Domino’s Pizza - Earnings Call - Q3 2010
October 19, 2010
Transcript
Speaker 0
Good morning. My name is Philip, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Third Quarter twenty ten Earnings Conference Call. After the speakers' remarks, there will be a question and answer session. Thank you.
Ms. Lodell, you may begin your conference.
Speaker 1
Thank you, Philip, and thank you everybody for joining us on our third quarter call. We are going to have some prepared remarks today as well as Q and A as Philip mentioned. And I will turn your attention, everyone, to our Safe Harbor statement in the event that forward looking statements are made. And then in addition, we would ask the members of the press to remain in a listen only mode. So with that, I'll introduce our participants today.
We have with us our Chief Executive Officer, Patrick Doyle and our Chief Financial Officer, Mike Lawton. And I'm going to turn the microphone over to Patrick first.
Speaker 2
Thanks, Lynn. I'm sure you all recall our news August when we announced that we named Mike Lauten as our CFO. I'd like to welcome him to his first earnings call today. As a reminder, Mike was most recently Executive Vice President of our International division. Mike joined Domino's back in 1999 as the Head of Finance for our International group and earned the top spot in International in February.
It's notable that under his leadership, the division saw a retail sales compounded annual growth rate of 12% and added over 1,100 stores. Before coming to Domino's, Mike and I worked together at Gerber Products. There, Mike gained broad consumer product, financial and general management experience, including serving as the Corporate Controller, Finance the President of its Alima Division in Poland and the Chief Operating Officer of its U. S. Operations.
Mike will now cover the financial portion of this call and afterward, I'll provide further commentary on the third quarter.
Speaker 3
Thanks, Patrick, and good morning, everyone. I'm excited to take on this new challenge as CFO, and I look forward to discussing our results with you this quarter and in future quarters. Today, I'm happy to report another strong quarter of results for our shareholders as we continue to build on the momentum we've had throughout the year. We achieved robust domestic and international same store sales growth and continued to grow stores internationally at a very strong pace. We grew our bottom line in the third quarter with a solid 59% adjusted EPS growth.
I'll start by taking a look at our system revenue for the quarter. First, global retail sales grew grew by 12.1 during the quarter, excluding the impact of foreign currency. When including this positive impact from currency, our global retail sales grew by 12.5%. The increase this quarter was driven by strong domestic same store sales growth resulting from the continued success of our reformulated pizza recipe and the effectiveness of the advertising for this product. This was combined with a strong international same store sales and the store count growth in our international markets.
Now looking at the different business units. Domestically, we proved the sustainability of our relaunch as we posted an 11.7 same store sales growth number this quarter. This was rolling over flat sales comps in the prior year quarter. Franchisee same store sales were up 11.7%, while company owned stores were up 11.8%. We closed a net four stores domestically during the quarter made up of 12 store openings and 16 closures.
We continue to make progress toward our goal of growing our domestic store count. Our overall store growth in the quarter was solely generated by our international division, which grew by a net 76 stores in the quarter. Further on our international division, international same store sales were positive 7% on a constant dollar basis, rolling over a positive 2.7% a year ago. This division continues to produce consistent results for our company, and we're proud of the accomplishments of this growth engine of our business. Our total revenues for the third quarter were $347,400,000 a 14.8% increase from the prior year.
We experienced revenue growth operating divisions versus the prior year quarter. Almost two thirds of the total revenue increase was attributable to our domestic supply chain operations. This increase was a result of higher sales volumes combined with commodity prices versus the prior year quarter. Additional revenue increases came from higher domestic royalties and company owned store revenues, which were driven by higher domestic same store sales and higher international revenues due to both same store sales and store count growth. More detail regarding our revenue by business unit can be found in our 10 Q that was filed this morning.
Moving on to our operating margin. Our consolidated operating margin increased $11,000,000 or 13.2% in the third quarter, due primarily to higher franchisee royalties, both domestic and internationally, and higher margin dollars in our domestic supply chain business. As a percentage of revenues, however, our consolidated operating margin decreased 0.4% in the third quarter versus the prior year quarter due primarily to lower company owned store margins, which was largely due to higher insurance expenses, which I'll discuss in a moment, as well as higher overall commodity cost. Our company owned store dollar operating margin was virtually flat quarter over quarter due primarily to higher traffic in our stores, which was offset by increases in commodities and the aforementioned insurance expenses. As percentage of revenues, our company owned store operating margin decreased 1.1% from the prior year quarter, primarily as a result of higher insurance expenses resulting from the adverse development of existing claims.
Further, commodity price inflation, including cheese and meats, hurt our company owned store margins during the quarter. Our top commodities, including cheese, increased versus the prior year. The average cheese block price in the third quarter was $1.53 per pound versus $1.19 last year or 28.6 percent increase. Offsetting these cost increases were lower labor and related costs as well as occupancy costs, which include rent, utilities and depreciation as a result of leveraging the fixed portion of these costs with a higher sales volumes. Now let's move on to supply chain margin.
