Papa John's F2Q08 (Qtr End 6/29/08) Earnings Call Transcript

Aug. 6.08 | About: Papa John's (PZZA)

Papa John's International, Inc. (NASDAQ:PZZA)

F2Q08 Earnings Call

August 6, 2008 10:00 am ET


Nigel Travis - President, Chief Executive Officer, Director

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

William M. Van Epps - President, USA

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


Mark Smith - Feltl and Company

Barry Stouffer - BB&T Capital Markets

Michael Wolleben - Sidoti & Company

Jill Forsythe - Analyst


Good morning. My name is Ron and I will be your conference operator today. At this time, I would like to welcome everyone to the Papa John's second quarter earnings call. (Operator Instructions) Mr. Flanery, you may begin your conference.

J. David Flanery

Thank you, Ron. Good morning. With me on the call today are our CEO and President Nigel Travis; President, USA Bill Van Epps; President PJ Food Service and Preferred Marketing Solutions, Julie Larner; and other members of our executive management team. After a brief financial update, Nigel will have comments about our business and the management team will then be available for Q&A.

Our discussion today will contain forward-looking statements that involves risks and uncertainties relating to future events. Actual events may differ materially from the projections discussed today. Certain factors that can cause actual results to materially differ are outlined in our earnings release and in our forms 10-Q and 10-K.

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

We were extremely pleased with second quarter results in a very tough economic and competitive environment. Excluding the consolidation of the BIBP’s purchasing entity, second quarter earnings were $0.41 per share, representing a 2.5% increase over the same prior year quarter. On the same basis, year-to-date earnings were $0.89 per share as compared to $0.84 for the prior year, an increase of 6%.

Pretax income for the second quarter excluding BIBP was $900,000, or 4.5% less than the prior year, and year-to-date pretax income was $400,000, or 1.1% less than the prior year on the same basis.

In addition to the expected year-over-year business unit margin pressures I’ll discuss in more detail in a moment, the comparative results were negatively impacted by an approximately $1.2 million reduction in executive incentive compensation in the second quarter of ’07, resulting from awards forfeited by our founder Chairman in connection with this change in status to a non-employee director during that recording period. Additionally, the first six months of the current year included approximately $1.1 million in incremental charges related to the sale or closure of company-owned restaurants as compared to the same period in the prior year.

Revenues increased 10.6% for the quarter and 10.7% 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 franchised units, a greater number of company-owned units due to the acquisitions from franchisees over the past year, higher PJ food services sales due mainly 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 franchised restaurants outside the U.S.

We were also very pleased to see our top line sales momentum continue with a domestic comparable sales increase of 2.4% for the quarter, 3.6% for company-owned units, and 1.9% for franchise units. This represents the fourth consecutive quarter and 13 out of the last 15 quarters of domestic comparable sales increases in an extremely challenging and competitive environment.

Our domestic comparable sales results have also outperformed the pizza category for 24 of the first 26 weeks in 2008, demonstrating the consistency of our momentum.

International franchise sales increased 30.1% in the second quarter and 31.6% year-to-date over the same periods in the prior year due to both unit growth and same-store sales increases. Nigel will have more to say about our second quarter performance and the overall sales environment in his remarks.

On a business segment basis, company-owned restaurant operating income decreased $400,000 for the quarter and $800,000 year-to-date over the same periods in the prior year. However, the results reflect operating income increases of $200,000 for the quarter and $900,000 for the year-to-date excluding the $1.1 million in incremental charges related to the sale and closure of certain units in the current year noted previously and a $600,000 gain on lease termination in the prior year’s second quarter.

The increase in operating income dollars, excluding the identified items, is primarily the result of the acquisition of 42 restaurants during the last six months of 2007 and the marginal profit for all units on comparable sales increases. However, these increases were partially offset by the fact that percentage margins were lower for the quarter and year-to-date due primarily to higher commodity costs. Restaurant segment margins would have been unfavorably impacted even further had the commissary passed through underlying operating cost increases fully during the quarter and six-month period.

Operating income for the domestic commissary segment was $300,000 lower in the second quarter and $1.9 million lower year-to-date as compared to the same periods last year, due to a combination of lower gross margin and higher below margin operating costs, primarily diesel fuel. The commissary has absorbed substantial cost increases thus far during the year, rather than passing them through completely to the system via higher food prices.

Domestic franchising operating income increased $1 million for the quarter and $2.5 million year-to-date over the same periods in the prior year, due primarily to the quarter point increase in royalty rate effective in 2008 and, to a lesser extent, to the comparable sales increases during the period.

Franchise units were relatively consistent from year to year as the impact of net new unit openings was substantially offset by the impact of the company acquisitions over the past year.

