Papa Murphys Holdings, Inc.
Papa Murphy's Holdings, Inc. (Form: 10-Q, Received: 08/13/2014 16:24:52)
Table of Contents

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 June 30, 2014
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 001-36432
–––––––––––––––––––––––––––––––––––––
Papa Murphy’s Holdings, Inc.
(Exact name of registrant as specified in its charter)
–––––––––––––––––––––––––––––––––––––
Delaware
(State or Other Jurisdiction of
Incorporation or Organization)
 
27-2349094
(IRS Employer
Identification No.)
8000 NE Parkway Drive, Suite 350
Vancouver, WA
(Address of principal executive offices)
 
98662
(Zip Code)
(360) 260-7272
(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 [ ].
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [X]. No [ ].
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “accelerated filer,” “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer [ ]
 
Accelerated filer [ ]
Non-accelerated filer [X]
 
Smaller reporting company [ ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ]. No [X].
At August 12, 2014 , there were 16,957,885 shares of the Registrant's common stock, $0.01 par value, outstanding.



Table of Contents

TABLE OF CONTENTS
 
 
 
 
PART I — FINANCIAL INFORMATION
 
 
 
Item 1.
Unaudited Condensed Consolidated Financial Statements
 
Unaudited Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) for the three and six months ended June 30, 2014 and July 1, 2013
 
Unaudited Condensed Consolidated Balance Sheets as of June 30, 2014 and December 30, 2013
 
Unaudited Condensed Consolidated Statement of Shareholders' Equity as of June 30, 2014
 
Unaudited Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2014 and July 1, 2013
 
Notes to Unaudited 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 1A.
Risk Factors
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.
Defaults Upon Senior Securities
Item 4.
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
 
 
 
SIGNATURES



Table of Contents

PART I — FINANCIAL INFORMATION
Item 1.        Financial Statements
PAPA MURPHY’S HOLDINGS, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Operations and Comprehensive Income (Loss)
(In thousands of dollars, except share and per share data)
(Unaudited)
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
July 1,
2013
 
June 30,
2014
 
July 1,
2013
Revenues
 
 
 
 
 
 
 
Franchise royalties
$
9,315

 
$
8,970

 
$
19,384

 
$
18,473

Franchise and development fees
862

 
823

 
2,031

 
1,705

Company-owned store sales
11,477

 
9,297

 
23,495

 
18,463

Lease and other
192

 
32

 
2,053

 
74

Total revenues
21,846

 
19,122

 
46,963

 
38,715

 
 
 
 
 
 
 
 
Costs and Expenses
 
 
 
 
 
 
 
Store operating costs (exclusive of depreciation and amortization shown separately below):
 
 
 
 
 
 
 
Cost of food and packaging
4,499

 
3,544

 
9,089

 
6,968

Compensation and benefits
2,905

 
2,658

 
5,935

 
5,230

Advertising
1,122

 
962

 
2,244

 
1,808

Occupancy
674

 
583

 
1,334

 
1,137

Other store operating costs
1,007

 
917

 
2,076

 
1,847

Selling, general, and administrative
8,824

 
5,513

 
17,023

 
11,247

Depreciation and amortization
1,967

 
1,743

 
3,808

 
3,442

Loss on disposal or impairment of property and equipment
36

 
37

 
42

 
101

Total costs and expenses
21,034

 
15,957

 
41,551

 
31,780

Operating Income
812

 
3,165

 
5,412

 
6,935

 
 
 
 
 
 
 
 
Interest expense
2,316

 
2,498

 
5,428

 
5,113

Interest income
(19
)
 
(22
)
 
(53
)
 
(44
)
Loss on early retirement of debt
1,191

 

 
1,191

 

Other expense, net
43

 
9

 
55

 
16

(Loss) Income Before Income Taxes
(2,719
)
 
680

 
(1,209
)
 
1,850

 
 
 
 
 
 
 
 
(Benefit from) provision for income taxes
(1,112
)
 
686

 
(421
)
 
1,145

Net (Loss) Income
(1,607
)
 
(6
)
 
(788
)
 
705

 
 
 
 
 
 
 
 
Other Comprehensive (Loss) Income
 
 
 
 
 
 
 
Foreign currency translation adjustment

 

 

 

Total Comprehensive (Loss) Income
$
(1,607
)
 
$
(6
)
 
$
(788
)
 
$
705

 
 
 
 
 
 
 
 
Loss per share of common stock
 
 
 
 
 
 
 
Basic
$
(0.19
)
 
$
(0.42
)
 
$
(0.39
)
 
$
(0.66
)
Diluted
$
(0.19
)
 
$
(0.42
)
 
$
(0.39
)
 
$
(0.66
)
Weighted average common stock outstanding
 
 
 
 
 
 
 
Basic
11,375,211

 
3,831,513

 
7,612,646

 
3,814,362

Diluted
11,375,211

 
3,831,513

 
7,612,646

 
3,814,362

  See accompanying notes.

3

Table of Contents

PAPA MURPHY’S HOLDINGS, INC. AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(In thousands of dollars, except par value and share data)
(Unaudited)
 
June 30,
2014
 
December 30,
2013
Assets
 
 
 
Current Assets
 
 
 
Cash and cash equivalents
$
4,009

 
$
3,705

Accounts receivable, net of allowance for doubtful accounts of $48 and $37, respectively
4,397

 
2,430

Notes receivable, net (including related party notes of zero and $39, respectively)
59

 
837

Inventories
440

 
495

Prepaid expenses and other current assets
5,503

 
7,054

Current deferred tax asset
1,798

 
1,856

Total current assets
16,206

 
16,377

Property and equipment, net
9,398

 
9,660

Notes receivable (including related party notes of zero and $444, respectively), net of current portion
255

 
444

Goodwill
96,080

 
96,089

Trade name and trademarks
87,002

 
87,002

Definite-life intangibles, net
46,267

 
48,744

Deferred finance charges, net
2,384

 
3,934

Other assets
3,642

 
2,252

Total assets
$
261,234

 
$
264,502

 
 
 
 
Liabilities and Equity
 
 
 
Current Liabilities
 
 
 
Accounts payable
$
2,515

 
$
3,673

Accrued and other liabilities
8,150

 
9,741

Unearned franchise and development fees
2,802

 
2,881

Current portion of long-term debt

 
1,670

Total current liabilities
13,467

 
17,965

Long-term debt, net of current portion
115,083

 
168,330

Unearned franchise and development fees
1,034

 
1,113

Deferred tax liability
40,702

 
41,465

Other long-term liabilities
1,493

 
1,482

Total liabilities
171,779

 
230,355

Commitments and contingencies (Note 14)


 


 
 
 
 
Equity
 
 
 
Papa Murphy’s Holdings Inc. Shareholders’ Equity
 
 
 
Series A preferred stock ($0.01 par value; zero and 3,000,000 shares authorized, respectively; zero and 2,853,809 shares issued and outstanding, respectively (aggregate liquidation preference zero and $61,476, respectively))

 
60,156

Series B preferred stock ($0.01 par value; zero and 1,000,000 shares authorized, respectively; zero and 26,551 shares issued and outstanding, respectively (aggregate liquidation preference zero and $722, respectively))

 
741

Preferred stock ($0.01 par value; 15,000,000 shares authorized; no shares issued or outstanding)

 

Common stock ($0.01 par value; 200,000,000 shares authorized; 16,962,123 and 4,347,882 shares issued and outstanding, respectively)
169

 
43

Additional paid-in capital
117,158

 
1,555

Stock subscription receivable
(100
)
 
(1,197
)
Accumulated deficit
(28,161
)
 
(27,373
)
Total Papa Murphy’s Holdings Inc. shareholders’ equity
89,066

 
33,925

Noncontrolling interests
389

 
222

Total equity
89,455

 
34,147

Total liabilities and equity
$
261,234

 
$
264,502

  See accompanying notes.

