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Edited Transcript of PZA.TO earnings conference call or presentation 10-May-17 1:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 Pizza Pizza Royalty Corp Earnings Call

Toronto May 18, 2017 (Thomson StreetEvents) -- Edited Transcript of Pizza Pizza Royalty Corp earnings conference call or presentation Wednesday, May 10, 2017 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Christine D'Sylva

Pizza Pizza Limited - Director of Finance and IR

* Curtis Feltner

Pizza Pizza Royalty Corp. - CFO of Pizza Pizza Limited - General Partner, SVP of Finance at Pizza Pizza Limited - General Partner and Director of Pizza GP Inc - General Partner

* Paul Goddard

Pizza Pizza Royalty Corp. - CEO of Pizza Pizza Limited, President of Pizza Pizza Limited and Director of Pizza GP Inc

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Conference Call Participants

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* Derek J. Lessard

TD Securities Equity Research - Research Analyst

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Presentation

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Operator [1]

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Ladies and gentlemen, thank you for standing by, and welcome to the Pizza Pizza Royalty Corp. first quarter results conference call.

(Operator Instructions) As a reminder, this conference is being recorded on Wednesday, May 10, 2017.

I will now turn the call over to Ms. Christine D'Sylva, Vice President of Finance and Investor Relations. Please go ahead.

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Christine D'Sylva, Pizza Pizza Limited - Director of Finance and IR [2]

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Thank you. Good morning, everyone, and welcome to the Pizza Pizza Royalty Corp.'s earnings call for the first quarter ended March 31, 2017.

With me on the call today are Pizza Pizza Limited's Chief Executive Officer, Paul Goddard; and Chief Financial Officer Curtis Feltner.

Our discussion today will contain forward-looking statements that may involve risks relating to future events. Actual events may differ materially from projections discussed today. All forward-looking statements should be considered in conjunction with the cautionary language in our earnings press release and the risk factors included in our annual information form. Please refer to our earnings press release and management's discussion and analysis in the investor relations section of our website for a reconciliation and other disclosures relating to non-IFRS measures mentioned today.

With that, I would like to turn the call over to Paul Goddard for business updates.

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Paul Goddard, Pizza Pizza Royalty Corp. - CEO of Pizza Pizza Limited, President of Pizza Pizza Limited and Director of Pizza GP Inc [3]

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Thanks, Christine. And thanks, everyone, for joining our call this morning.

We're pleased to report our first quarter results for Pizza Pizza Royalty Corp. Royalty Pool System Sales increased 0.6% to $133.9 million about $133.1 million in Q1 of last year. Last year contained an extra day of sales in February due to the leap year effect, and we estimated yesterday last year was approximately $1 million in additional sales. Same-store sales growth decreased by 0.7% for the quarter compared to a 2.5% increase in the same quarter of last year.

In Q1, the food industry as a whole continued to encounter economic challenges. And while Pizza Pizza and Pizza 73 both fell slightly short of our expectations this quarter, we continued to successfully execute well; and particularly on one of our major strategies, increasing restaurant profitability. I'll provide details on these successes in a moment. As a reminder, the company's main assets are the Pizza Pizza and Pizza 73 trademarks and brands. We're a top line royalty corp., which means we earn a monthly royalty on sales from the restaurants in the Royalty Pool which are operated by Pizza Pizza Limited. The royalty corp. is not exposed to restaurant operations. The company's royalty revenues are calculated as a percentage of Royalty Pool System Sales generated by the Pizza Pizza and Pizza 73 restaurants in the Royalty Pool.

Pizza Pizza Royalty Corp. has increased shareholder dividends 7 times in 5 years, including a 2.3% increase in June 2016. And the monthly dividend has grown over 20% in the past 5 years. Additionally, the company has accumulated a healthy $5 million reserve to support the dividends in the event of any short-term pressure on same-store sales growth.

