Papa Murphy's (FRSH) CEO Weldon Spangler on Q3 2017 Results - Earnings Call Transcript

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Papa Murphy's Holdings, Inc. (NASDAQ:FRSH-OLD) Q3 2017 Earnings Conference Call November 8, 2017 5:00 PM ET

Executives

Weldon Spangler - Chief Executive Officer

Mark Hutchens - Executive Vice President, Chief Operating Officer, Chief Financial Officer

Analysts

Will Slabaugh - Stephens Incorporated

Jon Tower - Wells Fargo

Operator

Good afternoon and welcome to today's Papa Murphy's Holdings, Inc. Third Quarter 2017 Earnings Conference Call. [Operator Instructions]. As a reminder, this call is being recorded.

I would now like to introduce Mark Hutchens, Executive Vice President, Chief Operating Officer and Chief Financial Officer. You may begin your conference.

Mark Hutchens

Thanks Homer. Good afternoon everyone and welcome to our third quarter earnings call. Let me start by noting that our formal remarks and responses to your questions may contain forward-looking statements regarding future events or the future financial performance of the company.

Any such items, including guidance with respect to expected results for 2017 and statements related to our future performance should be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Any forward-looking statements are not a guarantee of performance and actual events or results could differ materially from those anticipated in forward-looking statements due to a number of risks and uncertainties.

I would refer you to the company's Form 10-K for the year ended January 2, 2017, filed with the Securities and Exchange Commission, which identifies important risk factors that could cause actual results to differ materially from those anticipated in our projections or forward-looking statements.

The forward-looking statements made on this call speak only as of the date of this call and the company undertakes no obligation to publicly update any forward-looking statements. Today's discussion also includes non-GAAP financial measures that we believe may be important to investors as metrics to assess the operating performance of our business.

Our earnings release contains reconciliations of non-GAAP measures to the most directly comparable GAAP financial measures in accordance with the SEC rules and the release and reconciliations can be found on the company's corporate website at investors.papamurphys.com.

Here with me this afternoon is Weldon Spangler, our Chief Executive Officer. Weldon will talk about his first 90 days on the job and the path forward that is materializing, including a brief update on the status of some of our key strategic priorities. I'll then provide an update on refranchising and development and we’ll discuss third quarter results in detail and provide an update on full year outlook. Weldon will then provide some brief closing remarks before we open the call up for your questions.

With that, I’ll like to turn the call over to Weldon.

Weldon Spangler

Thank you, Mark. Good afternoon everyone and thank you all for joining us on the call today. Since I joined Papa Murphy's in early July, I along with Mark and other key members of my leadership team have had the opportunity to meet in person with over 300 of our franchise owners, representing well over half of the stores in our domestic system.

We met with these owners over the course of three weeks during nine in-person meetings held across the country, gaining perspective from owners on a wide range of topics and sharing insights from a recently completed segmentation and lapsed user study. Subsequent to those road shows, we hosted similar web-based sessions with the rest of our franchise owners and employees.

These meetings have reinforced my excitement for taking on the CEO role here at Papa Murphy’s and strengthened my confidence in our ability to return this system to sustain growth and profitability.

My initial impression coming out of these meetings, is that we have franchise owners who are passionate about their businesses and the Papa Murphy’s brand and who are committed to winning, and we have a hard working group of employees who are dedicated to serving our franchise owners and equally committed to executing this turnaround and returning the brand and business to sustain profitable growth. But we have a real opportunity to execute this turnaround with greater clarity and an even greater sense of urgency, and that’s start with communication, culture, focus and execution.

Open, honest and timely communication is the life blood of any successful relationship and even more so in franchise communities. What I found here at Papa Murphy's is the system that can improve on clear candid and timely communication, both with our franchise owners and within our own ranks. We are already working to resolve this by increasing the frequency and candor in which we communicate vital information that will better inform decision, literally removing walls and eliminating other barriers that have made the free flow of key information challenging.

