SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-K

 

 

Commission File Number:  0-21660

 

PAPA JOHN’S INTERNATIONAL, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  ý                                                                 No  o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Act).

Yes ý                                                                  Noo

 

As of March 14, 2003 there were 17,898,252 shares of the Registrant’s Common Stock outstanding.  The aggregate market value of the shares of Registrant’s Common Stock held by non-affiliates of the Registrant at such date was $252,528,750 based on the last sale price of the Common Stock on March 14, 2003 as reported by The NASDAQ Stock Market.  For purposes of the foregoing calculation only, all directors and executive officers of the Registrant have been deemed affiliates.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of Part III are incorporated by reference to the Registrant’s Proxy Statement for the Annual Meeting of Stockholders to be held May 15, 2003.

 

 

TABLE OF CONTENTS

 

PART I
Item 1.		Business
Item 2.		Properties
Item 3.		Legal Proceedings
Item 4.		Submission of Matters to a Vote of Security Holders
PART II
Item 5.		Market for Registrant’s Common Equity and Related Stockholder Matters
Item 6.		Selected Financial Data
Item 7.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 7A.		Quantitative and Qualitative Disclosures about Market Risk
Item 8.		Financial Statements and Supplementary Data
Item 9.		Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
PART III
Item 10.		Directors and Executive Officers of the Registrant
Item 11.		Executive Compensation
Item 12.		Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.		Certain Relationships and Related Transactions
Item 14.		Controls and Procedures
PART IV
Item 15.		Exhibits, Financial Statement Schedules and Reports on Form 8-K

 

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PART I

 

Item 1.  Business

 

General

 

Papa John’s International, Inc. (referred to as the “Company”, “Papa John’s” or in the first person notations of “we”, “us” and “our”) operates and franchises pizza delivery and carry-out restaurants under the trademark “Papa John’s”. At December 29, 2002, the Company and its franchisees operated domestically in 49 states, the District of Columbia and nine international markets, and under the trademark “Perfect Pizza” in the United Kingdom. The number of international markets opened increased to 11 through March 2003. The first Company-owned Papa John’s restaurant opened in 1985 and the first franchised restaurant opened in 1986. We acquired Perfect Pizza Holdings Limited (referred to as “Perfect Pizza” and “Papa John’s UK”) in 1999 as part of our plan to develop restaurants internationally (see Business - Development). At December 29, 2002, there were 2,792 Papa John’s restaurants in operation, consisting of 594 Company-owned and 2,198 franchised restaurants. Additionally, there were 144 franchised Perfect Pizza restaurants in operation.

 

All of our periodic report filings with the Securities and Exchange Commission (“SEC”) pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934, as amended, are available, free of charge, through our web site located at www.papajohns.com, including our annual report on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, and any amendments to those reports. These reports are available through our website as soon as reasonably practicable after we electronically file such reports or amendments with the SEC.

 

Strategy

 

Our goal is to build the strongest brand loyalty of all pizzerias internationally. The key elements of our strategy include:

 

Limited Menu.  Domestic Papa John’s restaurants offer a focused menu of high-quality pizza along with limited side items, including breadsticks, cheesesticks, chicken strips and canned or bottled soft drinks. Papa John’s traditional crust pizza is prepared using fresh dough (never frozen) and our thin crust pizza is made with a prepared crust. Papa John’s pizzas are made from a proprietary blend of wheat flour, cheese made from 100% real mozzarella, fresh-packed pizza sauce made from vine-ripened tomatoes (not from concentrate) and a proprietary mix of savory spices, and a choice of high-quality meat (100% beef and pork with no fillers) and vegetable toppings. Fresh onions, green peppers and baby portabella mushrooms can be purchased from the QC Center system, which delivers twice weekly. Each traditional crust pizza is served with a container of our special garlic sauce and two pepperoncinis, and each thin crust pizza is served with a container of special seasonings and two pepperoncinis. Although we have added chicken strips and will test products in certain situations, we continue to have a relatively small number of total menu items. In international markets, the menu mix (toppings and side items) is adapted to local tastes.

 

Efficient Operating System. We believe our operating and distribution systems, restaurant layout and designated delivery areas result in lower restaurant operating costs and improved food quality, and promote superior customer service. Our Quality Control Center (“QC Centers”) system takes advantage of volume purchasing of food and supplies, and provides consistency and efficiencies of scale in dough production.  This eliminates the need for each restaurant to order food from multiple vendors and commit substantial labor and other resources to dough preparation.

 

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Commitment to Team Member Training and Development.  We are committed to the development and motivation of our team members through training programs, incentive compensation and opportunities for advancement.  Team member training programs are conducted for corporate team members, and offered to our franchisees at training centers across the United States. We offer performance-based financial incentives to restaurant team members at various levels. Our management compensation program is designed to attract and retain highly motivated people.

 

Marketing.  Our restaurant-level marketing programs target the delivery area of each restaurant, making extensive use of targeted print materials in direct mail and store-to-door couponing. Local marketing efforts also include a variety of community-oriented activities with schools, sports teams and other organizations. Local marketing efforts are supplemented with radio and television advertising, produced locally and on a national basis.  Five national television campaigns aired in 2002.

 

Franchise System. We are committed to developing a strong franchise system by attracting experienced operators, partnering with them to expand and grow their business and monitoring their compliance with our high standards. We seek to attract franchisees with experience in multi-unit restaurant operations and with the financial resources and management capability to open multiple locations.  To ensure consistent food quality, each domestic franchisee is required to purchase dough and spice mix from our QC Centers and purchase all other supplies from our QC Centers or approved suppliers. QC Centers outside the U.S. may be operated by franchisees pursuant to license agreements. We devote significant resources to provide Papa John’s franchisees with assistance in restaurant operations, management training, team member training, marketing, site selection and restaurant design. We also provide significant assistance to licensed international QC Centers in sourcing high-quality ingredients in-country to the extent possible.

 

Unit Economics

 

We believe our unit economics are excellent.  In 2002, the 562 domestic Company-owned restaurants included in the most recent quarter’s comparable restaurant base generated average annual sales, based on a 52-week year, of $747,000, average cash flow (operating income plus depreciation) of $158,000 and average restaurant operating income of $132,000 (or 17.6% of average sales). Several restaurant initiatives undertaken during 2002 are expected to negatively impact Company-owned restaurant operating results during most of 2003 (see Company Operations – Restaurant Initiatives).

 

The average cash investment for the 10 domestic Company-owned restaurants opened during the 2002 fiscal year, exclusive of land, was approximately $250,000. We expect the average cash investment for the Company-owned restaurants expected to open in 2003 to be approximately $260,000.

 

Development

 

A total of 113 Papa John’s restaurants were opened during 2002, consisting of 10 Company-owned and 103 franchised restaurants, while 95 Papa John’s restaurants closed during 2002, consisting of 19 Company-owned and 76 franchised. In November 1999, we acquired Perfect Pizza, an operator and franchisor of 206 delivery and carry-out pizza restaurants in the United Kingdom. During 2002, two franchised Perfect Pizza restaurants were opened, six franchised restaurants were closed and we converted 45 (three Company-owned and 42 franchised) Perfect Pizza restaurants to Papa John’s. During the past three years a cumulative total of 60 (11 Company-owned and 49 franchised) Perfect Pizza restaurants have been converted to Papa John’s restaurants. We will continue to evaluate the conversion of the remaining 144 franchised Perfect Pizza restaurants to Papa John’s depending on financial performance and future growth opportunities.

 

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During 2003, we plan to open approximately 10 Company-owned restaurants domestically and expect franchisees to open approximately 65 to 90 restaurants (30 to 40 domestically and 35 to 50 internationally). We also expect that approximately 75 to 100 restaurants, primarily domestic franchised, could close during 2003.  Domestic unit expansion is expected to be spread throughout markets across the United States.  International expansion in 2003 is planned primarily in Central and South America, Europe, Asia and the United Kingdom.

 

The ability of the Papa John’s system to open new restaurants is affected by a number of factors, many of which are beyond our control and the control of our franchisees. These factors include, among other things, selection and availability of suitable restaurant sites, increases in food, paper or labor costs, negotiation of suitable lease or financing terms, constraints on permitting and construction of restaurants, cost of equipment, increased cost of fuel and utilities, rising costs of health, liability and workers compensation insurance, and the hiring, training and retention of management and other personnel.  International development is impacted by additional factors, including economic and political environments, the ability to source food and other products economically, and currency regulations and fluctuations. Accordingly, there can be no assurance that the Papa John’s system will be able to meet planned growth targets or open restaurants in markets now targeted for expansion.

 

Our Company-owned expansion strategy is to continue to open restaurants in existing markets, thereby increasing consumer awareness and enabling us to take advantage of operational, distribution and advertising efficiencies. Our experience in developing markets indicates that market penetration through the opening of multiple restaurants within a particular market results in increased average restaurant sales in that market. We have co-developed markets with some franchisees or divided markets among franchisees, and will continue to utilize market co-development in the future. We continually evaluate the number and market areas of our Company-owned restaurants, and may purchase or sell restaurants from time to time. We also have one joint venture and may consider entering into more of these arrangements in the future.

 

Restaurant Design and Site Selection

 

Backlit awnings, neon window designs and other visible signage characterize the exterior of most Papa John’s restaurants.  A typical domestic Papa John’s restaurant averages 1,100 to 1,500 square feet and a typical international Papa John’s restaurant averages 900 to 1,400 square feet. Papa John’s restaurants are designed to facilitate a smooth flow of food orders through the restaurant. The layout includes specific areas for order taking, pizza preparation and routing, resulting in simplified operations, lower training and labor costs, increased efficiency and improved consistency and quality of food products.  The typical interior of a Papa John’s restaurant has a vibrant red and white color scheme with green striping, and includes a bright menu board, custom counters and a carry-out customer area.  The counters are designed to allow customers to watch the team members slap out the dough and put sauce and toppings on pizzas.

 

We consider the location of a restaurant to be important and therefore devote significant resources to the investigation and evaluation of potential sites. The site selection process includes a review of trade area demographics, target population density, household income levels and competitive factors.  A member of our development team inspects each potential domestic Company-owned or franchised restaurant location and the surrounding market before a site is approved. Our restaurants are typically located in strip shopping centers or freestanding buildings that provide visibility, curb appeal and accessibility. Our restaurant design may be configured to fit a wide variety of building shapes and sizes, which increases the number of suitable locations for our restaurants.

 

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During the past several years, a number of freestanding restaurants have been opened in the Papa John’s system. We seek either existing buildings suitable for conversion, or locations suitable for the construction of our prototype restaurant.  Freestanding buildings generally provide more signage and better visibility, accessibility and parking.  We believe that these locations improve Papa John’s image and brand awareness. At year-end, freestanding units represented approximately 25% of domestic Company-owned restaurants, and a relatively small percentage of domestic franchised restaurants. We expect this composition to remain fairly constant in future years.

 

We provide layout and design services and recommendations for subcontractors, signage installers and telephone systems to Papa John’s franchisees. Although not required to do so, through 2002, substantially all Papa John’s franchisees purchased most of their equipment, fixtures and smallwares needed to open a Papa John’s restaurant from us. Beginning in December 2002, complete new store equipment packages could be purchased through an approved third party supplier under a commission arrangement with the Company. We continue to sell smallwares and related items to our franchisees through our Support Services subsidiary.

 

Quality Control Centers; Strategic Supply Chain Management

 

Our domestic QC Centers, comprised of 11 regional production and distribution centers, supply pizza dough, food products, paper products, smallwares and cleaning supplies twice weekly to each restaurant. This system enables us to monitor and control product quality and consistency, while lowering food costs. Our full-service QC Centers are located in Louisville, Kentucky; Dallas, Texas; Pittsburgh, Pennsylvania; Orlando, Florida; Raleigh, North Carolina; Jackson, Mississippi; Denver, Colorado; Rotterdam, New York; Portland, Oregon; Des Moines, Iowa; and Phoenix, Arizona. The QC Center system capacity is continually evaluated in relation to planned restaurant growth, and facilities are developed or upgraded as operational or economic conditions warrant.

