Freshworks Inc

NASDAQ:FRSH

Earnings Call Transcript 2018-Q2

[Operator]

Good afternoon and welcome to today's Papa Murphy's Holdings, Inc. Second Quarter 2018 Earnings Conference Call. All participants are now in a listen-only mode. After the presenters' remarks, there will be a question and answer session. As a reminder, this call is being recorded.

I would now like to introduce Nik Rupp, Chief Financial Officer. You may begin your conference.

[Mark Hutchens]

Thanks, you, Darren. Good afternoon, everyone, and welcome to our second quarter earnings call. Let me start by noting that our formal remarks and responses to your questions may contain forward-looking statements regarding future events or the future financial performance of the Company.

Any such items, including guidance with respect to expected results for 2018 and statements relating to our future performance should be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Any forward-looking statements are not a guarantee of performance and actual events or results could differ materially from those anticipated in forward-looking statements due to a number of risks and uncertainties.

I'd refer you to the Company's Form 10-K for the year ended January 1, 2018, filed with the Securities and Exchange Commission, which identifies important risk factors that could cause actual results to differ materially from those anticipated in our projections or forward-looking statements.

The forward-looking statements made on this call speak only as of the date of this call and the Company undertakes no obligation to publicly update any forward-looking statements. Today's discussion also includes non-GAAP financial measures that we believe may be important to investors as metrics to assess the operating performance of our business.

Our earnings release contains reconciliations of non-GAAP measures to the most directly comparable GAAP financial measures in accordance with the SEC rules and the release and reconciliations can be found on the Company's corporate website at investors.papamurphys.com.

Here with me this afternoon is Weldon Spangler, our Chief Executive Officer; and Mark Hutchens, our Chief Operating Officer. Weldon will provide some introductory remarks and highlights of the quarter and will take you through an update of the progress we are making against our turnaround plan. I will then take you through our second quarter financial results in detail, as well as our updated outlook for the year. Weldon will then provide some brief closing remarks before we open the call up for questions.

With that, I'd like to turn over to Weldon.

[Weldon Spangler, Chief Executive Officer]

Thank you, Nik. Good afternoon, everyone, and thank you all for joining the call today. I hate to make this a boring call for everyone, but, as in the past few quarters, we will be continuing to discuss our key focus areas of relevance and convenience and how these along with the focus on people and process will be the keys to delivering sustainable long-term growth and development.

Before I do that, let me quickly touch on the high-level results for the quarter. Today, we reported results for the second quarter that included a comparable store sales decline of 2.4% and adjusted EBITDA of $4.6 million.

While we believe we are making all of the necessary investments in the business to support the turnaround, we are also closely managing all discretionary expenditures, thus allowing us to maintain profitability even in the current sales environment.

We continue to build momentum across the system and have seen significant comparable sales improvement where owners have consistently adopted value as a relevance driver. Ultimately, we need to continue to show the benefits of adopting value at the key message across the system.

From a relevance perspective, we continued to make significant progress during the second quarter on our focus strategy designed to drive transactions and top-line sales while ensuring we create capabilities that provide long-term success.

Our efforts are focused around ensuring we engage customers with relevant offers that are compelling and provide the right value, while also looking to protect franchise owner profitability. Although we did not see positive system-wide comparable store sales in the quarter, we continue to see many examples where markets are turning the corner as they embrace and fully execute against these marketing initiatives.

To illustrate this point, in the second quarter, there were a total of 31 domestic markets representing about 44% of total domestic system sales that had same-store sales growth. This is an increase of 13 markets and 22% of the total domestic system sales where we are now seeing positive growth.

Although these growing markets are currently more than offset by those where comparable store sales declined, the number of markets in our supporting initiatives has increased significantly and we believe marks a turning point in terms of alignment and same-store sales growth.

From a convenience standpoint, the focus remains on ensuring we engage the consumers how and when they want to be engaged and further enhancing and adding to our stable of digital tools, so that we can close the existing gap and capability. The single largest of these assets and foundations for Papa Murphy’s is our online platform olo.com.