So with that backdrop, let's now look at Pizza Pizza Limited's restaurant operations, which is the underlying strength supporting same-store sales growth. As I mentioned, Pizza Pizza Limited is the private company which leases and operates the Pizza Pizza and Pizza 73 brands and pays a monthly royalty to the royalty corporation for use of the brands. Pizza Pizza Limited's mandate is to grow and protect the brands. Growth priorities include maintaining our brand dominance; modernizing the customer experience; and of course, staying relevant to our consumers. We believe these priorities align with evolving consumer needs and will drive long-term sustainable growth, especially when combined with our competitive advantages of convenience, innovation, high-quality menu offerings and our geographic diversification across Canada.

Strategically, at Pizza Pizza in Q1, we continued our focus on increasing restaurant profitability while also working to drive sales increases. Pizza Pizza, operating largely in Eastern Canada, reported a 0.7% decrease in same-store sales growth over a strong 4.9% increase in Q1 of last year. The environment in which both brands operate continued to be highly competitive and economically challenging in Q1. To put our results in context and what's happening in the overall QSR industry: Retail industry as a whole has been and continues to experience challenges with increasing customer traffic.

Same-store sales growth is largely driven by 2 factors: the movement in customer check; and customer traffic counts. Our average customer check increased in Q1. The slight decrease in same-store sales for Q1 is largely due to a decrease in customer traffic, specifically decrease in a number of customers who walked into our stores to order as opposed to those that ordered ahead of time. So our traffic is measured by customer transactions, in other words call center, digital orders and in-store customer visits. So looking at details of the quarter-over-quarter traffic decrease: Call center and digital orders showed solid traffic growth in Q1. However, this growth was offset by walking traffic decreasing. What's behind the decrease in walking traffic? Well, our focus on restaurant profitability is part of the reason, as we worked to decrease restaurant food costs. In May of last year, we cautiously increased pricing on one of our most popular walk-in specials, as an example. And meanwhile, we decided to discontinue a few lower-margin menu offerings in favor of increasing a restaurant's bottom line, especially with other restaurant offering costs rising.

Over the past 9 to 10 months, we've monitored consumer reaction to our price changes. We found consumers were very price sensitive at certain price points, especially around the $5 mark, so late in Q1, we decided to roll pricing back somewhat but not completely back to last year's pricing. Marketing campaigns supported the new price point. And we began to see positive traffic trends toward the end of Q1, especially as weather improved. The new pricing is still positive for restaurant profits, especially if traffic increases going forward. So we're obviously trying to find that balance and get price when we can.

In Q1, in addition to food costs, we targeted another restaurant expense, call center costs. And this is a significant expense item for franchisees. Over the years, this has been a major company focus, as we have moved nearly 50% of our customers to traditional channels. And that means that 50% still choose to place an order with a call center agent over the phone. As a test, in February, to entice more consumers to use our digital channels, we changed our popular pizza and Cineplex movie campaign. In past years, a free movie coupon is given away in all ordering channels. This year, we took a bold approach and we changed the offering so that a consumer could only get a Cineplex movie pass when they ordered via a self-served digital channel. Our strategy was to decrease customers' use of our call center, and it worked. We saw the change in behavior. We increased digital ordering component well above 50% during that promotion. After the promotion, interestingly, we have seen our digital channel usage remain several percentage points higher than prior in Cineplex promotion as well. So that's ultimately providing further savings to our restaurant owners.

As Canada's #1 pizzeria, digital ordering is one example of our investment in technology. Heavy investment in technology is giving Pizza Pizza a distinct advantage in the QSR segment, where contingence is a must when consumers place food orders.

Turning to our second brand. At Pizza 73, operating in Western Canada, same-store sales growth also decreased to -- by 0.7% in Q1. The decline in the price of oil has adversely affected Alberta's economy, also affecting consumer spending patterns. However, Pizza 73 is the leading pizza brand in Alberta, and we continued supporting sales-building efforts. One positive development in Alberta is that the Oilers and the Flames made it to the hockey playoffs. And for Pizza 73 this is particularly positive because we have major sponsorships in the organizations and sell pizza at both venues, both ranks. And as you may recall, last year, there were no Canadian hockey teams in the playoffs, so a big improvement this year. And we're obviously pulling for Oilers to get past this round, like the Senators have done in Ottawa, at least for Pizza Pizza.

