Pizza Pizza Royalty's (PZRIF) CEO Paul Goddard on Q2 2016 Results - Earnings Call Transcript

| About: Pizza Pizza (PZRIF)

Pizza Pizza Royalty Corp. (OTC:PZRIF) Q2 2016 Results Earnings Conference Call August 10, 2016 9:00 AM ET

Executives

Christine D´Sylva - Vice President, Finance & Investor Relations

Paul Goddard - President & CEO

Curtis Feltner - Chief Financial Officer and Vice President, Finance

Analysts

Derek Lessard - TD Securities Inc.

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Pizza Pizza Second Quarter Results Conference Call. During the presentation all participants will be in a listen-only mode. Afterwards we will conduct a question and answer session. [Operator instructions] As a reminder this conference call is being recorded on Wednesday, August 10, 2016.

I will now turn the call over to Christine D´Sylva, Vice President of Finance and Investor Relations. Please go ahead.

Christine D´Sylva

Thank you. Good morning everyone and welcome to the Pizza Pizza Royalty Corp.’s earnings call for the second quarter ended June 30, 2016. Joining me on the call today are Pizza Pizza Limited’s Chief Executive Officer, Paul Goddard; and Chief Financial Officer, Curtis Feltner.

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 language in our earnings press release and the risk factors included in our annual information form.

Please refer to our earnings press release and the MD&A in the Investor Relations section of our website for a reconciliation and other disclosures related to our non-IFRS financial measures mentioned on the call today.

With that, I’d like to turn the call over to Paul Goddard for a business update.

Paul Goddard

Thanks, Christine, and good morning everyone. Thanks for joining our call. We are pleased to report the results of Pizza Pizza Royalty Corp. for the second quarter of 2016. Royalty Pool system sales increased by 1.5% to $132.3 million for the quarter and for the first six months sales increased 2.4% to $265.3 million.

Sales increased as a result of adding six new restaurants to the Royalty Pool on January 1, one extra day in February due to the leap year effect and also our same store sales growth which increased 0.9% for the second quarter and increased 1.7% year to date. And the same store sales growth is unaffected by the additional day of sales.

Quarter over quarter we worked to increase shareholder value in addition to offering an attractive dividend yield backed by a healthy cash reserve. In June 2016, the company increased the monthly dividend by 2.4%. On an annualized basis, the dividend is now $0.86 a share. The last dividend increase was in November 2015, when the monthly dividend increased by 2.5%.

Consistent sales growth has enabled Pizza Pizza Royalty Corp. to increase shareholder dividends seven times in the past five years, including two increases last year. Monthly dividend has grown over 20% over the past five years. Additionally, the company has accumulated a healthy $4.8 million cash reserve to support the dividend in the event that the company encounters short term pressure on same store sales growth.

And as we also said, geographic diversification of our two brands across Canada has proven to be a successful strategy in building value. So by brand, our successes at Pizza Pizza operating largely in Ontario and Quebec are reflected in the 2.8% same store sales growth for the quarter and 3.8% year to date.

However, at Pizza 73 with more stores operating in Alberta, we reported a same store sales decrease of 7.8% in Q2 and the same store sales decreased to 7.9% over the six months. So clearly the Alberta economy continues to lag the rest of Canada as unemployment continues to increase due mostly to the decline in the price of oil and also low natural gas prices.

Let’s turn now to restaurant operations at Pizza Pizza Limited. During the second quarter, we continued our focus on increasing restaurant profitability. Sales at Pizza Pizza restaurants accounted for over 80% of Royalty Pool sales and sales were driven by two factors, the customer traffic counts and the average customer check.

During Q2, the average customer check increased significantly largely related to taking a price increase in our very popular $4.99 medium pepperoni pizza. We substituted our cheese pizza at the $4.99 price point set. And as we anticipated walk-in customer traffic decreased slightly as a result of these price adjustments, but traffic also was negatively impacted at the end of the quarter by the timing of four weeks of Ramadan, the Muslim holy month, which partially moved forward into June from July. So this negatively affected traffic counts.

Taking a step back, historically, traffic has rebounded shortly after initial price increase and we feel this will happen with the back to school shopping period. We did achieve our goal of increasing restaurant profitability, while also increasing same store sales growth by 2.8% at Pizza Pizza for the quarter.

And as I mentioned last quarter, at Pizza Pizza we’ve introduced our new Express menu concept. This is an additional customer convenience to decrease wait times within our restaurants. The Express menu allows customers to order lower price offerings in advance such as the $4.99 cheese pizza and also many other items such as our gourmet thin crust [indiscernible] but previously a customer was unable to place an advance order that was under $10 ticket.

