Pizza Pizza Royalty's (PZRIF) CEO Paul Goddard on Q4 2017 Results - Earnings Call Transcript

Pizza Pizza Royalty Corp. (OTCPK:PZRIF) Q4 2017 Results Earnings Conference Call March 1, 2018 9:00 AM ET

Executives

Christine D'Sylva - Vice President of Finance and Investor Relations

Paul Goddard - President, Chief Executive Officer

Curt Feltner - Chief Financial Officer

Analysts

Derek Lessard - TD Securities

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Pizza Pizza Royalty Corp. 2017 year-end results conference call. During the presentation, all participants will be in a listen-only mode. After the speakers' remarks, we will conduct a question-and-answer session. [Operator Instructions]. As a reminder, this conference is being recorded on Thursday, March 1, 2018.

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

Christine D'Sylva

Thank you Denise. Good morning everyone and welcome to Pizza Pizza Royalty Corp.'s Earnings Call for the fourth quarter and year ended December 31, 2017. Joining me on the call today are Pizza Pizza Limited Chief Executive Officer, Paul Goddard and Chief Financial Officer, Curt 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 relating to non-IFRS measures mentioned today. As a reminder, during the question-and-answer, we will only take question from analysts. Shareholders and investment advisors are welcome to contact us after this call.

With that, I would like to turn the call over to Paul Goddard for our business updates.

Paul Goddard

Thanks Christie and thanks everyone for joining our call this morning. Geographic diversification of our tow brands have historically produced stable sales growth and this was the case again this year. Pizza Pizza Royalty Corp's royalty pool sales increased 0.7% to $143.7 million in Q4 from $142.7 million in Q4 last year. For the year, royalty pool system sales increased 1.1% to $551.1 million from $544.9 million in 2016. This sales growth is solely attributable to the net 15 restaurants added to the royalty pool on January 1, 2017 as same-store sales growth ended the year down slightly at negative 0.1%. Our relatively flat annual results reflect a macro driven comparable sales decline in parts of Western Canada offset by comparable sales growth in other parts of the country.

Pizza 73, operating largely in Alberta, contributed 15% of this year's royalty pool sales but reported a decline in same store sales of.6% in Q4. Pizza Pizza, operating largely in Ontario and Quebec, reported minus 0.1% in Q4. So same store sales of the two brands combined in Q4 was minus 0.7%. And for the full year, Pizza Pizza, again operating largely in Eastern Canada, reported 0.2% same store sales growth for 2017, lagging the 3.3% in 2016. At Pizza 73 meanwhile in Western Canada, same-store sales decreased 2.2% in 2017% compared to 5.2% decrease in 216. So Pizza 73 continues to be negatively impacted by the weakened Alberta economy and an increased competitive environment.

Though we still have work to do, we are currently developing new marketing initiatives that we believe will help build momentum for improved result in 2018. And that's for both brands. Royalty pool sales have grown consistently over the past seven years. This consistent growth has enabled Pizza Pizza Royalty Corp. to increase shareholder dividends seven times in six years including the last dividend increase back in June 2016. The monthly dividend has grown over 20% in the past six years. Additionally, the company has accumulated a healthy $5.1 million reserve to support the dividend in the event of any short-term pressure on future same store sales growth.

Let's now look at Pizza Pizza Limited's restaurant operations, which is the underlying strength supporting the royalty pool's sales growth. You will recall, Pizza Pizza Limited is the private company which leases and operates the Pizza Pizza and Pizza 73 brands and pays a monthly royalty to Pizza Pizza Royalty Corp. for use of the brand. Pizza Pizza Limited's mandate is to grow and protect the brands. Growth priorities include maintaining our brand dominance, modernizing the customer experience and staying relevant to our consumers. We believe these key priorities align with evolving consumer needs and will drive long-term sustainable growth, especially when combined with our competitive advantages of convenience, innovation, high quality menu offerings and our geographic diversification right across Canada.