Our supply chain margin increased 0.3% from the prior year quarter, attributable to higher volumes in our supply chain centers as a result of increases in our domestic retail sales. Additionally, supply chain margins benefited from product mix changes as we continue to sell more dough, which carries a higher margin for our supply chain centers. Offsetting these increases was the impact of higher commodity costs, including cheese. As a reminder, higher cheese prices benefit our supply chain revenues, but do not impact our supply chain dollar profit. They do, however, negatively impact our supply chain margin as a percentage of revenues.
Speaker 2
Turning to G and A
Speaker 3
expenses. G and A increased $3,200,000 or 7.6% in the third quarter versus the prior year quarter. However, it decreased 0.9% as a percent of revenues. This dollar increase versus the prior year quarter was due primarily to higher performance based bonus expenses resulting from our very strong operating performance expenses we continue to incur for some of the new growth initiatives we've mentioned in previous calls. Regarding income taxes, we had no items of note this quarter and continue to expect that 39% will be our normalized effective tax rate for foreseeable future.
Lastly, our net income was down $1,200,000 or 6.9% for the third quarter. This decrease was primarily the result of the comparison to large gains recorded in the February related to our debt repurchases. Excluding these gains and other smaller items affecting comparability as outlined in our eight ks, our net income would have been up $6,770,000 or 70% quarter over quarter, primarily due to our improved operating performance. Our third quarter diluted EPS as reported on a GAAP basis and as adjusted for items affecting comparability was $0.27 The $0.27 as adjusted EPS figure is a $0.10 or 59% increase from the $0.17 reported in the February. Here's how the $0.10 difference breaks down.
Our improved operating results benefited us by $08 in the quarter. Our lower interest expense primarily as a result of our lower average debt balances benefited us by $02 in the quarter and we benefited $01 from our lower effective tax rate. Offsetting these amounts was a $01 negative impact resulting from our higher diluted share count due primarily to our higher share price. Now turning to our balance sheet. In the third quarter, we repurchased at a discount $20,000,000 of principal on our senior notes for a total pretax gain of approximately $938,000 Life to date, we have repurchased $289,600,000 of principal on our fixed rate notes at an average price of $0.78 on the dollar.
We're very encouraged by the current situation in the credit markets as illustrated by the recent deals being completed within the restaurant sector. These deals are are getting done at higher levels of leverage by companies with significantly higher CapEx requirements and lower sales momentum than Domino's. We ended the quarter with $39,200,000 of unrestricted cash. Free cash flow remained strong as we generated $66,000,000 during the first three quarters of twenty ten, averaging over 1,500,000 per week. I'd like to remind everyone that our February a fifty third week.
This extra week benefited diluted EPS by approximately $05 per share for both the fourth quarter and full year of 02/2009. In closing, we're pleased with the results we've generated through the end of the third quarter. We will continue to remain focused on driving shareholder value through improving our operating performance and through appropriate utilization of our free cash flow. Thanks for your time today. And now I'll turn it over to Patrick.
Speaker 2
Thanks, Mike. If I had to summarize my thoughts on the third quarter into one phrase, it would be it's working. Third quarter marked continued success for us on every front. Our new pizza is working here international division grew again at a healthy clip. Costs are in check.
Our balance sheet is optimized. Our franchisees and team members are motivated and playing to win. On our last earnings call, we said that our performance was sustainable. Here's the proof. This quarter, both our domestic and international businesses are outperforming most sales expectations.
In fact, this quarter marks our fifth consecutive quarter without a negative sales comp in our domestic business. We couldn't be more pleased to announce results like this. Domestically, we made improvements that have resulted in our growing faster than the vast majority of restaurants despite the weak economic environment around us. Things we've managed extremely well include markedly better TV commercials, more efficient use of television marketing and a transformative message straightforward and honest and we believe is compelling to consumers in a way that's unique in advertising. The message is resonating amazingly well with American consumers.
Accompanied by an affordable price point, it's driven exceptional results. All of the ads we've produced around this theme of transparency and honesty and value have off the chart advertising scores and have performed particularly well in the third quarter. Takeaway is that people love the new pizza. The value and honesty messages resonate and the ads are extremely effective. We're ten months into the strategy and it continues to work.
In short, we're a new Domino's. I'll focus a little more on our 11.7% same store sales comp because I'm pretty sure many of your questions are going to be about what we saw in the third quarter versus previous two quarters. First, even though we've been at this for ten months, we're still getting new customers. They continue to call and to try the new pizza. And maintaining strong repeat sales from the bigger base of customers we've built up throughout the year.