Q2 of 2018 was our first full quarter on our new online platform and we were extremely pleased with both the stability and performance of the system given the pressure testing that received on a few of our highest volume days in the year. Overall, online order mix continues to increase and we have further enhanced efforts to drive customer traffic online through a number of key marketing initiatives.

The other important factor to note is that we continue to see higher average check of around 20% for online orders. This platform also provides the backbone for loyalty and other convenience features including delivery.

We are also excited about the new capabilities that the olo.com platform is bringing to market and in particular around delivery that allows us to expand our offerings to deliver pizzas from our website and add convenience factors such as curbside pick-up.

The olo.com platform is not only driving more profitable sales, but increasing convenience and value for our customers. Given the success of the platform, we will continue to aggressively push more of our business online and are actively looking at store layout and design to ensure our stores are supporting the needs of the customers while remaining efficient for our franchise owners.

We are excited to also be relaunching our mobile app in the second half of the year and are exploring key attributes of a loyalty program. These will be great additions that help round out the consumer experience and deliver on our promise of convenience while giving us targeted marketing capabilities that we have yet to be able to fully activate.

Delivery is another key convenience element that we continue to address and expand across the entire system. More than a quarter of all of our stores now provide delivery as an option through at least one but sometimes multiple delivery partners. These include Amazon Restaurants, Grubhub, DoorDash, Uber Eats, City-Spree, Bite Squad, and GrubSub.

We believe delivery orders remain highly incremental with attractive and profitable check averages. We will continue driving the expansion of our delivery footprint and are on track to offer delivery in about half of our stores by year end.

As we noted earlier, relevance is the other focus for us alongside convenience. This has required us to relook at our brand positioning, digital marketing and social media to ensure we remain relevant to both existing and new customers in this rapidly changing environment.

Given that focus, we were pleased to announce last quarter, the introduction of a new creative agency, Mekanism, who brings strengths in these areas and who we felt could more closely capture the brand essence and positioning. We’ve engaged with both Mekanism and our franchise owners over the past quarter on this reset and have just completed the new marketing campaign materials that will start to air later this quarter.

We are extremely excited about this new creative as we believe this will go a long way to reinforcing our relevance with both existing and new customers to focusing on our product, highlighting our unique empowering do it yourself or DIY positioning and clearly demonstrating our differentiation.

These materials will be previewed at our franchise owner convention next week and will be rolled out through the various traditional and digital marketing channels later this quarter.

The change in mix towards more digital marketing allows us to get in front of more consumers in a more cost-effective manner and provides the necessary coverage in markets that did not have a full complement of traditional media.

This update to our brand positioning and creative coupled with a continuous focus on a few key marketing messages to drive sales through stronger value promotion, more efficient media mix and last, customer reengagement is key to ongoing growth.

Even before we launched the new creative, we continue to see that markets participating in these key initiatives, not only outperformed the other markets, but in fact, reversed the trend and grew sales in the quarter. As more franchise owners start to see the benefits of these initiatives, we are seeing greater adoption across the system that ultimately helps us move the system toward profitable comp store sales growth.

As we have discussed, we are working on many great things, but our ability to leverage and get more out of all of these will be influenced by the size of our consumer engagement databases, primarily the text and email databases. These play a key role in this development as they offer an opportunity to bring sales to our online platform at a higher average check and drive targeted messaging to a greater number of our customers.

The key enablers and non-consumer facing initiatives remain people and process and the most crucial element of this continues to be our relationship with our franchise owners. I feel we have made significant progress as an organization over the past twelve months in this regard and we believe a large number of franchise owners now feel the same way.

This can be seen through the significant number of franchise owners who are now actively adopting the focused marketing initiative that we have across the system and at times even pushing us to move faster.

This effort and engagement is not something that is one-off in nature but it’s much more a way of life for us as a company. We acknowledge the key to success will be a strong engaged partnership with our franchise owners and utilizing that trust to be able to pivot and adapt quickly in the ever changing phase of customer needs.

