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Edited Transcript of CEC^B14 earnings conference call or presentation 14-Aug-19 12:00pm GMT

Q2 2019 CEC Entertainment Inc Earnings Call

IRVING Sep 3, 2019 (Thomson StreetEvents) -- Edited Transcript of CEC Entertainment Inc earnings conference call or presentation Wednesday, August 14, 2019 at 12:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* James A. Howell

CEC Entertainment, Inc. - Executive VP & CFO

* Thomas Leverton

CEC Entertainment, Inc. - CEO & Director

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Conference Call Participants

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* Azeem Haider

BlueMountain Capital Management LLC - High Yield Debt Analyst

* Bryan Cecil Hunt

Wells Fargo Securities, LLC, Research Division - MD & Senior Analyst

* Luis Ricardo Chinchilla

Deutsche Bank AG, Research Division - Research Analyst

* Robert Vida;Elmwood Asset Management;Senior Analyst

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Presentation

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Operator [1]

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Good morning, and welcome to the CEC Entertainment Second Quarter 2019 Earnings Conference Call. On the call today are Tom Leverton, Chief Executive Officer; and Jim Howell, Chief Financial Officer. After comments from both Mr. Leverton and Mr. Howell, we will open the call for your questions. (Operator Instructions) As a reminder, this conference is being recorded.

It's now my pleasure to turn the conference over to Jim for opening remarks. Please go ahead.

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James A. Howell, CEC Entertainment, Inc. - Executive VP & CFO [2]

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Thank you, Rob, and thank you all for joining us for CEC Entertainment, Inc.'s Second Quarter 2019 Conference Call.

Before we begin our discussion this morning, I would like to call your attention to the fact that certain statements made during this call may constitute forward-looking statements within the meaning of federal securities laws. Forward-looking statements are based on management's expectations, beliefs, estimates and projections. These statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Therefore, actual results may differ materially from what is implied in forward-looking statements due to a variety of factors. Additional information regarding these factors is contained in the company's annual report on Form 10-K for the year ended December 30, 2018 filed with the SEC in March. The company disclaims and does not undertake any obligation to update or revise any forward-looking statement.

In addition, our remarks will include references to certain non-GAAP financial measures such as adjusted EBITDA. The company believes adjusted EBITDA is a measure that provides useful information to investors relating to its operating performance and its capacity to incur and service debt and fund capital expenditures. Further, we believe that adjusted EBITDA is used by many investors, analysts and rating agencies as a measure of performance. By referencing adjusted EBITDA, we provide a basis for comparison of our business operations between current, past and future periods by excluding items that we do not believe are indicative of our core operating performance. The non-GAAP financial measures discussed during this call should not be viewed as alternatives or substitutes for the company's reported GAAP results. A reconciliation of net income to adjusted EBITDA is found in our earnings release and Form 8-K filed with the SEC.

And now I would like to turn the call over to Tom.

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Thomas Leverton, CEC Entertainment, Inc. - CEO & Director [3]

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Thank you, Jim, and thank you, everyone, for joining us this morning. We certainly were pleased with our fifth consecutive quarter of positive same-store sales growth in Q2. While we posted same-store sales of 0.5% for the quarter, as discussed during our quarter 1 call, the calendar shifts of Easter and spring break shifted significant revenues into Q1. After accounting for that shift, Q2 was 2.3% positive on an adjusted basis.

Before we talk about business results, I'm certain some of you have questions about the decision to terminate the SPAC process with Leo Holdings. While there were very attractive aspects to this potential deal, during the process, specific market conditions changed.

We're strong believers that CEC Entertainment has strong momentum, as evidenced by 5 consecutive quarters of growth, and that we have tremendous growth ahead of us. As some in the market tied us to a specific comparable company whose valuation multiple fell recently, we didn't believe the market was giving CEC enough value to continue. Our Board of Directors will continue to have discussions on similar opportunities, but nothing's planned at this time.