Together we are rebuilding our culture around four core values: quality, service, integrity and team work. Each vale reflects our commitment to our guest and franchise owners and also to our employees, vendors, investors and the communities in which we do business. To us quality means not only that we will create and serve distinctive products make from the freshest ingredient, but also that we will hold ourselves to uncompromising standards in everything we do.

Service means that we strive to create positive in-store and online experiences for our guest. Equally we will work to employ an empathetic mindset as we support our franchise owners’ success, provide employees with a clear leadership and other resources they need to succeed, make the communities in which we do business better and be good stewards of capital for our shareholders.

Integrity means that we hold ourselves accountable to do the right thing always; and simply stated, teamwork means greater focus on ‘We’ and less focus on ‘Me.’ Together with our franchise owners we are refining our focus on key strategies around the things that matter most, with a near term priority of stabilizing and accelerating profitable sales growth.

At the company we are refranchising a majority of our company owned stores to better support our owners and continue to prudently manage capital and other resources, ensuring key business initiatives are adequately funded, while aggressively reducing costs in other areas.

We are in the process of chaining the ways that our people interact with our franchise owners, from the top of the organization to the bottom. We believe this will lead to increased franchise owner engagement, which in turn will improve local store marketing, execution and grass roots consumer loyalty.

I mentioned earlier that just ahead of embarking on the road shows to meet the franchise owners, we completed a comprehensive research study, designed to help us better understand the habits and beliefs of our new, regular and last customers. This research which will inform and shape our marketing and product strategies going forward, identify two significant opportunities we can address immediately as we work to win back last users.

The first opportunity identified by the research is improving our product consistency. Over time our operation has become more complex as we’ve introduced many great new products to our menu, including Pan Pizza, Gourmet Delights [inaudible]. That’s made execution in our back of house more challenging and created the potential for consistent quality to supper.

At the same time, additional crust platforms have made our guests’ role in baking our pizzas more challenging and our banking instructions have become more and more complex. This combination has led to increased inconsistency in the customer experience.

We’ve moved quickly to address this product consistency challenge, both in-store and with our customers. We’ve developed and rolled out new in-store training materials focused on connecting dough prep and portioning procedures, with the way the product actually bakes at home with our consumers. And expect to have more, new more intuitive banking instructions and consumer focused videos in test soon.

Lastly, we will be re-launching our Perfect Pizza Promise, a quality guarantee to reduce any risk for the consumer. We will continue to look for ways to reduce complexity in the stores and improve execution, insuring that every Papa Murphy's Home Baked Pizza is perfect when our customer puts it on the their table.

The second significant opportunity coming out of the research is that we need to improve our value perceptions. And we believe we can offer great value using the great products we already have on the menu.

During the quarter we continued to test the XLNY pizza, which was designed to be a high quality pizza sold profitably at a low price. We’ve tested the XLNY at various price points in multiple markets in order to identify the price points that best balances the transaction life and profitability. Another important way to highlight our value is through targeted digital marketing. We’ve expanded the test of our digital marketing efforts to both aggressively reacquire and reengage lapse users, as well as to acquire new customers.

Texting and emailing our dinner service for customers is an inexpensive way to drive engagement with the brand and remind customers of the value we offer. The more customers we get into the dinner circle, the more impactful this program can be. We are also testing new customer acquisition via social media platforms. We continue to be pleased with the results of these tests, giving us confidence to expand these efforts to additional markets.

I'd now like to provide an update on our convenience strategy. We continue to believe that our lack of convenience has been an inhibitor to our growth, and we are addressing that with both online ordering and delivery. As we have mentioned previously, we are in the process of transitioning our online ordering to Olo.com, the leading provider of online and mobile ordering capabilities.

Our first market will transition to Olo early next month and we continue to expect to be fully transitioned to this new platform by the end of the first quarter of next year. To remind you, the move to Olo will provide a seamless and convenient online ordering experience for both customers and franchise owners alike and will enable online and mobile ordering to be fully integrated with a variety of third party market places.

