Papa John’s International, Inc. — 2018 Form 10-K Summary
Business context and reporting period
The filing covers the 52-week fiscal year ended December 30, 2018; it is an annual Form 10-K rather than a standalone quarterly filing. Papa John’s operated or franchised 5,303 restaurants at year-end: 645 company-owned and 4,658 franchised, across the United States, Canada, and 46 international countries and territories. The business reports domestic company-owned restaurants, North America commissaries, North America franchising, and international operations.
2018 was materially affected by negative consumer sentiment and publicity related to founder and former spokesperson John H. Schnatter. The company formed a Special Committee, terminated his Founder Agreement, initiated culture and process reviews, and began brand and marketing initiatives.
Key financial metrics
| Metric | 2018 | 2017 | Change |
|---|---|---|---|
| Total revenue | $1.573 billion | $1.783 billion | Down 11.8%; down 10.1% excluding 2017’s 53rd week |
| Operating income | $30.4 million | $151.0 million | Down 79.9% |
| Net income attributable to the Company | $1.6 million | $102.3 million | Down 98.4% |
| Diluted EPS | $0.05 | $2.83 | Down from $2.83 |
| Adjusted diluted EPS | $1.34 | $2.51 on a 52-week basis | Down 46.6% |
| Operating cash flow | $72.8 million | $135.0 million | Down $62.2 million |
| Free cash flow | $30.8 million | $82.4 million | Down $51.6 million |
| Total debt | $625.0 million | $470.0 million | Up $155.0 million |
Operating income margin declined to 1.9% from 8.5%, while net income attributable to the Company was approximately 0.1% of revenue versus 5.7% in 2017. The domestic company-owned restaurant margin fell to 16.7% from 18.6%, and the North America commissary margin fell to 5.7% from 6.3%.
- Domestic company-owned restaurant sales were $692.4 million, down 15.2%.
- North America franchise royalties and fees were $79.3 million, down 25.7%, reflecting lower sales and approximately $15.4 million of royalty reductions.
- North America commissary revenue was $609.9 million, down 9.5%.
- International revenue was $110.3 million, down 3.2%, partly reflecting the sale of the China operations.
- Company-owned comparable sales declined 9.0%; North America franchised comparable sales declined 6.7%; international comparable sales declined 1.6%.
- System-wide restaurant count increased by 104 net units, including 208 net international additions, while North America declined by 104 units.
Material changes versus the prior comparable period
- Negative brand publicity contributed to declining sales, operating profits, and franchisee pressure. The company incurred $50.7 million of special charges, including $15.4 million of franchise royalty reductions, $5.8 million of reimaging and branded-asset costs, a $10.0 million marketing-fund contribution, and $19.5 million of legal and professional fees.
- Management expects additional costs of approximately $30 million to $50 million in 2019 related to branding, marketing, professional fees, litigation, and franchisee support.
- Domestic company-owned restaurants declined from 708 to 645, primarily because 62 restaurants were sold to franchisees. All international restaurants became franchised after the sale of 34 China restaurants and the related quality control center.
- Interest expense increased to $25.3 million from $11.3 million because of higher debt balances and interest rates.
- Topic 606 revenue recognition was adopted in 2018 using the modified retrospective method. The adoption reduced retained earnings by $21.5 million, increased 2018 revenue by $4.0 million, and reduced pre-tax income by $3.4 million. Comparability with 2017 is affected because prior periods were not restated.
- Share repurchases totaled $158.0 million, or approximately 2.7 million shares. The company paid $29.0 million of dividends, or $0.90 per common share.
Debt, liquidity, and cash flow
- Debt consisted of $375.0 million under the term loan and $250.0 million under the revolving facility. The facilities mature in August 2022.
- Remaining availability under the facilities was approximately $110.0 million, including letters of credit.
- The October 2018 credit amendment reduced the revolving facility maximum to $400.0 million, raised the permitted leverage ratio to 5.25-to-1.0 initially, and imposed tighter restrictions on repurchases and dividend increases.
- At year-end, the leverage ratio was 4.7-to-1.0 versus a permitted 5.25-to-1.0, and the interest coverage ratio was 2.8-to-1.0 versus a minimum of 2.0-to-1.0. The company was in compliance with its covenants.
- Cash and cash equivalents were $19.5 million. Contractual obligations totaled $945.3 million, including $735.5 million of debt and interest obligations and $209.8 million of operating leases.
- The company used interest-rate swaps covering $325 million of floating-rate debt, with fixed rates generally ranging from 1.99% to 2.36%.
Guidance, outlook, risks, and unusual items
Management did not provide a specific revenue or earnings forecast in the filing. It stated that North America comparable sales remained under pressure and that the duration and effectiveness of the brand-recovery initiatives could not be predicted. For December 31, 2018 through January 31, 2019, system-wide North America comparable sales declined 10.5%, while international comparable sales were flat.
On February 3, 2019, after year-end, the company sold $200 million of Series B convertible preferred stock to funds affiliated with Starboard Value LP, with an option for an additional $50 million. Approximately half of the proceeds was expected to reduce revolving debt, with the balance intended for brand, product, technology, human-capital, unit-economics, and general corporate investments. The preferred stock carries an initial 3.6% cumulative dividend, is convertible at $50.06 per common share, and may dilute common shareholders.
- Key risks include continued brand damage, declining comparable sales, franchisee closures or financial distress, intense competition, labor and commodity inflation, food safety and supply-chain disruptions, foreign currency and Brexit exposure, cybersecurity and privacy risks, litigation, and debt-covenant compliance.
- The company faces litigation involving Mr. Schnatter, a securities class action, and a conditional collective action involving delivery-driver mileage reimbursement. No liability was recorded for the specifically discussed matters because management did not believe losses were probable or reasonably estimable.
- The company guaranteed certain assigned franchisee leases; the estimated maximum undiscounted exposure was approximately $11.9 million.
- The company reported effective disclosure controls and effective internal control over financial reporting. A material weakness related to manual journal-entry review was remediated during the fourth quarter.
Important facts for investors to verify
- Whether North America comparable sales stabilize or recover following the new marketing and brand initiatives.
- The amount and timing of 2019 special charges relative to management’s $30 million to $50 million estimate.
- Debt reduction from the Starboard investment, remaining revolver availability, and compliance with progressively tighter leverage covenants.
- The final amount of Series B preferred stock issued, including any additional Starboard or franchisee investment and the resulting common-stock dilution.
- Whether franchisee financial health, store closures, royalty relief, and commissary volumes improve.
- The status and potential exposure of the Schnatter-related litigation, securities class action, driver collective action, and lease guarantees.
- The effect of Topic 606 and the 2019 lease standard on reported revenue, earnings, assets, liabilities, and retained earnings.