Another facet we noted last quarter is how we build and maintain trust and ongoing support from our franchise owners. This ultimately takes flawless execution and so we continue to look to enhance our internal capabilities and control at both the support center and in the field to ensure that we can perform at this level time and time again.

Before I turn the call over to Nik, I want to touch on the progress we are making on our store portfolio. We ended the quarter with 122 company-owned stores, which is a net decrease of 23 stores to last quarter and represents a net decrease of 27 stores compared to the end of the second quarter of 2017.

The decrease reflects a total of five stores that we closed over the last year and 22 stores that were refranchised.

During the quarter, we concluded the refranchising of 22 company-owned stores, 20 in Colorado and two in Arkansas and are in active discussions with existing franchise owners to refranchise additional company-owned stores.

Although we are committed to returning to at least a 95% franchise system and no more than 50 company-owned stores by 2020, our focus remains on ensuring we find the right owners to take over these stores rather than achieving a target number by the end of the year. We will provide updates on our progress as we have greater certainty around specific transactions and timing.

During the quarter, franchise owners opened two new domestic stores and closed a total of 27 domestic stores and one International store. At the end of the second quarter, the franchise store count was 1355 units, compared with 1401 units in the prior year quarter reflecting a total of 89 franchise store closures offset by 21 franchise store openings and a net refranchising of 22 company-owned stores over the last twelve months.

Consistent with the prior quarter, our near-term portfolio focus remains on refranchising and so we expect franchise owners to open only about ten new stores this year all in the U.S. Our belief is that, over the long-term, the system continues to have significant opportunity for franchise development, both in the U.S. and internationally.

With that, I’d like to turn the call over to Nik to review our second quarter results in detail.

[Nik Rupp, Chief Financial Officer]

Thank you, Weldon. As Weldon just noted, we reported today a second quarter comparable sales decline of 2.4% consistent with the outlook we provided last quarter and delivered an EPS of $0.08 and adjusted EBITDA of $4.6 million for the second quarter, $11.7 million for the six months ended 2nd of July 2018.

Looking more closely to our second quarter results, we saw revenue in the quarter of $30.8 million, a decrease of 14.7% compared to the second quarter of last year. The decrease in total revenue was driven primarily by three factors; firstly a net decrease of 73 stores comprised of a reduction of 27 company-owned stores, and 46 franchise stores.

Secondly, we saw a comparable net sales decline of 2.4% driven by a 2.2% decline for franchise stores and a 4.6% decline for company-owned stores. Lastly, in 2017, we had an additional contribution by all stores to the brand marketing fund of 0.85% or approximately $1.5 million to help fund a national TV advertising test.

Total franchise-related revenues decreased in the second quarter to $14.8 million, compared to $17.4 million for the same period last year. This was driven by the decline in franchise comparable store sales and net reduction of 46 franchise stores period-over-period and a decrease in brand funds related revenues. The net franchise store reductions comprise 21 new store openings, 89 closures and 22 refranchisings.

Sales of company-owned stores totaled $16 million, a decrease of $14.6 million from the prior year quarter. The decrease was driven by the net decrease of 27 company-owned stores over the last four quarters, 22 of which were refranchised and five of which were closed, as well as by a 4.6% decline in company-owned comparable store sales.

These refranchised stores had comparable store sales in the second quarter that were better than the average of the company-owned store portfolio and so their transfer added to the period-over-period comparable store sales decline.

Switching over to expenses, similar to the prior quarter, we have seen company-owned store operating expenses decreased as a percent of company-owned store sales to 93.4%. This is an improvement compared to the second quarter of 2017 of approximately ten basis points.

The decrease was driven by a 120 basis point lower appetite in cost and a 40 basis point decrease in cost of food and packaging, partially offset by a 90 basis point increase in compensation benefits and a 60 basis point increase in occupancy and other store operating costs.

