Pizza Pizza Royalty Corp.

Christine D’Sylva - Vice President, Finance & Investor Relations Paul Goddard - President & Chief Executive Officer Curtis Feltner - Chief Financial Officer and Vice President, Finance

Derek Lessard - TD Securities Montréal

Thank you. Good afternoon, everyone, and welcome to Pizza Pizza Royalty Corp.’

s earnings call for the second quarter ended June 30, 2017. With me on the call today are Pizza Pizza Limited Chief Executive Officer, Paul Goddard; and Chief Financial Officer, Curt Feltner.

Our discussion today will contain forward-looking statements that may involve risks relating to future events. Actual events may differ materially from the projections discussed today.

All statements should be considered in conjunction with the cautionary language in our earnings press release and the risk factors included in our annual information form. Please refer to our earnings press release and the MD&A in the Investor Relations section of our website for a reconciliation and other disclosures relating to our non-IFRS measures mentioned today.

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

Thanks, Christine, and thanks, everyone, for joining our call this summer afternoon. We are pleased to report Pizza Pizza Royalty Corp.’

s second quarter results. Royalty Pool System Sales for the quarter increased 1.7% to $134.6 million over the same quarter last year.

Sales for the six-month period increased 1.2% to $268.4 million over last year’s first six months. And last year by the way included an extra day of sales in February due to the leap year effect, which management estimates to be about $1 million.

Same-store sales growth, the key driver of shareholder yield growth increased 1.6% for the quarter, compared to 0.9% in the same quarter last year. So for the six months, same-store sales growth increased 0.5% over 1.7% in the same period last year.

Pizza Pizza Royalty Corp. has increased shareholder dividends 7 times in five years, including the 2.3% increase back in June of 2016, and the monthly dividend has grown over 20% in the past five years.

Additionally, the company has accumulated a healthy $4.8 million reserve to support the dividend in the event of any short-term pressure on same-store sales growth. As a reminder, the company’s main assets are the Pizza Pizza and Pizza 73 trademarks.

The company’s royalty revenues are calculated as a percentage of Royalty Pool System Sales, which are generated by the Pizza Pizza and Pizza 73 restaurants that are in the Royalty Pool. Restaurants are operated by Pizza Pizza Limited, the private operating company.

The Royalty Corp. is not exposed to restaurant operations.

With that backdrop, let’s look at restaurant operations, which is the underlying strength supporting the same-store sales growth. Pizza Pizza Limited’s mandate is to grow and protect the brands.

Growth priorities include maintaining our brand dominance, modernizing the customer experience and staying relevant to consumers. We believe these priorities align with evolving consumer needs and will drive long-term sustainable growth, especially when combined with our competitive advantages of convenience, innovation and technology, high-quality menu offerings and our geographic diversification across Canada.

With a strong focus on same-store sales growth and restaurant profitability, the Pizza Pizza brand operating largely in Eastern Canada reported a 2.3% increase in same-store sales growth. Meanwhile, our sister brand, Pizza 73 with the majority of its restaurants in Alberta reported negative same-store sales of 2.1%.

Same-store sales of Pizza 73, which accounts for less than 20% of our top line sales continue to be affected by the struggling Alberta and Saskatchewan economies. However, Pizza 73 marketing campaigns were successful in reversing the decline in customer traffic trends.

So we feel positive about the second half of Pizza 73, but obviously we still have work to do out west – continuing to push for stronger traffic out there. Pizza 73 continues to be the leading pizza brand in Alberta, and we continue to support creative sales building and marketing efforts along with strong operations execution for the second-half of the year and beyond.

At Pizza Pizza, with the majority of sales generated in Ontario and Québec, the value messages and a focus on quality ingredients drove our customer traffic counts higher in Q2. Marketing value messages and customer coupons built around our 50th anniversary, including price points like $11.11 and $19.67 resonated well with consumers for both delivery and walk-in channels.

Meanwhile, food quality messages featuring chicken raised without antibiotics, dairy-free vegan cheese and gluten-free supported our customer promise of “Always the best food, made especially for you.” So we are pleased with the 2.3% same-store sales growth at Pizza Pizza in its very competitive quick-service market.

At both brands, we continue heavily investing in technology as well. Innovative investment is giving our customers the convenience of placing orders easily on one of our many digital channels.

And we have recently made it even more convenient to order any pizza for pickup no matter the price, saving consumers the wait time for walk-in orders. A quick click call on your phone, your smartphone and your order is waiting for you when you walk in even for a $4.99 cheese pizza.

Very few competitors offer this convenience advantage, especially small independent operators. Turning now to new restaurant development.