Our marketing campaigns using print, digital and media buys, engage customers consistently throughout the year. We stay top of mind by employing multiple strategies including new product introductions, limited time only offerings, a variety of contests like the Raise a Slice contest, for instance, which celebrated Canada's 150th anniversary and Pizza Pizza's 50th anniversary which we are very of. These strategies reengage our customer base and work to increase customer visit frequency.

We also leveraged our main sports partnerships throughout the year, including the Raptors, the Leafs, Toronto FC, the Flames, the Oilers, the Fence, the Hounds, the Winnipeg Jets and many others as well, not just in the major leagues, but also some lower leagues and junior leagues and things. Pizza sold in these venues enhanced our brand dominance and reinforced our leading market share positions. And one of our marketing campaigns last year showcased our high-quality menu and reminded customers that quality ingredients do matter and you will see more of this going forward but just to give you a few examples here.

Our pizzas are made with 100% Canadian wheat and durum semolina and we have multigrain and popular gluten-free options as well. As well, all of our pizzas are topped with the best offerings in the market made from 100% vine-ripened tomatoes. We truly believe they are best-in-class. As well, we feature not only traditional mozzarella cheese but also dairy free vegan cheese which has really taken off and we are a real leader with that one. Our quality toppings include kalamata olives, real kalamata olives, unlike some people, sent from Kalamata, Greece, sun-dried tomatoes, fire-roasted peppers, amongst many other toppings. We have 50-odd toppings, across our brands. Also, our best-in-class wings, bites and real chicken toppings are from chickens raised without antibiotics, also unique in the industry. And of course, none of our products contain artificial flavors or colors, MSG or added trans-fats. And I think you will see us going forward emphasizing this aspect even more. It's sort of a very, very key advantage we have over some others that maybe go for cheap and cheerful. We believe in quality.

In addition to our quality messages and new product introductions, growing same-store sales requires balancing traffic count and retail sales prices. During the year, Pizza Pizza celebrated its 50th anniversary by rolling back some prices to award customers for their years of service. Price points such as our 11-11 pizza promo and our $1.50 Slice and a Coke fundraising game was well received by customers. These value offerings throughout the year were well received by customers however they also slightly decreased the average customer check.

Our brands have historically led the Canadian pizza industry in technological innovation. And to remain the leader, Pizza Pizza Limited is committed to consistently funding tech innovation in going forward as well. Doing so gives our brand the competitive edge, especially over the smaller independent pizza operators. Customer orders placed through our array of digital ordering platforms, now account for over 50% of all delivery and pickup orders. This reduces restaurant operating cost and manual labor while providing customers greater convenience in ordering. Additionally, our Club 11-11 royalty program is available on all digital platforms, unique in the industry, fully supported by market campaigns and we continue to evolve that program investment. Our investment in technology continues in 2018 as well. We currently are well underway with several strategic projects including finalizing our ERP software implementations, so stay tuned.

Looking at new restaurant development. For the year, PPL opened 26 locations, 14 were traditional restaurants and 12 were non-traditional locations. Of the 14 traditional openings, six were Pizza Pizza restaurants opened in Quebec, Ontario and Manitoba. Eight traditional Pizza 73 restaurants were opened, including six in Alberta, one in Saskatchewan and the first location up in Yukon in Whitehorse. PPL closed 18 locations, eight of which were traditional Pizza Pizza and 10 were non-traditional locations.

And one final one on restaurants, early in 2017, Pizza Pizza kicked off it's systemwide restaurant reimaging program to significantly modernize its store ambiance and customer experience. We have completed close to 50 locations now and expect to complete the program in three to five years. And by the way, Pizza 73 will also be part of that initiative, so it's nationwide across our brands. In 218, the total number or restaurants are projected to increase 2% with growth to come from a continuation of the national expansion strategy.

At both our brands, as many provinces increased minimum wage, 2018 marketing strategy is a little bit structured to guard restaurant profitability while also driving customer traffic to our restaurants and also to our wide array of digital ordering platforms, as I mentioned earlier.

In closing, I want to thank our employees, franchisees and our partners for their hard work, passion and their unwavering dedication to our brands.

