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Good day, ladies and gentlemen, and welcome to Papa John's Third Quarter 2018 Conference Call and Webcast. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded.
I would now like to introduce your host for today's conference, Mr. Steve Coke, Vice President of Investor Relations and Strategic Planning. Sir, you may begin.
Thank you, Chanel. Good afternoon. Joining me on the call today are President and CEO, Steve Ritchie; and our CFO, Joe Smith; and Mike Nettles, our Chief Operating and Growth Officer. Steve and Joe will have comments about our business and provide a financial update. After the prepared remarks, Steve, Joe, and Mike will be available for Q&A.
Our discussion today will contain forward-looking statements involving risk that could cause actual results to differ materially from these statements. Forward-looking statements should be considered in conjunction with the cautionary statements in our earnings release and the risk factors included in our SEC filings.
Please refer to our earnings release in the Investor Relations section of our website for a reconciliation of non-GAAP financial measures discussed on this call. Finally, we ask any members of the media to be in a listen-only mode.
Now, I'd like to turn the call over to Steve Ritchie for his comments. Steve?
Thank you, Steve, and good afternoon, everyone. Our third quarter results continue to reflect the brand challenges we have faced this year and were exacerbated by the negative impact of the media coverage that began on July 11. However, these events are not going to define the future of Papa John's. During the quarter, we took important actions to help repair our brand reputation and we believe good progress has been made.
Our performance shows the positive impact from these efforts with improved consumer sentiment, third quarter comp sales coming in better than our expectations, cash flows remaining strong, and an improvement in North America comp sales outlook for the remainder of the year. As we continue working to rebuild trust, sustained consistent improvements and sales performance will take time. Overall, North America comps for the third quarter were down 9.8%.
As you may recall, when we reported second quarter results, comps were down approximately 10.5% in July due to the consumer and brand sentiment challenges. We said that performance had stabilized, so the third quarter comps at 9.8% were better than our expectations at that time. That said, the consolidated numbers does not tell the full story. So let me provide some additional detail.
In September, we launched our new Voices of Papa John's marketing campaign supported by significant PR and social media effort to drive additional awareness. This work showcase the fact that Papa John's is made up of a team of 120,000 corporate and franchise team members. I am very proud of this team. The support they have shown and their collective commitment to the actions we are taking to move the company forward.
We had a strong positive response from internal and external stakeholders to the Voices campaign. Employees and franchisees express their appreciation for sharing a light on the real values and people who make up our company. Customers also responded positively which showed that the strategy to move in a new more modern and inclusive marketing direction is the right one. YouGov BrandIndex data shows that consumer sentiment is shifting from largely negative to neutral or positive. In addition, we have seen sentiment in traditional and social media shift from negative to neutral or positive.
According to research conducted by Kantar Millward Brown, a leading marketing research firm, the messaging of the Voices campaign has been a key contributor of these perception moves. The Voices campaign drove a modest improvement in traffic, resulting in September comps that improved compared to the July and August results.
As we entered the fourth quarter, we are pleased with the quick actions we've taken and the progress being made against a tough environment and unique challenges. At the same time, we have not lost focus on our need to continue executing on the company's five operating priorities, which we launched prior to recent events, which we believe are fundamental to supporting a strong foundation.
As you will recall, these five priorities include making people a priority, improving our brand differentiation, creating accessible value, implementing technological advancements, and improving unit economics. We believe our recently announced new organizational structure will support improvement in each of these areas. This new structure is anchored by a customer-centric growth organization.
We believe by putting the customer at the center of everything we do, including operations, technology, marketing, product, and communications, we can leverage customer data to integrate and innovate across every consumer touchpoint. This growth organization establishes dedicated roles and responsibilities around each of these consumer touchpoints and is led by Mike Nettles in the new position of Chief Operating and Growth Officer.
Moving on to our five priorities and the progress we are making. First, making people a priority. On our last earnings call, I mentioned a number of culture initiatives that are underway. As you know, we are working with a third-party to help identify opportunities to reinforce our commitment to diversity and inclusion. As part of this work, we are launching diversity, equity, and inclusion training this month for our 14,000 corporate team members which we expect will be completed in early 2019. The training will expand to include franchisees.