We actually expected to see a bit of a decline in the third quarter growth compared to the second quarter, but our results tell us that our message is still resonating with consumers. We also think that these double digit gains in the third quarter are likely a result among other things of the exceptional advertising we were running. In terms of overall advertising effectiveness, the ads we ran in the third quarter tested in the top 5% of all ads tested by our ad research firm over the past five years, and they're in the top 2% when you look to break through. And their newsworthiness is nearly twice the norm. These strong advertising scores make good levels of media great.
It increases consumer response, brings in more new encourages existing customers to order more frequently. But none of this would be possible if we didn't have the food quality to back it up, and we clearly do. Our franchisees' execution has been good during these busy months, and we continue to focus on making it even better. Their hustle and energy has been an important factor. This promotion has also been good for our franchisees who are still climbing out of a couple of tough years in our business.
Franchisee profitability on average has been higher this year than it was in 2008 and 02/2009. Store profitability is an area of constant focus for us. And despite the recent rise in cheese costs, our sustained sales volumes are keeping the profit needle pointing in the right direction for our stores, and we're working with our franchisees to make it even better. In addition to the advertising creative I just discussed, our value price point of two mediums for $5.99 each has driven strong consumer traffic, while allowing our franchisees flexibility to upsell additional toppings. This contrasts with the Pizza Hut strategy of fixed price points that doesn't allow their franchisees as much flexibility to drive their profit higher.
Based on our relative results, we're convinced we've got a superior strategy for driving orders and profits at the store level. So quarters one through three have been a big sales win for us, and we see no reason to think the fourth fourth quarter won't also result in positive sales. So we believe there are some modest earnings headwinds as we look at the fourth quarter. As Mike pointed out, we had an additional fifty third week in the fourth quarter last year, which makes our fourth quarter hurdle a little tougher. It's not clear that everyone has built this into their projections.
We're also rolling over positive comps, up 1.4% in Q4 two thousand and nine as well as the early weeks introduction of our new pizza, including one week of TV and the beginning of our pizza turnaround campaign, which got us more secondary buzz than anything we've ever seen. And food costs, cheese costs, in particular, look to be higher in the fourth quarter versus last year. So take these into account when you model the upcoming quarter, balancing those hurdles with the momentum and sales velocity we continue to experience. Now turning to our international business. If the catchphrase for domestic performance is it's working, then the equivalent for international is it's thriving.
Currently, this division represents over a third of our operating income and will be a primary growth driver of our business going forward. In the third quarter, our International division hit a positive 7% same store sales
Speaker 0
This is a tremendous result from a division that just keeps producing dynamic growth
Speaker 2
same quarter after quarter. This division continues to hit on all cylinders. All regions are posting positive sales with Asia leading the way this quarter just ahead of Europe. In the third quarter, we opened nearly a store a day in our international business, an amazing growth rate for a division that still has a lot of runway ahead of it. If you take a closer look at our international business via our four publicly traded or you can take a closer look at our international business via our four publicly traded master franchisees: Domino's Pizza, United Kingdom and Ireland, which trades on the London Stock Exchange under the ticker DOM Domino's Pizza Enterprises, which own stores in Australia, New Zealand and Europe, trades on the Australian Exchange under the ticker DMP.
Domino's Pizza in Mexico is owned by ALSAIA, which is publicly traded under the ticker ALSEA on the Mexican Exchange. And our Indian master franchisee is Jubilant FoodWorks, which trades under the ticker J U B I on the Bombay Stock Exchange. These publicly traded international master franchisees represent over half of our international stores and are responsible for much of our international success. If you want to look into the specifics of these businesses more, our UK master franchisee just released its latest earnings results on September 29 and reported a 9.9% same store sales increase. Our Indian master franchisee will be releasing its latest results on October 26, while our Mexican franchisee, Alcea reports on October 28.
Outside these public master franchisees, we also continue to see excellent growth in the business. We opened our first store in Romania in August, our first new store Eastern Europe, and we celebrated the grand opening of our first store in The Ukraine on October 8. Since 02/2005, international has posted six quarters of same store sales of 7% or better. At the end of the third quarter last year, we had 3,949 stores in international. I'm very pleased to note that we finished the third quarter of twenty ten with 4,264 stores, a three fifteen store increase for international over the course of the last twelve months.
Lastly, we continue to be confident about our balance sheet. We're in a good position with our debt, and we've been opportunistic with our buybacks. The nearly $300,000,000 in debt we've repurchased has put us in a better position to refinance when the presents itself. And it's encouraging to see how well the market has received some recent deals in our sector, which we think bodes well for refinancing options when the time comes. We will will continue to monitor the debt markets for the right opportunity for us in the future.
Meanwhile, we continue to enjoy our current and very favorable financing, knowing that we're in great shape to extend it to 2014. So in closing, we're thrilled with the quarter with our domestic and international sales, our product and our marketing. We're certainly a new Domino's. With that, I'd like to take
Speaker 0
And your first question is from the line of Mitch Spicer.