For the quarter, PPL continued its national expansion by opening five traditional locations. That was two Pizza Pizzas in Québec, two Pizza 73 locations in Alberta and one Pizza 73 restaurant in Saskatchewan.

Two non-traditional locations opened in the quarter. Also in the quarter, PPL closed two traditional Pizza Pizza restaurants, one in Ontario, one in Saskatchewan, and three nontraditional locations closed, that was 2 Pizza Pizzas and one Pizza 73.

So for the six months, 10 traditional restaurants have opened, five were Pizza Pizzas and five were Pizza 73 locations. In the six months, two traditional Pizza Pizzas closed and five nontraditional locations have closed.

So looking at total, the total number of restaurants increased to 758 locations across Canada as at June 30, 2017. Pizza Pizza has recently begun reimaging and renovating the customer area and exterior signage at our traditional restaurants and our nontraditional restaurants are following suit.

We are very excited about the program. It’s early in this program, but customer feedback to our franchisees is positive.

And currently, approximately 36 of 426 traditional Pizza Pizza restaurants have the new modernized look with warm paint colors, woodgrain finishes in the lobby, added communal tables and numerous other new features to create the warmer, more friendly and contemporary ambience for dine-in customers and pick-up customers. We anticipate the program to continue for three to five years roughly, depending on store age, franchisee tenure, construction schedules and financing obviously.

But so far, franchisee and customer enthusiasm had been strong for the new reimaged and refreshed look, so we’re really excited about that. On a corporate note, Pizza Pizza continues celebrating its 50th anniversary.

In the second-half of the year, customers will enjoy compelling value offerings, and in Q3, we will be launching a major concept to celebrate the anniversary. We don’t want to give away too much here, but we have some exciting and novel prizes in the pipeline to reward consumers for their loyalty over the years.

In closing, we will continue to build shareholder value by leveraging and further scaling our brand dominance at Pizza Pizza and Pizza 73. Growing our customer base through new product introductions, service enhancements and technological innovation pushes our brands forward to build on their market-leading positions.

With that, I’ll pass the call over to our Chief Financial Officer, Curt Feltner, for the financial update.

Thank you, Paul. Earlier today, Pizza Pizza Royalty Corp.

released its second quarter financial results. And as Paul had indicated, same-store sales growth increased to 1.6% for the quarter, compared to 0.9% increase in the same quarter last year, and that’s for the two brands combined.

For the six-month period, same-store sales increased 0.5% compared to 1.7% increase in 2016. And if you recall, our first quarter same-store sales was a negative 0.7%, so we’re pleased to be back in positive territory year-to-date.

And as a reminder, same-store sales is the key driver of yield growth for shareholders, and so same-store sales and new restaurants drive our top line sales. For same-store sales growth, it’s driven by a mixture between the average customer check and in customer traffic counts.

Both of these are and have been affected by our pricing strategy and our sales mix. So during the quarter and for the six months, the average check has actually decreased, while our customer orders increased when compared to the same periods last year.

So this is our strategy for this past Q2 and going forward for the rest of the year. So a decrease in the average check is a result of promotional activity and selective menu pricing, which we’ve discussed in previous quarters, and it’s designed to increase our traffic especially at the Pizza 73 brand.

And so we were pleased so far with this Q2 strategy. Just briefly on our corporate royalty structure, Pizza Pizza Limited, which is -- Pizza Pizza Royalty Limited Partnership, which is a subsidiary of Pizza Pizza Royalty Corp., owns the Pizza Pizza and Pizza 73 trademarks and brands.

And the partnership has two partners, Pizza Pizza Royalty Corp. and Pizza Pizza Limited, the private company.

One note on comparability before we get into the details of the financial results. On January 1 of each year, the number of restaurants in the company’s Royalty Pool is adjusted.

So this year, in Q1, the Royalty Pool increased by 15 restaurants to 751 from 736 in 2016, so that has some effect on our comparability. In exchange for adding these additional restaurants, Pizza Pizza Limited’s exchangeable shares as a percentage of fully diluted shares increased to 21.1% from 20.4% on January 1.

So now in the second quarter, Royalty Pool sales increased 1.7% to $134.6 million and for the six months increased 1.2% to $268.4 million. System Sales increased as a result of the new restaurants that I mentioned that were – we added to the Royalty Pool on January 1, and from the impact of course of our same-store sales growth.

So turning to the statement of earnings. The partnership receives royalty income from Pizza Pizza Limited based upon these top line restaurant sales.

