Papa John’s International, Inc. (NASDAQ:PZZA) Q2 2023 Earnings Call Transcript

Papa John’s International, Inc. (NASDAQ:PZZA) Q2 2023 Earnings Call Transcript August 3, 2023

Papa John’s International, Inc. reports earnings inline with expectations. Reported EPS is $0.59 EPS, expectations were $0.59.

Operator: Good day and thank you for standing by. Welcome to the Papa John’s Second Quarter 2023 Conference Call and Webcast. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. I would now like to hand the call over to your speaker today Stacy Frole. You may begin.

Stacy Frole: Good morning, and welcome to our second quarter earnings conference call. This morning, we issued our 2023 second quarter earnings release. A copy of the release can be obtained on our Investor Relations website at ir.papajohns.com under the News Releases tab or by contacting our Investor Relations department at investor_relations@papajohns.com. On the call this morning are Rob Lynch, our President and CEO, Ravi Thanawala, our new Chief Financial Officer; and Chris Collins, who previously served as our Interim Principal Financial and Accounting Officer. Before we begin, I need to remind you that comments made during this call will include forward-looking statement within the meaning of the federal securities laws.

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These statements may involve risks and uncertainties that could cause actual results to differ materially from these statements. Forward-looking statement should be considered in conjunction with the cautionary statements in our earnings release, and the risk factors included in our SEC filings. In addition, please refer to our earnings release for the required reconciliation of non-GAAP financial measures discussed on today’s call. Lastly, let me thank you in advance for asking only one question and getting back in the queue for more follow up. Rob?

Rob Lynch: Thank you, Stacy. Good morning, everyone, and thanks for joining us. Before we get started, I want to take a moment to welcome Ravi to the team. We look forward to leaning into his vast experience in finance and operations with global consumer brands as well as his international expertise. Most importantly, his passion for fostering collaboration and building high performing teams makes him a great addition to our leadership team. I also want to thank Chris Collins for stepping up and leading our financial team and being a strategic thought partner during this period of transition. Thank you, Chris. As you read in our earnings release this morning, we are pleased with a solid execution that our teams have demonstrated and what continues to be a challenging operating environment.

We know that we cannot control inflation or our customer spending behaviors, but we can control how we execute our operations to drive a better customer experience and better margins, how we create and introduce new menu innovation to expand our customer base and increase frequency and how we utilize our data to drive insights and revenue management strategies to optimize all sales channels. I’d like to particularly call out our domestic company restaurant performance, as we focused on faster service enhancing operational efficiencies, and effectively managing margins coming out of the pandemic. These efforts combined with the continued success of our menu innovation and advancements in our revenue management capabilities are producing results.

As our company owned restaurants achieve 2% comp sales growth in the second quarter and year-over-year margin improvement above and beyond the benefits of moderating food costs. The level of discipline that our teams and franchisees have implemented into our operations over the past year is remarkable. We’re also receiving external recognition for these efforts as the American Customer Satisfaction Index scores recently ranked Papa John’s as number one in guest experience in the pizza category and in the top five for all fast food restaurants. This recognition is further evidence that the operational improvements that we are making are building a solid foundation that is paying dividends today and will continue well into the future. However, the solid performance by our company-owned restaurants was not enough to offset the lower than anticipated comps, our domestic franchisees experience during the quarter.

Our teams have been partnering with our franchisees to find ways to drive business improvements in an ever-changing consumer environment. We have identified three core areas of opportunities for our franchisees, including modifications to their revenue management strategies, leveraging best operating principles, and deploying marketing optimizations. Our franchisees work to make the appropriate adjustments and they saw sequential improvement throughout the quarter and delivered positive comps by the end of June. More importantly, these positive trends have accelerated into the third quarter in both our company owned and franchise restaurants, giving us confidence we’ll produce positive comp sales in the back half of 2023 and over the longer term.

