pzza_Current folio_10Q

Table of Contents

 

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

(Mark One)

 

Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended July 1, 2018

 

OR

 

Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

Commission File Number:  0-21660

 

PAPA JOHN’S INTERNATIONAL, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

    

61-1203323

(State or other jurisdiction of

 

(I.R.S. Employer Identification

incorporation or organization)

 

number)

2002 Papa John’s Boulevard

Louisville, Kentucky 40299-2367

(Address of principal executive offices)

 

(502) 261-7272

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:  Yes ☒  No ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ☒  No ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ☒

    

Accelerated filer ☐

Non-accelerated filer ☐

 

Smaller reporting company ☐

 

 

Emerging growth company ☐

If an emerging growth company, indicate by check mark if the Registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes ☐  No ☒

 

At July 31, 2018, there were outstanding 31,619,630 shares of the registrant’s common stock, par value $0.01 per share.

 

 

 


 

Table of Contents

INDEX

 

 

 

Page No.

 

 

 

PART I. 

FINANCIAL INFORMATION

 

 

 

 

Item 1. 

Financial Statements

 

 

 

 

 

Condensed Consolidated Balance Sheets — July 1, 2018 and December 31, 2017

3

 

 

 

 

Condensed Consolidated Statements of Income — Three and Six months ended July 1, 2018 and June 25, 2017

4

 

 

 

 

Condensed Consolidated Statements of Comprehensive Income — Three and Six months ended July 1, 2018 and June 25, 2017

5

 

 

 

 

Condensed Consolidated Statements of Cash Flows — Six months ended July 1, 2018 and June 25, 2017

6

 

 

 

 

Notes to Condensed Consolidated Financial Statements

7

 

 

 

Item 2. 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

28

 

 

 

Item 3. 

Quantitative and Qualitative Disclosures About Market Risk

38

 

 

 

Item 4. 

Controls and Procedures

40

 

 

 

PART II. 

OTHER INFORMATION

 

 

 

 

Item 1. 

Legal Proceedings

40

 

 

 

Item 1A. 

Risk Factors

41

 

 

 

Item 2. 

Unregistered Sales of Equity Securities and Use of Proceeds

42

 

 

 

Item 6. 

Exhibits

44

 

 

2

 


 

Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

Papa John’s International, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

 

 

 

 

 

 

 

 

 

    

July 1,

    

December 31,

(In thousands, except per share amounts)

 

2018

 

2017

 

 

(Unaudited)

 

 

Assets

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

Cash and cash equivalents

 

$

25,719

 

$

22,345

Accounts receivable, net

 

 

62,973

 

 

64,644

Notes receivable, net

 

 

5,180

 

 

4,333

Income tax receivable

 

 

 —

 

 

3,903

Inventories

 

 

27,109

 

 

30,620

Prepaid expenses

 

 

26,729

 

 

28,522

Other current assets

 

 

7,223

 

 

9,494

Assets held for sale

 

 

2,786

 

 

6,133

Total current assets

 

 

157,719

 

 

169,994

Property and equipment, net

 

 

227,722

 

 

234,331

Notes receivable, less current portion, net

 

 

15,648

 

 

15,568

Goodwill

 

 

85,064

 

 

86,892

Deferred income taxes, net

 

 

709

 

 

585

Other assets

 

 

71,309

 

 

48,183

Total assets

 

$

558,171

 

$

555,553

 

 

 

 

 

 

 

Liabilities and stockholders’ (deficit)

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

Accounts payable

 

$

33,307

 

$

32,006

Income and other taxes payable

 

 

8,904

 

 

10,561

Accrued expenses and other current liabilities

 

 

81,197

 

 

70,293

Deferred revenue current

 

 

2,426

 

 

 —

     Current portion of long-term debt

 

 

20,000

 

 

20,000

Total current liabilities

 

 

145,834

 

 

132,860

Deferred revenue

 

 

15,329

 

 

2,652

Long-term debt, less current portion, net

 

 

556,387

 

 

446,565

Deferred income taxes, net

 

 

5,140

 

 

12,546

Other long-term liabilities

 

 

78,515

 

 

60,146

Total liabilities

 

 

801,205

 

 

654,769

 

 

 

 

 

 

 

Redeemable noncontrolling interests

 

 

7,356

 

 

6,738

 

 

 

 

 

 

 

Stockholders’ (deficit):

 

 

 

 

 

 

Preferred stock ($0.01 par value per share; no shares issued)

 

 

 —

 

 

 —

Common stock ($0.01 par value per share; issued 44,280 at July 1, 2018 and 44,221

 

 

 

 

 

 

    at December 31, 2017)

 

 

443

 

 

442

Additional paid-in capital

 

 

188,026

 

 

184,785

Accumulated other comprehensive income (loss)

 

 

2,240

 

 

(2,117)

Retained earnings

 

 

285,460

 

 

292,251

Treasury stock (12,733 shares at July 1, 2018 and 10,290 shares at

 

 

 

 

 

 

    December 31, 2017, at cost)

 

 

(742,695)

 

 

(597,072)

Total stockholders’ (deficit), net of noncontrolling interests

 

 

(266,526)

 

 

(121,711)

Noncontrolling interests in subsidiaries

 

 

16,136

 

 

15,757

Total stockholders’ (deficit) 

 

 

(250,390)

 

 

(105,954)

Total liabilities, redeemable noncontrolling interests and stockholders’ (deficit)

 

$

558,171

 

$

555,553

 

See accompanying notes.

3

 


 

Table of Contents

Papa John’s International, Inc. and Subsidiaries

Condensed Consolidated Statements of Income

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    

Three Months Ended

 

Six Months Ended

 

 

July 1,

 

June 25,

 

July 1,

 

June 25,

(In thousands, except per share amounts)

    

2018

    

2017

    

2018

    

2017

Revenues:

 

 

 

 

 

 

 

 

 

 

 

 

Domestic Company-owned restaurant sales

 

$

181,379

 

$

202,756

 

$

371,621

 

$

409,652

North America franchise royalties and fees

 

 

23,912

 

 

26,588

 

 

48,718

 

 

54,195

North America commissary

 

 

153,455

 

 

160,059

 

 

315,168

 

 

331,399

International

 

 

29,069

 

 

27,245

 

 

59,183

 

 

52,867

Other revenues

 

 

20,144

 

 

18,130

 

 

40,638

 

 

35,931

Total revenues

 

 

407,959

 

 

434,778

 

 

835,328

 

 

884,044

Costs and expenses:

 

 

 

 

 

 

 

 

 

 

 

 

Operating costs (excluding depreciation and amortization shown separately below):

 

 

 

 

 

 

 

 

 

 

 

 

Domestic Company-owned restaurant expenses

 

 

147,781

 

 

162,433

 

 

305,100

 

 

327,852

North America commissary

 

 

143,300

 

 

149,472

 

 

294,981

 

 

309,429

International expenses

 

 

18,248

 

 

17,272

 

 

37,278

 

 

33,063

Other expenses

 

 

20,698

 

 

17,482

 

 

41,656

 

 

35,029

General and administrative expenses

 

 

38,712

 

 

40,248

 

 

78,441

 

 

76,662

Depreciation and amortization

 

 

11,731

 

 

10,654

 

 

23,270

 

 

21,111

Total costs and expenses

 

 

380,470

 

 

397,561

 

 

780,726

 

 

803,146

Refranchising loss, net

 

 

(2,122)

 

 

 —

 

 

(1,918)

 

 

 —

Operating income

 

 

25,367

 

 

37,217

 

 

52,684

 

 

80,898

Net Interest expense

 

 

(5,662)

 

 

(1,759)

 

 

(10,617)

 

 

(3,569)

Income before income taxes

 

 

19,705

 

 

35,458

 

 

42,067

 

 

77,329

Income tax expense

 

 

7,040

 

 

10,476

 

 

12,022

 

 

22,448

Net income before attribution to noncontrolling interests

 

 

12,665

 

 

24,982

 

 

30,045

 

 

54,881

Income attributable to noncontrolling interests

 

 

(874)

 

 

(1,444)

 

 

(1,517)

 

 

(2,915)

Net income attributable to the Company

 

$

11,791

 

$

23,538

 

$

28,528

 

$

51,966

 

 

 

 

 

 

 

 

 

 

 

 

 

Calculation of income for earnings per share:

 

 

 

 

 

 

 

 

 

 

 

 

Net income attributable to the Company

 

$

11,791

 

$

23,538

 

$

28,528

 

$

51,966

Change in noncontrolling interest redemption value

 

 

 —

 

 

662

 

 

 —

 

 

1,182

Net income attributable to participating securities

 

 

(72)

 

 

(99)

 

 

(147)

 

 

(216)

Net income attributable to common shareholders

 

$

11,719

 

$

24,101

 

$

28,381

 

$

52,932

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per common share

 

$

0.37

 

$

0.66

 

$

0.87

 

$

1.44

Diluted earnings per common share

 

$

0.36

 

$

0.65

 

$

0.86

 

$

1.42

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic weighted average common shares outstanding

 

 

31,941

 

 

36,732

 

 

32,610

 

 

36,771

Diluted weighted average common shares outstanding

 

 

32,175

 

 

37,217

 

 

32,860

 

 

37,283

 

 

 

 

 

 

 

 

 

 

 

 

 

Dividends declared per common share

 

$

0.225

 

$

0.200

 

$

0.450

 

$

0.400

 

See accompanying notes.

 

 

4

 


 

Table of Contents

Papa John’s International, Inc. and Subsidiaries

Condensed Consolidated Statements of Comprehensive Income

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

 

Six Months Ended

 

 

July 1,

 

June 25,

 

July 1,

 

June 25,

(In thousands)

    

2018

    

2017

    

2018

    

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income before attribution to noncontrolling interests

 

$

12,665

 

$

24,982

 

$

30,045

 

$

54,881

Other comprehensive (loss) income, before tax:

 

 

 

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustments (1)

 

 

(5,295)

 

 

808

 

 

(3,312)

 

 

1,421

Interest rate swaps (2)

 

 

2,834

 

 

(1,857)

 

 

9,552

 

 

(2,325)

Other comprehensive (loss) income, before tax

 

 

(2,461)

 

 

(1,049)

 

 

6,240

 

 

(904)

Income tax effect:

 

 

 

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustments (1)

 

 

1,218

 

 

(299)

 

 

745

 

 

(526)

Interest rate swaps (3)

 

 

(627)

 

 

687

 

 

(2,172)

 

 

860

Income tax effect (4)

 

 

591

 

 

388

 

 

(1,427)

 

 

334

Other comprehensive (loss) income, net of tax

 

 

(1,870)

 

 

(661)

 

 

4,813

 

 

(570)

Comprehensive income before attribution to noncontrolling interests

 

 

10,795

 

 

24,321

 

 

34,858

 

 

54,311

Less: comprehensive income, redeemable noncontrolling interests

 

 

(319)

 

 

(745)

 

 

(404)

 

 

(1,539)

Less: comprehensive income, nonredeemable noncontrolling interests

 

 

(555)

 

 

(699)

 

 

(1,113)

 

 

(1,376)

Comprehensive income attributable to the Company

 

$

9,921

 

$

22,877

 

$

33,341

 

$

51,396

 


 

(1)

On June 15, 2018, the Company refranchised 34 Company-owned restaurants and a quality control center located in China.  In conjunction with the transaction, approximately $1,300 of accumulated other comprehensive income and $300 associated deferred tax related to foreign currency translation were reversed.  See “Note 7” of “Notes to Condensed Consolidated Financial Statements” for additional information.

 

(2)

Amounts reclassified out of accumulated other comprehensive income (loss) into net interest expense included $89 and $197 for the three and six months ended July 1, 2018, respectively, and $126 and $324 for the three and six months ended June 25, 2017, respectively.

 

(3)

The income tax effects of amounts reclassified out of accumulated other comprehensive income (loss) were $20 and $45 for the three and six months ended July 1, 2018, respectively, and $47 and $120 for the three and six months ended June 25, 2017, respectively.

 

(4)

As of January 1, 2018, we adopted ASU 2018-02, “Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income,” and reclassified stranded tax effects of approximately $450 to retained earnings in the first quarter of 2018.  See “Note 2” of “Notes to Condensed Consolidated Financial Statements” for additional information. 

 

 

See accompanying notes.

 

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Table of Contents

Papa John’s International, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(Unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

Six Months Ended

 

 

July 1,

 

June 25,

(In thousands)

    

2018

    

2017

Operating activities

 

 

 

 

 

 

Net income before attribution to noncontrolling interests

 

$

30,045

 

$

54,881

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

 

Provision for uncollectible accounts and notes receivable

 

 

3,591

 

 

(1,091)

Depreciation and amortization

 

 

23,270

 

 

21,111

Deferred income taxes

 

 

(2,511)

 

 

158

Stock-based compensation expense

 

 

4,929

 

 

5,571

Loss on refranchising

 

 

1,918

 

 

 —

Other

 

 

3,032

 

 

1,978

Changes in operating assets and liabilities, net of acquisitions:

 

 

 

 

 

 

Accounts receivable

 

 

(148)

 

 

(355)

Income tax receivable

 

 

3,678

 

 

(45)

Inventories

 

 

3,188

 

 

550

Prepaid expenses

 

 

1,159

 

 

2,966

Other current assets

 

 

5,524

 

 

(372)

Other assets and liabilities

 

 

(2,202)

 

 

(1,559)

Accounts payable

 

 

2,511

 

 

(3,950)

Income and other taxes payable

 

 

(1,656)

 

 

1,275

Accrued expenses and other current liabilities

 

 

(2,506)

 

 

(3,002)

Deferred revenue

 

 

379

 

 

(253)

Net cash provided by operating activities

 

 

74,201

 

 

77,863

Investing activities

 

 

 

 

 

 

Purchases of property and equipment

 

 

(21,562)

 

 

(30,457)

Loans issued

 

 

(1,904)

 

 

(1,476)

Repayments of loans issued

 

 

2,720

 

 

2,125

Acquisitions, net of cash acquired

 

 

 —

 

 

(21)

Proceeds from divestitures of restaurants

 

 

3,690

 

 

 —

Other

 

 

146

 

 

25

Net cash used in investing activities

 

 

(16,910)

 

 

(29,804)

Financing activities

 

 

 

 

 

 

Repayments of term loan

 

 

(10,000)

 

 

 —

Net proceeds of revolving credit facility

 

 

119,400

 

 

5,156

Cash dividends paid

 

 

(14,762)

 

 

(14,703)

Tax payments for equity award issuances

 

 

(1,353)

 

 

(2,282)

Proceeds from exercise of stock options

 

 

2,179

 

 

5,218

Acquisition of Company common stock

 

 

(148,440)

 

 

(33,968)

Distributions to noncontrolling interest holders

 

 

(1,110)

 

 

(1,389)

Other

 

 

231

 

 

494

Net cash used in financing activities

 

 

(53,855)

 

 

(41,474)

Effect of exchange rate changes on cash and cash equivalents

 

 

(62)

 

 

99

Change in cash and cash equivalents

 

 

3,374

 

 

6,684

Cash and cash equivalents at beginning of period

 

 

22,345

 

 

15,563

Cash and cash equivalents at end of period

 

$

25,719

 

$

22,247

See accompanying notes.

 

 

 

 

 

 

 

 

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Table of Contents

Papa John’s International, Inc. and Subsidiaries

 

Notes to Condensed Consolidated Financial Statements (Unaudited)

 

July 1, 2018

 

1.Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete annual financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Operating results for the three and six months ended July 1, 2018 are not necessarily indicative of the results that may be expected for the fiscal year ending December 30, 2018. For further information, refer to the consolidated financial statements and footnotes thereto included in the Annual Report on Form 10-K for Papa John’s International, Inc. (referred to as the “Company”, “Papa John’s” or in the first-person notations of “we”, “us” and “our”) for the year ended December 31, 2017.

 

2.Significant Accounting Policies

 

Use of Estimates

 

The preparation of Condensed Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Significant items that are subject to such estimates and assumptions include allowance for doubtful accounts and notes receivable, intangible assets, online customer loyalty program obligation, insurance reserves and tax reserves. Although management bases its estimates on historical experience and assumptions that are believed to be reasonable under the circumstances, actual results could significantly differ from these estimates. 

 

Noncontrolling Interests

 

At the beginning of 2018, Papa John’s had five joint venture arrangements in which there were noncontrolling interests held by third parties.  In the first quarter of 2018, one joint venture was divested and an additional joint venture was divested subsequent to the end of the second quarter.  That joint venture was classified as held for sale as of July 1, 2018.

