David, I would just add that I think that you think about and you I referenced it in my opening remarks, markets like the UK where we made sizable investments in infrastructure several years ago, a key market that held back that performance, now you have the flywheel working from that standpoint. I did also mention though that as we start thinking about going into very large countries or even new continents, there will be a balance of investment, but leveraging the flywheel that we have on the profitability side of the existing stores to push that. But certainly if you look at the sizable opportunity we have for growth given our current footprint, there will be a balance of investment, but more leverage than de-leverage.

Yes, David, I mean, Russia is doing quite well, Latin America under leadership of John [indiscernible] is on fire. UK, I just can’t say enough about Gareth and Andrew and the job they're doing over there. UK has just been a complete turnaround situation and they just did a fantastic job. So a lot of momentum in a lot of places and that's what you're seeing on the bottom line improvement.

And then just real quickly on China and then I'll hop out. You mentioned I think, Lance, in your prepared remarks that you guys saw some modest improvement in China year-over-year. I mean have we reached an inflection point there?

Yes, David I’ll start, it’s Steve. I think we're making some progress. It is still early. We do have an active strategic project that is in motion, David. We've talked about it before. It does incorporate menu, model, design, marketing, changes in some of the branding aspects. So too early to kind of take a look at an outcome on the full-year 2015. As we get further into the year, I think we'll be in a position to give you more detail and specifics around that. But the positive thing is some of the changes we made in the back half of the last year, there were some impairments, some restaurants, there is some positive margin improvement in the first quarter.

Thank you, guys, very much, for taking my questions.

Thanks David.

Thanks David.

Thank you. [Operator Instructions] Next question is from Mark Smith with Feltl and Company. Your line is open.

Hi, guys. First off, I just wanted to look at your comp guidance. Even though you raised the guidance for North American comps, looking at two-year cumulative trend, it looks like it may still be just slightly conservative. Any thoughts or feedback on that?

I'll start with that one Mark, so raised our comp guidance from 2 to 4, up to 3to 5. Certainly, we have a lot of momentum on the sales front. With that said, it still is only the very beginning of May. We do still have some reasonably difficult comparisons, particularly as you stack the two and the three-year comps, you know that we're rolling over. So we're optimistic, we feel good about where we are, we have the things in place that have driven the comps, but I think at this point in the year, it just makes sense to be 3 to 5 right now.

Yes, Mark its Steve. I think that you know our approach, we always have a conservative approach as we look at this aspect of the guidance, but I should reiterate that this is our 18 consecutive quarter of positive sales performance, in fact, the last five or six, I believe, none of them have been below 4% kind of comp growth and also, well in our way to our 12 consecutive year of positive, flat to positive comp sales. I think that's unrivaled from any other player within the category. But certainly, you take a look at our momentum, you've got to be optimistic, but I think we've got a fair guidance set forth.

Okay. And then can you guys make any comments, I know you've got some cheese block pricing out there on expectation, but can you talk about the rest of the commodity basket and what you expect?

Sure, Mark, I'll start with that one. This is Lance again. Overall for the year we're expecting the commodity basket to be down. In the neighborhood of 3% to 5%, which means on a cost of sales basis, 1% to 1.5%. That's what's incorporated into our guidance. And we talked about our guidance for cheese block for the year being kind of between $65 and $70. In the future markets it's held constant there for the most part. So I don’t think there should be much by way of changes from what we've already talked about there.

Okay. And then looking at the competitive front, can you talk about where you're taking market share from? Do you feel like you're taking some from some of the other bigger players or is the majority of it coming from small mom and pop and regional players?

Okay, Mark, it's Steve. I'll start. I think it's more of the same as we've spoken to before in that front. Certainly look at the overall category the national players continue to grow at a more significant clip. The overall category has shown some strength in the last couple of years, you know, roughly 2% to 3% kind of growth in the overall category, so certainly you look at large players in the aggregate, you know, the largers are really taking from the independents and the regionals. You know, one of the larger players continues to be, you know, a bit of a share donor, but, you know, I think strength in the national players and the larger chains are going to continue to kind away at some share gains there.

Mark, this is John. We, of course, respect all our competition. They're good at what they do. I think a lot of our business is coming from these millennials, because like Chipotle, we just use better ingredients and I think the kids can taste the difference.

Okay. Perfect. Thanks, guys.

Thank you. There are no further questions at this time. I would like to turn the call over to management for closing remarks.

Thank you, Tyrone. This is Lance and thanks everybody for being on the call, and we’ll talk to you after the second quarter.