Providing career growth and development opportunities has long been an important part of our commitment to making people a priority. And the leadership appointments and promotions we recently announced provide these opportunities while also recognizing the depth, talent, and contributions of our team. We are pleased that this new team reflects our commitment to diversity. We believe all of these steps will help us retain and attract the talent we need to move the business forward. Additionally, our positive actions will play a key role in rebuilding trust with customers.
Second, improving our brand differentiation. As we said in the last quarter, our work to drive new branding and marketing campaigns is more important than ever. Q3 was the start of our journey to make Papa John's a revitalized modern brand. The first step was to introduce the real team members behind the brand and the concept that we are better together. This concept was executed first through our App Download campaign then in the Voices of Papa John's campaign.
Consumers know our tagline, Better Ingredients. Better Pizza, but the brand strategy we are building will redefine the idea of better within the pizza category to encompass our product, experience, team, and community. We're transitioning to operate like a brand management organization, utilizing customer segmentation to deliver a deeper understanding of our customers and their needs, and to innovate around product, message and experience across consumer touchpoints.
Our first effort under this structure was a multi-channel Halloween marketing PR and limited-time offer campaign, leveraging one of our biggest sales opportunities of the year. We are following it up with an integrated campaign for the fan favorite limited-time specialty Double Cheeseburger Pizza. You will see more of this work, which is focused on communicating a call to action around products and experience, in Q4 and into 2019.
As it relates to creating accessible value, we have talked in the past about the fact that value goes beyond price to include menu choice and variety. We continue to see and pursue opportunities to provide everyday value to generate consumer appeal and build trust through pricing transparency. In the third quarter, we saw success through a number of promotional items including our specialty pizza offerings. These efforts will continue to be advanced through the elevation of Paul Fabre, as our SVP of Menu Strategy and Product Innovation. Paul will oversee product development, including menu management, and ensuring that the pizza and other products we offer to customers are what they crave. Another benefit of moving product and menu into the growth organization is that it provides a direct line to customer data that drives menu and product innovation to more customers to the brand.
Value can also be delivered through channels and the September app download promotion I mentioned earlier, was a successful test leveraging a single channel. In this case, the Papa John's app to provide exclusive offers. The promotion saw a lift in orders from both new and existing app customers without taking orders from existing digital channels.
In addition to channel test, this quarter, we are leveraging customer segmentation data to test a number of different value offers in corporate and franchise restaurants. We're also testing offers tailored to individuals that we've identified as customers who are seeking value. These tests are important to determine what will define accessible value for the Papa John's customer in the future.
Turning to technology. Since joining last year, Mike Nettles has significantly elevated the consumer experience across our digital and mobile platforms. Over this period, Papa John's mobile apps have become highly rated in both App Stores, the company has established new ordering partnerships including Facebook Instant Ordering, Amazon Alexa, and DoorDash, and Papa John's has established key data and analytics capabilities to improve restaurant operations and better inform customer engagement.
With the rollout of Google Maps, we have transitioned to a best-in-class solution across all business touchpoints from trade zones to routing and we are seeing improved delivery results. These results are translating into successful outcomes, as 99% of customer addresses are now being found on the customers' first try with our online delivery address search.
Because Google Maps uses real-time traffic data, the estimated delivery time has improved and we're seeing a significant uptime and wait time satisfaction from our customers. Given Mike's new role as Chief Operating and Growth Officer, we've asked Justin Falciola to serve as our new Chief Analytics and Technology Officer now overseeing product engineering, architecture, and delivery as well as enterprise insights and analytics.
Turning to unit economics. Operating efficiently at the unit level remains a key priority and our study of potential improvements to our restaurants has continuing with the assistance of third-party efficiency experts. In the third quarter, we received numerous innovative ideas from these experts and have deployed several of them in a testing environment. In addition, we are working with third-party food aggregators to determine best practices driving revenue and staffing augmentation. Taken together, incremental efficiencies and improvements like these and others can substantially improve how our franchisees operate and their profitability profile.