That royalty income earned by the partnership increased 1.3% to $8.7 million for the quarter and increased 0.8% to $17.4 million for the six months. So we use this royalty income to pay administrative expenses and interest expense before the partnership mix distributions to its two partners.

Administrative expenses for the quarter were $176,000, compared to $162,000 in Q2 in 2016. Administrative expenses for the six months were $314,000, compared to $326,000 in the first six months of 2016.

So an example, the administrative expenses that are incurred at the partnership, they are directors’ fees, audit, legal and public reporting fees, as well as directors’ and officers’ insurance. The increase in Q2 was related to auditor fees that we incurred on the IFRS 15 revenue recognition assessment.

In addition to admin expenses, the partnership pays interest expense on its $47 million credit facility. Interest expense was $330,000 for Q2 and was the same in the comparable quarter last year.

For the six months, interest was $642,000 versus $663,000 in the first six months last year. The difference largely relates to higher bank fee amortization last year.

The actual interest rate was unchanged for both years at 2.75%, and the company’s credit facility as a reminder, it matures in April of 2020. So after the partnership receives royalty income and pays admin and interest expense, the net cash is available for distribution to its partners based upon their ownership percentage.

Pizza Pizza Royalty Corp. owns 78.9% of the partnership at June 30 and consolidates the partnership into its financial statements.

So on the 78.9% share of partnership net income, the Royalty Corp. pays corporate income tax.

Corporate income tax for the quarter was $1.4 million and was the same in Q2 last year. For the six months, income tax was $2.7 million, compared to $2.8 million last year.

Adjusted earnings for the quarter increased 2.1% to $6.8 million, and for the six months, adjusted earnings increased 1.6% to $13.7 million. So management considers adjusted earnings from operations to be more meaningful measure in evaluating our company’s performance and a truer indication of our cash available for dividends to our shareholders.

And as Christine mentioned earlier, please refer to the company’s MD&A for a full reconciliation of adjusted earnings compared to our earnings calculated under IFRS. Briefly on shareholder dividends.

The company declared monthly dividends for the quarter totaling $0.213 per share. This is a 1.5% increase per share on a quarter-over-quarter basis.

The payout ratio was 104%. The last dividend increase was in June 2016 when the company increased the monthly dividend by 2.3%.

So just in conclusion, the company’s working capital reserve is $4.8 million at June 30, and the reserve is available to stabilize dividends and fund any other expenditures in the event of short to medium-term variability on System Sales. And so with the reserve in place, the company targets a 2017 payout ratio at or near 100% on an annualized basis.

So the company does not have any cap expenditure requirements or employees, so it can have this 100% payout ratio. So that concludes the financial overview.

I’ll now turn the call back to Iman for the questions. Iman?

Good afternoon, everyone.

Hi, Derek.

Just wondering maybe if you could – if we can just touch on firstly, if you could talk about some of the dynamic in Alberta. I guess, I was wondering how much of the difficult sales environment is tied to the economic backdrop and whether or not that’s feeding into some tougher competition there for you guys?

Yes. It’s a good question.

I mean, obviously, we are not thrilled with the results there. I mean, it’s nice to see some traffic increase obviously.

But on the same-store sales, we were certainly hoping by now we’d be looking a little better obviously. We just, look, I think the economy is still – if you look at it unemployment in Calgary, Edmonton, for instance, still not looking great.

Many people are starting to say that perhaps it’s hit the worst level and maybe it’s going to start getting better. It’s just we haven’t yet found, I think, something that we are really comfortable hanging our hat on in terms of a longer-term trend there.

So we are certainly really focusing on the traffic side, trying to get volume of orders, which is really important for us. We are – given our position in the market as well, we are well-positioned.

But it does seem like there are some people aggressively, I would say, taking various aggressive strategies to try and get share. I think a lot of people are really having a difficult time and we are part of that competitive market.

So it’s tough for us as well.

Did I catch that right in your prepared remarks that you did say that traffic or you did see a reversal in the decrease in traffic?

Correct. Traffic actually did increase lightly for the quarter, but obviously ticket is down.

At Pizza 73.

At 73. So yes, we did see traffic increase, which is a positive.

Okay. And I guess, another positive though would be the – despite the economic backdrop, you guys are opening or have opened more traditional stores now this year, I guess, the most since 2009.

Is that a sign of optimism on the part of the franchisees, or is it franchisees who are taking on a second store? Are there new franchise?

What is that – how is that dynamic working out?

A good observation. We have really looked at the market and said, look, we still believe there’s lots of opportunities to grow our network and we are going to keep doing that at both brands.