Now let’s dive a bit deeper into some of the key drivers of our improving North America sales trends and restaurant level margins. I’ll start with menu innovation. A key component of Papa John’s strategy is our winning menu innovation pipeline. In May, we launched our new proprietary menu offering Doritos, Cool Ranch, Papadia, in partnership with Pepsi and Frito Lay. And with a $7.99 price point, it is a great value. This launch generated a significant amount of buzz and additional traffic to our digital channels. In fact, we saw double-digit growth in digital sessions at the start of the promotion. Following this successful launch, our franchisees experienced improving weekly transactions while ticket remained consistent with the prior year.

Several weeks after introducing Doritos, Cool Ranch, Papadia, we brought our barbell strategy to life by also promoting our popular extra large New York style pizza at an attractive $12.99 national price point. This layered approach to our national promotions contributed to the positive franchisee comparable sales that we began to see by the end of the quarter and to our overall higher sales this past month. Continuing with our menu innovation, we recently expanded one of our most popular pizza platforms, Stuffed Crust. Our new limited time Garlic Epic Stuffed Crust Pizza, which launched nationwide this week is another example of how we are leveraging our brand equity of better ingredients, better pizza. Garlic Epic Stuffed Crust is layered with garlic, one of the ingredients for which Papa John’s is best known in three different ways, inside the crust, on top of the crust, and on the side with our signature garlic dipping sauce.

We’re also taking this offering up a notch with the introduction of spicy Garlic Epic Stuffed Crust at the end of this month to keep the momentum going. Another key driver of our improving sales is our back to better operation strategy, which focuses on introducing best in class unit level productivity and operational excellence initiatives across all of our restaurants. Faster out the door times that our company owned restaurants were an early win for us, and they continue to improve down more than 25% from where we were a year ago. As I previously mentioned, faster delivery ensures our products are hot when they arrive, which is the number one driver of product satisfaction for pizza. Our company owned restaurants we’re also reducing make times while delivering continuous improvement in product quality, order accuracy and labor allocation.

These efforts are not only driving comp sales, but are also increasing restaurant margins. Finally, our revenue management team remains focused on driving incremental sales by offering every customer the right product at the right price, at the right time in the right channel. During the second quarter, a gap remained between the performance of our company restaurants and that of our franchisees. Over the past year, our franchisees have been increasing their prices at a faster rate than our company-owned restaurants in an effort to preserve margins during this highly inflationary period. As a result, they have experienced a larger decline in transactions relative to our company-owned restaurants this past quarter. We’ve been performing ongoing business reviews with each franchisee, utilizing cross-functional teams to enhance their business operations, along with identifying opportunities to optimize their pricing and promotional models.

This surgical approach is delivering sequential improvement in transactions and higher customer satisfaction rating system-wide. We are pleased with the progress we have made to date, and with more than 85% of our transactions taking place through our digital channels, we see additional opportunities to close the gap by leveraging the data and consumer insights at our disposal to optimize our pricing strategies across the system. One more area of growth that I would like to highlight today is our aggregator model and its channel offerings. To give you some history, we were the first national pizza chain to holistically partner with the leading aggregators, giving us significant experience, deep expertise, and strong capabilities in this channel.

Today, we remain competitive on price, while still garnering margins comparable to our organic delivery business. Maintaining a strong value proposition in what is an increasingly competitive consumer environment in these marketplaces has consistently delivered growth quarter after quarter. We feel good about the opportunity to continue leading in the aggregator channel as our entire system embraces the model as a key driver of transaction growth. Going forward as these marketplaces bring on additional offerings, attracting even more customers, we’re excited about the broader opportunity presented to Papa John’s to continue to capture a new demand. We expect to deliver positive North America comps in the back half of 2023, but do not believe it will be enough to offset the softness already experienced by our franchisees in the first half of the year.

As a result, we’re adjusting our fiscal 2023 North America comp expectations to flat to up 2%. On a longer term, more normalized basis we remain confident in our ability to grow North America comp sales between 2% and 4% annually, and are not changing that long-term guidance. In our international business comps were down 1% from last year, which primarily reflects declines in the UK, our largest international market. However, we are pleased with the improved relative performance in the second quarter in the UK as we implement best practices developed within our domestic market, including marketing investments, specifically in the aggregator channels, menu innovation, and operational improvements. Excluding the UK, our international comp sales for the second quarter were positive, driven by strength in our Asia and Middle Eastern markets.

