Papa John’s International, Inc. (NASDAQ:PZZA) Q3 2023 Earnings Call Transcript
Papa John's International, Inc. (NASDAQ:PZZA) Q3 2023 Earnings Call Transcript November 2, 2023
Papa John's International, Inc. misses on earnings expectations. Reported EPS is $0.53 EPS, expectations were $0.56.
Operator: Good day and thank you for standing by. Welcome to the Papa John's Third Quarter 2023 Conference Call and Webcast. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to introduce your host for today's call, Stacy Frole, Vice President of Investor Relations. Please go ahead.
Stacy Frole: Good morning, and welcome to our third quarter earnings conference call. This morning, we issued our 2023 third quarter earnings release. A copy of the release can be obtained on our Investor Relations website at ir.papajohns.com under the News Releases tab or by contacting our Investor Relations department at investor_relations@papajohns.com. On the call this morning are Rob Lynch, our President and CEO and Ravi Thanawala, our Chief Financial Officer. Before we begin, I need to remind you that comments made during this call will include forward-looking statement within the meaning of the federal securities laws. These statements may involve risks and uncertainties that could cause actual results to differ materially from these statements.
Forward-looking statement should be considered in conjunction with the cautionary statements in our earnings release, and the risk factors included in our SEC filings. In addition, please refer to our earnings release for the required reconciliation of non-GAAP financial measures discussed on today's call. Lastly, let me thank you in advance for asking only one question and getting back in the queue for more follow up. Rob?
Rob Lynch: Thank you, Stacy. Good morning, everyone, and thanks for joining us. I would like to start out by thanking our team members and franchisees for their hard work and dedication for delivering the best experience and value proposition for our customers. The sales and transaction growth will speak to today are the direct result of their solid execution as they drive our business with agility and adjust the changing consumer purchasing behaviors. As you read in our earnings release this morning, the positive North America comp sales and transaction growth that we discussed at the end of the second quarter, continued throughout the third quarter at both our company-owned and franchised restaurants. Together, we delivered 3% increase in North America comp sales by remaining focused on what matters to our customers: product Innovation, operational excellence, and a strong value proposition.
We are particularly pleased that our growth in the quarter was driven by higher transactions, reaffirming the strength of our brand and continued demand for our products. Our company team remains committed to providing quality products, a winning customer experience, and great value, which led to a 6% comp sales growth in our company-owned restaurants. This transaction driven growth combined with lower food costs resulted an improving restaurant level margins in the quarter. Despite the strong sales growth in North America, our company's adjusted operating income was just in line with the third quarter last year due to the dilutive impact of our recently acquired restaurants in the UK. Today, I will focus on the key drivers of our North America business, including updates to our U.S. commissary operating model and provide an update on our recent acquisition of the UK restaurants.
I will then pass it on to Ravi, who will walk you through our third quarter financial results in more detail along with an update on our fiscal 2023 and long-term guidance before opening the lines to answer any questions that you may have. First, our North America business, our corporate teams continue to work closely with our franchisees to deliver our product innovation with excellence and create strong customer value through our revenue management capabilities. This has resulted in an increase in unit level profitability while preserving customer counts. In the current inflationary environment, we have watched as many restaurant brands have increased menu prices. We have found other ways to drive restaurant profitability and have executed a thoughtful approach to managing price and promotions.
As a result, we believe that our products offer an attractive value proposition to consumers compared with other QSRs. This was a key driver of our transaction growth in the quarter and we expect it to continue as many QSRs continue to take more price. To put the current pricing gap into perspective, at Papa John's, if you were looking to feed a family of four and order two large one topping pizzas and a 2 liter of soda for carryout, on average, it would cost you approximately $22. This ticket is well below what it may cost feed that same family of four add many QSR drive throughs where the ticket is likely to run more than $40 on average. In challenging economic times, this should lead to continued transaction growth. However, I want to emphasize that our goal is not only to provide pricing value, but a high quality premium offering.