 

Our subsidiary, Papa John’s UK, leases a distribution center in the United Kingdom. The primary difference between a full-service QC Center and a distribution center is that full-service QC Centers produce fresh pizza dough in addition to providing other food and paper products used in our restaurants. International full-service QC Centers, licensed to franchisees, are located in Canada, Mexico, Honduras, Saudi Arabia, Alaska, Puerto Rico, Costa Rica, Venezuela, and Guatemala. We expect future international QC Centers to be licensed to franchisees; however, we may open Company-owned QC Centers at our discretion. We also have the right to acquire licensed QC Centers from our international licensees in certain circumstances.

 

We set quality standards for all products used in our restaurants and designate approved outside suppliers of food and paper products that meet our quality standards.  In order to ensure product quality and consistency, all of our restaurants are required to purchase proprietary spice mix and dough from our QC Centers. Franchisees may purchase other goods directly from our QC Centers or approved suppliers. National purchasing agreements with most of our suppliers generally result in volume discounts to us, allowing us to sell products to our restaurants at prices that we believe are below those generally available in the marketplace. Within our domestic QC Center system, products are distributed to restaurants by refrigerated trucks leased and operated by us or transported by a dedicated logistics company.

 

PJ Food Service, our wholly-owned subsidiary that operates our domestic Company-owned QC Centers, has a purchasing arrangement with a third-party entity formed at the direction of the Franchise Advisory Council (see Franchise Program – Franchise Advisory Council) for the sole purpose of reducing cheese price volatility to our restaurants.  Under this arrangement, PJ Food Service purchases cheese at a fixed quarterly price based in part on historical average cheese prices.  Gains and losses incurred by the selling

 

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entity are passed to the QC Centers via adjustments to the selling price over time.  Ultimately, PJ Food Service purchases cheese at a price approximating the actual average market price, but with more predictability and less volatility than the previous purchasing method. See “Note 3” of “Notes to Consolidated Financial Statements” for additional information.

 

Marketing Programs

 

All Company-owned and franchised Papa John’s restaurants within a co-developed market are required to join an advertising cooperative (“Co-op”).  Each member restaurant contributes a percentage of sales to the Co-op for market-wide programs, such as radio, television and print advertising.  The rate of contribution and uses of the monies collected are determined by a majority vote of the Co-op’s members.  The restaurant-level and Co-op marketing efforts are supported by print and electronic advertising materials that are produced by the Papa John’s Marketing Fund, Inc., a non-profit corporation (the “Marketing Fund”).  The Marketing Fund produces and buys air time for Papa John’s national television commercials, in addition to other brand-building activities, such as consumer research. All domestic Company-owned and franchised Papa John’s restaurants are required to contribute a percentage of sales to the Marketing Fund. The contribution percentage was 1.25% throughout 2002 and increased to 2.0% for 2003.

 

Restaurant-level marketing programs target the delivery area of each restaurant, making extensive use of targeted print materials in direct mail and store-to-door couponing.  The local marketing efforts also include a variety of community-oriented activities with schools, sports teams and other organizations.  In markets in which Papa John’s has a significant presence, local marketing efforts are supplemented with radio and television advertising.

 

We provide both Company-owned and franchised restaurants with catalogs for the purchase of uniforms and promotional items and pre-approved print marketing materials. We also provide direct marketing services to Company-owned and franchised restaurants using customer information gathered by our proprietary point-of-sale technology (see Company Operations – Point of Sale Technology).

 

We have developed a system by which all domestic Papa John’s restaurant customers are able to place orders on-line via the internet. We receive a percentage fee based on on-line sales, from domestic franchisees, in addition to royalties, for this service.

 

Company Operations

 

Restaurant Personnel.  A typical Papa John’s restaurant employs a restaurant manager, one or two assistant managers and approximately 20 to 25 hourly team members, most of whom work part-time. The manager is responsible for the day-to-day operation of the restaurant and maintaining Company-established operating standards. The operating standards and other resources are contained in a comprehensive operations manual supplied to each restaurant. We seek to hire experienced restaurant managers and staff, provide comprehensive training on operations and managerial skills, and motivate and retain them by providing opportunities for advancement and performance-based financial incentives.

 

Historically, we employed area supervisors, each of whom had responsibility for overseeing three to six Company-owned restaurants. We also employed district managers who oversaw area supervisors and managers within their respective markets. Beginning in 2003, we combined the area supervisor and district manager positions into a director of operations position (see Company Operations – Restaurant Initiatives).

 

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Restaurant Initiatives. During 2002, several restaurant initiatives were undertaken with the ultimate goal of improving the quality and consistency of the customer experience. The first of these initiatives was the development of a systematic approach to monitor and evaluate key components of the total customer experience, the refinement and enhancement of which is ongoing. A second initiative was an across-the-board increase in base pay for restaurant general managers and assistant managers in an effort to attract and retain the desired quality of individuals to these critical positions.  In January 2003, we realigned field operations management by combining the area supervisor and district manager positions into a director of operations position. A director of operations is responsible for seven restaurants on average, thus providing higher-quality direct support to our general managers and their teams. The cost savings from the field management realignment are being invested back into our restaurants in the form of increased staffing and greater bonus opportunities for general managers and their assistants.

 

Training and Education. We have a department dedicated to training and developing team members, as well as assisting with new restaurant openings. We have regional training directors located strategically across the country. We provide an on-site training team three days before and three days after the opening of any Company-owned or franchised restaurant requesting assistance. Operations personnel, both corporate and franchise, complete our management training program and on-going development programs in which instruction is given on all aspects of our systems and operations.  The programs include classroom instruction and hands-on training at an operating Papa John’s restaurant or at Company-certified training centers. Our training includes new team member orientation, in-store and delivery training, core management skills training, new product or program implementation and ongoing developmental programs.

 

Point of Sale Technology.  Point of sale technology (our proprietary PROFIT System^TM) is in place in all domestic traditional Papa John’s restaurants and in a majority of Papa John’s international restaurants. We believe this technology facilitates faster and more accurate order taking and pricing, reduces paperwork and allows the restaurant manager to better monitor and control food and labor costs. We believe the PROFIT System enhances restaurant-level marketing capabilities through the development of a database containing information on customers and their buying habits with respect to our products.  Polling capabilities allow us to obtain restaurant-operating information, thereby improving the speed, accuracy and efficiency of restaurant-level reporting. During 2003, we will introduce the next generation of the PROFIT System to the domestic and international Papa John’s system. We believe this updated version will improve operational efficiencies at the restaurant level and improve our data collection process.

 

Reporting.  Management at Company-owned restaurants evaluates daily reports of sales, cash deposits and operating costs.  Physical inventories of all food and beverage items are taken nightly.

 

Hours of Operations.  Our domestic restaurants are open seven days a week, typically from 11:00 a.m. to 12:30 a.m. Monday through Thursday, 11:00 a.m. to 1:30 a.m. on Friday and Saturday and 12:00 noon to 11:30 p.m. on Sunday.

 

Franchise Program

 

General. We continue to attract franchisees with significant restaurant experience. We consider our franchisees to be a vital part of our system’s continued growth and believe our relationship with our franchisees is very good.  As of December 29, 2002, there were 2,198 franchised Papa John’s restaurants operating in 49 states, the District of Columbia, and nine international markets, and 144 franchised Perfect Pizza restaurants operating in the United Kingdom. We have development agreements with our domestic franchisees for approximately 239 additional franchised restaurants committed to open through 2010 and agreements for 567 additional international franchised restaurants to open through 2012. There

 

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can be no assurance that all of these restaurants will be opened or that the development schedule set forth in the development agreements will be achieved. Formal development agreements for franchised Perfect Pizza restaurants do not exist and we plan to open very few, if any, Perfect Pizza units. Our plan is to attract new franchisees and to work with existing franchisees, to open new Papa John’s restaurants in the United Kingdom and convert existing Perfect Pizza restaurants to the Papa John’s brand over time.  During the 2002 fiscal year, 103 (76 domestic and 27 international) franchised Papa John’s restaurants were opened, and two Perfect Pizza franchised restaurants were opened. There were also 42 franchised Perfect Pizza restaurants converted to Papa John’s restaurants during 2002.  Over the past three years, 49 franchised Perfect Pizza restaurants have converted to Papa John’s restaurants.

 

Approval.  Franchisees are approved on the basis of the applicant’s business background, restaurant operating experience and financial resources. We generally seek franchisees who will enter into development agreements for multiple restaurants.  We seek franchisees who have restaurant or retail experience. In the case of franchisees who do not have restaurant experience, we require the franchisee to either complete our training program or to hire a full-time operator who completes the training and has either an equity interest or the right to acquire an equity interest in the franchise operation.

 

Development and Franchise Agreements. We enter into development agreements with our domestic franchisees for the opening of a specified number of restaurants within a defined period of time and specified geographic area.  Under our current standard development agreement, the franchisee is required to pay, at the time of signing the agreement, a non-refundable fee of $5,000 per restaurant covered by the development agreement.  This amount is credited against the standard $20,000 franchise fee payable to us upon signing the franchise agreement for a specific location.  Generally, a franchise agreement is executed when a franchisee secures a location.

 

Our current standard domestic franchise agreement provides for a term of ten years (with one ten-year renewal option) and payment to us of a royalty fee of 4% of sales.  The current agreement, as well as substantially all existing franchise agreements, permit us to increase the royalty fee up to 5% of sales after the agreement has been in effect for three years. The royalty fee cannot be increased to an amount greater than the percentage royalty fee then in effect for new franchisees.

 

We have the right to terminate a franchise agreement for a variety of reasons, including a franchisee’s failure to make payments when due or failure to adhere to our policies and standards. Many state franchise laws limit the ability of a franchisor to terminate or refuse to renew a franchise.

 

We opened our first franchised restaurant outside the United States in 1998.  Beginning in 2001, we changed the definition of international markets to be all markets outside the contiguous United States.  In international markets, we enter into either a development agreement or a master franchise agreement with a franchisee for the opening of a specified number of restaurants within a defined period of time and specified geographic area.  Under a master franchise agreement, the franchisee has the right to subfranchise a portion of the development to one or more subfranchisees approved by us.  Under our current standard international development agreement (except for Hawaii and Alaska in which the initial fees are the same as domestic restaurants), the franchisee is required to pay total fees of $25,000 per restaurant, $5,000 at the time of signing the agreement, and $20,000 when the restaurant opens or the agreed-upon development date, whichever comes first.  Under our current standard master franchise agreement, the master franchisee is required to pay total fees of $25,000 per restaurant owned and operated by the master franchisee, under the same terms as the development agreement, and $15,000 for each subfranchised restaurant, $5,000 at the time of signing the agreement and $10,000 when the restaurant opens or the agreed-upon development date, whichever comes first.

 

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Our current standard international master franchise and development agreements provide for payment to us of a royalty fee of 5% of sales (including sales by subfranchised restaurants), with no provision for increase. The remaining terms applicable to the operation of individual restaurants are substantially equivalent to the terms of our standard domestic franchise agreement.

 

We franchise restaurants in the United Kingdom under Perfect Pizza franchise agreements, which were in effect at the time of our acquisition in 1999. These franchise agreements differ from our standard international franchise agreements in many respects, although with few material differences. A principal difference is the term of the agreement, which is five years. The franchisee fee is £18,500 (approximately $30,000 at an exchange rate of $1.60 as of December 29, 2002), and the royalty rate of 5% is the same as in our standard international agreements. The Perfect Pizza system has been developed principally through franchising of individual restaurants to single location franchisees. Thus, the system has no equivalent to our development agreements or master franchise agreements.

 

We have entered into a limited number of development and franchise agreements for non-traditional restaurant units and continue to analyze opportunities to expand these types of units. These agreements generally cover venues or areas not originally targeted for development and have terms differing from the standard agreement.  These agreements have not had a significant impact on our revenues or earnings.