This strength is also translating into accelerated unit development, as we have announced significant long-term development agreements within both of these markets. In June, we established a company-owned restaurant portfolio in the UK with the acquisition of 91 restaurants. We also recently acquired 27 additional locations in July, bringing our total ownership in the UK to 118 restaurants. I recently visited these locations and after meeting with our leadership team and those in the field, I’m excited about the long-term growth potential of these restaurants and the holistic UK market. We continue to make strategic investments across our international organization and infrastructure. It’ll take some time, but our investments in IT to support sales through improved capabilities like e-commerce, loyalty and revenue management are setting our global franchisees up for sustainable long-term success, which brings me to the final topic I’d like to discuss today unit development.

When I first joined Papa John’s in 2019, I highlighted one of our strategic priorities was to profitably expand our footprint domestically and internationally. At the time, we were experiencing negative domestic unit growth in 2018 and 2019, and due to the pandemic, we only opened five net new restaurants system-wide in 2020. Since that time, we have significantly improved our AUVs and restaurant level profitability. Signed some of the largest development agreements in company history and continued to accelerate new unit growth. This drove some of the highest system-wide net new unit openings in company history in 2021 and 2022, and in 2023, we are tracking to a record year as we remain unscheduled to open between 270 and 310 net new units.

At the midpoint, this is a 5% increase in total system-wide units. At the beginning of 2022, we introduced a new multi-year development goal of 1400 to 1800 net new units between 2022 and 2025. This implied global net new unit growth between 6% and 8% for fiscal years 2023 through 2025. Since we put these targets in place, we have experienced many unforeseen circumstances, including but not limited to an extended war in Ukraine, material inflation around the globe, permitting and construction delays within North America and higher financing costs due to the interest rate increases. Despite these various challenges, we continue to remain confident in our ability to meet our long-term expectations as our global pipeline continued to grow. This was supported by our most recent announcement of 650 new restaurants in India over the next 10 years.

We know that the investments we’re making in strategies we are executing today will enable us to capitalize on the significant white space we see all around the world, but we also recognize that there are still some near-term headwinds that continue to persist and therefore our rate of growth may be slightly lower than our initial target. As a result, we’re resetting our long-term net new unit growth rate from a range of 6% to 8% to an annual range of 5% to 7% going forward, which remains at a very healthy level. This new guidance would imply a net new unit range of 1,150 to 1,400 units between 2022 and 2025 compared with the original guidance of 1,400 to 1,800 net new units I mentioned earlier. Ongoing, we will continue our rapid pace of development to take advantage of the global white space that we see.

Before I turn the call over to Ravi, I want to reiterate the strength of our business model as demand for Papa John’s remains high driven by our innovative pipeline and our better ingredients, better pizza brand positioning. Although 2023 will once again be a record year of system sales, we have seen some near-term challenges in the first half of the year driven by macro pressures and difficult comparisons. Despite these challenges, we are confident heading into the second half of 2023 and over the long-term. Our back to better strategy coupled with our product offerings and our strong unit growth plan, both domestically and internationally, positions us well for the future. We have an extremely strong team in place to execute on our strategy and the future is bright.

Now, I’d like to turn the call over to Ravi.

Ravi Thanawala: Thank you, Rob, and good morning everyone. I’m excited to have the opportunity to talk with you today. While I’ve only been here for a couple weeks, I’m pleased to be able to say that what I saw from outside the Company is being validated with every conversation I have. Papa John’s is a differentiated brand with a robust pipeline of menu innovation and significant amount of white space for new store growth both domestically and internationally. I’m excited to partner with our marketing and insights team to activate the vast amount of data we have to incentivize consumer behavior with more than 85% of our transactions occurring through the digital channels, we are in a unique position within the QSR space to quickly identify and adjust the changing consumer trends, allowing us to optimize their experience each time they order from Papa John’s.

I’m also excited to work with and support our franchisees. I grew up in a franchisee family experiencing firsthand how the franchise model creates opportunities for so many people. I’ve also realized through my professional career how attracting experienced partners to a great brand with great products can enable a company to localize and scale quickly in new markets. I want to thank Chris and our finance team for their leadership and support during this period of transition. They have done an amazing job supporting the business and delivering value to all stakeholders to accurate and timely financials, discipline financial analysis, and collaborative business partnership. I also recognize how important it is for me to get to know all of you in the financial community.