As it relates to CEC's business, Q2 showed continued growth in our new product, All You Can Play. We now see 62% of our guests choosing All You Can Play over points. That's up from 57% in Q1 and 50% when we launched the product last year. This has helped drive increased average ticket, contributing to our same-store sales growth. We recognize guests' use of All You Can Play is growing because of the excellent experience we're delivering.

Our most recent class of 25 remodeled stores, which were generally completed in Q3 and Q4 of 2018, continued their great performance. They remain better than 16 percentage points of same-store sales growth better than the rest of the chain. Guest reactions continue to be extremely positive.

Lastly, I'd highlight that we had another great quarter for our international business. We now have 70 international Chuck E. Cheeses and 42 International Peter Piper Pizzas. Through Q2, we signed an additional 23 stores in 7 development agreements and opened an additional 3 stores.

I'll now hand it back to Jim to walk through our financials.

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James A. Howell, CEC Entertainment, Inc. - Executive VP & CFO [4]

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Thank you, Tom. For the 6-month period ended June 30, 2019, comparable venue sales increased 4.5% over the prior year period. Total revenues for the 6-month period ended June 30, 2019, increased from $472.3 million to $488.5 million. Our second quarter results were negatively impacted by the shift of the Easter holiday and several spring breaks into the second quarter of 2019 instead of the first quarter in 2018.

For the second quarter 2019, comparable venue sales increased 0.5% over the 2018 second quarter. Total revenues were $215.2 million in the second quarter of 2019 compared to $217.4 million for the second quarter of 2018. We continue to see a shift in spending with entertainment and merchandise as a percentage of total revenues increasing to 54.6% from 53.3% in the second quarter of 2018. This shift is attributable to the customer enthusiasm around All You Can Play and More Tickets.

Food and beverage costs for the second quarter 2019 decreased approximately 60 basis points from the 2018 quarter, reflecting favorability in commodity prices and volume. Entertainment and merchandise costs increased roughly 80 basis points, driven by the third quarter 2018 national launch of time-based play and More Tickets in all of our Chuck E. Cheese's company-operated venues.

Our overall venue labor cost as a percent of sales increased approximately 110 basis points with a decrease in labor hours on higher sales helping to offset a 5.4% increase in average wage rate. Our sales per labor hour improved approximately 4.6% from the second quarter of 2018 with hours decreasing approximately 3.7% on higher sales.

Turning to profitability. Adjusted EBITDA for the 6-month period ended June 30, 2019, increased $8.8 million or 8.4% to $114.5 million from $105.7 million for the 6-month period ended July 1, 2018.

Second quarter 2019 adjusted EBITDA was $38.4 million compared to $39.4 million in the second quarter of 2018. The year-over-year decrease in total revenues of $2.2 million resulted in a year-over-year decrease of $1.0 million in EBITDA versus the same quarter last year.

I'd note that our second quarter adjusted EBITDA was negatively impacted by a decrease in the year-over-year shift in Play Pass-related breakage revenue into the second quarter. For the second quarter of 2019, net breakage related to Play Pass of $1.3 million compared to $5.2 million for the second quarter of 2018, declining as a result of the third quarter 2018 introduction of All You Can Play, our time-based play offering. As you may recall, when guests buy points, a portion of their purchase is deferred for future periods. This is an estimated liability for the points that leave the building that aren't played on the initial time of visit. However, with All You Can Play, guests use their entire card in one visit. Thus, there is no deferred revenue. I specifically highlight this for year-over-year comparability purposes of our revenue and adjusted EBITDA. These shifts are just accounting issues and don't impact our operating cash flows nor our reported same-store sales figures.

Adjusting for this noncash impact, adjusted EBITDA for the second quarter increased year-over-year by $2.9 million or 8.5%. We ended the quarter with 749 venues worldwide, of which 608 were Chuck E. Cheeses and 141 were Peter Piper Pizzas. Cash at the end of the quarter was approximately $114 million. The principal outstanding on our debt at the end of the quarter was $975.1 million, consisting of $720.1 million on our term loan facility and $255 million in senior notes and we had a net availability of $86.5 million on our undrawn revolving facility. On August 1, 2019, we announced that we are seeking to obtain a new first lien senior secured facility to refinance in full our existing secured credit facilities.

