Pizza Pizza Royalty Corp.

Christine D'Sylva - IR Paul Goddard - CEO Curt Feltner - CFO

Derek Lessard - TD Securities Montreal

Thank you. Good morning, everyone, and welcome to Pizza Pizza Royalty Corp.'

s Earnings Call for the Third Quarter ended September 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 forward-looking 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 non-IFRS measures mentioned today.

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

Thanks, Christie, and thanks, everyone, for joining our call this morning. Pizza Pizza Royalty Corp.'

s third quarter sales were softer than anticipated, as the weakened Alberta economy continues to negatively impact sales at our Pizza 73 brand. Meanwhile, at our Pizza Pizza brand, witnessed in certain nontraditional sales locations due to an unusually wet summer resulted in reduced sales at several large outdoor nontraditional venues, which offsets same-store sales growth at our traditional locations.

Royalty Pool sales for the quarter increased 1.6% to $139 million over the same quarter last year. Consistent sales for the 9 months increased 1.3% to $407.4 million over the prior year period.

System sales in 2016 included an extra day of sales in February due to last year being a leap year, which management estimated to be about $1 million. Same-store sales growth, the key driver of shareholder yield growth decreased 0.5% for the quarter compared to an increase of 2.2% in the same quarter last year.

For the 9 months, same-store sales growth increased 0.1% over 1.9% in the same period of last year. So although the same-store sales growth was less than targeted, sound fundamentals at our brands successfully increased customer visits at Pizza Pizza and Pizza 73 during the past 2 quarters.

Over the past year, the quick service industry has struggled with negative traffic counts. So we were pleased to reverse the trend at our brands and see traffic up for both.

At the Pizza Pizza brand in Q3, we promoted major value offerings as part of our 50th anniversary celebrations. Price points such as our $11.11 price promo and several walk-in traffic were well-received by consumers.

These value offerings were successful in increasing customer order accounts. However, they also worked to slightly decrease the average customer check.

It's always hard to strike that exact balance. The net result was a 2.7% overall growth in Pizza Pizza Royalty Pool sales, but a slight decrease in same-store sales of 0.2%.

Keep in mind this decrease was up against a very strong 3.5% same-store sales growth in Q3 of last year, which featured a much more successful [indiscernible] team that went well into the play-offs and also a drier summer. We're looking forward to a promising hockey season this year.

Our Pizza 73, which operates in a weakened Alberta economy, we were pleased with the positive consumer responses to compelling walk-in and delivery specials as traffic increased, especially walk-in traffic. But like at Pizza Pizza, the average check decreased slightly resulting in a 2.2% decrease in same-store sales growth at Pizza 73 compared to a 4.6% decrease in Q3 last year.

With traffic trending upwards at both brands, towards the end of Q3, we began marketing strategies to grow the average check, especially with the pending January 1, 2018, minimum wage increase settled for Ontario. Looking at restaurant development for the quarter and for the 9 months; during the quarter Pizza Pizza Limited opened 5 restaurants and closed 9.

By brand, for the quarter, Pizza Pizza opened 3 nontraditional restaurants, 6 traditionals and 2 nontraditional locations were closed. Pizza 73 opened 2 traditional restaurants: one in Whitehorse, Yukon, which is a new market for the brand; and one Pizza 73 nontraditional is closed.

During 9-month period, Pizza Pizza Limited has opened 18 restaurants and closed 16. By brand, for the 9-month period, Pizza Pizza opened 5 traditional and 6 nontraditional restaurants, 8 traditional and 6 nontraditional locations were closed.

Pizza 73 opened 7 traditional restaurants and 2 Pizza 73 restaurants were closed. Historically, Pizza Pizza's restaurant closures have been lower compared to industry comps.

The closures in Q3 were underperforming corporate locations, and in more cases, the territories and sales were transferred to neighboring franchise locations, which strengthens those franchisees and, of course, the overall system. One final note on restaurants, early year-on-year Pizza Pizza kicked off a system-wide restaurant reimaging program to modernize dining areas and signage in our restaurants.

These refreshed environments will provide an enjoyable dining atmosphere to encourage loyalty and sales growth. Reimaging program is expected to be completed in 3 to 5 years.

And this is on top of all our newbuilds, which for some time now has also been exclusively with our new look. Pizza Pizza Royalty Corp.

has increased shareholder dividends 7x in 5 years, including the 2.3% increase in June of 2016. Monthly dividend has grown over 20% in the past 5 years.