Looking at new restaurant development. During the quarter, Pizza Pizza Limited opened 6 restaurants and closed 2. By brand, for the quarter, Pizza Pizza opened 3 traditional and 1 nontraditional restaurants. 2 nontraditional locations were also closed. Meanwhile, at Pizza 73 we opened 2 traditional restaurants. And no Pizza 73 restaurants were closed. So the total number of restaurants increased to 756 locations across Canada as at March 31, 2017.

And just one last note. In 2017, Pizza Pizza is celebrating our 50th anniversary, so it's exciting times here for us, our franchisees and our customers. Customers will be engaged through creative concepts and compelling value offerings featuring our extensive menu. To kick off the festivities, in early 2017, Pizza Pizza began a restaurant renovation program, including updating the store's interior and signage; and will further modernize the customer experience and set the course for future growth. We will continue to build shareholder value by leveraging our size and our scale. Growing our customer base and brand dominance, new product introductions, service enhancements and technological innovation pushes our brands forward to build on their market-leading positions.

With that, I'll pass the call over to our Chief Financial Officer, Curtis Feltner, for a financial update.

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Curtis Feltner, Pizza Pizza Royalty Corp. - CFO of Pizza Pizza Limited - General Partner, SVP of Finance at Pizza Pizza Limited - General Partner and Director of Pizza GP Inc - General Partner [4]

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Thank you, Paul.

Yesterday evening, Pizza Pizza Royalty Corp. released its first quarter financial results for March 31, 2017.

A few first quarter highlights, and these are compared to Q1 of 2016. Our Royalty Pool sales increased 0.6%. Adjusted earnings per share was flat for the quarter. The Royalty Pool of restaurants increased by a net 15, effective January 1, 2017. And so as Paul mentioned, same-store sales growth, which is a key driver of yield growth for shareholders of the company, decreased by 0.7% for the quarter compared to a 2.5% increase in the same quarter last year. And Paul also provided a robust breakdown by brand of the same-store sales, so I won't go over that again.

Before discussing the details of the financial results, I always find it worthwhile to briefly review our corporate royalty structure for investors. So Pizza Pizza Royalty Limited Partnership is a subsidiary of Pizza Pizza Royalty Corp., and the partnership owns the Pizza Pizza and Pizza 73 trademarks and brands. And the partner has -- partnership has 2 partners: Pizza Pizza Royalty Corp.; and Pizza Pizza Limited, which is a private company. Each month, the partnership earns royalty income from Pizza Pizza Limited. The royalty is earned as a percentage of restaurant sales. And it's compensation for Pizza Pizza Limited using the Pizza Pizza and Pizza 73 brands in its restaurants.

So with that said, let's review the financial results. The number of restaurants in the company's Royalty Pool increased by 15 to 751 on January 1, so the number of restaurants in the Royalty Pool will remain unchanged through December 31, 2017. In exchange for adding additional restaurants and a royalty stream to the Royalty Pool, Pizza Pizza Limited's equivalent shares as a percentage of fully diluted shares increased to 21.1% from 20.4%.

System Sales for the 3 months ended March 31 from the 751 restaurants in the Royalty Pool increased 0.6% to $133.9 million from $133.1 million in the prior year quarter, when there were 736 restaurants. So System Sales in the prior year quarter included an extra day of sales in February due to the leap year, which we estimate to be around $1 million. So Royalty Pool sales for the quarter increased over the prior year quarter as a result of the net impact of the new restaurants on January 1, 2017, offset by the recorded same-store sales decrease. And additionally, the extra day of sales in the prior year quarter should be considered. So as I mentioned earlier, the partnership receives royalty income from Pizza Pizza Limited based on these Royalty Pool restaurant sales.

