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Papa Johns International, Inc. (NASDAQ:PZZA)

Q3 2008 Earnings Call

November 5, 2008 10:00 am ET

Executives

J. David Flanery - Chief Financial Officer, Senior Vice President, Treasurer

Nigel Travis - President, Chief Executive Officer, Director

Julie L. Larner - Senior Vice President and President - PJ Food Service, Inc.

William M. Mitchell - Senior Vice President - Domestic Operations

Analysts

Brad Ludington - KeyBanc Capital Markets

[Oz Pengan - Paracapital Management]

Mark Smith - Feltl and Company

Michael Wolleben - Sidoti & Company, LLC

[Charles Pemal] - UBS

Operator

At this time I would like to welcome everyone to Papa Johns third 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) Mr. Flanery, you may begin your conference.

J. David Flanery

With me on the call today are our CEO and President Nigel Travis, Senior Vice President of US Operations Bill Mitchell, President of PJ Food Service and Preferred Marketing Solutions Julie Larner, and other members of our executive management team. President USA Bill Van Epps is home recovering from surgery and we send Bill our best wishes for a speedy recovery.

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 10Q and 10K.

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

Third quarter contained mixed results for us. We were pleased with our comparable sales growth, our worldwide net unit growth, the continued on-track improvement in our international business segment losses, and the fact that we made substantial progress with our domestic refranchising program. However our domestic sales trends weakened considerably throughout the quarter after a strong start in July. As Nigel will discuss in more detail, these soft sales trends have continued into Q4.

Revenues increased 6.6% for the quarter and 9.3% for the year-to-date over the same periods in the prior year primarily reflecting a combination of comparable sales increases at both company-owned and franchise units, a greater number of company-owned units due to acquisitions from franchisees in July of the past year, the increased royalty rate in 2008, higher PJ Food Service sales due to higher underlying commodity costs, and increased international revenues due to increases in both the number and average unit volumes of our company-owned and franchise restaurants outside the US.

Excluding the impact of the BIBP cheese purchasing entity and the other non-comparable items noted in the release, net income decreased $1.8 million or 18.8% and diluted earnings per share decreased $0.04 or 12.5% from the results for the prior year quarter.

On a business segment basis operating income for domestic company-owned restaurants decreased $1.1 million for the quarter and $200,000 year-to-date over the same periods in the prior year excluding losses related to unit divestitures in both periods and a prior year gain on lease termination. The decrease was mainly due to commodity cost increases, principally cheese and wheat.

Operating income for the domestic commissary segment decreased $3.5 million and $5.4 million for the quarter and year-to-date over the same periods in the prior year due to reduced sales volumes and margins coupled with increased distribution costs due to higher fuel prices. Absorbing higher commodity and fuel costs without passing them on to the restaurants provided a significant benefit to our system as Nigel will discuss in more detail in his remarks.

These operating income declines in the quarter and year-to-date periods were partially offset by increases in the domestic franchising business segment due to an increase in the royalty rate effective in January 2008 and in the international business segment due to leveraging of the support infrastructure as the result of unit growth and sales growth in existing units.

Unallocated corporate expenses also declined in the quarter due primarily to anticipated reductions in payments under certain cash and equity compensation programs.

Our free cash flow, a non-GAAP measure we define as net income excluding BIBP plus depreciation and amortization expense less capital expenditures, was $32.4 million for the year-to-date and $48.6 million for the trailing 12 months. The trailing 12 month results represent a free cash flow yield of 7.5% based upon 28.5 million average diluted shares outstanding for the year-to-date and a stock price at Monday’s market close of $22.69.

Our strong cash flow and conservative leverage position allowed us the flexibility to provide partial financing for the recently completed transactions for the refranchising of 26 company-owned restaurants. It also allows us to provide 100% of the financing for the refranchising of 37 additional company-owned restaurants now in process for which planned outside financing did not materialize as expected given the current credit market conditions. We recorded pre-tax losses of $3.9 million during the third quarter associated with these refranchising activities. Nigel will have more to say about our refranchising initiatives in his remarks.

We repurchased $17.4 million of our stock in the third quarter and $37.7 million during the first nine months of the year. We terminated our share repurchase Rule 10B51 trading plan in September in response to the uncertain market conditions but retained the ability to repurchase stock on a discretionary basis through the end of 2009 based on our current remaining $62.3 million authorization.

Our most recent forecast for the remainder of the year provides for continued top line sales pressure contributing to ongoing margin challenges for our company-owned restaurants and reduced sales and profitability for our commissary business. Even with this lack of clear visibility at the top line sales performance, we believe we will achieve 2008 results excluding the indicated non-comparable items near the $1.68 low end of our originally established earnings range for the year.