Additionally, the company has accumulated a healthy $4.8 million reserve to support the dividend in the event of short-term pressure on 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, high-quality menu offerings and our geographic diversification across Canada.

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

We've 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. This has proven very effective.

So now a quick click on your phone and your order is waiting for you when you walk in, even for, say, a $5.99 pepperoni pizza. Very few competitors offer this convenience advantage, especially the smaller independent operators.

In closing, we will continue to build shareholder value by leveraging brand dominance and economies of scale 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 our market-leading positions.

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

Thank you, Paul. Yesterday evening, Pizza Pizza Royalty Corp.

released its third quarter financial results. As Paul mentioned earlier, same-store sales decreased 0.5% for the quarter compared to a 2.2% increase in the same quarter last year; and for the 9 months, same-store sales increased 0.1% compared to a 1.9% increase in 2016.

Same-store sales is the key driver of yield growth for shareholders of the company. So before getting in too deep into the details of the financial results, I want to provide a quick reminder of our corporate royalty structure.

So Pizza Pizza Royalty Limited Partnership, which is a subsidiary of Pizza Pizza Royalty Corp. owns the Pizza Pizza and Pizza 73 trademarks and brands.

So this partnership has 2 partners, the Pizza Pizza Royalty Corp. and also Pizza Pizza Limited, which is a private company.

Each month, the partnership earns a royalty income from Pizza Pizza Limited. So the royalty is earned as a percentage of restaurant sales and is compensation for Pizza Pizza Limited, using the Pizza Pizza and Pizza 73 brands and its restaurants.

So having said that and set that stage, let's turn to the financial results. Starting at the top with Royalty Pool sales; January 1st of each year, the number of restaurants in the company's Royalty Pool is adjusted.

So this year, the Royalty Pool increased by 15 net new restaurants, taking the number up to 751 from 736 in the prior year. In exchange for adding additional royalties from new restaurants to the Royalty Pool, Pizza Pizza Limited's exchangeable shares, and these are measured as a percentage of fully diluted shares, so Pizza Pizza's ownership increased to 21.1% from 20.4%.

So, now with System Sales from the 751 restaurants in the Royalty Pool for the third quarter increased 1.6% to $139 million from a $136.9 million in the same quarter last year when they were 736 restaurants, I mentioned earlier. So System Sales for the 9 months increased 1.3% to $407.4 million from $402.2 million in the prior year compared to the [indiscernible] period.

So System Sales in 2016 included an extra day of sales in February due to the leap year. So when we're looking at increases or decreases, we should consider the estimated extra $1 million in last year.

Now turning to the statement of earnings for Pizza Pizza Royalty Corp, as I mentioned earlier, the partnership receives royalty income from Pizza Pizza Limited based upon top line restaurant sales. In this partnership, Pizza Pizza Royalty Limited Partnership is consolidated financially into the Pizza Pizza Royalty Corp.'

s financial reporting. So royalty income earned by the partnership increased 1.1% to $9 million for the quarter and increased 0.9% to $26.3 million for the 9 months.

So the partnership uses this royalty income first to pay admin expenses and interest expense before making partnership distributions to its 2 partners. Administrative expenses for the quarter were $142,000 compared to $139,000 in Q3 last year.

Administrative expenses for the 9 months were $457,000 compared to $464,000 in the same period last year. So, administrative expenses are relatively unchanged for the quarter and the 9-month period.

These administrative expenses are incurred at a partnership level and consists of directors' fees, audit, legal, public reporting fees as well as directors and officers' insurance. So in addition to administrative expenses, the partnership pays interest expense on its $47 million credit facility.

Interest expense was $347,000 in Q3, unchanged from Q3 last year. For the 9 months interest expense was $984,000 versus $1 million in the 9-month period last year.

So the difference relates to higher bank amortization last year versus this year. The actual interest rate for both years is 2.75%.

The company's credit facility matures in April of 2020. So now after the partnership has received royalty income and pays admin and interest expense, the net cash is available for distribution to its partners based upon ownership percentages.

Pizza Pizza Royalty Corp. owns 78.9% of the partnership at September 30.

So on it's 78.9% share of ownership -- of the partnership's distribution, the Royalty Corp. pays corporate income tax.

So, current income tax for the quarter was $1.5 million versus $1.3 million in Q3 last year. For the 9 months, income tax was $4.2 million versus $4.1 million in same 9 months last year.