 

Franchise Restaurant Development. We provide assistance to Papa John’s franchisees in selecting sites, developing restaurants and evaluating the physical specifications for typical restaurants.  Each franchisee is responsible for selecting the location for its restaurants but must obtain our approval of restaurant design and location based on accessibility and visibility of the site and targeted demographic factors, including population, density, income, age and traffic. We provide design plans, fixtures and equipment for most franchisee locations. Beginning in December 2002, complete new store equipment packages could be purchased through an approved third party supplier under a commission arrangement with the Company. Internationally, our franchisees buy their equipment from approved third party suppliers.

 

Franchisee Loans. Selected franchisees have borrowed funds from our subsidiary, Capital Delivery, Ltd., principally for use in the construction and development of their restaurants. We have also entered into loan agreements with a few franchisees that purchased restaurants from us. Loans made to franchisees typically bear interest at fixed or floating rates (ranging from 3.8% to 12.0% at December 29, 2002, with an average of 5.9%) and in most cases are secured by the fixtures, equipment and signage (and where applicable, the land) of the restaurant and the ownership interests in the franchisee. At December 29, 2002, franchisee loans outstanding totaled $14.1 million, net of a $4.4 million reserve for uncollectible amounts. We do not plan to extend loans to franchisees in the future. See “Note 10” of “Notes to Consolidated Financial Statements” for additional information.

 

We have a commitment to lend up to $2.6 million to BIBP Commodities, Inc. (“BIBP”), an independent franchisee-owned corporation. At December 29, 2002, no amounts were outstanding to BIBP. See “Note 3” of “Notes to Consolidated Financial Statements” for additional information.

 

Franchise Insurance Program.  We provide our franchisees an opportunity to purchase various insurance policies, such as non-owned automobile and workers compensation, through our insurance agency, Risk Services Corp.  In October 2000, we established a captive insurance company located in Bermuda, RSC Insurance Services, Ltd., to accommodate this business. We have specific and aggregate reinsurance to limit the exposure to the captive insurance company. As of December 29, 2002, approximately 79% of domestic franchise restaurants had obtained insurance coverage through Risk Services Corp. See “Note 11” of “Notes to Consolidated Financial Statements” for additional information.

 

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Franchise Training and Support.  Every franchisee is required to have a principal operator approved by us who satisfactorily completes our required training program and who devotes his or her full business time and efforts to the operation of the franchisee’s restaurants.  Each franchise restaurant manager is also required to complete our Company-certified management training program. We provide an on-site training crew three days before and three days after the opening of a franchisee’s first two restaurants. Ongoing supervision of training is monitored by the corporate franchise training team. Multi-unit franchisees are encouraged to appoint training store general managers or hire a full-time training coordinator certified to deliver Company-approved programs in order to train new team members and management candidates for their restaurants. Our area franchise directors maintain open communication with the franchise community, relaying operating and marketing information and new ideas between franchisees and us. Internationally, training is monitored by our international director of training as well as regional directors and international business managers assigned to specific franchisee territories.

 

Franchise Operations.  All franchisees are required to operate their Papa John’s restaurants in compliance with our policies, standards and specifications, including matters such as menu items, ingredients, materials, supplies, services, fixtures, furnishings, decor and signs.  Each franchisee has full discretion to determine the prices to be charged to its customers.

 

Franchise Advisory Council. We have a Franchise Advisory Council that consists of Company and franchisee representatives of domestically owned restaurants.  The Advisory Council and subcommittees hold regular meetings to discuss new marketing ideas, operations, growth and other relevant issues.

 

Reporting and Business Processes. We collect weekly and monthly sales and other operating information from Papa John’s franchisees. During 2002, enhancements were made to the reporting processes for franchise operational performance, allowing area and regional franchise directors to better monitor and benchmark such performance. We have agreements with substantially all Papa John’s domestic franchisees permitting us to electronically debit the franchisees’ bank accounts for the payment of royalties, Marketing Fund contributions, risk management services, purchases from our Print and Promotions operations and QC Center purchases. This system significantly reduces the resources needed to process receivables, improves cash flow and mitigates the amount of past-due accounts related to these items. Franchisees generally are required to purchase and install the Papa John’s PROFIT System in their restaurants (see Company Operations — Point of Sale Technology).

 

Industry and Competition

 

The restaurant industry is intensely competitive with respect to price, service, location and food quality, and there are many well-established competitors with substantially greater financial and other resources than Papa John’s. Competitors include a large number of international, national and regional restaurant chains, as well as local pizza operators. Some of our competitors have been in existence for a substantially longer period than us and may be better established in the markets where our restaurants are, or may be located. Based on research conducted by NPDFoodworld CREST, the United States Quick Service Restaurant (“QSR”) Pizza category, which includes dine in, carry out and delivery, had sales of approximately $33 billion for the year ended December 2002, of which Papa John’s share was reported as 6%. Within the pizza segment of the restaurant industry, we believe our primary competitors are the international pizza chains, including Pizza Hut, Domino’s and Little Caesars, and several regional chains. A change in the pricing or other marketing strategies of one or more of our competitors could have an adverse impact on our sales and earnings. Additionally, a continued increased emphasis on carry-out business by traditional casual dining restaurants, such as Applebee’s and Outback, could also have an adverse impact on our sales and earnings.

 

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Changes in consumer tastes, national, regional or local economic conditions, demographic trends, traffic patterns and the type, number and location of competing restaurants often affect the restaurant business.  In addition, factors such as inflation and economic recession, increased cheese and other commodity costs, fuel costs, labor and benefits costs, insurance costs, utility costs and the lack of experienced management and hourly team members may adversely affect the restaurant industry in general and our restaurants in particular.

 

With respect to the sale of franchises, we compete with many franchisors of restaurants and other business concepts.  In general, there is also active competition for management personnel and attractive commercial real estate sites suitable for our restaurants.

 

Government Regulation

 

We, along with our franchisees, are subject to various federal, state and local laws affecting the operation of our respective businesses.  Each Papa John’s restaurant is subject to licensing and regulation by a number of governmental authorities, which include health, safety, sanitation, building and fire agencies in the state or municipality in which the restaurant is located.  Difficulties in obtaining, or the failure to obtain, required licenses or approvals could delay or prevent the opening of a new restaurant in a particular area. Our full-service QC Centers are licensed and subject to regulation by state and local health and fire codes, and the operation of our trucks is subject to Department of Transportation regulations. We are also subject to federal and state environmental regulations.

 

We are subject to Federal Trade Commission (“FTC”) regulation and various state laws regulating the offer and sale of franchises.  Several state laws also regulate substantive aspects of the franchisor-franchisee relationship.  The FTC requires us to furnish to prospective franchisees a franchise offering circular containing prescribed information. Substantive state laws that regulate the franchisor-franchisee relationship presently exist in a substantial number of states, and bills have been introduced in Congress from time to time which would provide for federal regulation of the franchisor-franchisee relationship in certain respects. The state laws often limit, among other things, the duration and scope of non-competition provisions and the ability of a franchisor to terminate or refuse to renew a franchise. Some foreign countries also have disclosure requirements and other laws regulating franchising and the franchisor-franchisee relationship. Further government initiatives, such as “living wage” or other proposed increases in minimum wage rates, could adversely affect Papa John’s as well as the restaurant industry. As we expand internationally, we will be subject to applicable laws in each jurisdiction where franchised units are established.

 

Trademarks

 

Our rights in our principal trademarks and service marks are a significant part of our business. We are the owner of the federal registration of the trademark “Papa John’s.” We have also registered “Pizza Papa John’s and design” (our logo), “Better Ingredients. Better Pizza.” and “Pizza Papa John’s Better Ingredients. Better Pizza. and design” as trademarks and service marks. We also own federal registrations for several ancillary marks, principally advertising slogans. We have also applied to register our primary trademark, “Pizza Papa John’s and design,” in more than 90 foreign countries and the European Community. The “Perfect Pizza” trademark is also registered in the United Kingdom. We are aware of the use by other persons in certain geographical areas of names and marks which are the same as or similar to our marks. It is our policy to pursue registration of our marks whenever possible and to oppose vigorously any infringement of our marks.

 

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Employees

 

As of December 29, 2002, we employed 15,327 persons, of whom approximately 13,224 were restaurant team members, 725 were restaurant management and supervisory personnel, 588 were corporate personnel and 790 were QC Center and support services personnel.  Most restaurant team members work part-time and are paid on an hourly basis. None of our team members is covered by a collective bargaining agreement. We consider our team member relations to be excellent.

 

Forward-Looking Statements

 

This Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Act”), including information within Management’s Discussion and Analysis of Financial Condition and Results of Operations.  The following cautionary statements are being made pursuant to the provisions of the Act and with the intention of obtaining the benefits of the “safe harbor” provisions of the Act.  Although we believe that our expectations are based on reasonable assumptions, actual results may differ materially from those in the forward-looking statements as a result of various factors, including but not limited to, the following:

 

1.         The ability of the Papa John’s system to continue to open new restaurants is affected by a number of factors, many of which are beyond our control. These factors include, among other things, selection and availability of suitable restaurant locations, increases in food, paper, labor and insurance costs, negotiation of suitable lease or financing terms, constraints on permitting and construction of restaurants, higher than anticipated construction costs, and the hiring, training and retention of management and other personnel.  Accordingly, there can be no assurance that system-wide, Papa John’s will be able to meet planned growth targets, open restaurants in markets now targeted for expansion, or continue to operate in existing markets.

 

2.         The restaurant industry is intensely competitive with respect to price, service, location and food quality, and there are many well-established competitors with substantially greater financial and other resources than the Papa John’s system.  Some of these competitors have been in existence for a substantially longer period than Papa John’s and may be better established in the markets where restaurants operated by us or our franchisees are, or may be, located.  A change in the pricing or other marketing or promotional strategies of one or more of our major competitors could have an adverse impact on sales and earnings of our system-wide restaurant operations.

 

3.         An increase in the cost of cheese or other commodities could adversely affect the profitability of our system-wide restaurant operations. Cheese costs, historically representing 35% to 40% of our food cost, and other commodities are subject to seasonal fluctuations, weather, availability, demand and other factors that are beyond our control. Additionally, sustained increases in fuel and utility costs could adversely affect profitability of our restaurant and QC Center businesses.

 

4.         Changes in consumer taste, demographic trends, traffic patterns and the type, number and location of competing restaurants could adversely affect our restaurant business.

 

5.         System-wide restaurant operations are subject to federal and state laws governing such matters as wages, working conditions, citizenship requirements and overtime. A significant number of hourly personnel employed by our franchisees and us are paid at rates related to the federal minimum wage.  Accordingly, further increases in the federal minimum wage or the enactment of additional state or local “living wage” proposals will increase labor costs for our system-wide operations. Additionally, labor shortages in various markets could result in higher required wage rates.

 

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6.         Any or all of the factors listed in 1. through 5. potentially adversely impacting restaurant sales or costs could be especially harmful to the financial viability of franchisees in under-penetrated or emerging markets. A decline in or failure to improve financial performance for this group of franchisees could lead to unit closings at greater than anticipated levels and therefore impact contributions to marketing funds, PJFS and support services efficiencies and other system-wide results.

 

7.         Our domestic and international operations could be negatively impacted by significant changes in international economic and political conditions. In addition, our international operations are subject to additional factors, including currency regulations and fluctuations, cultures and consumer preferences, diverse government regulations and structures, availability and cost of land and construction, ability to source high quality ingredients and other commodities in a cost-effective manner, and differing interpretation of the obligations established in franchise agreements with international franchisees. Accordingly, there can be no assurance that our operations will achieve or maintain profitability or meet planned growth rates.

 

8.             Our planned conversion of Perfect Pizza restaurants to Papa John’s restaurants represents the first time we have attempted to expand the Papa John’s brand in this manner.  There can be no assurance that all conversion issues will be identified and successfully addressed in a timely, cost-effective manner or that the existing Perfect Pizza market share can be successfully converted to Papa John’s.