The international business segment operating loss improved by $500,000 for the quarter and $1.1 million for the year-to-date over the same periods in the prior year due to organizational leverage from both new unit openings and higher per unit sales volumes. This level of improvement is on track with our expectations of approximately $3 million in total operating loss improvement for the full year.

Operating income for the all others business segment improved $300,000 for the quarter and $1.8 million year-to-date over the same periods in the prior year, due primarily to better results at our preferred marketing solutions subsidiaries. This unit increased both its commercial sales and related margins significantly over relatively weak performance in the first quarter of the prior year and achieved a more sustainable level of improvement in the second quarter.

Unallocated corporate expenses, including net interest costs, increased approximately $1.7 million in the second quarter and $2.6 million year-to-date as compared to the same periods in the prior year, primarily due to increases in incentive compensation as a result of an expected higher level of goal achievement in 2008 and the previously noted $1.2 million reduction in prior year expense related to the founder Chairman’s change in employment status.

Additionally, the current year reflects increases in certain severance related costs and employee benefit related expenses.

Cash flow from operations for the year-to-date excluding BIBP increased approximately $8.6 million over the prior year, due primarily to working capital improvements. Free cash flow, a non-GAAP measure we define as net income excluding BIBP, plus depreciation and amortization expense less capital expenditures, was $25.9 million year-to-date as compared to $24.8 million for the same period in the prior year.

Free cash flow, as defined, for the trailing 12 months was approximately $55.2 million and represents a free cash flow yield of 6.8% based upon 28.8 million average diluted shares outstanding for the year-to-date and a stock price at market close yesterday of $28.98.

We continued our share repurchase activity, buying $18 million of stock during the quarter and an additional $6.9 million during July. We had $22.8 million remaining under our existing share repurchase authorization as of the end of July and expect to complete the authorization during the remainder of the year.

We reaffirmed earnings guidance of $1.68 to $1.76 for the year. We believe restaurant margins could be somewhat volatile for the remainder of the year due to the current unpredictable commodity and fuel cost environment. This may also lead us to continue some level of commodity cost subsidy for the system through reduced commissary margins as compared to prior year levels. Accordingly, we have not increased full-year guidance in response to the favorable first and second quarter results.

We also reaffirmed guidance related to domestic system-wide comparable sales increases in the range of 1.25% to 2.75%, and worldwide net unit growth of 160 to 190 units, although we advised that net unit growth would more likely be nearer the low end of this range due to the possibility of reduced unit openings or increased unit closings as a result of continued margin pressures.

We do expect that the current commodity cost trends will continue into 2009. Wage rates will also continue to rise in 2009 with the third and final installment of the federal minimum wage adjustment to $7.25 effective in July 2009.

Accordingly, we expect that restaurant margins will continue to be under significant pressure and it is likely that we will continue to identify ways to support the system, similar to what we have done thus far in 2008.

Our goal would be to minimize restaurant closures, thereby protecting and likely growing market share so that our brand would be well-positioned to take maximum advantage of the economic recovery currently forecast to start in 2010.

And now I would like to turn the call over to Nigel Travis, CEO and President. Nigel.

Nigel Travis

Thanks a lot, David and good morning, everyone. Last quarter I took a balanced scorecard approach to discussing our business outlook, given the tough operating and cost environment. I am pleased to say the positive aspects of our scorecard continue to perform very favorably in the second quarter. Let me just give you some highlights.

We had strong domestic comparable sales results, we maintained our domestic unit count while continuing to add to our development pipeline, our international business continued to exhibit strong unit growth and profitability improvements and, probably most important, our free cash flow continued to support aggressive share repurchase activity without increasing balance sheet leverage.

Unfortunately, the negative scorecard factors are still affecting our business. The U.S. consumer is under continued pressure from major economic factors such as the housing market and financial industry issues have not improved. And although fuel costs have receded from their recent record prices, they are still at historically high levels.

Commodities also remain at very high levels, further impacting consumer confidence and overall discretionary spending habits.

Higher commodity prices also pressure operating margins at both our company-owned and franchised restaurants. In addition, the credit market tightness has impacted the speed that larger transactions can get. The key takeaway from a review of our performance in the context of these balanced scorecard factors is that both our brand and our business model are performing very well in the worst of business environments.

The fact that our operating income for the first half of 2008 is essentially flat to the prior year while overcoming more than 2 million of unfavorable, non-comparable items, as David noted in his remarks, confirms this assessment.

The ability of our business model to generate free cash flow, which we have consistently used to repurchase stock while maintaining a conservative debt level, is a key component of our ability to drive earnings per share growth and shareholder value.