And with that, I will pass the call over to our Chief Financial Officer, Curt Feltner, for a financial update.

Curt Feltner

Thank you Paul. Yesterday evening, Pizza Pizza Royalty Corp. released its fourth quarter and full-year financial results. Before discussing the details of the financial results, I feel it's helpful for investors to understand the company's royalty organizational structure, especially for our new investors.

The company's main assets are the Pizza Pizza and Pizza 73 trademarks and brand-name which are held by its subsidiary Pizza Pizza Royalty Limited partnership. So the partnership has two partners, which is Pizza Pizza Royalty Corp. and also Pizza Pizza Limited, a private company. We are a topline royalty corp which means we earn a monthly royalty calculated as a percentage of royalty pool system sales generated by the Pizza Pizza and Pizza 73 restaurants in the royalty pool. Restaurants are operated by Pizza Pizza Limited and the Royalty Corp. is not exposed to these restaurant operations.

So now turning to the company's financial results, starting at the top with royalty pool sales. For January 1 of each year, the number of restaurants in the company's royalty pool is adjusted by the net restaurants opened by Pizza Pizza Limited in the prior year. So in January 2017, the royalty pool increased by 15 restaurants to 751 restaurants. In exchange for the additional royalties from these new restaurants, Pizza Pizza Limited's exchangeable shares as a percentage of fully diluted shares increased to 21.1% from 20.4%. Pizza Pizza Royalty Corp.'s royalty pool sales increased 0.7% to $143.7 million in Q4 and increased 1.1% to $551.1 million for the year. As Paul mentioned, sales growth is totally attributable to the net 15 restaurants added to the royalty pool on January 1 since the other sales drive our same store sales growth ended the year down slightly at 0.1% negative.

So now turning to the statement of earnings. For the Royalty Corp., as I mentioned, the partnership receives royalty income monthly from Pizza Pizza Limited based on topline restaurant sales and the partnership is ultimately consolidated into Pizza Pizza Royalty Corp.'s financial reporting. Royalty income earned by the partnership increased 0.4% to $9.3 million for the quarter and increased 0.8% to $35.6 million for the year. A 6% royalty was earned on $121.2 million in system sales from the 651 Pizza Pizza restaurants reporting for the quarter and the Pizza Pizza restaurants reported $456.2 million for the year. At Pizza 73, a 9% royalty was earned on the royalty pool of 100 Pizza 73 restaurants reporting $22.5 million in system sales for the quarter and $84.9 million for the year.

So using this royalty income, the partnership paid administrative expenses and interest expense before making partnership distributions. Admin expenses for the year decreased slightly to $645,000 from $678,000 in 2016. And just as a reminder, admin expenses are incurred at the partnership level and consist of directors' fees, audit, legal and public reporting fees as well as directors' and officers' insurance. The Royalty Corp., as a reminder, has no employees. In addition to admin expenses, the partnership pays interest expense on its $47 million credit facility. The actual interest paid was $332,000 in Q4 and $1,316,000 for the year, which is relatively unchanged from 2016. The interest rate was 2.75% for both years and it's hedge through to the credit facility's maturity date of April 2020. Interest expense on the statement of earnings differs from actual interest paid due to hedge accounting. A full interest expense reconciliation could be found in the company's MD&A.

So now, after the partnership receives the royalty income, pays admin and interest expense, the net cash is available for distribution to its partners based upon the ownership percentages. Pizza Pizza Royalty Corp. owns 78.9% of the partnership distributions at December 31, 2017. So after deducting amortization of the rights and marks from its share of the partnership distributions, the Royalty Corp. pays corporate income tax. Current income tax for the quarter was $1.5 million compared to $1.6 million in the same quarter last year. For the year, current income tax was $5.8 million compared to $5.6 million in 2016. The tax expense in the year increased due to a slight increase in royalty income plus the fact that the available tax amortization on undepreciated capital assets has decreased on a declining basis.