4

Table of Contents

PAPA MURPHY’S HOLDINGS, INC. AND SUBSIDIARIES
Condensed Consolidated Statement of Shareholders' Equity
(In thousands)
(Unaudited)
 
CUMULATIVE
SERIES A PREFERRED
STOCK
 
CUMULATIVE
SERIES B
PREFERRED
STOCK
 
COMMON STOCK
 
ADDITIONAL
PAID-IN
CAPITAL
 
STOCK
SUBSCRIP-
TION
RECEIVABLE
 
ACCUMU- LATED
DEFICIT
 
TOTAL
PAPA
MURPHY’S
HOLDINGS
INC.
SHARE-
HOLDERS’
EQUITY
 
NON
CONTROLLING
INTERESTS
 
TOTAL
EQUITY
 
SHARES
 
AMOUNT
 
SHARES
 
AMOUNT
 
SHARES
 
AMOUNT
 
 
 
 
 
 
 
 
 
 
 
 
BALANCE, December 30, 2013
2,854

 
60,156

 
27

 
741

 
4,348

 
43

 
1,555

 
(1,197
)
 
(27,373
)
 
33,925

 
222

 
34,147

Common stock issued, net of transaction costs

 

 

 

 
5,833

 
58

 
54,590

 

 

 
54,648

 

 
54,648

Common stock repurchases

 

 

 

 
(131
)
 
(1
)
 
(1,360
)
 

 

 
(1,361
)
 

 
(1,361
)
Conversion of preferred stock to common stock
(2,854
)
 
(60,156
)
 
(27
)
 
(741
)
 
6,912

 
69

 
60,828

 

 

 

 

 

Repayment of note receivable issued to fund the purchase of stock

 

 

 

 

 

 

 
1,097

 

 
1,097

 

 
1,097

Stock based compensation expense

 

 

 

 

 

 
1,545

 

 

 
1,545

 

 
1,545

Investment by noncontrolling interest

 

 

 

 

 

 

 

 

 

 
167

 
167

Net loss

 

 

 

 

 

 

 

 
(788
)
 
(788
)
 

 
(788
)
BALANCE, June 30, 2014

 
$

 

 
$

 
16,962

 
$
169

 
$
117,158

 
$
(100
)
 
$
(28,161
)
 
$
89,066

 
$
389

 
$
89,455


  See accompanying notes.


5

Table of Contents

PAPA MURPHY’S HOLDINGS, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(In thousands of dollars)
(Unaudited)
 
Six Months Ended
 
June 30,
2014
 
July 1,
2013
Operating Activities
 
 
 
Net (loss) income
$
(788
)
 
$
705

Adjustments to reconcile net (loss) income to net cash from operating activities
 
 
 
Depreciation and amortization
3,808

 
3,442

Loss on disposal or impairment of property and equipment
42

 
101

Loss on early retirement of debt
1,191

 

Bad debt expense
9

 

Non-cash employee equity compensation
1,545

 
177

Amortization of deferred finance charges
365

 
418

Change in operating assets and liabilities
 
 
 
Trade and other receivables
(1,978
)
 
170

Inventories
55

 
(11
)
Prepaid expenses and other current assets
77

 
941

Unearned franchise and development fees
(157
)
 
428

Accounts payable
(1,210
)
 
(527
)
Accrued expenses
(1,744
)
 
(1,275
)
Deferred taxes
(706
)
 
1,005

Other assets and liabilities
19

 
71

Net cash from operating activities
528

 
5,645

Investing Activities
 
 
 
Acquisition of property and equipment
(1,085
)
 
(957
)
Acquisition of stores, less cash acquired
(141
)
 
(3,101
)
Proceeds from sale of stores
138

 

Payments received on notes receivable
948

 
16

Investment in cost-method investee
(1,500
)
 

Net cash from investing activities
(1,640
)
 
(4,042
)
Financing Activities
 
 
 
Payments on long-term debt
(54,918
)
 
(440
)
Advances on revolver
1,000

 
500

Payments on revolver
(1,000
)
 
(2,200
)
Issuance of common stock, net of underwriting fees
59,675

 
57

Repurchases of common stock
(1,109
)
 
(9
)
Debt issuance and modification costs, including prepayment penalties
(6
)
 
(289
)
Payments received on subscription receivables
1,097

 

Costs associated with initial public offering
(3,490
)
 

Investment by noncontrolling interest holders
167

 

Net cash from financing activities
1,416

 
(2,381
)
 
 
 
 
Net change in cash and cash equivalents
304

 
(778
)
Cash and Cash Equivalents, beginning of year
3,705

 
2,428

Cash and Cash Equivalents, end of period
$
4,009

 
$
1,650

 
 
 
 
Supplemental Disclosures of Cash Flow Information
 
 
 
Cash paid during the period for interest
$
6,882

 
$
4,786

Cash paid during the period for income taxes
$
106

 
$
75

Deferred offering costs paid in 2013 reclassified to equity
$
1,537

 
$

Noncash Supplemental Disclosures of Investing and Financing Activities
 
 
 
Issuance of note receivable for preferred and common stock
$

 
$
113

Acquisition of property and equipment in accounts payable
$
51

 
$
52

See accompanying notes.