On this point, I want to spend a minute discussing how our work with our franchisees during the quarter. We continue to engage with our franchisees and saw a significant majority of them at our Annual Operators Conference during the quarter. They have been supportive of us and we are committed to their long-term financial health. We are also appreciative of our two franchise representative bodies, the Franchise Advisory Council and the Papa John's Franchise Association, for the collaborative approach they've demonstrated to pursue improved performance for all of our stakeholders.
In August, we made our commitment to franchisees clear through our assistance program for North America. Also, in early October, we committed to investing $10 million during the remainder of 2018 into our national marketing fund. These funds are being used for additional media support. Total costs for the assistance program, including this incremental marketing investment, are consistent with the updated outlook we provided in our earnings press release.
Before turning the call to Joe, let me also touch on International. Total sales and net development both grew at a double-digit pace in the quarter. We now have added over 300 new restaurants in the last 12 months which is a record for the company. Also I want to highlight that, during the quarter, we expanded our presence in Central Asia with our first restaurant in Kazakhstan. We have entered 11 new countries since 2016 and Papa John's is now in 46 countries and territories around the globe. We are quickly approaching 2,000 restaurants.
To further enhance our international growth opportunities, we recently announced a new organizational structure that provides Jack Swaysland, our International Chief Operating Officer, with direct oversight of the International supply chain and quality assurance function. With the growth of the International business over the past few years coupled with a number of suppliers located outside the U.S., it's the right time to locate these functions within the teams they serve.
We believe this new structure will foster accelerated growth in unit development and support improve unit economics. We are very positive on our overall International growth opportunity despite the International comp sales decrease of 3.3% which continues to be driven by performance in the U.K. and Middle East. In the U.K., where we now have over 400 restaurants, Q3 comps were impacted by industry pressures as well as last year's Pan Pizza launch.
The U.K. continues to take actions to work through a tough year. However, increased clarity around our customer demographics and needs has enabled the creation and implementation of a more focused marketing strategy. Although, it is early in the rollout of the strategy, we are seeing positive signs.
In summary, progress is being made and we took important steps during the quarter to align talent and resources in a way that enhances our customer-oriented approach, but we still face challenges and know that more work needs to be done to restore consumer trust. We are seeing improved consumer sentiment. Our attention now is on activating that sentiment to drive increased sales. Let me turn the call now over to Joe Smith for a financial review of the quarter. Joe?
Thank you, Steve. We reported a diluted loss of $0.41 per share in the third quarter on a GAAP basis. Adjusted diluted earnings per share were $0.20 on a non-GAAP basis compared to $0.60 in the third quarter of 2017. The decline in our EPS was primarily attributable to our special charges, the impact of lower North America comparable sales, higher restaurant operating cost, as well as increased interest expense.
During the third quarter, we incurred special charges of $24.8 million, which is $19.3 million on an after-tax basis including $3.6 million of cost to replace or write-off branded assets and reduce royalties to domestic franchisees amounting to $9.9 million. The remainder of the special charges were primarily cost associated with activities of the special committee of the board including the third-party audit of the culture of Papa John's and additional legal and advisory cost.
Our third quarter net loss on a GAAP basis was $13 million. Excluding the special charges, our third quarter after-tax income was $6.2 million compared to $21.8 million for the corresponding quarter in 2017. Consolidated third quarter revenues decreased $67.7 million or 15.7% primarily driven by lower comparable sales for North America which resulted in lower company-owned restaurant revenues lower royalties and decreased North America commissary sales.
In addition, the refranchising of 62 company-owned restaurants in North America earlier in the year reduced total revenues on a quarter and year-to-date basis by approximately $15 million and $27.2 million as compared to prior year periods. International revenues also decreased due to the refranchising of 34 China company-owned restaurants. Domestic company-owned restaurants operating margin decreased $12 million or 3.3% as a percentage of related revenues primarily due to the impact of lower comparable sales and higher non-owned automobile cost.