Current tax expense increased over last year due to a combination of an increase in royalty income and by a decrease in available tax amortization. Actual earnings from operations for the quarter decreased slightly to $6.7 million from $6.8 million in the comparable quarter last year.

And the decrease in earnings resulted largely from an increase in current taxes. For the 9 months, earnings increased 1% to $20.1 million compared to $19.9 million in the same period of 2016.

And this increase in earnings on the 9 months resulted from an increase in royalty income offset by an increase in current taxes. So in addition to earnings based on IFRS for the quarter, management considers adjusted earnings from operations to be a more meaningful measure in evaluating our company's performance and an actual truer indication of cash available for dividends to our shareholders.

So, just touching on adjusted earnings; adjusted earnings from operations were $7 million compared to $7.1 million in Q3. And year-to-date adjusted earnings were $20.6 million versus $20.5 million in the prior year.

Please refer to the company's MD&A for a full reconciliation of adjusted earnings compared to earnings calculated under IFRS. So just turning to shareholder dividends, the company declared shareholder dividends of $5.3 million for the quarter.

That's $0.2139 per share. And that was unchanged from the same quarter in 2016, and the payout ratio was 101% for the quarter and was 97% in the same quarter last year.

For the nine months, the company declared shareholder dividends of $15.8 million or $0.6417 per share. And this was up slightly from $0.6337 per share for the prior year comparable period.

The payout ratio for the 9 months is 102% versus 100% in the same 9-month period last year. The last dividend increase was in June of 2016 when the company increased the monthly dividend by 2.3%.

And just to note on our sales trends for the year, our Q4 Royalty Pool sales have historically been our strongest quarter of the 4 quarters for the year. The company's working capital reserve, as Paul mentioned, is $4.8 million at September 30.

The reserve decreased slightly by $65,000 in Q3 and it decreased $374,000 [ph] over the 9-month period. And this reserve is available to stabilize dividends and fund other unusual expenditures in the event of short- to medium-term variability on System Sales.

With this reserve in place, the company continues to target 2017 payout ratio at or near 100% on an annualized basis. The company does not have capital expenditure requirements or employees.

So that concludes my financial overview. I'll now turn the call back to Marie for questions.

Yes, good morning everybody.

Good morning, Derek.

Good morning, Derek.

Paul, I mean, you have some sales momentum in Q2 on which to build. I was just wondering if you could add some color to the drop-off in same-store sales despite some heavy promo in the quarter.

Yes, I mean, I'm trying to get a little bit on my prepared comments, but I mean, I think potentially I'm trying to comment a little bit. I hate to serve blame things like weather.

We actually did expect to do better, obviously, on the traditional side and on non-traditionals. This one is strong as we thought.

We need to put a lot of effort into our 50th anniversary celebrations in [indiscernible] Montréal, in addition to really across the country. And then, tremendous amount of effort by our marketing groups, everything from costly promotions to culminating October 17th birthday celebration with the Mayor of Toronto and some celebrities there.

We drill a ton of traffic that day, that is, that's October, but -- yes, frankly, we do expect more. I mean, we put a ton of effort into that.

And we -- I think we generated a lot of excitement. And it did result in positive traffic.

But I think it's difficult to say precisely it's culmination of a few things. But I think when you do look at average check at both brands being down; perhaps we overcorrected a little much on that in the effort to drive traffic would be much of an overall synopsis.

Okay. So I think the weather is a valid excuse for a lot of retailers this year.

But outside of your nontraditional sites and where they got hurt at those outdoor venues, like, have you seen any changes in the competitive environment? Just wondering if it's gone tough out there because you're not doing QSR that's experienced pressure on their same-store sales?

Right. I think it has intensified.

I mean, different people are trying different things. There's obviously new entrants in the market all the time.

There is also -- you see sort of in the delivery areas, just in general, more competition across the board with different players and people that are trying to, obviously, focus on delivery and try to assess or attribute lost businesses, specifically and quantify it, but I just think it is and customers have never had more choice. And I think a lot of people in the market have never been more aggressive in terms of what they are prepared to do to try and drive short-term sales.

So we're caught up in that. We like to think we're really quick at adapting our traffics as well.

Sometimes it maybe be over correct, maybe it's on check and see traffic suffer if we -- our check is too high and vice versa, which is I think is a bit of story this time. But it definitely hasn't justified.

I think we do feel that. And so, we sort of look back at our strategies, and I think [indiscernible] comes on us to actually start being, frankly, a little more creative in events of about some of the strategy that we employ going forward.

