UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

(Mark One)

 

ý	Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended March 27, 2005
OR
o	Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

Commission File Number:  0-21660

 

PAPA JOHN’S INTERNATIONAL, INC.

(Exact name of registrant as specified in its charter)

 

 

2002 Papa Johns Boulevard
Louisville, Kentucky 40299-2334

(Address of principal executive offices)

 

(502) 261-7272

(Registrant’s telephone number, including area code)

 

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

 

Yes ý

No o

 

At April 29, 2005, there were outstanding 16,567,833 shares of the registrant’s common stock, par value $.01 per share.

 

 

INDEX

 

PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets – March 27, 2005 and December 26, 2004
	Consolidated Statements of Income – Three Months Ended March 27, 2005 and March 28, 2004
	Consolidated Statements of Stockholders’ Equity – Three Months Ended March 27, 2005 and March 28, 2004
	Consolidated Statements of Cash Flows – Three Months Ended March 27, 2005 and March 28, 2004
	Notes to Condensed Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds
Item 6.	Exhibits

 

1

 

PART I.  FINANCIAL INFORMATION

Item 1. Financial Statements

 

Papa John’s International, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

 

(In thousands)		March 27, 2005			December 26, 2004
		(Unaudited)			(Note)
Assets
Current assets:
Cash and cash equivalents		$	14,105		$	14,698
Accounts receivable		24,739			28,384
Inventories		22,444			23,230
Prepaid expenses and other current assets		12,980			15,208
Deferred income taxes		8,569			7,624
Total current assets		82,837			89,144
Investments		8,344			8,552
Net property and equipment		193,275			197,103
Notes receivable from franchisees and affiliates		6,555			6,828
Deferred income taxes		6,046			6,117
Goodwill		51,071			51,071
Other assets		15,130			15,672
Total assets		$	363,258		$	374,487
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable		$	26,915		$	35,934
Income and other taxes		22,324			17,270
Accrued expenses		46,144			44,771
Current portion of debt		84,445			15,709
Total current liabilities		179,828			113,684
Unearned franchise and development fees		7,865			8,208
Long-term debt, net of current portion		—			78,521
Other long-term liabilities		33,131			34,851
Stockholders’ equity:
Preferred stock		—			—
Common stock		327			325
Additional paid-in capital		248,343			242,656
Accumulated other comprehensive loss		(66		)	(555		)
Retained earnings		327,107			317,142
Treasury stock		(433,277		)	(420,345		)
Total stockholders’ equity		142,434			139,223
Total liabilities and stockholders’ equity		$	363,258		$	374,487

 

Note:                   The balance sheet at December 26, 2004 has been derived from the audited consolidated financial statements at that date but does not include all information and footnotes required by accounting principles generally accepted in the United States for a complete set of financial statements.

 

See accompanying notes.

 

2

 

Papa John’s International, Inc. and Subsidiaries

Consolidated Statements of Income

(Unaudited)

 

		Three Months Ended
(In thousands, except per share amounts)		March 27, 2005			March 28, 2004
Domestic revenues:
Company-owned restaurant sales		$	110,714		$	106,173
Variable interest entities restaurant sales		5,167			—
Franchise royalties		13,365			12,911
Franchise and development fees		703			534
Commissary sales		100,912			94,536
Other sales		13,392			14,724
International revenues:
Royalties and franchise and development fees		2,122			1,764
Restaurant and commissary sales		5,999			6,267
Total revenues		252,374			236,909
Costs and expenses:
Domestic Company-owned restaurant expenses:
Cost of sales		25,240			25,859
Salaries and benefits		34,139			33,519
Advertising and related costs		9,611			9,447
Occupancy costs		6,600			6,401
Other operating expenses		14,066			13,643
Total domestic Company-owned restaurant expenses		89,656			88,869
Variable interest entities restaurant expenses		4,612			—
Domestic commissary and other expenses:
Cost of sales		82,428			78,797
Salaries and benefits		7,454			7,179
Other operating expenses		14,170			14,237
Total domestic commissary and other expenses		104,052			100,213
Loss from the franchise cheese-purchasing program, net of minority interest		1,009			372
International operating expenses		5,035			5,202
General and administrative expenses		21,728			18,534
Provision for uncollectible notes receivable		85			232
Restaurant closure, impairment and disposition losses		119			139
Other general expenses		1,762			953
Depreciation and amortization		7,374			7,561
Total costs and expenses		235,432			222,075
Operating income		16,942			14,834
Investment income		377			141
Interest expense		(1,502		)	(1,397		)
Income before income taxes		15,817			13,578
Income tax expense		5,852			5,092
Net income		$	9,965		$	8,486
Basic earnings per common share		$	0.60		$	0.48
Earnings per common share - assuming dilution		$	0.59		$	0.47
Basic weighted average shares outstanding		16,589			17,833
Diluted weighted average shares outstanding		16,782			18,149