Royalty income earned by the partnership increased 0.4% to $8.7 million for the quarter. So a 6% royalty was earned on the 651 Pizza Pizza restaurants reporting $112.5 million in System Sales. And a 9% royalty was earned on the 100 Pizza 73 restaurants, which reported $21.4 million in System Sales. When doing the math, Pizza 73 was approximately 16% of total Royalty Pool sales for the quarter.

So using this royalty income of $8.7 million, the partnership payed interest expense and administrative expenses before making partnership distributions. Administrative expenses for the quarter were $135,000 compared to $163,000 for Q1 2016. And as a reminder, administrative expenses are incurred at the partnership level; and consist of directors' fees, audit, legal and public reporting fees as well as D&O insurance. The decrease in expenses for the quarter relates to one less director and lower legal fees. So in addition to administrative expenses, the partnership paid interest expense on its $47 million credit facility. Interest expense was $314,000 for the quarter compared to $332,000 in Q1 2016. The company's credit facility, the $47 million facility, matures April 2020.

So after the partnership receives royalty income and pays admin and interest expense, the net cash is available for distribution to its partners, based on ownership percentages. So Pizza Pizza Royalty Corp., which consolidates the partnership into its quarterly financial statement, owns 78.9% of the partnership at March 31, 2017. So on its 78.9% share of the partnership's income, the royalty corp. pays corporate income tax. So corporate income tax for Q1 was $1.4 million, and it was the exact same for Q1 2016. Earnings for the quarter increased 2% to $6.8 million from $6.6 million. And the increase in earnings resulted from a slight increase in royalty income, plus a decrease in admin expenses.

So in addition to earnings from operations that is calculated under International Financial Reporting Standards, the company feels adjusted earnings from operations and adjusted EPS are more meaningful in evaluating our company's performance and a truer indication of cash available for dividends. So our MD&A has a full reconciliation of non-IFRS measures. Adjusted earnings from operations for the quarter of $6.85 million was consistent with the $6.77 million in Q1 last year. Adjusted EPS was unchanged for the prior year quarter at $0.219 per share.

Turning to shareholder dividends. The company declared shareholder dividends of $5.3 million or $0.2139 per share compared to $0.2091 per share in the prior year comparable quarter. So this is a 2.3% per share increase on a quarter-over-quarter basis, and the increase relates to the June 2016 dividend increase. The payout ratio was 103% for the quarter and was 100% in the prior year comparable quarter. The company's working capital reserve was $5 million at March 31 and decreased $150,000 for the quarter. And the $5 million reserve is available to stabilize dividends and fund any other unusual expenditures in the event to -- of short- to medium-term variability in System Sales. So with this reserve in place with $5 million, going forward the company will continue to target a payout ratio at or near 100% on an annualized basis. And we had the same target in 2016.

And just to remind you, the company does not have capital expenditure requirements or employees.

So that concludes a financial overview for the quarter. I'll now turn the call back to operator for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question is from Derek Lessard from TD Securities Montréal.

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Derek J. Lessard, TD Securities Equity Research - Research Analyst [2]

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Paul, I was just maybe wondering. And thanks for giving us some color on your opening remarks, but I was just wondering if you could somehow quantify how much of the decline in same-store sales was, for lack of a better word, self-inflicted. Like you touched on the pricing and promo decisions versus market, market forces or other things that were out of your control.

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Paul Goddard, Pizza Pizza Royalty Corp. - CEO of Pizza Pizza Limited, President of Pizza Pizza Limited and Director of Pizza GP Inc [3]

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It's an intriguing question. It is difficult to assess really exact causality on it. I mean I think these -- there's obviously market factors, just competitiveness in the market as well, looking at everything we did versus last year. It just does feel overall a little tighter in the market. So I think it's, like I said, somewhat self-inflicted and as we focus on the profitability side a little more, but it's really hard to quantify, honestly. I think I really don't know exactly how I would allocate that.

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Derek J. Lessard, TD Securities Equity Research - Research Analyst [4]

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Okay. I guess then the follow-up would have been, I think, are you confident that maybe this was -- just was a blip and given what has been some pretty decent growth for you guys for the last 2 years? Just wondering if you could point again to the specific initiatives that you have that should drive the better numbers going forward.