This is ultimately what sets Papa John's apart from others in the pizza category and why we are on the path to achieving our fourth consecutive year of positive North America comparable sales growth. Our consistent annual sales growth is driven in large part by our menu innovation, which has been a strong sales and engagement driver for us. No one in the pizza space innovates like we do. We have repeatedly delivered sales driving creatable new products. In the third quarter, we continued our innovation by expanding our popular Epic Stuffed Crust Pizza platform. Our new Garlic Epic Stuffed Crust Pizza was a direct response to the love that our fans have shown for our Epic Stuffed Crust and our iconic special garlic sauce. The pizza launched in July for a limited time at a premium price point of $13.99.
We then turned the heat up even more with our Spicy Garlic Epic Stuffed Crust which followed in August. We also launched new all white meat Boneless Wings. The Boneless Wings were introduced as another great option within our nationally advertised Papa Pairings program where customers can select two or more menu items for just $6.99 each. Providing products such as Garlic Epic Stuffed Crust Pizza at $13.99 and Boneless Wings at $6.99 demonstrates our commitment to our barbell strategy as we look to provide value to our customers across a broad range of price points and product offerings. Last week, we announced the return of our Chacaroni pizza. Our pizza with a purpose donates $1 from every Shaq-a-Roni pizza sold to the Papa John's Foundation for building community.
A perennial fan favorite, we expect it to help close 2023 on a positive note. We also expanded our Papa Bites platform with a limited time new dessert, Twix Papa Bites, served with a caramel dipping sauce. I highly recommend that you place an order or two as part of your Papa John's research. Another foundational component of our model is the continual evolution and improvement of our digital platform. We've been an industry leader in digital as technology has made it easier for us to engage and service our customers from any device. Our years of leadership in digital give us a competitive advantage over other QSRs entering this space, as more than 85% of our transactions already occur through digital channels, providing us with a significant amount of insights to drive differentiation through better innovation and ongoing digital product improvements.
Today, I would like to share an update on three components of our digital universe e-commerce, aggregators, and loyalty. Recent enhancements to our e-commerce platforms have focused on highlighting value for our most price sensitive customer segments and are driving improved website and app conversion rates. We're also focused on simplifying our digital ordering journey by offering clear, fast, and easy to understand navigation paths into the menu which can increase attachment rates. When it comes to third-party aggregators, Papa John's has been a leader in aggregator integration since 2019. We are excited about the partnerships that we have built over these four years and continue to grow rapidly in the space. We remain committed to meeting customers where they want to order from us and to giving them high quality innovative products, providing great value, and delivering excellent service regardless of the channel in which they order.
Currently, approximately 85% of our sales take place in our organic carryout and delivery channels, with carryout mixing slightly higher when compared with the same period last year. The other 15% comes from third-party aggregators. Additionally, as new national pizza chains arrive on the aggregator platforms, the pizza category has continued to expand its share of the overall aggregator market. It turns out pizza is a great product for home delivery. Since the first day that we entered this platform, we have been competing with thousands of hometown pizza shops. Over the last three years, Pizza Hut and Little Caesar's also entered this channel. And despite the increased national pizza chain competition, our DoorDash sales have grown more than 150% over that same time period.
There continues to be a lot of room for category expansion, indicating that competitive entries do not necessarily lead to significant volume loss for brands that have been thriving in this space for years. Lastly, we are excited about the opportunity that this business model provides for us to increase our volume in the lunch and late night day parts, which today are a smaller segment of our business, but represent opportunities for significant future gains. Historically, it has been challenging to execute our delivery model at lunch and late night due to the lack of consistent ordering patterns and commensurately the ability to accurately forecast the labor necessary to meet the variable demand. The on-demand labor that the aggregators provide through their delivery-as-a-service model solves this challenge for us.