While we would not normally be satisfied with the earnings per share growth of 2.5% for the second quarter, or the 6% for the first six months of 2008, we are quite pleased with this performance in the current environment.

So let’s take a closer look at our second quarter performance and the activities that we believe drove that performance. We said all along that driving top line growth is the most effective way to address the difficult cost environment our restaurants are facing. That’s why we are very pleased with the 2.4% increase in comparable sales for the quarter. This continues and improves upon the sales momentum we demonstrated the two previous quarters, with 2.1% comps in the fourth quarter of 2007, followed by 1.7% growth in the first quarter of this year.

In order to explain this sales momentum, let me walk through what I believe may have been the most ambitious three months of consecutive new product and promotional activity that at Papa John's have ever executed.

First in May, we launched our expanded line of specialty pizzas throughout the U.S. Although there was no national television support, this promotion differed from how many of our local windows have been conducted in the past. It was truly a coordinated national promotion across all of our advertising media, including local television support in numerous markets.

I would like to take this opportunity to commend our franchisees for their execution of this program.

We were extremely pleased that the specialty pizza launch generated a system-wide shift in mix, similar to the improvement we saw in our test markets. Not only is the focus on an expanded line of specialty pizzas in perfect sync with our brand image and quality, but the shift in mix effectively functions as a self-selected price increase to our customers. This was an important objective of this promotion, given the overall increase we are facing in commodity costs.

We followed this with the June introduction of a whole wheat crust as a new fresh crust option. As the only national chain to offer a whole wheat crust throughout the U.S., we believe this better for you crust alternative is another example of a new product introduction that is perfectly aligned with our quality brand positioning.

We believe having a whole wheat crust option encourages new customers to try Papa John's and we were very pleased with the results of this system-wide promotion, which was support with a two-week flight of national television. We continue to receive excellent PR regarding the introduction of whole wheat, even after the conclusion of the national promotion.

Our subsequent promotion in July contained several first for Papa John's. It was the first time we supported a system-wide promotion with national television in July and it was the first time we’ve sponsored a promotional tie-in with the theatrical release of a motion picture. Additionally, it was the first time elements of a U.S.-based promotion of this type have been extended to several markets around the world.

We were very pleased to team with Universal Pictures to promote the release of The Mummy: Tomb of the Dragon Emperor into theaters worldwide. Our U.S. promotion featured an exciting value for consumers -- that was three medium one-topping pizzas for $21, delivered in custom-designed Mummy boxes and with a coupon for $3 off one or $5 off both The Mummy and The Mummy Returns DVDs.

Although I can’t give any specifics of the results of the July Mummy promotion, I can say that this trio of consecutive promotions demonstrates our ability to execute the level of new product development and creative promotional activity that we believe is necessary to drive top line sales in this environment.

The next scorecard item that we believe continued to be positive for us is unit growth. Our domestic unit growth flattened in the second quarter. However, we are still the only one of the big three brands to have net unit growth for the first half of the year. Our unit count increased by nine restaurants during this period, while Pizza Hut had 18 fewer units and Domino’s had 48 fewer units during the same time period.

We also continued to sign new territories for development, both to existing and new franchisees. At the end of the second quarter, we had more than 300 units in our domestic development pipeline and we projected an estimated 500 additional traditional units are available for development in the U.S., or a total of 800 additional domestic units. If you look at that, that’s a 29% increase on our current base of domestic units.

We also continued to focus on non-traditional developments and recently signed a contract for our first military base units.

Our international business unit continues to perform in line with our high expectations, with both unit growth and profitability improvements solidly on the positive side of our scorecard. We added 33 net new units for the quarter, giving us a total of 53 net new international units for the year-to-date. As in the U.S., international development is somewhat weighted towards the back half of the year, so we are well on track to have our most successful year ever in net unit openings outside the U.S. by a substantial margin.

We ended the second quarter with more than 500 Papa John's restaurants operating outside the U.S., an impressive accomplishment only 10 years after the opening of our first international unit in July 1998. We believe this puts us in the top 15 U.S. restaurants brands based on the number of units outside the U.S.

However, we know that we are just getting started with our international growth. We have had an excellent year so far in signing new developments internationally. The strength of the Papa John's brand is attracting an outstanding caliber of prospective franchisees and we are capitalizing on our reputation and momentum to execute exciting new development agreements.

For example, we recently announced the signing of a 100 unit development agreement for Malaysia with the Berjaya Pizza Company, a well-respected business group in that country with substantial restaurant franchising experience with Starbucks, Wendy’s, and Kenny Rogers’ Roosters. This was on top of the signing of agreements with five new franchise groups in Canada for a total of 77 units to be developed in four new markets and the recent signing of 20 units in the Dominican Republic.