 

As of July 1, 2018, there were 215 restaurants that comprise these joint ventures, including our held for sale joint venture as compared to 223 restaurants at June 25, 2017.  As of the beginning of the third quarter of 2018, there were 184 restaurants under these joint venture arrangements.  See Note 7 for more information on these related divestitures.

 

We are required to report the consolidated net income at amounts attributable to the Company and the noncontrolling interests. Additionally, disclosures are required to clearly identify and distinguish between the interests of the Company

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and the interests of the noncontrolling owners, including a disclosure on the face of the Condensed Consolidated Statements of Income attributable to the noncontrolling interest holders.

 

The income before income taxes attributable to these joint ventures for the three and six months ended July 1, 2018 and June 25, 2017 was as follows (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    

 

 

 

 

    

Three Months Ended

 

Six Months Ended

 

 

July 1,

 

June 25,

 

July 1,

 

June 25,

 

    

2018

    

2017

    

2018

    

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

Papa John’s International, Inc.

 

$

1,577

 

$

2,341

 

$

2,872

 

$

4,703

Noncontrolling interests

 

 

874

 

 

1,444

 

 

1,517

 

 

2,915

Total income before income taxes

 

$

2,451

 

$

3,785

 

$

4,389

 

$

7,618

 

The following summarizes the redemption feature, location and related accounting within the Condensed Consolidated Balance Sheets for these joint venture arrangements:

 

 

 

 

 

 

 

    

 

    

 

Type of Joint Venture Arrangement

    

Location within the Balance Sheets

    

Recorded Value

 

 

 

 

 

Joint venture with no redemption feature

 

Permanent equity

 

Carrying value

Option to require the Company to purchase the noncontrolling interest - not currently redeemable

 

Temporary equity

 

Carrying value

 

Revenue Recognition

 

Revenue is measured based on consideration specified in contracts with customers and excludes incentives and amounts collected on behalf of third parties, primarily sales tax.  The Company recognizes revenue when it satisfies a performance obligation by transferring control over a product or service to a customer.  Taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction, that are collected by the Company from a customer, are excluded from revenue.  Delivery costs, including freight associated with our domestic commissary and other sales are accounted for as fulfillment costs and are included in operating costs.

 

As further described in Accounting Standards Adopted and Note 3, the Company adopted ASC Topic 606, “Revenue from Contracts with Customers” (“Topic 606”), in the first quarter of 2018. Prior year revenue recognition follows ASC Topic 605, Revenue Recognition.

 

The following describes principal activities, separated by major product or service, from which the Company generates its revenues:

 

Company-owned Restaurant Sales 

 

The domestic and international Company-owned restaurants principally generate revenue from retail sales of high-quality pizza, side items including breadsticks, cheesesticks, chicken poppers and wings, dessert items and canned or bottled beverages. Revenues from Company-owned restaurants are recognized when the products are delivered to or carried out by customers.

 

Our domestic customer loyalty program, Papa Rewards, is a spend-based program that rewards customers with points for each online purchase.  Papa Rewards points are accumulated and redeemed online for free products. The accrued liability in the Condensed Consolidated Balance Sheets, and corresponding reduction of Company-owned restaurant sales in the Condensed Consolidated Statements of Income is for the estimated reward redemptions at domestic Company-owned restaurants based upon historical redemption patterns. Currently, the liability related to Papa Rewards is calculated using the estimated selling price of the products for which rewards are expected to be redeemed. Revenue is recognized when the customer redeems points for products.  Prior to the adoption of Topic 606, the liability related to Papa Rewards was estimated using the incremental cost accrual model which was based on the expected cost to satisfy the award and the

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corresponding expense was recorded in general and administrative expenses in the Condensed Consolidated Statements of Income.

 

Commissary Sales 

 

Commissary sales are comprised of food and supplies sold to franchised restaurants and are recognized as revenue upon shipment or delivery of the related products to the franchisees. Payments are generally due within 30 days.

 

Franchise Royalties and Fees

 

Franchise royalties which are based on a percentage of franchise restaurant sales are recognized as sales occur.  Royalty reductions, offered as part of a new store development incentive or as incentive for other behaviors including acceleration of restaurant remodels or equipment upgrades, are recognized at the same time as the related royalty as they are not separately distinguishable from the full royalty rate. Franchise royalties are billed on a monthly basis.

 

The majority of initial franchise license fees and area development exclusivity fees are from international locations. Initial franchise license fees are billed at the store opening date.  Area development exclusivity fees are billed upon execution of the development agreements which grant the right to develop franchised restaurants in future periods in specific geographic areas.  Area development exclusivity fees are included in deferred revenue in the Condensed Consolidated Balance Sheets and allocated on a pro rata basis to all stores opened under that specific development agreement.  Franchise license renewal fees for both domestic and international locations, which generally occur every 10 years, are billed before the renewal date.  The pre-opening services provided to franchisees do not contain separate and distinct performance obligations from the franchise right; thus, the fees collected will be amortized on a straight-line basis beginning at the store opening date through the term of the franchise agreement, which is typically 10 years. Fees received for future license renewal periods are amortized over the life of the renewal period.  For periods prior to adoption of Topic 606, revenue was recognized when we performed our obligations related to such fees, primarily the store opening date for initial franchise fees and area development fees, or the date the renewal option was effective for license renewal fees.

 

The Company offers various incentive programs for franchisees including royalty incentives, new restaurant opening incentives (i.e. development incentives) and other support initiatives. Royalties, franchise fees and commissary sales are reduced to reflect any incentives earned or granted under these programs that are in the form of discounts. Other development incentives for opening restaurants are offered in the form of Company equipment through a lease agreement at substantially no cost to the franchisee. This equipment is amortized by us over the term of the lease agreement, which is generally three to five years, and is recognized in general and administrative expenses in our Condensed Consolidated Statements of Income.  The equipment lease agreement has separate and distinguishable obligations from the franchise right and is accounted for under ASC Topic 840, Leases. 

 

Other Revenues

 

Fees for information services, including software maintenance fees, help desk fees and online ordering fees are recognized as revenue as such services are provided and are included in other revenue.

 

Revenues for printing, promotional items, and direct mail marketing services are recognized upon shipment of the related products to franchisees and other customers. Direct mail advertising discounts are also periodically offered by our Preferred Marketing Solutions subsidiary. Other revenues are reduced to reflect these advertising discounts.

 

Rental income, primarily derived from properties leased by the Company and subleased to franchisees in the United Kingdom, is recognized on a straight-line basis over the respective operating lease terms, in accordance with ASC Topic 840, Leases. 

 

Franchise Marketing Fund revenues represent contributions collected by various international and domestic marketing funds (“Co-op” or “Co-operative”) where we have determined that we have control over the activities of the fund.  Contributions are based on a percentage of monthly restaurant sales.  The adoption of Topic 606 revised the principal versus agent determination of these arrangements. When we are determined to be the principal in these arrangements,

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advertising fund contributions and expenditures are reported on a gross basis in the Condensed Consolidated Statements of Income.  Our obligation related to these funds is to develop and conduct advertising activities in a specific country, region, or market, including the placement of electronic and print materials.  Marketing fund contributions are billed monthly.

 

For periods prior to the adoption of Topic 606, the revenues and expenses of certain international advertising funds and the Co-op Funds in which we possess majority voting rights, were included in our Condensed Consolidated Statements of Income on a net basis as we previously concluded we were the agent in regard to the funds based upon principal/agent determinations in industry-specific guidance in GAAP that was in effect during those time periods.

 

Deferred Income Tax Accounts and Tax Reserves

 

We are subject to income taxes in the United States and several foreign jurisdictions.  Significant judgment is required in determining Papa John’s provision for income taxes and the related assets and liabilities. The provision for income taxes includes income taxes paid, currently payable or receivable and those deferred. We use an estimated annual effective rate based on expected annual income to determine our quarterly provision for income taxes. Discrete items are recorded in the quarter in which they occur.

 

Deferred tax assets and liabilities are determined based on differences between financial reporting and tax basis of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the differences reverse. Deferred tax assets are also recognized for the estimated future effects of tax attribute carryforwards (e.g., net operating losses, capital losses, and foreign tax credits). The effect on deferred taxes of changes in tax rates is recognized in the period in which the new tax rate is enacted. Valuation allowances are established when necessary on a jurisdictional basis to reduce deferred tax assets to the amounts we expect to realize.

 

On December 22, 2017, the Tax Cuts and Jobs Act (the “Tax Act”) was enacted, significantly decreasing the U.S. federal income tax rate for corporations effective January 1, 2018.  As a result, we remeasured our deferred tax assets, liabilities and related valuation allowances in 2017.  This remeasurement yielded a one-time benefit of approximately $7.0 million due to the lower income tax rate in 2017.  Given the substantial changes associated with the Tax Act, the estimated financial impacts for 2017 are provisional and subject to further interpretation and clarification of the Tax Act during 2018.    As of July 1, 2018, the Company has not made any material adjustments to the December 30, 2017 estimates.  Our net deferred income tax liability was approximately $4.4 million at July 1, 2018. 

 

In February 2018, the FASB issued ASU 2018-02, “Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income” (“ASU 2018-02”), that allows for an entity to reclassify disproportionate income tax effects in accumulated other comprehensive income (loss) (“AOCI”) caused by the Tax Act to retained earnings. See “Accounting Standards Adopted” section below for additional details. 

 

Tax authorities periodically audit the Company. We record reserves and related interest and penalties for identified exposures as income tax expense. We evaluate these issues on a quarterly basis to adjust for events, such as statute of limitations expirations, court or state rulings or audit settlements, which may impact our ultimate payment for such exposures.

 

Fair Value Measurements and Disclosures

 

The Company is required to determine the fair value of financial assets and liabilities based on the price that would be received to sell the asset or paid to transfer the liability to a market participant. Fair value is a market-based measurement, not an entity specific measurement. The fair value of certain assets and liabilities approximates carrying value because of the short-term nature of the accounts, including cash and cash equivalents, accounts receivable and accounts payable. The carrying value of our notes receivable, net of allowances, also approximates fair value. The fair value of the amount outstanding under our term debt and revolving credit facility approximates its carrying value due to its variable market-based interest rate (Level 2).

 

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Certain assets and liabilities are measured at fair value on a recurring basis and are required to be classified and disclosed in one of the following categories:

 

·

Level 1: Quoted market prices in active markets for identical assets or liabilities.

·

Level 2: Observable market-based inputs or unobservable inputs that are corroborated by market data.

·

Level 3: Unobservable inputs that are not corroborated by market data.

 

Our financial assets that were measured at fair value on a recurring basis as of July 1, 2018 and December 31, 2017 are as follows (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Carrying

 

Fair Value Measurements

 

 

    

Value

    

Level 1

    

Level 2

    

Level 3

 

July 1, 2018

 

 

 

 

 

 

 

 

 

 

 

 

 

Financial assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash surrender value of life insurance policies (a)

 

$

29,771

 

$

29,771

 

$

 —

 

$

 —

 

Interest rate swaps (b)

 

 

10,203

 

 

 —

 

 

10,203

 

 

 —

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2017

 

 

 

 

 

 

 

 

 

 

 

 

 

Financial assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash surrender value of life insurance policies (a)

 

$

28,645

 

$

28,645

 

$

 —

 

$

 —

 

Interest rate swaps (b)

 

 

651

 

 

 —

 

 

651

 

 

 —

 


(a)

Represents life insurance policies held in our non-qualified deferred compensation plan.

(b)

The fair value of our interest rate swaps are based on the sum of all future net present value cash flows. The future cash flows are derived based on the terms of our interest rate swaps, as well as considering published discount factors, and projected London Interbank Offered Rates (“LIBOR”).

 

Our assets and liabilities that were measured at fair value on a non-recurring basis as of  December 31, 2017 include assets and liabilities held for sale.  The fair value was determined using a market-based approach with unobservable inputs (Level 3) less any estimated selling costs. 

 

There were no transfers among levels within the fair value hierarchy during the six months ended July 1, 2018.

 

Variable Interest Entity

 

Papa John’s domestic restaurants, both Company-owned and franchised, participate in Papa John’s Marketing Fund, Inc. (“PJMF”), a nonstock corporation designed to operate at break-even for the purpose of designing and administering advertising and promotional programs for all participating domestic restaurants. PJMF is a variable interest entity as it does not have sufficient equity to fund its operations without ongoing financial support and contributions from its members. Based on the ownership and governance structure and operating procedures of PJMF, we have determined that we do not have the power to direct the most significant activities of PJMF and therefore are not the primary beneficiary. Accordingly, consolidation of PJMF is not appropriate.

 

Accounting Standards Adopted

 

Revenue from Contracts with Customers

 

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”), which supersedes nearly all existing revenue recognition guidance under GAAP, including industry-specific requirements, and provides companies with a single revenue recognition framework for recognizing revenue from contracts with customers. In March and April 2016, the FASB issued Topic 606. This update and subsequently issued amendments require companies to recognize revenue at amounts that reflect the consideration to which the companies expect to be entitled in exchange for those goods or services at the time of transfer. Topic 606 requires that we assess contracts to determine each separate and distinct performance obligation.  If a contract has multiple performance obligations, we

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allocate the transaction price using our best estimate of the standalone selling price to each distinct good or service in the contract.

 

The Company adopted Topic 606 as of January 1, 2018. See Note 3 for additional information.

 

Certain Tax effects from Accumulated Other Comprehensive Income

 

In February 2018, the FASB issued ASU 2018-02, which allows for an entity to reclassify disproportionate income tax in AOCI caused by the Tax Act to retained earnings.  The guidance is effective for fiscal years beginning after December 15, 2018 with early adoption permitted, including interim periods within those years.  The Company adopted ASU 2018-02 in the first quarter of 2018 by electing to reclassify the income tax effects from AOCI to retained earnings.  The impact of the adoption was not material to our condensed consolidated financial statements.

 

Accounting Standards to be Adopted in Future Periods

 

Leases

 

In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842),” (“ASU 2016-02”), which amends leasing guidance by requiring companies to recognize a right-of-use asset and a lease liability for all operating and capital leases (financing) with lease terms greater than twelve months.  The lease liability will be equal to the present value of lease payments. The lease asset will be based on the lease liability, subject to adjustment, such as for initial direct costs.  For income statement purposes, leases will continue to be classified as operating or capital (financing) with lease expense in both cases calculated substantially the same as under the prior leasing guidance. In July 2018, the FASB issued the following amendments to clarify the implementation guidance: ASU 2018-10, “Codification Improvements to Topic 842, Leases,” and ASU 2018-11, “Leases (Topic 842): Targeted Improvements.”  The amendment allows for a modified retrospective adoption approach and new required lease disclosures for all leases existing or entered into after either the beginning of the year of adoption or the earliest comparative period in the consolidated financial statements.  ASU 2016-02 is effective for interim and annual periods beginning after December 15, 2018, and early adoption is permitted. The Company has not yet determined the full impact of the adoption on its consolidated financial statements but expects the adoption will result in a significant increase in the non-current assets and liabilities reported on our Consolidated Balance Sheet. 

 

Goodwill

 

In January 2017, the FASB issued ASU 2017-04, “Intangibles – Goodwill and Other,” (“ASU 2017-04”), which simplifies the accounting for goodwill.  ASU 2017-04 eliminates the second step of the goodwill impairment test, which requires a hypothetical purchase price allocation.  The goodwill impairment is the difference between the carrying value and fair value, not to exceed the carrying amount.  ASU 2017-04 is effective for annual and interim periods in fiscal years beginning after December 15, 2019.  The Company is currently evaluating this standard and its potential impact on our consolidated financial statements.

 

Reclassification

 

Certain prior year amounts have been reclassified in the Condensed Consolidated Statements of Income.  See Note 11 for additional information.

 

3.  Adoption of ASU 2014-09, “Revenue from Contracts with Customers”

 

The Company adopted Topic 606 using the modified retrospective transition method effective January 1, 2018.  Results for reporting periods beginning after January 1, 2018 are presented in accordance with Topic 606, while prior period amounts are not adjusted and continue to be reported in accordance with our historical accounting under Topic 605, Revenue Recognition. 

 

The cumulative effect adjustment of $21.5 million was recorded as a reduction to retained earnings as of January 1, 2018 to reflect the impact of adopting Topic 606.   The impact of applying Topic 606 for the three and six months ended July

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1, 2018, was an increase in revenues of $1.8 million and $4.3 million respectively and a decrease in pre-tax income of $1.4 million and $1.9 million, respectively.

 

The adoption of Topic 606 did not impact the recognition and reporting of our three largest sources of revenue: sales from Company-owned restaurants, commissary sales, or continuing royalties or other revenues from franchisees that are based on a percentage of the franchise sales.  The items impacted by the adoption include the presentation and amount of our loyalty program costs, the timing of franchise and development fees revenue recognition, and the presentation of various domestic and international advertising funds as further described below.