Additionally, Olo’s digital platform gives us the opportunity to accelerate a host of other initiatives, including delivery. Speaking of delivery, we continue to see an expanded delivery footprint as a big opportunity for Papa Murphy's. Pizza is best served fresh out of the oven, which is why our Take ‘n' Bake pizza that our customer bakes at home is uniquely positioned for success and delivery. We have continued to expand our delivery pilot since its launch in March, with delivery now available in roughly 80 stores across the Seattle, Portland, Denver and Colorado Springs market and we are adding more stores each week.

Delivery orders, through these third party market places appear to be highly incremental with attractive check level economies and our franchise owners and customers across our system are eager for delivery. We are pleased with the results of the pilot and will continue to expand this offering in the coming months to meet the growing demand. We expect to have delivery capabilities in about a quarter of our stores by the end of the year.

In a moment I’ll hand over the call to Mark to update you on our refranchising and development initiatives and review in detail the financial results for the third quarter. But before I do, let me talk briefly about Mark’s role in the business as we move forward. As you all know, we named Mark, Chief Operating Officer of the company in the middle of the third quarter and launched a search for a new CFO. Mark will transition fully into that operating role once the new CFO is in place, but until then is firmly committed to oversee finance, accounting, technology and supply chain, while engaging more fully with our franchise owners and field teams.

In the new role Mark will be instrumental in leading the effort to achieve great execution in the core business in areas like product consistency and guest service, as well as flawless implementation of new products like XLNY, services like delivery in Olo and franchise owner relationships through the filed team leadership. By bringing all of these things together, we can improve franchise-owner profitability leading to growth and better outcomes for everybody.

Now I’ll turn the call over to Mark.

Mark Hutchens

Thanks Weldon. Although we didn’t close on any additional refranchising transactions in the third quarter, we remain committed to executing the strategy with a sense of urgency and returning to at least 95% franchise owned as soon as possible.

In addition to pursuing a couple of large transactions directly, over the quarter we also finalized the engagement of Unbridled Capital LLC, a proven leader in the franchise M&A arena. Within the week, along with Unbridled Capital, we expect to launch a formal structured process to market our company stores for sale, to both existing franchise owners and new prospects.

We continue to believe that we have the opportunity to refranchise up-to 35 stores in 2017, but with the complexity of negotiations and challenges of transitioning store operations in a way that limits risk of execution, it’s difficult to land these transactions firmly on a specific data.

Related to refranchising, in the quarter we recorded a one-time pre-tax non-cash impairment charge of $4.4 million to reduce the carrying value on our balance sheet, of four company-owned markets representing approximately 36 stores. This is one example when the accounting model doesn’t align perfectly with the larger economic opportunity, as we continue to believe that we will be able to refranchise these stores through one or more franchise owners who will develop additional stores in the markets, leaving us with a consistent royalty annuity going forward.

Looking now at development, during the quarter we opened nine new franchise stores, including eight stores in the U.S. This brings our total to 29 new franchise openings year-to-date, including 25 domestic locations and we are on track to open between 30 and 35 domestic units this year.

Following up on the area of development agreement we mentioned on our last call, we are excited to be partnering with a group of experienced and development oriented operators, including an existing franchise owner to bring Papa Murphy's to Richmond, Virginia. This is a great example of our development strategy in action with experienced and well capitalized operators quickly developing a market, the store penetration at which brand awareness, sales and profitability markedly improve.

We continue to believe we have a significant development opportunity, however in the very near term, as the system focuses on stabilizing and growing sales and absorbing the refranchising of over 100 company stores, we don’t expect new unit development to be significant. As such, last week we took steps to reduce excess capacity in the franchise sales and development functions, an action that we expect will reduce SG&A expenses in 2018 by over $1 million, while still ensuring we have the right level of resources to support our existing franchise owners and continue with activities like market planning, store design and other functions that are critical to ramping up new unit developments when the time comes.

I’ll now review the quarterly results in detail for our fiscal third quarter ended October 2, 2017.