The compensation benefits increase was driven by state minimum wage increases, while occupancy cost increased due to higher than anticipated repairs and maintenance. As you saw in the prior quarters, I’ll now discuss results for 57 stores in eight markets unaffected by the portfolio changes we have made at our company store division over the last 14 quarters.

Comparable store sales performance of these stores was roughly consistent with the overall store base, while margin declined around a 190 basis points in these stores as compared with the prior year quarter. Total operating cost as a percent of sales totaled 87.1% for the quarter.

Overall, stores opened by the company over the previous 14 quarters negatively affected second quarter EBITDA by about $400,000 and reduced earnings per share by approximately $0.02. Reported selling, general and administrative expense in the quarter was $11.4 million including a litigation reserve of $89,000 million and CEO transition and restructuring cost of $119,000.

Excluding these items from SG&A for 2018, SG&A expense would have been $11.2 million or 36% of total revenue. This compares to $10.7 million or 30% of total revenue in the second quarter of last year, which also excludes $131,000 in CEO transition and restructuring costs.

The change compared to the second quarter of last year is driven by a combination of the additional 0.85% brand marketing fund contribution and lower marketing expense as the expense relating to the national appetizing test which focused in the first quarter of 2017.

Additionally, the company-owned store revenues were lower due to the reduced number of stores and comp sales reductions.

Moving to EBITDA, in the second quarter of 2018, EBITDA was $5.1 million excluding the effect of litigation cost and other non-recurring expenses, adjusted EBITDA in the quarter was $4.6 million or 14.9% of total revenue. This compares to adjusted EBITDA of $8 million in the prior year second quarter.

The decrease period-over-period was driven primarily by the lower brand marketing fund revenues, lower SG&A in the second quarter of 2017, due to the phasing of the marketing cost being heavily weighted to the first quarter of 2017 and the quarterly decline in comparable store sales.

For the first six months of 2018, adjusted EBITDA was $11.7 million compared to $5.7 million for the same period last year. A reconciliation of EBITDA and adjusted EBITDA to GAAP net income is included in our earnings release.

Depreciation and amortization expense in the quarter was $1.9 million, approximately $1 million less than the prior year quarter. Net interest expense in the second quarter was $1.3 million, flat to last year. Net income in the quarter was $1.4 million or $0.08 per diluted share, compared to a net loss of $6.1 million in the second quarter of 2017 or a $0.36 loss per diluted share.

Note that after-tax is reported net income in the quarter was reduced by $400,000 or $0.02 per share due to litigation costs and other non-recurring expenses. Excluding these unusual items, pro forma net income in the quarter would have been $1 million or $0.06 per diluted share. A reconciliation of pro forma net income to GAAP net income is included in our earnings release.

Our effective tax rate for the quarter was 28.3%. We ended the quarter with approximately $1.7 million cash on the balance sheet and gross debt of $84.8 million, $6.2 million less than the prior quarter, reflecting net positive cash generated in the quarter, primarily from refranchising activities. The $20 million revolver was undrawn at the end of the quarter.

We also ended the quarter in full compliance with all covenants under our amended credit facility. We reported a leverage ratio of 3.88 times, compared to a maximum permitted leverage ratio of five times and reported an interest coverage ratio of 4.63 times, compared to a minimum permitted coverage ratio of 3.5 times.

We continue to believe that in the current business environment, it's prudent to maintain an even more conservative balance sheet and continue to expect to use operating cash generated by the business and net proceeds from refranchising to further pay down debt.

Based on our current growth plans and financial forecast, we believe that the expected cash flow from operations and refranchising and available liquidity under the amended credit facility and revolver are sufficient to fund our business and anticipated capital expenditures going forward within the financial covenants prescribed within our amended credit facility.

We are currently working with our existing bank partners to refinance or extend the existing amended credit facility, which expires on August of 2019 and continue discussions to that end. Based on those conversations, we expect to complete that effort prior to the existing facility going current in August of this year.