Given the recent and projected sales trends we believe that we will achieve domestic comparable sales results near or below the low end of our previously stated range of 1.25% to 2.75%. We also believe we will achieve worldwide net unit growth for 2008 near the low end of our previous range of 160 to 190 net units. While we would normally be somewhat disappointed in results at the low end of our initial guidance, we believe 2008 has been an unusually challenging year for the entire restaurant industry.

As Nigel will discuss in more detail, we have consistently provided financial assistance to our franchisees throughout 2008 and expect that we will continue to do so for the remainder of the year and into 2009. We are in the process of evaluating overall system needs and have not yet finalized the type, amount or timing of any such ongoing franchise support. It is possible that decisions regarding incremental support during Q4 of ’08 could lead to overall earnings results for the company below our existing guidance range. We will update our guidance as necessary once any such decisions are finalized.

One decision impacting Q4 favorably for our domestic system is that the BIBP cheese pricing formula has been modified for the last two months of the year so that cheese will be priced at the projected futures market price plus an interest carry cost effectively deferring the reduction of the accumulated deficit during this period. This move was made in response to current restaurant margin pressures and the recent significant downward movements in the cheese market resulting in a $0.28 per pound reduction in the cost of cheese at restaurant level effective October 27, 2008.

Now I’d like to turn the call over to Nigel Travis, CEO and President.

Nigel Travis

Since we last provided an update on our business and the pizza category in general back in August, it’s safe to say the economy has faced unprecedented challenges. These challenges are very well documents and I won’t repeat them here but it’s sufficient to say that consumers are pulling back in nearly all areas of spending in response to worldwide recessionary conditions that are expected to last 12 to 18 months or more.

One of the most highly correlated economic indicators for our business is unemployment and nearly all experts predict increased unemployment levels throughout this recessionary period. I’ll share our plans for how we intend to manage and perhaps even prosper by some measures during this difficult period shortly.

Before I address these future initiatives, I’d like to focus on some of the successes and positive trends in our business today. Our domestic comparable sales increased 1.7% for the quarter and 1.9% for the year-to-date. While September and October results have softened considerably, we believe we’re still on track to produce full year comparable sales near or slightly below the 1.25% low end of our original guidance range. We do believe this is a very solid accomplishment in this environment and one that will stand up well against the overall category performance.

As I look back over the past three and a half years, our top line performance has been exceptional. We now face in the whole food service industry different challenges and they will require different strategies, tactics and even products. I know that through our very open and collaborative relationship with our franchisees we will respond and continue to be successful.

We continue to outpace our two larger competitors in domestic net unit openings with eight net unit openings for the quarter and 17 year-to-date. This compares favorably to the year-to-date net unit closings of 32 for Pizza Hut and 69 for Domino’s. Just to repeat those numbers, that’s 17 positive for us, 32 negative for Pizza Hut and 69 for Domino’s. The combination of this net unit opening advantage and our comparable sales results produce clear market share gains for us during the first three quarters of the year. The challenge I have set for the whole system is to increase our market share further over what we believe will be a very difficult next 18 months.

I’ll have more to say about unit openings and closings later in my remarks.

We’re very pleased with the progress made during Q3 and early Q4 in our refranchising initiative. Since we announced this initiative back in February, we’ve been working very hard to identify the company-owned markets where we believe refranchising makes the most strategic sense. Among the key factors we consider are the current and projected performance of the market and the company ownership and the existence of a financially and operationally strong franchise group to take the market over.

The completed and in-process transactions referenced in our earnings release and David’s remarks represent a total of 63 restaurants or nearly 10% of our existing company-owned restaurant base. Upon completion of these transactions our company-owned ratio of domestic units will decline by about 2.3% to 21.1% from the Q3 level. And importantly, given the financial performance of these units we expect that 2009 operating income will improve over actual 2008 results as it relates to these refranchising transactions.

We will continue to pursue additional logical refranchising opportunities while acknowledging that the current credit market environment may continue to make this difficult without some level of financing assistance from the company. Additionally, as in the past we are willing to lend financial assistance where it makes sense to help facilitate transfers of underperforming franchise units either to stronger existing operators or new franchisees. Our ability to provide this type of targeted financing is just another benefit of our very strong balance sheet.

Let’s turn now to international. International operating losses improved by $800,000 for the quarter and $1.9 million year-to-date as compared to the same periods last year. We opened 39 net units internationally during the quarter and 92 on a year-to-date basis. Our development pipeline is very strong at over 1,000 international units contractually obligated to open over the next 10 years. We had 540 international units as of the end of Q3 with Asia and Western Europe continuing to be our most concentrated areas. Of the 540 total units, 180 or 1/3 were in China and Korea and 112 or about 20% were in the United Kingdom and Ireland.