 

Cumulative adjustment from adoption

 

As noted above, an after-tax reduction of $21.5 million was recorded to retained earnings in the first quarter of 2018 to reflect the cumulative impact of adopting Topic 606. This is comprised of $10.8 million related to franchise fees, $8.0 million related to the customer loyalty program and $2.7 million related to marketing funds.

 

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The following chart presents the specific line items impacted by the cumulative adjustment.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Adjusted

 

 

As Reported

 

 

 

 

 

Balance Sheet

 

    

December 31,

    

 

Total

 

 

at January 1,

(In thousands, except per share amounts)

 

2017

 

 

Adjustments

 

 

2018

 

 

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

22,345

 

$

4,279

 

$

26,624

Accounts receivable, net

 

 

64,644

 

 

493

 

 

65,137

Notes receivable, net

 

 

4,333

 

 

 —

 

 

4,333

Income tax receivable

 

 

3,903

 

 

 —

 

 

3,903

Inventories

 

 

30,620

 

 

 —

 

 

30,620

Prepaid expenses

 

 

28,522

 

 

(4,959)

 

 

23,563

Other current assets

 

 

9,494

 

 

 —

 

 

9,494

Assets held for sale

 

 

6,133

 

 

 —

 

 

6,133

Total current assets

 

 

169,994

 

 

(187)

 

 

169,807

Property and equipment, net

 

 

234,331

 

 

 —

 

 

234,331

Notes receivable, less current portion, net

 

 

15,568

 

 

 —

 

 

15,568

Goodwill

 

 

86,892

 

 

 —

 

 

86,892

Deferred income taxes, net

 

 

585

 

 

 —

 

 

585

Other assets

 

 

48,183

 

 

(907)

 

 

47,276

Total assets

 

$

555,553

 

$

(1,094)

 

$

554,459

 

 

 

 

 

 

 

 

 

 

Liabilities and stockholders’ equity (deficit)

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

 

 

Accounts payable

 

$

32,006

 

$

(2,161)

 

$

29,845

Income and other taxes payable

 

 

10,561

 

 

 —

 

 

10,561

Accrued expenses and other current liabilities

 

 

70,293

 

 

15,860

 

 

86,153

Deferred revenue current

 

 

 —

 

 

2,400

 

 

2,400

     Current portion of long-term debt

 

 

20,000

 

 

 —

 

 

20,000

Total current liabilities

 

 

132,860

 

 

16,099

 

 

148,959

Deferred revenue

 

 

2,652

 

 

10,798

 

 

13,450

Long-term debt, less current portion, net

 

 

446,565

 

 

 —

 

 

446,565

Deferred income taxes, net

 

 

12,546

 

 

(6,464)

 

 

6,082

Other long-term liabilities

 

 

60,146

 

 

 —

 

 

60,146

Total liabilities

 

 

654,769

 

 

20,433

 

 

675,202

 

 

 

 

 

 

 

 

 

 

Redeemable noncontrolling interests

 

 

6,738

 

 

 —

 

 

6,738

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity (deficit):

 

 

 

 

 

 

 

 

 

Preferred stock ($0.01 par value per share; no shares issued)

 

 

 —

 

 

 —

 

 

 —

Common stock ($0.01 par value per share; issued 44,221 at December 31, 2017

 

 

442

 

 

 —

 

 

442

Additional paid-in capital

 

 

184,785

 

 

 —

 

 

184,785

Accumulated other comprehensive loss

 

 

(2,117)

 

 

 —

 

 

(2,117)

Retained earnings

 

 

292,251

 

 

(21,527)

 

 

270,724

Treasury stock (10,290 shares at December 31, 2017, at cost)

 

 

(597,072)

 

 

 —

 

 

(597,072)

Total stockholders’ (deficit), net of noncontrolling interests

 

 

(121,711)

 

 

(21,527)

 

 

(143,238)

Noncontrolling interests in subsidiaries

 

 

15,757

 

 

 —

 

 

15,757

Total stockholders’ (deficit) 

 

 

(105,954)

 

 

(21,527)

 

 

(127,481)

Total liabilities, redeemable noncontrolling interests and stockholders’ (deficit)

 

$

555,553

 

$

(1,094)

 

$

554,459

 

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The impact of adoption for the second quarter of 2018 is as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

As Reported

 

 

 

 

 

Balance Sheet

 

    

July 1,

    

 

Total

 

 

Without Adoption

(In thousands, except per share amounts)

 

2018

 

 

Adjustments

 

 

of Topic 606

 

 

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

25,719

 

$

(3,130)

 

$

22,589

Accounts receivable, net

 

 

62,973

 

 

(359)

 

 

62,614

Notes receivable, net

 

 

5,180

 

 

 —

 

 

5,180

Income tax receivable

 

 

 —

 

 

 —

 

 

 —

Inventories

 

 

27,109

 

 

 —

 

 

27,109

Prepaid expenses

 

 

26,729

 

 

4,827

 

 

31,556

Other current assets

 

 

7,223

 

 

 —

 

 

7,223

Assets held for sale

 

 

2,786

 

 

 —

 

 

2,786

Total current assets

 

 

157,719

 

 

1,338

 

 

159,057

Property and equipment, net

 

 

227,722

 

 

 —

 

 

227,722

Notes receivable, less current portion, net

 

 

15,648

 

 

 —

 

 

15,648

Goodwill

 

 

85,064

 

 

 —

 

 

85,064

Deferred income taxes, net

 

 

709

 

 

 —

 

 

709

Other assets

 

 

71,309

 

 

907

 

 

72,216

Total assets

 

$

558,171

 

$

2,245

 

$

560,416

 

 

 

 

 

 

 

 

 

 

Liabilities and stockholders’ equity (deficit)

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

 

 

Accounts payable

 

$

33,307

 

$

1,493

 

$

34,800

Income and other taxes payable

 

 

8,904

 

 

 —

 

 

8,904

Accrued expenses and other current liabilities

 

 

81,197

 

 

(15,457)

 

 

65,740

Deferred revenue current

 

 

2,426

 

 

(2,426)

 

 

 —

     Current portion of long-term debt

 

 

20,000

 

 

 —

 

 

20,000

Total current liabilities

 

 

145,834

 

 

(16,390)

 

 

129,444

Deferred revenue

 

 

15,329

 

 

(11,157)

 

 

4,172

Long-term debt, less current portion, net

 

 

556,387

 

 

 —

 

 

556,387

Deferred income taxes, net

 

 

5,140

 

 

6,682

 

 

11,822

Other long-term liabilities

 

 

78,515

 

 

 —

 

 

78,515

Total liabilities

 

 

801,205

 

 

(20,865)

 

 

780,340

 

 

 

 

 

 

 

 

 

 

Redeemable noncontrolling interests

 

 

7,356

 

 

 —

 

 

7,356

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity (deficit):

 

 

 

 

 

 

 

 

 

Preferred stock ($0.01 par value per share; no shares issued)

 

 

 —

 

 

 —

 

 

 —

Common stock ($0.01 par value per share; issued 44,280 at July 1, 2018)

 

 

443

 

 

 —

 

 

443

Additional paid-in capital

 

 

188,026

 

 

 —

 

 

188,026

Accumulated other comprehensive income (loss)

 

 

2,240

 

 

 —

 

 

2,240

Retained earnings

 

 

285,460

 

 

23,091

 

 

308,551

Treasury stock (12,733 shares at July 1, 2018, at cost)

 

 

(742,695)

 

 

 —

 

 

(742,695)

Total stockholders’ (deficit), net of noncontrolling interests

 

 

(266,526)

 

 

23,091

 

 

(243,435)

Noncontrolling interests in subsidiaries

 

 

16,136

 

 

19

 

 

16,155

Total stockholders’ (deficit) 

 

 

(250,390)

 

 

23,110

 

 

(227,280)

Total liabilities, redeemable noncontrolling interests and stockholders’ (deficit)

 

$

558,171

 

$

2,245

 

$

560,416

 

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As Reported

 

 

 

 

 

 

 

Three Months Ended

 

 

 

 

Income Statement

 

 

July 1,

 

Total

 

Without Adoption of

(In thousands, except per share amounts)

    

2018

    

Adjustments

    

Topic 606

Revenues:

 

 

 

 

 

 

 

 

 

Domestic Company-owned restaurant sales

 

$

181,379

 

$

812

 

$

182,191

North America franchise royalties and fees

 

 

23,912

 

 

82

 

 

23,994

North America commissary

 

 

153,455

 

 

 —

 

 

153,455

International

 

 

29,069

 

 

175

 

 

29,244

Other revenues

 

 

20,144

 

 

(2,883)

 

 

17,261

Total revenues

 

 

407,959

 

 

(1,814)

 

 

406,145

Costs and expenses:

 

 

 

 

 

 

 

 

 

Operating costs (excluding depreciation and amortization shown separately below):

 

 

 

 

 

 

 

 

 

Domestic Company-owned restaurant expenses

 

 

147,781

 

 

(272)

 

 

147,509

North America commissary

 

 

143,300

 

 

 —

 

 

143,300

International expenses

 

 

18,248

 

 

 —

 

 

18,248

Other expenses

 

 

20,698

 

 

(2,951)

 

 

17,747

General and administrative expenses

 

 

38,712

 

 

34

 

 

38,746

Depreciation and amortization

 

 

11,731

 

 

 —

 

 

11,731

Total costs and expenses

 

 

380,470

 

 

(3,189)

 

 

377,281

Refranchising loss, net

 

 

(2,122)

 

 

 —

 

 

(2,122)

Operating income

 

 

25,367

 

 

1,375

 

 

26,742

Net Interest expense

 

 

(5,662)

 

 

 —

 

 

(5,662)

Income before income taxes

 

 

19,705

 

 

1,375

 

 

21,080

Income tax expense

 

 

7,040

 

 

306

 

 

7,346

Net income before attribution to noncontrolling interests

 

 

12,665

 

 

1,069

 

 

13,734

Income attributable to noncontrolling interests

 

 

(874)

 

 

 —

 

 

(874)

Net income attributable to the Company

 

$

11,791

 

$

1,069

 

$

12,860

 

 

 

 

 

 

 

 

 

 

Calculation of income for earnings per share:

 

 

 

 

 

 

 

 

 

Net income attributable to the Company

 

$

11,791

 

$

1,069

 

$

12,860

Net income attributable to participating securities

 

 

(72)

 

 

 —

 

 

(72)

Net income attributable to common shareholders

 

$

11,719

 

$

1,069

 

$

12,788

 

 

 

 

 

 

 

 

 

 

Basic earnings per common share

 

$

0.37

 

$

0.03

 

$

0.40

Diluted earnings per common share

 

$

0.36

 

$

0.03

 

$

0.40

 

 

 

 

 

 

 

 

 

 

Basic weighted average common shares outstanding

 

 

31,941

 

 

31,941

 

 

31,941

Diluted weighted average common shares outstanding

 

 

32,175

 

 

32,175

 

 

32,175

 

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As Reported

 

 

 

 

 

 

 

Six Months Ended

 

 

 

 

Income Statement

 

 

July 1,

 

Total

 

Without Adoption of

(In thousands, except per share amounts)

    

2018

    

Adjustments

    

Topic 606

Revenues:

 

 

 

 

 

 

 

 

 

Domestic Company-owned restaurant sales

 

$

371,621

 

$

1,076

 

$

372,697

North America franchise royalties and fees

 

 

48,718

 

 

120

 

 

48,838

North America commissary

 

 

315,168

 

 

 —

 

 

315,168

International

 

 

59,183

 

 

324

 

 

59,507

Other revenues

 

 

40,638

 

 

(5,770)

 

 

34,868

Total revenues

 

 

835,328

 

 

(4,250)

 

 

831,078

Costs and expenses:

 

 

 

 

 

 

 

 

 

Operating costs (excluding depreciation and amortization shown separately below):

 

 

 

 

 

 

 

 

 

Domestic Company-owned restaurant expenses

 

 

305,100

 

 

(338)

 

 

304,762

North America commissary

 

 

294,981

 

 

 —

 

 

294,981

International expenses

 

 

37,278

 

 

 —

 

 

37,278

Other expenses

 

 

41,656

 

 

(6,310)

 

 

35,346

General and administrative expenses

 

 

78,441

 

 

538

 

 

78,979

Depreciation and amortization

 

 

23,270

 

 

 —

 

 

23,270

Total costs and expenses

 

 

780,726

 

 

(6,110)

 

 

774,616

Refranchising loss, net

 

 

(1,918)

 

 

 —

 

 

(1,918)

Operating income

 

 

52,684

 

 

1,860

 

 

54,544

Net Interest expense

 

 

(10,617)

 

 

 —

 

 

(10,617)

Income before income taxes

 

 

42,067

 

 

1,860

 

 

43,927

Income tax expense

 

 

12,022

 

 

418

 

 

12,440

Net income before attribution to noncontrolling interests

 

 

30,045

 

 

1,442

 

 

31,487

Income attributable to noncontrolling interests

 

 

(1,517)

 

 

 —

 

 

(1,517)

Net income attributable to the Company

 

$

28,528

 

$

1,442

 

$

29,970

 

 

 

 

 

 

 

 

 

 

Calculation of income for earnings per share:

 

 

 

 

 

 

 

 

 

Net income attributable to the Company

 

$

28,528

 

$

1,442

 

$

29,970

Net income attributable to participating securities

 

 

(147)

 

 

 —

 

 

(147)

Net income attributable to common shareholders

 

$

28,381

 

$

1,442

 

$

29,823

 

 

 

 

 

 

 

 

 

 

Basic earnings per common share

 

$

0.87

 

$

0.04

 

$

0.91

Diluted earnings per common share

 

$

0.86

 

$

0.04

 

$

0.91

 

 

 

 

 

 

 

 

 

 

Basic weighted average common shares outstanding

 

 

32,610

 

 

32,610

 

 

32,610

Diluted weighted average common shares outstanding

 

 

32,860

 

 

32,860

 

 

32,860

 

 

Transaction Price Allocated to the Remaining Performance Obligations

 

The following table (in thousands) includes estimated revenue expected to be recognized in the future related to performance obligations that are unsatisfied at the end of the reporting period.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Performance Obligations by Period

 

 

Less than 1 Year

 

1-2 Years

 

2-3 Years

 

3-4 Years

 

4-5 Years

 

Thereafter

 

Total

Franchise Fees

 

$

2,426

 

$

2,179

 

$

1,948

 

$

1,732

 

$

1,503

 

$

3,795

 

$

13,583

 

An additional $4.2 million of area development fees related to unopened stores and unearned royalties are included in deferred revenue. Timing of revenue recognition is dependent upon the timing of store openings and franchisee’s revenues.

 

As of July 1, 2018, the amount allocated to the Papa Rewards loyalty program is $15.8 million and is reflected in the Condensed Consolidated Balance Sheet as part of the contract liability included in accrued expenses and other current

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liabilities.  This will be recognized as revenue as the points are redeemed, which is expected to occur within the next year.

 

The Company applies the practical expedient in ASU paragraph 606-10-50-14 and does not disclose information about remaining performance obligations that have original expected durations of one year or less.

 

4.    Revenue Recognition

 

Disaggregation of Revenue

 

In the following table (in thousands), revenue is disaggregated by major product line. The table also includes a reconciliation of the disaggregated revenue with the reportable segments.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reportable Segments

 

 

Three Months Ended July 1, 2018

Major Products/Services Lines

 

Domestic Company-owned restaurants

 

North America commissaries

 

North America franchising

 

International

 

All others

 

Total

Company-owned restaurant sales

$

181,379

$

 -

$

 -

$

2,783

$

 -

$

184,162

Commissary sales

 

 -

 

204,947

 

 -

 

17,299

 

 -

 

222,246

Franchise royalties and fees

 

 -

 

 -

 

24,928

 

8,987

 

 -

 

33,915

Other revenues

 

 -

 

 -

 

 -

 

5,656

 

22,139

 

27,795

Eliminations

 

 -

 

(51,492)

 

(1,016)

 

(73)

 

(7,578)

 

(60,159)

Total

$

181,379

$

153,455

$

23,912

$

34,652

$

14,561

$

407,959

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reportable Segments

 

 

Six Months Ended July 1, 2018

Major Products/Services Lines

 

Domestic Company-owned restaurants

 

North America commissaries

 

North America franchising

 

International

 

All others

 

Total

Company-owned restaurant sales

$

371,621

$

 -

$

 -

$

6,237

$

 -

$

377,858

Commissary sales

 

 -

 

422,534

 

 -

 

34,978

 

 -

 

457,512

Franchise royalties and fees

 

 -

 

 -

 

50,753

 

17,969

 

 -

 

68,722

Other revenues

 

 -

 

 -

 

 -

 

11,143

 

45,289

 

56,432

Eliminations

 

 -

 

(107,366)

 

(2,035)

 

(143)

 

(15,652)

 

(125,196)

Total

$

371,621

$

315,168

$

48,718

$

70,184

$

29,637

$

835,328

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The revenue summarized above is described in Note 2 under the heading “Significant Accounting Policies – Revenue Recognition.”