Based on current information and reflective of the new accounting standards, we are updating our full-year outlook for fiscal 2018, which ends on 31st of December, 2018 as follows: full year system comparable store sales are expected to decline low single-digits, as compared to previous guidance of about flat to the year. We expect comparable store sales growth in the third quarter to be approximately flat.

Domestic franchise new store openings of approximately 10 units; full year selling, general and administrative expenses of approximately $49 million, a reduction of $1 million as compared to previous guidance.

This includes approximately $24 million of expenditures in the Brand Funds and excludes certain non-recurring costs totaling around $4 million. Adjusted EBITDA of at least $20 million, flat to prior quarter guidance after adjusting for the second quarter refranchising activities.

Cash flow from operations of around $12.3 million, excluding expected legal settlements totaling approximately $6.7 million, cash provided by investing activities of approximately $6 million, which includes $7 million net proceeds from refranchising activities, less approximately $1 million in capital expenditures. Full-year effective tax book tax rate of approximately 27.8% and diluted share count of approximately 17 million.

Note that the 2018 financial outlook does not reflect the impact of any additional refranchising in the year. We will continue to update our outlook for refranchising activity as the financial impact and timing of any additional changes are more fully known.

I will now hand the call back to Weldon for closing remarks.

[Weldon Spangler, Chief Executive Officer]

Thanks Nik. We’ve come a long way over the past month and now more than ever are excited about the activation of the strategies with our franchise owners and the opportunities that this supports to return this unique brand to positive growth.

We have an amazing product and an extremely loyal customer following. And through the new marketing strategies, combined with a focus on relevance and convenience, we will be able to not only enhance the experience for those loyalists but to bring many new customers to the brand.

We remain a highly differentiated brand with inherent competitive advantage, coupled with an enthusiastic team of employees, dedicated to serving our passionate franchise owners.

As you have heard, we remain committed to a focused strategy of improving consumer convenience and relevance including improved consumer value enabled by people and process enhancements that will drive profitable and sustainable comp sales growth, both in the short and the long-term.

While we are confident that we will return to same-store sales growth in the near-term, we continue to manage all discretionary costs very closely to ensure we deliver strong profitability and cash flows. We remain convinced that the ongoing successful execution of this strategy will drive positive and sustained results and create substantial long-term value for all of our stakeholders.

We will now open it up for any questions.

[Operator]

[Operator Instructions] Our first question comes from Andy Barish of Jefferies. Please proceed with your question.

[Alex Slagle, Jefferies LLC]

Hey, thanks for taking my questions. This is actually Alex on for Andy.

[Weldon Spangler, Chief Executive Officer]

Hey, Alex

[Alex Slagle, Jefferies LLC]

Hey, how are you? Just wanted to, just talk little bit about the refranchising and I think you had originally spoken to targeting 60 company stores by year-end. It sounds like that might be pushed back a little bit. But I thought that some of the Colorado stores had those were planning on closing in July the transaction. Can you give a little bit more color on that and the timing there?

[Weldon Spangler, Chief Executive Officer]

Yes, the closing of the Colorado stores did goes through actually a little earlier. So they went through in the last half of June. So we pulled those forward. So, the 22 stores we mentioned were actually the refranchising of the Colorado stores and the Arkansas stores. So those are actually in there already.

And then for the remainder of the year, as we’ve noted, we are still looking and having conversations with existing franchise owners. We still have a lot to go through in regard to those.

And so, at this point in time, we are not guiding to a particular number and as we said, we are really looking to make sure that we get the right partners aligned up, so that ultimately we are handing this over to those who we believe can truly can take those and make them successful.

[Alex Slagle, Jefferies LLC]

Got it. Looking at the franchise closures this quarter, 27 last year, I guess, 23 last quarter, how should we think about that trending in the near-term? Will it continue at similar levels?

[Weldon Spangler, Chief Executive Officer]

Yes, that, when we think about the closures, there are couple of ways to look at it. One is, about a third of the closures we are seeing are coming from larger owners in markets with multiple stores and so some of that the natural pruning and with – in some cases, considerable sales transfer. The other thing – the other way to look at it is we are really anniversaring about five years from when we were opening large number of stores.