We know that we can be best-in-class in this channel and garner more than our fair share of the transactions, because we believe that our product innovation, premium positioning, coupled with great value, is a unique combination of category attributes that give us an advantage over the competition. The aggregator marketplace dynamic makes it more difficult to win on low prices alone as the incremental fees reduce the ability to offer steep discounts. In turn, this enhances the value of our premium and innovative products. Complementing this growth is our core business, where we will continue to innovate and deliver targeted promotions to our most valuable customer base, our Papa John's rewards members. Our goal is to be able to offer our rewards members attractive incentives to order through our organic channels.
This will ensure that they continue to have higher frequency and higher tickets. We are currently working to enhance our loyalty program and anticipate even better program performance in 2024 and beyond. We will also benefit from the improved productivity that we expect from the advertising and media review process that we are currently conducting. Turning to our Commissary business, which we do not always talk a lot about, we have some exciting news to share. Although this segment of our business operates at a lower margin, it is a consistent way to provide our system with the fresh ingredients necessary to deliver the level of quality that our customers expect. We are relatively unique in the QSR industry with a vertically-integrated supply chain and distribution network that operates on a fixed operating margin basis, which is currently set at 4%.
This business is our largest source of company revenue and as our business continues to scale, we continue to evolve our approach with our franchisees to increase investment in our supply chain infrastructure. These efforts will ensure that we continue to deliver high quality ingredients to our restaurants and support our system growth as well as incentivize our franchisees to grow. Beginning in 2024, we will increase the fixed operating market that our U.S. domestic commissaries charge by 100 basis points in each of the next four years, moving from 4% today to 8% in 2027. At the same time, we are offering new opportunities for our franchisees to earn annual incentive-based rebates as they increase volume and open new restaurants, which will drive even more continued productivity for our system.
The incentive based rebates will provide the opportunity for our franchisees to earn a reduced effective supply chain rate as they continue to grow on an annual basis. Finally, I would like to briefly touch upon our UK market. As previously discussed, we have been making targeted investments in our international organization, setting us up for long-term success in this growing segment of our business. Our efforts over the past year have also focused on repositioning our UK portfolio in a way that ensures our franchisees in the total market will drive healthy growth over the long-term. This has led to the rotation of some franchise entities to other more proven franchisees. These efforts are paying dividends, as we continue to see improved performance from these locations quarter-after-quarter.
Lastly, as you recall, in June, we announced the purchase of a portfolio of franchise restaurants, with the goal helping to realign this market for long-term profitable growth. Although we expected and communicated that, these stores would be dilutive to earnings during our first year of operations, they are slightly more dilutive than we anticipated, as evidenced in our third quarter results, and they will continue to be a drag on profits in the fourth quarter and into 2024. However, we anticipate sequential quarterly improvements in profitability, and we are making the necessary investments to improve their sales and profitability with a focus on labor optimization, product innovation, and e commerce enhancements. We continue to be confident in long-term potential of the UK market.
Now, I'd like to turn the call over to Ravi to cover the financial portion of today's call. Ravi?
Ravi Thanawala: Thank you, Rob, and good morning, everyone. Over the past few months, I've had the chance to get to know many of you within the financial community and I've enjoyed listening to and learning from you. Furthermore, I've been able to dive deeper into all aspects of our business, working alongside our finance team and our executive leaders to gain a better understanding of Papa John's long-term potential. My conviction in the Company has only grown stronger. As I see notable opportunities to continue driving top-line sales and improve profitability over the long-term. Our approach to innovation is core to our competitive advantage it allows us to adapt at the pace of the consumer. Additionally, with the overwhelming majority of our transactions occurring on digital platforms, we have the opportunity to test and learn quickly to drive impact in the marketplace.
Finally, while we remain in a dynamic operating environment internationally, which will continue to weigh on our near-term results, there remains amazing earnings potential over the long-term through improving average unit volumes or AUVs and continued development. Now on to our third quarter financial results. For the quarter, global system wide restaurant sales were 1.23 billion, up 5% in constant currency from the prior year. New restaurant openings and strong North America comp sales were the primary drivers of the higher system wide sales. This continued growth demonstrates the strength of our brand and the opportunity to develop more restaurants. As Rob mentioned earlier, our 3% increase in North America comp sales was the result of a 6% increase in our company-owned restaurants and a 2% increase in our franchised restaurants.