 

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Contract Balances

 

The contract liabilities primarily relate to franchise fees which we classify as “Deferred revenue” and customer loyalty program obligations which are classified with “Accrued expenses and other current liabilities.” During the three and six months ended July 1, 2018, the Company recognized $3.1 million and $7.0 million in revenue, respectively, related to deferred revenue and customer loyalty program.

 

The contract liability balances are included in the following (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

July 1, 2018

 

 

January 1, 2018

 

 

Change

Deferred revenue

 

$

17,755

 

$

15,850

 

$

1,905

Customer loyalty program

 

 

15,800

 

 

14,724

 

 

1,076

Total contract liabilities

 

$

33,555

 

$

30,574

 

$

2,981

 

 

5.    Stockholders’ Equity / (Deficit)

 

Shares Authorized and Outstanding

 

The Company has authorized 5.0 million shares of preferred stock and 100.0 million shares of common stock. The Company’s outstanding shares of common stock, net of repurchased common stock, were 31.5 million shares at July 1, 2018 and 33.9 million shares at December 31, 2017. There were no shares of preferred stock issued or outstanding at July 1, 2018 and December 31, 2017.

 

Share Repurchase Program

 

Our Board of Directors has authorized the repurchase of up to $2.075 billion of common stock under a share repurchase program that began on December 9, 1999 and expires on February 27, 2019. Funding for the share repurchase program has been provided through our credit facility, operating cash flow, stock option exercises and cash and cash equivalents.

 

On March 1, 2018, the Company announced a $100 million accelerated share repurchase agreement (“ASR Agreement”) with Bank of America, N.A. (“BofAML”).  Pursuant to the terms of the ASR Agreement, we paid BofAML $100.0 million in cash, and on March 6, 2018, we received an initial delivery of approximately 1.3 million shares of common stock for approximately $78.0 million.  The remaining $22.0 million of the ASR Agreement was completed May 14, 2018 delivering approximately 400,000 additional shares.  Under the competed ASR Agreement, approximately 1.7 million shares were repurchased for $100.0 million.

Cash Dividend

 

The Company paid dividends of approximately $14.8 million ($0.45 per common share) during the six months of 2018.  Subsequent to the second quarter on August 1, 2018, our Board of Directors declared a third quarter dividend of $0.225 per common share (approximately $7.2 million based on current shareholders of record). The dividend will be paid on August 24, 2018 to shareholders of record as of the close of business on August 13, 2018.  

 

Stockholder Rights Plan

 

On July 22, 2018, the Board of Directors of the Company approved the adoption of a limited duration stockholder rights plan (the “Rights Plan”) with an expiration date of July 22, 2019 and an ownership trigger threshold of 15% (with a threshold of 31% applied to John H. Schnatter, together with his affiliates and family members).  In connection with the Rights Plan, the Board of Directors authorized and declared a dividend to stockholders of record at the close of business on August 2, 2018 of one preferred share purchase right (a “Right”) for each outstanding share of Papa John’s common stock.  Upon certain triggering events, each Right would entitle the holder to purchase from the Company one one-thousandth (subject to adjustment) of one share of Series A Junior Participating Preferred Stock, $0.01 par value per share of the Company (“Preferred Stock”) at an exercise price of $250.00 (the “Exercise Price”) per one one-thousandth of a share of Preferred Stock. In addition, if a person or group acquires beneficial ownership of 15% or more of the

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Company’s common stock (or in the case of Mr. Schnatter, 31% or more) without prior board approval, each holder of a Right (other than the acquiring person or group whose Rights will become void) will have the right to purchase, upon payment of the Exercise Price and in accordance with the terms of the Rights Plan, a number of shares of the Company’s common stock having a market value of twice the Exercise Price.  The complete terms of the Rights are set forth in a Rights Agreement (the “Rights Agreement”), dated as of July 22, 2018, between the Company and Computershare Trust Company, N.A., as rights agent. The Rights expire on July 22, 2019 or upon an earlier redemption or exchange as provided in the Rights Agreement.

 

6.Earnings Per Share

 

We compute earnings per share using the two-class method. The two-class method requires an earnings allocation formula that determines earnings per share for common shareholders and participating security holders according to dividends declared and participating rights in undistributed earnings. We consider time-based restricted stock awards to be participating securities because holders of such shares have non-forfeitable dividend rights. Under the two-class method, undistributed earnings allocated to participating securities are subtracted from net income attributable to the Company in determining net income attributable to common shareholders.

 

The calculations of basic and diluted earnings per common share are as follows (in thousands, except per-share data):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

 

Six Months Ended

 

 

July 1,

 

June 25,

 

July 1,

 

June 25,

 

 

2018

    

2017

    

2018

    

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per common share:

 

 

 

 

 

 

 

 

 

 

 

 

Net income attributable to the Company

 

$

11,791

 

$

23,538

 

$

28,528

 

$

51,966

Change in noncontrolling interest redemption value

 

 

 —

 

 

662

 

 

 —

 

 

1,182

Net income attributable to participating securities

 

 

(72)

 

 

(99)

 

 

(147)

 

 

(216)

Net income attributable to common shareholders

 

$

11,719

 

$

24,101

 

$

28,381

 

$

52,932

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

 

31,941

 

 

36,732

 

 

32,610

 

 

36,771

Basic earnings per common share

 

$

0.37

 

$

0.66

 

$

0.87

 

$

1.44

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per common share:

 

 

 

 

 

 

 

 

 

 

 

 

Net income attributable to common shareholders

 

$

11,719

 

$

24,101

 

$

28,381

 

$

52,932

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

 

31,941

 

 

36,732

 

 

32,610

 

 

36,771

Dilutive effect of outstanding equity awards (a)

 

 

234

 

 

485

 

 

250

 

 

512

Diluted weighted average common shares outstanding

 

 

32,175

 

 

37,217

 

 

32,860

 

 

37,283

Diluted earnings per common share

 

$

0.36

 

$

0.65

 

$

0.86

 

$

1.42


(a) Excludes 1,257 and 1,143 awards for the three and sixth months ended July 1, 2018, respectively, and 325 and 215 awards for the three and six months ended June 25, 2017, respectively, as the effect of including such awards would have been antidilutive.

 

7.Divestitures

 

In the first quarter of 2018, the Company refranchised 31 restaurants owned through a joint venture in the Denver, Colorado market.  The Company held a 60% ownership share in the restaurants being refranchised.  The noncontrolling interest portion of the joint venture arrangement was previously recorded at redemption value within the Condensed Consolidated Balance Sheet.  Total consideration for the asset sale of the restaurants was $4.8 million, consisting of cash proceeds of $3.7 million, including cash paid for various working capital items, and notes financed by Papa John’s for $1.1 million.

 

In connection with the divestiture, we wrote off $700,000 of goodwill.  This goodwill was allocated based on the relative fair value of the sales proceeds versus the total fair value of the Company-owned restaurants’ reporting unit. 

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As a result of assigning our interest in obligations under property leases as a condition of the refranchising of the Denver market, we are contingently liable for payment of the 31 leases. These leases have varying terms, the latest of which expires in 2024. As of July 1, 2018, the estimated maximum amount of undiscounted payments the Company could be required to make in the event of nonpayment by the primary lessees was $3.6 million. The fair value of the guarantee is not material.

 

On June 15, 2018, the Company refranchised 34 Company-owned restaurants and a quality control center located in Beijing and Tianjin, China.  The assets and liabilities associated with the China operations were previously classified as Held for Sale in the Condensed Consolidated Balance Sheet as of December 31, 2017.  We recorded a pre-tax loss of approximately $1.9 million associated with the sale of the restaurants and reversed $1.3 million of accumulated other comprehensive income related to foreign currency translation as part of the disposal. The $1.9 million pre-tax loss is recorded in refranchising losses, net on the Condensed Consolidated Statements of Income.  In addition, we also had $2.4 million of additional tax expense associated with the China refranchise.  This additional tax expense is primarily attributable to the required recapture of operating losses previously taken by the Company.

 

Subsequent to the second quarter on July 2, 2018, the Company completed the refranchising of 31 stores owned through a joint venture in the Minneapolis, Minnesota market for $3.75 million. The Company holds a 70% ownership share in the stores being refranchised. We do not expect the divestiture to result in a significant refranchising gain or loss.  The following summarizes the assets that are held for sale (in thousands) as of July 1, 2018 related to the Minneapolis, Minnesota market:

 

 

 

 

 

Property and equipment

 

$

1,936

Goodwill

 

 

678

Inventory

 

 

153

Other

 

 

19

Assets held for sale

 

$

2,786

 

 

8.Debt                                                                                                                                                                                   

 

Long-term debt, net consists of the following (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

July 1,

 

 

December 31,

 

 

 

 

2018

 

 

2017

Outstanding debt

 

 

$

579,400

 

$

470,000

Unamortized debt issuance costs

 

 

 

(3,013)

 

 

(3,435)

Current portion of long-term debt

 

 

 

(20,000)

 

 

(20,000)

Total long-term debt, less current portion, net

 

 

$

556,387

 

$

446,565

 

Our outstanding debt of $579.4 million at July 1, 2018 represented amounts outstanding under our credit agreement executed in August 2017.  Our credit agreement provides for an unsecured revolving credit facility in an aggregate principal amount of $600.0 million (the “Revolving Facility”) and an unsecured term loan facility in an aggregate principal amount of $400.0 million (the “Term Loan Facility” and together with the Revolving Facility, the “Facilities”).  Additionally, we have the option to increase the Revolving Facility or the Term Loan Facility in an aggregate amount of up to $300.0 million, subject to certain conditions.  Our outstanding debt as of July 1, 2018 under the Facilities of $579.4 million was composed of $385.0 million outstanding under the Term Loan Facility and $194.4 million outstanding under the Revolving Facility. Including outstanding letters of credit, the remaining availability under the Facilities was approximately $371.8 million as of July 1, 2018. In connection with our credit agreement, the Company capitalized $3.2 million of debt issuance costs, which are being amortized into interest expense, over the term of the Facilities.

 

Loans under the Facilities accrue interest at a per annum rate equal to, at the Company’s election, either a LIBOR rate plus a margin ranging from 75 to 200 basis points or a base rate (generally determined by a prime rate, federal funds rate or a LIBOR rate plus 1.00%) plus a margin ranging from 0 to 100 basis points. In each case, the actual margin is determined according to a ratio of the Company’s total indebtedness to earnings before interest, taxes, depreciation and amortization (“EBITDA”) for the then most recently ended four-quarter period (the “Leverage Ratio”).  An unused

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commitment fee at a rate ranging from 15 to 30 basis points per annum, determined according to the Leverage Ratio, applies to the unutilized commitments under the Revolving Facility.  Loans outstanding under the credit agreement may be prepaid at any time without premium or penalty, subject to customary breakage costs in the case of borrowings for which a LIBOR rate election is in effect.  Up to $35.0 million of the Revolving Facility may be advanced in certain agreed foreign currencies, including Euros, Pounds Sterling, Canadian Dollars, Japanese Yen, and Mexican Pesos

 

The Facilities mature on August 30, 2022.  Quarterly amortization payments are required to be made on the Term Loan Facility in the amount of $5.0 million which began in the fourth quarter of 2017.  The obligations under the credit agreement are guaranteed by certain direct and indirect material subsidiaries of the Company. 

 

The credit agreement contains customary affirmative and negative covenants, including financial covenants requiring the maintenance of specified fixed charges and leverage ratios. At July 1, 2018, we were in compliance with these financial covenants.

 

We attempt to minimize interest risk exposure by fixing our rate through the utilization of interest rate swaps, which are derivative financial instruments. Our swaps are entered into with financial institutions that participate in our credit agreement. By using a derivative instrument to hedge exposures to changes in interest rates, we expose ourselves to credit risk. Credit risk is due to the possible failure of the counterparty to perform under the terms of the derivative contract.

 

We use interest rate swaps to hedge against the effects of potential interest rate increases on borrowings under our Facilities. As of July 1, 2018, we have the following interest rate swap agreements:

 

 

 

 

 

 

 

 

 

Effective Dates

    

Floating Rate Debt

    

Fixed Rates

 

April 30, 2018 through April 30, 2023

 

$

55

million  

 

2.33

%

April 30, 2018 through April 30, 2023

 

$

35

million  

 

2.36

%

April 30, 2018 through April 30, 2023

 

$

35

million  

 

2.34

%

January 30, 2018 through August 30, 2022

 

$

100

million  

 

1.99

%

January 30, 2018 through August 30, 2022

 

$

75

million  

 

1.99

%

January 30, 2018 through August 30, 2022

 

$

75

million  

 

2.00

%

January 30, 2018 through August 30, 2022

 

$

25

million  

 

1.99

%

 

The gain or loss on the swaps is recognized in other comprehensive income/(loss) and reclassified into earnings as adjustments to interest expense in the same period or periods during which the swaps affect earnings. Gains or losses on the swaps representing hedge components excluded from the assessment of effectiveness are recognized in current earnings.

 

The following table provides information on the location and amounts of our swaps in the accompanying condensed consolidated financial statements (in thousands):

 

 

 

 

 

 

 

 

 

Interest Rate Swap Derivatives

 

 

Fair Value

 

Fair Value

 

 

July 1,

 

December 31,

Balance Sheet Location

 

2018

 

2017

 

 

 

 

 

 

 

Other current and long-term assets

 

$

10,203

 

$

651

 

There were no derivatives that were not designated as hedging instruments.

 

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The effect of derivative instruments on the accompanying condensed consolidated financial statements is as follows (in thousands): 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Location of Gain

 

Amount of Gain

 

 

Derivatives -

 

Amount of Gain or

 

or (Loss)

 

or (Loss)

 

Total Interest Expense

Cash Flow

 

(Loss) Recognized

 

Reclassified from

 

Reclassified from

 

on Consolidated

Hedging

 

in AOCI/AOCL

 

AOCI/AOCL into

 

AOCI/AOCL into

 

Statements of

Relationships

 

on Derivative

 

Income

 

Income

 

Income

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate swaps for the three months ended:

 

 

 

 

 

 

July 1, 2018

 

$

2,207

 

 

Interest expense

 

$

(89)

 

$

(5,911)

June 25, 2017

 

$

(1,170)

 

 

Interest expense

 

$

(126)

 

$

(1,894)

Interest rate swaps for the six months ended:

 

 

 

 

 

 

 

 

 

July 1, 2018

 

$

7,380

 

 

Interest expense

 

$

(197)

 

$

(11,131)

June 25, 2017

 

$

(1,465)

 

 

Interest expense

 

$

(324)

 

$

(3,840)

 

The weighted average interest rates on our debt, including the impact of the interest rate swap agreements, were 3.6% for the three and six months ended July 1, 2018, compared to 2.3% for the corresponding prior year periods. Interest paid, including payments made or received under the swaps, was $5.8 million and $2.1 million for the three months ended July 1, 2018 and June 25, 2017, respectively, and $10.7 million and $3.9 million for the six months ended July 1, 2018 and June 25, 2017, respectively. As of July 1, 2018, the portion of the aggregate $10.2 million interest rate swap asset that would be reclassified into earnings during the next twelve months as interest income approximates $2.4 million.

 

9.Commitments and Contingencies

 

Litigation

 

The Company is involved in a number of lawsuits, claims, investigations and proceedings consisting of intellectual property, employment, consumer, commercial and other matters arising in the ordinary course of business. In accordance with ASC 450, “Contingencies” the Company makes accruals and or disclosures, with respect to these matters, where appropriate.

Ameranth, Inc. vs Papa John’s International, Inc. In August 2011, Ameranth, Inc. (“Ameranth”) filed various patent infringement actions against a number of defendants, including the Company, in the U.S. District Court for the Southern District of California (the “California Court”), which were consolidated by the California Court in October 2012 (the “Consolidated Case”). The Consolidated Case was stayed until January 2018 when Ameranth decided to proceed on only one patent, after the Company received a favorable decision by the Patent and Trademark Office on certain other patents.  A Markman hearing was held in December 2017, which did not dispose of Ameranth’s claims, and the California Court set a jury trial date of November 13, 2018 for the claims against the Company. The Company believes this case lacks merit and that it has strong defenses to all of the infringement claims. The Company intends to defend the suit vigorously. However, the Company is unable to predict the likelihood of success of Ameranth’s infringement claims. The Company has not recorded a liability related to this lawsuit as of July 1, 2018, as it does not believe a loss is probable or reasonably estimable.