Additionally, the adoption of the new revenue recognition standard reduced the restaurant operating margin due to the revised method of accounting for the customer loyalty program. North America franchise royalties and fees decreased $12.8 million or approximately 50% as compared to the third quarter of 2017 as a result of the previously mentioned $9.9 million of the short-term royalty waivers granted to the entire North America franchise system as part of the franchise assistance program. Our 2018 royalties were further reduced due to the negative comparable sales and an increase in other franchise royalty waivers granted to individual franchisees.
North America commissary operating margin remained relatively flat at $8.3 million for the quarter. Our International operating margin decreased $400,000 due to lower income from the United Kingdom quality control center. The reduction in income from the UK operation was partially offset by higher royalties from increased equivalent units throughout the world.
For the third quarter, G&A costs increased $19.7 million primarily due to the previously mentioned special charges including the cost to replace or write-off branded assets. The remainder of the increase is primarily due to higher technology initiative costs and the change in the timing of our Annual Operators Conference to the third quarter in 2018 as compared to 2017 when it was hosted in the second quarter.
Net interest expense increased $3.4 million due to an increase in the average outstanding debt, including the impact of share repurchases as well as higher interest rates. At the end of the third quarter, our debt balance was $578.6 million.
For the nine months ended September 30, 2018, our EPS was $0.47 on a GAAP basis. Adjusted diluted earnings per share were $1.18 on a non-GAAP basis compared to $2.02 for the same period in 2017. The decline in EPS for 2018 is primarily due to the same reasons previously mentioned.
On a year-to-date basis, our effective tax rate was 21.1%. Our free cash flow, which is a non-GAAP measure that we define as cash flow from operations less capital expenditures, was approximately $68.2 million on a year-to-date basis which is a decrease of $3.5 million from 2017.
We paid a cash dividend of $7.1 million or $0.225 per common share during the third quarter. Subsequent to the third quarter, on November 1, 2018, our Board of Directors declared a fourth quarter dividend of $0.225 per common share. On a year-to-date basis, the company repurchased 2.7 million shares of stock for $158 million. As previously reported, the company has no plans to repurchase any additional stock in 2018.
Turning now to our outlook for the remainder of 2018, we expect adjusted diluted EPS of $1.30 to $1.60 for the year. This excludes the impact of restaurant divestitures and the previously mentioned special charges related to recent events. Last quarter, we provided a preliminary range on special charges of $30 million to $50 million as we worked to gather information on the necessary expenditures to support the business. The special charges are now expected to be in a range of $50 million to $60 million, including a $10 million contribution to our domestic national marketing fund during the fourth quarter.
North America comp sales for the year are expected to be in a range of negative 6.5% to negative 8.5%, which is an improvement from our previous guidance of negative 7% to negative 10%. International comp sales are expected to be in a range of negative 2% to positive 1% for the year. Finally, as previously announced, we recently amended our existing credit agreement. With the company's history of strong cash flow, our constructive long-term relationship with our banks and our comprehensive plans to improve the business, we were able to obtain the appropriate modifications to the financial covenants.
I'll now turn the call back over to Steve Ritchie for his final remarks before we take Q&A. Steve?
Thank you, Joe. As we entered the fourth quarter, we're optimistic about the opportunities ahead for Papa John's. While the challenges that have been created for our company are still there, you're seeing early indications that our improvement actions are working. The improved consumer sentiment in North America, our stabilizing comps, the outspoken support both internally and externally, our significant international white space, and our continued strong cash flows all support our confidence for the future. We are absolutely committed to building on this momentum in moving the company forward to greater success. We appreciate your continued support and I'll now turn the call over to the operator for Q&A. Chanel?
Thank you. Our first question comes from the line of Will Slabaugh of Stephens. Your line is now open.
Yeah. Thanks, guys. Wanted to ask a follow-up on the $50 million to $60 million number that you increased this quarter. Can you talk a little bit more about where that's going exactly? I know you mentioned the $10 million going to the ad fund, I believe that stayed constant or maybe that was an increase going into the fourth quarter, just curious on some of the color around that?