Speaker 4
First off, great comps in the third quarter, especially in The U. S. And it sounds like a lot of it, not just the new pizza, and it was also very new and unique marketing. In particular, though, I would like to ask versus the second quarter, was the relative marketing expense, was it any different on a year over year basis in the third quarter versus the second quarter?
Speaker 2
No, it was pretty consistent between the quarters.
Speaker 4
Great. And separately, on the concerning debt, I believe you bought your debt back at about $0.96 or so on the dollar here in the third quarter. The price of the debt has gone up. Do you continue is debt paydown still the focus going forward at the rate that you have been paying down debt?
Speaker 2
Yes. I mean, our job is to use the cash flow in the manner that is best going to provide value to our shareholders. And we continue to believe that buying in the debt is the right answer, and that's clearly what we were doing in the third quarter. But we're always going to look at it, and we're going to do what we think is going to create the best value for our shareholders over time.
Speaker 4
Great. And my last question is on costs. Didn't seem like wheat was a negative impact to your margins in the third quarter. Wheat has begun to spike up. Should we also build that into model starting in the fourth quarter, the escalation in wheat costs?
Speaker 3
Well, this is Mike. While commodity costs certainly are high, wheat is not one of our more significant cost inputs. And we actually have our wheat fixed right up through the end of the first quarter with 100% of our needs and 50% of our needs in the second and third quarter. But overall, it is not one of the biggest it is not one of the more significant components of our food cost.
Speaker 4
Great. Thank you very much.
Speaker 0
Your next question is from the line of Michael Waldman.
Speaker 5
Hi, good afternoon, guys. I just wanted to go back and touch on a couple of your promotions that are out there. With the two for $5.99 deal and where cheese is at this point, is there a point where the price of cheese where you guys have to adjust that pricing on that two for $5.99 deal?
Speaker 2
I think we've got to provide the price that's going to get consumers to buy from Domino's. And fortunately, it looks like cheese has eased just a little bit the last couple of days. So we're hoping it's relatively near to the top, but we'll see. The new promotion that we've got out now just this past week is still the two medium two tops for $5.99 but we've also got we've added ability to add one of our specialty pizzas, American Legends, for $2 more to the $5.99 So we think that will help a little bit with ticket. And we like bringing the Wisconsin six Cheese in.
We think it is going to drive some further interest. And if we can get the extra couple of bucks, it's clearly a profit driver for us as well.
Speaker 5
The margins on those specialty pies, are they significantly better than on a regular two topping pie, especially with the $7.99 price point on them?
Speaker 2
Yes. Mean, certainly, for a couple bucks more, yes. It's definitely going to be a profit generator.
Speaker 5
Then guess last thing here. On the advertising side of the business, I mean, obviously, with the increase that you did to the national level here this year, you guys are getting great results out of it. Have you guys seen a shift in what the franchisees are doing at the local level? And is that having an impact in driving this traffic as well?
Speaker 2
Actually, I mean, the change that we made at the beginning of the year was we went from a four percent national ad fund and a mandatory 2% spend at the co op level to 5.5% national. And so it actually gave them an opportunity depending on what they did, they could choose to do whatever they wanted then with their co ops as well as with their spend. But there really is not a material change in the dollars that they're spending on LSM. And for the most part, the co ops are not spending at kind of the just the regional co op level. So you've really got three parts of the spend in the past.
You had national co op and local store marketing. Today, you've got national, a little bit of co op spend, but for the most part, they're not doing that now, and then still the local store marketing. And so net net, there was a shift to national, but it was concurrent reduction in the co op spend. So overall, I don't think that there is any of the increase that's been driven by additional dollars. It's really been about spending the dollars that we're getting wisely.
And so we think we've simply got a more efficient spend.
Speaker 5
Okay, great. Thank you.
Speaker 0
Your next question is from the line of Jeffrey Bernstein.
Speaker 6
Great. Thank you very much. Few questions. Just first on the margin front since you, I think, pretty thoroughly addressed impressive comp. But with that 12% comp in The U.
S. And 7% international, I mean, it did seem like there was a lack of leverage. I know you talked about the higher commodities. But the sequential swing from leverage to the deleverage this quarter seemed somewhat extreme despite that confident. Is there any unusual beneath that or whether you can provide any thoughts perhaps on earnings as we look to 2011 when it would seem like comps should slow off of these levels and the costs sounds like are heading a little bit higher.
I'm just wondering from a leverage standpoint this quarter and then the outlook for 'eleven based on those numbers.
Speaker 3
Well, the answer on the margin is, if you look at the 10 Q, we provided a lot of detail about what has gone on with the corporate store margin. And we've talked about the fact on this call that commodity prices are rough, that has put a little pressure on it. But offsetting that is the fact that our labor and occupancy costs are getting more heavily leveraged. There is an unusual adjustment in there because we did have an insurance adjustment that affects our corporate stores to the tune of 1.9% of corporate store revenue. And that might be part of the reason that you're seeing less leverage from these higher sales than what you were expecting.