Earnings for the quarter increased 1.6% to $6.9 million from $6.8 million in the comparable quarter last year. The increase in earnings resulted from an increase in royalty income and from a decrease in admin expenses and taxes. For the year, earnings increased to $27.1 million from $26.7 million in 2016. In addition to IFRS earnings, management considers adjusted earnings from operations to be a more meaningful measure in evaluating our company's performance and a truer indication of cash available for dividends. Adjusted EPS for the quarter increased 0.7% to $0.233 per share when compared to the same period in 2016. And for the year, adjusted EPS decreased 0.1% to $0.894 for the year compared to 2016 and this decrease is directly related to the flat same-store sales growth. So as a reminder, please refer to the company's MD&A for a full reconciliation of regular earnings to adjusted earnings.

Now just in the final note for shareholder dividends paid on a monthly basis. In the quarter, the company declared shareholder dividends totaling $0.2139 per share, which is unchanged from the prior year comparable quarter. Payout ratio was 95% for the quarter and 96% in the same quarter last year. For the year, the company declared shareholder dividends of $0.8556 per share, compared to $0.8476 cents per share for 2016. The payout ratio was 101% for the year compared to 99% in the prior year. The company had targeted a 100% payout ratio in 2017. The dividends, for federal tax purposes the dividend is considered a taxable eligible dividend.

The company's working capital reserve is $5.1 million at December 31, which is a slight decrease of $119,000 since December 31, 2016. The decrease in the reserve was the result of the relatively flat adjusted earnings, coupled with an increase in the dividend, which was effective in mid-year of 2016. With this reserve in place, the company will continue to target an annual payout ratio of 100% for 2018 since the company has no employees or capital expenditure requirements and has no mandate to retain cash.

That concludes my financial overview. Thank you for joining the call. I will now turn the call back to our operator, Denise, for questions.

Question-and-Answer Session

Operator

[Operator Instructions]. Your first question comes from Derek Lessard from TD Securities. Your line is open.

Derek Lessard

Good morning everybody.

Paul Goddard

Good morning.

Derek Lessard

Good morning. Just wondering, aside from the slower pickup in economic activity in Alberta, just wondering if you can point to any other drivers of the weaker sales performance there?

Paul Goddard

Aside from the economic backdrop, you are saying?

Derek Lessard

Yes.

Paul Goddard

I guess it still continues to be the biggest factor, I think, Derek. But I think overall, I will say there is heightened competition is one area and also the advent and we talked about this before of the third-party delivery services. So I think those are two impacts. They are two additional factors on top of the economic backdrop.

Derek Lessard

Okay. And that's happening in Alberta as well, right?

Paul Goddard

Yes, definitely.

Derek Lessard

Okay. And just maybe a follow-up on that. Like where are you in terms the initiatives to boost the sales there? And then, I guess I am pointing specifically to the lunch openings and those initiatives that you guys have started to put in place, I would say, about a year ago?

Paul Goddard

Yes. Well, we certainly continue have large success with driving lunch as a day part, for sure. We have also launched what we call, solo pizzas, single pizzas. So we are covering the market, not only the lunch day part but the different demographics, I think, a little more thoroughly now. And that's really been encouraging so far. And we also have had other successes, like our Android app. We only historically had an iPhone app with Pizza 73 which is tremendous tool. But now we have an Android app and it's mixing really well. So that's additional new customers, it's not just cannibalization of the existing customers impacting receipt. So there is a bunch of things going on in parallel that, again, we are not pleased, obviously but we do think that some of the things we have done and continue to do will start to bear fruit.

Curt Feltner

Derek, we are seeing some bright spots in some of our areas that are, say, heavily influenced by the oil and gas weakness, some of the Grand Prairie's and Fort McMurray's. Those sales were seeing some relatively positive improvements which is a good sign. We do have a very strong underlying belief in the strength of this brand. It's number one in Alberta. Competition is there, always there. But in this past year, we opened up eight Pizza 73 restaurants and as Paul mentioned, our first one up in Yukon. So we plan to continue expanding and waiting, I guess, a little bit more for the economy. We are seeing some weakness, maybe in capital expenditure projections for 2018 there in Alberta. So there is still weakness but we still are number one brand strength and our marketing is going to be strong. We do see some projections for positive GDP for 2018. So that's a good positive sign.