Second quarter capital expenditures were $16.3 million, of which $6.5 million related to growth initiatives, $0.4 million related to various IT initiatives and $9.4 million related to maintenance capital.

In conjunction with the SPAC transaction that Tom discussed earlier, we provided certain forward-looking information to assist outside parties in evaluating the transaction. With the termination of the transaction, we are reverting to our previous practice of not providing guidance on any upcoming quarter or for the fiscal year.

To conclude, I share Tom's positive sentiment on our first half results. We were very pleased with our comparable venue sales growth and adjusted EBITDA. With 5 consecutive quarters of same-store sales growth, we believe the business is going in a great direction.

I'll now turn the call back over to Tom.

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Thomas Leverton, CEC Entertainment, Inc. - CEO & Director [5]

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Looking forward to the rest of 2019, I'd highlight 3 parts of our business. First, we expanded our second generation of More Tickets products to 156 locations. These locations are testing 8 tickets per game play versus the rest of the chain at 5 tickets per game play. It's still early in the test, but we're hopeful that this will be dollar profit positive.

We also have 2 markets testing our second generation of All You Can Play. These markets generally eliminate the point option for guests, driving them to our new product. While a change like that can be disruptive, we know that guests have a terrific experience with All You Can Play, so we believe it's the right decision for the long term.

Second, we continue to push our business forward with strong LTOs. Just recently, we launched our new cauliflower crust across the country. This product is great-tasting and gluten-free. Based on the initial guest perception, we're considering this as a permanent addition to our menu going forward.

Third, as we look to the rest of the year, we're targeting 12 new international locations. We also continued to advance discussions in brand-new markets like Turkey and China. Thus far in Q3, the international franchise team has already signed 3 additional development agreements for 7 additional stores, including 2 new markets in Malaysia and Morocco, bringing the year-to-date tally to 10 new development agreements in 2019 for 30 additional stores. The international team at CEC continues to perform very well at driving this high flow-through part of the business.

That concludes our prepared remarks. We're happy to take any questions. Operator, would you please open the line?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question is from Bryan Hunt with Wells Fargo.

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Bryan Cecil Hunt, Wells Fargo Securities, LLC, Research Division - MD & Senior Analyst [2]

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I was wondering if you could discuss your loyalty program. It's been in place for a little more than a year now. I believe it was February of last year. Could you share with us some of your insights you gained from acquiring this data? And I know part of the driver has been to drive frequency. Are you seeing incremental frequency for your loyalty guests?

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Thomas Leverton, CEC Entertainment, Inc. - CEO & Director [3]

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Thanks for that. We are excited about the loyalty program. So we launched that in February of 2018. And the overall approach is, for your first year of a loyalty program like that, you're certainly trying to drive increased visits, but the real goal is you get a baseline of data on your guests. We now have more than 600,000 people signed up for our loyalty program. And based on the time they signed up, we are about 6 or 8 months of average data on those guests. So we learn their frequency, we learn what they buy and what they haven't tried before.

Right now, we are pivoting, starting to use that data to give them different incentives. For example, if you come in, generally speaking, and you only buy a pizza and an hour of play but have never tried the dessert, now that we have that baseline of data on who buys what and how frequently they come, we can target specific offers at that example guests, we can offer them a free dessert that expires in 30 days, trying to drive an incremental visit and increased purchase as they go forward. We are pleased with the number of sign-ups that we've had so far, and those guests are certainly visiting more frequently now than our traditional baseline guests. But I do think we're just at the early innings of that product.

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Bryan Cecil Hunt, Wells Fargo Securities, LLC, Research Division - MD & Senior Analyst [4]

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Very good. My second question is you talked about your international business, mainly how many stores you've signed up. One, can you just discuss maybe how many do you think will open this year and next year out of the international agreements? And then two, maybe broadly discuss the economics that the company receives from those franchisees?