We built a marketing campaign around this enhancement leveraging our digital channels and this digital convenience factor we feel puts Pizza Pizza one step further ahead of competitors. Meanwhile in Alberta, home of Pizza 73, the average consumer continues to spend less on away-from-home meals due to economic constraints. This has reflected in the decrease in both traffic counts and in the average customer check in the Western markets.

We feel consumers will continue this pattern until the Alberta economy improves. Until then, we continue monitoring and supporting individual Western markets with added marketing campaigns with the intent of stealing market share during this widespread economic downturn.

Our sales growth and market share are supported by strong restaurant operations and exceptional marketing, but technological innovation at Pizza Pizza has also contributed in a big way to five years of consistent overall sales growth. Customer delivery orders transaction to our array of digital ordering platforms have captured nearly 50% of all orders which is a significant change from five years ago. Our customers love the convenience that our stores benefit from the lower cost model versus using live order takers which are of course more expensive.

Additionally, we continue investing in our Club 11-11 royalty program which is available on all digital platforms fully supported by marketing campaigns. And in particular one thing I want to highlight is our digital royalty registrations are multiples higher than our hard plastic royalty cards, so it’s interesting to see the explosive mobile growth there.

Technological investment in the quick service industry has quickly given larger operators like Pizza Pizza a distinct advantage over the smaller independent pizza operators. The independents on a combined basis have historically had the largest pizza market share.

Looking briefly at new restaurant developments, during the quarter, Pizza Pizza Limited opened seven restaurants and closed two. By brand for the quarter, Pizza Pizza opened three traditional and four non-traditional restaurants, two non-traditional locations were also closed and there were no changes at Pizza 73.

For the six month period, Pizza Pizza Limited opened 11 restaurants and closed four, increasing the number of restaurants by seven. By brand for the six months, Pizza Pizza opened five traditional restaurants and five non-traditional locations and two non-traditional locations were also closed. Pizza 73 opened one non-traditional location and two non-traditional locations were closed. And so we continued our national expansion program, opening traditional locations in Quebec, Manitoba and in Ontario. There are now 746 total locations across Canada.

We continue to build shareholder value to leveraging our size and our scale. Growing our customer base through brand dominance, new product introductions, service enhancements and technological advances allows our brands to build on their market leading positions. We continue to be super ambitious about our future growth and we remain as passionate as ever about maintaining our lead in our key markets.

And lastly, I just want to quickly thank our whole team of employees, franchisees and our partners for their tireless dedication and energy.

With that, I will now turn the call over to Curt Feltner, our Chief Financial Officer, for the financial update. Thank you.

Curtis Feltner

Thank you, Paul. Yesterday evening Pizza Pizza Royalty Corp. reported a solid quarter of financial results, especially in light of the underperforming Alberta economy. Second quarter highlights include Royalty Pool sales increased 1.5%, we had a monthly dividend increase 2.4% during the quarter, restaurants grew by five net locations and same store sales increased 0.9% when the two brands are combined in the quarter.

Same store sales growth is the key driver of shareholder yield growth. Looking at the same store sales growth by brand, Pizza 73 reported a 7.8% decline in same store sales which weighed on the combined 0.9% same store sales growth for Q2. Pizza 73 operates largely in Alberta where the decline in the energy sector activity has resulted in increased unemployment. In the comparable quarter last year, Pizza 73 reported a 5.7% increase in same store sales.

At our other brands, Pizza Pizza operating largely in Ontario and Quebec, but certainly across the country, same store sales increased 2.8% over the comparative quarter in 2015 when same store sales growth was 6%. Year to date highlights for the six months ended June 30, Royalty Pool sales increased 2.4%; same store sales 1.7%; and the network of restaurants grew by seven locations.

Before discussing the company’s Q2 financial results, I want to briefly summarize our corporate organizational structure. Each month, Pizza Pizza Limited, the private operating company, pays a percentage of Royalty Pool system sales to Pizza Pizza Royalty Limited partnership. This partnership owns the Pizza Pizza and Pizza 73 brands. The partnership has two partners, Pizza Pizza Royalty Corp. and Pizza Pizza Limited, the private company.

As Paul mentioned, total Royalty Pool sales from the 736 restaurants in the Royalty Pool increased by 1.5% to $132.3 million in the second quarter from $130.3 million in the prior quarter when there were 730 restaurants in the Royalty Pool. For the six month period, Royalty Pool system sales increased 2.4% to $265.3 million from $259.1 million in the same period last year.