6

Table of Contents

PAPA MURPHY’S HOLDINGS, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Note 1—Description of Business and Basis of Presentation
Description of business —Papa Murphy’s Holdings, Inc. (“Papa Murphy’s” or the “Company”), together with its subsidiaries, is a franchisor and operator of a Take ‘N’ Bake pizza chain. The Company franchises the right to operate Take ‘N’ Bake pizza franchises and operates Take ‘N’ Bake pizza stores owned by the Company. As of June 30, 2014 , the Company had 1,436 stores consisting of 1,411 domestic stores ( 1,343 franchised stores and 68 company-owned stores) across 38 states, plus 25 franchised stores in Canada and the United Arab Emirates.
Public offering and stock split —On May 7, 2014 , the Company completed an initial public offering (the "IPO") of 5,833,333 shares of common stock at a price to the public of $11.00 per share. The Company received net proceeds from the offering of approximately $54.6 million after offering fees and expenses. The net proceeds, along with additional cash on hand, were used to repay $55.5 million of the Company's loans outstanding under the Company's senior secured credit facility after which the Company had $112.1 million outstanding under the facility with the revolver undrawn.
Immediately prior to the IPO, the Company amended and restated its certificate of incorporation to reflect the conversion of all outstanding Series A Preferred Stock and Series B Preferred Stock (together, the "Preferred Shares") to 3,054,318 shares of common stock. The total liquidation preference on the Preferred Shares at the time of conversion was $64.3 million . As part of the IPO, the Company increased its authorized shares from 3,000,000 shares of common stock, $0.01 par value per share, to 200,000,000 shares of common stock, $0.01 par value per share. The Company also authorized the issuance of 15,000,000 shares of preferred stock, $0.01 par value per share, with no shares outstanding.
In connection with the IPO, on May 1, 2014, the Company amended its certificate of incorporation to effect a 2.2630 for 1 stock split of its common stock. Concurrent with the stock split, the Company adjusted the number of shares subject to, and the exercise price of, its outstanding stock option awards under the Company's 2010 Amended Management Incentive Plan (the "2010 Plan") such that the holders of the options were in the same economic position both before and after the stock split. As a result of the stock split, all previously reported share amounts, including options in these unaudited condensed consolidated financial statements and accompanying notes, have been retrospectively restated to reflect the stock split. After the conversion of the Preferred Shares and the stock split, but before the shares were sold in the IPO, the Company had 11,134,070 common shares outstanding.
Basis of presentation —The accompanying interim unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (the "SEC"). Accordingly, they do not include all information and footnotes required by generally accepted accounting principles in the United States (“GAAP”) for complete financial statements. In the Company’s opinion, all necessary adjustments, consisting of only normal recurring adjustments, have been made for the fair presentation of the results of the interim periods presented. The results of operations for such interim periods are not necessarily indicative of the results to be expected for the full year. The accompanying interim unaudited condensed consolidated financial statements should be read in conjunction with the audited financial statements and the related notes thereto for the year ended December 30, 2013 included in the Company’s Registration Statement (Registration No. 333-194488) which was declared effective by the SEC on May 1, 2014 (as amended, the "Registration Statement").
Principles of consolidation —The interim unaudited condensed consolidated financial statements include the accounts of Papa Murphy’s Holdings, Inc. and its subsidiaries. The Company reports noncontrolling interests in consolidated entities as a component of equity separate from shareholders’ equity. All significant intercompany transactions and balances have been eliminated.
Throughout the interim unaudited condensed consolidated financial statements and these Notes, “Papa Murphy’s” and “the Company” refer to Papa Murphy’s Holdings, Inc. and its consolidated subsidiaries.
Fiscal year —The Company uses a 52- or 53-week fiscal year, ending on the Monday nearest to December 31. Fiscal years 2014 and 2013 are 52-week years. All three month periods presented herein contain 13 weeks. All references to years and quarters relate to fiscal periods rather than calendar periods. References to 2014 and 2013 are references to fiscal years ending December 29, 2014 and ended December 30, 2013 , respectively.
Internal use software —Expenditures for major software purchases and software developed for internal use are capitalized and amortized over the useful life of the software ( three to five years ) on a straight-line basis. The Company’s policy provides for the capitalization of external direct costs of materials and services associated with developing or obtaining

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internal-use computer software. Costs associated with preliminary project stage activities, training, maintenance and all other post-implementation stage activities are expensed as incurred.
Software revenue recognition —The Company recognizes revenues for the resale of software licenses upon delivery to franchise owners to the extent collectability is probable. In an effort to obtain more favorable pricing and expedite the roll-out of point-of-sale ("POS") systems, the Company acquired $4.5 million of POS software licenses in a lump sum purchase in 2013 and intends to resell them to franchise owners at cost. As of June 30, 2014 , the Company expects the licenses to be resold within the next six to nine months .
Recent accounting pronouncements —In July 2013, the Financial Accounting Standards Board ("FASB") issued ASU No. 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists, which prescribes that an unrecognized tax benefit or a portion of an unrecognized tax benefit should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar loss, or a tax credit carryforward, except in certain cases where the unrecognized tax benefit should be presented as a liability and should not be combined with deferred tax assets. This update is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013, with early adoption permitted. This update should be applied prospectively to all unrecognized tax benefits that exist at the effective date, with retrospective application permitted. The Company adopted ASU No. 2013-11 effective December 30, 2013. The adoption concerns presentation and disclosure only and did not have an effect on the Company’s consolidated financial position or results of operations.
In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, a new standard to achieve a consistent application of revenue recognition within the U.S., resulting in a single revenue model to be applied by reporting companies under U.S. generally accepted accounting principles. Under the new model, recognition of revenue occurs when a customer obtains control of promised goods or services in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In addition, the new standard requires that reporting companies disclose the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. This new standard is effective for fiscal years beginning after December 15, 2016; early adoption is prohibited. This new standard is required to be applied retrospectively to each prior reporting period presented or retrospectively with the cumulative effect of initially applying it recognized at the date of initial application. The Company has not yet selected a transition method nor has it determined the effects of the new standard on its condensed consolidated financial statements .
Note 2—Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consist of the following (in thousands):
 
June 30,
2014
 
December 30,
2013
Prepaid media development costs
$
622

 
$
16

Prepaid rents and insurance
778

 
458

Equity issuance costs

 
1,537

POS software licenses for resale
2,622

 
4,548

Convention deposits
1,119

 

Other
362

 
495

Total prepaid expenses and other current assets
$
5,503

 
$
7,054

 
Prepaid media development costs represent costs incurred for advertisements that have not aired. During the three and six months ended June 30, 2014 , the Company recognized $0.1 million and $1.9 million in software license revenue upon the resale of POS software licenses to franchise owners at cost. The income from the sale is included in Lease and other revenues and the related expense is recorded in Selling, general, and administrative expenses on the Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) .
Note 3—Property and Equipment
Property and equipment are net of accumulated depreciation of $7.7 million and $6.5 million at June 30, 2014 and December 30, 2013 , respectively. Depreciation expense for the three months ended June 30, 2014 and July 1, 2013 was $0.7 million and $0.6 million , respectively. Depreciation expense for the six months ended June 30, 2014 and July 1, 2013 was $1.3 million and $1.2 million , respectively.