 

See accompanying notes.

 

3

 

Papa John’s International, Inc. and Subsidiaries

Consolidated Statements of Stockholders’ Equity

(Unaudited)

 

(In thousands)		Common Stock Shares Outstanding		Common Stock			Additional Paid-In Capital			Accumulated Other Comprehensive Income (Loss)			Retained Earnings			Treasury Stock			Total Stockholders’ Equity
Balance at December 28, 2003		18,113		$	317		$	219,584		$	(3,116	)	$	293,921		$	(351,434	)	$	159,272
Comprehensive income:
Net income		—		—			—			—			8,486			—			8,486
Change in valuation of interest rate swap agreement, net of tax of $124		—		—			—			203			—			—			203
Other, net		—		—			—			77			—			—			77
Comprehensive income																			8,766
Exercise of stock options		363		4			9,532			—			—			—			9,536
Tax benefit related to exercise of non-qualified stock options		—		—			1,162			—			—			—			1,162
Acquisition of treasury stock		(728	)	—			—			—			—			(24,558		)	(24,558		)
Other		—		—			560			—			—			—			560
Balance at March 28, 2004		17,748		$	321		$	230,838		$	(2,836	)	$	302,407		$	(375,992	)	$	154,738
Balance at December 26, 2004		16,730		$	325		$	242,656		$	(555	)	$	317,142		$	(420,345	)	$	139,223
Comprehensive income:
Net income		—		—			—			—			9,965			—			9,965
Change in valuation of interest rate swap agreement, net of tax of $334		—		—			—			520			—			—			520
Other, net		—		—			—			(31		)	—			—			(31		)
Comprehensive income																			10,454
Issuance of common stock from treasury stock		27		—			—			—			—			1,000			1,000
Exercise of stock options		186		2			5,223			—			—			—			5,225
Tax benefit related to exercise of non-qualified stock options		—		—			251			—			—			—			251
Acquisition of treasury stock		(403	)	—			—			—			—			(13,932		)	(13,932		)
Other		—		—			213			—			—			—			213
Balance at March 27, 2005		16,540		$	327		$	248,343		$	(66	)	$	327,107		$	(433,277	)	$	142,434

 

At March 28, 2004, the accumulated other comprehensive loss of $2,836 was comprised of net unrealized loss on the interest rate swap agreement of $2,995, net unrealized loss on investments of $27 and unrealized foreign currency translation gains of $186.

 

At March 27, 2005, the accumulated other comprehensive loss of $66 was comprised of net unrealized loss on the interest rate swap agreement of $444, offset by unrealized foreign currency translation gains of $378.

 

See accompanying notes.

 

4

 

Papa John’s International, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

 