We also have a very ambitious new market opening schedule for the back half of this year with initial units opening in at least six new markets around the world. There has been some indication that China’s economy is experiencing the predicted post-Olympic slowdown. However it is important to realize that even at a slowed pace China will continue to be one of the fastest growing markets in the world for the foreseeable future. One advantage of even this modest slowdown appears to be some moderating of both real estate rents and wage inflation which should improve overall unit economics in that country.

We’re also continuing our expansion into second and third tier cities in China as well as products and delivery and carryout only units. We’ve done just the opposite in Korea with the [inaudible] of limited service sit-down restaurants in what has been historically a delivery/carryout only market as a way of driving further our quality brand positioning in a very competitive market.

The UK continues its strong momentum as I last described in August with both same-store sales and new unit growth through Q3 on pace to achieve 2008 targets. The strong early results for the fresh dough authentic thin crust pizza product also continued throughout the quarter.

Overall, the investments we have made in operating losses to build support infrastructure over the past three years appears to be resulting in the development of a very strong international business and one that will act as our growth vehicle for many years into the future.

I’d now like to focus my remaining remarks on the challenges we are facing and how we intend to address those challenges. The pizza category is seeing sales pressures on numerous fronts even as some casual diners trade down into the category.

The major obstacles facing pizza are trends towards reduced dinner occasions which has historically been the strongest pizza day part, reduce early week occasions as consumers save up to treat themselves on weekends, and intrusions into the value convenience niche long held by the delivery/carryout pizza from a variety of competitors. The competitors include the Subway five foot footlong sub promotion, targeted value comparisons made by Wal-Mart regarding its take-and-bake pizza, and similar value comparisons made by frozen pizza brands.

The recent and ongoing crisis in the housing and financial markets only serve to further curtail consumers’ discretionary spending and drive them to focus much more on pure value than they have previously.

As I mentioned at the beginning of my remarks, there is a great degree of correlation between pizza category sales and unemployment measures. Based on the view from most economic experts regarding unemployment expectations, we believe we will face top line sales pressures for the next 12 to 18 months. However there are some recent trends that should work to improve our position.

First, as I’ve noted in prior quarters, the pizza category is 65,000 units are more than any other food category. In previous calls we’ve discussed the 5% reduction in units and it appears this economic climate is not only going to accelerate category consolidation at these or greater levels.

The second favorable trend is softening commodity costs in many areas. Oil falling back to below $70 per barrel may be the most obvious example of the expected worldwide slowing of consumer demand but we’re also pleased with the recent substantial decline in the cheese futures markets. Since we last spoke to you in early August, the 12-month cheese futures average price has fallen nearly $0.30 per pound representing annual savings of around $30 million for our domestic system.

How do we plan to tackle the very tough environment that we expect to face for the next 12 to 18 months? There are several key steps already underway, the most important of which is doing everything we can to support the overall health of our franchise system with a strong focus on franchise store economics. While we may provide incremental support from time to time internationally, this is by and large a domestic system issue.

As we’ve discussed throughout the year, we’ve already provided significant financial support to our domestic franchise system in various ways. The three most significant are our promissory system, our ability to provide royalty relief and marketing assistance, and finally the support of the BIBP cheese purchasing entity.

Year-to-date operating profit for our domestic commissary business was $5.4 million lower through Q308 than for the same period in the prior year. Although there has been some falloff in volumes, much of this decrease was directly due to margin reductions as commodity cost increases were not passed through by higher pricing and the additional absorption of below margin operating cost increases, primarily the impact of significantly higher diesel fuel on distribution costs.

Before we end 2008, we will provide a combination of royalty relief and marketing support to the franchise system mostly on a very cognitive basis approximating the roughly $4 million impact of the 0.25% royalty rate increase effective at the beginning of the year. it should be noted that even after the 0.25% increase, our 4.25% royalty rate was substantially lower than our two main competitors’ rates.

Finally, the BIBP cheese purchasing entity has absorbed approximately $43 million of cheese costs during 2007 and the first three quarters of 2008, of which about $32 million is effectively the provision of working capital loans to the domestic franchise system.

We believe the combination of these support initiatives has provided a substantial financial benefit to our franchisees especially as compared to the amount and type of support capable of being provided by other franchisors in this environment. By providing both system-wide benefits such as the commissary margin reductions and BIBP cheese mechanism as well as specifically targeted benefits such as royalty waivers or deferrals and co-op level marketing support, we believe we’ve positioned our system to take advantage of the tough environment faced by our many national, regional and local competitors.