 

Durling et al v. Papa John’s International, Inc., is a conditionally certified collective action filed in May 2016 in the United States District Court for the Southern District of New York (“the New York Court”), alleging that corporate restaurant delivery drivers were not properly reimbursed for vehicle mileage and expenses in accordance with the Fair Labor Standards Act ("FLSA"). In July 2018, the New York Court granted a motion to certify a conditional corporate collective class.  The Company continues to deny any liability or wrongdoing in this matter and intends to vigorously defend this action.  The Company has not recorded any liability related to this lawsuit as of July 1, 2018 as it does not believe a loss is probable or reasonably estimable.

 

Other Matters

 

Subsequent to the end of the second quarter, the Company has experienced negative publicity and consumer sentiment as a result of statements and actions by the Company’s founder and former spokesperson, John H. Schnatter.  Mr. Schnatter

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resigned as Chairman of the Board on July 11, 2018 and a Special Committee of the Board of Directors consisting of all of the independent directors was formed on July 15, 2018 to evaluate and take action with respect to all of the Company’s relationships and arrangements with Mr. Schnatter. Following its formation, the Special Committee terminated Mr. Schnatter’s Founder Agreement, which defined his role in the Company, among other things, as advertising and brand spokesperson for the Company. The Special Committee is also overseeing the previously announced external audit and investigation of all the Company’s existing processes, policies and systems related to diversity and inclusion, supplier and vendor engagement and Papa John’s culture. 

 

On July 17, 2018, the Company announced that the Special Committee appointed Akin Gump Strauss Hauer & Feld LLP to oversee the cultural audit and investigation.  This audit and investigation is ongoing.  In addition, on July 27, 2018, the Company announced that the Board’s Lead Independent Director, Olivia F. Kirtley, had been unanimously appointed by the Board of Directors to serve as Chairman of the Company’s Board of Directors.

 

The Company experienced, and expects to continue to experience, a decline in sales resulting from the aforementioned negative consumer sentiment.  While we are still in the process of gathering and estimating future costs, the Company currently expects to incur costs as a result of the recent events that include, but are not limited to, the following:

 

·

re-imaging costs at nearly all domestic and international restaurants,

·

costs to accelerate our replacement of certain branded assets and related marketing efforts, 

·

financial assistance to domestic franchisees, such as short-term royalty reductions, in an effort to mitigate closings,

·

additional costs for branding initiatives, including but not limited to, launching a new advertising and marketing campaign and promotional activities to mitigate negative consumer sentiment and negative sales trend,   

·

costs associated with a third-party audit of the culture at Papa John’s commissioned by the Special Committee as well as costs associated with implementing new policies and procedures to address any findings as a result of the audit, and

·

additional legal and advisory costs, including costs associated with the activities of the Special Committee.

The Company expects these costs to be material. 

 

On July 26, 2018, John H. Schnatter filed a complaint in the Court of Chancery of the State of Delaware seeking to inspect certain books and records of the Company.  While the Company believes that the request for inspection is not for a proper purpose under Delaware law and includes certain categories of documents relating to the Special Committee to which Mr. Schnatter is not entitled, the Company will comply with any decision of the Court of Chancery of the State of Delaware.

 

10.Segment Information

 

We have five reportable segments: domestic Company-owned restaurants, North America commissaries, North America franchising, international operations and “all other” units. The domestic Company-owned restaurant segment consists of the operations of all domestic (“domestic” is defined as contiguous United States) Company-owned restaurants and derives its revenues principally from retail sales of pizza and side items, including breadsticks, cheesesticks, chicken poppers and wings, dessert items and canned or bottled beverages. The North America commissary segment consists of the operations of our regional dough production and product distribution centers and derives its revenues principally from the sale and distribution of food and paper products to domestic Company-owned and franchised restaurants in the United States and Canada. The North America franchising segment consists of our franchise sales and support activities and derives its revenues from sales of franchise and development rights and collection of royalties from our franchisees located in the United States and Canada. The international segment principally consists of distribution sales to franchised Papa John’s restaurants located in the United Kingdom and Mexico and our franchise sales and support activities, which derive revenues from sales of franchise and development rights and the collection of royalties from our international franchisees. International franchisees are defined as all franchise operations outside of the United States and Canada. All other business units that do not meet the quantitative thresholds for determining reportable segments, which are not operating segments, we refer to as our “all other” segment, which consists of operations that derive revenues from the sale, principally to Company-owned and franchised restaurants, of printing and promotional items, franchise

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contributions to marketing funds and information systems and related services used in restaurant operations, including our point-of-sale system, online and other technology-based ordering platforms.

 

Generally, we evaluate performance and allocate resources based on profit or loss from operations before income taxes and intercompany eliminations. Certain administrative and capital costs are allocated to segments based upon predetermined rates or actual estimated resource usage. We account for intercompany sales and transfers as if the sales or transfers were to third parties and eliminate the activity in consolidation.

 

Our reportable segments are business units that provide different products or services. Separate management of each segment is required because each business unit is subject to different operational issues and strategies. No single external customer accounted for 10% or more of our consolidated revenues.

 

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Our segment information is as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

July 1,

 

June 25,

 

July 1,

 

June 25,

(In thousands)

 

    

2018

    

2017

    

2018

    

2017

Revenues

 

 

 

 

 

 

 

 

 

 

 

 

 

Domestic Company-owned restaurants

 

 

$

181,379

 

$

202,756

 

$

371,621

 

$

409,652

North America commissaries

 

 

 

153,455

 

 

160,059

 

 

315,168

 

 

331,399

North America franchising

 

 

 

23,912

 

 

26,588

 

 

48,718

 

 

54,195

International

 

 

 

34,652

 

 

30,230

 

 

70,184

 

 

58,748

All others

 

 

 

14,561

 

 

15,145

 

 

29,637

 

 

30,050

Total revenues

 

 

$

407,959

 

$

434,778

 

$

835,328

 

$

884,044

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Intersegment revenues:

 

 

 

 

 

 

 

 

 

 

 

 

 

North America commissaries

 

 

$

51,492

 

$

59,202

 

$

107,366

 

$

120,938

North America franchising

 

 

 

1,016

 

 

751

 

 

2,035

 

 

1,515

International

 

 

 

73

 

 

68

 

 

143

 

 

131

All others

 

 

 

7,578

 

 

4,084

 

 

15,652

 

 

9,110

Total intersegment revenues

 

 

$

60,159

 

$

64,105

 

$

125,196

 

$

131,694

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before income taxes:

 

 

 

 

 

 

 

 

 

 

 

 

 

Domestic Company-owned restaurants

 

 

$

8,304

 

$

15,550

 

$

15,533

 

$

31,037

North America commissaries (1)

 

 

 

8,730

 

 

12,088

 

 

17,340

 

 

24,332

North America franchising

 

 

 

21,380

 

 

23,999

 

 

43,739

 

 

48,874

International

 

 

 

2,278

 

 

3,265

 

 

5,815

 

 

7,609

All others (1) (2)

 

 

 

(1,728)

 

 

905

 

 

(2,638)

 

 

1,365

Unallocated corporate expenses (1) (2)

 

 

 

(19,324)

 

 

(19,086)

 

 

(37,454)

 

 

(35,467)

Elimination of intersegment (profits) losses

 

 

 

65

 

 

(1,263)

 

 

(268)

 

 

(421)

Total income before income taxes

 

 

$

19,705

 

$

35,458

 

$

42,067

 

$

77,329

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Property and equipment:

 

 

 

 

 

 

 

 

 

 

 

 

 

Domestic Company-owned restaurants

 

 

$

229,887

 

 

 

 

 

 

 

 

 

North America commissaries

 

 

 

138,452

 

 

 

 

 

 

 

 

 

International

 

 

 

17,064

 

 

 

 

 

 

 

 

 

All others

 

 

 

65,245

 

 

 

 

 

 

 

 

 

Unallocated corporate assets

 

 

 

195,279

 

 

 

 

 

 

 

 

 

Accumulated depreciation and amortization

 

 

 

(418,205)

 

 

 

 

 

 

 

 

 

Net property and equipment

 

 

$

227,722

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1)

The Company refined its overhead allocation process in 2018 resulting in transfers of expenses from Unallocated corporate expenses of $3.4 million to other segments, primarily North America commissaries of $1.9 million and All others of $900,000 for the three months ended July 1, 2018. The six months ended July 1, 2018 included transfers of expenses from Unallocated and corporate expenses of $7.2 million to other segments, primarily North America commissaries of $4.2 million and All others of $1.8 million. These allocations were eliminated in consolidation. 

(2)

Certain prior year amounts have been reclassified to conform to current year presentation.

 

 

 

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Note 11.     Reclassifications of Prior Year Balances

 

As shown in the table below we have reclassified certain prior year amounts within the Condensed Consolidated Statements of Income for the three and six months ended June 25, 2017 in order to conform with current year presentation. These reclassifications had no effect on previously reported total consolidated revenues, total costs and expenses and net income.

 

 

 

 

 

 

 

 

 

 

Papa John's International, Inc. and Subsidiaries

Condensed Consolidated Statements of Income

Summary of Income Statement Presentation Reclassifications

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended June 25, 2017

(In thousands, except per share amounts)

As reported

 

Reclassifications

 

Adjusted

Revenues:                                                                  

 

 

 

 

 

 

 

 

    North America commissary and other sales (1)

 

175,204

 

 

(15,145)

 

 

160,059

    International (2)

 

30,230

 

 

(2,985)

 

 

27,245

    Other revenues (1) (2)

 

 -

 

 

18,130

 

 

18,130

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

    North America commissary and other expenses (1)

 

162,989

 

 

(13,517)

 

 

149,472

    International expenses (2)

 

19,482

 

 

(2,210)

 

 

17,272

    Other expenses (1) (2) (3)

 

 -

 

 

17,482

 

 

17,482

    General and administrative expenses (3)

 

42,003

 

 

(1,755)

 

 

40,248

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Six Months Ended June 25, 2017

(In thousands, except per share amounts)

As reported

 

Reclassifications

 

Adjusted

Revenues:                                                                  

 

 

 

 

 

 

 

 

    North America commissary and other sales (1)

 

361,449

 

 

(30,050)

 

 

331,399

    International (2)

 

58,748

 

 

(5,881)

 

 

52,867

    Other revenues (1) (2)

 

 -

 

 

35,931

 

 

35,931

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

    North America commissary and other expenses (1)

 

336,701

 

 

(27,272)

 

 

309,429

    International expenses (2)

 

37,472

 

 

(4,409)

 

 

33,063

    Other expenses (1) (2) (3)

 

 -

 

 

35,029

 

 

35,029

    General and administrative expenses (3)

 

80,010

 

 

(3,348)

 

 

76,662

 

(1)

Includes reclassification of previous amounts reported in North America commissary and other sales and expenses including print and promotional items, information systems and related services used in restaurant operations, including our point of sale system, online and other technology-based ordering platforms.

(2)

Includes reclassification of previous amounts reported in International related to advertising expenses and rental income and expenses for United Kingdom head leases which are subleased to United Kingdom franchisees.

(3)

Includes reclassification of various technology related expenditures for fee-based services discussed in (1) above and advertising expenses to be consistent with 2018 presentation.

 

 

                                                                                                                           

 

 

 

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Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview

 

Papa John’s International, Inc. (referred to as the “Company,” “Papa John’s” or in the first-person notations of “we,” “us” and “our”) began operations in 1984. As of July 1, 2018, there were 5,247 Papa John’s restaurants (678 Company-owned and 4,569 franchised) operating in all 50 states and 46 international countries and territories. Our revenues are principally derived from retail sales of pizza and other food and beverage products to the general public by Company-owned restaurants, franchise royalties, sales of franchise and development rights, sales to franchisees of food and paper products, printing and promotional items, and information systems and related services used in their operations.

 

Recent Developments and Trends

 

Background on the Recent Negative Publicity

 

We have recently experienced negative publicity and consumer sentiment as a result of statements and actions by the Company’s founder and former spokesperson John H. Schnatter, which have materially and negatively impacted our sales.  The Company believes that the negative response to Mr. Schnatter’s recent statements and actions has been intensified due to Mr. Schnatter’s previous controversial statements and actions, including his statements in the fourth quarter of 2017 regarding his opinion that the National Football League (“NFL”) mishandled player protests during the national anthem. The Company is working to address these issues through its appointment of the Special Committee (as described below) together with various brand initiatives, including but not limited to, a new advertising and marketing campaign.

 

Mr. Schnatter resigned as Chairman of the Board on July 11, 2018 and a Special Committee of the Board of Directors consisting of all of the independent directors (the “Special Committee”) was formed on July 15, 2018 to evaluate and take action with respect to all of the Company’s relationships and arrangements with Mr. Schnatter.  Following its formation, the Special Committee terminated Mr. Schnatter’s Founder Agreement, which defined his role in the Company, among other things, as advertising and brand spokesperson for the Company. The Special Committee is also overseeing the previously announced external audit and investigation of all the Company’s existing processes, policies and systems related to diversity and inclusion, supplier and vendor engagement and Papa John’s culture.  On July 17, 2018, the Company announced that the Special Committee appointed Akin Gump Strauss Hauer & Feld LLP to oversee the cultural audit and investigation. This audit and investigation is ongoing.  In addition, on July 27, 2018, the Company announced that the Board’s Lead Independent Director, Olivia F. Kirtley, had been unanimously appointed by the Board of Directors to serve as Chairman of the Company’s Board of Directors. The Company is working to ensure that its corporate values of equity, diversity and inclusion are upheld throughout the organization and to address the challenges created by Mr. Schnatter’s words and actions.

 

Comparable Sales Trends.  In addition to the above actions, the Company is implementing various brand initiatives, including but not limited to, a new advertising and marketing campaign.  Still, the recent negative publicity caused by Mr. Schnatter’s statements and actions has impacted the Company’s brand and July sales in North America.  Our North America comparable sales for the July period decreased approximately 10.5%.  At this time, the Company cannot predict how long and the extent to which the negative customer sentiment will continue to impact future sales.

 

Future CostsThe Company also expects to incur significant costs as a result of the recent events that include, but are not limited to, the following:

 

·

re-imaging costs at nearly all domestic and international restaurants,

·

costs to accelerate our replacement of certain branded assets and related marketing efforts, 

·

financial assistance to domestic franchisees, such as short-term royalty reductions, in an effort to mitigate closings,

·

additional costs for branding initiatives, including but not limited to, launching a new advertising and marketing campaign and promotional activities to mitigate negative consumer sentiment and negative sales trends,   

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·

costs associated with a third-party audit of the culture at Papa John’s commissioned by the Special Committee as well as costs associated with implementing new policies and procedures to address any findings as a result of the audit, and

·

additional legal and advisory costs, including costs associated with the activities of the Special Committee.

The Company is still gathering information regarding these costs but has developed a preliminary range of $30 million to $50 million for the remainder of 2018.    

 

Presentation of Financial Results

 

The results of operations for the three and six months ended July 1, 2018 are based on the preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”). The preparation of consolidated financial statements requires management to select accounting policies for critical accounting areas and make estimates and assumptions that affect the amounts reported in the consolidated financial statements. Significant changes in assumptions and/or conditions in our critical accounting policies could materially impact our operating results. See “Notes 1, 2 and 3” of “Notes to Condensed Consolidated Financial Statements” for a discussion of the basis of presentation and the significant accounting policies.