Paul Goddard

Yes. And just to echo Curt as well, Derek, the tech innovation in general, right across both brands, we are continuing as far as the operating. We know it's a major competitive advantage for us and we are going to absolutely double-down on that. It's already achieved success. The new restaurant growth is a definite benefit. And also, we invested in a new commissary there in Beddington, which is a massive operational supply chain enhancement, okay. And that's just being finished. So we are taking this opportunity to reinvest heavily and really go on offense, not through punching our horns, play it safe, hold our guards up. We are definitely going off on an offense right now, especially when others are pulling back. Despite lackluster sales, for sure, we are never happy when we see that. Out there, I have to say, I think the barometer of our partners out there, our JV partners that run these locations, it's actually very high. Their dividend or profits aren't as high as they have been, okay. But we are in great financial shape out there at unit level and that's something that's unique in the industry out there whereas a lot our competitors even if they are being aggressive and building the stores, most of them have traditional franchise model with significant leverage. In this tough environment, with minimum wage and whatnot increasing, we believe that certain people that have bigger lungs, if you like, to weather the storm and in fact it may be an advantage to us.

Derek Lessard

That's very good color, guys. Thank you for that. I guess maybe coming back to your tech comment. I was just wondering how much room you guys think you have to leverage the tech into higher sales? I think you mentioned, Paul, 50% of all delivery was now done on the app. I don't know if I got that wrong. But I was just wondering.

Paul Goddard

Yes. That's right. In fact, it's really all channels, all ordering from our customers, basically, it's over 50%, basically because we have a lot of pickup and pre-orders which we are also leveraging because most people don't have an app where you can actually pre-order and get mobile pickup and express menu. And this is what a lot of small independents don't have, even large chains, really, except for a small number. And we believe our apps are better. So we definitely, you are right, hitting the nail on the head there. We are definitely doing things that will not only drive that channel for the sake of driving digital, but what we are trying to do and we think we can do a better job going forward is to drive the check in those digital channels so that it's actually superior to our non-digital channel, right. And that's actually a challenge you have got to be really smart about how you do that but we think that we can get more check. And in some cases we are and in some cases we are maybe not. So we think if we really do it right in how to use our digital analytics and whatnot more thoroughly, we will have a massive architectural advantage as well with our data warehouse, unique in the market, I believe, that once we are now where we think can harness that, that should really result in that check going up on the digital side as well.

Derek Lessard

I know it's early stages. Have you guys been able to harness some of that data that you have been getting?

Paul Goddard

We have. I think with our ERP project now being done, that was a little bit of a missing link for some aspects of our business. I don't want to give too much detail but just to be open, that was kind of the one missing link and now that last puzzle piece is kind of in the slot it kind of rounds out our entire architecture where we have invested heavily for years. So now we really feel that we can really get going on this stuff and leveraging all sorts of, what we feel, are analytical in-house advantages, proprietary advantages using unique software and intel and BI, business intelligence type tools and things. So we really have to get going on that. But we know we are sitting at the top of this massive gold mine of data and we have already done some things but I do feel we are only at the tip of the iceberg. So I think it's pretty exciting how we leverage that going forward.

Derek Lessard

Okay. And maybe just switching gears. I am wondering, like how much of a lift you have seen in the 50 or so locations that you said have been reimaged? And then maybe just a follow-up to that, I was just wondering have you started on the Pizza 73 reimaging?