As I mentioned, the partnership owns the Pizza Pizza and Pizza 73 trademarks and receives royalty income from Pizza Pizza Limited based on top line Royalty Pool sales and Pizza Pizza Limited pays this royalty income for the use of the Pizza Pizza and Pizza 73 brands. So the partnership received royalty income of $8.6 million and that was an increase of 0.8% for the quarter over last year and the royalty income increased 1.6% to $17.2 million for the six month period.

Breaking it down a bit, a 6% royalty was earned on $110.8 million of Pizza Pizza restaurant sales for the quarter and $222 million for the six months. Pizza Pizza’s sales accounted for 84% of total royalty sales for Q2. A 9% royalty was earned on $21.5 million Pizza 73 restaurant sales for the quarter and $43.4 million for the six months.

So using this royalty income the partnership pays interest expense and administrative expenses before making partnership distributions to Pizza Pizza Royalty Corp. and Pizza Pizza Limited based on their proportionate ownership of the partnership. So administrative expenses of the partnership include director’s fees, audit, legal and filing fees as well as directors and officers insurance.

Administrative expenses for the quarter were $162,000 and $326,000 for the six month period. For the prior year, administrative expenses were $139,000 and $264,000, respectively. The increases are due to an increase in TSX filing fees, legal costs and director fees.

So in addition to administrative expenses, the partnership pays interest expense on its $47 million credit facility. Interest paid was $331,000 for the quarter compared to $379,000 in the same quarter last year. For the six months, interest paid was $663,000 compared to $864,000 in the same period last year. The decrease was a result of amending and extending the credit facility in April 2015 and as a result the interest rate decreased to 2.75% at that time.

The credit facility matures April 2020. So after the partnership receives royalty income, pays administrative expenses and interest expense, a net profit is available for distribution to its partners based on ownership percentages. So Pizza Pizza Royalty Corp., which consolidates the partnership in its financial statements own 79.6% of the partnership.

The Royalty Corp. pays corporate income tax on its 79.6% share of the partnership income. So the company’s current income tax for the quarter was $1.4 million and $2.8 million for the six month period. This compared to $1.1 million and $2.3 million, respectively, in the same periods last year.

The increase in tax expense over the prior year periods is largely due to the company’s increased ownership percentage of partnership earnings in the current year over previous year as well prior year’s taxable income was sheltered by $1.2 million non-cash swap termination costs. Details of the effect on last year’s earnings and earnings per share can be found in yesterday’s press release and in the company’s management discussion and analysis, but I’ll also touched on this shortly.

So moving to consolidated net earnings and earnings per share for the quarter for the company as opposed to earnings as calculated per International Financial Reporting Standards, the company feels adjusted earnings from operations and adjusted EPS are more meaningful measures in evaluating the company’s performance and a true indication of cash available for dividends. Our MD&A has a full reconciliation of non-IFRS measures.

So for the quarter, adjusted EPS on a fully diluted basis was $0.2106 per share. Adjusted EPS in the prior year comparable quarter was just slightly higher, $0.2205, but it included a one-time tax benefit of $0.0101 per share as a result of the tax shelter from the swap termination cost I mentioned earlier.

If the tax benefit were normalized, adjusted EPS in the second quarter of last year would have been $0.2143 compared to this year’s $0.2106 or an increase of 0.8% over last year. Applying the same normalization to the current six month period, adjusted EPS would have increased 1.1% over the same period last year.

Now moving to shareholder dividends, in June 2016, the company increased the monthly dividend by 2.3%. On an annualized basis, the dividend was increased $0.0109 to $0.86 per share. And as Paul mentioned, last year there were two dividend increases, the most recent prior to our June increase was in November 2015 and the monthly dividend was increased 2.5%.

So the company declared shareholder dividends of $0.2107 per share for the quarter compared to $0.2040 in the prior year comparable quarter. The payout ratio was 103% for the quarter and 94% for the prior year comparable quarter. For the six months, the company declared dividends of $0.4198 per share compared to $0.4041 for the prior year. The payout ratio was 102% for the six months and was 96% in the prior year comparable quarter.

As a reminder, Royalty Pool sales for the first quarter have generally been the softest, while sales for the fourth quarter have generally been the strongest. The company’s working capital reserve is $4.8 million at June 30, which is a decrease of $133,000 for the quarter. The decrease was related to higher taxes payable and an increase in the dividend.