But I do think we've also -- we're always making investments in the business as well. So whether it's the IT infrastructure, it's been a huge area for us or in our investment in Canada, we're just in the middle of constructing a brand new skilled up warehouse in the Edmonton market.

We're picked -- placing long-term bets on our business. And I think some of those may take a little longer to bear fruit as well.

But I do think that unlike some other QSRs that may be strong financially, we have a kind of a very long-term perspective. And I think some of those investments will take a lot to pay off.

But I won't shy away from the fact that it's very intense. So I'd say, bottom line is, it is more intense.

People are aggressively, whether they are discounting heavily or trying various short-term tactics to try and win business, that is, we're caught up in that, and it's difficult.

Would you call it -- is that an irrational level at this point? Or is it just -- you got more players, everybody kind of trying to go out to the same meal dollar?

Yes, I think it's more the latter. I don't know whether it's completely irrational.

You might see that as infringes [ph] but I would say, most of the mainstream competitors -- I mean, you just see a lot of very aggressive behavior, I suppose. I don't know how it goes far as say it's irrational.

But when you do sort of look at how you're trying to also make a profit in your business down at the restaurant levels that's key for all QSRs. And we really try and focus on that as well.

We do see some people, some cases selling at levels that are not profitable. And so far us, we have no interest in that.

We do want to have a profitable business as well. So we try to be disciplined financially there for the long-term sake.

In some cases, I think people are doing things that are not just going to throw our profits for the business. So I'd like to think those people are not kind of just sustainable as we are.

Okay. Fair enough.

And is there any, I guess, geographic market, in particular, or is it broad-based nationally?

I'd say it's fairly broad-based. I don't know if Curt or Christine will have anything to add there.

I mean, I would say, places like Montreal or international markets, I should be overall been very happy. I think we -- our sales continue to have great momentum there.

So, I'm excited about that and all of those restaurants have our new look; they -- virtually all of them in the portfolio. So that's exciting.

I think people are rewarding us I think for that. I think we are patchy in some places, even in the GTA, I mean it's our core market above all.

We're generally strong there. But we've seen some challenges there.

There's parts of the GTA, for instance, that are extremely competitive. And so it started to get a little patchy.

Okay. And maybe just one final one from me, in the anticipation of the minimum wage hikes coming, and I realize the sensitivity.

But I was wondering if you could maybe just talk about some of the strategies that you guys have in the pipeline, maybe to help the franchisees offset the potential impact on their profitability?

Well, obviously, I mean, there's two main things you can do, right, is to obviously drive sales and the other is to try and take cost out of the system. So I think we're trying to do that more than ever.

We just actually are back in early October from a, I'd say, very successful convention with our franchisees. There's a lot of two-way consultation there.

Certainly, minimum wages are hot topic in the whole industry and is with our franchisees. So we are trying to make sure that we do things that do stay at bottom line.

So if we can hold the line on input cost, I think we've had a good track record of doing that, our food costs are actually looking very good. And it's challenging, but it's an area where we've had some success, so that helps them.

Obviously, use of technology also drives efficiency and reduces manual labor. And coming up with products as well, the convenience side is one side with -- technology is part of that.

But also just reducing that manual labor or extremely tedious product design, let's say, or menu design, we're trying to avoid that as well. So yes, we're driven, number one, by what our customers want.

But we're also trying to get things that our stores can execute efficiently as well. So that in a way also reduces their labor component a bit in the face of minimum age.

So that's on the cost side. On the revenue side, I still feel, and I've said it I believe on number of calls is, we feel we're not getting enough credit for the quality of our product.

We truly believe our product is better than our competitors. And I think maybe we're not getting enough credit for that.

And perhaps we need to enhance that more. But I think you'll start to see things like that, I think, some other attributes aside from just competing on price.

And I think we've tried to do that already to some degree and had some success. But I think the quality of our product should speak for itself.

And that's a real differentiator for us. And then hopefully that should enable us to get at least with some market segments, some customer demographics, some recognition for that.

And so we do need to kind of try and increase that top line as well and selectively get more price points, attractive price points at a higher level possibly.

Thanks guys for taking my questions. Have a good day.

Thanks, Derek.

Thanks so much, Derek.

Thank you, Marie. And thank you everyone for joining us on the call this morning.

If you have any questions after this call, please contact us. Our information is on the earnings press release.

Thank you, and have a great day.