 

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Item 2.  Properties

 

As of December 29, 2002, there were 2,792 Papa John’s restaurants and 144 Perfect Pizza restaurants system-wide.

 

Company-owned Papa John’s Restaurants

 

 

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Domestic Franchised Papa John’s Restaurants

 

 

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International Franchised Papa John’s Restaurants

 

 

(1)  The four franchised restaurants in Guatemala closed in March 2003. During the first three months of 2003, we opened our first franchised restaurant in Greece, Aruba and the Grand Bahama Island.

 

Effective January 1, 2001, for restaurant unit purposes, “domestic” operations includes only those units located in the contiguous United States.

 

Most Papa John’s restaurants are located in leased space.  The initial term of most restaurant leases is generally five years with most leases providing for one or more options to renew for at least one additional term. Virtually all of our leases specify a fixed annual rent. Generally, the leases are triple net leases, which require us to pay all, or a portion of the cost of insurance, taxes and utilities.  Certain leases further provide that the lease payments may be increased annually, with a small number of escalations based on changes in the Consumer Price Index.

 

Approximately 56 Company-owned restaurants are located in buildings we own on land either owned or leased by us. These restaurants range from 1,200 to 2,200 square feet. Six of these restaurants are located in multi-bay facilities. These multi-bay facilities contain from 2,800 to 5,000 square feet, and the space not utilized by the Papa John’s restaurant in each facility is leased or held for lease to third party tenants.

 

We have 223 restaurants located in the United Kingdom (70 franchised and nine Company-owned Papa John’s restaurants and 144 franchised Perfect Pizza restaurants). In addition to leasing the nine Company-owned restaurant sites, we lease and sublease to franchisees 178 of the 214 franchised restaurant sites. The initial lease terms on the Company and franchised sites are generally 10 to 15 years. The initial lease terms of the franchisee subleases are generally five to ten years.

 

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Information with respect to our leased QC Centers and other facilities as of December 29, 2002 is set forth below.

 

 

We own approximately five acres in Orlando, Florida on which our 63,000 square foot full-service commissary is located. We also own eight acres and a 175,000 square foot facility in Dallas, Texas, of which 77,500 square feet is used by our full-service commissary and the remaining space is available for future production or for leasing. In addition, we own approximately 72 acres in Louisville, Kentucky with a 42,000 square foot building housing our printing operations and a 247,000 square foot building, approximately 30% to 40% of which accommodates the Louisville QC Center operation and promotional division. The remainder of the building houses our corporate offices.

 

The Papa John’s UK management team is located in 6,000 square feet of leased office space in London with a remaining lease term of 13 years. In addition, Papa John’s UK leases a distribution center located in a 30,000 square foot facility in Staffordshire, England.

 

Item 3.  Legal Proceedings

 

We are subject to claims and legal actions in the ordinary course of our business. We believe that all such claims and actions currently pending against us are either adequately covered by insurance or would not have a material adverse effect on us if decided in a manner unfavorable to us.

 

Item 4.  Submission of Matters to a Vote of Security Holders

 

Not applicable.

 

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EXECUTIVE OFFICERS OF THE REGISTRANT

 

Set forth below are the executive officers of Papa John’s, together with their ages as of January 1, 2003, their positions and the years in which they first became an officer:

 

Name		Age		Position		First Elected Executive Officer
John H. Schnatter		41		Founder, Chairman of the Board, Chief Executive Officer and President		1985
Robert J. Wadell		47		President of PJ Food Service, Inc. and Chief Operating Officer		1990
Charles W. Schnatter		40		Senior Vice President, Chief Development Officer and Secretary		1991
Mary Ann Palmer		45		Senior Vice President and Chief Resource Officer		1999
Julie Larner		42		Senior Vice President, Chief Administrative Officer and Treasurer		2001
Michael R. Cortino		46		Senior Vice President of Corporate Operations		2000
J. David Flanery		45		Senior Vice President of Finance		1994
Richard J. Emmett		47		Senior Vice President and General Counsel		1992
Christopher J. Sternberg		37		Vice President, Office of the Chairman		2001
William M. Van Epps		54		Managing Director, International		2002

 

John Schnatter created the Papa John’s concept and founded Papa John’s in 1985.  He has served as Chairman of the Board and Chief Executive Officer since 1990, and from 1985 to 1990, served as President, a position to which he was reappointed in January 2001.  He has been a franchisee since 1986.

 

Robert Wadell has served as Chief Operating Officer since February 2001 and as President of PJ Food Service, Inc. since 1995, after having served in various senior management positions in our QC Center Operations from 1990 to 1995.

 

Charles Schnatter has served as Chief Development Officer since February 2001 and Secretary since 1991. Mr. Schnatter also held the position of General Counsel from 1991 to March 2002; he has been a Senior Vice President since 1993. From 1988 to 1991, he was an attorney with Greenebaum Doll & McDonald PLLC, Louisville, Kentucky, a law firm, which provides legal services to us. Charles Schnatter has been a franchisee since 1989.

 

Mary Ann Palmer has served as Senior Vice President and Chief Resource Officer since February 2001.  Ms. Palmer served as Vice President, People Department from 1999 to 2001 and Vice President of Education and Training from 1997 to 1999. From 1996 to 1997, Ms. Palmer held the position of Senior

 

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Counsel in our legal department. Prior to joining Papa John’s, Ms. Palmer practiced law as a partner with the law firm Wyatt, Tarrant & Combs.

 

Julie Larner has served as Senior Vice President, Chief Administrative Officer and Treasurer since February 2001, responsible for People, Finance, Information Systems and Office Services.  Ms. Larner has been with Papa John’s since 1992, serving as controller for PJ Food Service, Inc. from 1992 to 1997 and its Vice President of Finance and Administration since 1998.

 

Mike Cortino has served as Senior Vice President of Corporate Operations since May 2000 after having served as Vice President of Operations Support since November 1999.  Prior to joining Papa John’s, Mr. Cortino served five years as Vice President of Corporate Operations for AFC Enterprises – Church’s Chicken Brand and ten years as a market manager and other positions with Taco Bell.

 

David Flanery has served as Senior Vice President of Finance since August 2002 and is the Principal Accounting Officer. He served as Vice President of Finance from 1995 through August 2002, after having joined Papa John’s in 1994 as Corporate Controller.  From 1979 to 1994, Mr. Flanery was with Ernst & Young LLP in a variety of positions, most recently as Audit Senior Manager.  Mr. Flanery is a licensed Certified Public Accountant.

 

Richard Emmett was promoted to Senior Vice President and General Counsel in March 2002, after serving as Senior Vice President and Senior Counsel since March 1997. Mr. Emmett also served as Senior Vice President of Development from August 1996 to March 1997. From 1992 to 1996, Mr. Emmett held the position of Vice President and Senior Counsel.  From 1983 to 1992, Mr. Emmett was an attorney with the law firm of Greenebaum Doll & McDonald PLLC, having become a partner of the firm in 1989.  Mr. Emmett has been a franchisee since 1992.

 

Chris Sternberg has served as Vice President, Office of the Chairman since July 2000, after serving as Vice President, Corporate Communications from 1997 to 2000. Mr. Sternberg joined the Company in 1994 as Assistant Counsel in our Legal Department.  From 1990 to 1994, he was an attorney with Greenebaum Doll & McDonald PLLC, Louisville, Kentucky.

 

William Van Epps has served as Managing Director, International since September 2001. Prior to joining Papa John’s, Mr. Van Epps served for two years as President, International Division of Yorkshire Global Restaurants, responsible for the international development of Long John Silver’s and A&W restaurants. From 1993 to 1999, he served in several positions with AFC Enterprises, including President of its International Division.  From 1988 to 1993, he was Vice President, Marketing and International for Western Sizzlin, Inc.

 

John and Charles Schnatter are brothers.  There are no other family relationships among the executive officers and other key personnel.

 

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PART II

 

Item 5.  Market for Registrant’s Common Equity and Related Stockholder Matters

 

Our common stock trades on the NASDAQ National Market tier of The NASDAQ Stock Market under the symbol PZZA. As of March 14, 2003, there were approximately 897 record holders of common stock. The following table sets forth for the quarters indicated the high and low closing sales prices of our common stock, as reported by The NASDAQ Stock Market.

 

		High			Low
2002
First Quarter		$	28.50		$	23.42
Second Quarter		34.70			27.86
Third Quarter		33.05			27.35
Fourth Quarter		30.73			24.48
2001
First Quarter		$	24.63		$	20.88
Second Quarter		29.32			22.63
Third Quarter		26.05			23.79
Fourth Quarter		28.73			24.62

 

Since our initial public offering of common stock in 1993, we have not paid dividends on our common stock, and have no plans to do so in the foreseeable future.

 

Item 6.  Selected Financial Data

 

The selected financial data presented on the following page for each of the years in the five-year period ended December 29, 2002 was derived from our audited consolidated financial statements. The selected financial data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and Notes thereto included in Item 7 and Item 8, respectively, of this Form 10-K.

 

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Selected Financial Data

 

		Year Ended(1)
(In thousands, except per share data)		Dec. 29, 2002			Dec. 30, 2001			Dec. 31, 2000			Dec. 26, 1999			Dec. 27, 1998
System-wide Restaurant Sales
Domestic: Company-owned		$	429,813		$	445,849		$	456,637		$	394,636		$	344,089
Domestic: Franchised		1,319,575			1,301,124			1,212,369			1,031,277			812,005
International: Franchised		38,428			40,115			17,723			6,803			177
United Kingdom: Company-owned(2)		3,986			4,471			4,305			455			—
United Kingdom: Franchised(2)		65,796			59,611			60,578			5,175			—
Total		$	1,857,598		$	1,851,170		$	1,751,612		$	1,438,346		$	1,156,271
Income Statement Data
Domestic revenues:
Restaurant sales		$	429,813		$	445,849		$	456,637		$	394,636		$	344,089
Franchise royalties		51,386			50,768			47,145			40,567			32,120
Franchise and development fees		1,734			2,927			5,559			6,511			5,325
Commissary sales(3)		381,217			390,889			356,101			311,005			258,480
Equipment and other sales		50,055			52,730			53,233			53,078			45,404
International revenues:
Royalties and franchise and development fees		5,846			5,895			5,302			1,063			131
Restaurant and commissary sales(2)		26,168			26,014			25,546			2,561			—
Total revenues		946,219			975,072			949,523			809,421			685,549
Operating income(4)		81,427			82,783			57,389			72,484			53,688
Investment income		1,126			1,958			1,943			3,384			4,100
Interest expense		(7,677		)	(8,857		)	(7,746		)	(151		)	(643		)
Income before income taxes and cumulative effect of a change in accounting principle		74,876			75,884			51,586			75,717			57,145
Income tax expense		28,079			28,639			19,762			28,431			22,181
Income before cumulative effect of a change in accounting principle		46,797			47,245			31,824			47,286			34,964
Cumulative effect of accounting change, net of tax(5)		—			—			—			—			(2,603		)
Net income		$	46,797		$	47,245		$	31,824		$	47,286		$	32,361
Basic earnings per common share:
Income before cumulative effect of a change in accounting principle		$	2.33		$	2.09		$	1.29		$	1.57		$	1.18
Cumulative effect of accounting change, net of tax(5)		—			—			—			—			(.09		)
Basic earnings per common share		$	2.33		$	2.09		$	1.29		$	1.57		$	1.09
Earnings per common share - assuming dilution:
Income before cumulative effect of a change in accounting principle		$	2.31		$	2.08		$	1.28		$	1.52		$	1.15
Cumulative effect of accounting change, net of tax(5)		—			—			—			—			(.09		)
Earnings per common share - assuming dilution		$	2.31		$	2.08		$	1.28		$	1.52		$	1.06
Basic weighted average shares outstanding		20,068			22,600			24,703			30,195			29,537
Diluted weighted average shares outstanding		20,300			22,753			24,907			31,080			30,455
Balance Sheet Data
Total assets		$	365,469		$	387,439		$	395,658		$	372,051		$	319,724
Total debt		140,085			105,310			146,607			6,233			8,420
Stockholders’ equity		121,947			195,632			166,321			292,133			254,170

 

(1)          We operate on a 52-53 week fiscal year ending on the last Sunday of December of each year.  All fiscal years presented consisted of 52 weeks, except the 2000 fiscal year, which consisted of 53 weeks.