We were reporting that overall domestic comparable store sales declined in the quarter by 4.1%, including a decline of 4.2% at the franchise owned stores and a decline of 2.7% at company owned stores. This matched the first quarter since Q4 of 2015 that comp sales at company owned stores outperformed franchise stores. In addition, although we don’t disclose specific period numbers within the quarter, I can tell you that the comp sales trend intra-quarter was promising; both at company owned and franchise units.

Looking now at the numbers, total revenue in the quarter was $26.8 million, a decrease of 5.9% compared to the third quarter of last year. The decrease in total revenue was driven primarily by the decrease in domestic system comparable store sales, as well as to a net decrease of 30 domestic stores over the prior five quarters.

Franchise royalties in the quarter totaled $8.5 million compared to $8.8 million in the third quarter of last year, a decrease of 3.3%. The decrease was driven by the 4.2% decrease in comparable store sales at domestic franchise stores and a net decrease of 22 franchise units over the previous five quarters.

At the end of the third quarter, the domestic franchise store count was 1,353 units compared with 1,375 units in the prior year quarter, reflecting 78 domestic franchise store closures, offset by 47 domestic franchise store openings and a net acquisition of nine company-owned stores over the last 12 months.

Franchise and development fees in the quarter totaled $310,000 compared to $645,000 in the prior year quarter. The decrease was driven by fewer franchise new store openings and fewer renewal agreements.

Sales at company-owned stores totaled $17.5 million, down 6.3% compared with the prior year third quarter. The decrease was driven by the 2.7% decline in company-owned comparable store sales, as well as by the net decrease of eight company owned stores over the last five quarters.

Switching over to expenses, we ended the quarter with 148 company owned stores, a net decrease of one store compared to the previous quarter and a net decrease of 18 stores compared to the end of the third quarter of 2016.

Reported company store operating expenses in the quarter as a percentage of company owned store sales decreased by 300 basis points compared with the prior year third quarter and totaled 95%. The decrease was driven primarily by a 360 basis point decrease in other store operating costs, the result of having no new store pre-opening cost in the current year third quarter. In addition, we increased our advertising spend by about 200 basis points in the quarter, which was offset by savings in other cost categories.

As we’ve done it in prior quarters I’ll now discuss the results for 73 stores in 10 markets unaffected by the portfolio changes we had made at our company store division over the last 12 quarters. Comp store sales performance at these stores declined only $0.08 a percent in the quarter, outperforming the broader company store portfolio by 190 basis points. We did see margin compression of around 98 basis points in these stores compared with the prior year third quarter with total operating costs as a percentage of sales totaling 89%.

Again, as we execute our refranchising strategy, we would expect the overall margins in the company store portfolio to more closely approximate the margins in this subset of stores. Overall, stores opened by the company over the previous 11 quarters negatively impacted the third quarter EBITDA by about $400,000 and reduced earnings per share by approximately $1.04.

Reported selling, general and administrative expense in the quarter was $5.6 million, reflecting a $1.7 million recovery of the ad fund deficit, approximately $190,000 of onetime costs related to the CEO transition and restructuring and approximately $460,000 related to litigation settlements. Excluding these unusual items, SG&A expense would have been $6.6 million or 24.6% of total revenue compared to $6.2 million or 21.7% of total revenue in the third quarter of last year.

Reported EBITDA in the quarter was $198,000 excluding the CEO transition and restructuring costs, non-cash expenses associated with store closures and impairments and the litigation settlements, adjusted EBITDA would have been $5.3 million or 19.7% of total revenue. This compares to $3.8 million or 13.3% of total revenue in the prior year third quarter. The increased period-over-period was driven by a net reduction in the ADF deficit of $1.7 million compared to the prior year third quarter, offset partially by the quarterly decline in comparable store sales. A reconciliation of EBITDA and adjusted EBITDA to GAAP net income is included in our earnings release.

Depreciation and amortization expense in the quarter was $2.3 million, $801,000 less than the prior year quarter. Net interest expense in the third quarter was $1.3 million, roughly $104,000 higher than the prior year quarter, primarily due to the slight increase in the average effective interest rate.