Speaker 6
And that insurance adjustment, that is a onetime third quarter? Or should we expect something to flow through from that going forward?
Speaker 3
We certainly hope that this is more of a onetime adjustment, but that remains to be seen based on the actual results from actuarial valuations that are prepared before year end.
Speaker 6
Okay. And then just second, from a G and A perspective, it looks like leverage on those comps did drive the upside, at least versus our estimates. I don't know if there's any specific or identifiable reduction in spend or whether it was just a I mean, talk about targeted incremental spend or whether it was just straight leverage on the comps that gave you that favorability and whether there's any insight into what the fourth quarter or perhaps what 2011 could look like from G and A, whether you with the increased complement and whether you reinvest in the business or what your thoughts are on G and A for this quarter and going forward?
Speaker 3
The most of the benefit of the reduction of G and A as a percentage of revenue is coming from the increase in revenue as opposed to a reduction of cost.
Speaker 6
But going forward, I mean, with these comp levels, is it the idea to reinvest some of that incremental flow through on other projects? Or should we see that leverage continue going forward?
Speaker 2
We're going to continue to manage our G and A tightly in this environment. We're not losing track of the fact that the economy is out there is still pretty tough out there. So we love where we are. We love the growth that we're driving and the results that we're driving. But we're not losing sight of the fact that the economy is still tough, and we're going to continue to manage expenses as if we are operating in tough environment.
And to the extent we continue to drive great sales growth, terrific.
Speaker 6
Okay. And then just lastly, I guess, having Mike now in from international, maybe he can shed some light on this. But when you think about the international strength, one part of the question is just I'm wondering whether there's obstacles in the master franchise model to perhaps accelerate that unit growth. I know, Patrick, you've talked about that's our big opportunity, and we're going to push that forward. But I just want to make there's no short term limitation on unit potential, constraints.
I mean, we could see an acceleration on the unit side from an international standpoint. Just wondering whether there's color on 2011 from a unit growth perspective, that would be great. Thank you.
Speaker 3
Well, obviously, our goal when we were when I was running the international group was grow it as fast as we reasonably could and keep it under control. And we've certainly over the last three years, over the last two years, we reached a point where we were opening more than 300 stores a year. That is certainly the kind of numbers that we'd like to see, if not higher than that. The fact that we're using the master franchise model has not been a significant stumbling block to getting our store growth up to levels that we'd like to see it at.
Speaker 2
Yes, it's really been just the opposite. I mean, fact is, the stores are generating terrific EBITDA at the store level. And our master franchisees are incented to grow stores when the store level economics are strong, and they are clearly very strong right now. And so their motivations align very nicely with ours.
Speaker 0
And your next question is from the line of Jon Ivanko.
Speaker 7
Thanks. Just thinking about the international comp maybe for 2011. Obviously, I mean, there's going to be somewhat of a difficult comparison obstacle in The U. S, which is fairly easily understood. But are there any obstacles in the international business that we should be aware of in terms of continuing these types of results into next year?
And could you remind me whether you've done anything in terms of like the all new pizza internationally that you've done in The U. S. And whether that might be an opportunity across the world?
Speaker 3
Well, we've had 67 straight quarters of same store sales growth in international. And so we've got quite a long consistent track record of being able to grow the business. And the portfolio of markets that we have has helped us do that. In answer to the specific question of launching new and improved, it happens that we have done markets. In fact, most recently, the business in Mexico launched an improved product with new advertising, and we'll continue to look at whether that makes sense in other markets.
Speaker 7
But to your point, I mean, there's nothing unusual that's driving, for example, the third quarter of 'ten that we need to worry about as a lap into 'eleven?
Speaker 3
No, there's not.
Speaker 7
Okay. And secondly, if I may, and I thought the comments on the current high yield market refinancing market were interesting. Do you have an opportunity to do a partial refinancing of your whole business securitization? Or is that something that needs to be taken out in entirety if that's the route that you decide to go?
Speaker 3
While there are some very limited options, it is not very likely that we would wind up doing something that would involve a partial.
Speaker 7
Okay. All right. And in terms of is there a way I mean, I guess, it's a little bit putting you on the spot. Is there a way to think about like what the interest rate might be if you were to decide to refinance today? I mean if there's at least some kind of guideline that we could be thinking about in terms of what some people might be telling you that you could refinance at?
It certainly is interesting that your debt is trading at such a narrow discount relative to par at this point.
Speaker 3
I don't think that until we actually tried to go to market that we'd have a real clear picture of that. And we've got some reasons that it's including the fact that we have a significant make whole period if we were to go out and recapitalize today that have kept us from really going far down this road.
Speaker 7
Okay. Thank you very much.
Speaker 0
Your next question is from the line of Joe Buckley.