Stacy is in the process of setting up a schedule to meet with many of you in the next few weeks. I’m looking forward to those meetings and hearing your thoughts firsthand. Now, I’d like to turn the call over to Chris to cover the financial portion of today’s call. Chris?

Chris Collins: Thank you, Ravi, and good morning everyone. It was a great pleasure serving in the interim role, and I look forward to working closely with Ravi as he steps into the CFO role at Papa John’s. For the second quarter, global system-wide restaurant sales were $1.22 billion, up 2% in constant currency from the prior year. Net unit growth primarily in international markets contributed to the higher system-wide sales. North America comp sales were down 1%, a result of 2% increase in our company-owned restaurants offset by a 2% decrease in franchisee restaurants. For the quarter our domestic company owned restaurants saw year-over-year ticket and transaction growth while franchisee ticket growth was offset by lower transactions.

A variety of factors have impacted transaction growth in the short-term, including the timing of national promotions relative to the prior year and franchisees prioritizing margin over transactions. As Rob highlighted both franchisee and company-owned restaurants saw transaction improvement month after month during the quarter, resulting in positive North America comps for the month of June, and we maintained that positive growth into the third quarter. International comps were down 1% in the second quarter as inflation continued to pressure consumer spending in our UK market, strengthen other international markets, especially in Asia and the Middle-East largely offset these pressures. In the second quarter, we completed the purchase of 91 formally franchised restaurants in the UK.

These restaurants begin operating as an international company owned restaurants effective June 2nd. Therefore, our second quarter results include royalty revenues for these restaurants for the period until June 2nd, and the restaurants are consolidated after this date with results reflected in international revenues and expenses. This transaction impact on adjusted operating income in the second quarter is nominal in neutral to EPS. Total revenues for the second quarter were $515 million down $8 million from the second quarter last year. Excluding the purchase of the UK restaurants, total revenues were down $10 million versus a prior year. The decrease in year-over-year revenues is largely related to our North America commissary segment. Revenues for this segment were down due to lower sales volumes at our franchise restaurants and lower commodity prices partially offset by the comparable sales growth we saw at our company-owned restaurants.

Turning to profits, adjusted operating income for the second quarter was $37 million compared with $40 million for the same period last year. Adjusted operating margins were 7.2%, a 50 basis point decline versus last year. Our back to better strategic initiative led to higher restaurant level margins at our domestic company-owned restaurants through higher comp sales and labor efficiencies, which I’ll discuss in a moment. These improvements were offset by anticipated higher G&A expense due to the return of our franchisee conference in April for the first time since 2019 and higher variable compensation expense when compared with the second quarter last year. In addition, there was higher depreciation and amortization expense related to our continued investments in restaurants and technology support.

For modeling purposes, we anticipate depreciation and amortization expense to be between $60 million and $65 million in 2023. Our teams continue to do an excellent job taking a disciplined approach to managing costs while maintaining our high performance culture and supporting our strategic growth initiatives. So let’s take a deeper dive into our operating segments. In our domestic company-owned restaurant segment food basket costs improved 50 basis points compared with a prior year as we are beginning to experience meaningful relief from prior year peaks, especially in cheese and poultry. Labor costs improved more than 100 basis points during the second quarter, reflecting continued improvements to our labor modeling and adherence to labor scheduling guidelines.

These efforts have increased our throughput and reduced our overtime spend, supporting our continued margin improvement in our restaurants. On a combined basis, commodities and labor costs represented more than 150 basis points of margin improvement year-over-year in our domestic company-owned restaurant segment. Higher than anticipated health insurance claims largely offset these improvements resulting in an approximate 20 basis point increase in restaurant level margins compared with a year ago. As we look towards the second half of the year, we expect to see more improvement in our domestic company owned restaurant margins. As food costs continue to moderate in our team continues to execute on our strategic initiatives. In our North America commissary segment, second quarter revenues declined by 6% year-over-year, driven by the lower volumes and lower commodity pricing I mentioned earlier.

