UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

(Mark One)

 

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

 

For the quarterly period ended March 27, 2016

 

OR

 

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

 

Commission File Number:  0-21660

 

PAPA JOHN’S INTERNATIONAL, INC.

(Exact name of registrant as specified in its charter)

 

 

2002 Papa Johns Boulevard

Louisville, Kentucky 40299-2367

(Address of principal executive offices)

 

(502) 261-7272

(Registrant’s telephone number, including area code)

 

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

 

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

 

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

 

 

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

 

At April 26, 2016, there were outstanding 37,242,152 shares of the registrant’s common stock, par value $0.01 per share.

 

 

INDEX

 

 

 

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

Papa John’s International, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

 

 

 

See accompanying notes.

 

 

Papa John’s International, Inc. and Subsidiaries

Condensed Consolidated Statements of Income

(Unaudited)

 

 

See accompanying notes.

 

 

Papa John’s International, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(Unaudited)

 

 

 

 

See accompanying notes.

 

Papa John’s International, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

 

 

 

See accompanying notes.

 

Papa John’s International, Inc. and Subsidiaries

 

Notes to Condensed Consolidated Financial Statements (Unaudited)

 

March 27, 2016

 

1.Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Operating results for the three months ended March 27, 2016 are not necessarily indicative of the results that may be expected for the fiscal year ended December 25, 2016. For further information, refer to the consolidated financial statements and footnotes thereto included in the Annual Report on Form 10-K for Papa John’s International, Inc. (referred to as the “Company”, “Papa John’s” or in the first person notations of “we”, “us” and “our”) for the year ended December 27, 2015.

 

2.Significant Accounting Policies

 

Noncontrolling Interests

 

Papa John’s has four joint venture arrangements in which there are noncontrolling interests. These joint ventures include 213 restaurants at March 27, 2016 and 200 restaurants at March 29, 2015. We are required to report the consolidated net income at amounts attributable to the Company and the noncontrolling interests. Additionally, disclosures are required to clearly identify and distinguish between the interests of the Company and the interests of the noncontrolling owners, including a disclosure on the face of the condensed consolidated statements of income attributable to the noncontrolling interest holder.

 

The income before income taxes attributable to these joint ventures for the three months ended March 27, 2016 and March 29, 2015 was as follows (in thousands):

 

 

The following summarizes the redemption feature location and related accounting within the condensed consolidated balance sheets:

 

*The change in redemption value is recorded as an adjustment to “Redeemable noncontrolling interests” and “Retained earnings” in the condensed consolidated balance sheets.

 

Deferred Income Tax Accounts and Tax Reserves

 

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

 

Deferred tax assets and liabilities are determined based on differences between financial reporting and tax basis of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the differences reverse. Deferred tax assets are also recognized for the estimated future effects of tax loss carryforwards. The effect on deferred taxes of changes in tax rates is recognized in the period in which the new tax rate is enacted. As a result, our effective tax rate may fluctuate. Valuation allowances are established when necessary on a jurisdictional basis to reduce deferred tax assets to the amounts we expect to realize. As of March 27, 2016, we had a net deferred tax liability of approximately $7.4 million.

 

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

 

Fair Value Measurements and Disclosures

 

The Company is required to determine the fair value of financial assets and liabilities based on the price that would be received to sell the asset or paid to transfer the liability to a market participant. Fair value is a market-based measurement, not an entity specific measurement. The fair value of certain assets and liabilities approximates carrying value because of the short-term nature of the accounts, including cash, accounts receivable and accounts payable. The carrying value of our notes receivable net of allowances also approximates fair value. The fair value of the amount outstanding under our revolving credit facility approximates its carrying value due to its variable market-based interest rate. These assets and liabilities are categorized as Level 1 as defined below.

 

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

 

 

Our financial assets and liabilities that were measured at fair value on a recurring basis as of March 27, 2016 and December 27, 2015 are as follows (in thousands):

 

 

There were no transfers among levels within the fair value hierarchy during the three months ended March 27, 2016.