No. Well, the $10 million was actually new from our previous guidance that we gave in the third quarter. That was something that we approved late, basically in early October. So that's kind of a new contribution that was not considered when we gave the previous guidance. Then again, the rest of it will be against some more assistance to the franchisees and then again some work from special committee – advisors working with the special committee of the board.
Got it. I'm wondering if you can talk a little bit more about the trends that you saw during the quarter, you mentioned it got a little bit better and then I know you said in September particular they did improve. Can you give us any more color around numbers how they may have looked and then any color into October after you've had a little time under your belt with the new launch of the Voices campaign would be helpful as well?
Sure, Will. It's Steve. So I'm not going to probably get into specifics around the fourth quarter, I'll probably start getting back to just kind of full year guidance numbers. I'll give you a little bit of color there on the third quarter. So as we did give visibility of the cadence of the comps in third quarter in July being down 10.5%, that trend kind of continued through August and then we saw a significant improvement in September, some of that is attributed to a couple of factors around the new campaign work that had launched, one being the new Voices brand campaign, but the other being the App Download campaign that we called out and it was very concentrated effort from a promotional standpoint just on the weekends for four weekends within the quarter.
So I think just indicating as we get the right promotional balance, the right media buying with the right brand messaging, we know that we can get significant improvement from a comp standpoint. And, obviously, we got expectations that the fourth quarter will improve versus the third quarter. Some of that is just the nature of the rollovers from prior year from the November 1 event, but we do expect based on the leading indicators of the consumer sentiment improvement from the voices campaign, we think that is definitely a leading indicator to continued sales improvement as we progress through the rest of this year.
Got it. Thank you.
Thank you, Will.
Thank you. Our next question comes from the line of Alex Slagle of Jefferies. Your line is now open.
Thanks. Just wondering if you guys could remind us what the cadence of your same-store sales domestically look like last year through the fourth quarter to the degree, I guess, the trends accelerate starting in November but any color you could provide on that.
Sure. Alex, so the third quarter we were basically, we were up 1%, we were up – fourth quarter we were down 3.9%. So just think about kind of trends in the third quarter continuing through October and then a big precipitous drop-off in November and December. So clearly we're, in real-time, hurdling some of those numbers from prior year, but the business had decelerated a bit in 2017, but was above the flat line. So the predominant amount of the issues from a comp standpoint certainly related to consumer sentiment issues related to the two trigger events, one from of course November from last year and then of course earlier this year in July.
Okay. And could you talk about the health of your franchisees, just recent conversations you've had with them and any updated thoughts on the potential for increased number of closures in the coming quarters and whatever you're doing, ongoing efforts to ensure the stores are all in the right hands?
Sure, sure. Happy to. It's Steve again, Alex. So, I mean, I think, first off, unit economics and the health of our franchisees is always a top priority. As you guys know, I'm also a franchisee, have been one since 2005. So I understand the importance of unit economics on the backs, the strength of the franchisees is how we grow the business. The good thing is we've had a very nice run, dating all the way back to 2011. It's been the best five, six year run in the history of the company. So 2015 and 2016, were back – record back-to-back years in terms of sales and profitability for the vast majority of our franchisees. So I note that because that's clearly important as we see a slowdown in 2017 and this precipitous drop-off from a comp standpoint from the fourth quarter last year and went all the way through the third quarter.
So I think we've taken the appropriate action, working collaboratively with our franchisees, those two big bodies, our Franchise Advisory Council and the Papa John's Franchise Association, that does make up nearly 50% of the units on the franchise base.
So what we put in place was bridge solutions to make up for the cash flow declines that they've experienced because of the sales comp issues here. So I think we made the right decisions with the commitments that we put forth through the end of 2018 in terms of royalty relief, some relief in terms of food cost through the PJ Food Service. We also did delay the increase on our national marketing fund that was scheduled to go increased 0.25 point in the fourth quarter and we've also continued to not increase the online fee even though we're making significant investments this year on the technology side of the business.
So I think we're working very collaboratively with our partners being the franchisees, recognizing the top priority needs to be to continue to quickly accelerate the improvement in top-line sales and that will improve the unit economics for our franchisees.