Adjusted operating margins remain consistent with our cost plus fixed margin model. For our international operating segment adjusted operating income was down in the second quarter compared with the prior year. As mentioned earlier, the UK is our largest market and it is the only international market, where we own the commissary. Given that our UK markets revenue streams come from royalties and our commissary sales, the challenges we are facing have a more pronounced impact on our international profits. Partially offsetting declines in our UK market is our continued development and diversification into other international markets. As of the end of the second quarter, we have seen an 8% increase in net new unit growth within our international markets when compared with a year ago.

Moving on to cash flow and balance sheet, for the first six months of the year, net cash provided by operating activities was 94 million up from 46 million a year ago. Free cash flow increased to 59 million reflecting favorable changes in working capital, partially offset by a $4 million increase in capital expenditures as we continue to invest in the development of new domestic restaurants and technology innovation. We ended the quarter with ample liquidity, which totaled approximately 270 million in cash and borrowings available under our revolving credit facility and a gross leverage ratio of 3.4 times down from 3.5 times at the end of the first quarter. Based on our strong balance sheet and positive outlook, I’m pleased to say that our board has declared a 10% increase in our 2023 third quarter dividend to $0.46 per common share, or a $1.84 on an annualized basis.

Our capital structure provides us with substantial operating flexibility. We’ll continue to take a disciplined and balanced approach to managing our cash flows, creating value for our shareholders through a combination of organic growth investments, cash dividends, and share repurchases. Now to our outlook. As Rob previously announced, we are adjusting our 2023 North America comp guidance to a range of flat to plus 2%. We do expect to see positive comps for the second half of the year driven by new menu innovations, execution of our back to better strategic initiatives and continuous improvements in our revenue management capabilities. Furthermore, we are reiterating our expectations of growing our North America comps between 2% and 4% annually over the longer term.

For the full year, we anticipate international comps will remain under pressure as challenges within the UK continue to persist but will improve each quarter as our new UK restaurants are integrated into our corporate organizational structure and other international markets continue to perform and grow. We expect our adjusted operating margins to be comparable to up slightly to the level achieved in 2022 as we benefit from several tailwinds, including our back to better initiatives, positive North America comps and the benefit of a 53rd week in 2023. Offsetting these tailwinds are the investments we are making in the UK, including the creation of some operational and back office infrastructure to support the recent acquisition of restaurants and higher corporate G&A expenses as performance based comp ramps back up versus the prior year.

I want to emphasize that we expect longer term margin benefit from our recently acquired UK restaurants once they’re fully integrated into our corporate structure, but there will be some near-term pressure as we integrate these stores. And for modeling purposes, remember that the third quarter is typically our lowest margin quarter due to seasonality of sales. Finally, in terms of non-operating expense items, we expect our net interest expense to remain between $40 million and $45 million, our capital expenditures to remain between $80 million and $90 million, and our tax rate to remain the higher end of our 21% to 24% range. All non-operating expense items are in line with previous guidance. As we look forward, we remain focused on driving growth and profitability at Papa John’s to deliver shareholder value.

We have numerous initiatives in place to help us achieve our objectives, including menu innovation, digital enhancements, operational productivity improvements, unit growth, and strategic capital allocation. We remain confident in our ability to capitalize on our position of strength and to execute our long-term strategy, driving value for our customers, our franchisees, and our shareholders. And with that, I’ll turn the call over to Rob for some final comments. Rob?

Rob Lynch: Thank you, Chris. As I mentioned at the beginning of the call, we continue to operate a challenging environment. Despite a challenging start to the first half of the year, the improving trends throughout the second quarter and solid start to the third supports that we are on the right path forward and that consumer demand for our products remain strong. The foundation of our success has been and will continue to be the solid execution against our. They are building a culture of leaders who believe in diversity, inclusivity and winning, improving unit level profitability of our operations and franchisees, establishing the superiority of our pizza through our commercial platforms, building a technology infrastructure that enables our business operations and expanding our footprint domestically and internationally.

We’re excited about the opportunities available to us and have confidence in the sustainability of our progress. At this point, we’d like to open the call up for any questions you may have.