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Note 4—Goodwill
The following summarizes changes to the Company’s goodwill, by reportable segment (in thousands):
 
 
DOMESTIC
COMPANY STORES
 
DOMESTIC
FRANCHISE
 
TOTAL
Balance at December 30, 2013
$
14,543

 
$
81,546

 
$
96,089

Disposition
(9
)
 

 
(9
)
Balance at June 30, 2014
$
14,534

 
$
81,546

 
$
96,080

 
There is no goodwill associated with the International Segment. During the three months ended June 30, 2014 , the Company has determined that there have not been any triggering events that would require an updated impairment review.
Note 5—Intangible Assets
Intangible assets are net of accumulated amortization of $16.7 million and $14.3 million as of June 30, 2014 and December 30, 2013 , respectively. Amortization expense for the three months ended June 30, 2014 and July 1, 2013 was $1.2 million and $1.1 million , respectively. Amortization expense for the six months ended June 30, 2014 and July 1, 2013 was $2.5 million and $2.2 million , respectively.
Note 6—Notes Receivable
Notes receivable consists of the following (in thousands):
 
June 30,
2014
 
December 30,
2013
Note issued on sale of company-owned restaurants maturing in 2020, bearing interest at 9.0%. Monthly payments of principal and interest of $6 are due through July 2014. Monthly payment amounts increase annually pursuant to an agreed schedule until they reach a monthly maximum of $9 in August 2018. Collateralized by restaurant assets. Note was moved from related party to 3rd party in 2014 (see Note 15).
$

 
$
443

Uncollateralized note issued to an employee, maturing in 2017, bearing interest at 0.88%. Note was paid in full in 2014.

 
40

Total related party notes receivable

 
483

Notes issued to finance franchise owners’ purchase of point of sale systems, three year term, maturing during 2014 and bearing interest at 10.5%. Monthly payments of principal and interest due through 2014. Collateralized by POS systems.
5

 
23

Note issued on the sale of company-owned restaurants maturing during 2015, denominated in Canadian dollars, bearing interest at 4%. Monthly payment terms of interest only through 2015. Collateralized by restaurant assets.
829

 
825

Note issued on sale of company-owned restaurants maturing in 2020, bearing interest at 9.0%. Monthly payments of principal and interest of $6 are due through July 2014. Monthly payment amounts increase annually pursuant to an agreed schedule until they reach a monthly maximum of $9 in August 2018. Collateralized by restaurant assets.
309

 

Note issued on the sale of company-owned restaurants maturing during 2014, bearing interest at 8%. Note was paid in full in 2014.

 
775

Total notes receivable
1,143

 
2,106

Less allowance for doubtful notes receivable
(829
)
 
(825
)
Notes receivable, net of allowance for doubtful notes receivable
314

 
1,281

Less current portion
(59
)
 
(837
)
Notes receivable, net of current position
$
255

 
$
444


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Note 7—Financing Arrangements
Long-term debt consists of the following (in thousands):
 
June 30,
2014
 
December 30,
2013
Senior secured credit facility
 
 
 
Term loan
$
112,083

 
$
167,000

Notes payable
3,000

 
3,000

Total long-term debt
115,083

 
170,000

Less current portion

 
(1,670
)
Total long-term debt, net of current portion
$
115,083

 
$
168,330

  PMI Holdings Inc., a wholly-owned subsidiary of the Company, has a $177.0 million senior secured credit facility consisting of a $167.0 million senior secured term loan and a $10.0 million revolving credit facility, which includes a $2.5 million letter of credit subfacility. The senior secured credit facility matures in October 2018 . The senior secured credit facility bore interest at an average rate of 6.2% for the second quarter of 2014 .
On May 7, 2014 , the Company prepaid $55.5 million of its long-term debt in connection with the IPO. A proportionate share of deferred financing costs of $1.2 million were expensed at the time of this debt prepayment.
Papa Murphy's Company Stores, Inc., a wholly-owned subsidiary of the Company, has a note payable for $3.0 million which bears interest at 5% and matures in December 2018 . This note is subordinated to the senior secured credit facility.
Note 8—Fair Value Measurement  
The fair value of cash and cash equivalents, accounts receivables and accounts payable approximates carrying value because of the short-term nature of the accounts. The fair value of notes receivable was $0.3 million and $1.3 million as of June 30, 2014 and December 30, 2013 , respectively, and was based on Level 3 inputs. The fair value of the notes receivable was estimated primarily using a discounted cash flow method based on a discount rate, reflecting the applicable credit spread. The fair value of long-term debt, including the current portion thereof, was approximately $116.2 million and $168.9 million as of June 30, 2014 and December 30, 2013 , respectively, and was based on Level 3 inputs. The fair value of long-term debt was estimated using a discounted cash flow method based on a discount rate, reflecting the applicable credit spread. The fair value of the Company's investment in Project Pie, LLC ("Project Pie"), a cost-method investee, approximates book value due to the recent nature of the investment and subsequent investments.
Note 9—Accrued and Other Liabilities
Accrued and other liabilities consist of the following (in thousands):
 
June 30,
2014
 
December 30,
2013
Accrued payable for POS software licenses
$
1,882

 
$
2,729

Accrued compensation and related costs
2,308

 
2,232

Gift cards and certificates payable
2,189

 
2,829

Accrued interest and non-income taxes payable
235

 
384

Convention fund
1,054

 
576

Other
482

 
991

 
$
8,150

 
$
9,741

Note 10—Income Taxes
The Company recognized an income tax benefit of $1.1 million on loss before income taxes of $2.7 million , or an effective tax rate of 40.9% , for the three months ended June 30, 2014 , compared to an income tax expense of $0.7 million on income before income taxes of $0.7 million , or an effective tax rate of 100.9% , for the three months ended July 1, 2013 . The effective tax rate for the second three months of 2014 includes the effect of a discrete adjustment for accelerated vesting of restricted stock. The effective tax rate for the second three months of 2013 includes the effect of a discrete adjustment for a change in the blended state tax rate.

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The Company recognized an income tax benefit of $0.4 million on loss before income taxes of $1.2 million , or an effective tax rate of 34.8% , for the six months ended June 30, 2014 , compared to an income tax expense of $1.1 million on income before income taxes of $1.9 million , or an effective tax rate of 61.9% , for the six months ended July 1, 2013 . The effective tax rate for the six months of 2014 includes the effect of a discrete adjustment for accelerated vesting of restricted stock. The effective tax rate for the first six months of 2013 includes the effect of a discrete adjustment for a change in the blended state tax rate.
Note 11—Shareholders’ Equity
Preferred stock —Prior to the IPO, the Company’s preferred stock consisted of Series A Preferred Shares (the “Series A Preferred Shares”) and Series B Preferred Shares (the “Series B Preferred Shares,” and together with the Series A Preferred Shares, the “Preferred Shares”). The Preferred Shares had a cumulative preferred dividend of 6.00%  per year based on an original liquidation value of $36.68 per share. Upon liquidation of the Company, the holders of the Preferred Shares were entitled to receive the unpaid liquidation value plus accreted dividends before any distribution could be made to the holders of common stock. In addition, the Preferred Shares participated in 20% of all remaining earnings if distributed to common stockholders. The unpaid liquidation value of the Series A and Series B Preferred Shares was $21.14 and $26.80 per share, respectively, as of the IPO. At the IPO, the Preferred Shares were converted into 3,054,318 shares of common stock.
Noncontrolling interests —During the three and six months ended June 30, 2014 the Company received an additional investment of $0.1 million and $0.2 million by noncontrolling interest holders in its majority-owned subsidiary Project Pie Holdings, LLC.
Note 12—Share-based Compensation
Restricted common shares and stock options —In May 2010, the Company’s Board of Directors approved the 2010 Plan. In May 2014, the Company's Board of Directors adopted the 2014 Equity Incentive Plan (the "2014 Plan," and together with the 2010 Plan, the "Incentive Plans"). With the adoption of the 2014 Plan, the Company has discontinued selling stock and issuing awards out of the 2010 Plan, but stock previously purchased and awards previously granted under the 2010 Plan remain outstanding.
The Incentive Plans reserve 2,116,747 common shares for equity incentive awards consisting of incentive stock options, non-qualified stock options, restricted stock awards, and unrestricted stock awards. Under the Incentive Plans, the Company has sold 622,880 and 753,783 shares of restricted common stock to eligible employees as of June 30, 2014 and December 30, 2013 , respectively. In addition, the Company has issued 963,913 and zero stock options under the Incentive Plans to eligible employees as of June 30, 2014 and December 30, 2013 , respectively.
Information with respect to restricted stock sales is as follows:
 