(2)          We purchased Perfect Pizza in November 1999 (see Business – Development).

(3)          Prior year commissary sales have been restated to conform to the current year presentation.

(4)          Operating income for 2000 includes special charges of $20.9 million as well as a provision for uncollectible notes receivable of $4.2 million.  Operating income for 1999 includes special charges of $6.1 million.  See “Note 7” of Notes to Consolidated Financial Statements.

(5)          Reflects the cumulative effect on income and earnings per share of a change in accounting principle, net of tax, as required by Statement of Position 98-5 “Reporting the Costs of Start-Up Activities”.

 

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Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Introduction

 

Papa John’s International, Inc. (referred to as the “Company,” “Papa John’s” or in the first person notations of “we,” “us” and “our”) began operations in 1985 with the opening of the first Papa John’s restaurant in Jeffersonville, Indiana. At December 29, 2002, there were 2,792 Papa John’s restaurants in operation, consisting of 594 Company-owned and 2,198 franchised, and 144 franchised Perfect Pizza restaurants in the United Kingdom. Our revenues are principally derived from retail sales of pizza to the general public by Company-owned restaurants, franchise royalties, sales of franchise and development rights, sales to franchisees of food and paper products, restaurant equipment, printing and promotional items, risk management services, and information systems and related services used in their operations.

 

New unit openings in 2002 were 115 as compared to 210 in 2001. Several factors impacted this reduction in unit openings, including the competitive sales environment, operating margin pressures due to increased wages, insurance and other costs and the overall economic environment including franchisees’ access to capital. The rate of future unit expansion will also be impacted by these and other factors. Unit closings in 2002 were 101 as compared to 105 in 2001. The closings in 2002 and 2001 were due to many of the same factors impacting unit openings and the rate of future closings will also be impacted by these and other factors.

 

We believe our strategy has allowed us to continue to enjoy strong average sales from our Company-owned restaurants even with a very competitive market environment. Our expansion strategy is to cluster restaurants in targeted markets, thereby increasing consumer awareness and enabling us to take advantage of operational, distribution and advertising efficiencies.  Average sales for our most recent quarter’s comparable base restaurants increased to $747,000 for 2002 (52-week year), from $739,000 for 2001 (52-week year), as compared to $782,000 for 2000 (53-week year).  Average sales volumes in new markets are generally lower than in those markets in which we have established a significant market position.

 

The comparable annual sales for Company-owned restaurants increased 0.2% in 2002, decreased 2.9% in 2001 and increased 3.0% in 2000.  The relatively flat comparable sales in 2002 and the decrease in comparable sales during 2001 is the result of an increased competitive market. The decrease in 2001 also reflects our decision to decrease our advertising expenditures as we concentrated on improving restaurant operations.

 

We continually strive to obtain high-quality sites with good access and visibility, and to enhance the appearance and quality of our restaurants. We believe that these factors improve our image and brand awareness. The average cash investment for the 10 domestic Company-owned restaurants opened during 2002, exclusive of land, decreased to approximately $250,000 from $273,000 for the 20 units opened in 2001. We expect the average cash investment for restaurants opening in 2003 to be approximately $260,000.

 

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Approximately 48% of our revenues for 2002, 47% for 2001 and 45% for 2000 were derived from the sale to franchisees of food and paper products, restaurant equipment, printing and promotional items, risk management services and information systems equipment and software and related services by us, our commissary subsidiary, PJ Food Service, Inc., our support services subsidiary, Papa John’s Support Services, Inc., our insurance subsidiaries, RSC Insurance Services, Ltd. and Risk Services Corp. and our United Kingdom subsidiary, Papa John’s UK. We believe that, in addition to supporting both Company and franchised growth, these subsidiaries contribute to product quality and consistency and restaurant profitability throughout the Papa John’s system.

 

Our fiscal year ends on the last Sunday in December of each year.  All fiscal years presented consist of 52 weeks, except for the 2000 fiscal year, which consists of 53 weeks.

 

Restaurant Initiatives

 

We have developed and implemented certain quality initiatives, intended to better evaluate and monitor the quality and consistency of the customer experience, which we believe will help us deliver on the “Better Ingredients.  Better Pizza.” promise.  The costs of these initiatives were approximately $1.1 million in 2002 and are expected to be approximately $2.0 million in 2003 on a fully implemented basis.

 

In August 2002, we implemented an across-the-board increase in base pay for restaurant general managers and assistant managers in an effort to attract and retain the desired quality of individuals to these critical positions.  The cost of these increases was approximately $1.4 million in 2002 and is expected to be approximately $3.2 million in 2003 on a full-year basis.

 

In January 2003, we realigned field operations management by combining the area supervisor and district manager positions into a director of operations position. A director of operations is responsible for seven restaurants on average, thus providing higher-quality direct support to our general managers and their teams.

 

The cost savings from the field management realignment are being invested back into our restaurants in the form of increased staffing and greater bonus opportunities for general managers and their assistants.  From a financial reporting perspective, this will result in a shift in reported expenses from the general and administrative expense category to the restaurant salaries and benefits expense category in the consolidated income statement.  The 2003 full year impact of this shift is expected to approximate $4.5 million, representing a 0.5% decrease in general and administrative costs as a percentage of total consolidated revenues and a 1.0% increase in restaurant salaries and benefits as a percentage of restaurant sales, each compared to the 2002 actual results.

 

Management believes these initiatives are beginning to produce improvements in product and service quality and consistency at our restaurants. Additionally, turnover in the key restaurant management positions has been reduced since the August 2002 base pay increase, further improving operations’ ability to deliver a consistently high-quality customer experience. Given the extremely competitive sales environment and generally sluggish economy, management is unable to predict when meaningful improvement in restaurant sales and other financial results attributable to these restaurant initiatives will occur.

 

Results of Operations and Critical Accounting Policies and Estimates

 

The results of operations are based on the preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States. The preparation of consolidated financial statements requires management to select accounting policies for critical accounting areas as

 

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well as estimates and assumptions that affect the amounts reported in the consolidated financial statements. Significant changes in assumptions and/or conditions in our critical accounting policies could materially impact the operating results. We have identified the following accounting policies and related judgments as critical to understanding the results of our operations.

 

Substantially all revenues are derived from the retail sales of pizza to the general public by Company-owned restaurants, franchise royalties, sales of franchise and development rights and sales to franchisees of food and paper products, restaurant equipment, printing and promotional items, risk management services and information and related services used in their operations. We recognize franchise fees when a franchised restaurant begins operation, at which time we have performed our obligations related to such fees. Fees received pursuant to development agreements, which grant the right to develop franchised restaurants in future periods in specific geographic areas, are deferred and recognized on a pro rata basis as the franchised restaurants subject to the development agreements begin operations. Both franchise and development fees are nonrefundable. Franchise royalties, which are based on a percentage of franchise restaurants’ sales, are recognized as earned. Domestic production and distribution revenues are comprised of food, equipment and supplies sales to franchised restaurants located in the United States and are recognized as revenue upon shipment of the related products to the franchisees. Information services, including software maintenance fees, help desk fees, customer opportunity desk fees and on-line ordering fees are recognized as revenue as the related services are provided. Insurance premiums and commissions are recognized as revenue over the term of the policy period. International revenues are comprised of restaurant sales, royalties and fees received from foreign franchisees and the sale and distribution of food to foreign franchisees, and are recognized consistently with the policies applied for revenues generated in the United States.

 

We establish reserves for uncollectible accounts and notes receivable based on overall receivable aging levels and a specific evaluation of accounts and notes for franchisees with known financial difficulties.

 

The recoverability of long-lived and intangible assets (i.e., goodwill) is evaluated annually or more frequently if an impairment indicator exists.  We consider several indicators in assessing if impairment has occurred, including historical financial performance, operating trends and our future operating plans. If impairment indicators exist, we evaluate long-lived assets on an operating unit basis (e.g. an individual restaurant) whether impairment exists on the basis of undiscounted expected future cash flows before interest for the expected remaining useful life of the operating unit. If impairment indicators exist for goodwill, impairment is evaluated on a reporting unit basis using criteria similar to that of long-lived assets. Recorded values that are not expected to be recovered through undiscounted future cash flows are written down to current fair value, which is generally determined from estimated discounted future net cash flows for assets held for use or net realizable value for assets held for sale. If these estimates or their related assumptions change in the future, we may be required to record initial or increased impairment charges for these assets.

 

Our insurance programs for workers compensation, general liability, owned and non-owned automobiles and health insurance coverage provided to our employees, and the captive insurance program provided to our franchisees are self-insured up to certain individual and aggregate reinsurance levels. Claims in excess of self-insurance levels are fully insured. Losses are accrued based upon estimates of the aggregate retained liability for claims incurred using certain actuarial projections and our claims loss experience. The estimated insurance claims losses could be significantly affected should the frequency or ultimate cost of claims significantly differ from historical trends.

 

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Accounting Changes

 

SFAS No. 142

In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (SFAS) No.142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001. With the adoption of SFAS No. 142, companies no longer amortize goodwill and intangible assets with indefinite useful lives. Instead, goodwill and intangible assets with indefinite useful lives are subject to an annual review for impairment. Other intangible assets will continue to be amortized over their useful lives and reviewed for impairment.

 

As of December 29, 2002 and December 30, 2001, our consolidated balance sheets included $48.8 million and $48.3 million of goodwill, net of accumulated amortization of $7.9 million and $8.2 million, respectively. The adoption of SFAS No. 142 resulted in a reduction of approximately $2.8 million in amortization expense beginning in 2002. Proforma earnings per common share, assuming dilution, for 2001 under the provisions of SFAS No. 142 were $2.15. The impairment review performed by the Company at the beginning of fiscal 2002 and as of December 29, 2002, in accordance with the provisions of SFAS No. 142, had no impact on the consolidated financial statements. See “Note 5” of “Notes to Consolidated Financial Statements” for additional information.

 

SFAS No. 144

In 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, effective for the Company in fiscal year 2002. SFAS No. 144 superseded SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and the accounting and reporting provisions of Accounting Principles Board Opinion No. 30, Reporting the Results of Operations – Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. SFAS No. 144 required one accounting model to be used for long-lived assets to be disposed of by sale, whether previously held or used or newly acquired, and it broadened the presentation of discontinued operations to include more disposal transactions. The adoption of SFAS No. 144 did not have a significant impact on our results of operations or our consolidated financial statement presentation in 2002. See “Note 6” of “Notes to Consolidated Financial Statements” for additional information.

 

SFAS No. 146

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, effective for the Company in fiscal 2003. SFAS No. 146 addresses the recognition, measurement, and reporting of costs associated with exit or disposal activities, and nullifies Emerging Issues Task Force Issue No. 94-3 (EITF 94-3), Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). The principal difference between SFAS No. 146 and EITF 94-3 relates to the recognition date of a liability for costs associated with an exit or disposal activity. Under SFAS No. 146, companies will be required to recognize a liability for a cost associated with an exit or disposal activity when the liability is incurred instead of at the date of a company’s commitment to an exit plan as once permitted under EITF 94-3. Costs addressed by SFAS No. 146 include: one-time termination benefits provided to employees that are involuntarily terminated, costs to terminate a contract that is not a capital lease, costs to consolidate or close facilities, and costs to relocate employees. We do not expect the adoption of SFAS No. 146 to have a significant impact on our results of operations or our consolidated financial statement disclosures.