The $4.8 million reserve is available to stabilize dividends and fund other expenditures in the event of short to medium term variability in system sales and thus the company’s royalty income. With this reserve in place going forward the company will continue to target a payout ratio at or near 100% on an annualized basis. The company does not have capital expenditure requirements or employees.

So that concludes my financial overview for the quarter. With that I’ll now turn the call back to our operator for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from Derek Lessard from TD Securities Montreal.

Derek Lessard

I’m going to start on Alberta, just wondering if you’ve seen any hints or any signs of improvement in the consumer there or anything that points to some rise of hope?

Paul Goddard

I think overall, I mean, we certainly see choppiness I guess. Yes, certain signs make us feel like, yeah, we’re trending better, but then sort of see it kind of fall back. So honestly we’d like to say yes, but I think right now it’s still pretty darn tough out there. You may have seen this as our report this morning just say another indicator that Alberta and Saskatchewan consumers are falling behind on their debt payment worse than before.

So in some sense I wonder I think it’s getting worse, I hope they’re not, but certainly here looks like that. And we look at other things like the [liquor store indicators] not all that rosy this quarter and it was negative slightly for that company. So I tend to think it’s still going to be a war. I mean, it’s all I think the fundamentals improve, I frankly expect sort of more the same for the overall economy, I think.

I don’t know if Curtis has anything to add to that, but I think it’s early to sort of see the commodity come back and unemployment abate. I think it will still be quite challenging. Our view is, we’ve always said, we’re resistant to a recession type environment, but we’re not immune to it either. So we do think that there are people that are suffering far worse than us, especially in our specific sector.

So we think that [indiscernible] market share because you know that financially we’re very strong despite sales and partner dividends being lower than they have been a year or ago, right. But overall if you go back a few years, our partnership is still in really good shape there. So we think we can weather it, but, yes, sure, it’d be a lot nicer if we could see some real sunrise over the horizon there and I personally don’t really see much immediate cause for optimism I guess I could say.

Curtis Feltner

Derek, just quickly add to that, our close to 8% decline in same store sales compared to last year to 5.7% at Pizza 73 in the same quarter last year, on a comp basis, we’re now – and Q3 last year was the beginning of Pizza 73 being affected by the decline in energy-related activity there.

We are looking at concentrating on those areas where we’ve been successful growing sales in the past. Our walk-in activity is improving. On the counter to that, our loss is in 90% of our business which is the delivery, right, but 10% to 12% we are seeing some good pickup there in single pizzas and concentrate on lunch business.

And we also are looking that programs in Q3 that we are hearing that the unemployment rate may increase during Q3 and 4 and moderate in early 2017. So with without giving forward looking information, the programs that are currently in the marketplace and in public knowledge right now you’ll see that we’re bringing back the successful [indiscernible] that’s starting to – that’s in Q3. But people are seeing that now.

Derek Lessard

I guess maybe just a follow up to that, Paul, you said it was a chance for you guys to steal market share. I know one of your competitors has gotten pretty big out west. Have you seen any more aggressive competitive reactions given the tightness in the market?

Paul Goddard

I don’t think we’ve really seen anything. If you look across a whole province in a macro level or in a micro level in specific communities, Calgary, Edmonton or small towns, I mean, we honestly don’t really see any massive direct impact as a result of say one or two competitors. I just think overall it’s tighter. I mean, we just think that overall customers are more cautious, there’s just not as much discretionary spend overall. I don’t really see – and obviously there is pockets in the province that might be more competitive than others, but I don’t really know if there’s a recent dramatic change really that’s material in terms of us being [indiscernible] competitor or two.

Derek Lessard

And maybe just switching gears, just wondering if you could add some color on the price increases you took maybe in terms of the categories or bundles or percentage increase and just wondering if it was just in the Ontario market or was it in all of the markets that you’re doing well namely Quebec and Manitoba?

Paul Goddard

I think we’ve been selective about increases, I mean we have our bundled specials at some of our most well known specials that are at circa $20, $21 price range and we actually took those up a dollar at Pizza Pizza. I mentioned in my prepared remarks the walk-in pepperoni which has been a long standing strong product for us we actually had a pretty bold move there by increasing the price there and making – substituting a plain cheese pizza and put in a $6.99 price point for any one topping that you want to add to that medium serve plain cheese pizza, right.