The reported net loss in the quarter was $1.9 million or a loss of $0.11 per diluted share compared to a net loss of $421,000 in the third quarter of 2016 or $0.03 per share per diluted share. The CEO transition and restructuring expenses, store closure and impairment expenses and litigation settlements reduced reported net income in the quarter by $3.1 million or $0.18 per share. Excluding these costs, pro forma net income in the quarter would have been $1.3 million or $0.07 per diluted share.

Due to the non-cash impairments taken in the quarter and the resulting swing to an expected full year pretax net loss, our effective tax rate for the quarter was 45.7% compared to the prior year third quarter effective tax rate of 23.6%. We ended the quarter with approximately $900,000 of cash on the balance sheet and net debt of $99.5 million, $3.8 million less than the prior year quarter, reflecting net positive cash generated in the quarter. The $20 million revolver was completely undrawn at quarter end.

We ended the quarter in full compliance with all covenants under our amended credit facility. We have reported a leverage ratio of 4.04x compared to a maximum permitted leverage ratio of 5.25x and reported an interest coverage ratio of 5.01x compared to a minimum permitting coverage ratio of 3.5x.

In the current business environment we continue to believe that its prudent to maintain a conservative balance sheet. As such, we expect to use operating cash generated by the business and net proceeds from refranchising to further pay down debt. Based on our current growth plans and financial forecasts, we continue to believe that the expected cash flow from operations and refranchising and available liquidity under the amending credit facility and revolver are sufficient to fund our business and anticipated capital expenditures going forward within the financial covenants prescribed in our amended credit facility.

Based on our current information, we're updating our full year outlook for fiscal 2017 which ends on January 1, 2018. We continue to expect full year domestic system wide comparable store sales to decline in the range of mid-to-low single digits. We now expect domestic franchise new store openings of between 30 and 35 units for the year compared to previous guidance of around 40 units. We continue to believe that we could refranchise up to 35 company stores this year, but due to uncertainties around the exact timing we have not included any additional refranchising in our adjusted EBITDA or cash flow outlook.

We are increasing our guidance on expected full year selling, general and administrative expenses to approximately $30.7 million, including non-recurring costs of $5.1 million. This compares with previous guidance of approximately $30 million, including non-recurring costs of $4 million. We are reducing our outlook for adjusted EBITDA, which excludes non-recurring impairment store costs, closure costs and other non-recurring costs to be at least $19 million, compared with previous guidance of at least $20 million.

We are maintaining our outlook for cash to investing activities, CapEx net of cash proceeds from refranchising to be no more than $2 million. We are reducing our outlook for cash flow from operations less cash to investing activities to be at least $14 million compared to previous guidance of at least $15 million. We continue to expect our full year effective books tax rate to be approximately 34.3% and we continue to expect diluted share-count to be approximately $16.8 million.

I’ll now hand the call back to Weldon for closing remarks.

Weldon Spangler

Thanks Mark. After spending time over the last few months with many of franchise partners and team members, I am confident in our ability to return Papa Murphy’s to growth and prosperity, but believe we need to work with an even greater sense of urgency to support the success of our franchise owners.

Toward that end, we are taking actions to improve communications and engaging our people and franchise owners through a clear set of core values. We are singularly focused of stabilizing and growing comparable store sales by employing a set of strategies aimed at improving the quality and consistency of our products, improving key value perceptions, expanding our digital marketing footprint and making our products more convenient.

On the company side, we are committed to our refranchising strategy as the means to return to a 95% franchise mix as soon as possible and are taking steps to accelerate that transition.

We thank you again for your interest in Papa Murphy’s and look forward to updating you on our progress on future calls.

Homer, we are now ready to open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from Will Slabaugh, Stephens Incorporated. Please proceed with your question.

Will Slabaugh

Yes, thanks guys. In terms of getting out the value message that you mentioned earlier, how have you found that to be most effective? Should we think about that as being low cost, ROI driven, texting and email and maybe some POP or are there other loyalty or other means of breaking through that might be planned as well?

