An SEC Comment Challenge: Find the Non-GAAP Measure Issue – Post Four

In this series of posts we are focusing on non-GAAP measure problems and related SEC comments.  As the first, second and third posts in this series did, this post gives you an opportunity to see if you can spot the issue, and then provides the background and SEC guidance behind the issue.

As a brief reminder, the SEC’s guidance about the use of non-GAAP measures is primarily in three places:

  1. Regulation G for non-GAAP measures used anywhere,
  2. S-K Item 10(e), for non-GAAP measures in filed documents, and
  3. Compliance and Disclosure Interpretations.

Just like the first, second and third posts in this series, you can read the excerpt of the release behind the comment and try to spot the issue.  If you prefer, you can read straight through to the comment and explanation that follow.

These excerpts are from Papa John’s International, Inc’s Form 10-K for the fiscal year ended December 29, 2019.  You may recognize this Company as we highlighted their 10-K in our third post in this series.  Can you spot the non-GAAP issue?  As you review this information, focus your thoughts on the “special charges,” and within the detailed list of “special charges” look at the “Royalty relief” line item.

To begin, here is one of the non-GAAP measures presented by Papa John’s:

PapaJohn One

Papa John’s also provided this detail about the special charges:

PapaJohn Two

As you review the list of non-GAAP adjustments, letter (a) about royalty relief to franchisees seems like a typical kind of adjustment.  But the issue here is more complex, as royalty income is a significant source of revenue for Papa John’s.

This is the comment the SEC issued about this non-GAAP adjustment:

Form 10-K for the Fiscal Year Ended December 29, 2019

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Items Impacting Comparability; Non-GAAP Measures, page 40

  1. Please tell us the consideration you gave to Question 100.04 of the Non-GAAP Financial Measures Compliance and Disclosure Interpretations in adjusting your non-GAAP measures to add revenues you did not receive due to royalty relief.

The C&DI referenced, Question 100.04 makes a very important point:

Question 100.04

Question: A registrant presents a non-GAAP performance measure that is adjusted to accelerate revenue recognized ratably over time in accordance with GAAP as though it earned revenue when customers are billed. Can this measure be presented in documents filed or furnished with the Commission or provided elsewhere, such as on company websites.

Answer: No. Non-GAAP measures that substitute individually tailored revenue recognition and measurement methods for those of GAAP could violate Rule 100(b) of Regulation G. Other measures that use individually tailored recognition and measurement methods for financial statement line items other than revenue may also violate Rule 100(b) of Regulation G.   [May 17, 2016]

This is Papa John’s first of two responses to this comment:

We did consider the guidance in Question 100.04 in connection with our inclusion in “Special charges” of royalty reductions that are above and beyond the level of franchise support the Company would incur in the ordinary course of its business. We also evaluated Rule 100(b) of Regulation G, which states that a registrant may not make public a non-GAAP financial measure that, taken together with the information accompanying the measure, is misleading.   We believe the adjustment reflects the add-back of contractually due and waived franchise royalties in our financial statements rather than the tailoring of the recognition or measurement principles under GAAP.

 Papa John’s franchisees are contractually required to pay a 5% royalty on sales. As part of its voluntary program to provide temporary financial assistance for traditional North America franchisees in response to declining North America sales discussed above, the Company extended financial assistance to its traditional North America franchisees in the form of a reduction in the contractually due royalties beginning in the third quarter of 2018, for a limited time period. The decline in sales was due to the negative publicity and consumer sentiment surrounding the Company’s brand as noted in Comment 1 (Note:  See the third post in this series for this information) above. Sales remained negative into 2019, which led the Company to formalize a temporary relief package, publicly announced in July 2019, to provide its franchisees with certainty regarding the availability and schedule of the relief which will continue through the third quarter of 2020. The total royalty relief included in “Special charges” was $19.1 million and $15.4 million for the years ended December 29, 2019 and December 30, 2018, respectively. The scheduled royalty reductions presented in “Special charges” represent the difference between the usual 5.0% contractual royalty rate applicable to North America franchise sales and the reduced royalty rate under our franchisee assistance program ranging from 0.5% to 2.0% of franchise restaurant sales varying by quarter. Additionally, North America franchisees that met certain defined service measures also received a 0.25% reduction in the royalty rate in the third and fourth quarters of 2019.

We believe that presenting these royalty reductions as “Special charges” is consistent with the objectives of our non-GAAP presentation, which is to show the financial performance of our ongoing operations excluding the temporary impact of the Company’s initiative of providing short-term support and financial assistance to the North America franchise system in response to the severe decline in North America sales. The Company did not receive the revenue foregone from its royalty relief program, as it is waiving a contractual right to recognize the revenue earned. We excluded the temporary waiver of this contractual right together with the marketing investments discussed in our response to Comment 1 for internal comparison purposes when evaluating the Company’s underlying operating performance and when analyzing trends. When presented next to the most directly comparable GAAP measure, we believe we are presenting a supplemental measure that shows the impact of our discretionary, non-contractual franchise support and relief program to our operating results. Accordingly, the Company respectfully advises the staff that we have considered the prescribed guidance and we believe that the presentation of royalty relief from our non-GAAP financial results, taken together with the information accompanying the measure, does not cause those results to be misleading.

To help further clarify the nature of the royalty reductions, beginning in our Form 10-Q for the quarter ended March 29, 2020, we will revise the footnoted description of the royalty relief in our “Special charges” table as follows: “Represents financial assistance provided to the North America system in the form of temporary royalty reductions that are above and beyond the level of franchise support the Company would incur in the ordinary course of its business. This temporary financial assistance provides our North America franchisees with certainty regarding the availability and schedule of the temporary relief through the third quarter of 2020. Under the formal relief program, the franchisees pay royalties below the 5.0% contractual rate on franchise restaurant sales with varying rates by quarter as specified under the terms of the program.”

After this first response the SEC and Papa John’s had further phone discussions about this issue.  Interestingly, the SEC did not issue a second comment letter.  While we cannot know the content of these discussions, they were clearly substantive.  They resulted in this final answer by Papa John’s:

Response: As discussed during the phone conversation between the Staff and the Company on April 24, 2020, beginning with the Company’s earnings release for the first quarter of fiscal 2020, the Company will no longer present adjusted (non-GAAP) financial results adjusted to add revenues we did not receive due to royalty relief.

As always, your thoughts and comments are welcome!

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