I’ve said previously, even before the financial crisis hit with full force, that we believe the brand can navigate this downturn with the least negative system impact which will be the brand that has the fewest net closings will be the big winner when the recovery occurs which hopefully will be sometime in early to mid-2010. This point was further emphasized by statistics from one of our major competitors who quoted a possible range of closings next year of up to 250.

That’s why we intend to continue our current level of franchise system support and are even considering increasing it in 2009 possibly to include a suspension of the 0.25% in royalty rates scheduled for January 2009. Said another way, we intend to use all of our resources to grow market share as the category declines.

These tactics may be the same as previously used or even new ones but we intend to be as supportive of our franchisees as possible. Yes, there will likely be some short-term interruption in our earnings growth but saving stores from closure will benefit our brand in many ways including through incremental royalties, continued commissary profits, more critical mass and as the third player in the category most importantly more marketing dollars.

Let me give you an example. By using assistance to help keep 50 underperforming franchise restaurants open that may have otherwise closed, they could be worth on an annual basis about $1.1 million in royalties, $400,000 in commissary profits, and around $2 million in total system advertising dollars.

One area of increased support that David has already mentioned was the change in the BIBP pricing formula for the last two months of 2008 and we are considering whether to continue with this modification into 2009. Our strong cash flow and conservative balance sheet allow us to consider maintaining the current BIBP deficit without repayment during 2009, thus allowing the domestic system to receive full advantage of the projected lowest spot market cheese prices during a time when enhancing unit level margins is critical.

One other area of increased support was part of the new franchise agreement negotiation and it is scheduled to become effective at the beginning of 2009. That’s the fee for online ordering. This will be reduced from its current level of 3% to 2%. Given that online orders represent in excess of 20% of total sales and that the average domestic unit, this 1% fee reduction will provide about 20 basis points of margin improvement at store levels. We also believe it will encourage franchisees to further market and support our online ordering advantage, the benefits of which we’ve discussed many times in the past.

As noted in our release and mentioned in David’s remarks, we’re currently on track to achieve 2008 earnings near the $1.68 low end of our original guidance range for the year. Since I joined the company in 2005 we’ve had an excellent track record of raising guidance throughout the year and exceeding initial expectations. So it is somewhat disappointing that we won’t accomplish this during 2008. however given the environment in which we’ve been operating and in comparison to many other restaurant companies’ results for the year, we have performed admirably while making the best long-term investments in the health of our franchisees.

In conclusion, we’re in the process of assessing what total package of support initiatives will be most effective in providing assistance to our franchisees. As referenced earlier we may choose to provide incremental franchisee support starting as early as Q4, in other words in the last few weeks of this year, and on into 2009.

Depending upon the nature, timing and amounts of such incremental assistance our 2008 earnings could be reduced below the low end of our current guidance range and 2009 earnings could be negatively impacted. We will provide more information on our earnings outlook once we’ve made a final determination as to the optimal package of franchise support to be implemented.

We believe the course of action that calls for incremental franchise support during these exceptional times will provide the best long-term value for Papa Johns shareholders. We’re fortunate to be in a position enabling us to make this choice rather than being unable to provide assistance to those deserving franchisees as necessary. With this focus on the avoidance of closing in the USA and the pleasing developments of our international business, we remain confident that Papa Johns with our global emphasis on quality will continue to be one of the fastest growing food brands in the world.

With that I’ll turn it back to David for questions.

J. David Flanery

If you want to go ahead and open up the line for Q&A, that’d be great.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Brad Ludington - KeyBanc Capital Markets.

Brad Ludington - KeyBanc Capital Markets

If fuel costs stay down at current levels, since you haven’t been passing that through to the franchisees, what kind of impact could that have on financials on the commissary margins?

J. David Flanery

The easiest way to give you a feel for that is to say we use a little over 3 million gallons of diesel a year and at the high point this year I think we were in excess of $4.50 a gallon in the market place on an original budget for the year under $3. That’ll give you a range for every dime change in fuel costs that could be about $300,000 of potential margin improvement at food service.

Julie L. Larner

Also keep remembering that we’re still seeing not as much of an improvement on the diesel side as we are certainly on the crude and the gasoline side. The trends are improving but yea-rover-year we’re still paying significantly higher diesel prices on both our inbound and our outbound transportation.

Brad Ludington - KeyBanc Capital Markets

Looking at G&A, should we expect that third to fourth quarter lower as a percentage of revenue even though may be same-store sales might be a little strained?

J. David Flanery

Yes. I think the idea there is we’ve certainly pulled out a lot of the same efforts that other companies are doing to control G&A and travel and open positions and those sorts of things, so I think that’s a fair assessment that we will try certainly to manage our G&A very tightly in this environment.