NUMBER OF SHARES OF
RESTRICTED COMMON STOCK
 
 
 
TIME VESTING
 
MARKET CONDITION
VESTING
 
WEIGHTED AVERAGE
SALE DATE
FAIR VALUE
Unvested, December 30, 2013
243,475

 
236,707

 
$
2.49

Sold/Granted

 

 

Vested
(90,510
)
 
(4,555
)
 
4.55

Forfeited/Repurchased
(7,239
)
 
(9,052
)
 
0.32

Unvested, June 30, 2014
145,726

 
223,100

 
$
2.32



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Information with respect to stock option activity is as follows:
 
NUMBER OF SHARES OF
STOCK OPTIONS
 
 
 
 
 
 
 
TIME
VESTING
 
MARKET
VESTING
 
WEIGHTED
AVERAGE
EXERCISE
PRICE
 
WEIGHTED
AVERAGE
REMAINING
CONTRACTUAL
TERM
 
AGGREGATE
INTRINSIC
VALUE
(in thousands)
Outstanding, December 30, 2013

 

 
$

 
 
 
 
Granted
740,932

 
231,655

 
11.16

 
 
 
 
Exercised

 

 

 
 
 
 
Forfeited
(5,783
)
 
(2,891
)
 
11.00

 
 
 
 
Outstanding, June 30, 2014
735,149

 
228,764

 
$
11.16

 
9.8 years
 
$

Exercisable, June 30, 2014
337,664

 

 
$
11.20

 
9.8 years
 
$

Vested and expected to vest at June 30, 2014
675,526

 
194,449

 
$
11.16

 
9.8 years
 
$

The weighted average fair value of share-based compensation awards granted and vested, and the intrinsic value of options exercised during the period were (in thousands, except per share amounts):
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
July 1,
2013
 
June 30,
2014
 
July 1,
2013
Restricted Stock Sales:
 
 
 
 
 
 
 
Weighted average sale date fair value per share
$

 
$
7.01

 
$

 
$
6.77

Total fair value of shares sold
$

 
$
119

 
$

 
$
230

Total fair value of shares vested
$
47

 
$
29

 
$
432

 
$
29

Stock Option Awards:
 
 
 
 
 
 
 
Weighted average grant date fair value per share
$
4.27

 
$

 
$
4.27

 
$

Total fair value of awards granted
$
3,367

 
$

 
$
4,151

 
$

Total fair value of awards vested
$
1,147

 
$

 
$
1,432

 
$

Total intrinsic value of options exercised
$

 
$

 
$

 
$


Compensation cost and valuation— Total compensation costs recognized in connection with the Incentive Plans for the three months ended June 30, 2014 and July 1, 2013 were $1.0 million and $0.2 million , respectively. Total compensation costs recognized in connection with the Incentive Plans for the six months ended June 30, 2014 and July 1, 2013 were $1.5 million and $0.2 million , respectively. Income tax benefits recognized for the three months ended June 30, 2014 and July 1, 2013 were $0.4 million and zero , respectively. Income tax benefits recognized for the six months ended June 30, 2014 and July 1, 2013 were $0.5 million and zero , respectively.
As of June 30, 2014 , the total unrecognized stock-based compensation expense, net of estimated forfeitures, was $1.8 million and the remaining weighted average contractual life was 2.6 years .
Prior to the IPO, the valuation of the Company’s common stock and Preferred Shares was based on the principles of option-pricing theory. This approach is based on modeling the value of the various components of an entity’s capital structure as a series of call options on the proceeds expected from the sale of the entity or the liquidation of its assets at some future date. Specifically, each of the preferred and common equity is modeled as a call option on the aggregate value of the Company with an exercise price equal to the liquidation preferences of the more senior securities. In estimating the fair value of the aggregate value of the Company, the Company considered both the income approach and the market approach.
The key inputs required to calculate the value of the common stock using the option-pricing model included the risk free rate, the volatility of the underlying assets, and the estimated time until a liquidation event. The Company applied a marketability discount to the value of common stock based on facts and circumstances at each valuation date.

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During the reported periods prior to the IPO, the Company assumed the following:
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014 (A)
 
July 1,
2013
 
June 30,
2014 (A)
 
July 1,
2013
Risk free rate
 
0.50%
 
0.36%
 
0.28~0.50%
Volatility of the underlying assets
 
35%
 
45%
 
35~40%
Estimated time until a liquidation event
 
(B)  
 
(C)  
 
(B)  
Marketability discount—common stock
 
(B)  
 
(C)  
 
(B)  
Marketability discount—preferred stock
 
(B)  
 
(C)  
 
(B)  
(A)
The last valuation of the Company was performed as of March 31, 2014.
(B)
On July 1, 2013, the Company began to apply a probability weighted expected return method, where equity values were calculated using an option pricing model under an IPO and non-IPO scenarios and each value was weighted based on estimated probability of occurrence. During the period, 1.25 ~ 2.50 years were used as estimated time until a liquidation event and 20 ~ 30% of marketability discount were used for common stock, depending on an IPO or non-IPO scenarios, respectively. No valuation of preferred stock was performed for preferred stock as of July 1, 2013 and no preferred stock was issued during the following quarter. As of July 1, 2013 , a 10% weight was given to the IPO scenario.
(C)
During the period, 0.58 ~ 1.75 years were used as estimated time until a liquidation event and 10 ~ 25% and 8 ~ 15% of marketability discount were used for common and preferred stock, respectively, depending on an IPO or non-IPO scenarios. As of March 31, 2014, the date of the last valuation performed by the Company, a 95% weight was given to the IPO scenario.
The fair value of the stock option awards granted in the three and six months ended June 30, 2014 was estimated with the following weighted-average assumptions.
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
July 1,
2013
 