Speaker 8
A couple of questions as well. First on the sales comments, third quarter to second quarter, it sounds like the advertising rates were fairly consistent. Was there some shift in the message or just some shift in the ratings of the commercials? You seem to cite the high ratings on the commercials in the third quarter. I'm wondering if that's different from the second quarter, if there was some difference in the message or tone.
Speaker 2
Joe, when I was talking about the advertising scores, I'm talking about the outside ad score testing that we do, so not kind of the ratings of programs that we run. I'm talking about we go out and do quantitative testing on all of the advertising we run. And the ads we ran in the third quarter tested stronger than the ads we ran in the second quarter. And so while advertising weights, while the amount of media we ran was consistent between the two quarters. We just think we had slightly more compelling copy out there and thirty second spots out there than we had in the second quarter.
And we think that's at least part of why our comps were stronger in the third quarter than in the second quarter.
Speaker 8
Okay, that's helpful. And then question on ad, the ad budget, which is calculated as a percent of sales. Sales have been so much stronger this year, does that ad fund build and carry over into 2011? Or is the spending in 2010, does that rise along with the sales?
Speaker 2
Yes. First of all, you're exactly right. I mean, our ad fund is 5.5% of our system revenues in The U. S. And so with sales up as much as they are, I mean, digit year to date, that means we got a lot more dollars in that ad fund.
And I'm not going to get into the specifics on how we're approaching 2011. But I would say, we're certainly going to be conservative about how we manage the budget and make sure that we're in good shape next year as well as this year. There is some media inflation for next year. The upfront has already come and gone and ad costs were a little bit higher for this upfront than they were last year. So we're going to make sure we're in good shape over the course of both years.
But you're right, when sales go up this much, momentum is a really powerful thing. And that success just breeds more success because we got more dollars to use for advertising.
Speaker 8
Your
Speaker 0
next question question is from the line of John Glass.
Speaker 9
A couple of clarifications, please. First is, is the improvement in comps from the second to third quarter all a function of improved traffic or did pricing get better as well?
Speaker 2
No, it was pretty consistent between the two quarters.
Speaker 9
Meaning it was traffic driven increase then sequentially?
Speaker 3
Yes, absolutely. Absolutely.
Speaker 9
Yes. Okay. And then Mike, you talked a little bit about the current financing environment, so maybe suggesting you're looking a little bit closer in the market right now, but then you had a caveat on an answer to another question about either a make whole payment or some sort of prepayment penalty. Is there a point in time in which you can avoid refinancing costs?
Speaker 3
The prepayment penalty amortizes off between now and the first quarter of twenty twelve. And that prepayment penalty today is about $70,000,000
Speaker 9
And does that go to zero ratably over the next two years?
Speaker 3
Between now and the first quarter of twenty twelve.
Speaker 2
So eighteen months? The answer is yes.
Speaker 3
Okay. Your
Speaker 9
math is just figure out when you can when that penalty is worthwhile, I guess, absorbing in the market, right, for a better pricing and financing, I guess?
Speaker 3
That's correct. Okay. And we do believe I mean, we're sitting here, we've got a year and a half left on the notes plus, if we were given the current ratios that we have, we have the right to automatically extend should we be able to maintain those ratios, which gives us three point five years on the existing notes.
Speaker 9
And the last question is, Patrick, you alluded to sort of pricing differences between you and Pizza Hut. I mean, bigger picture, where do you think are these incremental sales still coming at the expense of non Pizza QSR or independents? It seems to me that both you and Pizza Hut, and I'm not maybe less clear on where Papa John's stands today, but seem to be thriving and not really taking share from one another in this environment. So where do you think do you have any updated views on where this is all coming from then?
Speaker 2
Yes. I think the pizza category is a little better than most of the restaurant category at this point. But it's still a tough environment out there. And if you look at the two year comps, Pizza Hut was still negative for the third quarter. I mean, they were up 8% against negative 13% a year ago.
So their two year number was about a negative 5%. We were up 11.7% against flat a year ago. So we're clearly taking share. And we think it is largely coming from regionals and smaller players. We have yet to see the Papa John's comp for the third quarter.
So stay tuned on that one. But I also think there's a little bit of category share coming our way. If you look at I think what is relative outperformance of the pizza category against the rest of the restaurant industry, that means we're picking up a little bit of share there as well. But I think it's more about the biggest part of it is us taking share from other players in the pizza category.
Speaker 10
Thank you. Your
Speaker 0
next question is from the line of Howard Pinney.
Speaker 8
Hi, thanks.