		Three Months Ended
(In thousands)		March 27, 2005			March 28, 2004
Operating activities
Net income		$	9,965		$	8,486
Adjustments to reconcile net income to net cash provided by operating activities:
Restaurant closure, impairment and disposition losses		119			139
Provision for uncollectible accounts and notes receivable		593			851
Depreciation and amortization		7,374			7,561
Deferred income taxes		(1,221		)	159
Tax benefit related to exercise of non-qualified stock options		251			1,162
Other		394			844
Changes in operating assets and liabilities:
Accounts receivable		2,545			(3,900		)
Inventories		785			923
Prepaid expenses and other current assets		2,229			289
Other assets and liabilities		(593		)	(4,723		)
Accounts payable		(9,019		)	(4,708		)
Income and other taxes		5,054			1,603
Accrued expenses		1,440			1,546
Unearned franchise and development fees		(343		)	871
Net cash provided by operating activities		19,573			11,103
Investing activities
Purchase of property and equipment		(3,356		)	(4,378		)
Proceeds from sale of property and equipment		5			15
Purchase of investments		(3,443		)	(1,014		)
Proceeds from sale or maturity of investments		3,680			995
Loans to franchisees and affiliates		(1,260		)	—
Loan repayments from franchisees and affiliates		450			1,573
Net cash used in investing activities		(3,924		)	(2,809		)
Financing activities
Net proceeds (repayments) from line of credit facility		(10,300		)	6,500
Net proceeds from short-term debt - variable interest entities		2,150			2,400
Payments on long-term debt		—			(250		)
Proceeds from issuance of common stock from treasury stock		1,000			—
Proceeds from exercise of stock options		5,225			9,536
Acquisition of treasury stock		(13,932		)	(24,558		)
Other		(331		)	(236		)
Net cash used in financing activities		(16,188		)	(6,608		)
Effect of exchange rate changes on cash and cash equivalents		(54		)	85
Change in cash and cash equivalents		(593		)	1,771
Cash resulting from consolidation of variable interest entities		—			203
Cash and cash equivalents at beginning of period		14,698			7,071
Cash and cash equivalents at end of period		$	14,105		$	9,045

 

See accompanying notes.

 

5

 

Papa John’s International, Inc. and Subsidiaries

 

Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

March 27, 2005

 

1.              Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Operating results for the three months ended March 27, 2005, are not necessarily indicative of the results that may be expected for the year ended December 25, 2005. For further information, refer to the consolidated financial statements and footnotes thereto included in the Annual Report on Form 10-K for Papa John’s International, Inc. (referred to as the “Company”, “Papa John’s” or in the first person notations of “we”, “us” and “our”) for the year ended December 26, 2004.

 

2.              Accounting for Variable Interest Entities

 

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (FIN 46). FIN 46 provides a framework for identifying variable interest entities (“VIEs”) and determining when a company should include the assets, liabilities, noncontrolling interests and results of activities of a VIE in its consolidated financial statements.

 

In general, a VIE is a corporation, partnership, limited-liability corporation, trust, or any other legal structure used to conduct activities or hold assets that either (1) has an insufficient amount of equity to carry out its principal activities without additional subordinated financial support, (2) has a group of equity owners that are unable to make significant decisions about its activities, or (3) has a group of equity owners that do not have the obligation to absorb losses or the right to receive returns generated by its operations.

 

FIN 46 requires a VIE to be consolidated if a party with an ownership, contractual or other financial interest in the VIE (“a variable interest holder”) is obligated to absorb a majority of the risk of loss from the VIEs activities, is entitled to receive a majority of the VIEs residual returns (if no party absorbs a majority of the VIEs losses), or both. A variable interest holder that consolidates the VIE is called the primary beneficiary. Upon consolidation, the primary beneficiary generally must initially record all of the VIEs assets, liabilities and noncontrolling interests at fair value and subsequently account for the VIE as if it were consolidated based on majority voting interest. FIN 46 also requires disclosures about VIEs that the variable interest holder is not required to consolidate but in which it has a significant variable interest.

 

We have a purchasing arrangement with BIBP Commodities, Inc. (“BIBP”), a special purpose entity formed at the direction of our Franchise Advisory Council in 1999, for the sole purpose of reducing cheese price volatility to domestic system-wide restaurants. BIBP is an independent, franchisee-owned corporation. 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 (both Company-owned and franchised) at a set quarterly price. PJFS purchased $37.9 million and $32.9 million of cheese from BIBP for the three months ended March 27, 2005 and March 28, 2004, respectively.

 

As defined by FIN 46, we are the primary beneficiary of BIBP, a VIE, and we began consolidating the balance sheet of BIBP as of December 28, 2003. We recognize the operating losses generated by BIBP if BIBP’s shareholders’ equity is in a net deficit position. Further, we will recognize the subsequent operating income generated by BIBP up to the amount of any losses previously recognized. We recognized pre-tax losses of $1.6 million ($1.0 million net of tax, or $0.06 per share) in the first quarter of 2005 and $1.6 million ($1.0 million net of tax, or $0.05 per share) for the comparable period in 2004 from the consolidation of BIBP. The impact on future operating income from the consolidation of BIBP is expected to continue to be significant for any given reporting period due to the noted volatility of the cheese market, but is not expected to be cumulatively significant over time.