Nigel Travis

I think we’re saying that as a percentage of sales, G&A expense year-to-date in 2008 was 9.5% compared to 10% in the same period last year and that’s even taking into account the one-time benefit that we had in 2007.

I think it’s also worth pointing out that I know some people are slightly skeptical of our ability to get to the low end of our range. One of the ways our finances work and I guess most companies work the same way is that there are various self-correcting elements that if we don’t hit a certain number effectively bonus accruals, and that’s probably the easiest example to describe, go down. It’s self correcting and helps balance out any shortfall elsewhere.

Brad Ludington - KeyBanc Capital Markets

One more brief question before I give somebody else a chance. On the share repurchases, looking into ’09 I know you can’t really give guidance but is it fair to assume just maybe minimal like as low as 200,000 shares in the year?

J. David Flanery

It’s tough looking forward to 2009 on that as you said. I think the best way to look at it is in the very near term we’ll probably take a little more conservative look as part of canceling the trading plan and going to a more discretionary basis as we kind of see how the overall economic and consumer environment’s going to shake out.

But over the longer term and throughout even ’09 into ’10 we still believe the best use of our free cash flow which we still have plenty of is share repurchase absent any other potential capital investments that again we don’t anticipate at this time. So I think longer term we would still share repurchase as a reasonable use of that free cash flow.

Operator

Our next question comes from [Oz Pengan - Paracapital Management].

[Oz Pengan - Paracapital Management]

You mentioned that the comps have slowed down in September and October. Can you give us some sense, a little bit more color as to where they are and I guess your guidance assumes negative comps for the quarter, but a little bit more color on that if you can please?

Nigel Travis

We saw a slowdown which seemed to correlate with the slowdown in the economy. When some of the hideous weeks hit the stock market and everything else happened, we seemed to see a very strong correlation. I think it’s true to say that we were disappointed with September; we saw that going into October.

One of the great things at Papa Johns is that we’re well positioned and with our quality positioning we’re also very quick on our feet and we’ve managed to make adjustments. So even though we had a few weeks of softness, I think we’ve made necessary adjustments, our franchisees are right on board with those adjustments. There may have been an element of perhaps we got a little bit carried away with the pricing points that we had. We’ve already learned our lesson there.

I think it’s interesting that we’ve recently carried out some of our own research and the consumers’ behavior has changed pretty dramatically. This is our own research; it’s not external. If you look at the attributes as to where to order pizza, back in June 23% of people said they did it based on price. That jumped in October to 31%. That is a big difference and is something we’ve had to take into account, so we’ve sharpened our edge somewhat.

I’m obviously not going to reveal all our plans but we’ve learned some lessons the changing consumer sentiment, we’re responding strongly, and I think we’re confident that we’re going to see better results. And that should enable us to get to the lower end of our comp sales guidance.

[Oz Pengan - Paracapital Management]

So maybe more advertising and more targeted advertising and sharpening your value offering?

Nigel Travis

I think that’s a very good summation of what we’ll be doing but we’re all over this. The franchisees have worked very hard with us. One of the great attributes I always talk about is our relationship with our franchisees and they’ve worked very hard in the last few weeks as we’ve made adjustments to our calendar.

[Oz Pengan - Paracapital Management]

Sure. That’s one of your most important assets. Nigel, you mentioned your guidance and the fourth quarter and so on and so forth. You mentioned some offsetting factors but I guess in this environment you’re doing the right thing for the long term. We had a little bit of a tough time getting our hands around your implied fourth quarter guidance because it seems a pretty significant pickup in margins. Are there other things like the bonus accruals going down or other things that we may be missing that may give us more confidence on that?

Nigel Travis

I think this is probably the key question of the call and one that I know other people have raised effectively the same question. So we’re going to focus on it. We’ll try and give you as much explanation as we can. I’m going to pass it over to David who I think has got all the details.

J. David Flanery

The biggest items there are: First of all, a good control over G&A. We think there are certainly some of the discretionary types of G&A expenditures that we will be controlling very tightly, and we started that even leading into fourth quarter. I think that’s certainly one of the largest things.

Then the other item is as Nigel explained earlier the self-correcting mechanism of some of the compensation programs and not just the immediate bonus plan but also some of the equity related plans that would tend to vary in relation to the price of stock for example. So if the stock is down, the accruals there will come down. There are some other factors like that that would impact that G&A.

Then the last thing I’ll mention is we talk about that the sales environment is tough but one of the key things there is the transaction environment impacts PJ Food Service so as we see us getting a little more aggressive as you pointed out the rest of the quarter, the hope would be that there would be some improvement in the transactional trends. I think a stabilization is maybe the way we’ve commented on that. That could also have an impact for part of our business.