 

Variable Interest Entity

 

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

 

Accounting Standards Adopted

Income Taxes

In November 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2015-17 “Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes”. ASU 2015-17 requires the Company to classify deferred tax assets and liabilities as noncurrent amounts in the consolidated balance sheets. Such amounts were previously required to be classified as current and noncurrent assets and liabilities. The Company is required to adopt the provisions of ASU 2015-17 for fiscal 2017; however, the Company elected to retrospectively adopt the provisions in fiscal 2015, as allowed, and reclassified all previously reported current amounts as long-term.

Deferred Debt Issuance Costs

 

In April 2015, the FASB issued “Interest – Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs” (ASU 2015-03). The update requires that deferred debt issuance costs be reported as a reduction to long-term debt (previously reported in other noncurrent assets). We adopted ASU 2015-03 in the first quarter of 2016 and for all

retrospective periods, as required. The impact of the adoption was not material to our condensed consolidated financial statements. See Debt Footnote for more details.

 

Accounting Standards to be Adopted in Future Periods

 

Employee Share-Based Payments

 

In March 2016, the FASB issued ASU 2016-09, “Compensation – Stock Compensation: Improvements to Employee Share-Based Payment Accounting” (ASU 2016-09). The guidance changes how companies account for certain aspects of share-based payment awards to employees, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows. ASU 2016-09 is effective for the Company beginning in fiscal 2017, with early application permitted. Based on the significance of our employee stock compensation program, we expect the adoption could have a material impact to our condensed consolidated statements of income. 

 

Leases

 

In February 2016, the FASB issued ASU 2016-02, “Leases,” which amends leasing guidance by requiring companies to recognize a right-of-use asset and a lease liability for all operating and capital leases (financing) with lease terms greater than twelve months.  The lease liability will be equal to the present value of lease payments. The lease asset will be based on the lease liability, subject to adjustment, such as for initial direct costs.  For income statement purposes, leases will continue to be classified as operating or capital (financing) with lease expense in both cases calculated substantially the same as under the prior leasing guidance. ASU 2016-02 is effective for interim and annual periods beginning after December 15, 2018 (fiscal 2019 for the Company), and early adoption is permitted.  The Company has not yet determined the effect of the adoption on its condensed consolidated financial statements.

 

Revenue from Contract with Customers

 

In May 2014, the FASB issued “Revenue from Contracts with Customers” (ASU 2014-09), a comprehensive new revenue recognition standard that will supersede nearly all existing revenue recognition guidance under GAAP. This update requires companies to recognize revenue at amounts that reflect the consideration to which the company expects to be entitled in exchange for those goods or services at the time of transfer. In doing so, companies will need to use more judgment and make more estimates than under today’s guidance. Such estimates may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. Companies can either apply a full retrospective adoption or a modified retrospective adoption.

 

We are required to adopt the new requirements in the first quarter of 2018. We are currently evaluating the method of adoption and impact of the new requirements on our consolidated financial statements. We currently do not believe the impact will be significant.

 

Reclassifications

 

Certain prior year captions have been combined in the condensed consolidated statement of income and certain amounts within the consolidated statement of cash flows have been reclassified to conform to the current year presentation.

 

3.Calculation of Earnings Per Share

 

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

 

Additionally, in accordance with Accounting Standards Codification (“ASC”) 480, “Distinguishing Liabilities from Equity”, the change in the redemption value for the noncontrolling interest of PJ Denver, LLC increases or decreases income attributable to common shareholders.

 

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

 

(a) Excludes 476 awards for the three months ended March 27, 2016 and 112 awards for the three months ended March 29, 2015, as the effect of including such awards would have been antidilutive.

 

4.Acquisition of Restaurants

 

For the three months ended March 27, 2016, we completed the acquisition of 20 franchised Papa John’s restaurants located in Alabama, Florida and Kentucky in two separate transactions with an aggregate purchase price of $11.2 million. These acquisitions were accounted for by the purchase method of accounting, whereby operating results subsequent to the acquisition date are included in our consolidated financial results.

 

The aggregate purchase price of the acquisitions has been allocated based on initial fair value estimates as follows (in thousands):

 

 

The excess of the purchase price over the aggregate fair value of net assets acquired was allocated to goodwill for the domestic Company-owned restaurants segment and is eligible for deduction over 15 years under U.S. tax regulations. 