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Paul Goddard, Pizza Pizza Royalty Corp. - CEO of Pizza Pizza Limited, President of Pizza Pizza Limited and Director of Pizza GP Inc [5]

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Yes. Well, I think we obviously are pushing as hard as we can to get that resurgence in traffic, but it's -- we've always talked about on this calls. It's that tug-of-rope between getting check and traffic balanced perfectly, right? And I think we've got it quite well. I mean we had -- we can see the consumer behavior. We are really encouraged by the digital mass migration to digital for a lot of people and a lot of new customers, not just existing customers, with our Cineplex deal this quarter. So I think we're going to continue to push digital very hard. We will continue to get price where we can, but we're also going to be very conscious and not give in on volume, right? And we do have some volume gain, largely. And so we want to make sure we do have the right special, the right a la carte offerings, the right balance of new product introductions, a lot of local store marketing. I think you can expect us to do more of them in the future as well that's tailored to specific regions that might have slightly different tastes, preferences and spending patterns. So we're trying to look at the data a little more, I guess, and be a little more informed as we make our decisions for marketing overall offering for both mass market and local store.

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Curtis Feltner, Pizza Pizza Royalty Corp. - CFO of Pizza Pizza Limited - General Partner, SVP of Finance at Pizza Pizza Limited - General Partner and Director of Pizza GP Inc - General Partner [6]

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Yes. Derek, yes, just one addition to that is, like, I think Paul mentioned a -- we did do just a slight tack towards the end of the quarter back towards more value for our walk-in offerings. And so we should -- we'll be working to increase traffic based on that movement back to value.

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Derek J. Lessard, TD Securities Equity Research - Research Analyst [7]

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And seeing it's not -- but it's not the -- as Paul said, it's not a full movement, right, talking to the medium pepperoni pizza in particular?

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Curtis Feltner, Pizza Pizza Royalty Corp. - CFO of Pizza Pizza Limited - General Partner, SVP of Finance at Pizza Pizza Limited - General Partner and Director of Pizza GP Inc - General Partner [8]

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Yes, that's right. I'd say that we're still -- have our eyes on restaurant profitability and growing. And we're -- we feel our quality in our pizza is superior. And we'll continue to try to get that price, but Paul also mentioned how fickle our consumers seem to be at certain price points, so -- but no, I think we'll see some good upswing.

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Derek J. Lessard, TD Securities Equity Research - Research Analyst [9]

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Okay. And then I guess, just on the strategy of boosting the franchise profitability. Even though it's a top line-driven business, like what are the -- what do things like the lower call center costs and food savings have on the business longer term? I guess I'm just trying to get to the benefits of improving franchise profitability over volume growth, strictly volume growth.

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Paul Goddard, Pizza Pizza Royalty Corp. - CEO of Pizza Pizza Limited, President of Pizza Pizza Limited and Director of Pizza GP Inc [10]

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Yes, I mean I think it just overall speaks to the sustainability of the brand and attractiveness of the brand. I mean you'd want to have profitable franchisees. And obviously, they want positive sales growth as well. I mean they go hand-in-hand, but you don't want to have, I think, volume growth at any cost where your franchisees are starting to really have difficulties having a satisfactory income coming in after all their efforts. So I think we feel we've got a lot of tools in our arsenal to work with, right? The digital advantage, the convenience advantage, just our footprint, our mass market abilities, our analytics, our loyalty program, all these different things. And we don't always get it right. And I mean we'll be the first to say every quarter we don't always get it bang on, but I think we try to sort of hold the course on what we feel are the proper long-term strategies. And giving them more bottom line will always help the franchisees do better, right? Whether it's changing our mix of delivery to walk-in or the speed of delivery and the convenience, the diversity of offerings, they got to be able to make enough money to be excited about what they're doing. And so it would be easy to just keep sales growth positive every quarter if we just discounted our way down to nothing, but we need to find that balance appropriately. And the customer has to agree, of course, right? But that's why we put a lot of focus on our quality in our convenience and service.