June 30,
2014
 
July 1,
2013
Risk free rate
2.1%
 
 
2.0%
 
Expected volatility
34.9%
 
 
35.0%
 
Expected term
6.5 years
 
 
6.3 years
 
Expected dividend yield
0.0%
 
 
0.0%
 
 
Preferred and common stock subject to put options— In July 2011, the Company entered into a share repurchase and put option agreement with an executive officer, pursuant to which the executive officer had the right and option to have the Company repurchase 74,491 shares of unrestricted preferred stock and 92,951 shares ( 41,075 pre-stock split) of unrestricted common stock, which the employee previously acquired at fair value, at a redemption value on December 31 of any given calendar year following December 31, 2011 ("Put Option") after a certain condition is met. In December 2012, the Put Option became exercisable.
The Put Option was considered compensatory in nature as it was entered into in conjunction with an employment agreement modification. The combined shares and Put Option were evaluated in accordance with ASC Topic 718 and determined to be a liability-classified instrument on the date the Put Option was granted to the employee. Subsequent changes to the combined fair value of the shares and embedded Put Option are recorded as compensation expense. The fair value of the preferred and common stock subject to put options was determined by adding the fair value of put options to the fair value of common and preferred stock. The fair value of put options was determined using an option pricing method in a Monte Carlo simulation framework where total equity value at the hypothetical exit event among various equity classes of the Company was simulated and the payoff at the exercise of the put options was calculated based on the exercise price of the put options and the share values in each simulated scenario. The payoff of the put options in all scenarios was averaged and a present value calculated for each valuation date. The change in the fair value of the Put Option during the three and six months ended July 1, 2013 resulted in additional compensation expense of $0.2 million and $0.1 million . In December 2013, the share repurchase and put option agreement was canceled.
Note 13—Earnings per Share (EPS)
The number of shares and earnings per share ("EPS") data for all periods presented are based on the historical weighted-average shares of common stock outstanding. Prior to the IPO, the Company’s cumulative preferred stockholders were entitled to participate in 20% of all remaining earnings or dividends if distributed to common stockholders. As such, the Company has calculated EPS using the two-class method. The two-class method determines EPS for common stock and

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participating securities according to dividends and dividend equivalents and their respective participation rights in undistributed earnings.
EPS is calculated by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during each period. Diluted earnings per share (“diluted EPS”) is calculated using income available to common stockholders divided by diluted weighted-average shares of common stock outstanding during each period, which includes restricted common stock. Diluted EPS considers the impact of potentially dilutive securities except in periods in which there is a loss because the inclusion of the potential common shares would have an anti-dilutive effect.
The following table sets forth the computations of basic and dilutive earnings per share (in thousands, except per share data):
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
July 1,
2013
 
June 30,
2014
 
July 1,
2013
Earnings:
 
 
 
 
 
 
 
Net (loss) income
$
(1,607
)
 
$
(6
)
 
$
(788
)
 
$
705

Less: cumulative Series A and B Preferred dividends not subject to put options
(552
)
 
(1,615
)
 
(2,150
)
 
(3,208
)
Net loss available to common stockholders
$
(2,159
)
 
$
(1,621
)
 
$
(2,938
)
 
$
(2,503
)
Shares:
 
 
 
 
 
 
 
Weighted average common shares outstanding
11,375

 
3,832

 
7,613

 
3,814

Dilutive effect of restricted equity awards*

 

 

 

Diluted weighted average number of shares outstanding
11,375

 
3,832

 
7,613

 
3,814

Loss per share:
 
 
 
 
 
 
 
Basic loss per share
$
(0.19
)
 
$
(0.42
)
 
$
(0.39
)
 
$
(0.66
)
Diluted loss per share
$
(0.19
)
 
$
(0.42
)
 
$
(0.39
)
 
$
(0.66
)
*
Unvested restricted stock was not included in the computation of diluted earnings per share for the three months ended June 30, 2014 and July 1, 2013 since the effect would have been anti-dilutive. For the three months ended June 30, 2014 and July 1, 2013 , an aggregated total of 388,000 shares and 277,000 shares have been excluded from the diluted income per share calculation since their effect would have been anti-dilutive. For the six months ended June 30, 2014 and July 1, 2013 , an aggregated total of 341,000 shares and 289,000 shares have been excluded from the diluted income per share calculation since their effect would have been anti-dilutive.
Note 14—Commitments and Contingencies
Commitment to purchase additional equity subscriptions —In connection with its investment in Project Pie, the Company has committed as of June 30, 2014 to fund, upon demand, up to an additional $1.0 million prior to December 2016 in increments of $0.5 million through the purchase of additional Series A Preferred Units of Project Pie. The number of units to be purchased will be determined based upon the then-current pre-money valuation. During the three and six months ended June 30, 2014 the Company invested an additional $1.0 million and $1.5 million in Series A Preferred Units of Project Pie.
Operating lease commitments —The Company leases facilities and various office equipment under non-cancelable operating leases which expire through January 2021 . Lease terms for its store units are generally for five years with renewal options and generally require the Company to pay a proportionate share of real estate taxes, insurance, common area, and other operating costs.
The Company has entered into operating leases that it has subleased to three franchise owner store locations. These operating leases have minimum base rent terms and contingent rent terms if individual franchise store sales exceed certain levels and have terms expiring on various dates from May 2015 to January 2016 .
Lease guarantees —The Company is the guarantor for operating leases of eight franchise owner store locations that have terms expiring on various dates from July 2015 to September 2018 . The obligations from these leases will generally continue to decrease over time as the leases expire. As of June 30, 2014 , the Company does not believe it is probable it would be required to perform under the outstanding guarantees. The applicable franchise owners continue to have primary liability for these operating leases.
Legal proceedings —The Company is currently subject to litigation with a group of franchise owners. In January 2014, six franchise owner groups claimed that the Company misrepresented sales volumes, made false representations to them and