 

BIBP has a $20.0 million line of credit with a commercial bank. The $20.0 million line of credit is not guaranteed by Papa John’s. If the line of credit is substantially utilized, Papa John’s will provide additional funding in the form of a loan to

 

6

 

BIBP. As of March 27, 2005, BIBP had outstanding borrowings of $16.2 million under the commercial bank facility and $10.0 million under the line of credit from Papa John’s (the $10.0 million outstanding balance under the line of credit is eliminated upon consolidation of the financial results of BIBP with Papa Johns).

 

In addition, Papa John’s has extended loans to certain franchisees. Under FIN 46, Papa John’s is deemed the primary beneficiary of four of these franchise entities even though we have no ownership interest in them. These entities operate a total of 33 restaurants with annual revenues approximating $20.0 million. Our net loan balance receivable from these four entities is $5.1 million at March 27, 2005, with no further funding commitments. The consolidation of these entities resulted in the recording of goodwill approximating $2.8 million and the elimination of the $5.1 million net loan balance receivable. The consolidation of these four franchise entities has had no significant impact on Papa John’s operating results and is not expected to be significant in future periods.

 

The following table summarizes the balance sheets for our consolidated VIEs as of March 27, 2005 and December 26, 2004:

 

		March 27, 2005									December 26, 2004
(In thousands)		BIBP			Franchisees			Total			BIBP			Franchisees			Total
Assets:
Cash and cash equivalents		$	1,554		$	77		$	1,631		$	1,666		$	115		$	1,781
Accounts receivable		—			37			37			—			59			59
Accounts receivable - Papa John’s		3,423			—			3,423			6,484			—			6,484
Other assets		984			542			1,526			193			594			787
Net property and equipment		—			3,720			3,720			—			3,794			3,794
Goodwill		—			2,752			2,752			—			2,752			2,752
Deferred income taxes		9,406			—			9,406			8,817			—			8,817
Total assets		$	15,367		$	7,128		$	22,495		$	17,160		$	7,314		$	24,474
Liabilities and stockholders’ equity (deficit):
Accounts payable and accrued expenses		$	4,849		$	1,345		$	6,194		$	7,777		$	1,260		$	9,037
Short-term debt - third party		16,225			—			16,225			14,075			1,634			15,709
Short-term debt - Papa John’s		10,000			5,058			15,058			10,000			3,575			13,575
Total liabilities		$	31,074		$	6,403		$	37,477		$	31,852		$	6,469		$	38,321
Stockholders’ equity (deficit)		(15,707		)	725			(14,982		)	(14,692		)	845			(13,847		)
Total liabilities and stockholders’ equity (deficit)		$	15,367		$	7,128		$	22,495		$	17,160		$	7,314		$	24,474

 

Effective at the beginning of second quarter of 2005, one of these franchisees, with 19 restaurants and annual revenues approximating $12.0 million, sold its restaurants to a third party. The loan from Papa John’s was partially repaid and the remainder was written off in connection with the sale. Accordingly, beginning in second quarter of 2005, we will no longer be required to consolidate the operating results of these 19 restaurants. The portion of the loan written off in connection with the second quarter sale was fully reserved as of the end of the first quarter. The sale of these restaurants and related loan write-off will not have any significant impact on Papa John’s consolidated financial statements.

 

7

 

3.              Debt

 

Our debt is comprised of the following (in thousands):

 

		March 27, 2005			December 26, 2004
Revolving line of credit		$	68,200		$	78,500
Debt associated with VIEs *		16,225			15,709
Other		20			21
Total debt		84,445			94,230
Less: current portion of debt		(84,445		)	(15,709		)
Long-term debt		$	—		$	78,521

 

*The VIEs’ third-party creditors do not have any recourse to Papa John’s.

 

The $68.2 million outstanding balance under the line of credit is classified as a current liability as of March 27, 2005 since the line of credit expires in January 2006. We do not anticipate any problems in renewing the line of credit.

 

4.              Calculation of Earnings Per Share

 

The calculations of basic earnings per common share and earnings per common share – assuming dilution are as follows (in thousands, except per share data):

 

		Three Months Ended
		March 27, 2005			March 28, 2004
Basic earnings per common share:
Net income		$	9,965		$	8,486
Weighted average shares outstanding		16,589			17,833
Basic earnings per common share		$	0.60		$	0.48
Earnings per common share - assuming dilution:
Net income		$	9,965		$	8,486
Weighted average shares outstanding		16,589			17,833
Dilutive effect of outstanding common stock options		193			316
Diluted weighted average shares outstanding		16,782			18,149
Earnings per common share - assuming dilution		$	0.59		$	0.47

 

5.              Stock-Based Compensation

 

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 Statement of Financial Accounting Standards (SFAS) No. 123, Accounting and Disclosure of Stock-Based Compensation. Under SFAS No. 123, the fair value for options is estimated at the date of grant using a Black-Scholes-Merton (“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.

 

In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment, which is a revision of FASB Statement No. 123. We expect to continue using the Black-Scholes option pricing model upon the required adoption of SFAS No. 123(R) at the beginning of fiscal 2006. If we had adopted SFAS No. 123 (R) in prior years, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net income and earnings per share in the table which follows. SFAS No. 123(R) also requires the benefit of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after the adoption.

 

8

 

While we cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of the tax deductions recognized from the exercise of stock options in operating cash flows for the three months ended March 27, 2005 and March 28, 2004 were $251,000 and $1.2 million, respectively.

 

The following table illustrates the effect on income and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period:

 

		Three Months Ended
(In thousands, except per share data)		March 27, 2005			March 28, 2004
Net income (as reported)		$	9,965		$	8,486
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		144			350
Deduct: Stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects		(147		)	(353		)
Pro forma net income		$	9,962		$	8,483
Earnings per share:
Basic - as reported		$	0.60		$	0.48
Basic - pro forma		$	0.60		$	0.48
Assuming dilution - as reported		$	0.59		$	0.47
Assuming dilution - pro forma		$	0.59		$	0.47

 

6.              Segment Information

 

We have defined five reportable segments: domestic restaurants, domestic commissaries, domestic franchising, international operations and variable interest entities (VIEs).

 

The domestic restaurant segment consists of the operations of all domestic (“domestic” is defined as contiguous United States) Company-owned restaurants and derives its revenues principally from retail sales of pizza and side items, such as breadsticks, cheesesticks, chicken strips, chicken wings and soft drinks to the general public. The domestic commissary segment consists of the operations of our regional dough production and product distribution centers and derives its revenues principally from the sale and distribution of food and paper products to domestic Company-owned and franchised restaurants. The domestic franchising segment consists of our franchise sales and support activities and derives its revenues from sales of franchise and development rights and collection of royalties from our domestic franchisees. The international operations segment principally consists of our Company-owned restaurants and commissary operation located in the United Kingdom and our franchise sales and support activities, which derive revenues from sales of franchise and development rights and the collection of royalties from our international franchisees. VIEs consist of entities in which we are the primary beneficiary, as defined in Note 2, and include BIBP and certain franchisees to which we have extended loans. All other business units that do not meet the quantitative thresholds for determining reportable segments consist of operations that derive revenues from the sale, principally to Company-owned and franchised restaurants, of printing and promotional items, risk management services, and information systems and related services used in restaurant operations.

 

Generally, we evaluate performance and allocate resources based on profit or loss from operations before income taxes and eliminations. Certain administrative and capital costs are allocated to segments based upon predetermined rates or actual estimated resource usage. We account for intercompany sales and transfers as if the sales or transfers were to third parties and eliminate the related profit in consolidation.

 

Our reportable segments are business units that provide different products or services. Separate management of each segment is required because each business unit is subject to different operational issues and strategies. No single external customer accounted for 10% or more of our consolidated revenues.

 

9

 

Our segment information is as follows:

 

		Three Months Ended
(In thousands)		March 27, 2005			March 28, 2004
Revenues from external customers:
Domestic Company-owned restaurants		$	110,714		$	106,173
Domestic commissaries		100,912			94,536
Domestic franchising		14,068			13,445
International		8,121			8,031
Variable interest entities (1)		5,167			—
All others		13,392			14,724
Total revenues from external customers		$	252,374		$	236,909
Intersegment revenues:
Domestic commissaries		$	32,384		$	29,133
Domestic franchising		298			194
International		44			66
Variable interest entities (1)		37,867			32,947
All others		3,092			3,348
Total intersegment revenues		$	73,685		$	65,688
Income (loss) before income taxes:
Domestic Company-owned restaurants (2)		$	4,557		$	1,935
Domestic commissaries (3)		6,952			5,545
Domestic franchising		12,807			11,837
International		44			216
Variable interest entities (1)		(1,595		)	(1,645		)
All others		787			607
Unallocated corporate expenses (4)		(7,678		)	(4,907		)
Elimination of intersegment (profits) losses		(57		)	(10		)
Total income before income taxes		$	15,817		$	13,578
Property and equipment:
Domestic Company-owned restaurants		$	146,062
Domestic commissaries		74,742
International		2,780
Variable interest entities (5)		6,693
All others		12,041
Unallocated corporate assets		117,753
Accumulated depreciation and amortization		(166,796		)
Net property and equipment		$	193,275

 

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(1)          The revenues from external customers for variable interest entities are attributable to the four franchise entities to which we have extended loans that qualify as consolidated VIEs.  The intersegment revenues for variable interest entities of $37.9 million in 2005 and $32.9 million in 2004 and the income (loss) before income taxes for variable interest entities of losses of $1.6 million in both 2005 and 2004 are attributable to BIBP.

 

(2)          The operating results for domestic Company-owned restaurants improved $2.6 million in the first quarter of 2005 as compared to the same period of the prior year. The improved operating results are primarily attributable to the fixed cost leverage associated with increased comparable sales for the first quarter of 3.9% and improved margin from an increase in restaurant pricing, partially offset by increased commodity costs (principally cheese).

 

(3)          The 2005 results for the domestic commissaries segment improved $1.4 million due to an increased operating margin from product cost savings and lower administrative costs.  The improvement in the commissary operating results was partially offset by a $925,000 pre-tax charge associated with the closing of the Jackson, Mississippi commissary.

 

(4)          The increase in 2005 unallocated corporate expenses from 2004 is primarily due to a $1.6 million increase in bonuses to business unit and corporate management for meeting pre-established performance goals and increased professional fees, the majority of which related to consulting expenses associated with a project to improve the effectiveness and profitability of our franchisees.

 

(5)          Represents assets of VIE franchisees to which we have extended loans.

 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

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 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.

 

Allowance for Doubtful Accounts and Notes Receivable

 

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. These reserves and corresponding write-offs could significantly increase if the identified franchisees continue to experience deteriorating financial results.

 

Long-Lived and Intangible Assets

 

The recoverability of long-lived assets is evaluated annually or more frequently if impairment indicators exist.  Indicators of impairment include historical financial performance, operating trends and our future operating plans.  If impairment indicators exist, we evaluate the recoverability of long-lived assets on an operating unit basis (e.g., an individual restaurant) based on undiscounted expected future cash flows before interest for the expected remaining useful life of the operating unit. Recorded values for long-lived assets 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.

 

The recoverability of intangible assets (i.e., goodwill) is evaluated annually, or more frequently if impairment indicators exist, on a reporting unit basis by comparing the fair value derived from discounted cash flows of the reporting unit to its carrying value.

 

At March 27, 2005, we had a net investment of approximately $28.0 million associated with PJUK, our United Kingdom subsidiary, which was substantially composed of goodwill associated with our acquisition of the subsidiary. PJUK has reported deteriorating operating results for the past two years primarily due to lower sales by Perfect Pizza restaurants and a decrease in net franchise units due to restaurant closings. We have developed plans for PJUK to improve its operating results, which include an anticipated increase in net franchise unit openings over the next several years. While our analyses to date do not indicate an impairment of our investment in PJUK has occurred, if these plans are not successful and operating results continue to deteriorate, we may be required to record a significant impairment charge associated with our United Kingdom subsidiary.

 

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Insurance Reserves

 

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. Losses are accrued based upon estimates of the aggregate retained liability for claims incurred using certain third-party 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 used to estimate the insurance reserves recorded by the Company.

 

Effective October 2004, a third party commercial insurance company began providing fully-insured coverage to franchisees participating in the franchise insurance program and we ceased providing new coverage via our captive insurance subsidiary. Accordingly, this new arrangement eliminates our risk of loss for franchise insurance coverage written after September 2004. Our operating income will still be subject to potential adjustments for changes in estimated insurance reserves for policies written from October 2000 to September 2004. Such adjustments, if any, will be determined in part based upon semi-annual actuarial valuations.

 

Consolidation of BIBP Commodities, Inc. (“BIBP”) as a Variable Interest Entity

 

BIBP is a franchisee-owned corporation that conducts a cheese-purchasing program on behalf of domestic Company-owned and franchised restaurants. As required by the Financial Accounting Standards Board’s (“FASB”) Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (FIN 46), we began consolidating the financial results of BIBP in the fourth quarter of 2003. We recognized pre-tax losses of approximately $1.6 million for both the three months ended March 27, 2005 and March 28, 2004 from the consolidation of BIBP. We expect the consolidation of BIBP to continue to have a significant impact on Papa John’s operating income in future periods due to the volatility of cheese prices. Papa John’s will recognize the operating losses generated by BIBP if the shareholders’ equity of BIBP is in a net deficit position. Further, Papa John’s will recognize subsequent operating income generated by BIBP up to the amount of BIBP losses previously recognized by Papa John’s.

 

Deferred Income Tax Assets and Tax Reserves

 

As of March 27, 2005, the Company had a net deferred income tax asset balance of $14.6 million, of which approximately $9.4 million relates to BIBP’s net operating loss carryforward. We have not provided a valuation allowance for the deferred income tax assets, including BIBP’s net operating losses, since we believe it is more likely than not that the Company’s future earnings will be sufficient to ensure the realization of the net deferred income tax assets for federal and state purposes.

 

Certain tax authorities periodically audit the Company. We provide reserves for potential exposures when we consider it probable that a taxing authority may take a sustainable position on a matter contrary to our filed position. We evaluate these issues on a quarterly basis to adjust for events, such as court rulings or audit settlements, that may impact our ultimate payment for such exposures.

 

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Restaurant Progression:

 

		Three Months Ended
		March 27, 2005		March 28, 2004
Papa John’s Restaurant Progression:
U.S. Company-owned:
Beginning of period		568		568
Opened		1		2
Closed		—		(2	)
End of period		569		568
International Company-owned:
Beginning of period		1		2
End of period		1		2
U.S. franchised:
Beginning of period		1,997		2,006
Opened		23		20
Closed		(19	)	(9	)
End of period		2,001		2,017
International franchised:
Beginning of period		263		214
Opened		16		12
Closed		(5	)	(4	)
End of period		274		222
Total restaurants — end of period		2,845		2,809
Perfect Pizza Restaurant Progression:
Franchised:
Beginning of period		118		135
Opened		1		—
Closed		(5	)	(8	)
Total restaurants - end of period		114		127

 

Results of Operations

 

Variable Interest Entities

 

As required by FIN 46, beginning in 2004, our operating results include the operating results of BIBP. The consolidation of BIBP had a significant impact on the first quarter of 2005 and the first quarter and full-year 2004 operating results, and is expected to have a significant ongoing impact on our future operating results and income statement presentation as described below.

 

Consolidation accounting requires the net impact from the consolidation of BIBP to be reflected primarily in three separate components of our statement of income. The first component is the portion of BIBP operating income or loss attributable to the amount of cheese purchased by Company-owned restaurants during the period. This portion of BIBP operating income (loss) is reflected as a reduction (increase) in the “Domestic Company-owned restaurant expenses - cost of sales” line item. This approach effectively reports cost of sales for Company-owned restaurants as if the purchasing arrangement with BIBP did not exist and such restaurants were purchasing cheese at the spot market prices (i.e., the impact of BIBP is eliminated in consolidation).

 

The second component of the net impact from the consolidation of BIBP is reflected in the caption “Loss (income) from the franchise cheese-purchasing program, net of minority interest.” This line item represents BIBP’s income or loss from purchasing cheese at the spot market price and selling to franchised restaurants at a fixed quarterly price, net of any income or loss attributable to the minority interest BIBP shareholders. The amount of income or loss attributable to the BIBP shareholders depends on its cumulative shareholders’ equity balance and the change in such balance during the reporting period.  The third component is reflected as investment income or interest expense depending upon whether BIBP is in a net investment or net borrowing position during the reporting period.

 

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