Higher transactions drove this growth as we saw an increase in sales through our aggregated channels along with improved year-on-year conversion rates through our own digital channels. Exiting the quarter, our year-over-year sales comparisons remain positive. Our FP&A and revenue management teams continue to do a great job analyzing daily and weekly trends to ensure our business models are evolving with the latest consumer trends, ultimately enabling us to continue optimizing revenues and maximizing long-term profitability. International comps, which were down less than 1% in the third quarter, have sequentially improved throughout 2023. For the third quarter, positive comp sales in the Middle East and our turnaround efforts in the UK were offset by softening sales within our Asia and Latin America markets.
Total revenues for the third quarter were $523 million, up 2% versus the third quarter last year, driven by growth in our North America sales and the consolidation of the 118 restaurants we acquired in the UK. This growth was somewhat offset by lower commissary revenues due to decreased commodities prices. You'll recall in June, we completed the purchase of 91 formerly franchised restaurants in the UK, and in July, we acquired 27 additional locations. The results of these restaurants are now reflected in our international revenues and expenses. Excluding the impact of these acquisitions, total revenues were up 1% year-over-year. Turning to profits, adjusted operating income for the third quarter was $34 million in line with the prior year period while adjusted operating margins were 6.4% down slightly from a year ago.
As Rob mentioned, we are pleased with the progress in our North America business, driving comp sales, improving corporate restaurant margins 130 basis points. However, as we are in early innings of our UK turnaround, the recently acquired company-owned restaurants were dilutive to our profitability. Our back to better strategic initiatives led to higher restaurant level margins at our domestic company-owned restaurants due higher comp sales and labor efficiencies, which I will discuss in a moment. These improvements were somewhat offset by anticipated higher G&A expense due to higher variable compensation expense when compared with the third quarter last year along with higher health care costs. In addition, there was higher depreciation and amortization expense related to our continued investment in restaurant and technology support along with the recently acquired UK restaurants.
For modeling purposes, we expect depreciation and amortization expense to be at the higher end of our guidance of $60 million to $65 million in 2023. Our teams continuing to take a disciplined approach to managing costs while supporting strategic growth initiatives. As we look to 2024, higher variable compensation insurance costs along with the full year impact of our UK acquisition will continue to be a headwind for year-on-year comparisons. So let's take a deeper dive into our domestic company-owned restaurant level margins. For the third quarter, food basket costs at our company-owned restaurants improved 290 basis points compared with the prior year as we experienced meaningful relief from prior year peaks, particularly in cheese and proteins.
Labor costs improved 60 basis points during the quarter as our restaurants teams are doing a great job executing our back to better initiatives. On a combined basis, commodities and labor costs contributed approximately 350 basis points of margin improvement year-on-year in our domestic company-owned restaurant segment. Somewhat offsetting the 350 basis points improvement was a lower average ticket as carry up and third-party aggregator mix was higher. Overall, company-owned restaurant operating margins improved by approximately 130 basis points when compared with the same period a year ago. Moving on to cash flow and balance sheet. For the first nine months of the year, net cash provided by operating activities was $127 million up from $77 million a year ago.
After deducting $51 million in capital expenditures for the development of new domestic restaurants and investments in technology innovation, we generated free cash flows of $76 million. This is up from $28 million in the first nine months of 2022, reflecting the positive impact of our overall business performance, lower performance compensation and working capital changes. We ended the quarter with a healthy liquidity position, which totaled approximately $260 million in cash and borrowings available under our revolving credit facility and a gross leverage ratio of 3.4 times. Based on our strong balance sheet and positive free cash flow outlook, our board has declared a fourth quarter dividend of $0.46 per common share, which is a $1.84 on an annualized basis and in line with our third quarter payment.