14

Table of Contents

charged excess advertising fees, among other things. The Company engaged in mediation with these franchise owners, which is required under the terms of their franchise agreements, in order to address and resolve their claims, but was unable to reach a settlement agreement. On April 4, 2014, a total of 12 franchise owner groups representing 52 open franchise stores, including those franchise owners that previously made the allegations described above, filed a lawsuit against the Company in the Superior Court in Clark County, Washington, making essentially the same allegations for violation of the Washington Franchise Investment Protection Act, fraud, negligent misrepresentation and breach of contract and seeking declaratory and injunctive relief, as well as monetary damages. Based on motions filed by the Company in that lawsuit, the court ruled on July 9, 2014 that certain of the plaintiffs' claims under the anti-fraud and nondisclosure provisions of the Washington Franchise Investment Protection Act should be dismissed and that certain other claims in the case would need to be more specifically alleged. The court also ruled that the six franchise owner groups who had not mediated with the Company prior to filing the lawsuit must do so, and that their claims shall be stayed until they have completed mediating with the Company in good faith.
On June 18, 2014, an additional 16 franchise owner groups, represented by the same counsel as the plaintiffs described above, filed a lawsuit in the Superior Court in Clark County, Washington making essentially the same allegations as made in the lawsuit described above and seeking declaratory and injunctive relief, as well as monetary damages. The court has consolidated the two lawsuits into a single case and ordered that the plaintiffs in the new lawsuit, none of whom had mediated with the Company prior to filing the lawsuit, must do so, and that their claims shall be stayed until they have completed mediating with the Company in good faith.
The Company believes the allegations in these consolidated lawsuits lack merit and is vigorously defending its interests, including by asserting a number of affirmative defenses; and, as to one franchise owner group, counterclaims. The Company provides no assurance that it will be successful in its defense of these lawsuits; however, it does not currently expect the cost of resolving them to have a material adverse effect on its consolidated financial position, results of operations, or cash flows.
In addition to the foregoing, the Company is subject to routine legal proceedings, claims, and litigation in the ordinary course of its business. The Company may also engage in future litigation with franchise owners to enforce the terms of franchise agreements and compliance with brand standards as determined necessary to protect the Company's brand, the consistency of products and the customer experience. Lawsuits require significant management attention and financial resources and the outcome of any litigation is inherently uncertain. The Company does not, however, currently expect that the costs to resolve these routine matters will have a material adverse effect on its consolidated financial position, results of operations, or cash flows.
Note 15—Related Party Transactions
Advisory services and monitoring agreement —Prior to the IPO, the Company was a party to an advisory services and monitoring agreement with affiliates of Lee Equity Partners, LLC (Lee Equity Partners, LLC, together with its affiliates, "Sponsor"). In accordance with the terms of the agreement, the Company paid the Sponsor for ongoing advisory and monitoring services such as management consulting, financial analysis, and other related services. As compensation, the Company paid an annual fee of $0.5 million in four equal quarterly installments plus direct expenses incurred which are included in selling, general and administrative expenses. The agreement did not call for a minimum level of services to be furnished and provided that fees paid to the Sponsor could be deferred at the discretion of the Sponsor or if required by the Company's senior secured credit facility.
On May 7, 2014, the Company completed the IPO and paid the Sponsor $1.5 million in accordance with the terms of the agreement. With the completion of the IPO, the advisory services and monitoring agreement between the Company and the Sponsor has been terminated.
Employee loans related to share purchases (see Note 12—Share-based Compensation)—In connection with share-based compensation, the Company has made several loans to certain officers and non-officer employees of the Company. Loans made in connection with the issuance of the Company’s equity have been recognized in stock subscription receivables as a reduction of equity.
In March 2014, the Company entered into agreements with certain executive officers to repurchase an aggregate of 109,779 shares of common stock ( 48,516 shares pre-stock split) at a price of $11.85 per share ( $26.80 per share pre-stock split), for a total purchase price of $1.3 million . Included among the repurchased shares were 31,707 shares of common stock ( 14,014 shares pre-stock split) for which vesting terms were accelerated in connection with the repurchase. The Company received a payment of $1.0 million from the same executive officers to repay their outstanding stock subscription receivables. Concurrent with the share repurchase, the Company entered into agreements with the same executive officers to issue 109,779 stock options ( 48,516 stock options pre-stock split) to purchase shares at an exercise price of $11.85 per share ( $26.80 per share pre-stock split), including 78,072 fully vested options ( 34,502 options pre-stock split) and 31,707

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options ( 14,014 options pre-stock split) subject to time-based or market condition-based vesting provisions. In connection with the acceleration of vesting and the issuance of the fully vested options, the Company recorded stock-based compensation expense of $0.5 million for the six months ending June 30, 2014 .
All loans made to officers of the Company were repaid prior to the IPO. Some loans made to non-officer employees of the Company were still outstanding at the time of the IPO. As of June 30, 2014 and  December 30, 2013 , the Company had stock subscription receivables of $0.1 million and $1.2 million , respectively.
Notes receivable (see Note 6—Notes Receivable)—On August 18, 2009, the Company obtained a note receivable from a third party in connection with the sale and refranchising of Company-owned stores. Subsequently, in March 2011 a member of the third party became an employee of the Company. As of June 30, 2014, the member of the third party ceased to be an employee of the company. During the second quarter of 2014, the notes receivable outstanding balance of $0.3 million was reclassified from related party notes receivable to third party notes receivable. The outstanding balance for this transaction as of December 30, 2013 was $0.4 million .
Related party revenue —For the three and six months ended June 30, 2014 , the Company was party to transactions to sell services to Project Pie, a cost-method investee. The Company recorded revenues of $45,000 and $0.1 million for the three and six months ended June 30, 2014 , respectively. Revenue from these transactions are recorded as Lease and other revenues on the Condensed Consolidated Statements of Operations and Comprehensive Income (Loss) .
Note 16—Segment Information
The Company has the following reportable segments: (i) Domestic Company Stores; (ii) Domestic Franchise; and (iii) International. The Domestic Company Stores segment includes operations with respect to company-owned stores in the United States and derives its revenues from retail sales of pizza and side items to the general public. The Domestic Franchise segment includes operations with respect to franchise stores in the United States and derives its revenues from franchise and development fees and the collection of franchise royalties from the Company’s franchise owners located in the United States. The International segment includes operations related to the Company’s operations outside the United States and derives its revenues from franchise and development fees and the collection of franchise royalties located outside the United States.
The following tables summarize information on profit or loss and assets for each of the Company's reportable segments (in thousands):
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
July 1,
2013
 
June 30,
2014
 
July 1,
2013
Revenues
 
 
 
 
 
 
 
Domestic Franchise
$
10,324

 
$
9,800

 
$
23,371

 
$
20,202

Domestic Company Stores
11,477

 
9,297

 
23,495

 
18,463

International
45

 
25

 
97

 
50

Other

 

 

 

Total
$
21,846

 
$
19,122

 
$
46,963

 
$
38,715

Segment Operating Income (Loss)
 
 
 
 
 
 
 
Domestic Franchise
$
4,234

 
$
5,034

 
$
10,228

 
$
9,557

Domestic Company Stores
158

 
(161
)
 
678

 
(71
)
International
(121
)
 
(34
)
 
(225
)
 
(83
)
Other
(3,459
)
 
(1,674
)
 
(5,269
)
 
(2,468
)
Total
$
812

 
$
3,165

 
$
5,412

 
$
6,935


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Table of Contents

 
June 30,
2014
 
December 30,
2013
Total Assets
 
 
 
Domestic Franchise
$
148,690

 
$
139,471

Domestic Company Stores
28,057

 
29,489

International
539

 
515

Other (*)
142,244

 
119,375

Total
$
319,530

 
$
288,850

Elimination of intersegment assets:
 
 
 
Intercompany note
(21,690
)
 
(21,690
)
Intercompany receivables
(36,606
)
 
(2,658
)
Total Consolidated
$
261,234

 
$
264,502

(*)
  Other assets which are not allocated to the individual segments primarily include trade names & trademarks, unamortized deferred financing charges, and an intercompany note.