 

SFAS No. 148

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure an amendment of FASB Statement No. 123, (SFAS No. 123), effective for the Company in fiscal 2003. The only pertinent changes to the Company, as provided by SFAS No. 148, are

 

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the required disclosures regarding the method used by a company in accounting for stock-based employee compensation and the effect of the method on reported results in both interim and annual financial statements. The Company adopted the required disclosures in fiscal 2002.

 

SFAS No. 123

Effective at the beginning of fiscal 2002, we elected to expense the cost of employee stock options in accordance with the fair value method contained in SFAS No. 123. Under SFAS No. 123, the fair value for options is estimated at the date of grant using a Black-Scholes option pricing model which requires the input of highly subjective assumptions including the expected stock price volatility. The election was effective as of the beginning of fiscal 2002 and applies to all stock options issued after the effective date. The compensation expense recognized in 2002 due to the adoption of SFAS No. 123 was minimal.

 

Prior to 2002, we followed Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and related Interpretations, in accounting for our employee stock options. Under APB No. 25, no compensation expense is recognized provided the exercise price of employee stock options equals or exceeds the market price of the underlying stock on the date of grant. Had we followed SFAS No. 123 in prior years by recording the fair value of options at the date of grant as a compensation expense over the vesting period, earnings per share would have been reduced by $0.03 in 2002, $0.04 in 2001 and $0.24 in 2000. See “Note 18” of “Notes to Consolidated Financial Statements” for additional information.

 

Interpretation No. 46 of Accounting Research Bulletin No. 51

In January 2003, the FASB issued Interpretation No. 46 of Accounting Research Bulletin No. 51, Consolidated Financial Statements, that addresses the potential consolidation of Variable Interest Entities (VIE’s). This interpretation would be applied to existing VIE’s as of the beginning of the first interim period subsequent to June 15, 2003 and would apply immediately to VIE’s created after January 31, 2003.

 

We have a purchasing arrangement with a third-party entity, BIBP Commodities, Inc. (“BIBP”), formed at the direction of our Franchise Advisory Council for the sole purpose of reducing cheese price volatility. BIBP purchases cheese at the market price and sells it to our distribution subsidiary, PJ Food Service, Inc. (“PJFS”), at a fixed quarterly price based in part upon historical average market prices.  PJFS in turn sells cheese to Papa John’s restaurants (Company-owned and franchised) at a set quarterly price. The purchase of cheese by PJFS from BIBP is not guaranteed. PJFS purchased $147.7 million, $154.1 million and $136.6 million of cheese during 2002, 2001 and 2000, respectively, from BIBP.

 

BIBP has a $15 million line of credit with a commercial bank. The $15 million line of credit is not guaranteed by Papa John’s. Papa John’s has a commitment to lend up to $2.6 million to BIBP if the $15 million line of credit is fully utilized. BIBP did not have any outstanding borrowings under either credit facility at December 29, 2002 or December 30, 2001.

 

Gains or losses incurred by BIBP, due to differences in the actual market price of cheese purchased and the established quarterly sales price, are factors used to determine the price for subsequent quarters. Had BIBP not been in existence and PJFS had therefore been required to purchase cheese at actual market prices, our consolidated net income would have increased by approximately $3.0 million in 2002, decreased by approximately $1.6 million in 2001 and increased by approximately $1.2 million in 2000.

 

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The following are summarized financial statements of BIBP:

 

Summarized Statements of Operations (in thousands):

 

		2002			2001			2000
Sales to PJFS		$	147,685		$	154,058		$	136,584
Cost of sales		(128,718		)	(163,824		)	(129,031		)
Administrative expense		(118		)	(102		)	(77		)
Investment income (expense)		35			(160		)	310
Income (loss) before income taxes		18,884			(10,028		)	7,786
Income tax (expense) benefit		(7,270		)	3,861			(2,998		)
Net income		$	11,614		$	(6,167	)	$	4,788

 

Summarized Balance Sheets (in thousands):

 

		2002			2001
Cash and cash equivalents		$	16,442		$	1,356
Other current assets		4,454			7,787
Total assets		$	20,896		$	9,143
Current liabilities		$	10,239		$	10,055
Stockholders’ equity (deficit)		10,657			(912		)
Total liabilities and stockholders’ equity (deficit)		$	20,896		$	9,143

 

We are currently reviewing Interpretation No. 46 and the organizational structure of BIBP to determine the impact, if any, on our consolidated financial statements.

 

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The following tables set forth the percentage relationship to total revenues, unless otherwise indicated, of certain income statement data, and certain restaurant data for the years indicated.

 

		Year Ended
		Dec. 29, 2002		Dec. 30, 2001		Dec. 31, 2000
Income Statement Data:
Domestic revenues:
Restaurant sales		45.4	%	45.7	%	48.1		%
Franchise royalties		5.4		5.2		5.0
Franchise and development fees		0.2		0.3		0.6
Commissary sales		40.3		40.1		37.4
Equipment and other sales		5.3		5.4		5.6
International revenues:
Royalties and franchise and development fees		0.6		0.6		0.6
Restaurant and commissary sales		2.8		2.7		2.7
Total revenues		100.0		100.0		100.0
Costs and expenses:
Domestic restaurant cost of sales(1)		23.0		24.8		24.4
Domestic restaurant operating expenses(1)		56.1		56.6		56.4
Domestic commissary, equipment and other expenses(2)		90.1		89.9		89.8
International operating expenses(3)		83.8		83.6		84.9
General and administrative expenses		7.7		7.1		7.6
Special charges(4)		—		—		2.2
Provision for uncollectible notes receivable(5)		0.3		0.1		0.4
Pre-opening and other general expenses		0.8		0.4		0.2
Depreciation and amortization		3.4		3.6		3.6
Total costs and expenses		91.4		91.5		94.0
Operating income		8.6		8.5		6.0
Net interest		(0.7	)	(0.7	)	(0.6		)
Income before income taxes		7.9		7.8		5.4
Income tax expense		3.0		3.0		2.0
Net income		4.9	%	4.8	%	3.4		%

 

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		Year Ended
		Dec. 29, 2002			Dec. 30, 2001			Dec. 31, 2000
Restaurant Data:
Percentage increase (decrease) in comparable Company-owned restaurant sales(6)		0.2		%	(2.9)		%	3.0		%
Number of Company-owned restaurants included in the respective year’s most recent quarter’s comparable restaurant base		562			573			534
Average sales for Company-owned restaurants included in the year’s most recent comparable restaurant base(7)		$	747,000		$	739,000		$	782,000
Papa John’s Restaurant Progression:
U.S. Company-owned:
Beginning of period		601			631			573
Opened		10			20			42
Closed		(19		)	(17		)	(2		)
Acquired from franchisees		3			16			25
Sold to franchisees		(10		)	(49		)	(7		)
End of period		585			601			631
International Company-owned:
Beginning of period		10			10			—
Opened		—			—			2
Converted(8)		3			—			8
Sold to franchisees		(4		)	—			—
End of period		9			10			10
U.S. franchised:
Beginning of period		1,988			1,902			1,681
Opened		76			139			271
Closed		(71		)	(72		)	(32		)
Acquired from Company		10			49			7
Sold to Company		(3		)	(16		)	(25		)
Reclassification(9)		—			(14		)	—
End of period		2,000			1,988			1,902
International franchised:
Beginning of period		130			69			26
Opened		27			48			43
Closed		(5		)	(8		)	—
Converted(8)		42			7			—
Acquired from Company		4			—			—
Reclassification(9)		—			14			—
End of period		198			130			69
Total restaurants – end of period		2,792			2,729			2,612

 

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		Year Ended
		Dec. 29, 2002		Dec. 30, 2001		Dec. 31, 2000
Perfect Pizza Restaurant Progression:
Company-owned
Beginning of period		3		3		12
Opened		—		1		—
Closed		—		—		(1	)
Acquired from franchisees		—		—		1
Sold to franchisees		—		(1	)	(1	)
Converted (8)		(3	)	—		(8	)
End of period		—		3		3
Franchised
Beginning of period		190		202		194
Opened		2		2		11
Closed		(6	)	(8	)	(3	)
Acquired from company		—		1		1
Sold to company		—		—		(1	)
Converted (8)		(42	)	(7	)	—
End of period		144		190		202
Total restaurants - end of period		144		193		205

 

(1)                      As a percentage of Domestic Restaurant sales.

(2)                      As a percentage of Domestic Commissary sales and Equipment and other sales on a combined basis.

(3)                      As a percentage of International Restaurant and commissary sales.

(4)                      See “Note 7” of “Notes to Consolidated Financial Statements.”

(5)                      See “Note 10” of “Notes to Consolidated Financial Statements.”

(6)                      Includes only Company-owned restaurants open throughout the periods being compared.

(7)                      Year 2002 and 2001 are 52-week years and 2000 is based on a 53-week year.

(8)                      Represents Perfect Pizza restaurants converted to Papa John’s restaurants.

(9)                      Represents the reclassification of 11 Hawaii units and three Alaska units opened prior to 2001 from domestic franchising to international franchising. Effective January 1, 2001, for restaurant unit purposes, “domestic” operations includes only those units located in the contiguous United States.

 

2002 Compared to 2001

 

Revenues. Total revenues decreased 3.0% to $946.2 million in 2002, from $975.1 million in 2001.

 

Domestic Company-owned restaurant sales decreased 3.6% to $429.8 million in 2002, from $445.8 million in 2001. This decrease was primarily due to a 6.2% decrease in the number of equivalent Company-owned units open in 2002 as compared to 2001 as a result of the sale or closure of Company-owned units (the divested restaurants having lower than average sales). This decrease is partially offset by a 0.2% increase in comparable sales for the 2002 period. “Equivalent units” represents the number of restaurants open at the beginning of a given period, adjusted for restaurants opened, closed, acquired or sold during the period on a weighted average basis.

 

Domestic franchise sales increased 1.4% to $1.32 billion in 2002, from $1.30 billion in 2001. This increase primarily resulted from a 2.6% increase in the number of equivalent franchised domestic restaurants open in 2002 compared to 2001, partially offset by a 1.8% comparable sales decrease in 2002. Domestic franchise royalties increased 1.2% to $51.4 million in 2002, from $50.8 million in 2001, due to the increase in domestic franchise sales noted above.

 

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The comparable sales base and average weekly sales for 2002 and 2001 for domestic Company-owned and domestic franchised restaurants consisted of the following:

 

		Year Ended December 29, 2002						Year Ended December 30, 2001
		Company			Franchise			Company			Franchise
Total domestic units (end of year)		585			2,000			601			1,988
Equivalent units		581			1,982			619			1,931
Comparable sales base units		550			1,764			551			1,559
Comparable sales base percentage		94.8		%	89.0		%	89.0		%	80.7		%
Average weekly sales - comparable units		$	14,409		$	13,122		$	14,296		$	13,554
Average weekly sales - other units		$	11,100		$	10,238		$	10,198		$	10,456
Average weekly sales - all units		$	14,236		$	12,805		$	13,844		$	12,957

 

Domestic franchise and development fees, including amounts recognized upon development cancellation, were $1.7 million for 2002 compared to $2.9 million for 2001 as there were 76 domestic franchise unit openings in 2002 as compared to 139 in 2001.

 

Domestic commissary, equipment and other sales decreased 2.8% to $431.3 million in 2002, from $443.6 million in 2001, primarily due to lower commissary sales from lower volumes and reduced prices charged for certain commodities such as boxes and meats. In addition, there were lower equipment sales as a result of fewer unit openings in 2002 as compared to 2001, partially offset by an increase in our print and insurance services operations.

 

International revenues consist of the Papa John’s UK operations which are denominated in British Pounds Sterling and converted to U.S. dollars (93.0% of total 2002 international revenues) and combined revenues from operations in eight other international markets denominated in U.S. dollars. Total international revenues were substantially flat in 2002 at $32.0 million as lower Company-owned restaurant and commissary sales and development fees were offset by higher royalties due to an increased number of international franchise units in 2002 as compared to 2001. Additionally, there was a $1.3 million increase in revenues from the exchange rate difference in 2002 as compared to 2001.