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Q&A Session

Operator: [Operator Instructions] And our first question will come from Brian Bittner of Oppenheimer. Your line is open.

Brian Bittner: As it relates to the same store sales, Rob, can you just talk a little bit more about what specifically surprised you in the second quarter relative to the update you gave us in early May at the time I think you expected comps to sequentially accelerate throughout the year. And what do you believe secondly is bending the trend back in the right direction in June and July? Is there, I know you talked a lot about a lot of different things on the call related to sales drivers, but based on your insights, what’s specifically driving this improvement back to kind of where you thought you’d be? Thanks.

Rob Lynch: Thanks for the question Brian. So, April was the worst month that we’ve had since I’ve been at Papa John’s in terms of comp performance. A lot of macro issues and company specific issues, yes, that was kind of where we really discovered and spent some time talking about some of the pricing that had gotten out of front, out in front of where the consumer was willing to spend. And so, that’s where we really dug in on the revenue management side with our franchisees. Making sure that they understood kind of where we were headed from a consumer standpoint. In addition to that, it’s not talked about a lot, but I think also the discretionary spending power of the customer was impacted in April due to a lot of the decrease in the tax refund.

So, that kind of hit us as well. But when I met with a lot of analysts and investors in May, my bullishness on the quarter was really focused on the innovation that we were about to bring. I knew we had Doritos, Papadia and then more recently Garlic Stuffed Crust, so I had a lot of excitement about that. Also, just the work that we were doing in our company restaurants, we were seeing consistent sequential margin improvement regardless of some of the challenges on top-line sales in the month of April. And over the quarter we did see both improvement in sales and margin throughout the quarter. And that’s why we’ve given some color in the Q3 as well, because Q3 has continued that momentum and actually accelerated. So, we do believe that the innovation that we’ve brought the operational improvements that we’re making, are driving both top-line and bottom-line results for our company restaurants.

And we are laser focused on working with our franchisees. We can continue to outpace franchisees in terms of comp growth in our company restaurants and a lot of that growth is transaction growth. And that gives us even more confidence because we’re not just winning by taking pricing or increasing our revenues, it’s about bringing more customers. And so there is a lot of demand for our products, and that’s what gives us a lot of confidence in the back half of this year and moving forward.

Brian Bittner: And I know it’s just one question, but I have to follow-up on that specifically because you did identify that there’s this pricing variance between franchise stores and company owned stores, and that being a big driver of the traffic issues you’re seeing in franchise stores relative to the Company owned, and obviously the franchise system and how they perform from a sales perspective is very important for the Company. Can you talk about how meaningful the variance in price was that that led to the traffic bifurcation and franchise stores? And again, what are you doing specifically to correct this issue and help franchise stores restore kind of the price value equation?

Rob Lynch: Yes, so I mean, as I think we’ve talked about it in the past, this is a relative to most traditional QSRs. This is a relatively complex revenue management segment of the QSR industry. In QSR, when you pull into a drive-through and you look at the menu board, what the price that’s on the menu board is what you pay. This model that we deal with here in pizza is more of an e-commerce model where it’s planned ahead and there’s shopping that goes on. So as customers come into the storefront, which is essentially our digital channels, they are looking at what is being offered both from a new product standpoint as well as a special slash discount standpoint. And in this segment of the industry, there’s typically over 20% discounts applied on average to each transaction.

So from a revenue management standpoint, it’s not as simple as just saying, hey, we’re going to take our menu prices up, but we’re going to take our menu prices down. How our menu places interact with the specials that we offer, with the promotions that we’re running both national and at the local level is all kind of an algorithm that has to work together. So as we work with our franchisees, we’re not just going in and saying, hey, you have to take your prices down on your regular menu price. It’s how they show up in pricing on the aggregators, it’s how they execute their e-deals and the discounts that they offer on their in through the digital channels. All of that is in play, even carry out specials as some volume shifts, a little bit from delivery into carry out, making sure you have the lay offering there.

So, we are working with them not just to come in and tell them how they can maximize their margin, it’s really how they can build the successful long-term relationship between all those different facets of revenue management.