The final piece is the change in the BIBP cheese formula will produce about a 1.4% margin improvement in our company-owned restaurants for November and December, which is also a pickup too.

Nigel Travis

David while you were making those remarks, I just jotted down three more things to add to the list.

One is fuel that we’ve covered. That’s obviously better than it was earlier in the year. Labor, I think we talked about it on the last two calls we’ve done. Bill Mitchell and his team have done a great job this year managing the labor line and I know it’s being managed very well. I was very pleased with our October numbers which obviously I won’t be sharing today, but they were very well controlled. And finally, our closings are less than one might have expected. We’re pleased with the closing number and when we look at some of the competition, we feel that that’s effectively a kind of upside.

All the factors David has mentioned, the fact that we’re totally focused on the top line, and I think another message I want to make - this is very important to get this message over - yes, life’s been tough but we’re in a great situation and the world’s not coming to an end. We’ve got a lot of franchisees that are out there doing very well and yes, some are struggling but a lot of people are still doing very well because they’re doing the right things behind our brand.

J. David Flanery

The one other comment that I’ll make that I was thinking while you were talking is the 63 stores in our refranchising program, in a lot of cases if you sell very high performing stores in a refranchising program you can actually have operating income go backwards. In our case we’ve certainly strategically targeted some of our lesser performing markets for refranchising. 26 of the stores have already closed. We expect the other 37 to close by the end of November.

The closings of those transactions will improve the operating loss run rate if you will of those particular stores and that provides benefit to fourth quarter. Not huge but as Nigel said it’s kind of the accumulation of a lot of these little things that gives us confidence with w here we are.

[Oz Pengan - Paracapital Management]

Sure. You guys have a great long-term plan and to your point people that come out of this crisis in a strong way will be much stronger and get to a point much faster than otherwise because you’re going to see a lot of people fall out. From the tone of the conversation it sounded like you’re still close to doing some additional things in the fourth quarter so this is the time to maybe be more conservative and get all the stuff downsized. I just wanted to make sure we’re not missing something on your guidance as it relates to that.

In terms of the outlook for store openings for ’09 and ’10, are you guys going to give us an update at the end of the fourth quarter?

Nigel Travis

That’s our normal practice and unless something unforeseen happens we will endeavor to do that.

I think your comments about our long-term approach to this are absolutely right. I was reflecting overnight before this call that John Schnatter did a spectacular job putting the system in the shape it’s in from 2001 to 2004. He left me with an excellent legacy in terms of the operations of the company.

I think we’re painting a long-term view about building international and as I said that’s ahead of schedule so we’re pleased with that and I think you have to look at this; you can’t look at this over a three-month period; you’ve got to look at it over probably a two to three year period. Probably the best way of describing our support is a hand up rather than a hand out.

We’re going to take advantage of this downturn. We’ve said that message continually over the last few calls, and this is an opportunity. It may appear a problem. We think it is an opportunity to really move our system forward.

[Oz Pengan - Paracapital Management]

Your guidance assumes somewhere in the -3% comps for the fourth quarter. Is that right David?

J. David Flanery

That’s maybe a little heavy but yes. If you say we were at 1.9% for the first three quarters and we should be near the lower end of the range for the full year. I think if you do that math, it’s not that heavy.

[Oz Pengan - Paracapital Management]

I was using 2.7% for some reason.

J. David Flanery

You were looking at just company. I was looking at the whole system was 1.9% so I think if you use that math, you’ll see that it’s a lesser negative than that but you’re right; it does look negative at this time.

Operator

Our next question comes from Mark Smith - Feltl and Company.

Mark Smith - Feltl and Company

Looking at the cash and pulling the 10B51, any update on cap ex guidance here for the fourth quarter?

J. David Flanery

We didn’t specifically give cap ex guidance. Our full-year guidance was about $35 million. I think it’s safe to say that we’ll come in under that for the year. We typically do a pretty good job of managing our cap ex anyway but in this environment we’ve again challenged things. So rather than give you a specific number, I think it’s very safe to say directionally you can see us coming in below our current guidance.

Mark Smith - Feltl and Company

Nigel, you had talked about unemployment and the impact that that has on your top line and people’s sentiment. Can you talk about gas prices as it pertains to the consumer outside of your operating expenses and any potential impact on the decline that we’ve seen in gas prices?

Nigel Travis

I think that’s an interesting question and it’s one I think a lot of industries analyze. I sit on another Board and we spent a Board meeting yesterday some time talking about that.

I think the gas issue has probably passed us buy because obviously gas prices have come down but I think what consumers are now doing is they’re concerned about their investments, they’re concerned about their house prices. The house prices have come down whatever the number is, 20%? So they’re looking at their overall net worth and they’re cutting back overall. I wouldn’t say it’s gas prices despite the fact that they’ve come back.