 

Restaurant Progression

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    

Three Months Ended

 

Six Months Ended

 

    

July 1, 2018

    

June 25, 2017

    

July 1, 2018

    

June 25, 2017

 

 

 

 

 

 

 

 

 

 

 

 

 

North America Company-owned:

 

 

 

 

 

 

 

 

 

 

 

 

Beginning of period

 

 

679

 

 

705

 

 

708

 

 

702

Opened

 

 

 1

 

 

 —

 

 

 5

 

 

 2

Closed

 

 

(2)

 

 

 —

 

 

(4)

 

 

 —

Acquired from franchisees

 

 

 —

 

 

 —

 

 

 —

 

 

 1

Sold to franchisees

 

 

 —

 

 

 —

 

 

(31)

 

 

 —

End of period

 

 

678

 

 

705

 

 

678

 

 

705

International Company-owned:

 

 

 

 

 

 

 

 

 

 

 

 

Beginning of period

 

 

34

 

 

41

 

 

35

 

 

42

Closed

 

 

 —

 

 

(2)

 

 

(1)

 

 

(3)

Sold to franchisees

 

 

(34)

 

 

 —

 

 

(34)

 

 

 

End of period

 

 

 —

 

 

39

 

 

 —

 

 

39

North America franchised:

 

 

 

 

 

 

 

 

 

 

 

 

Beginning of period

 

 

2,745

 

 

2,723

 

 

2,733

 

 

2,739

Opened

 

 

26

 

 

28

 

 

44

 

 

43

Closed

 

 

(42)

 

 

(28)

 

 

(79)

 

 

(58)

Acquired form Company

 

 

 —

 

 

 —

 

 

31

 

 

 —

Sold to Company

 

 

 —

 

 

 —

 

 

 —

 

 

(1)

End of period

 

 

2,729

 

 

2,723

 

 

2,729

 

 

2,723

International franchised:

 

 

 

 

 

 

 

 

 

 

 

 

Beginning of period

 

 

1,754

 

 

1,613

 

 

1,723

 

 

1,614

Opened

 

 

61

 

 

49

 

 

114

 

 

87

Closed

 

 

(9)

 

 

(41)

 

 

(31)

 

 

(80)

Acquired from Company

 

 

34

 

 

 —

 

 

34

 

 

 

End of period

 

 

1,840

 

 

1,621

 

 

1,840

 

 

1,621

Total restaurants - end of period

 

 

5,247

 

 

5,088

 

 

5,247

 

 

5,088

 

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Item Impacting Comparability; Non-GAAP Measures

 

The following table reconciles our GAAP financial results to the adjusted (non-GAAP) financial results, excluding the Special items detailed below.  We present these non-GAAP measures because we believe the Special items impact the comparability of our results of operations.  For additional information about the Special items, see “Note 7” of “Notes to Condensed Consolidated Financial Statements.”

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

 

Six Months Ended

 

 

July 1,

 

June 25,

 

July 1,

 

June 25,

(In thousands, except per share amounts)

    

2018

    

2017

 

2018

    

2017

GAAP Income before income taxes

 

$

19,705

 

$

35,458

 

$

42,067

 

$

77,329

Special items:

 

 

 

 

 

 

 

 

 

 

 

 

 Refranchising losses, net

 

 

2,122

 

 

 —

 

 

1,918

 

 

 —

Adjusted income before income taxes

 

$

21,827

 

$

35,458

 

$

43,985

 

$

77,329

 

 

 

 

 

 

 

 

 

 

 

 

 

GAAP Net income

 

$

11,791

 

$

23,538

 

$

28,528

 

$

51,966

Special items:

 

 

 

 

 

 

 

 

 

 

 

 

 Refranchising losses, net (1)

 

 

1,647

 

 

 —

 

 

1,488

 

 

 —

 Tax impact of China refranchising

 

 

2,435

 

 

 —

 

 

2,435

 

 

 —

Adjusted net income

 

$

15,873

 

$

23,538

 

$

32,451

 

$

51,966

 

 

 

 

 

 

 

 

 

 

 

 

 

GAAP Diluted earnings per share

 

$

0.36

 

$

0.65

 

$

0.86

 

$

1.42

Special items:

 

 

 

 

 

 

 

 

 

 

 

 

 Refranchising losses, net

 

 

0.05

 

 

 —

 

 

0.05

 

 

 —

 Tax impact of China refranchising

 

 

0.08

 

 

 —

 

 

0.07

 

 

 —

Adjusted diluted earnings per share

 

$

0.49

 

$

0.65

 

$

0.98

 

$

1.42

(1)

Tax effect was calculated using the Company’s marginal rate of 22.4%.

 

On June 15, 2018, we refranchised our China operations including our 34 Company-owned restaurants and the quality control center. The refranchising losses, net of tax, of $1.6 million for the second quarter of 2018 and $1.5 million for the six months ended July 1, 2018 primarily occurred due to the China refranchise. We also had $2.4 million of additional tax expense associated with the China refranchise. This additional tax expense is primarily attributable to the required recapture of operating losses previously taken by the Company.  See “Results of Operations” for further analysis regarding the impact of the Special items.

 

The non-GAAP adjusted results shown above should not be construed as a substitute for or a better indicator of the Company’s performance than the Company’s GAAP results. Management believes presenting the financial information excluding these Special items is important for purposes of comparison to prior year results. In addition, management uses these metrics to evaluate the Company’s underlying operating performance, to analyze trends, and to determine compensation.

 

Results of Operations

 

Revenue Recognition and Income Statement Presentation

 

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”), which supersedes nearly all existing revenue recognition guidance under GAAP, including industry-specific requirements, and provides companies with a single revenue recognition framework for recognizing revenue from contracts with customers. In March and April 2016, the FASB issued the following amendments to clarify the implementation guidance: ASU 2016-08, “Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)” and ASU 2016-10, “Revenue from Contracts with Customers (Topic 606):

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Identifying Performance Obligations and Licensing”. This update and subsequently issued amendments (collectively “Topic 606”) requires companies to recognize revenue at amounts that reflect the consideration to which the company expects to be entitled in exchange for those goods or services at the time of transfer. The standard requires that we assess contracts to determine each separate and distinct performance obligation.  If a contract has multiple performance obligations, we allocate the transaction price using our best estimate of the standalone selling price to each distinct good or service in the contract. 

 

We adopted Topic 606 using the modified retrospective transition method effective January 1, 2018.  Results for reporting periods beginning after January 1, 2018 are presented under Topic 606, while prior period amounts are not adjusted and continue to be reported in accordance with our historical accounting under Topic 605, Revenue Recognition. 

 

The cumulative effect adjustment of $21.5 million was recorded as a reduction to retained earnings as of January 1, 2018 to reflect the impact of adopting Topic 606. The impact of applying Topic 606 for the three and six months ended July 1, 2018 included the following (dollars in thousands, except for per share amounts):

 

 

 

 

 

 

 

 

Three Months

 

Six Months

 

Ended

 

Ended

 

July 1, 2018

 

July 1, 2018

Total revenue impact (a)

$

1,814

 

$

$ 4,250

Pre-tax income impact (b)

 

(1,375)

 

 

(1,860)

Diluted EPS

 

(0.03)

 

 

(0.04)

 

(a)

The increase in total revenues of $1.8 million and $4.3 million for the three and six months ended July 1, 2018 is primarily due to the requirement to present revenues and expenses related to marketing funds we control on a “gross” basis. This increase was partially offset by lower Company-owned restaurant revenues attributable to the revised method of accounting for the loyalty program. The marketing fund gross up is reported in the new financial statement line items, Other revenues and Other expenses, as discussed further below.

(b)

The $1.4 million and $1.9 million decreases in pre-tax income for the three and six months ended July 1, 2018 are primarily due to the revised method of accounting for the loyalty program, marketing fund co-ops we control and franchise fees.

 

While not required as part of the adoption of Topic 606, our income statement includes newly created Other revenues and Other expenses line items.  Other revenues and Other expenses include the Topic 606 “gross up” of respective revenues and expenses derived from certain domestic and international marketing fund co-ops we control, as previously discussed. Additionally, Other revenues and Other expenses include various reclassifications from North America Commissary and Other, International and general and administrative expenses to better reflect and aggregate various domestic and international services provided by the Company for the benefit of franchisees.  Related 2017 amounts have also been reclassified to conform to the new 2018 presentation. These reclassifications had no impact on total revenues or total costs and expenses reported.

 

Review of Consolidated Operating Results

 

Revenues. Domestic Company-owned restaurant sales decreased $21.4 million, or 10.5%, and $38.0 million, or 9.3%, for the three and six months ended July 2018, respectively.  These decreases were primarily due to reductions of 7.2% and 6.7% in comparable sales and reductions of 3.6% and 2.4% in equivalent units for the three and six months ended July 1, 2018, respectively, driven by the refranchising of the Denver market in the first quarter of 2018.  “Comparable sales” represents the change in year-over-year sales for the same base of restaurants for the same fiscal periods.  “Equivalent units” represents the number of restaurants open at the beginning of a given period, adjusted for restaurants opened, closed, acquired or sold during the period on a weighted average basis. 

 

North America franchise royalties and fees decreased $2.7 million, or 10.1%, and $5.5 million, or 10.1%, for the three and six months ended July 1, 2018, respectively, primarily due to comparable sales decreases of 5.7% and 5.3% for the three and six months ended July 1, 2018, respectively, and an increase in franchise royalty waivers.  North America

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franchise restaurant sales decreased 4.6% to $539.7 million and 4.8% to $1.1 billion for the three and six months ended July 1, 2018, respectively.  North America franchise restaurant sales are not included in Company revenues; however, our North America franchise royalties are derived from these sales.

 

North America commissary sales decreased $6.6 million, or 4.1%, and $16.2 million, or 4.9%, for the three and six months ended July 1, 2018, respectively.  The decreases were primarily due to lower sales volumes attributable to lower restaurant sales, partially offset by higher commodity pricing. 

 

International revenues increased $1.8 million, or 6.7%, and $6.3 million, or 11.9%, for the three and six months ended July 1, 2018, respectively.  These increases were primarily due to an increase in equivalent units and the favorable impact of foreign exchange rates for the three and six months ended July 1, 2018. The favorable impacts of foreign currency exchange rates were approximately $1.2 million and $4.0 million for the three and six months ended July 1, 2018 which was primarily attributable to foreign exchange rates in the United Kingdom (“UK”). 

 

International franchise restaurant sales increased 12.7% to $207.0 million and 12.4% to $415.5 million in the three and six months ended July 1, 2018, respectively, excluding the impact of foreign currency.  The increases for the three and six-month periods were primarily due to an increase in equivalent units. International franchise restaurant sales are not included in Company revenues; however, our international royalty revenue is derived from these sales.

 

Other revenues increased $2.0 million, or 11.1%, and $4.7 million, or 13.1%, for the three and six months ended July 1, 2018, respectively.  The increases were primarily due to the required 2018 reporting of franchise marketing fund revenues and expenses on a gross basis for the various funds we control in accordance with Topic 606 guidelines. These amounts were previously reported on a net basis. As we did not restate the 2017 amounts in accordance with our adoption of Topic 606 guidelines using the modified retrospective approach, comparability between 2018 and 2017 amounts is reduced. See “Note 3” of “Notes to Condensed Consolidated Financial Statements” for more details. This increase was partially offset by lower revenues for Preferred Marketing Solutions, our print and promotions subsidiary.

 

Costs and expenses.  The operating margin for domestic Company-owned restaurants was 18.5% and 17.9% for the three and six months ended July 1, 2018, respectively, compared to 19.9% and 20.0% in the corresponding 2017 periods, and consisted of the following (dollars in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended

 

Six months ended

 

July 1, 2018

 

 

June 25, 2017

 

 

July 1, 2018

 

June 25, 2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Restaurant sales

$

181,379

 

 

 

 

$

202,756

 

 

 

 

$

371,621

 

 

 

 

$

409,652

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of sales

 

39,438

 

 

21.7%

 

 

46,202

 

22.8%

 

 

 

82,583

 

 

22.2%

 

 

93,114

 

22.7%

Other operating expenses

 

108,343

 

 

59.7%

 

 

116,231

 

57.3%

 

 

 

222,517

 

 

59.9%

 

 

234,738

 

57.3%

Total expenses

$

147,781

 

 

81.5%

 

$

162,433

 

80.1%

 

 

$

305,100

 

 

82.1%

 

$

327,852

 

80.0%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Margin

$

33,598

 

 

18.5%

 

$

40,323

 

19.9%

 

 

$

66,521

 

 

17.9%

 

$

81,800

 

20.0%

 

Domestic Company-owned restaurants margin decreased $6.7 million and $15.3 million in the three and six months ended July 1, 2018, respectively.  The margin decreases for the second quarter and six-month period were primarily attributable to lower comparable sales of 7.2% and increased operating costs including higher commodities and minimum wages as well as increased non-owned automobile costs.  Additionally, the adoption of Topic 606 reduced restaurant operating margin due to the revised method of accounting for the customer loyalty program. 

 

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North America commissary margins were 6.6% and 6.4% for the three and six months ended July 1, 2018, respectively, compared to 6.6% for both the three and six months ended June 25, 2017 and consisted of the following (dollars in thousands):

 

 

 

 

 

 

 

 

 

 

 

Three months ended

 

July 1, 2018

 

 

June 25, 2017

North America commissary sales

$

153,455

 

 

 

$

160,059

 

 

North America commissary expenses

 

143,300

 

 

 

 

149,472

 

 

Margin

$

10,155

 

6.6%

 

$

10,587

 

6.6%

 

 

 

 

 

 

 

 

 

 

 

Six months ended

 

July 1, 2018

 

 

June 25, 2017

North America commissary sales

$

315,168

 

 

 

$

331,399

 

 

North America commissary expenses

 

294,981

 

 

 

 

309,429

 

 

Margin

$

20,187

 

6.4%

 

$

21,970

 

6.6%

 

North America commissary operating margins were consistent as a percentage of sales for the three and six months ended July 1, 2018, compared to the corresponding periods in 2017, but decreased $400,000 and $1.8 million, respectively, primarily due to lower sales volumes. 

 

The international operating margins were 37.2% and 37.0% for the three and six months ended July 1, 2018, compared to 36.6% and 37.5% for the corresponding 2017 periods and consisted of the following (dollars in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended

 

July 1, 2018

 

 

June 25, 2017

 

Revenues

 

Expenses

 

Margin $

 

Margin %

 

 

Revenues

 

Expenses

 

Margin $

 

Margin %

Franchise royalties and fees

$

8,987

 

$

 -

 

$

8,987

 

 

 

 

$

8,195

 

$

 -

 

$

8,195

 

 

Restaurant, commissary and other

 

20,082

 

 

18,248

 

 

1,834

 

9.1%

 

 

 

19,050

 

 

17,272

 

 

1,778

 

9.3%

Total international

$

29,069

 

$

18,248

 

$

10,821

 

37.2%

 

 

$

27,245

 

$

17,272

 

$

9,973

 

36.6%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Six months ended

 

 

July 1, 2018

 

 

June 25, 2017

 

Revenues

 

Expenses

 

Margin $

 

Margin %

 

 

Revenues

 

Expenses

 

Margin $

 

Margin %

Franchise royalties and fees

$

17,969

 

$

 -

 

$

17,969

 

 

 

 

$

16,131

 

$

 -

 

$

16,131

 

 

Restaurant, commissary and other

 

41,214

 

 

37,278

 

 

3,936

 

9.6%

 

 

 

36,736

 

 

33,063

 

 

3,673

 

10.0%

Total international

$

59,183

 

$

37,278

 

$

21,905

 

37.0%

 

 

$

52,867

 

$

33,063

 

$

19,804

 

37.5%

 

The increase in margin of approximately $800,000 and $2.1 million for the three and six months ended July 1, 2018, respectively, was primarily attributable to higher royalties on increased franchise restaurant sales, primarily due to an increase in equivalent units and higher income from the United Kingdom Quality Control Center.

 

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As previously discussed, other revenues and other expenses are new financial statement line items in 2018. The margin from Other operations decreased $1.2 million and $1.9 million for the three and six months ended July 1, 2018, respectively, primarily due to higher costs related to various technology initiatives and increased advertising spend in the United Kingdom. The Other revenues and expenses consisted of the following for the three and six months ended July 1, 2018 (dollars in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended

 

July 1, 2018

 

 

June 25, 2017

Other revenues

$

20,144

 

 

 

$

18,130

 

 

Other expenses

 

20,698

 

 

 

 

17,482

 

 

Margin (loss)

$

(554)

 

-2.8%

 

$

648

 

3.6%

 

 

 

 

 

 

 

 

 

 

 

Six months ended

 

July 1, 2018

 

 

June 25, 2017

Other revenues

$

40,638

 

 

 

$

35,931

 

 

Other expenses

 

41,656

 

 

 

 

35,029

 

 

Margin (loss)

$

(1,018)

 

-2.5%

 

$

902

 

2.5%

 

 

 

 

 

 

 

 

 

 

Operating margin is not a measurement defined by GAAP and should not be considered in isolation, or as an alternative to evaluation of the Company’s financial performance. In addition to an evaluation of GAAP consolidated income before income taxes, we believe the presentation of operating margin is beneficial as it represents an additional measure used by the Company to further evaluate operating efficiency and performance of the various business units. Additionally, operating margin discussion may be helpful for comparison within the industry. The operating margin results detailed herein can be calculated by business unit based on the specific revenue and operating expense line items on the face of the Condensed Consolidated Income Statement. Consolidated income before income taxes reported includes general and administrative expenses, depreciation and amortization, refranchising losses and net interest expense that have been excluded from this operating margin calculation.