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Thomas Leverton, CEC Entertainment, Inc. - CEO & Director [5]

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Sure. So I'll do the economics, and Jim, you can talk about the other part. So for the economics on the international business, Chuck E. Cheese gets, generally speaking, between $50,000 and $75,000 when partners signs the development agreement per store, then we get 5% royalties for the revenue. We get an incremental $50,000 to $75,000 when they open the location. And then lastly, there's a 0.75% contribution to our overall marketing.

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James A. Howell, CEC Entertainment, Inc. - Executive VP & CFO [6]

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Yes. And Bryan, the way we're thinking about these going forward is there's probably somewhere around 80 to 90 like agreements in the pipeline right now. So as we look out over the next several years, we'll open roughly a dozen in the next couple of years and it starts to ramp up to a sort of the 15, 16 level.

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Bryan Cecil Hunt, Wells Fargo Securities, LLC, Research Division - MD & Senior Analyst [7]

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Okay. And are your AUBs on your international stores similar to the domestic ones?

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Thomas Leverton, CEC Entertainment, Inc. - CEO & Director [8]

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Yes, they are on average, but you do see big distribution. The stores in central South America tend to be smaller, the stores in the Middle East tend to be larger, but the average still works out about average.

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Bryan Cecil Hunt, Wells Fargo Securities, LLC, Research Division - MD & Senior Analyst [9]

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All right. And one last question, and I'll hand it off and get back in the queue. We're really starting to see some inflation in cheese and proteins. And I think that there's probably momentum into next year. Can you talk about what your expectation for commodity inflation is? And whether you have opportunities to either raise prices and/or hedge?

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Thomas Leverton, CEC Entertainment, Inc. - CEO & Director [10]

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So there's a few different points in there. So we have been very fortunate to date in seeing very small amounts of inflation in the commodity side of it. We do see some movement certainly, but it has been very manageable. We forward buy. We do not hedge specifically. So for example, going forward in the quarters, we can be 75% purchased through contracted prices in 1 quarter out, 50% purchased 2 quarters out, 25% purchased 3 quarters out, just to smooth the overall effects.

And then from a price standpoint, we believe that we are market priced. So we do look specific market by market, we are now pushing into 6 different grids across the country based on what the individual markets can bear, cost of living, overall inflation, wage rate. But we have been successful in managing the prices that at least correspond to the commodity prices.

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Operator [11]

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The next question is from the line of Ricardo Chinchilla with Deutsche Bank.

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Luis Ricardo Chinchilla, Deutsche Bank AG, Research Division - Research Analyst [12]

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I was wondering when there is an innovation component like the All You Can Play, there's usually a period in which it drives attention, but then it becomes the new normal. And when it becomes the new normal, then there's a decrease in frequency just because it gets normalized. Have you guys started to see some of this in some of the stores that have been implementing this system just yet? Or are you guys like factoring this is going to be like 1 year in the way or it's going to be 6 months from now? Or how are you guys thinking about that innovation factor going away? And if you guys could comment a little bit on what are you continuing to see on the labor inflation side, that will be very helpful.

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Thomas Leverton, CEC Entertainment, Inc. - CEO & Director [13]

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So on the first point, when we launch new products, All You Can Play and More Tickets, we do not see a decrease in the second year. We do have stores that were in our initial tests that are 4 or 5 months into their second year and they are not showing negative trends. For our business, I think that, that's a result of the infrequency of visits. If you are in a business like quick serve, we might have a guest visit twice a month and you launch a new product. Because of that frequency in the second year or even before the second year, they could get fatigued of your new product. Average guests come to Chuck E. Cheese 3 times a year. And when they are experiencing these products, for us, if we can convert that guest to 3.3x a year, doesn't sound like a lot, but that's a 10% increase in same-store sales if we just get 3.3 visits per year. That infrequency of visit keeps the new product special. And so I think that is why we do not see that drop-off in the second year.

As far as labor rates go, like Jim said, we are seeing north of a 5% increase in wage, and it is in the markets that have driven very specific increases in minimum wage. We, at CEC, we do have general managers, district managers out there, but we also employ a lot of people in their very first job while they're in high school, and those are true minimum wage employees. We have been able to drive ongoing improvements in sales per labor hour, but that helps stem the tide of the wage, it doesn't fully overcome it.