We expect the first restaurants under each of these agreements to be open before the end of this year.

We have also extended development agreements with existing successful franchisees in the Middle East and Latin America. We currently have approximately 1,100 units in our international development pipeline scheduled to be open through 2018.

So to demonstrate the trajectory of our international unit growth, we achieved 500 units in our first 10 years and we expect to open our next 500 international units within the next three years.

One development note related specifically to the U.K. portion of our international business is their successful efforts to sign multi-unit franchisees and to open non-traditional units, two areas that we believe are critical to our long-term success in that very competitive market.

Also of note relative to the U.K. is their recent launch of a new fresh dough thin-crust product intended to differentiate us from the competition by emphasizing our fresh quality positioning. Early results from this new product launch are very encouraging.

The operating losses from our international unit improved by $500,000 during the quarter and by $1.1 million for the year-to-date, as David noted. We are pleased that our profit improvement is on track with our previous projections and we’re excited about achieving overall profitability for international by 2010.

Certainly our strong cash flow -- sorry, our strong free cash flow is a positive scorecard factor. David included the specifics for 2008 in his remarks and I’ll only add that we expect an increased focus on controlling capital expenditures, coupled with our refranchising initiatives to drive even greater improvements in free cash flow in 2009 and beyond.

A final positive scorecard item I would like to discuss briefly is the launching of a set of widgets to complement our industry-leading online ordering capabilities. These tools are designed to make ordering Papa John's pizza even more convenient by streaming current offers directly to a consumers desktop and providing one-click access to the ordering process. The widgets are designed for download and integration into a variety of the most popular social networking sites for even more top-of-mind awareness and ease of ordering. They are a great addition to our text and mobile ordering capabilities and enhance our superb reputation as the technology leader within the industry.

On the negative side of our scorecard are the twin evils of record high commodity costs and a consumer that is reeling from the housing market meltdown and near record-high gasoline prices. This combination of factors means that we have to be very, very careful with the natural inclination to raise prices in the face of higher commodity costs. We can’t afford to raise prices above levels that consumers find acceptable. That is why we continue to subsidize our franchisees so that they avoid the issues of even higher costs. The battleground is keeping stores open through this turbulent time and we are determined to win this battle.

This is where we believe the national chains have significant advantages over the small regional chains and independents, which collectively make up a large percentage of the total pizza category. Our scale provides opportunities for efficiencies in marketing and purchasing that the small players can’t duplicate. We continue to believe that there will be consolidation with the industry, with as many as 2% to 3% of the 65,000 existing pizza restaurants closing in the next 12 to 18 months. This should benefit the stronger national chains and we believe our quality brand positioning will work to our favor in picking up business from these closed competitor locations.

We are also working very diligently on ways to improve our food costs by teaming with suppliers on any and all ideas that could reduce costs without compromising our very important quality positioning with the consumer.

We also have the advantage of controlling distribution in our PJ Food Services subsidiary and we are working on several technology based initiatives to reduce both distribution and warehousing costs. The early results of this are very encouraging.

A final negative scorecard item is the current state of the financial markets and the impact that they may have on our future unit developments. While we haven’t seen any slowing of development yet attributable to franchisee financing problems, we believe the possibility exists for that to occur.

We have seen financing issues impact restaurant consolidation within our system, including creating additional hurdles for some of our refranchising initiatives. We do believe, however, we will complete select refranchising transactions prior to year-end. However, as we work towards our goal of reducing company-owned units below 20% of the system.

So all this poses one more question -- how do we see the future? We are assuming that 2009 will continue to be as tough or even tougher than this year. We feel it’s better to plan that way and we are already in advanced planning sessions with our franchisees. We intend to do everything we can to maintain our store numbers and we believe that the real pay-off will come in 2010 and 2011, when we believe the environment should be better.

We continue to believe our quality positioning gives Papa John's an advantage in weathering these tough times.

A final word before I turn the call back to David for Q&A -- the importance of the relationship between the franchisor and franchisees in this tumultuous environment cannot be overstated. The execution of any initiatives required to drive the business forward will be much more difficult without the full support of the franchise community.

We conducted our quarterly meeting with the franchisee advisory council just last week and I am thrilled to report that the overall tone of the meeting was one of complete collaboration and cooperation.

We certainly don’t always agree on each and every issue that comes before the FAC but there is no question that we are all in this together and we are always striving to arrive at solutions that are best for the entire Papa John's system.

Life is not easy in the restaurant business at present, but having a strong relationship with our franchisees certainly makes it a lot easier and with that, I’ll turn back to David for the Q&A session.

J. David Flanery

Thank you, Nigel. And Ron, if you’ll go ahead and open up the lines for questions, that would be great.