Our capital structure provides us with substantial operating flexibility. We will continue to take a disciplined and balanced approach to managing our cash flows, creating shareholder value through a combination of organic growth investments, debt repayments, cash dividends and share repurchases. Turning to development. In the third quarter, we added eight net new units in North America, bringing our total North America accounts to 3,397 units. We currently have 45 units under construction and most are expected to open in the fourth quarter. To-date, we have been pleased with the performance of new restaurants. Internationally, we opened 37 net new units in the quarter, bringing our international account to 2,428 units and our total system-wide restaurants to 5,825 units.
Consistent with prior years, our system-wide development is weighted towards the second half of the year, with the largest number of openings expected to recur in the fourth quarter. Now to our outlook. We are narrowing our 2023 North America comp guidance to a range of flat to plus 1%. Furthermore, we are reiterating our long-term expectations of growing our North America comps between 2% and 4% annually. This growth will be driven by new menu innovations, enhancements to our digital experience, and execution of our back-to-better strategic initiatives. We anticipate international comps will remain under pressure for the fourth quarter, as sales headwinds within our Asia markets are expected to persist and the geopolitical uncertainty related to the evolving Middle East conflict weighs on our results.
We are confident in the success of our international markets over the long-term, but approaching the remainder of 2023 and 2024 with appropriate caution given the ongoing dynamic environment globally. We now expect our adjusted operating margins in 2023 to be down, when compared with 2022, primarily driven by the recent acquisition of the UK restaurants. This headwind will all set the benefit of the 53rd week and positive impact of our operational excellence initiatives, within our domestic company-owned restaurants. In terms of our non-operating expense items, we expect our net interest expense to remain between $40 million and $45 million and our capital expenditures to remain between $80 million and $90 million, and our tax rate to be between 22% and 24%.
Finally, from a development perspective, in 2023, we expect to open between 245 to 260 net new units, which is strong growth, but below our prior guidance of 270 to 310 net new units. This new range reflects a higher degree of uncertainty in the Middle East, potential closures in the UK and a more cautious outlook in Asia for the remainder of the year. We are focused on thoughtfully expanding in our most important markets and entering new markets. With that said, we do expect that our 2024 development will be lower than our long-term guide of 5% to 7% system-wide annual growth. This assumes the same challenges we anticipate entering the fourth quarter, continue into 2024. As I mentioned before, we are pleased with the performance of our recently opened restaurants in North America and expect net new unit development for North America to increase in 2024 relative to 2023 net openings.
Recall, development in the United States is our most profitable development given the higher AUVs these restaurants produce. I'd like to close by thanking all of our team members who have proven their agility to operate through dynamic environments while also staying focused on our long-term strategy. Their commitment to better helps to drive our strategic growth initiatives forward and further strengthens our business model. Thank you. And with that, I'll turn the call over to Rob for some final comments. Rob?
Rob Lynch: Thank you, Ravi. In closing, our North America business remains strong and our system wide sales continue to grow despite some near-term challenges that we face in this global macroeconomic environment. Our healthy performance in the quarter was driven by menu innovation, revenue management enhancements and continued growth in our third-party aggregator channel. We are on track to report our fourth straight year of positive comps in North America and the structural changes that we announced today in our commissary business will significantly improve our company's long-term profitability. We recognize that our international markets will remain under pressure temporarily, but we see a long runway ahead in terms of development and I'm confident that we have the right strategies in place to achieve success.
We are also pleased to see our UK comps turn positive this quarter as we reposition this market and expect to see sequential improvement looking forward. Our targeted investments across our business will enable us to improve our sales and profitability as we focus on product innovation, labor optimization operational excellence through our back to better initiatives and digital enhancements. This quarter has been a great example of how our back to better initiatives resulted in strong performance on the top- and bottom-line for our North America business. Finally, I am so proud of the culture we've created within Papa John's and our efforts continue to be recognized externally as Forbes recently named Papa John's one of the World's Best Employers for a second year in a row.
I remain excited about the growth opportunities and earnings potential ahead. At this point, I'd like to open it up for questions.
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