I did a personal calculation and it probably benefits a house to the tune of $50 a week. I think consumers are beginning to say, “I’m pocketing that because I need to be saving more.” They’re not going to go out and spend it. You might argue that gas prices coming down is a potential upside. We’re not seeing it like that and I think the research that I referenced earlier is a clear demonstration that consumers are very worried about the prices of everything. But I think it comes from the overall environment; not just gas.

J. David Flanery

The one other area and Bill Mitchell can talk to this too, where gas affects us is with our drivers and their costs. Bill, do you want to comment on that?

William M. Mitchell

Yes. Some of what we’re seeing the impact is both the company and the franchise stores have been able to use a sliding scale in reimbursement to our drivers so we’ve been able to in effect take care of our drivers and also save some funds at the same time. This is very favorable in a delivery business in this environment.

Mark Smith - Feltl and Company

David, can you talk about as international gets to be bigger here, any potential impact on the shift that we’re seeing in currency right now that we could see in fourth quarter?

J. David Flanery

Yes. It’s still a relatively small part and at this point if there were any kind of impact, it was only $25,000 to $50,000 in Q3 from the strengthening dollar and there’s obviously different opinions out there as to which way the dollar may go going forward. It’s interesting relative to the UK, we are currently having operating losses there that are declining and as you bring back an operating loss with the strengthening dollar, it can actually be helped. There’s kind of an offset there. The royalty stream certainly we collected. It’s in local currency and we collect in US dollars so we watch that. But at this point there’s no significant impact in any kind of major directional currency changes.

Mark Smith - Feltl and Company

Can you just talk about your thought process? In helping to subsidize your franchisees, in choosing to go more through the commissary rather than through royalty relief and kind of your thought process there and looking forward if we could see a shift in that and which is easier to recoup once the environment improves?

Nigel Travis

I think you have to go back to the middle of last year to understand our philosophy. We identified that commodity costs were going to be a big issue in ’08. We came up with a plan that I won’t go through again because I’ve articulated it on just about every call, but it basically meant that we went out and were pretty tough with our suppliers; we improved our productivity at Food Service. But most of all we identified a need to reduce our margins at Food Service and protect our franchisees from the sudden shockwaves that they were going to receive in terms of commodity prices

We couldn’t do much on the labor side with minimum wage. I think it’s fair to say though we’ve actually done more than we may have expected at the time. Bill Mitchell and his team working with other functions in the organization came up with a whole range of programs on tip credit, split wages and what have you. It was more by example there that we helped.

I think as the commodity increases have declined; and I just want to make one thing clear, some of the commodity increases are still coming through. They haven’t totally gone the other way even though that’s the trend that you’ve seen and probably the trend is going to be a lot better next year than I would have told you a month ago. But what we identified is the fact that with commodities coming down, we probably have to support our franchisees in other ways.

We started on the commissary side and we’re now moving to some other opportunities to help. We’re in a very strong financial position to help our franchisees. Not all pizza companies are in that strong financial position. We think given our quality position and given the sales growth that we’ve had over the past four years, we’re very well positioned to capture significant market share over the next few years.

So our logic has moved just to simplify it from supporting the commodities to what we can do to take advantage of this situation.

Operator

Our next question comes from Michael Wolleben - Sidoti & Company, LLC.

Michael Wolleben - Sidoti & Company, LLC

I just wanted to touch on a couple of things you already touched on here. With the suspension of the 10B51 plan, what’s the main use of holding on to this cash here? Is it just to be safe?

J. David Flanery

Yes. Remember, when we suspended that it was in early September right when the financial markets were seizing up and the bailout hadn’t occurred yet and the stock market was going crazy, and we just said, “Let’s just be a little more conservative.” So basically that cash at this point is just going in to reducing our line of credit. It also gives us the increased flexibility to look at the initiatives like not recouping the deficit from BIBP. We certainly don’t have to worry about that level of cash flow. We’ve got a very conservative balance sheet. So I think the immediate use of that is merely paying down debt to keep our flexibility as great as possible.

Michael Wolleben - Sidoti & Company, LLC

On the international side, are we still on track for I believe it was 2010 for better profitability and what are your thoughts here on the global environment slowing down seeing some of these issues that we’ve seen here in America?

Nigel Travis

Firstly I want to compliment David. He’s led international splendidly this year and I think we’re in a very good position to take advantage internationally.

Just giving you some backup to that statement, the UK which clearly is a turnaround as a major issue has performed very, very well. Some of it is market driven. I would also note that Domino’s UK has had a terrific run so some of it is market driven but our UK team has done a splendid job.