 

5.Debt

 

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

 

 

Our outstanding debt is comprised entirely of a $400 million unsecured revolving line of credit (“Credit Facility”) with an expiration date of October 31, 2019. Including outstanding letters of credit, the remaining availability under the Credit Facility was approximately $58.8 million as of March 27, 2016.We have the option to increase the Credit Facility by an additional $100 million.

 

The interest rate charged on outstanding balances is LIBOR plus 75 to 175 basis points. The commitment fee on the unused balance ranges from 15 to 25 basis points.

 

The Credit Facility contains customary affirmative and negative covenants, including financial covenants requiring the maintenance of specified fixed charges and leverage ratios. At March 27, 2016, we were in compliance with these covenants.

 

We attempt to minimize interest risk exposure by fixing our rate through the utilization of interest rate swaps, which are derivative financial instruments. Our swaps are entered into with financial institutions and have reset dates and critical terms that match those of our existing debt and the anticipated critical terms of future debt. By using a derivative instrument to hedge exposures to changes in interest rates, we expose ourselves to credit risk. Credit risk is the failure of the counterparty to perform under the terms of the derivative contract.

 

As of March 27, 2016, we have the following interest rate swap agreements, including three forward starting swaps executed in 2015 that become effective in 2018 upon expiration of the two existing swaps for $125 million:

 

 

The weighted average interest rate on the revolving line of credit, including the impact of the interest rate swap agreements, was 2.1% for the three months ended March 27, 2016 and March 29, 2015. Interest paid, including payments made or received under the swaps, was $1.6 million and $1.3 million for the three months ended March 27, 2016 and March 29, 2015, respectively.  As of March 27, 2016, the portion of the $5.6 million interest rate swap liability that would be reclassified into earnings during the next twelve months as interest expense approximates $723,000.

 

6.Segment Information

 

We have five reportable segments: domestic Company-owned restaurants, domestic commissaries, North America franchising, international operations and “all other” units. The domestic Company-owned restaurant segment consists of the operations of all domestic (“domestic” is defined as contiguous United States) Company-owned restaurants and derives its revenues principally from retail sales of pizza and side items, including breadsticks, cheesesticks, chicken poppers and wings, dessert items and canned or bottled beverages. The domestic commissary segment consists of the operations of our regional dough production and product distribution centers and derives its revenues principally from the sale and distribution of food and paper products to domestic Company-owned and franchised restaurants. The North America franchising segment consists of our franchise sales and support activities and derives its revenues from sales of

franchise and development rights and collection of royalties from our franchisees located in the United States and Canada. The international operations segment principally consists of Company-owned restaurants in China and distribution sales to franchised Papa John’s restaurants located in the United Kingdom, Mexico and China and our franchise sales and support activities, which derive revenues from sales of franchise and development rights and the collection of royalties from our international franchisees. International franchisees are defined as all franchise operations outside of the United States and Canada. All other business units that do not meet the quantitative thresholds for determining reportable segments, which are not operating segments, we refer to as our “all other” segment, which consists of operations that derive revenues from the sale, principally to Company-owned and franchised restaurants, of printing and promotional items, risk management services, and information systems and related services used in restaurant operations, including our point-of-sale system, online and other technology-based ordering platforms.

 

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

 

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

 

Our segment information is as follows (in thousands):

 

 

 

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

 

Overview

 

Papa John’s International, Inc. (referred to as the “Company,” “Papa John’s” or in the first person notations of “we,” “us” and “our”) began operations in 1984. At March 27, 2016, there were 4,903 Papa John’s restaurants (773 Company-owned and 4,130 franchised) operating in all 50 states and 40 international countries and territories. Our revenues are principally derived from retail sales of pizza and other food and beverage products to the general public by Company-owned restaurants, franchise royalties, sales of franchise and development rights, sales to franchisees of food and paper products, printing and promotional items, risk management services, and information systems and related services used in their operations.

 

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

 

Restaurant Progression

 

 

 

Results of Operations

 

Income Statement Presentation

We have streamlined our income statement presentation by combining certain income statement captions in the condensed consolidated statements of income and have conformed prior year amounts to this new presentation.