And then if you recall it, Derek, I mean, you’ve been looking at that for a long time, but even when the market was really suffering and sort of [indiscernible] and things like that, I mean, we – in a way, we did expand quite heavily, especially in Pizza 73. And that was a pretty dramatic increase.

And we believe that sometimes when other’s in defensive mode, we need to really go on offense, and we really attempted to do that. And I don’t want to get too specific about our particular strategies in terms of how we are growing, but it is a combination of existing partners and new partners and even to some extent sort of smaller locations, in some instances, with franchisees and tailoring our model a little bit depending what we need in certain markets.

So definitely, we have to actually grow a little quicker than perhaps in some markets out there even though, certainly, it’s still concerning the overall economic backdrop, especially, I would say, the urban centers.

Okay. And in the MD&A, you talked about building on Q2’s momentum.

Just wondering if you can – and I know you mentioned some of them. But maybe talk about some of the initiatives you expect to get you guys there, and maybe you could just add some context around how it’s working so far, I know the quarter is early?

Yes, it is really is early. I mean, we like to look at the whole quarter, and I as often say, when we try and look at the quarter and even at the year as a whole, whether [it gives me a bad news] [ph].

But we – I think we are trying to really be more creative than we have then. I mean, our marketing team is very creative, our operations side.

We’re really focusing on what we call perfect orders, which is minimizing the number of complaints per store, good execution. But on the marketing side, I think, we are really trying to look at things that will really drive traffic and especially in the tough market in Alberta right now.

We are seeing a lot of people being very aggressive with pricing. We believe – many places, we think we deserve more pricing based on our focus on quality, but the market is very tough right now.

So wherever we can get some price, we will do that, but we have to be very judicious. I mean, there’s places where we have to actually put up with a lower ticket than we deserve in order to drive that traffic and order volume.

And we also have various strategies in terms of driving the delivery channel and in the pickup side. Obviously, delivery is much bigger at 73, and that’s a real strength there.

But we’ve seen great growth in things like lunch and the pickup side. And the new Pizza Pizza, I mean, on the 50th anniversary side, we’ve got a lot more coming down the line.

We’ve already seen a lot of interest, social media. We’ve seen lots of prizes and interesting specials that have really resonated well, the $11.11 special that was extremely successful.

And so we are trying to be very creative really at both brands. Obviously, stronger economy out here in Ontario, Eastern Canada, but still very competitive here too.

Curt, anything to add to that?

Yes. Just, Derek, the only thing – just things that we’ve said in the past is, we do feel like some of the initiatives at Pizza Pizza to drive traffic and Pizza Pizza’s 80% -- over 80% of our top line sales.

So we are having really, really good luck generating traffic, especially around our $11.11. What we did is, we took out a promo of add-ons from a $13.99 price point and started driving transactions without the bundling.

So we are finding that, that’s good momentum. And so we are pleased with the 2.3% numbers that we had, especially coming off of Q1.

So we got good momentum there. And our – the Pizza Pizza brand itself celebrating the 50 years.

We started here in Ontario, so a lot of the recognition and is locally based, and so it’s not out west or anything. So we’re getting bigger traffic here in Ontario and Québec.

So, yes, no, I just wanted to add that to make sure we’re focused on the bigger engine. I know, we hear a lot from all the brands about the struggles in Alberta.

But we’re going to continue working, as Paul mentioned, driving traffic at both brands. But we are having good luck at Pizza Pizza, which we are really happy with.

Thanks to that color, guys. Maybe just a follow-up to that is, I guess, your longer-term focus has been on franchisee profitability.

So just wondering how you balance that with this sort of shorter-term focus on growing traffic?

Yes. So the – even though we have a new price point, we are seeing some good traction with our food cost for our franchisees.

So that was like a win-win for us, because if we come off of a price point that’s $13.99, it has other products in there. So taking those out doesn’t mean, we are increasing our food cost by starting at a lower ticket price.

So we use that $11.11 base now and try to up-sell and bring that check back up to the $13.99. But it’s working out well on both sides for our franchisees at this point.

Okay, all right. Just maybe on the minimum wage, I mean, there has been some talk in the press that the government is in discussions with QSR industry participants.

Just wondering, if you add any additional comments or insights on where these talks may be?

I don’t really have any specific comments on that. I know that we’ve sort of articulated our position overall as a part of the industry through Restaurants Canada.

In terms of minimum wage, obviously, there’s a big potential impacting on Ontario and Alberta specifically with the magnitude of the scheduled increases coming. So I mean, I think everyone is aware of it.

It’s obviously something that can have a profound impact. And so I think we and everyone in the industry, I think is trying to adapt as best as we can with our model to make sure that it works out for everyone hopefully.

