Papa John’s International, Inc. — Form 10-Q Summary
Reporting period: Three and six months ended July 1, 2018, compared with June 25, 2017. Results are unaudited and prepared under U.S. GAAP. At quarter-end, the company operated 5,247 restaurants, including 678 company-owned and 4,569 franchised locations, in the United States and 46 international countries and territories.
Financial performance and liquidity
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Revenue | $408.0 million | $434.8 million | $835.3 million | $884.0 million |
| Operating income | $25.4 million | $37.2 million | $52.7 million | $80.9 million |
| Net income attributable to company | $11.8 million | $23.5 million | $28.5 million | $52.0 million |
| Diluted EPS | $0.36 | $0.65 | $0.86 | $1.42 |
| Operating margin | 6.2% | 8.6% | 6.3% | 9.1% |
| Net margin | 2.9% | 5.4% | 3.4% | 5.9% |
| Net cash from operating activities | — | — | $74.2 million | $77.9 million |
| Free cash flow | — | — | $52.6 million | $47.4 million |
Revenue declined 6.2% in the quarter and 5.5% year to date. Domestic company-owned restaurant sales fell 10.5% in the quarter and 9.3% year to date; North America franchise royalties and fees fell 10.1% in both periods; and North America commissary sales fell 4.1% and 4.9%, respectively. International revenue increased 6.7% in the quarter and 11.9% year to date, aided by unit growth and favorable foreign exchange.
Domestic company-owned restaurant operating margin declined to 18.5% in the quarter and 17.9% year to date, from 19.9% and 20.0%, respectively. Management cited lower comparable sales, higher commodity and wage costs, higher non-owned automobile costs, and the revised loyalty-program accounting. North America commissary margin was 6.6% in the quarter and 6.4% year to date. International margin was 37.2% and 37.0%, respectively.
Interest expense increased to $5.7 million in the quarter and $10.6 million year to date, versus $1.8 million and $3.6 million in the comparable periods, primarily due to higher debt balances and interest rates. The effective tax rate was 35.7% in the quarter and 28.6% year to date; excluding the China refranchising impact, the rates were 23.4% and 22.8%.
Balance sheet, debt, and capital allocation
- Cash and cash equivalents were $25.7 million at July 1, 2018, compared with $22.3 million at December 31, 2017.
- Total debt was $579.4 million, consisting of $385.0 million under the term loan and $194.4 million under the revolving facility. Net long-term debt, after issuance costs and the current portion, was $556.4 million.
- Remaining availability under the credit facilities, including letters of credit, was approximately $371.8 million. The facilities mature August 30, 2022.
- The company was in compliance with its debt covenants at quarter-end. Actual leverage and interest coverage ratios were both 3.4 to 1.0; the permitted leverage ratio was 4.5 to 1.0 and the minimum interest coverage ratio was 2.75 to 1.0.
- The company repurchased $148.4 million of common stock during the first six months, including approximately 1.7 million shares for $100.0 million under an accelerated share repurchase agreement. It paid $14.8 million in dividends, or $0.45 per share.
- Total stockholders’ deficit was $250.4 million at July 1, 2018, compared with $106.0 million at December 31, 2017, primarily reflecting share repurchases and the revenue-recognition adoption adjustment.
Material changes versus the prior comparable period
- Net income attributable to the company declined 49.9% in the quarter and 45.1% year to date. Diluted EPS declined 44.6% and 39.4%, respectively.
- Lower North America sales and restaurant volumes reduced company-owned restaurant, franchise royalty, and commissary results. North America comparable sales declined 7.2% for company-owned restaurants in the quarter and 5.7% for North America franchise royalties.
- Interest expense increased substantially as debt was used in part to fund share repurchases.
- The company refranchised 34 company-owned restaurants and a quality control center in China, recording a $1.9 million pretax refranchising loss and $2.4 million of additional tax expense. It also refranchised 31 Denver joint-venture restaurants earlier in the year.
- Effective January 1, 2018, the company adopted ASC Topic 606 using the modified retrospective method. The adoption reduced retained earnings by approximately $21.5 million, increased reported revenue by $1.8 million in the quarter and $4.3 million year to date, and reduced pretax income by $1.4 million and $1.9 million, respectively. Prior-year amounts were not restated.
- Reported 2018 revenue includes gross presentation of certain controlled marketing-fund activity, reducing comparability with 2017.
Outlook, commentary, risks, and unusual items
Management reported that negative publicity and consumer sentiment related to founder and former spokesperson John H. Schnatter materially affected sales. Mr. Schnatter resigned as chairman on July 11, 2018, and the independent directors formed a Special Committee. The committee terminated his Founder Agreement and is overseeing an external cultural audit and investigation.
North America comparable sales for the July period declined approximately 10.5%. Management stated that it cannot predict the duration or extent of the sales impact. The company expects $30 million to $50 million of additional costs during the remainder of 2018 for restaurant re-imaging, branding and marketing, franchisee financial assistance, cultural-audit activities, legal fees, and advisory costs.
Management indicated that it may need to work with lenders to address the possibility of future covenant pressure under a revised lower financial forecast. A failure to obtain a waiver or amendment following a covenant violation could restrict borrowing and letters of credit, accelerate debt repayment, require collateralization, or increase borrowing costs.
- Pending litigation includes the Ameranth patent case, with a jury trial scheduled for November 2018, and the Durling collective action concerning delivery-driver mileage reimbursement. No liabilities were recorded because losses were not considered probable or reasonably estimable.
- A July 22, 2018 stockholder rights plan expires July 22, 2019 and generally has a 15% ownership trigger, with a 31% threshold for Mr. Schnatter and related parties.
- The company remains exposed to interest rates, foreign currency, commodity prices, labor costs, food-safety events, supply-chain disruption, technology and data-security risks, and international operating conditions.
- The company expects adoption of the new lease standard to significantly increase reported non-current assets and liabilities, although the full impact had not yet been determined.
Facts investors should verify
- Whether North America comparable sales recover after the approximately 10.5% July decline and whether the projected $30 million to $50 million remediation cost range changes.
- Progress and findings of the Special Committee’s cultural audit and investigation, including related legal, advisory, marketing, and franchisee-support costs.
- Debt covenant headroom, lender discussions, and the effect of further sales declines on leverage and interest coverage.
- The sustainability of cash flow and dividends while debt remains elevated and share repurchases continue.
- The accounting impact of ASC Topic 606 on future comparability, deferred revenue, loyalty-program liabilities, and retained earnings.
- Developments in the Ameranth and Durling proceedings and any additional litigation or claims arising from the negative publicity.