But we’ve also tried to do things like bringing the two for $5 specials, so still preserve the $5 price point at Pizza Pizza for some of those customers that are really looking to the value, but we try to sort of diversify our product mix more there. At Pizza 73 as well, I think we’ve been pretty careful there. But we focused on the menu introduction, including free chicken bites and things like that.

We’re pushing the lunch [indiscernible] at price points that we think work. I’m not sure on 73, the price point – I think we had a small amount of price changes there, maybe we went up on something, but obviously we’ve been pretty cautious there because this is in some places where you have to actually reduce prices in order to try and drive traffic.

Curtis Feltner

Derek, if I could just add to that. In Paul’s prepared remarks, we really tried to message that our restaurant profitability is something we’re working on right now. In the past few years, we’ve been disappointed with the number of traditional restaurants that we’ve opened and so this $4.99 medium pepperoni was something that was something we listened to our franchisees and our partners and we decided to substitute that pepperoni for cheese and that’s made a significant difference in food costs at our restaurants. So we are working to make our restaurants’ profitability more and more attractive.

We’re ramping up to continue our successful expansion in Montreal, so we won’t soon be looking back into our largest market here in Ontario that’s been very successful for us and accelerating our growth plans. We certainly feel like the Ontario economy has some good foundation under it in my opinion and we should start seeing an acceleration and our growth of our restaurants into the latter half of this year and next year. That’s where we feel like we’ll start really making traction, taking market share, driving market share and driving total Royalty Pool system sales.

Derek Lessard

And maybe just in terms of the – I mean there was a slight decrease in traffic, but where do you see in terms of customers accepting it now? Has there been any pushback or even any competitive responses from your competitors maybe trying to undercut you?

Paul Goddard

I think we certainly see once in a while sort of an emulation of our marketing strategies, check at other competitors which we sort of take as our strategies are working if we see it as a copycat strategy. So we do see a little bit of that. If you’re asking the Ontario market, I don’t think I can specifically say as quite as much in Alberta market or in some of the other smaller markets.

But things like Ramadan have had a big effect, just the timing this year, I mean for Q2, I mean it’s amazing how many people that we have that actually – we see a direct impact of that, just the dramatic shift in timing this year. So that’s probably the biggest impact really there in Q2. Not to use that as an excuse, but it’s definitely a real thing we’ve seen shift into June and July we see early indication that we have volume there for July to offset that June, but obviously kind of forward looking.

So I don’t think we’re really seeing anything too dramatic there in terms of – not everything we do does work. We always say that. But we do like to try and tweak things and we learn and we will adapt them again. If we think we take took too much price for instance, we’ll look at another strategy. We introduced recently this two for $5 chicken sandwiches, RWA chicken, and we’re really pushing the health and quality as we’ve said for some quarters now that we’re really trying to get that quality message out there as well as innovation and digital.

So we think that people are really accepting us, especially on the mobile side. So if you look at – you can kind of pull apart the macro numbers and I don’t want to go to too much detail with some of our – where we’re strong, where we are weak just for competitive reasons, but it’s really interesting when you kind of parse it out where you do see people still coming to you and coming to you even more around other segments or other demographics, other channels not as strong.

So we’re just sort of trying to fine tune things. And I guess because we are quite diversified and have that scale, we feel, well, on a portfolio level, we’re sort of pretty well hedged, right. We’re going to try and focus and invest more where we get the bigger return, bigger bang for the buck, I’d say mobile and digital royalty and things like that. And other areas, we used to want to cover all the bases, but we’re going to focus where we really see more reward. Does that make sense?

Derek Lessard

Absolutely. And I think you guys have shown over time that you’ve been pretty nimble on the pricing side. That’s great color, thanks. Maybe just one more for me, and it’s probably for Curt, you’ve built up a real nice buffer in the cash reserve, but you’ve dipped into it over the last couple of quarters, is there anything to take away from that?

Curtis Feltner

Other than it’s pretty – it’s something that we intended, I mentioned that our fourth quarter sales are strongest, so our target, our annualized target of 100% is something we will definitely take to and then the early first half of the year, in order to do that you usually have to go over the 100%, so, no concerns from our standpoint at 102% year to date at this point.

Operator

[Operator Instructions] We have no further question registered at this time. So I would like to turn back over to D´Sylva.

Christine D´Sylva

Thank you, Rick, and thank you everyone for being on the call today. If you have any questions after the call, please contact us. Our information is on the earnings release. Thank you and have a good day.

Operator

Thank you. The conference call has now ended. Please disconnect your lines at this time and we thank you for your participation.

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