And for us, it means increasing our efficiency. It means even further pushing our digital and use of technology in self-serve ordering for customers to potentially alleviate some labor cost and increases that are obviously coming down the line.

And where we can and it depends, I guess, which markets we’re talking about, where we can get some pricing. Obviously, we and others, I think, we will look to get more where we can.

But it is a difficult balance, especially when we are trying to push traffic and order volume as well.

Okay. And maybe just one final one for me on the reimaging program.

You’ve given a timeline over the next three to five years. Just like how are you thinking of this?

And is the plan to reimage the entire network, or are you just looking at specific markets, in particular?

We are sequencing it depending on where we get the biggest bang for the buck. But we started, I think, I said on previous calls in places – the newer markets like Montréal, for instance.

So all the new stores we’ve built there in recent times have the new look. There still are a few downtown older looking Montréal locations, but we’ve really been at it a while there and our newer more markets.

We really haven’t built any new stores with the old look in quite some time now. So we wanted to also line out the kinks and really learn from our franchisees and then from customers as to what was working well.

And I think we hit the mark actually quite well with our designs. But really, we haven’t been as yet really in sort of prime time in the core GTA market, for instance.

So many people really haven’t seen our new stores, even though, there is a few that do exist, Brampton and Tobacco [ph] and things like that. So their strategy is to essentially go across the network for our traditional stores.

The nontraditional stores also follow suit. They are a lot easier to implement, because they are a lot smaller and we can invest a lot less to make the renovations happen there.

And so where there’s a new build component, all new stores with a new look, new imaging, and there is also renovation program. And as part of our franchisees on the renewals of their agreements, they’ve got to come up to our current standard.

So we want to make that smooth for them. We want to make sure that they get positive return for doing that, because it is an increased investment.

So we sort of try to sequence this in certain markets. But we would say that over the whole traditional chain and nontraditional over the years, it should all get renewed.

It’s just it’s going to take time and we are being a little bit judicious about where we start and which ones we prioritize.

Have you – and I might have missed this in your comments. But have you seen an uptick in traffic and check, because at those that have been touched or your newer stores?

It’s a bit early. I think we do have some, and then take the GTA, for instance, I mean, in established markets, we have so few of the new ones yet that.

Okay.

It’s a bit unfair to say. I would say, I mean, I would say, early indications are kind of exciting.

But I would look overall, it’s more like a broad view somewhere like Montréal, where we have a lot of the new stores, and we definitely have been happy with our growth there. And despite the fact that, a couple of years ago, we weren’t really well known there.

And I think, it’s really – I personally think it’s really helped us have sustained sales strength there because of the reimaged look there looking at that whole market. But for other places, it’s more one off.

We just haven’t built enough or renovated enough yet really to say, yes, it’s had a dramatic increase, that would be overstating, I think.

Okay. In terms of your – in terms of, everybody knows who Pizza Pizza is in Ontario, where are you, do you think in your mind in Québec right now?

We think we have very strong brand awareness there. I mean, I think, in Montréal, certainly our partnership with – at the Bell Centre with the halves and other venues has really helped us there.

I think, as you start to get outside into the very more remote locations and very French only, it really does vary community by community, certainly places where we would not be known. But there is also places that we’ve been pleasantly surprised to see that we’ve gained traction very quickly in a very, say, French-only market.

So it does – it’s obviously a bigger challenge there in those smaller markets and we are trying to be a little careful how we go there and testing the market a little bit. But we think, overall, it’s become real snowball, good momentum there in Québec overall.

But it’s going to take time to build in the area around and outside beyond Montréal.

In terms of your, I guess, longer-term penetration, how many more stores do you think you can build in the province, or do you think you have the critical mass right now, or – and if not, how many more stores do you think you need to get there?

We – I don’t think, I want to put a specific number just for competitive reasons. But I think we certainly see a lot of opportunity to build more in Montréal and elsewhere.

But we – I think we do have the critical mass. I think the brand has done very, very well there.

And it – our ability to sort of scale our marketing right now, that’s sort of our strength of our mass marketing machine we have. It just gets so much better when we do have that critical mass.

So now we are 40-odd stores, I guess, in Québec and there is the nontraditionals as well that really help us. It’s becoming a significant force.

I mean, we are a major player in that market, even though it’s been to date quite fragmented in that – the pizza market in Québec, but I think there’s a lot of growth still there.

Thanks for that, everybody.

Thanks, Derek.

Thank you, everyone, for joining us today. Should you have any questions after this call, please feel free to contact us, our information is on the earnings press release.

Thank you and have a good afternoon.