Question-and-Answer Session


(Operator Instructions) Your first question is from the line of Mark Smith.

Mark Smith - Feltl and Company

Just a handful of questions here -- first, can you talk about the subsidizing of your franchisees? Is that primarily in the commissary line where that’s been mostly affected?

Nigel Travis

Good morning. Yeah, primarily it’s in the commissary line. As I said in my remarks, we are concerned about pricing becoming a major issue and a major deterrent with consumers, so we are trying to encourage the system to make sure that they are sensible in the way that they price. Clearly legally we can’t tell them how to price but it is important that we make it easier for them to be sensible in their pricing. So we’ve worked very hard in a number of areas and there’s a whole series of actions that we have worked. In fact, from the middle of last year when we started to anticipate the problems this year, we’ve subsidized the franchisees some. We’ve tried to improve our deals with our suppliers, as I mentioned in my remarks. We’ve also I think worked very hard at trying to improve the efficiency of our PJ Food Service operations. I mean, some of the things they are doing with technology, it’s just simply amazing.

And this is all the result of a significant investment we made in software starting last year and carrying on to this year.

So it’s a mixed bag but primarily we’re trying to ensure that our franchisees are cushioned from the worst excesses of price increases.

J. David Flanery

Mark, the other thing that we have the ability to do, which is really no different than how we normally act, is on the area of royalties where a particular area may, a franchisee may have issues. We do have the ability to do some subsidy there, although we use that sparingly and that’s kind of our rifle approach, whereas food service is something that affects the whole system.

Nigel Travis

I think it’s worth saying that, I mentioned it a couple of times in my remarks and so did you, about this desire to keep stores open. We want to keep great franchisees in business. People who do not fit the brand or could be deemed as bad franchisees, we want them out of the system and the whole franchise community supports us in that desire. So we are very focused on keeping good franchisees healthy during these tough times and I believe that will be great for the system down the road.

Mark Smith - Feltl and Company

Talking about pricing, looking at your last promotion here with the mediums for $7, is there -- should people be worried if this is a discounting or is this price really coming down, or do you still feel like you are priced high enough above the competition that you are still kind of driving off the quality of your product?

Nigel Travis

I think that’s a good question, Mark, and one I’m pleased to address. In this environment, I think we have a natural advantage with our quality positioning and as I said in my previous question, in my previous answer, we’ve tried to be very sensible in the way that we price. But we felt that it was important to get consumers some value orientation. We also saw this as an opportunity to, if you like, get more customers into the system because it is an attractive price but I would say nowhere near as aggressive as some of our competition.

I think what was interesting about that promotion was it wasn’t just a price promotion. We added value through The Mummy promotion. We called it the Adventure Trio. Customers liked that. I remember my days in running Burger King Europe, Middle East and Africa, sometimes we just took the same hamburger but themed it, and that really does seem to appeal to the consumers.

So I wouldn’t see it as too much of an aggressive price promotion. I would see it more as a move to extol the virtues of our quality but at the same time, give consumers great value, which as I’ve said many times isn’t just cheap prices.

J. David Flanery

And Mark, when you look at the fact that the cost of making a delivery is a major part of our cost infrastructure. This promotion had a $21 price point, so that’s a -- that actually gives us a very good dollar margin on the promotion, so we viewed it as a very positive promotion all the way around.

Mark Smith - Feltl and Company

And that’s kind of my next question -- if you can comment on the same-store sales trend during the quarter as you move from promotion to promotion and how the check may have been affected by this $21 promotion.

Nigel Travis

Well, first thing I’m going to say, Mark, is we’re not going to talk about the results for July. We just put July into my remarks to try and demonstrate some of the complexity of the execution that we placed on the system and how well the franchisees have responded.

I think one of the things we all learned from the success of McDonald’s is from time to time you need to make your menu a little bit more complicated, so we’re not going to talk about July. And as we don’t report individual months, we’re not going to go into that.

What I would say though is that we were very pleased with both the specialty pizza promotion and the whole wheat promotion. As I said in my remarks, I think it moved the system forward. Whole wheat I think was a significant move forward and I think that’s going to really be great for the system as we progress through the years and I think more and more people will move to whole wheat. I mean, it’s interesting -- I’ve got two little kids and when my kids go to birthday parties, I’ve noticed a trend that all the moms are starting to order whole wheat. I mean, that’s exactly what we want to see happening.

Mark Smith - Feltl and Company

Great, and then last question, just looking at your international business, can you talk at all about I guess a same-store sales basis, if we looked at some of the international restaurants that would be in a comp, kind of how those restaurants are performing?