 

General and administrative (“G&A”) expenses were $38.7 million, or 9.5%, and $78.4 million, or 9.4% of revenues for the three and six months ended July 1, 2018, respectively, compared to $40.2 million, or 9.3% and $76.7 million, or 8.7% for the corresponding 2017 periods, respectively.  The decrease of $1.5 million was primarily due to lower management incentive and benefit costs as well as a shift in timing of the annual operators’ conference to the third quarter of 2018.  These costs were partially offset by an increase in various technology initiative costs and higher bad debt expense.  The increase of $1.8 million for the six months period was due to an increase in various technology initiatives costs, and higher bad debt expenses and legal fees.

 

Depreciation and amortization. Depreciation and amortization was $11.7 million, or 2.9% and $23.3 million, or 2.8% of revenues for the three and six months ended July 1, 2018, respectively, compared to $10.7 million, or 2.5% and $21.1 million, or 2.4% of revenues for the corresponding periods in 2017, respectively. These increases are primarily due to additional depreciation on technology related investments and higher depreciation associated with our new Georgia Quality Control Center.

 

Refranchising losses, net. Refranchising losses of $2.1 million and $1.9 million for the three and six months ended July 1, 2017, respectively, were primarily related to the refranchising of China.  For additional information on the refranchising loss, net, see “Note 7” of “Notes to Condensed Consolidated Financial Statements.”

 

Interest expense. Interest expense increased approximately $3.9 million and $7.0 million for the three and six months ended July 1, 2018, respectively, primarily due to both an increase in average outstanding debt balance, which is primarily due to share repurchases, as well as higher interest rates.

 

Income before income taxes. For the reasons discussed above, income before income taxes decreased approximately $15.8 million, or 44.4% for the three months ended July 1, 2018 compared to the same periods in 2017, and decreased approximately $35.3 million, or 45.6% for the six months ended July 1, 2018 as compared to the same period in 2017.

 

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Income tax expense.  The effective income tax rates were 35.7% and 28.6% for the three and six months ended July 1, 2018, respectively, representing an increase of 6.2% and a decrease of 0.5% from the prior year comparable periods.  The increase for the three-month period ending July 1, 2018 was due to the additional income tax from the China refranchising, as previously discussed.  See “Note 7” of “Notes to Condensed Consolidated Financial Statements” for additional information. Excluding the China refranchising impact of 12.4% and 5.8%, the effective income tax rates were 23.4% and 22.8% for the three and six months ended July 1, 2018.

 

Diluted earnings per share. Diluted earnings per share decreased 44.6% to $0.36 for the second quarter of 2018 and decreased 39.4% to $0.86 for the six months ended July 1, 2018.  Adjusted diluted earnings per share decreased 24.6% to $0.49 for the second quarter of 2018 and 31.0% to $0.98 for the six months ended. 

 

Liquidity and Capital Resources

 

Debt 

 

Our outstanding debt of $579.4 million at July 1, 2018 represented amounts outstanding under our credit agreement executed in August 2017. The credit agreement provides for an unsecured revolving credit facility in an aggregate principal amount of $600.0 million (the “Revolving Facility”) and an unsecured term loan facility in an aggregate principal amount of $400.0 million (the “Term Loan Facility” and together with the Revolving Facility, the “Facilities”).  Additionally, we have the option to increase the Revolving Facility or the Term Loan Facility in an aggregate amount of up to $300.0 million, subject to certain conditions.  Our outstanding debt of $579.4 million as of July 1, 2018 under the Facilities was composed of $385.0 million outstanding under the Term Loan Facility and $194.4 million outstanding under the Revolving Facility. Including outstanding letters of credit, the remaining availability under the Facilities was approximately $371.8 million as of July 1, 2018. In connection with the credit agreement, the Company capitalized $3.2 million of debt issuance costs, which are being amortized into interest expense, over the term of the Facilities.

 

Loans under the Facilities accrue interest at a per annum rate equal to, at the Company’s election, either a LIBOR rate plus a margin ranging from 75 to 200 basis points or a base rate (generally determined by a prime rate, federal funds rate or a LIBOR rate plus 1.00%) plus a margin ranging from 0 to 100 basis points. In each case, the actual margin is determined according to a ratio of the Company’s total indebtedness to earnings before interest, taxes, depreciation and amortization (“EBITDA”) for the then most recently ended four-quarter period (the “Leverage Ratio”).  An unused commitment fee at a rate ranging from 15 to 30 basis points per annum, determined according to the Leverage Ratio, applies to the unutilized commitments under the Revolving Facility.  Loans outstanding under the credit agreement may be prepaid at any time without premium or penalty, subject to customary breakage costs in the case of borrowings for which a LIBOR rate election is in effect.  Up to $35.0 million of the Revolving Facility may be advanced in certain agreed foreign currencies, including Euros, Pounds Sterling, Canadian Dollars, Japanese Yen, and Mexican Pesos

 

We use interest rate swaps to hedge against the effects of potential interest rate increases on borrowings under our Facilities. As of July 1, 2018, we have the following interest rate swap agreements, including three forward starting swaps executed in 2015 that became effective on April 30, 2018 upon expiration of the two existing swaps for $125 million.  In addition, in 2017 we executed an additional four interest rate swaps for $275 million that became effective on January 30, 2018.

 

 

 

 

 

 

 

 

Effective Dates

    

Floating Rate Debt 

    

Fixed Rates

 

April 30, 2018 through April 30, 2023

 

$

55 million

 

2.33

%

April 30, 2018 through April 30, 2023

 

$

35 million

 

2.36

%

April 30, 2018 through April 30, 2023

 

$

35 million

 

2.34

%

January 30, 2018 through August 30, 2022

 

$

100 million

 

1.99

%

January 30, 2018 through August 30, 2022

 

$

75 million

 

1.99

%

January 30, 2018 through August 30, 2022

 

$

75 million

 

2.00

%

January 30, 2018 through August 30, 2022

 

$

25 million

 

1.99

%

 

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Our credit agreement contains affirmative and negative covenants, including the following financial covenants, as defined by the credit agreement:

 

 

 

 

 

 

 

 

 

Actual Ratio for the

 

 

 

 

Quarter Ended

 

    

Permitted Ratio

    

July 1, 2018

Leverage Ratio

 

Not to exceed 4.5 to 1.0

 

3.4 to 1.0

 

 

 

 

 

Interest Coverage Ratio

 

Not less than 2.75 to 1.0

 

3.4 to 1.0

 

As stated above, our leverage ratio is defined as outstanding debt divided by consolidated EBITDA for the most recent four fiscal quarters.  Subsequent to the end of the second quarter of 2018, the Leverage Ratio permitted decreased to 4.25 to 1.00 in accordance with the terms of the credit agreement.  The Leverage Ratio permitted by the credit agreement will decrease over time to 3.75 to 1.00.

 

Our interest coverage ratio is defined as the sum of consolidated EBITDA and consolidated rental expense for the most recent four fiscal quarters divided by the sum of consolidated interest expense and consolidated rental expense for the most recent four fiscal quarters.

 

We were in compliance with all financial covenants as of July 1, 2018.  Based on our revised lower financial forecast, we plan to work with the banks within our Credit Facility to evaluate options with the covenants to mitigate the possibility of violating a financial covenant in the future.  If a covenant violation occurs or is expected to occur, we would be required to seek a waiver or amendment from the lenders under the credit agreement.  The failure to obtain a waiver or amendment on a timely basis would result in our inability to borrow additional funds or obtain letters of credit under our credit agreement and allow the lenders under our credit agreement to declare our loan obligations due and payable, require us to cash collateralize outstanding letters of credit or increase our interest rate. If any of the foregoing events occur, we would need to refinance our debt, or renegotiate or restructure, the terms of the credit agreement.

 

Cash Flows

 

Cash flow provided by operating activities was $74.2 million in the six months ending July 1, 2018 compared to $77.9 million in the corresponding period in 2017. The decrease of approximately $3.7 million was primarily due to lower net income somewhat offset by favorable changes in working capital items. 

 

Our free cash flow, a non-GAAP financial measure, was as follows in the second quarter of 2018 and 2017 (in thousands):

 

 

 

 

 

 

 

 

 

Six Months Ended

 

    

July 1,

    

June 25,

 

 

2018

 

2017

 

 

 

 

 

 

 

Net cash provided by operating activities

 

$

74,201

 

$

77,863

Purchases of property and equipment

 

 

(21,562)

 

 

(30,457)

Free cash flow (a)

 

$

52,639

 

$

47,406


(a)

Free cash flow, a non-GAAP measure, is defined as net cash provided by operating activities (from the consolidated statements of cash flows) less the purchases of property and equipment. We view free cash flow as an important liquidity measure because it is one factor that management uses in determining the amount of cash available for discretionary investment. However, it does not represent residual cash flows available for discretionary expenditures.  Free cash flow is not a term defined by GAAP, and as a result, our measure of free cash flow might not be comparable to similarly titled measures used by other companies. Free cash flow should not be construed as a substitute for or a better indicator of our liquidity or performance than the Company’s GAAP measures.

 

Cash flow used in investing activities was $16.9 million in the six months ending July 1, 2018 compared to $29.8 million for the same period in 2017, or a decrease of $12.9 million. The decrease in cash flow used in investing activities was primarily lower capital spend as 2017 included construction costs for our commissary in Georgia, which opened in July of 2017.  We also received $3.7 million in proceeds from the refranchising of our joint venture in Denver, Colorado which was completed in the first quarter of 2018.

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We also require capital for share repurchases and the payment of cash dividends, which are funded by cash flow from operations and borrowings from our credit agreement. In the six months ending July 1, 2018, we had net proceeds of $109.4 million from the issuance of long-term debt and spent $148.4 million on share repurchases.  In the six months ending June 25, 2017, we had net proceeds of $5.2 million from issuance of long-term debt and spent $34.0 million of share repurchases. 

 

On March 1, 2018 the Company announced a $100 million accelerated share repurchase agreement (“ASR Agreement”) with Bank of America, N.A. (“BofAML”).  Pursuant to the terms of the ASR Agreement, we paid BofAML $100 million in cash.  On March 6, 2018, we received an initial delivery of approximately 1.3 million shares of common stock for approximately $78.0 million, or 78% of the total ASR Agreement.  The remaining $22.0 million of the ASR Agreement was completed May 14, 2018, delivering approximately 400,000 additional shares.  Under the completed ASR Agreement, approximately 1.7 million shares were repurchased for $100.0 million. 

 

The Company does not expect to repurchase any more shares in 2018 after the current trading plan expires in early August.

 

We paid cash dividends of approximately $14.8 million ($0.45 per common share) and $14.7 million ($0.40 per common share) for the six months ended July 1, 2018 and June 25, 2017, respectively. Subsequent to the second quarter on August 1, 2018, our Board of Directors declared a third quarter dividend of $0.225 per common share (approximately $7.2 million based on the number of shares outstanding). The dividend will be paid on August 24, 2018 to shareholders of record as of the close of business on August 13, 2018. The declaration and payment of any future dividends will be at the discretion of our Board of Directors, subject to the Company’s financial results, cash requirements, and other factors deemed relevant by our Board of Directors.

 

Forward-Looking Statements

 

Certain matters discussed in this report, including information within Management’s Discussion and Analysis of Financial Condition and Results of Operations, constitute forward-looking statements within the meaning of the federal securities laws.  Generally, the use of words such as “expect,” “intend,” “estimate,” “believe,” “anticipate,” “will,” “forecast,” “plan,” “project,” or similar words identify forward-looking statements that we intend to be included within the safe harbor protections provided by the federal securities laws. Such forward-looking statements may relate to projections or guidance concerning business performance, revenue, earnings, cash flow, contingent liabilities, resolution of litigation, commodity costs, profit margins, unit growth, unit level performance, capital expenditures, ability of the Company to mitigate negative consumer sentiment through advertising, marketing and promotional activity, corporate governance, shareholder and other stakeholder engagement, strategic decisions and actions, the ongoing cultural audit and investigation, share repurchases, dividends, effective tax rates, the impact of the Tax Cuts and Job Act and the adoption of new accounting standards, and other financial and operational measures. Such statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions, which are difficult to predict and many of which are beyond our control. Therefore, actual outcomes and results may differ materially from those matters expressed or implied in such forward-looking statements. The risks, uncertainties and assumptions that are involved in our forward-looking statements include, but are not limited to: 

 

·

negative publicity and consumer sentiment as a result of statements and actions by the Company’s founder and former spokesperson, which may continue to cause sales to decline and/or change consumers’ acceptance of and enthusiasm for our brand;

·

the results of the previously announced external audit and investigation the Special Committee is overseeing regarding the Company’s existing processes, policies and systems related to diversity and inclusion, supplier and vendor engagement and the Company’s culture;

·

costs the Company expects to incur as a result of the recent negative publicity and negative consumer sentiment, including costs related to the audit and investigation, costs associated with the operations of the Special Committee, any costs associated with related litigation, legal fees, and increased costs for branding initiatives and launching a new advertising and marketing campaign and promotions to mitigate negative consumer sentiment and negative sales trends;

·

costs the Company expects to incur relating to franchisee financial assistance to mitigate store closings;

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·

the ability of the Company to mitigate the negative consumer sentiment through advertising, marketing and promotional activities;

·

the Company’s ability to regain lost customers;

·

aggressive changes in pricing or other marketing or promotional strategies by competitors, which may adversely affect sales and profitability; and new product and concept developments by food industry competitors;

·

changes in consumer preferences or consumer buying habits, including the growing popularity of delivery aggregators, as well as changes in general economic conditions or other factors that may affect consumer confidence and discretionary spending; 

·

the adverse impact on the Company or our results caused by product recalls, food quality or safety issues, incidences of foodborne illness, food contamination and other general public health concerns about our Company-owned or franchised restaurants or others in the restaurant industry;

·

the effectiveness of our initiatives to improve our brand proposition and operating results, including marketing, advertising and public relations initiatives, technology investments and changes in unit-level operations;

·

the risk that any new advertising or marketing campaign may not be effective in increasing sales;

·

the ability of the Company and its franchisees to meet planned growth targets and operate new and existing restaurants profitably, including difficulties finding qualified franchisees, store level employees or suitable sites;

·

increases in food costs or sustained higher other operating costs. This could include increased employee compensation, benefits, insurance, tax rates, new regulatory requirements or increasing compliance costs;

·

increases in insurance claims and related costs for programs funded by the Company up to certain retention limits, including medical, owned and non-owned vehicles, workers’ compensation, general liability and property;

·

disruption of our supply chain or commissary operations which could be caused by our sole source of supply of cheese or limited source of suppliers for other key ingredients or more generally due to weather, natural disasters including drought, disease, or geopolitical or other disruptions beyond our control;

·

increased risks associated with our international operations, including economic and political conditions, instability or uncertainty in our international markets, especially emerging markets, fluctuations in currency exchange rates, difficulty in meeting planned sales targets and new store growth;

·

the impact of current or future claims and litigation and our ability to comply with current, proposed or future legislation that could impact our business including compliance with the European Union General Data Protection Regulation;

·

maintaining compliance with debt covenants under our credit agreement if restaurant sales and operating results continue to decline, and our ability to obtain a waiver or modification to the credit agreement from our lenders if we are unable to maintain compliance; 

·

failure to effectively execute succession planning;

·

disruption of critical business or information technology systems, or those of our suppliers, and risks associated with systems failures and data privacy and security breaches, including theft of confidential company, employee and customer information, including payment cards;

·

changes in Federal or state income, general and other tax laws, rules and regulations, including changes from the Tax Cuts and Jobs Act and any related Treasury regulations, rules or interpretations if and when issued; and

·

changes in generally accepted accounting principles including new standards for revenue recognition and leasing.

For a discussion of these and other risks that may cause actual results to differ from expectations, refer to “Part I. Item 1A. – Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2017, as updated by “Part II. Item 1A. – Risk Factors” in this Quarterly Report on Form 10-Q, as well as subsequent filings. We undertake no obligation to update publicly any forward-looking statements, whether as a result of future events, new information or otherwise, except as required by law.

 

Item 3.Quantitative and Qualitative Disclosures About Market Risk

 

Interest Rate Risk

 

Our outstanding debt of $579.4 million at July 1, 2018 represented amounts outstanding under our credit agreement executed in August 2017.  Our credit agreement provides for an unsecured revolving credit facility in an aggregate

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principal amount of $600.0 million (the “Revolving Facility”) and an unsecured term loan facility in an aggregate principal amount of $400.0 million (the “Term Loan Facility” and together with the Revolving Facility, the “Facilities”).  Additionally, we have the option to increase the Revolving Facility or the Term Loan Facility in an aggregate amount of up to $300.0 million, subject to certain conditions.  Our outstanding debt as of July 1, 2018 under the Facilities of $579.4 million was composed of $385.0 million outstanding under the Term Loan Facility and $194.4 million outstanding under the Revolving Facility. Including outstanding letters of credit, the remaining availability under the Facilities was approximately $371.8 million as of July 1, 2018.