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Derek J. Lessard, TD Securities Equity Research - Research Analyst [11]

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Okay. And -- sorry...

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Curtis Feltner, Pizza Pizza Royalty Corp. - CFO of Pizza Pizza Limited - General Partner, SVP of Finance at Pizza Pizza Limited - General Partner and Director of Pizza GP Inc - General Partner [12]

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Yes, just last one addition to that. So this -- with Pizza Pizza and Pizza 73, I mean, we're talking about franchisees, so really we look to speaking to Pizza Pizza. But really both these brands are market leaders in each of their geographic regions, so we do have the ability to steer the market with value and with traffic. So we -- and I mean we have always said in the past that we look at full year earnings, as far as the same-store sales growth, but at the same time, we're looking at this restaurant profitability. A movement with decreasing cost per call and food usage -- driving the food usage down even 0.5% as a percent of sales can equate to cash directly to the bottom line for our franchisees and our joint venture partners at Pizza 73. So I mean -- and so going back to your question trying to quantify it: We don't really release those results, but 1% of the average store at Pizza Pizza and at Pizza 73 can be very significant to the bottom line.

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Derek J. Lessard, TD Securities Equity Research - Research Analyst [13]

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Okay. And just beyond pricing, how is the innovation pipeline looking? And any new initiatives there that's got you guys excited in the coming months?

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Paul Goddard, Pizza Pizza Royalty Corp. - CEO of Pizza Pizza Limited, President of Pizza Pizza Limited and Director of Pizza GP Inc [14]

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Well, we continue to innovate on all levels and do product innovation, and we've done quite a few things recently that you see in pan pizza and other things like that. We're now delivering our Pizza-dilla specials at Pizza Pizza. So that's basically you could call it channel innovation or getting more products that were just traditionally available for walk-in now on a delivery channel as well. So we'll continue to do things like that. And I think on the technical side we're always looking to do more. Despite the sort of lackluster traffic, I guess, at Pizza Pizza this last quarter, we have been encouraged by where -- we think we have better-than-ever sense for knowing which buttons to push in order to change customer behavior. So in things like the Cineplex deal with the digital behavior, we could see how people really went for that. It's very confirming of our assumptions, and we can see the data prove it out. So I think we're just -- we're going to keep pushing digital. We'll keep innovating on all fronts. And we'd like to keep some things surprises, of course, rather than tell our competitors everything, but we are trying to do a lot of new things this year with the 50th anniversary and get some benefits from that...

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Derek J. Lessard, TD Securities Equity Research - Research Analyst [15]

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Okay. Yes, I think that's fair enough, Paul. That's good color. And just maybe one last question for you guys there. Do you have any updates on -- you mentioned it in your prepared comments as well, on the restaurant renovation program? Just particularly any success stories that you could point to or some of the challenges in further penetrating like the GTA area and what you think the opportunity is there.

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Paul Goddard, Pizza Pizza Royalty Corp. - CEO of Pizza Pizza Limited, President of Pizza Pizza Limited and Director of Pizza GP Inc [16]

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I think it's still early days for our renovation program, but we're underway. We've got some under our belts. It's I would say there hasn't been that much time yet, but the -- sort of anecdotally talking individual stores where we've seen renovations, it's been positive, for sure. And I look at places like Québec, where you are. We've been very successful there. And then virtually all our restaurants we've built there in recent times have the new look, and our sales there are proving out that fact that customers really like our environment there if they're in the store. So I think that's the best thing that's happened overall of -- with our success with our reimaged look.

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Operator [17]

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(Operator Instructions) There are no further questions registered at this time. I would now like to turn the meeting back to Ms. D'Sylva. Please go ahead.

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Christine D'Sylva, Pizza Pizza Limited - Director of Finance and IR [18]

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Thank you. And thank you, everyone, for joining us on our call this morning. If you do have any questions after the call, please contact us. Our information is on the earnings release.

Thank you, and we look forward to speaking to again.

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Operator [19]

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Thank you. The conference has now ended. Please disconnect your lines at this time. And we thank you for your participation.