They’ve had some record weeks in recent weeks. They seem to be firing on far more cylinders than in the past. As I mentioned they launched this authentic thin crust. It’s a great product that seems to appeal to the UK consumer. They’ve driven online. They’ve driven their database. They’ve done all the things that we expected and we feel pleased about that.

China, David and his team have worked very hard to get focused there. We’ve managed to develop lots of stores. We had a situation where our franchisee is now financially stronger than they were. I won’t go into the details. We feel pleased about that.

We’re also pleased about the comps in places like Korea. Latin America is doing extremely well. The Middle East is growing very fast.

Many of the issues that I referred to probably two or three years ago on these calls seem to have dissipated through I think some very good hands-on management by our international team. So we’re in a situation where as I referenced we have 1,000 stores signed up contractually. We don’t see the slowdown impacting us at all. We review the numbers regularly.

We seem to be attracting very good franchisees now. A good example is we just brought an excellent franchisee in Malaysia. I was in Turkey about four weeks ago. Very impressed with the team there. I know that that’s one of Domino’s best markets so we feel good to challenge them there. I find it hard to be anything other than optimistic about international even in the environment.

It seems just taking the UK which was probably the most significant one because of the losses that the environment’s actually helped us, and if you go to the UK which obviously I do quite often, I think the trade-down from top end dining has been far more sharp than it’s even been here in the US.

David, do you want to add anything?

J. David Flanery

The only other thing I’ll add there is just as a reminder, except for a very small number of company-owned stores in Beijing and in the UK we are all franchised outside the US. So as long as our unit development stays on pace, which at this point we see that happening, our profitability is less susceptible to maybe small fluctuations in the comp sales of those various countries.

Because you‘re right. Countries are going to have different economic conditions as this becomes a worldwide issue but not as much impact on us because of the franchise nature so long as we make sure that our unit economics stay in place so that franchisees are still meeting their development commitments on new unit openings. And again, at this point we don’t see any issues on that side of the business. That gives us some comfort.

Michael Wolleben - Sidoti & Company, LLC

This refranchising of these 63 units really looks like poor performers based on that revenue number that you guys put out. With you guys providing the financing for this until the franchisees can obtain it on their own, what’s the risk to you here with poor performing stores and you guys carrying the loan at this point?

J. David Flanery

The deals that are closed, we have very little lending. There is some lending there. It’s merely timing. There are bank loans in process. We’re very comfortable we’re going to get paid out of the deals that have already closed.

It’s the deal that hasn’t closed yet so that’s why I’m a little hesitant to talk specifics of the geography of the deal, but that’s the one where we’re going to do 100%. What we can tell you though is that the franchisee that’s acquiring that is putting equity into the deal. They do have existing successful stores surrounding this area and they’re proven operators. They’ve done a good job with their existing stores, they know the area, so that’s what gives us more comfort than if those factors weren’t in place.

Nigel Travis

I think all I would say is, and again I won’t name the geography, but by going in and originally making that a corporate market I think we saved the market and we thought about new growth. I would fully echo what David said. This is an exceptionally good franchisee. We have great confidence in this franchisee and we also have a good level of confidence in their ability to repay this debt. I think the only reason that it is out there is because some of the major lenders changed their approach to life fairly quickly.

Operator

Our next question comes from [Charles Pemal] - UBS.

[Charles Pemal] - UBS

With the adjustments in real estate prices, what kind of opportunities are you seeing both for new locations and potentially relocating existing locations?

Nigel Travis

Simple answer. Lots.

Joking aside, we have a meeting called a development meeting every Monday and we’ve been talking about this for probably six months. We’ve already seen the ability to negotiate some of our corporate leases down. Sometimes you have to extend the term of the lease. We’re very pleased with that. Given the pressures on the commercial real estate market though very well documented, we’ve really pushed our teams to pressure landlords. They’re very keen to have Papa Johns as a tenant, not only because of our great brand but also because of our financial strength.

We’ve taken those lessons to regional meetings with our franchisees. We’ve demonstrated to them how we’ve negotiated. We’ve given them guidance. You can only go so far. You can’t actually go through the process for them but we’ve given them guidance how to do it. So I come back and say there are plenty of opportunities for great new deals and plenty of opportunities to reduce our current rents.

Operator

There are no further questions at this time.

Nigel Travis

Thank you everyone for your interest. This has been an interesting period. I want to reiterate what I said earlier. The world’s not coming to an end. The way we see it is we’re going to use our resources to take advantage of the world situation and the situation in the pizza industry on building our brand strength. Papa Johns will continue to flourish for the years to come. Thank you very much for your interest.

Operator

This concludes today’s conference. You may all disconnect.

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Source: Papa Johns International, Inc. Q3 2008 Earnings Call Transcript
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