 

Costs and Expenses.  The restaurant-operating margin for domestic Company-owned units was 20.9% in 2002 compared to 18.6% in 2001, consisting of the following differences:

 

•      Cost of sales was 1.8% lower in 2002 due to lower prices for certain commodities such as boxes and meats and a higher average sales price point.

•      Salaries and benefits were 0.2% lower in 2002 due to the higher average sales price point, partially offset by the impact of the across-the-board increase in base pay for general managers and assistant managers implemented during the third quarter of 2002, and other general compensation increases.

•      Advertising and related costs were 0.4% ($513,000) higher in 2002 as compared to 2001.

•      Occupancy costs were 0.2% lower in 2002 due primarily to lower utilities.

•      Other operating expenses were 0.5% lower in 2002 primarily due to improved controls over mileage reimbursement and lower training costs, partially offset by an increase in workers compensation insurance costs.

 

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Domestic commissary, equipment and other margin was 9.9% for 2002 compared to 10.1% in 2001. Cost of sales was 71.7% of revenues in 2002 compared to 73.0% in 2001 primarily due to a decrease in lower margin equipment sales and an increase in sales of higher margin insurance-related services to franchisees. Salaries and benefits and other operating costs increased to 18.4% in 2002 from 16.9% in 2001, primarily as a result of lower sales by commissaries (certain operating costs are fixed in nature), and expanded insurance-related services provided to franchisees.

 

International operating margin decreased to 16.2% in 2002 from 16.4% in 2001 due primarily to increased food and operating costs associated with the United Kingdom commissary operation.

 

General and administrative expenses were $72.4 million or 7.7% of revenues in 2002 as compared to $69.5 million or 7.1% of revenues in 2001. The primary components of the $2.9 million increase were $3.6 million of additional corporate and restaurant management bonuses and $1.1 million of costs related to the development of certain quality initiatives, intended to better evaluate and monitor the quality and consistency of the customer experience, partially offset by savings in salaries and travel cost.

 

A provision for uncollectible notes receivable of $2.8 million was recorded for 2002 based on our evaluation of our franchise loan portfolio. The provision for uncollectible notes receivable was $537,000 in 2001.

 

Pre-opening and other general expenses were $7.1 million for 2002 compared to $3.5 million in 2001.  The 2002 amount includes $156,000 of pre-opening costs, $590,000 of relocation costs, $3.2 million of disposition and valuation losses for restaurants and other assets, $900,000 of estimated costs related to the refurbishment program for our heated delivery bag system and $1.7 million of losses related to a terminated vendor relationship. The vendor was obligated to repay certain funds advanced by us upon obtaining outside bank financing in the fourth quarter of 2002. The vendor was not able to obtain such financing by the required date and, accordingly, we terminated the relationship and reserved amounts advanced based upon an evaluation of their collectibility.  The 2001 amount includes pre-opening costs of $246,000, relocation costs of $906,000 and net losses on impairment and disposition-related costs of $1.1 million. The 2001 amount also includes costs related to certain franchisee support initiatives.

 

As noted above, we incurred approximately $900,000 of costs during 2002 in connection with a refurbishment plan developed by the supplier of our heated delivery bag system, expected to reduce the failure rate of such systems currently in use at substantially all domestic Company-owned restaurants and approximately 1,200 domestic franchised restaurants. At December 29, 2002, we held delivery bag system inventory valued at approximately $3.0 million for resale to franchised restaurants or installation in Company-owned restaurants, and also had approximately $450,000 of outstanding accounts receivable related to the sale of delivery bag systems to franchisees.  Through year-end, approximately 80% of the deployed heated delivery bag system units had been refurbished under the plan, and the failure rate for those refurbished units has met thresholds of acceptability established by the Company.  Accordingly, we do not expect additional losses related to the heated delivery bag system, including the realization of inventory values or collection of receivables related thereto.

 

Depreciation and amortization was $31.7 million (3.4% of revenues) in 2002 compared to $35.2 million (3.6% of revenues) in 2001, including goodwill amortization of $2.8 million for 2001. There is no goodwill amortization in 2002 with the adoption of SFAS No. 142. On a pro forma basis, depreciation and amortization for the year ended 2001 would have been $32.4 million (3.3% of revenues) had SFAS No. 142 been adopted at that time. See “Note 5” of the “Notes to Consolidated Financial Statements” for additional information.

 

32

 

Net Interest.  Net interest expense was $6.6 million in 2002 compared to $6.9 million in 2001 primarily due to lower effective interest rates in 2002, which were partially offset by reduced franchise notes receivable in 2002.

 

Income Tax Expense. The effective income tax rate was 37.5% in 2002 compared to 37.7% in 2001.

 

Operating Income and Earnings per Common Share.  Operating income in 2002 was $81.4 million, or 8.6% of total revenues, compared to $82.8 million, or 8.5% of total revenues in 2001.

 

Diluted earnings per share were $2.31 in 2002 compared to $2.08 in 2001. On a pro forma basis, assuming the adoption of SFAS No. 142 in 2001, operating income would have been $85.6 million, or 8.8% of total revenues, and diluted earnings per share would have been $2.15 in 2001. The decrease in 2002 operating income as a percentage of sales as compared to the pro forma 2001 percentage is primarily due to increased general and administrative and pre-opening and other general expenses, partially offset by an increased restaurant operating margin.

 

In December 1999, we began a repurchase program for our common stock. Through December 29, 2002, an aggregate of $345.7 million had been repurchased (representing 13.4 million shares, or approximately 43.9% of shares outstanding at the time the repurchase program was initiated, at an average price of $25.87 per share). The repurchase of our common shares resulted in an increase in diluted earnings per share of approximately $0.15 in 2002 as compared to 2001.

 

2001 Compared to 2000

 

Revenues. Total revenues increased 2.7% to $975.1 million in 2001, from $949.5 million in 2000.

 

Domestic Company-owned restaurant sales decreased 2.4% to $445.8 million in 2001, from $456.6 million in 2000. This decrease was primarily due to a 2.9% comparable sales decrease in 2001 along with 2000 having 53 weeks while 2001 was a 52-week year (a 1.9% decrease in operating weeks), partially offset by a 4.0% increase in equivalent units.

 

Domestic franchise sales increased 7.3% to $1.30 billion in 2001, from $1.21 billion in 2000. This increase primarily resulted from a 10.1% increase in the number of equivalent franchised domestic restaurants open in 2001 compared to 2000 and a 1.2% comparable sales increase in 2001, partially offset by the 1.9% decrease in operating weeks in 2001. Domestic franchise royalties increased 7.7% to $50.8 million in 2001, from $47.1 million in 2000, due to the increase in domestic franchise sales previously described.

 

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The comparable sales base and average weekly sales for 2001 and 2000 for domestic Company-owned and domestic franchised restaurants consisted of the following:

 

		Year Ended December 30, 2001						Year Ended December 31, 2000
		Company			Franchise			Company			Franchise
Total domestic units (end of year)		601			1,988			631			1,902
Equivalent units		619			1,931			596			1,764
Comparable sales base units		551			1,559			498			1,281
Comparable sales base percentage		89.0		%	80.7		%	83.6		%	72.6		%
Average weekly sales - comparable units		$	14,296		$	13,554		$	14,917		$	13,836
Average weekly sales - other units		$	10,198		$	10,456		$	12,167		$	10,670
Average weekly sales - all units		$	13,844		$	12,957		$	14,466		$	12,969

 

Domestic franchise and development fees were $2.9 million for 2001 compared to $5.6 million for 2000 due primarily to 139 domestic franchise unit openings in 2001 as compared to 271 in 2000.

 

Domestic commissary, equipment and other sales increased 8.4% to $443.6 million in 2001, from $409.3 million in 2000, resulting primarily from the increase in domestic franchise sales as previously noted, as well as an increase in the prices of cheese and certain other commodities.

 

International revenues consist of the Papa John’s UK operations (90.5% of total 2001 international revenues), and combined revenues from operations in eight other international markets. Total international revenues increased 3.4% to $31.9 million in 2001 compared to $30.8 million in 2000 (8.9% prior to the unfavorable impact of exchange rates) due primarily to an increase in the number of equivalent international franchise units open in 2001 compared to the 2000 period.

 

Costs and Expenses.  The restaurant-operating margin for domestic Company-owned units was 18.6% in 2001 compared to 19.2% in 2000, consisting of the following differences:

 

•      Cost of sales was 0.4% higher in 2001 due primarily to higher cheese costs. The cost of cheese, representing approximately 35% to 40% of food cost, and other commodities are subject to significant price fluctuations caused by weather, availability, demand and other factors. Most of the factors affecting the cost of cheese are beyond our control (see “Item 1. Business - Quality Control Centers: Strategic Supply Chain Management” and “Note 3” of “Notes to Consolidated Financial Statements”).

•      Salaries and benefits were 1.5% higher in 2001 due primarily to increased wage rates.

•      Advertising and related costs were 1.2% lower ($6.4 million) in 2001 due to overall spending reductions given the economic environment.

•      Occupancy costs were 0.6% higher in 2001 due primarily to increased utility and rent costs.

•      Other operating expenses were 0.7% lower in 2001 primarily due to improved controls in mileage reimbursement and bad debt expense.

 

Domestic commissary, equipment and other margin was 10.1% in 2001 compared to 10.2% in 2000. Cost of sales decreased to 73.0% in 2001 compared to 74.3% in 2000, primarily resulting from operational improvements and the impact of increased revenues from expanded insurance and other services provided in 2001 with no corresponding cost of sales. Salaries and benefits and other operating costs as a

 

34

 

percentage of sales increased to 16.9% in 2001 from 15.5% in 2000 primarily as a result of the costs related to expanded insurance and other services provided to franchisees in 2001.

 

International operating margin increased to 16.4% in 2001 from 15.1% in 2000 with the improvement primarily in Company-owned restaurant operations in the United Kingdom.

 

General and administrative expenses decreased to 7.1% of revenues for 2001 compared to 7.6% of revenues in 2000. The decrease reflects our efforts to control costs primarily through organizational efficiencies resulting from our management restructuring in 2001.

 

The special charges of $20.9 million incurred in 2000 related principally to the impairment or closing of certain restaurants, impairment of certain technology assets, closing of field offices and related severance as well as advertising litigation expense (see “Note 7” of the “Notes to Consolidated Financial Statements”). The special charges resulted in a write-down of asset carrying value of $16.0 million and the establishment of accrued liabilities for cash payments of $4.9 million, including $1.0 million of litigation costs associated with the “Better Ingredients. Better Pizza” lawsuit with Pizza Hut.

 

The impairment of the restaurant and other corporate assets in 2000 reduced depreciation and amortization in 2001 approximately $2.1 million as compared to 2000. The closing of the 20 field offices and the severance and exit costs reduced salaries and operating expenses approximately $900,000 in 2001 as compared to 2000.

 

The provision for uncollectible notes receivable was $537,000 in 2001 compared to $4.2 million in 2000. Substantially all of the reserve at December 31, 2000 related to notes receivable with a related party franchisee, which was written off during 2001 without any additional impact on earnings.

 

Pre-opening and other general expenses increased to $3.5 million in 2001 from $2.2 million in 2000.  Pre-opening costs of $246,000, relocation costs of $906,000, impairment losses of $556,000 and net losses on restaurant and other asset dispositions of $555,000 were included in the 2001 amount. Pre-opening costs of $1.1 million, relocation costs of $1.3 million and net gains on restaurant and other asset dispositions of $200,000 were included in the 2000 amount. The 2001 amount also includes costs related to franchise support initiatives undertaken during 2001.

 

Depreciation and amortization was $35.2 million and $34.2 million in 2001 and 2000, respectively, or 3.6% of revenues for both years, including goodwill amortization of $2.8 million for 2001 and $2.9 million for 2000.

 

Net Interest.  Net interest expense was $6.9 million in 2001 compared to $5.8 million in 2000 due to an increase in the average debt balance outstanding for 2001 incurred by the Company to fund our share repurchase program, partially offset by lower effective interest rates. The average interest rate on our debt was 6.6% in 2001 compared to 7.1% in 2000.