As far as a continuation into 2019, clearly we're in the evaluation stages of that now to understand what the outlook looks like for 2019 from a sales standpoint and what level of support and how we may support our franchisees and we'll clearly give you guys a very detailed outlook of that in February when we report our fourth quarter numbers.
Great. And last one from me, if you could provide any commentary around recent 8-K filing on the executive retention program and any other actions related to that that you can comment on?
Sure. Alex, it's Steve. I'd be happy to. So, I mean, I think as you know it's a war on talent out there and priority number one for me is to make certain that I'm retaining the top talent of this organization. And I think the compensation committee working with an independent compensation consultant has taken some very appropriate actions, benchmarking our business across our peer group and also looking at what best practices are done broadly throughout the industry. And they took some actions there to ensure that we're putting forth the right efforts to retain that talent. So there was some amendments to some of the severance (29:57) components of those plans and we feel confident those actions put us at parity against the industry which we certainly don't want to be disadvantaged especially during a time where we've got a – clearly, we're in a transformational stage for the brand.
Great. Thanks for that.
Thank you. Our next question comes from the line of Chris O'Cull of Stifel. Your line is now open
Thanks. Good afternoon, guys. Steve, just as a follow-up to that last question, when do you expect to make a decision regarding the level of franchise support for 2019?
We're in our budgeting phase now, Chris, so we're close. So we actually have our Franchise Advisory Council in this week so this is one of the points of discussion just to understand the outlook for the franchisee perspective and, clearly, understanding the cadence of the improvement in comp is directly tied to the levels of support. So we'll make some decisions here in the near future. But in terms of externally making those announcements, it likely won't be externally until we announce fourth quarter earnings but we're certainly working through that right now.
Okay. And then, Joe, commissary sales were down about 11% which makes sense given the transaction declines but profits were down only 2%. Does this mean that the company has not provided any commissary markup or pricing release to franchisees?
No. We actually did take our profits down a little bit and have committed that for the rest of the year that our margin will be lower. I do think you have a little bit and we can – if we take that offline – we have a little bit of shift on some of the income with our – now that we have less company-owned stores so that does make that margin change a little bit, that's more of an accounting issue than anything else.
Okay. And can you give some color or explain why the International commissary sales were down so much?
That would be with the China sale. We had a commissary there. Well, there's two things. Obviously, we have the sale of the China operation. The other part is just the U.K. operation being having some lower sales and that reflects some of their lower volumes.
Okay. Okay. And then, Steve, I apologize if I missed this in the presentation, but has the cultural audit been completed?
It's still ongoing, Chris. So – and they have not announced any timeline of completion, but it is still ongoing. And clearly, we take those things very seriously. So not waiting on an output of the audit, however, we are excited to get some of the output of that so we can make sure that we make the adjustments to enhance the culture, but we are continuing as I stated in some of the early presentation of making people a priority.
So there's number of initiatives that are in motion here to continue to enhance the culture, specifically as it relates to D&I, so we did earlier this year announced that we have a new Chief of Diversity, Equity, and Inclusion. So there's a number of efforts around that and a lot of external things that we're working to also improve the perception of the company.
Okay. And then I believe the board may have mentioned at one point that they were looking to expand the number of members, is that still the plan?
I think they're keeping an open mind. Certainly, they look at the size of our board. It's a relatively small board of six directors, of course, one non-independent and another five independent directors. So that is something certainly the board has been very thoughtful of having evaluating the options that they may have. And, obviously, as we make decisions on that, those things will be communicated.
Okay. Great. Thanks, guys.
Thank you, Chris.
Thank you. And I'm showing no further questions at this time. I would now like to turn the call over to Mr. Steve Ritchie for closing remarks.
All right. Well, I just want to thank you everybody for joining us today on the call. And clearly, we're very excited about the future of this brand. Here, we got a lot of work to do, but hopefully you're seeing that we are demonstrating, making the right steps to take the brand in the right direction. So we look forward to talking to you again after our fourth quarter results in February. Thank you.
Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone have a great day.