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Luis Ricardo Chinchilla, Deutsche Bank AG, Research Division - Research Analyst [14]

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Perfect. That's very helpful. If I may ask another question. When you guys started with -- started noticing some of the incremental competition, you guys noted that it had impact them too much. Could you guys like provide like an update in there are some particular markets where you still see like ramping up competition from these? In the past, it was like the inflatables and bouncy houses. Is that the case? Or if there's like somebody new that is still like a threat to you guys in the longer term? Or what you guys are seeing? Because as retail continues to be weakened, then some of locations will definitely continue to lower rent. And that was one of the triggers, if I'm not mistaken, for you guys having incremental competition from pop-and-mom shops.

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Thomas Leverton, CEC Entertainment, Inc. - CEO & Director [15]

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Yes. So we have seen growth in competition. I do think that there was some explosive growth a few years ago as some retail and restaurant locations were getting Amazon-ed out. But I do believe that the rate of growth, the rate of increase for competition has likely slowed. We're still seeing new markets, but I don't think it's at that explosive level that it was several years ago just because the market has somewhat normalized.

As far as pointing to a specific competitor, that's not really the way that our market works. We have -- we're blessed that Chuck E. Cheese is truly unique. We have 42 years of executing in this kid-focused eatertainment business. And we do see mom-and-pops come in, bouncy houses, trampoline parks, it's relatively low capital to get in that, but it is difficult to stay active in that business. So we see small players come in and come out of the markets across the country. We do compete with those. We compete with the bigger boxes to some extent, especially when you get to the older kids. But there's not one specific competitor that poses a big threat to Chuck E. Cheese one way or another. Little players can come in and come out. But again, they have shown much more difficulty in having a sustainable, stable business like Chuck E. Cheese has established.

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Operator [16]

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Our next question is from the line of Robert Vida with Elmwood Asset Management.

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Robert Vida;Elmwood Asset Management;Senior Analyst, [17]

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Can you guys discuss the rationale for coming to the market now and addressing the loans instead of waiting potentially until the bond steps down? And what's your thoughts on addressing the bond when it does step down to par?

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James A. Howell, CEC Entertainment, Inc. - Executive VP & CFO [18]

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Yes. I mean I think we -- the term loan comes due in February of 2021. The bonds are about a year after that. So we're addressing the nearer-term maturity right now. And then we will address the bonds once we get past that step and we'll be discussing that with our Board.

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Robert Vida;Elmwood Asset Management;Senior Analyst, [19]

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Do you have a -- would you consider going to like a unitranche-type structure or is it just all secured debt? Or would you want to keep like a first, second lien or bank bond type structure? What's your guy's preference?

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James A. Howell, CEC Entertainment, Inc. - Executive VP & CFO [20]

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Well, I think there's a lot of options and choices to be made around all that. We're working with our advisers and again, speaking internally about that. But we don't have any decisions on any of that right now.

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Operator [21]

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Our next question is from the line of Azeem Haider with BlueMountain Capital.

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Azeem Haider, BlueMountain Capital Management LLC - High Yield Debt Analyst [22]

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I think the first one is about inflation on food costs. I just need a little bit more clarification on your previous comment. Because the trends we're seeing in terms of protein prices, be it pork or beef, I think they're all hinting towards sort of increase in Food Away From Home sort of inflation trends. Could you expand it more when you say you're not seeing that much pressure on the protein costs?

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Thomas Leverton, CEC Entertainment, Inc. - CEO & Director [23]

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Well, I said on our overall food commodity, to be clear. And for us, our food really drives on sauce, cheese and dough. With the toppings costs, those are a very small part of the business, so maybe us even taking one step back. When I do talk to peers in the restaurant industry, especially pizza side of it, I rarely have a conversation with someone from the pizza industry 5 minutes in where you're not talking about the price of cheese because the price of cheese is a dominant factor for their business. For us, we have well north of 50% of our revenue is entertainment. And so even cheese for us is an important cost, but it's not dominant like the restaurant side of it. Cheese, sauce and dough drives our food costs and then toppings becomes a very, very small part. So yes, just to be -- just to clarify my remarks, it was on overall food costs, which are certainly dominated by cheese, sauce and dough.