 

Review of Consolidated Operating Results

 

Revenues. Domestic Company-owned restaurant sales were $205.7 million for the first quarter of 2016, an increase of $8.4 million, or 4.3%, compared to the first quarter of 2015, primarily due to an increase in equivalent units, including 20 restaurants acquired from franchisees during the first quarter, and a 1.0% increase in comparable sales. “Equivalent units” represents the number of restaurants open at the beginning of a given period, adjusted for restaurants opened, closed, acquired or sold during the period on a weighted average basis.  “Comparable sales” represents the change in year-over-year sales for the same base of restaurants for the same fiscal periods.

 

Domestic franchise royalties and fees were $26.5 million for the first quarter of 2016, an increase of approximately $850,000, or 3.3%, compared to the first quarter of 2015. The increase was primarily due to reduced levels of royalty incentives in the first quarter of 2016. Domestic franchise restaurant sales increased 0.3% to $564.4 million in the first quarter of 2016, primarily due to a 0.6% increase in equivalent units, partially offset by a 0.2% decrease in comparable sales. Franchise restaurant sales are not included in Company revenues; however, our domestic royalty revenue is derived from these sales.

 

Domestic commissary and other sales decreased $15.0 million, or 8.1%. The decrease was due to the prior year inclusion of approximately $8.5 million of point-of-sale system (“FOCUS”) equipment sales to franchisees. The higher levels of 2015 FOCUS sales had no impact on 2015 operating results. Additionally, domestic commissary sales decreased by approximately $6.4 million as revenues associated with lower pricing for certain commodities, including meats and dough, were somewhat offset by an increase in sales volumes.

 

International revenues increased approximately $2.0 million, or 8.0%, primarily due to the following:

 

 

The negative impact of foreign currency exchange rates was approximately $1.9 million on international revenues.

 

Costs and expenses.  The operating margin for domestic Company-owned restaurants was 21.6% in the first quarter of 2016 compared to 21.4% in the first quarter of 2015 and consisted of the following (dollars in thousands):

 

 

Domestic Company-owned restaurants cost of sales was approximately 1.2% lower primarily due to lower commodity costs, including meats and dough. Domestic restaurants other operating expenses were approximately 1.0% higher as a percentage of sales primarily due to higher labor costs, including minimum wage increases, and insurance costs.

 

The domestic commissary and other operating margin was 7.2% in the first quarter of 2016, compared to 7.4% in the first quarter of 2015 and consisted of the following (dollars in thousands):

 

 

 

 

The 0.5% lower margin for domestic commissary was primarily due to the reclassification of certain expenses from general and administrative to operating expenses beginning in the first quarter of 2016, which had no impact on commissary income before income taxes. The higher margin of 1.4% for “Other” was primarily due to the prior year including FOCUS equipment sales to franchisees which had no significant margin.

 

The international operating margin was 35.9% in the first quarter of 2016 compared to 39.1% in the first quarter of 2015. The 3.2% lower margin was primarily due to the following:

 

 

The international operating margins consisted of the following (dollars in thousands):

 

 

General and administrative (G&A) expenses were $40.3 million, or 9.4% of revenues in the first quarter of 2016, as compared to $43.7 million, or 10.1% of revenues, in the same period of 2015. The decrease of $3.5 million was primarily due to the following:

 

 

Depreciation and amortization. Depreciation and amortization was $9.7 million (2.3% of revenues) for the first quarter of 2016 and $10.0 million (2.3% of revenues) for the first quarter of 2015.

 

Net interest (expense) income. Net interest expense increased approximately $300,000 primarily due to a higher average outstanding debt balance.

 

Income tax expense.  The effective income tax rate was 32.3% for the first quarter of 2016 and 33.5% for the same period in 2015. Our effective income tax rate may fluctuate from quarter to quarter for various reasons, including the timing of various deductions and credits.

 

Diluted earnings per share. Diluted earnings per share were $0.69 in the first quarter of 2016, compared to $0.55 in the first quarter of 2015, an increase of $0.14, or 25.5%.

 

Discussion of Operating Results by Segment

 

See “Review of Consolidated Operating Results” above for revenue highlights.

 

First quarter 2016 income before income taxes was $41.4 million, compared to $36.4 million in the prior year comparable period, or a 13.6% increase as summarized in the following table on a reporting segment basis (in thousands):

 

 

 

Changes in income before income taxes are summarized on a segment basis as follows: