Papa John's Pizza - 10-Q quarterly report FY

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x                              Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2007

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 40299-2367

(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  x      No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):  Yes  o      No  x

At October 31, 2007, there were outstanding 28,693,780 shares of the registrant’s common stock, par value $0.01 per share.

Papa John’s International, Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited)

September 30, 2007

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 nine months ended September 30, 2007 are not necessarily indicative of the results that may be expected for the fiscal year ended December 30, 2007. 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 31, 2006.

2.              Accounting for Uncertainty in Income Taxes (FIN 48)

The Company adopted the provisions of the Financial Accounting Standards Board (“FASB”) Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48), on January 1, 2007. FIN 48 addresses the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. In addition, FIN 48 expands the disclosure requirements concerning unrecognized tax benefits as well as any significant changes that may occur in the next twelve months associated with such unrecognized tax benefits.  As a result of the implementation of FIN 48, the Company recognized an approximate $614,000 decrease in the liability for unrecognized tax benefits, which is accounted for as an increase to the January 1, 2007 balance of retained earnings. As of the adoption date, we had tax affected unrecognized benefits of approximately $9.6 million. To the extent these unrecognized tax benefits are ultimately recognized, the effective tax rate will be impacted in a future period.

The Company files income tax returns in the U.S. federal jurisdiction and various states and foreign jurisdictions. The Company, with few exceptions, is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2003.  During the third quarter of 2007, the Company recognized a $1.5 million decrease in the liability for unrecognized tax benefits and a decrease of income tax expense due to the expiration of certain statutes of limitations for previously filed tax returns. The Company is currently undergoing examinations by various state and local tax authorities.  The Company anticipates that the finalization of these current examinations and other issues will result in a decrease in the liability for unrecognized tax benefits (and a decrease of income tax expense) of approximately $624,000 during the next 12 months.

The Company recognizes interest accrued and penalties related to unrecognized tax benefits as a part of income tax expense.  The Company recognized interest expense of $129,000 and $110,000 for the three months ended September 30, 2007 and September 24, 2006, respectively, and $410,000 and $487,000 for the nine months ended September 30, 2007 and September 24, 2006, respectively. The Company had approximately $2.1 million and $2.5 million for the payment of interest and penalties accrued at September 30, 2007 and December 31, 2006, respectively.

6

3.              Acquisitions

During the first quarter of 2007, we completed the acquisition of six restaurants located in Pennsylvania, Texas and Oklahoma.  The purchase price for these restaurants totaled $1.2 million, which was paid in cash, of which approximately $779,000 was recorded as goodwill.

During the second quarter, we completed the acquisition of 13 restaurants in Georgia.  The purchase price for these restaurants totaled $7.4 million, which was paid in cash, of which approximately $6.4 million was recorded as goodwill.

During the third quarter, we acquired 31 restaurants located in Missouri and Kansas.  The purchase price for these restaurants totaled $10.3 million, which was paid in cash, of which approximately $7.2 million was recorded as goodwill. Also in the third quarter, we acquired 11 restaurants located in the Washington, D.C. area. The purchase price for these restaurants was $6.1 million, which was paid in cash, of which $4.7 million of the purchase price was recorded as goodwill.

The acquisitions described in the previous paragraphs were accounted for by the purchase method of accounting, whereby operating results subsequent to the acquisition dates are included in our consolidated financial results.

4.              Accounting for Variable Interest Entities

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

In general, a VIE is a corporation, partnership, limited liability company, 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 VIE’s activities, is entitled to receive a majority of the VIE’s residual returns (if no party absorbs a majority of the VIE’s 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 VIE’s assets, liabilities and non-controlling 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 $38.2 million and $99.2 million of cheese from BIBP for the three and nine months ended September 30, 2007, respectively, and $34.0 million and $105.9 million of cheese for the comparable periods in 2006, respectively.

As defined by FIN 46, we are the primary beneficiary of BIBP, a VIE, and thus we consolidate the financial statements of BIBP. 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.

7

8.              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, dessert pizza 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 distribution sales to franchised Papa John’s restaurants located in the United Kingdom, China and Mexico 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 deemed the primary beneficiary, as defined in Note 4, 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, information systems and related services used in restaurant operations and certain partnership development activities.

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.

10

Our segment information is as follows:

(1)          The revenues from external customers for VIEs are attributable to the franchise entities to which we have extended loans that qualify as consolidated VIEs. The intersegment revenues for VIEs are attributable to BIBP.

(2)          The operating results for domestic Company-owned restaurants decreased approximately $2.1 million and $3.8 million for the three and nine months ended September 30, 2007, respectively, primarily due to an increase in wages (including the impact of federal minimum wage increases in July 2007 and certain other minimum wage increases in various states), increased commodity costs and increased marketing expenditures at the local market level. The third quarter results also include a loss of $500,000 associated with our plan to sell certain Company-owned restaurants in one market.  The nine-month period results were favorably impacted by a $594,000 pre-tax gain associated with the termination of a lease arrangement in the second quarter of 2007.

(3)          The operating results for the domestic commissaries segment increased approximately $1.5 million and $3.6 million for the three and nine months ended September 30, 2007, respectively, principally due to increased volumes of higher margin fresh dough products and improved margin from other commodities.

11

(4)          The operating results for the domestic franchising segment decreased $501,000 and $1.1 million for the three- and nine-month periods ended September 30, 2007, respectively, principally due to an increase in our field organizational support staff to improve the performance of our domestic franchise operations. Royalty revenue was flat, as a decrease in equivalent franchise units of approximately 2.0% due to various acquisitions of franchise units by the Company was offset by a reduction in royalty waivers granted to franchisees.

(5)          The international segment, which excludes the Perfect Pizza operations that were sold in March 2006, reported operating losses of $2.0 million and $6.4 million for the three and nine months ended September 30, 2007, respectively, compared to losses of $2.0 million and $6.8 million, respectively, in the prior comparable periods. The improvement in the operating results for the nine-month period was due to the prior year results including a $470,000 charge incurred in the second quarter of 2006 related to costs associated with management reorganization with one of our international operating units. Increased current year revenues due to growth in number of units and unit volumes were substantially offset by increased personnel and infrastructure investment costs.

(6)          Unallocated corporate expenses decreased approximately $1.0 million and $4.0 million for the three- and nine-month periods ended September 30, 2007, respectively, as compared to the corresponding periods of 2006. The decreases in both periods are primarily due to lower general and administrative costs, including management incentives, health insurance and legal costs. The nine-month period decrease was also impacted by the collection of a $650,000 receivable, which had previously been reserved, from Papa Card, Inc., a nonstock, nonprofit corporation, which administers the Papa John’s gift card program.

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

Results of Operations and Critical Accounting Policies and Estimates

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. At September 30, 2007, there were 3,139 Papa John’s restaurants (660 Company-owned and 2,479 franchised) operating in all 50 states and 27 countries. Our revenues are principally derived from retail sales of pizza and other food and beverage products to the general public by Company-owned restaurants, franchise royalties, sales of franchise and development rights, sales to franchisees of food and paper products, printing and promotional items, risk management services, and information systems and related services used in their operations.

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 and make 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.

12

Long-Lived and Intangible Assets

The recoverability of long-lived assets is evaluated 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 indefinite-lived 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 expected cash flows of the reporting unit to its carrying value. At September 30, 2007, our United Kingdom subsidiary, Papa John’s UK (“PJUK”), had goodwill of approximately $17.2 million. In addition to the sale of the Perfect Pizza operations, which occurred in March 2006, we have restructured management and developed plans for PJUK to improve its future operating results. The plans include efforts to increase Papa John’s brand awareness in the United Kingdom and increase net PJUK franchise unit openings over the next several years. We will continue to periodically evaluate our progress in achieving these plans. If our initiatives are not successful, impairment charges could occur.

Insurance Reserves

Our insurance programs for workers’ compensation, general liability, owned and non-owned automobiles and health insurance coverage provided to our employees 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 us.

From October 2000 through September 2004, our captive insurance company, which provided insurance to our franchisees, was self-insured. In October 2004, a third-party commercial insurance company began providing fully-insured coverage to franchisees participating in the franchise insurance program. 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 the inception of the captive insurance company in October 2000 to September 2004. Such adjustments, if any, will be determined in part based upon periodic actuarial valuations.

Deferred Income Tax Assets and Tax Reserves

As of September 30, 2007, we had a net deferred income tax asset balance of $18.6 million, of which approximately $7.0 million relates to BIBP’s net operating loss carryforward.  We have not provided a valuation allowance for the deferred income tax assets since we believe it is more likely than not that the Company’s future earnings, including BIBP, will be sufficient to ensure the realization of the net deferred income tax assets for federal and state purposes.

The Company adopted the provisions of the Financial Accounting Standards Board (“FASB”) Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48), on January 1, 2007. FIN 48 addresses the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. In addition, FIN 48 expands the disclosure requirements concerning unrecognized tax benefits as well as any significant changes that may occur in the next twelve months associated with such unrecognized tax benefits. As a result of the implementation of FIN 48, the Company recognized an approximate $614,000 decrease in the liability for unrecognized tax benefits, which is accounted for as an increase to the January 1, 2007 balance of retained earnings. As of the adoption date, we had

13

tax-affected unrecognized benefits of approximately $9.6 million. To the extent these unrecognized tax benefits are ultimately recognized, the effective tax rate will be impacted in a future period.

Certain tax authorities periodically audit the Company. We provide reserves for potential exposures based on FIN 48 requirements described above.  We evaluate these issues on a quarterly basis to adjust for events, such as court rulings or audit settlements, which may impact our ultimate payment for such exposures. During the third quarter of 2007, the Company recognized a $2.4 million reduction in income tax expense composed of a $1.5 million reduction in the liability for unrecognized tax benefits (see Note 2, Accounting for Uncertainty in Income Taxes (FIN 48)) and a $900,000 adjustment for the finalization of certain income tax issues.

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 FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (FIN 46), we consolidate the financial results of BIBP since we qualify as the primary beneficiary, as defined by FIN 46, of BIBP.  We recognized pre-tax losses of $10.7 million and $19.4 million for the three and nine months ended September 30, 2007, respectively, and pre-tax income of approximately $5.3 million and $17.0 million for the three and nine months ended September 24, 2006, respectively, from the consolidation of BIBP. In future periods, we expect the consolidation of BIBP to have a significant impact on Papa John’s operating income in any given reporting period due to the volatility of cheese prices, but BIBP’s operating results are not expected to be cumulatively significant over time. 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.

New Accounting Standard

In September 2006, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements. SFAS No. 157 requires companies to determine fair value based on the price that would be received to sell the asset or paid to transfer the liability to a market participant. SFAS No. 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement. The effective date of SFAS No. 157 will be the first quarter of 2008. SFAS No. 157 could impact our future estimates of valuing long-lived and intangible assets such as our annual fair value evaluation of PJUK. We have not determined the impact, if any, of adopting SFAS No. 157.

Franchise Renewal Program

In October 2007, the Company communicated to its domestic franchisees a Franchise Agreement Renewal Program (the “Renewal Program”). Substantially all existing franchise agreements have an initial 10-year term with a 10-year renewal option.  Many of these original agreements have reached or will reach the end of their initial term in the next few years and will therefore require renewal.

The Company collaborated with the Franchise Advisory Council, which consists of Company and franchisee representatives of domestically owned restaurants, to develop a revised form of franchise agreement that will be available for execution upon renewal by existing franchisees (the “Negotiated Agreement”).  The primary objectives of the negotiation of a revised form of franchise agreement included:

•                  Providing visibility to franchisees as to the potential timing and amount of future royalty rate increases;

•                  Ensuring minimum funding levels for the National Marketing Fund given the scale advantages of our larger competitors;

•                  Providing a funding mechanism for continued investment in maintaining and enhancing our online technological capabilities; and

•                  Addressing alternative marketing or other business developments to ensure the new form of franchise agreement is consistent and up to date.

14

Under the Renewal Program, the Company is offering certain renewal fee discounts to encourage all existing franchisees to renew under the Negotiated Agreement by December 31, 2007.  Additionally, existing franchisees electing not to renew under the Negotiated Agreement by this date will be offered the then-current standard form of franchise agreement (the “New Standard Agreement”) upon their subsequent renewal.

Key provisions of the Negotiated Agreement in comparison to existing franchise agreements and the New Standard Agreement are as follows:

Royalty Rate — Under the form of franchise agreement to which substantially all franchisees are currently subject, the royalty rate can be increased from 4% to 5% at any time at the discretion of the Company.  The Negotiated Agreement limits the royalty rate increase to a maximum of one-quarter percent per year beginning in 2008, reaching 5% no earlier than 2011 and further limits the royalty rate to a maximum of 5% through 2020.  Royalty rate increases subsequent to 2020 are also limited to one-quarter percent per year and cannot exceed 5.5% through 2025, with a maximum rate of 6% thereafter.  The royalty rate increase provisions of the Negotiated Agreement are more favorable to the franchisees than the provisions of either the majority of existing agreements as noted above or the New Standard Agreement, which provides for a minimum 5% royalty rate that can be increased to 6% at any time at the discretion of the Company.

Marketing Expenditures — The Negotiated Agreement provides for certain minimum contributions as a percentage of sales to the National Marketing Fund and a minimum level of spending as a percentage of sales on all marketing activities, consisting of contributions to both the National Marketing Fund and local marketing cooperatives, as well as local store marketing initiatives.

Online Ordering System Fees — The Negotiated Agreement limits the fee charged for online transactions to 3% of the amount of the transaction.  Additionally, once the Company has recovered a certain portion of its initial investment in the development of the online system via the net operating profits of the system, the online business unit will be operated at a break-even level through either a reduction in the fee percentage or a contribution of any net operating profits into the National Marketing Fund at the discretion of the Board of the National Marketing Fund.

The Negotiated Agreement also addresses several other issues, including sharing of profits from partnership marketing or alternative sales channels activities, development of a process for defining trade areas for alternative ordering methodologies and marketing contribution requirements for non-traditional units.

The Company believes that a substantial number of the existing franchisees will elect to renew their existing franchise agreements under the provisions of the Negotiated Agreement.  The financial implications of this renewal activity for the Company are expected to be as follows:

•                  Franchise renewal fee income is expected to increase in the fourth quarter to a level that could approach or exceed $2 million. Given the current commodity cost environment, the Company has chosen to reinvest substantially all of this expected incremental renewal fee income to support the entire domestic system via reduced commissary margins, thus partially mitigating commodity cost increases, and to support Company-owned restaurants with incremental marketing activities.

•                  The royalty rate will be increased to 4.25% effective December 31, 2007, for those franchisees who renew subject to the Negotiated Agreement.  The royalty rate for most franchisees that choose not to renew under the Negotiated Agreement will increase to 5% effective December 31, 2007, although this higher rate is not expected to apply to a significant number of franchisees.  The current annual impact of a one-quarter percent royalty rate increase is approximately $3.5 to $4.0 million; however, given the current and projected cost environment for 2008, the Company anticipates that a portion of the incremental royalty income to be received in 2008 as a result of the rate increase will be expended in the form of investments in the franchise system, particularly to developing markets that have not yet reached critical mass.

15

•                  The Company has communicated its intention to further increase the royalty rate for franchisees that renew their Franchise Agreement subject to the Negotiated Agreement to 4.50% in 2009, 4.75% in 2010 and 5.00% in 2011, in accordance with the terms of the negotiation.  Facts and circumstances existing at such future dates may impact the Company’s final determination as to whether to reinvest any of the funds for the benefit of the system.

•                  The Company will recognize approximately $3.0 million of operating income from the online ordering system business unit in 2007 and expects to recognize a similar amount in 2008, completing the negotiated amount of recovery of the Company’s initial investment in the development of the system.  As noted above, this business unit will subsequently be operated at a break-even level and, accordingly, the amount of operating income recognized by the Company related to this business unit is expected to be approximately $3.0 million less in 2009 than in 2008.  The impact of this reduction should be somewhat mitigated by either a reduction in online fee percentage for Company-owned restaurants or incremental funds contributed to the National Marketing Fund to be expended for the benefit of the entire domestic system.

Restaurant Progression:

16