Speaker 3
I have two questions. The first
Speaker 11
one is the word sustainability, which you used twice. And I was curious if that was referring to or maybe potentially referring to an acceleration in or capital committed to growing the stores or if not as the profitability not improved enough to do that and or are you just too saturated? And then lastly, sort of your comments about the share gains. Given the downturn and the acceleration in your business, will an acceleration in the economy actually help or hurt
Speaker 3
your share? Yes. Sustainability,
Speaker 2
I mean, I'm really talking about same store sales and how consumers have reacted to the pizza and why the third quarter looked very good versus the first half overall. In terms of what it means from a store growth standpoint, we've been saying all year that we expect kind of net zero in The U. S. On stores, and still where our expectation is. In terms of whether the bad economy is a good thing for us, absolutely not.
We're outperforming dramatically in what is still a relatively weak restaurant category. And I'd be thrilled to have some tailwinds instead of headwinds. And we think there are still more headwinds out there from the relative strength of the economy and the relative strength of the restaurant industry more than any tailwind. So I'll be happy when the economy turns again as well.
Speaker 12
Your next question is from the line of Matt DiFrisco. Just a clarification first on the insurance. In
Speaker 4
the Q,
Speaker 12
you say it's about 5.4% of sales were insurance costs. Did is that should we look at that as an accrual? Or was that onetime? It was unclear when that was asked earlier if that was a one time charge in this quarter or is that your going forward relative cost assumption?
Speaker 3
The 5.4% is what the total insurance cost was for the quarter, which was about 1.9% higher than what we would have on a typical going forward what we would have had over the last few periods and what we would expect as more of a going forward basis. The answer that I gave was that we're always dealing with some estimates as it relates to insurance. As we talked about in our 10 ks, we have some fairly high self insurance reserves. We try to adjust those as is appropriate, and we'll be doing so, of course, as we approach our year end. But we it became clear to us we made needed to make some adjustments, and we did so.
Speaker 12
Okay. So that's an adjustment. And going forward, the 1,900,000,000.0 you don't expect to be sustained? As
Speaker 3
I say, I mean, as we adjust as we make adjustments, we'll do what we need to do to keep our accruals appropriate, but I don't think that that's reflective of a long term ongoing rate.
Speaker 12
Okay. Thank you for clarifying. Looking at also the supply chain margin dollars, it looks I mean, historically, last four or five quarters, you've significantly outpaced your overall system sales growth. And you refer in the Q also to higher volumes, but also changes in product mix. Looks like the gap or the pace of outpacing your sales growth has narrowed a little bit in this last quarter.
How long how much longer or sustainable is that favorable benefit of product mix where you think you'll be able to outpace your double digit the 11 or 12% comp growth here, you did about a 20% growth of operating margin. I'm wondering out of the domestic supply chain, I'm wondering, are you also expecting that to sort of cool down a little bit as we now lap the introduction of the new pizzas and the product mix shift benefit?
Speaker 2
Yes. I mean, the answer is, with the volume growth that we're getting this year and which is all from orders, in fact, more from orders even than the sales growth. I mean, we've said, I think, a number of times, we're running a little bit negative ticket this year. So our order growth is higher than our sales growth. And so between that and leveraging fixed costs in the supply chain, the profits have been up in the supply chain.
But to the extent to which you see the order growth decrease over time, certainly, you'll see the pace of growth in the supply chain also slow down somewhat.
Speaker 12
Okay. And then also just last, you spoke a lot about your comp being driven by transaction. Where do we stand as far as in your belief you have of hitting store capacity? I mean, obviously, with an 11% comp, some other concepts might turn this as a validation for greater expansion and growth, yet you seem pretty content with staying flat as far as domestic growth. So are you assuming then there's a lot of store capacity still left at the current operations?
Speaker 2
Yes, there is. And we're certainly not content with flat. We've got franchisees who were digging out of a pretty rough 2008 and 02/2009, particularly 02/2008. They're getting their balance sheet squared away. They're watching the momentum from the business.
And I think like you and like us, we were all waiting to see kind of what would happen in the out quarters after we launched this program. And we've continued to weed out weaker operators along the way. And so stronger operators buy out weaker operators, and they bring some of their cash, if they've got available cash to buy those weaker operators out of the system. So the answer is, we think we've still got 1,000 plus stores to build domestically. That answer has been, I think, pretty consistent over time.
And as confidence builds in the system, you've seen us go from negative 100 in net in each of 'eight and about flat this year. And as confidence continues to grow and balance sheets get where they need to be and potentially you start to see some lenders starting to open up again to financing store growth, then you'll see us return to store growth domestically. And that's certainly our goal.
Speaker 0
Your next question is from the line of Mark Smith.
Speaker 10
And just to follow-up on that last question, quantify at all your current pipeline of domestic franchise restaurants?
Speaker 2
Nothing more than kind of what we've already talked about. And really at this point, again, you're seeing transfers from weaker franchisees to stronger franchisees. We've always got a little bit of horizon on leases that have been signed and stores under construction. But that kind of visibility is only out a quarter kind of maximum two. I think you hear concepts talking about contracted growth.