 

Loans under the Facilities accrue interest at a per annum rate equal to, at the Company’s election, either a LIBOR rate plus a margin ranging from 75 to 200 basis points or a base rate (generally determined by a prime rate, federal funds rate or a LIBOR rate plus 1.00%) plus a margin ranging from 0 to 100 basis points. In each case, the actual margin is determined according to a ratio of the Company’s total indebtedness to earnings before interest, taxes, depreciation and amortization (“EBITDA”) for the then most recently ended four quarter period (the “Leverage Ratio”).  An unused commitment fee at a rate ranging from 15 to 30 basis points per annum, determined according to the Leverage Ratio, applies to the unutilized commitments under the Revolving Facility.  Loans outstanding under the credit agreement may be prepaid at any time without premium or penalty, subject to customary breakage costs in the case of borrowings for which a LIBOR rate election is in effect.  Up to $35.0 million of the Revolving Facility may be advanced in certain agreed foreign currencies, including Euros, Pounds Sterling, Canadian Dollars, Japanese Yen, and Mexican Pesos.  

 

We attempt to minimize interest risk exposure by fixing our rate through the utilization of interest rate swaps, which are derivative financial instruments. Our swaps are entered into with financial institutions that participate in our credit agreement. By using a derivative instrument to hedge exposures to changes in interest rates, we expose ourselves to credit risk. Credit risk is the failure of the counterparty to perform under the terms of the derivative contract.

 

As of July 1, 2018, we have the following interest rate swap agreements, including three forward starting swaps executed in 2015 that became effective in April 2018 upon expiration of the two existing swaps for $125 million.  In addition, we executed four additional interest rate swaps for $275 million that became effective on January 30, 2018.

 

 

 

 

 

 

 

 

Effective Dates

    

Floating Rate Debt 

    

Fixed Rates

 

April 30, 2018 through April 30, 2023

 

$

55 million

 

2.33

%

April 30, 2018 through April 30, 2023

 

$

35 million

 

2.36

%

April 30, 2018 through April 30, 2023

 

$

35 million

 

2.34

%

January 30, 2018 through August 30, 2022

 

$

100 million

 

1.99

%

January 30, 2018 through August 30, 2022

 

$

75 million

 

1.99

%

January 30, 2018 through August 30, 2022

 

$

75 million

 

2.00

%

January 30, 2018 through August 30, 2022

 

$

25 million

 

1.99

%

 

The weighted average interest rate on the borrowings under the credit agreement, including the impact of the interest rate swap agreements, was 3.6% as of July 1, 2018. An increase in the present interest rate of 100 basis points on the line of credit balance outstanding as of July 1, 2018 would increase annual interest expense by $1.8 million.

 

Foreign Currency Exchange Rate Risk

 

We are exposed to foreign currency exchange rate fluctuations from our operations outside of the United States, which can adversely impact our revenues, net income and cash flows. Our international operations principally consist of distribution sales to franchised Papa John’s restaurants located in the United Kingdom and Mexico and our franchise sales and support activities, which derive revenues from sales of franchise and development rights and the collection of royalties from our international franchisees. For each of the periods presented, between 6% and 7% of our revenues were derived from these operations.

 

We have not historically hedged our exposure to foreign currency fluctuations. Foreign currency exchange rate fluctuations had a favorable impact on our International revenues of approximately $1.2 million and $4.0 million for the three and six months ended July 1, 2018 and a $2.5 million and $5.6 million unfavorable impact for the three months and six months ended June 25, 2017.  Foreign currency exchange rate fluctuations had no significant impact on income before income taxes for the three and six months ended July 1, 2018 and June 25, 2017.    

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The outcome of the June 2016 referendum in the United Kingdom was a vote for the United Kingdom to cease to be a member of the European Union (known as “Brexit”).  This resulted in a lower valuation, on a historical basis, of the British Pound in comparison to the US Dollar. The future impact of Brexit on our franchise operations included in the European Union could also include but may not be limited to additional currency volatility and future trade, tariff, and regulatory changes.  As of July 1, 2018, 29.9% of our total international restaurants are in countries within the European Union.

 

Commodity Price Risk

 

In the ordinary course of business, the food and paper products we purchase, including cheese (our largest individual food cost item), are subject to seasonal fluctuations, weather, availability, demand and other factors that are beyond our control. We have pricing agreements with some of our vendors, including forward pricing agreements for a portion of our cheese purchases for our domestic Company-owned restaurants, which are accounted for as normal purchases; however, we still remain exposed to on-going commodity volatility.

 

The following table presents the actual average block price for cheese by quarter through the second quarter of 2018 and the projected average block price for cheese by quarter through 2018 (based on the July 31, 2018 Chicago Mercantile Exchange cheese futures market prices):

 

 

 

 

 

 

 

 

 

2018

 

2017

 

 

Projected

 

Actual

 

    

Block Price

    

Block Price

 

 

 

 

 

 

 

Quarter 1

 

$

1.522

 

$

1.613

Quarter 2

 

 

1.607

 

 

1.566

Quarter 3

 

 

1.573

 

 

1.642

Quarter 4

 

 

1.682

 

 

1.639

Full Year

 

$

1.596

*  

$

1.615

 

*The full year estimate is based on futures prices and does not include the impact of forward pricing agreements we have for a portion of our cheese purchases for our domestic Company-owned restaurants.  Additionally, the price charged to restaurants can vary somewhat by quarter from the actual block price based upon our monthly pricing mechanism.

 

Item 4.Controls and Procedures

 

Under the supervision and with the participation of the Company’s management, including its chief executive officer and chief financial officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Based upon this evaluation, the chief executive officer and chief financial officer have concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective.

 

During the most recently completed fiscal quarter, there was no change made in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. We implemented internal controls to ensure we adequately evaluated our contracts and properly assessed the impact of the new accounting standards related to revenue recognition on our financial statements to facilitate their adoption on January 1, 2018. There were no changes to our internal control over financial reporting that materially affected the Company’s internal control over financial reporting due to the adoption of the new standards.

 

PART II.  OTHER INFORMATION

 

Item 1.  Legal Proceedings

 

The Company is involved in a number of lawsuits, claims, investigations and proceedings consisting of intellectual property, employment, consumer, commercial and other matters arising in the ordinary course of business. In accordance with Financial Accounting Standards Board Accounting Standards Codification 450, “Contingencies”, the Company has

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made accruals with respect to these matters, where appropriate, which are reflected in the Company’s consolidated financial statements. We review these provisions at least quarterly and adjust these provisions to reflect the impact of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular case.  The legal proceedings described in “Note 9” of “Notes to the Condensed Consolidated Financial Statements” are incorporated herein by reference.

 

Item 1A. Risk Factors

 

Except as set forth below, there have been no material changes to the risk factors disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2017:

 

We have recently experienced negative publicity and consumer sentiment as a result of statements and actions by the Company’s founder and former spokesperson John H. Schnatter, which may continue to negatively impact our results of operations.

 

In July 2018, the Company was the subject of significant negative media reports as a result of certain statements and actions by Mr. Schnatter, who resigned as Chairman of the Board on July 11, 2018.

 

As a result of the negative publicity and consumer sentiment, the Company experienced, and expects to continue to experience, a decline in sales. The negative consumer sentiment and declining sales compound the adverse financial and operating impacts the Company has been experiencing since Mr. Schnatter’s controversial statements in November 2017. If Mr. Schnatter continues to make statements that harm the Company’s reputation, if the negative publicity and negative consumer sentiment toward the Company continues or worsens, or if we are unable to improve the reputation and perception of our brand, our sales can be directly and negatively impacted as a result.

 

We will incur costs related to addressing and remediating the impact of recent negative publicity surrounding our brand as a result of John H. Schnatter, which will adversely impact our financial performance.

 

In connection with the controversy surrounding Mr. Schnatter, a Special Committee of the Board of Directors, consisting of all of the independent directors, was formed to evaluate and take action with respect to all of the Company’s relationships and arrangements with Mr. Schnatter. Following its formation, the Special Committee terminated Mr. Schnatter’s Founder Agreement, which defined his role in the Company, among other things, as advertising and brand spokesperson for the Company. The Special Committee is also overseeing the previously announced external audit and investigation of all the Company’s existing processes, policies and systems related to diversity and inclusion, supplier and vendor engagement and Papa John’s culture.

 

In connection with these and other actions, the Company also expects to incur significant non-recurring costs, including costs related to branding initiatives, marketing and advertising expenses and increased professional fees. In addition, the Company expects to materially increase its franchisee financial assistance in an effort to mitigate store closings.  These costs and any additional costs we may be required to incur are expected to adversely affect our profitability and financial performance. There is no guarantee that our actions will be effective in attracting customers back to our restaurants and mitigating negative sales trends.

 

The recent negative publicity has had a negative impact on our business, and we cannot assure it will not have a long-term effect on our business or our relationships with customers, partners and franchisees.

 

Our business and reputation has been negatively affected by the recent negative publicity resulting from Mr. Schnatter’s statements and actions.  If we are unable to rebuild the trust of our customers, franchisees, business partners and suppliers, and if further negative publicity continues, we could experience a substantial negative impact on our business. We could also experience additional claims or litigation as a consequence of these recent events.

 

Our Board of Directors has adopted a limited duration stockholder rights agreement, which could delay or discourage a merger, tender offer, or assumption of control of the Company not approved by our Board of Directors.

 

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On July 22, 2018, the Board of Directors approved the adoption of a limited duration stockholder rights plan (the “Rights Plan”) with an expiration date of July 22, 2019 and an ownership trigger threshold of 15% (with a threshold of 31% applied to John H. Schnatter, together with his affiliates and family members). In connection with the Rights Plan, the Board of Directors authorized and declared a dividend to stockholders of record at the close of business on August 2, 2018 of one preferred share purchase right (a “Right”) for each outstanding share of common stock of the Company. Upon certain triggering events, each Right entitles the holder to purchase from the Company one one-thousandth (subject to adjustment) of one share of Series A Junior Participating Preferred Stock, $0.01 par value per share (“Preferred Stock”) of the Company at an exercise price of $250.00 (the “Exercise Price”) per one one-thousandth of a share of Preferred Stock.  In addition, if a person or group acquires beneficial ownership of 15% or more of the Company’s common stock (or in the case of Mr. Schnatter, 31% or more) without prior board approval, each holder of a Right (other than the acquiring person or group whose Rights will become void) will have the right to purchase, upon payment of the Exercise Price and in accordance with the terms of the Rights Plan, a number of shares of the Company’s common stock having a market value of twice the Exercise Price.

 

The adoption of the Rights Plan is intended to enable all of our stockholders to realize the full potential value of their investment in the Company and to protect the interests of the Company and its stockholders by reducing the likelihood that any person or group gains control of the Company through open market accumulation or other tactics without paying an appropriate control premium. The Rights Plan could render more difficult, or discourage, a merger, tender offer, or assumption of control of the Company that is not approved by our Board of Directors. The Rights Plan, however, should not interfere with any merger, tender or exchange offer or other business combination approved by our Board of Directors. In addition, the Rights Plan does not prevent our Board of Directors from considering any offer that it considers to be in the best interest of the Company’s stockholders.

 

We are subject to debt covenant restrictions.

 

Our credit agreement contains affirmative and negative covenants, including financial covenants.   Based on our revised lower financial forecast, we plan to work with the banks within our Credit Facility to evaluate options with the covenants to mitigate the possibility of violating a financial covenant in the future.  If a covenant violation occurs or is expected to occur, we would be required to seek a waiver or amendment from the lenders under the credit agreement.  The failure to obtain a waiver or amendment on a timely basis would result in our inability to borrow additional funds or obtain letters of credit under our credit agreement and allow the lenders under our credit agreement to declare our loan obligations due and payable, require us to cash collateralize outstanding letters of credit or increase our interest rate. If any of the foregoing events occur, we would need to refinance our debt, or renegotiate or restructure, the terms of the credit agreement. 

 

 

 

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds

 

Our Board of Directors has authorized the repurchase of up to $2.075 billion of common stock under a share repurchase program that began on December 9, 1999 and expires on February 27, 2019.  Through July 1, 2018, a total of 115.0 million shares with an aggregate cost of $1.8 billion and an average price of $15.61 per share have been repurchased under this program. Subsequent to July 1, 2018, through July 31, 2018, we acquired an additional 133,900 shares at an aggregate cost of $6.5 million. As of July 31, 2018, approximately $272.8 million remained available for repurchase of common stock under this authorization.

 

The following table summarizes our repurchases by fiscal period during the second quarter of 2018 (in thousands, except per-share amounts):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    

 

    

 

 

    

Total Number

    

Maximum Dollar

 

 

 

Total

 

Average

 

of Shares Purchased

 

Value of Shares

 

 

 

Number

 

Price

 

as Part of Publicly

 

that May Yet Be

 

 

 

of Shares

 

Paid per

 

Announced Plans

 

Purchased Under the

Fiscal Period

 

    

Purchased

    

Share

    

or Programs

    

Plans or Programs

 

 

 

 

 

 

 

 

 

 

 

 

4/2/2018 - 4/29/2018

 

 

29

 

$

60.24

 

114,591

 

$

306,033

4/30/2018 - 5/27/2018

 

 

371

 

$

59.40

 

114,962

 

$

284,015

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5/28/2018 - 7/1/2018

 

 

90

 

$

52.01

 

115,052

 

$

279,324

 

The Company utilizes a written trading plan under Rule 10b5-1 under the Exchange Act from time to time to facilitate the repurchase of shares of our common stock under this share repurchase program. The Company does not expect to repurchase any more shares in 2018 after the current trading plan expires in early August. 

 

During the fiscal quarter ended July 1, 2018, the Company acquired approximately 300 shares of its common stock from employees to satisfy minimum tax withholding obligations that arose upon (i) vesting of restricted stock granted pursuant to approved plans and (ii) distribution of shares of common stock issued pursuant to deferred compensation obligations.

 

 

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Item 6.  Exhibits

 

Exhibit

 

 

Number

    

Description

 

 

 

3.1

 

Certificate of Designation of Series A Junior Participating Preferred Stock of Papa John’s International, Inc.  Exhibit 3.1 to our report on Form 8-K as filed on July 23, 2018 is incorporated herein by reference.

 

 

 

4.1

 

Rights Agreement dated as of July 22, 2018, by and between Papa John’s International, Inc. and Computershare Trust Company, N.A., as rights agent.  Exhibit 4.1 to our report on Form 8-K as filed on July 23, 2018 is incorporated herein by reference.

 

 

 

4.2

 

Form of Rights Certificate.  Exhibit 4.2 to our report on Form 8-K as filed on July 23, 2018 is incorporated herein by reference.

 

 

 

10.1

 

Amendment to Employment Agreement between Papa John’s International, Inc. and Steve M. Ritchie effective May 3, 2018. 

 

 

 

10.2

 

Employment Agreement between Papa John’s International, Inc. and Joseph H. Smith IV effective May 3, 2018.

 

 

 

10.3

 

Papa John’s International, Inc. 2018 Omnibus Plan. Registration Statement on Form S-8 (Registration No. 333-224770) dated May 9, 2018 is incorporated herein by reference.

 

 

 

31.1

 

Certification of Chief Executive Officer Pursuant to Exchange Act Rule 13a-15(e), As Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

31.2

 

Certification of Chief Financial Officer Pursuant to Exchange Act Rule 13a-15(e), As Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

32.1

 

Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

32.2

 

Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

101

 

Financial statements from the quarterly report on Form 10-Q of Papa John’s International, Inc. for the quarter ended July 1, 2018, filed on August 7, 2018, formatted in XBRL: (i) the Condensed Consolidated Balance Sheets, (ii) the Condensed Consolidated Statements of Income, (iii) the Condensed Consolidated Statements of Comprehensive Income, (iv) the Condensed Consolidated Statements of Cash Flows and (v) the Notes to Condensed Consolidated Financial Statements.

 

 

 

 

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SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

    

PAPA JOHN’S INTERNATIONAL, INC.

 

 

(Registrant)

 

 

 

 

 

 

Date: August 7, 2018

 

/s/ Joseph H. Smith, IV

 

 

Joseph H. Smith, IV

 

 

Senior Vice President, Chief Financial Officer

 

 

 

 

 

 

 

 

45