Papa John’s International, Inc. — Fiscal 2019 Q3 Form 10-Q
Reporting period: Three and nine months ended September 29, 2019, compared with September 30, 2018; balance-sheet comparisons are with December 30, 2018. Results are unaudited. The 2018 comparative financial statements were restated to consolidate Papa John’s Marketing Fund, Inc. (PJMF), which management characterized as an immaterial error correction.
Business context
Papa John’s operated 5,343 restaurants in 49 countries and territories at quarter-end, including 621 company-owned and 4,722 franchised restaurants. The company was executing a strategic turnaround involving franchisee assistance, marketing investments, management changes, refranchising and a $252.5 million Series B convertible preferred-stock investment from Starboard Value and certain franchisees.
Key financial metrics
| Metric | Q3 2019 | Q3 2018 | 9M 2019 | 9M 2018 |
|---|---|---|---|---|
| Total revenue | $403.7 million | $385.2 million | $1,201.7 million | $1,265.3 million |
| Operating income | $4.9 million | $(14.2) million | $24.7 million | $38.9 million |
| Income before taxes | $0.7 million | $(20.2) million | $9.9 million | $21.9 million |
| Net income attributable to the company | $0.4 million | $(13.3) million | $7.0 million | $15.3 million |
| Net income attributable to common shareholders | $(3.1) million | $(13.3) million | $(2.0) million | $15.2 million |
| Diluted EPS | $(0.10) | $(0.42) | $(0.06) | $0.47 |
| Cash flow from operations | — | — | $50.0 million | $105.0 million |
| Free cash flow | — | — | $15.8 million | $74.4 million |
Q3 revenue increased 4.8% year over year, while nine-month revenue declined 5.0%, primarily reflecting restaurant refranchising, lower North America sales volumes and international refranchising. Q3 operating results benefited from improved company-owned restaurant performance, lower special charges and a $1.7 million refranchising gain.
Margins and segment trends
- Domestic company-owned restaurant non-GAAP operating margin was 18.8% in Q3 and 18.7% for the nine months, compared with 13.9% and 16.6%, respectively, in the prior-year periods.
- North America commissary margin was 6.5% in Q3 and 6.8% for the nine months, versus 5.7% and 6.2% in 2018.
- International operating margin was 45.1% in Q3 and 43.9% for the nine months, versus 40.8% and 38.2% in 2018.
- Systemwide North America comparable sales improved to positive 1.0% in Q3, including 2.2% for company-owned restaurants and 0.6% for franchised restaurants. The nine-month comparable-sales trends remained negative.
- Adjusted diluted EPS was $0.21 in Q3 and $0.80 for the nine months, compared with $0.19 and $1.18, respectively, in the prior-year periods.
Liquidity, debt and capital allocation
- Cash and cash equivalents were $28.4 million at September 29, 2019, compared with $33.3 million at December 30, 2018.
- Total outstanding debt was $378.1 million, including $369.0 million under the primary credit facilities and $9.1 million of PJMF debt. Primary debt declined $247.0 million from year-end, principally because preferred-stock proceeds were used to repay revolver borrowings.
- The primary credit facilities mature August 30, 2022. Remaining availability, including letters of credit, was approximately $352.8 million.
- The company reported a 3.0-to-1.0 leverage ratio and a 2.8-to-1.0 interest-coverage ratio, versus permitted thresholds of 5.25-to-1.0 and 2.0-to-1.0, respectively, and was in compliance with its debt covenants.
- Operating cash flow fell $55.0 million year over year, driven by lower earnings and unfavorable working-capital changes, including PJMF effects. Capital expenditures were $27.5 million.
- Common dividends paid were $21.4 million in the first nine months; preferred dividends and pass-through dividends totaled approximately $6.6 million. No share repurchases were made in the first nine months of 2019.
Material changes, unusual items and outlook
- The company committed to an approximately $80 million franchisee-support program covering marketing investments, royalty reductions, royalty-based service incentives and targeted relief, with approximately half expected in 2019 and half in 2020. It incurred $11.4 million under the program in Q3 and expects total 2019 special charges of approximately $50 million to $60 million.
- Special charges were $14.2 million in Q3 and $35.4 million for the nine months, compared with $24.8 million in each comparable 2018 period. 2019 items included royalty relief, marketing-fund investments, former-CEO severance, license-termination costs, legal and advisory fees, and a $5.9 million preferred-stock option mark-to-market adjustment.
- On August 1, 2019, the company refranchised 19 Georgia restaurants for $5.6 million and recognized a $1.7 million pretax gain. A subsequent South Florida refranchising transaction involving 23 restaurants was completed September 30, 2019; the company expected to recognize a gain in Q4.
- Series B preferred stock was classified as temporary equity at $251.1 million. It carries a 3.6% annual dividend, participates in common dividends, is convertible at a $50.06 conversion price, and may create future dilution or redemption funding requirements.
- The company adopted the new lease standard in fiscal 2019, recognizing approximately $157.1 million of lease right-of-use assets and $157.3 million of lease liabilities at September 29, 2019. Management stated that adoption did not materially affect operating results or cash flows.
- Robert Lynch became president and chief executive officer in August 2019; a further executive management restructure was announced November 6, 2019.
Risks, contingencies and controls
- Disclosure controls and procedures were not effective at quarter-end because of previously reported material weaknesses related to PJMF consolidation and complex variable-interest-entity accounting. Remediation was underway but had not yet operated for a sufficient period to be deemed effective.
- PJMF’s $20.0 million revolving facility matured December 27, 2019 and had $9.1 million outstanding at quarter-end.
- The company remained contingently liable for approximately 103 assigned domestic property leases, with maximum undiscounted payments of approximately $14.8 million if primary lessees defaulted. The Macon transaction added approximately $5.7 million of contingent lease-guarantee exposure.
- The company disclosed ongoing employment and securities litigation, including the Durling delivery-driver collective action and Danker investor litigation, for which no liability was recorded because a loss was not considered probable or reasonably estimable. The Ameranth patent ruling was affirmed on November 1, 2019.
- Principal operating risks include franchisee financial health, consumer sentiment, competition, food and labor costs, cheese and other commodity prices, supply-chain concentration, foreign exchange and Brexit-related risks, technology and cybersecurity, litigation, dividend capacity, preferred-stock redemption funding, and execution of the turnaround.
Investor verification checklist
- Verify whether positive North America comparable sales continue and whether the improvement converts into sustained franchisee profitability and royalty growth.
- Reconcile GAAP results with adjusted results and assess the recurring versus nonrecurring nature of the $50 million to $60 million projected 2019 special charges.
- Monitor cash generation, covenant headroom, the December 2019 PJMF debt maturity and the August 2022 primary debt maturity.
- Assess the economic dilution, dividend obligations and potential redemption requirements associated with the Series B preferred stock.
- Track remediation of the PJMF-related material weaknesses and review subsequent filings for control effectiveness.
- Evaluate contingent lease guarantees, outstanding litigation and the company’s ability to fund dividends and turnaround investments from operating cash flow.