Weldon Spangler

Yes, so I think you called it definitely on the texting, on emails. I think also through we still have a very good television presence and POP is always a good one to get people’s attention especially when they are driving by. So it’s all of those things and we think we have some really good products that we can help drive that value message, because it’s just a – the XLNY is just a great product, it’s a good price point and people feel good about it because it’s such a large great pizza.

Will Slabaugh

And when you talk to your franchisees about value and I’m sure they realize that it’s obviously a very competitive market out there in terms of price point. What’s your typical feedback there throughout your conversation that you’ve had here recently. I’m curious if they are wanting to get more aggressive with value and how they want to do that?

Weldon Spangler

Yeah its – that’s a great question. It’s a mix of wanting to be aggressive without really a major impact on profitability. So when we are dealing with the franchise owners, it’s a delicate balance of hitting the right price point, the right quality and the right message out there. So it’s – we spend a lot of time talking about it. We spend a lot of time looking at the competition, talking with the franchise owners, really about the business environment in general and helping them to understand it. We want to protect their profitability and drive transactions, and there is not an easy answer to that. I think of it as a delicate dance.

Will Slabaugh

Got it, and one more if I could around the model. I’m curious what CapEx looks like, as we get into this 95% franchise model. What an ongoing sort of maintenance number might look like if we strip out some of the other moving pieces over the last couple of years. Because you guys have continued to print a decent amount of operating cash flow that continues to be there and obviously that’s going to be a lot more stable once it becomes 95% franchise. I’m just curious what a cash flow number might look like once we get to a run rate?

Mark Hutchens

Yeah so, we talked about it being no more than $2 million this year. We haven’t given specific guidance on that, Will. I know you’d like something specific for your model. I think its $1 million to $2 million range.

Will Slabaugh

That’s helpful. Thank you.

Operator

[Operator Instructions] Our next question is from Jon Tower, Wells Fargo. Please proceed with your question.

Jon Tower

Yeah, my questions, just a few. First on the G&A cut related to new store development with franchisees, just curious to think about how we should consider franchised unit growth going forward in the context of obviously having to absorb or at least trying to absorb 100 company refranchise stores for the next however many years?

Weldon Spangler

Yeah, so we haven’t given specific guidance. I would expect to be in a position to give more specific guidance in one of the conferences in early January. I would say that we had excess capacity for the units that we will open this year. You know, so I think we took it down to a capacity that would probably not quite support the number of units that we opened this year, but you know broadly speaking consistent with that though not ready to provide specific unit projects for next year this time.

Jon Tower

Okay and then just on the incentives tied to refranchising, obviously you’ve done 2017, seven stores so far. Just curious to know what sort of incentives these franchisees are getting to pick up the stores as a royalty abatement. Is there less marketing tied to it in the early years. Can you just maybe speak to what you are doing?

Weldon Spangler

Yeah, right now we don’t really have any incentives. For the stores that we refranchised to-date, we sold them, but we thought was a fair price to our franchise owners that wanted to get scale in our market. Now that may be different as we think about some of the markets where we’ve gone out and gotten them to what I call the minimum level of penetration. You may see some incentives that are more closely approximate, the incentive program that we put out for a franchisee coming in and scaling a new market from ground zero. But for the stores in the more mature markets, they are really just cash flow transactions.

Jon Tower

Okay, and then just lastly in terms of sticking on this line of incentives, are you having to do anything with the franchise, the existing franchise base in order for them to adopt some of the initiatives that you are pushing through. For example, going more aggressive after value or you know transitioning more sales to the digital platforms; anything you can offer there?

Weldon Spangler

No, I mean we are getting there by and because we are testing it and we are seeing these results and they want ultimately to drive more sales and make more money, which is exactly what we want for them also.

Jon Tower

All right, thank you.

Weldon Spangler

Yep.

Operator

Ladies and gentlemen, we have reached the end of the question-and-answer session and I would like to turn the call back to Weldon Spangler for closing remarks.

Weldon Spangler

Thank you, Homer. Thank you everybody for attending today. We appreciate your support and your questions and look forward to updating you in the future and next quarter.

Operator

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation. Have a great day.

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