Paul Goddard

Not really. As we speak, as we are building our new locations, we certainly are designing around that. But the Pizza Pizza sites are definitely far ahead, okay. We also kind of do have already a more modern base look already for the new 73s we built in recent times. So it's not like we have to completely reimage, let's say, as much there, okay. But we do intend to improve that. And that's just getting underway because frankly it's been very busy with the Pizza Pizza side and we prioritized that initially because our existing Pizza Pizza look was really in need of an overhaul, right. So basically that's where we have close to 50 Pizza Pizza side. But even new locations of even Pizza 73 this year, they all have all a very contemporary look as well. So you will just see more of that happening. In terms of the lift, yes, it's kind of early days. I would like to see a little more time pass, but definitely we need to have that ROI. And of course, it helps us if our franchisees and partners are the best ambassadors saying, hey, you know what, I saw the lift, I made an investment of X dollars and I am getting that lift. So that's incumbent on us to get that and we do feel that the way we are doing it, we are not just trying to do a cosmetic sort of overhaul. We are trying to also offer them with some real unique advantages of doing that overhaul in terms of either operationally or using tech or marketing, et cetera. So it's more how and why of doing that refresh that will get us the sale. And some of that is still evolving, okay. But we have been encouraged, I would say, by the redesigns.

Derek Lessard

Okay. And maybe just one final one for me. On the Pizza Pizza banner, just wondering where you guys are seeing the biggest pressure?

Paul Goddard

You mean where, geographically or more to a channel? I would need more --

Derek Lessard

I guess I would say, I am talking about sales pressure, like whether it's from third-party, is it from increased competitive behavior from other big pizza brands? Just wondering where all the pressure is coming from?

Paul Goddard

I don't want to point to any one thing. And I think it does depend where, I would say, just overall, there is definitely heightened competitive activity for sure across the board. I guess, it just always gets more intense. And we like our position there. But is certainly isn't getting any easier. And I think that third-party delivery element, we are definitely going to school on that which is a very disruptive channel. By the way, not all necessarily downside. So we look at it, we don't ignore that channel. We can't afford to. And we have done some limited piloting and things with some of those folks. So we prefer organic, what we call oven to doorstep. We like to control our brand and control the customer experience. That's absolutely what we prefer and we are great at it. We believe we are the experts, but to ignore that other channel or those channels, it is potentially, it could be viewed as a customer acquisition channel as well, albeit a more expensive one and you can see the industry in general, I would say, reacting, almost overreacting in a way, but you see people flooding on to these platforms, especially people that don't have the organic strength we have. So we are kind of experimenting with it and we will see. So I think they are having an impact and it's not all negative. It's somewhat negative and maybe taking away because every restaurant now is a competitor of ours. But on the other hand, we are also access new customers that use these platforms. And so people like us may be able to scale that to our advantage more than others. So it's a double-edged sword.

Derek Lessard

Okay. Do you think you guys are first of mind when you are on those channels? I am talking relative to, you did have your own distribution or your delivery channel. But do you think that you are first of mind when it comes to, like the other competitors out there, whether it be a burger offering or Chinese or what have you?

Paul Goddard

I don't have to start and say that we are the leader in that, I think we are probably in there. I think we are looking at all the data. And I think, look, all of these people are growing their sales through it but it also puts pressure on margins. It's an expensive channel. I actually had a question on the entire business model of the third-party delivery services right now because it might be lucrative for them but the commissions they are charging to all their restaurant customers and QSR, i.e. us and others are very, very high, especially with things like minimum wage happening. So frankly, I don't know sustainable it is at this commission level, but it is disruptive and those people are growing. Maybe they are not growing profitably, these third-party people, but I think they are here to stay and they are going to get better at it and I expect commissions will actually come down over time as others enter the market, potentially people like Google and Amazon. So we will see. So I think we are top of mind for people that are thinking about pizza. We are on there. And we are significantly on there. It's more of a pilot mode right now, but we are learning a lot right now.

Derek Lessard

Okay. That's it for me. Thanks for answering my questions, everybody.

Paul Goddard

You are welcome. Good questions. Thanks Derek.

Operator

[Operator Instructions]. And there are no further questions queued up at this time. I turn the call back over to Christine D'Sylva.

Christine D'Sylva

Thank you Denise. Thank you everyone for being on the call today. If you have any questions after the call, please feel free to contact us. Our information is on the earnings release on our website. Thank you and have a great day.

Operator

This concludes today's conference call. You may now disconnect.