And frankly, I don't put a whole lot of strength behind those claims around contracted growth. I mean, it really becomes meaningless if the economics in the business aren't good. Having a store signed or a commitment from a franchisee that they're going to build stores, if the economics aren't working for them, that store is not going to get built. And so while we've got contracted growth out there and particularly we've got more visibility internationally, maybe even domestically with the master franchise model. At the end of the day, growth happens because smart operators see great returns being available and building new stores.
Stop. That's what drives it. And so we've got a little bit of visibility from leases and stores under construction. And clearly, at that point, those sorts of numbers are meaningful. But I'm not a great believer that signing a piece of paper saying you're going to build a lot of stores means a lot if the unit economics aren't there.
Speaker 10
And then second, without giving out too much competitively, can you talk about your new customers that order online versus those that order via the telephone and any positive impact from that mix?
Speaker 2
We continue to see a shift across to online ordering. I think as online ordering becomes a bigger and bigger part of our sales, kind of the mix between new and repeat online starts to look a little bit more like the overall mix. When there were kind of the early users of online ordering were coming on a few years back, I think you may have seen a heavier mix of new customers coming in that way than over the phone. We still still like the
Speaker 0
profile of online customers better
Speaker 2
phone. Than phone customers just in terms of repeat levels satisfaction ratings that we get back, all of those signs are very, very positive. But I think kind of the profile of new versus repeat as that becomes a bigger and bigger part of the business, kind of regresses to the mean a bit, if you will. Okay.
Speaker 10
And then lastly, just to clarify a little bit, I realize that wheat maybe gets attention in this market than it should for you guys. But can you clarify your contract on wheat on how long you're locked on that? And then any other opportunities or updates on any other contracts?
Speaker 2
Yes. Let me kind of size it for you a little bit. Mean, first of all, we're we've been locked in for a while through the first quarter. We got about 50% of our needs put away at a little bit higher level in the second and third quarter. But to kind of give you order of magnitude, a dollar a bushel is in the range of a penny and a half or so per dough ball on a pizza.
So while the percentages look big on movements in the bushels out there, it just isn't that big a driver of our food cost. I think it's fifth or sixth on the list behind cheese and meats and boxes. And there's just a lot of other things that come before we get down to wheat. So it is clearly up, but order of magnitude, it's not one of
Speaker 3
the biggest items we've got.
Speaker 10
Are there any other contracts that you currently have or that you perhaps have the opportunity to lock in here?
Speaker 2
No. I mean, we've got the same contract we've had on Cheese for quite some time, which still floats with the block. But the way we've got it worked out, the contract kind of reduces about a third of that volatility. So we continue to be very happy with that contract. And we'll opportunistically go out a quarter or two on other things as we look at movements.
But for the most part, once you get out past two, three quarters, we're really looking at market pricing.
Speaker 10
Perfect. Thank you. Your
Speaker 0
next question is from the line of Peter Stalla.
Speaker 2
Great. Thanks for taking my question. I just want to circle back on the ad budget for 2011. Did the franchisees have to vote on the budget and have they voted already? They had what they did was a year ago, we went out to them and asked them to move to a 5.5% national spend from a 4% national two percent co op.
And we had 100% of our franchisees sign an amendment committing to 5.5% over a five year timeframe. So the 5.5% is locked in for at least the next five years and then can extend from there based on performance. So you're looking at 5.5% for a number of years now. And then can you talk a little bit about just the part mixes? Have you seen any more strength at lunch or dinner?
I think we've seen a little bit more relative strength at dinner just with the overall strength on pizza. And as we've been talking about pizza all year long, the mix on dinner is probably a little bit better. But we're seeing growth on an absolute basis across all the dayparts. Great. Thanks very much.
Speaker 0
Your next question is from the line of Chris O'Cull.
Speaker 7
My question is related to the balance sheet. Mike, the restricted cash balance has been coming down as your financial ratios have improved. Is there a threshold amount that you must carry?
Speaker 3
There are a number of different reasons that we've got some of the restricted cash. Some is related to debt. Some is related to our insurance reserves. We've got in the near term, there really is not a lot of opportunity to bring the restricted cash down further.
Speaker 7
How much of it is related to the securitization?
Speaker 3
At any point in time, depends upon the payment of our interest expense because we've got to be making deposits that are being paid, obviously, not on a monthly basis, but on a quarterly basis. So that number can be as much as about $30,000,000
Speaker 10
related to the debt. And
Speaker 0
there are no further questions at this time.
Speaker 2
All right. Well, listen, thank you everybody for joining the call today. As we draw near to the date of our fiftieth anniversary, which is December 9, it's amazing to see where this company started from a small pizza shop in Ypsilanti, Michigan to where we're headed today and into the near future. We're going to be cutting the ribbon on our 10,000 store before the middle of this decade. We're a strong growing global brand with great franchisees, team members and shareholders.
And I'd like to thank you for your time and your questions
Speaker 4
today.