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Azeem Haider, BlueMountain Capital Management LLC - High Yield Debt Analyst [24]

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Okay. That's helpful. And then also just looking at your P&L. I think it goes without saying that labor pressure is sort of consistent with the other players we're seeing in the industry. So how should I think about what level of same-store sales growth you need to sort of achieve over a long term period of time to keep the margin line flat to offset all these sort of cost pressures?

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Thomas Leverton, CEC Entertainment, Inc. - CEO & Director [25]

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So as is, when we are between 1% and 2% same-store sales, you can overcome labor without other action. So there's other things you potentially can do, but if you are truly run rate, that kind of sales growth is able to overcome wage. Now again, we are taking other actions on the cost side of it, driving continued improvements in sales per labor hour. But -- that's the direct answer to your question. I would only add on to it and say that right now, we are seeing that north of 5% wage growth. If you take a place like California, they're driving $1 increase in the minimum wage year after year. Each year, that decreases on a percentage basis. So what used to be a 10% increase when they went from $10 to $11, as we go from $14 to $15, even though that's the same dollar increase, the percent hit decline. And so that should be more and more manageable going forward, barring other states or federal action.

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Azeem Haider, BlueMountain Capital Management LLC - High Yield Debt Analyst [26]

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Got it. And lastly, I just have a more of a big-picture question here. Following the termination of IPO, how should we think about future strategic sort of options for the company?

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Thomas Leverton, CEC Entertainment, Inc. - CEO & Director [27]

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So we continue to speak with our sponsor, Apollo, about options and we will continue to do so. There are a variety of opportunities for CEC. We are fortunate in that, again, with 5 consecutive quarters of same-store sales growth, generating a lot of cash for the business, we are in a good position to look at different opportunities.

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Operator [28]

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Next question is from the line of (inaudible) with (inaudible) Investments.

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Unidentified Analyst, [29]

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Just a question on remodels. Just curious what the disruption is when you're remodeling a store, like how long is the store out of operation? And how long it takes just from start to finish the remodel?

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Thomas Leverton, CEC Entertainment, Inc. - CEO & Director [30]

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So Chuck E. Cheese traditionally has not closed the stores. And I've been in several different businesses and I have never seen that, but the operations team here and the construction team and the real estate team, they have developed this process where they keep a store open even during a very significant remodel or even a reimaging, like we're doing right now. So the hammers swing for about 6 weeks in the store and they rotate the remodel efforts really corner by corner. So they'll shut off a corner, do the work, move the operations, shut off a different corner and do the work. And so it takes about 6 weeks overall. During those 6 weeks, the store is disrupted, call it, 10% or 15%, but that economically works out far better than shutting the store completely for, for example, 4 weeks to get the effort done. So they do an excellent job and our guests give us a lot of leeway. Again, infrequently visited business and delivering the great experience that we do, people understand we're making the product better for them.

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Unidentified Analyst, [31]

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Okay. And then also can you talk about how many leases you kind of have renewing in 2019? And kind of your expectation for how those renewals may be in terms of whether there should be an expectation of higher or lower rent?

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James A. Howell, CEC Entertainment, Inc. - Executive VP & CFO [32]

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Yes. We probably have around 40 leases that will come up for renewal in the next sort of 12 months. And we'll go in and negotiate every one of those on a case-by-case basis. We'll put boots on the ground. We'll look at the site, look at the traffic, look at what's around it. And I think, in general, our guys have done a really nice job of actually negotiating sort of flat rents. There might be -- you might win a few, you might lose a few. But in general, we feel like we've been able to manage the costs sort of on a normal basis -- normalized basis.

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Operator [33]

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There are no further questions at this time. I'll turn the floor back over to Tom Leverton for closing comments.

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Thomas Leverton, CEC Entertainment, Inc. - CEO & Director [34]

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Really appreciate everyone making the time this morning, and we look forward to discussing our Q3 results the next time. Thank you.

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Operator [35]

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This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.