J. David Flanery

We’re not yet releasing comp information internationally. I think what we have said in the release and in remarks is that our overall revenue increase internationally was due to both unit growth and comp sales within the units, so from that you can certainly determine that it’s positive but we want to kind of stay away from country-to-country releasing of information at this point for competitive reasons and also because we just don’t have any type of saturation yet in these markets.

Nigel Travis

I think what it’s worth saying, Mark, is there’s a number of things we’re pleased with. We’ve got a number of countries that are really beginning to fire quite positively. We are pleased with the results in China. I think I’d reference The Wall Street Journal article today where it’s Pizza Hut and us that are highlighted in China. I think that article captured very well if you like the thing I’ve talked about before, the convenience cycle in China. We are just moving up that cycle whereby convenience is something that the Chinese people are beginning to value. We are pleased with several other countries. We continue to be pleased with what’s going on in the U.K., which is effectively a turnaround.

But I think one of the things that is really encouraging is the quality of the franchisees and also the support we are giving them. The reason we’ve had losses internationally is to support these countries properly. And international is a fairly complex animal. It’s not just the delivery units that we have in the U.S., primarily. In many of these countries, we have the complex restaurant-based delivery. That means we have to think about the quality of our sit-down experience, how quickly we serve the customer. We also have to think about how we manage our online business, which some countries have, some don’t.

I carried out a fairly recent review of all of that and I am very pleased with the progress that we are making country by country.

J. David Flanery

The only other thing I will add, Mark -- we’re at 500 stores now. We have several countries that are getting close to getting some sort of critical mass. I think you will see us in the relatively near-term probably start disclosing our international comp. That’s a decision we’ll probably make.

Mark Smith - Feltl and Company

Sounds great. Thanks, guys.


Your next question comes from the line of Barry Stouffer.

Barry Stouffer - BB&T Capital Markets

Good morning, gentlemen. I was hoping you might give us some sense of preference for the whole wheat product and also your premium pizzas that you added during the second quarter.

Nigel Travis

By preference, what do you --

Barry Stouffer - BB&T Capital Markets

Like trial, for instance, of what kind of percentage mix would whole wheat have gotten during the promo?

Nigel Travis

Barry, this is something for competitive reasons we don’t disclose. What I will tell you though is that whole wheat actually beat our expectations, so we are pleased with that, and specialty pizzas, it’s something we’ve talked about before. I think this is something that highlights our brand. I think it demonstrates the quality that everyone associated with Papa John's, and obviously we saw, as I said in my remarks, two opportunities there. One is to highlight that we have those pizzas, which is all about quality, and secondly to improve the ticket mix, and we achieved all our goals on that and it’s something that we closely follow.

I think just going back to whole wheat, I talked about the experiences I’ve personally had, as an example of one, but whole wheat we believe is a niche that we’ve already seen in other categories -- bread is a good example -- that it’s going to keep growing. People think about their health and I think the whole wheat product halos that trend, so we are pleased with it.

Barry Stouffer - BB&T Capital Markets

Okay, and any chance that you could quantify the subsidies in the commissary to the franchisee system?

J. David Flanery

I think the best way to look at that is probably just looking at the quarter over quarter change in profitability for that segment. The majority of that change was effectively costs that weren’t passed through. We didn’t do any other major kind of pricing changes or anything like that, and a lot of it was indeed the diesel, so I think that’s your best way, is just looking at the year-over-year comparative profitability coming out of food service.

Barry Stouffer - BB&T Capital Markets

Okay, and could you discuss the cost component within the restaurant segment -- food, labor, operating expenses?

J. David Flanery

I’ll start at a real high level and Nigel or Bill can jump in. Clearly where we are facing the pressure was on commodities, and then kind of to our pleasant surprise, our restaurant ops guys did a great job managing labor, even though you are facing that stair-stepping up of last year’s minimum wage and state minimum wages and so on, so they did a great job managing labor. And then, in the middle of the P&L, we really just hunkered down -- again, great job by our operators, and every other line item, every other category was a tenth better here or a tenth better there and it all adds up.

But commodities is the big thing going against us and then kind of pleasant surprises in the rest of the P&L, due to some good management.

Nigel Travis

I think one of the things I would say there is we are proud of our communications with our franchisees and we managed to communicate a lot of the lessons that David talked about, like the -- what we call it here, the middle of the P&L and also the labor line to our franchisees to try and improve their flow-through.

I think, as David said, we did a great job controlling the labor line in particular but longer term, we have in place and we are working through it as fast as we can, much stronger plans to improve our labor productivity. This is a real focus for us. It’s something that technology is going to help us with and I for one am very enthusiastic about the projects that we are working on there.