 

Income Tax Expense. The effective income tax rate was 37.7% in 2001 compared to 38.3% in 2000 due primarily to effective state and local tax planning strategies.

 

Operating Income and Earnings per Common Share.  Operating income in 2001 was $82.8 million, or 8.5% of total revenues, compared to $57.4 million, or 6.0% of total revenues in 2000. The increase in 2001 operating income as a percentage of sales was principally due to the impact of the special charges recorded in 2000 ($20.9 million), a decrease in the provision for uncollectible notes receivable ($3.7 million), and a decrease in general and administrative expenses ($2.9 million). These increases in operating income were partially offset by a decrease in restaurant operating margin.

 

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Diluted earnings per share were $2.08 in 2001 compared to $1.28 in 2000. In December 1999, we began a repurchase program for our common stock. Through December 30, 2001, an aggregate of $217.3 million had been repurchased (representing 8.9 million shares, or approximately 29.1% of shares outstanding at the time the repurchase program was initiated, at an average price of $24.54 per share). The repurchase of our common shares resulted in an increase in diluted earnings per share of approximately $0.11 in 2001 as compared to 2000.

 

Liquidity and Capital Resources

 

Cash flow from operations was relatively consistent at $95.6 million in 2002 compared to $96.4 million in 2001, as unfavorable changes in inventory levels, due primarily to heated delivery bags, and deferred income taxes were substantially offset by favorable changes in accrued expenses, due primarily to insurance claims reserves, and other components of working capital.

 

Cash flow from operations for 2001 increased to $96.4 million from $76.7 million in 2000 due primarily to changes in deferred income taxes and other working capital, principally a reduction in inventory levels.

 

In January 2003, we entered into an agreement to extend our revolving line of credit facility (“New Line of Credit”). The New Line of Credit allows us to borrow up to $175.0 million with an expiration date in January 2006. Outstanding balances for the New Line of Credit accrue interest at 62.5 to 100.0 basis points over the London Interbank Offered Rate (LIBOR) or other bank developed rates at our option. The commitment fee on the unused balance ranges from 15.0 to 20.0 basis points. The increment over LIBOR and the commitment fee are determined quarterly based upon the ratio of total indebtedness to earnings before interest, taxes, depreciation and amortization (EBITDA).

 

We require capital primarily for the development, acquisition and maintenance of restaurants, new or replacement QC Centers and Support Services facilities, the enhancement of corporate systems and facilities and the funding of franchisee loans. Additionally, we began a common stock repurchase program in December 1999. During 2002, common stock repurchases of $128.4 million and capital expenditures of $18.8 million were primarily funded by cash flow from operations, net proceeds from the revolving line of credit facility, net loan repayments from franchisees, proceeds from stock option exercises and available cash and cash equivalents.

 

Total 2003 capital expenditures are expected to be approximately $25.0 million to $30.0 million, about one-half of which is for the development, relocation or remodeling of restaurants, including routine replacement of worn equipment, and about one-half of which is for QC Centers, Support Services and corporate requirements. During 2003, we plan to open approximately 10 new domestic Company-owned restaurants.

 

As of December 29, 2002, we had loans to franchisees of $14.1 million, net of allowance for doubtful accounts of $4.4 million. We do not have any additional loan funding commitments related to existing franchisee loans at December 29, 2002. We do not plan to extend loans to franchisees in the future.

 

The Board of Directors has authorized up to $375.0 million for the share repurchase program through December 28, 2003. At December 29, 2002, a total of 13.4 million shares have been repurchased for $345.7 million at an average price of $25.87 per share since the repurchase program started in 1999 (approximately 4.5 million shares in 2002, 1.2 million shares in 2001, 6.4 million shares in 2000 and 1.3 million shares in 1999). Subsequent to year-end (through March 14, 2003), we acquired an additional 150,000 shares at an aggregate cost of $4.1 million. As of March 14, 2003, approximately $25.2 million of common stock remains available for repurchase under this authorization.

 

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We expect to fund the planned capital expenditures and any additional share repurchases for the next twelve months from operating cash flow and any remaining availability under our New Line of Credit, reduced for outstanding letters of credit of $9.6 million.  Our debt, which is primarily due to the share repurchase program, was $140.1 million at December 29, 2002, compared to $105.3 million at December 30, 2001.

 

Through December 2002, we have earned approximately $8.3 million ($1.2 million in 2002, $1.1 million in 2001 and $6.0 million in previous years) of an expected $13.0 million in incentives under the Kentucky Jobs Development Act in connection with the relocation of the corporate offices. We expect to earn the remaining $4.7 million of such incentives through 2007.

 

Contractual obligations and payments as of December 29, 2002 due by year (reflecting the January 2003 New Line of Credit terms) are as follows (in thousands):

 

		Payments Due by Period
		Less than									After
		1 Year			1 - 3 Years			3 - 5 Years			5 Years			Total
Contractual Obligations:
Long-term debt		$	235		$	250		$	—		$	—		$	485
Revolving line of credit(1)		—			—			139,600			—			139,600
Total debt		235			250			139,600			—			140,085
Operating leases		21,622			35,459			21,473			22,598			101,152
Total contractual obligations		$	21,857		$	35,709		$	161,073		$	22,598		$	241,237

 

(1)    Excludes a fair value adjustment of $8.1 million included in other long-term liabilities in the consolidated balance sheet related to our interest rate collar and swap that hedge against the effects of rising interest rates on forecasted future borrowings.

 

We have certain other commercial commitments where payment is contingent upon the occurrence of certain events. Such commitments include the following by year (in thousands):

 

Amount of Commitment Expiration Per Period

Less than

After

1 Year

1 - 3 Years

3 - 5 Years

5 Years

Total

Other Commercial Commitments:

Standby letters of credit

$

9,568

$

—

$

—

$

—

$

9,568

 

See “Notes 8, 11 and 15” of “Notes to Consolidated Financial Statements” for additional information related to contractual and other commitments.

 

Impact of Inflation

 

We do not believe inflation has materially affected earnings during the past three years. Substantial increases in costs, particularly commodities, labor, benefits, utilities and fuel, could have a significant impact on us.

 

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Forward-Looking Statements

 

Certain information contained in this annual report, particularly information regarding future financial performance and plans and objectives of management, is forward-looking. Certain factors could cause actual results to differ materially from those expressed in forward-looking statements. These factors include, but are not limited to, the selection and availability of suitable restaurant locations; increases in commodities, labor and insurance costs; negotiation of suitable lease or financing terms; constraints on permitting and construction of restaurants; higher than anticipated construction costs; the hiring, training and retention of management and other personnel; changes in pricing or other marketing or promotional strategies of one or more of our major competitors; changes in consumer taste, demographic trends, traffic patterns and the type, number and location of competing restaurants; and federal and state laws governing such matters as wages, working conditions, citizenship requirements and overtime. These factors might be especially harmful to the financial viability of franchisees in under-penetrated or emerging markets, possibly leading to greater unit closings than anticipated. Our domestic and international operations could be negatively impacted by significant changes in international economic and political conditions. In addition, our international operations are subject to additional factors, including currency regulations and fluctuations; differing cultures and consumer preferences; diverse government regulations and structures; availability and cost of land and construction; ability to source high quality ingredients and other commodities in a cost-effective manner; differing interpretation of the obligations established in franchise agreements with international franchisees; and the successful conversion of Perfect Pizza restaurants to Papa John’s restaurants.

 

Item 7A.  Quantitative and Qualitative Disclosures about Market Risk

 

Our debt at December 29, 2002 is principally comprised of a $139.6 million outstanding principal balance on the $200.0 million unsecured revolving line of credit. The interest rate on the revolving line of credit is variable and is based on LIBOR plus a 50 to 87.5 basis point spread, tiered based upon debt and cash flow levels. The interest rate on the revolving line of credit was 2.04% as of December 29, 2002. In March 2000, we entered into a $100.0 million interest rate collar, which was effective until March 2003. The collar established a 6.36% floor and a 9.50% ceiling on the LIBOR base rate on a no-fee basis. As a result of the collar, the effective interest rate on the line of credit was 5.58% as of December 29, 2002. An increase in the interest rate of 100 basis points on the debt balance outstanding as of December 29, 2002, as mitigated by the interest rate collar based on present interest rates, would increase interest expense approximately $396,000 annually.

 

During 2001, we entered into an interest rate swap agreement that provides for a fixed rate of 5.31%, as compared to LIBOR, on $100.0 million of floating rate debt from March 2003 to March 2004, reducing to a notional value of $80.0 million from March 2004 to March 2005, and reducing to a notional value of $60.0 million in March 2005 with an expiration date of March 2006. Accordingly, in connection with the expiration of the interest rate collar and initiation of the interest rate swap in March 2003, interest expense on the first $100 million of outstanding debt will decrease approximately $1.0 million on an annualized basis. Additionally, in March 2003, an increase in the interest rate of 100 basis points, as mitigated by the interest rate swap, would have the same impact on interest expense as that noted in connection with the interest rate collar as of December 29, 2002, assuming similar debt balances.

 

Substantially all of our business is transacted in U.S. dollars. Accordingly, foreign exchange rate fluctuations do not have a significant impact on the Company.

 

Cheese costs, historically representing 35% to 40% of our total food cost, are subject to seasonal fluctuations, weather, availability, demand and other factors that are beyond our control. We have a purchasing arrangement with a third-party entity (BIBP) formed at the direction of our Franchise

 

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Advisory Council for the sole purpose of reducing cheese price volatility. Under this arrangement, we are able to purchase cheese at a fixed price per pound throughout a given quarter, based in part on historical average cheese prices. Gains and losses incurred by the selling entity are used as a factor in determining adjustments to the selling price over time. As a result, for any given quarter, the established price paid by the Company may be less than or greater than the prevailing average market price. Over the long term, we expect to purchase cheese at a price approximating the actual average market price, with less short-term volatility. The average quarterly block market price and the equivalent block market price paid by Papa John’s by quarter for 2002, 2001 and 2000 are as follows:

 

 

See “Note 3” of “Notes to Consolidated Financial Statements” for further information.

 

We do not generally make use of financial instruments to hedge commodity prices, in part because of the purchasing arrangement with BIBP.

 

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Item 8.  Financial Statements and Supplementary Data

 

Papa John’s International, Inc. and Subsidiaries

Consolidated Statements of Income

 

(In thousands, except per share amounts)		Year Ended
		December 29, 2002			December 30, 2001			December 31, 2000
Domestic revenues:
Restaurant sales		$	429,813		$	445,849		$	456,637
Franchise royalties		51,386			50,768			47,145
Franchise and development fees		1,734			2,927			5,559
Commissary sales		381,217			390,889			356,101
Equipment and other sales		50,055			52,730			53,233
International revenues:
Royalties and franchise and development fees		5,846			5,895			5,302
Restaurant and commissary sales		26,168			26,014			25,546
Total revenues		946,219			975,072			949,523
Costs and expenses:
Domestic restaurant expenses:
Cost of sales		98,717			110,632			111,609
Salaries and benefits		125,473			130,882			127,318
Advertising and related costs		35,810			35,297			41,729
Occupancy costs		23,571			25,326			23,248
Other operating expenses		56,517			60,721			65,074
		340,088			362,858			368,978
Domestic commissary, equipment and other expenses:
Cost of sales		309,021			323,954			304,338
Salaries and benefits		29,823			30,124			27,682
Other operating expenses		49,831			44,893			35,582
		388,675			398,971			367,602
International operating expenses		21,918			21,739			21,700
General and administrative expenses		72,403			69,487			72,402
Special charges		—			—			20,922
Provision for uncollectible notes receivable		2,838			537			4,200
Pre-opening and other general expenses		7,129			3,521			2,158
Depreciation and amortization		31,741			35,176			34,172
Total costs and expenses		864,792			892,289			892,134
Operating income		81,427			82,783