And with the sales challenges we’ve had over the last three years, as the first five year term on those leases start to come up, it’s not surprising to see that the stores that were performing at or near breakeven are going to be closing. So, we wouldn’t be surprised if the trend stays about the same. But we don’t expect it to accelerate and as we make progress on the comp sales, we should see that improve.

[Alex Slagle, Jefferies LLC]

So, those stores that are closing as they come up towards the end of the term, are those typically large owners or those more mom and pops? And should we expect a shift for more of these large multi-unit franchisees as you, A refranchise, and B see a closure these less profitable stores?

[Weldon Spangler, Chief Executive Officer]

So, what we are seeing is about a third of them are from the larger owners, meaning, so obviously, two-thirds are the smaller owners and we don’t have – we are not actively moving toward larger franchise systems. What we do see though in some of the refranchising is that, some of it will be done through larger owners. So, we’ll see some of that naturally, but it’s not an active strategy to move to more those larger ones.

[Alex Slagle, Jefferies LLC]

Got it. That makes sense. And then if I could just ask one more on, just shifting gears a little bit to comments on both trial and value. Obviously, new relationship with Mekanism and shift towards digital marketing. But can we dig a little bit more into the value strategy?

What are you going to – what are you doing sort of get credit for the current value in the menu, right, the $10 Tuesdays and do you see sort of the – a balance more toward new product news like the extra large extra-large pizza- extra-large New York pizza? Or is it going to be more a price point discounts across the core items? How should we think about that?

[Weldon Spangler, Chief Executive Officer]

Yes, great question. So couple things. You mentioned $10 Tuesday and what we are working on right now, what we are finding is, markets that are heavily leaning in on $10 Tuesday, really promoting it, really making it an important part of the week are performing very well. And so, we are actually working with the other markets who are – who have been less all in.

We are working with them and sharing those results from the markets that are really performing well. And taking advantage of that. You mentioned that that’s one that that we already have this a great value play and we are now working hard to leverage that. On the new product side, we think the XLNY is just a – it’s a great product, because it’s new news in a product. It’s an excellent pizza.

But it's a great price point and good unit economics. So, in our minds, it really checks a lot of the boxes that gives us something, at price point that we can really get excited about and good margin for the franchisees. What - we’ve been talking about the XLNY for a few quarters, but the reality is, we have not had full adoption until really as we look into the balance of the year, we will have it in the majority of stores.

So, we see that as one that we are going to get more credit for, as it gets expanded into more stores. On the new product side, what we are seeing, we think that there is an opportunity for new product news, not right this minute, but at some point in the future. What's really driving the industry right now is, the convenience, the value, and some of that more personal marketing.

So that’s what we are spending a lot of our efforts today, but we think in the future there is definitely an opportunity for more product news and if it’s a great value offering like the XLNY, that’s even better.

[Alex Slagle, Jefferies LLC]

Got it. That makes sense. I guess, just one last one then on that personalized marketing front. The dinner circle today, is there any targeted marketing within that of personalization or is it really just scratching the surface of those databases and leveraging from here once you’ve got an online transaction history?

[Weldon Spangler, Chief Executive Officer]

Yes, I think that we are early in our works to make that work harder for us. We have the text and email databases. We need to grow those and we need to really make the dinner circle work harder for us. And we think there is a lot of opportunity to do that. As we think about the early work we are doing in loyalty, we are working right now to tie all of those things together, because we think that there is a big opportunity now.

[Alex Slagle, Jefferies LLC]

Great. Thank you. That’s all for me.

[Weldon Spangler, Chief Executive Officer]

Okay, thank you.

[Operator]

[Operator Instructions] As there are no further questions, I would like to turn the call back to Mr. Weldon Spangler for closing remarks.

[Weldon Spangler, Chief Executive Officer]

Great. Thank you very much. Thanks everybody for participating today and we look forward to sharing our progress next quarter. Thank you.

[Operator]

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