J. David Flanery

Barry, just to put some quantity around that, the food cost on the external basis for our corporate restaurants pulling out the impact of BIBP, cost of sales were 2% higher and then we made some of that back on salaries and benefits, occupancy and other costs, about a tenth lower each. And then we were down a little bit in advertising and some of that honestly was the dollars were okay -- we just had good sales, so the percentage became a little improved percentage on the advertising due to the better sales.

Nigel Travis

And sorry, Barry, to keep pounding on but I think just to David’s point there, we have made a strategic decision that we are not going to cut advertising. This is the one area that we believe as we go through these tough times, we have to keep investing in the brand. We have to recognize we are the number three player and we need every single dollar to get the message out there because this is a highly competitive tough category.

Barry Stouffer - BB&T Capital Markets

So the labor savings you saw in the first quarter carried over into the second quarter, so you would think that you will see that also carry through the balance of the year?

J. David Flanery

I’d be very surprised if we couldn’t continue to control it extremely well and I know the management of the stores are very focused on it. We do have to take into account the July of this year’s next ratcheting up of minimum wage but from a labor productivity point of view, we do believe we will continue to see the same kind of benefit. It will be dampened a little bit by that wage rate increase though.

Barry Stouffer - BB&T Capital Markets

And I know you won’t give me the traffic number but given the comp number, should we assume that transactions were probably not positive in the quarter?

Nigel Travis

Barry, I have great pleasure in telling you that this was yet another creative and brilliant scheme to get me to give out traffic numbers and the answer is your assumptions I’m going to say are just neutral.

Barry Stouffer - BB&T Capital Markets

That’s all I had. Thank you.


Your next question comes from the line of Michael Wolleben.

Michael Wolleben - Sidoti & Company

Good afternoon. I was wondering if we could go back and just touch on the subsidies to the franchisees here one more time. From your comments, are you guys keeping that subsidy at about the same level here for the back half of the year or is there thought of increasing that?

J. David Flanery

I’ll start. I think what we tried to say in the call scripts and the release is that we would certainly expect to maintain those levels the back half of the year. The commodity costs aren’t coming down. The other factors facing our franchisees and our corporate stores too are all out there, that we are fighting against. So I think what we’ve tried to say -- and that’s one of the reasons that even in the face of a very good first and second quarter, we aren’t raising guidance for the year because we know the back half could be tougher and we will do what it takes, as Nigel said, to help make sure we don’t lose stores.

Michael Wolleben - Sidoti & Company

If you guys could touch on a little bit of what you are seeing out there in the market. Are you guys still seeing consumers trading down from casual dining into this category?

Nigel Travis

It is tough to say but overall our view is that there is some trading down taking place, and then you have to assume that because the casual dining category seems to be having a pretty rough time that there is some trade-down. I think you then get into the pizza category, which is a very complex picture when you look at it in terms of the main chains, the independents, frozen pizza category, take and bake -- you know, there’s all kinds of options that consumers have and that’s why it’s extremely competitive. But overall, I believe there is a trade-down and our challenge is to make sure that we get our message out. That’s why marketing is so important.

And going back to the previous question, Michael, one of the reasons we’ve done the subsidization is to make sure that our consumers -- sorry, make sure that our franchisees keep investing the money in marketing because Papa John's really needs to keep getting the message out there.

So I think I would say there is some trade-down but it’s a trade-down into a very competitive field and that’s why we have to keep coming up with great initiatives and execute them better than we’ve done before, and I certainly think we’ve done that over the last three months.

Michael Wolleben - Sidoti & Company

All right and just one last question here -- looking at the cheese prices that you guys are projecting here moving forward, it looks like they’ve certainly come off of previous predictions that cheese prices were going to come down a little bit in the back half of this year and into next year. Can you just comment on that, what your guys are telling you about prices moving forward?

J. David Flanery

Yeah, you’re looking at our 10-Q and we’re showing actual blocked prices still staying above $1.90 for the next four quarters, basically. The best thing I think the commodity experts that we are talking to, the best thing we are hearing now is that it appears there’s not any factors out there that will cause it to go even higher. They are kind of not even talking about it coming down. The issue was, was it even going to find perhaps new all-time highs and what we are hearing is no, those factors don’t appear to be in place, so we think we’re stuck at this level of near $2 cheese, which obviously impacts how we go about pricing through the BIBP mechanism back to the franchisees, eventually paying that debt down. But we feel like we will probably be a dime or so higher than the market over time to pay the debt down -- not enough to be a significant competitive impact.

Nigel Travis

And I think it’s worth saying that’s why we look into 2009 and we are making the assumptions that life is going to be as tough in 2009 as 2008. I mean, if you listen to someone like John Chambers of Cisco this morning and he seemed very optimistic -- we’re not that optimistic but let’s hope he’s right and our planning for, if you like, bad news, it’s a prudent thing and if there’s upside, we’ll take it.

But certainly looking out on the commodity costs, I think everyone is getting excited because commodities are seemingly coming down at the moment but all the predictions we have from the experts are that 2009 will continue to be very difficult.

Michael Wolleben - Sidoti & Company

Great. Thank you.


Your next question comes from the line of Jill Forsythe.

Jill Forsythe - Analyst

A couple of quick questions -- I see that your CapEx has remained relatively flat year-to-date with the previous year. With your initiatives in Malaysia, et cetera, do you expect that number to trend upwards at all this year?

And the second question is I realize you were mentioning in your balanced scorecard that innovation is obviously a key part of your strategy. I just read recently that Pizza Hut is taking on some green initiatives and I’m kind of surprised I haven’t seen more of that in the pizza industry. I’m just wondering if you are thinking of taking any initiatives in that respect in terms of marketing or otherwise.

J. David Flanery

Jill, could you repeat your first -- you said something remained relatively flat but you were a little garbled.

Jill Forsythe - Analyst

Sorry, capital expenditures.

J. David Flanery

Okay. I’ll start with the first one and then Nigel can jump in on the green initiative. Yes, we -- that’s one of the things in this environment that we are committed to do, is controlling CapEx. We’re certainly spend investment capital on technological items that we know give us a very good operational return. You’ve seen our corporate unit growth probably slow down a little bit for the reasons of the environment. We are in Beijing and the U.K. corporately outside of the U.S. We will continue to add stores in those markets but not at any type of accelerate pace at this time, since we are still just growing out the initial stages of those markets from a corporate point of view.

So yeah, I think you can see us control that CapEx going forward at similar levels, if not even trying to -- we haven’t given any formal guidance for 2009 but that’s certainly an area that we’ll try to make sure we manage very carefully.

Jill Forsythe - Analyst

Thank you very much.

Nigel Travis

Jill, on the green initiatives, I think we’ve actually got a very good record in this area. I think the first thing that makes great business sense is that PJ Food Service is doing a spectacular job in terms of controlling our miles per gallon on our tractors. I think I talked about that on the last call, but even since the last call they’ve got better, and it’s things like stopping idling, which has reduced dramatically quarter to quarter. I mean, our tractors now idle 10% of the time. It was as high as 40%, so that’s a green initiative that we are very proud of and that makes great business sense because it reduced the cost.

Secondly, I think it was with terrific insight that we invested in the Wow ovens for most of our corporate stores. Most of them have got them now and a lot of franchise stores. The Wow ovens, just to remind you, shut themselves off and that saves energy, and it also saves noise, which is another form of pollution. So the return on that, which we calculated a couple of years is highly acceptable -- I’m sure it’s off the charts now given the price of natural gas.

We’re also looking at all kinds of other ideas. For instance, we have spent a lot of time talking about utility management. Again, we shared this with our franchisees. The franchisees have to make a very small investment to roll out, for instance, e-stat, which are electronic thermostats. They are doing that with some enthusiasm. We help them with looking at their energy and their electricity bills, and that’s very consistent with our philosophy of working closely with our franchisees to really help their bottom line, so we are pleased with that but we can certainly do more and it’s something that we talked to our employees a lot about because there’s a lot of energy and a lot of savings that we can continue to look at.

Jill Forsythe - Analyst

And the interesting thing about Pizza Hut’s strategy is they are communicating that to their customers, which I think is a great idea. I mean, it helps the environment, it helps your marketing for the company as well. I’m just wondering -- I did notice that you reduced the height of your boxes and I was wondering if that was communicated at all, just the fact that you are reducing materials used, that sort of thing.

Nigel Travis

Sorry, again we had a little bit of trouble hearing you. You said --

Jill Forsythe - Analyst

I was just saying I noticed that you actually reduced the height of your boxes. You actually reduced the material usage in your packaging and that’s the type of thing that would be great to communicate to your customers.

Nigel Travis

I think this is always an interesting area and again, in previous companies. I’ve gone into this in some detail. I think there has to be very focused communications with your consumers and admittedly, a lot of people are interested in this but there is a limit to how much stuff you can actually communicate with them. So I think your point is an interesting one but I think we just have to be careful we don’t confuse the consumer with too many messages.

Jill Forsythe - Analyst

Sure. Okay, thank you very much.


(Operator Instructions) And there are no further questions, sir.

Nigel Travis

Okay, well, I would like to thank everyone for their interest this morning in the report of Papa John's. We feel we’ve gone through another quarter with high-quality results and I’m absolutely delighted with our performance in these brutal times, so thank you very much and have a good day.


Ladies and gentlemen, this does conclude today’s conference call. You may now disconnect.

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