17

Table of Contents

Item 2.        Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the accompanying unaudited consolidated financial statements and related notes in Item 1 and with the audited consolidated financial statements and the related notes included in the Registration Statement. To match our operating cycle, we use a 52- or 53-week fiscal year, ending on the Monday nearest to December 31. Our fiscal quarters each contain 13 operating weeks, with the exception of the fourth quarter of a 53-week fiscal year, which contains 14 operating weeks. Fiscal years 2014 and 2013 are 52-week periods ending on December 29, 2014 and December 30, 2013, respectively.
Cautionary Note Regarding Forward-Looking Statements
In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors including, but not limited to, those discussed in the section entitled "Risk Factors" in this Quarterly Report on Form 10-Q and our Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2014. All statements other than statements of historical fact or relating to present facts or current conditions included in this discussion and analysis are forward-looking statements. Forward-looking statements give our current expectations and projections relating to our financial condition, results of operations, plans, objectives, future performance and business. You can identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. Examples of forward-looking statements include those regarding our future financial or operating results, cash flows, business strategies and priorities, resolution of litigation and claims, commodity prices, expansion and growth opportunities, exposure to foreign currency and interest rate risk, asset dispositions, as well as industry trends and outlooks. These statements may include words such as “anticipate,” “estimate,” “expect,” “project,” “plan,” “intend,” “believe,” “may,” “should,” “can have,” “likely” and other words and terms of similar meaning in connection with any discussion of the timing or nature of future operating or financial performance or other events .
The forward-looking statements contained in this discussion and analysis are based on assumptions that we have made in light of our industry experience and our perceptions of historical trends, current conditions, expected future developments and other factors we believe are appropriate under the circumstances. As you read and consider this discussion and analysis, you should understand that these statements are not guarantees of performance or results. They involve risks, uncertainties (many of which are beyond our control) and assumptions. Although we believe that these forward-looking statements are based on reasonable assumptions, you should be aware that many factors could affect our actual operating and financial performance and cause our performance to differ materially from the performance anticipated in the forward-looking statements. We believe these factors include, but are not limited to, those described under the section entitled "Risk Factors" in this Quarterly Report on Form 10-Q and our Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2014. Should one or more of these risks or uncertainties materialize, or should any of these assumptions prove incorrect, our actual operating and financial performance may vary in material respects from expectations based on these forward-looking statements.
Any forward-looking statement made by us in this discussion and analysis speaks only as of the date on which we make it. Factors or events that could cause our actual operating and financial performance to differ may emerge from time to time, and it is not possible for us to predict all of them. We undertake no obligation to publicly update any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by law.
Overview
Papa Murphy’s is a franchisor and operator of the largest Take ‘N’ Bake pizza chain in the United States. We were founded in 1981 and have grown our footprint to a total of 1,436 system-wide stores as of June 30, 2014 . The Papa Murphy’s experience is different from traditional pizza restaurants. Our customers:
CREATE their fresh customized pizza with high-quality ingredients in our stores or online;
TAKE their fresh pizza home; and
BAKE their pizza fresh in their ovens, at their convenience, for a home-cooked meal served hot.
We have been repeatedly rated the #1 pizza chain in the United States by multiple third-party consumer studies. In 2014, we were rated the #1 pizza chain and the #2 fast food chain overall by a leading consumer magazine. In 2014, we were rated #1 in the Pizza Category by Market Force Information, including the top spot in food quality, healthy food, and friendly service. In 2014, 2013, 2012 and 2011, we were rated the #1 pizza chain overall by Nation’s Restaurant New s, and in 2012, 2011 and 2010, we were rated the #1 pizza chain by Zagat . Compared to broader restaurant chain competition, we were

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also recognized by Technomic in 2014 and 2013 as the #1 chain overall among all restaurants and all food categories, by Nation’s Restaurant News in 2013 and 2012 as one of the Top 5 Overall limited service restaurant chains across all food categories, and by Zagat in 2012 as one of the Top 5 Overall fast food chains across all food categories.
2014 Highlights
Restaurant Development
As of June 30, 2014 , we had 1,411 stores in the United States ( 1,343 franchised stores and 68 company-owned stores), 20 in Canada and 5 in the United Arab Emirates. Our domestic and international franchise owners opened 20 stores in the three months ended June 30, 2014 , including 18 in the United States. Through the six months ended June 30, 2014 , our domestic and international franchise owners opened 41 stores, including 37 in the United States. We expect the majority of our expansion will result from new franchise store openings, and we also plan to strategically expand our company-owned store base in select markets.
Comparable Store Sales Growth
Comparable store sales increased by 1.5% at domestic restaurants, 1.2% at domestic franchise-owned restaurants, and 5.7% at company-owned restaurants in the three months ended June 30, 2014 compared to the three months ended July 1, 2013 . The comparable store sales growth was primarily the result of a favorable product mix partially offset by an unfavorable holiday shift with the Easter holiday falling in the second quarter of 2014, instead of the first quarter as in 2013. Most of our stores are closed on Easter.
Comparable store sales increased by 2.5% at domestic restaurants, 2.2% at domestic franchise-owned restaurants, and 6.4% at company-owned restaurants in the six months ended June 30, 2014 compared to the six months ended July 1, 2013 . The comparable store sales growth was primarily the result of a favorable product mix and the result of a favorable holiday shift with the 2013 New Year's Eve falling in the first week of 2014 compared to the 2012 New Year's Eve falling in the last week of 2012.
Common Stock Repurchases
In March 2014, we repurchased an aggregate of 109,779 shares of common stock from certain of our executive officers, including an aggregate of 31,707 shares of common stock for which vesting terms were accelerated in connection with the repurchase. We repurchased the shares at a price of $11.85 per share, the then-current fair market value of our common stock.
Initial Public Offering
On May 7, 2014 , we completed the IPO of 5,833,333 shares of common stock at a price to the public of $11.00 per share. We received net proceeds from the offering of approximately $54.6 million from this transaction after estimated offering fees and expenses. The net proceeds were used to repay $55.5 million of our loans outstanding under our senior secured credit facility after which we had $112.1 million outstanding under the facility with the revolver undrawn.
Immediately prior to the IPO, we amended and restated our certificate of incorporation to reflect the automatic conversion of all outstanding Preferred Shares to 3,054,318 shares of common stock. The total liquidation preference on the Preferred Shares at the time of conversion was $64.3 million . As part of the IPO, we increased our authorized shares from 3,000,000 shares of common stock, $0.01 par value per share, to 200,000,000 shares of common stock, $0.01 par value per share. We also authorized the issuance of 15,000,000 shares of preferred stock, $0.01 par value per share, with no shares outstanding.
In connection with the IPO, on May 1, 2014, we amended our certificate of incorporation to effect a 2.2630 for 1 stock split of our common stock. Concurrent with the stock split, we adjusted the number of shares subject to, and the exercise price of, our outstanding stock option awards under the 2010 Plan so that the holders of the options were in the same economic position both before and after the stock split. As a result of the stock split, all previously reported share amounts, including options in these unaudited condensed consolidated financial statements and accompanying notes, have been retrospectively restated to reflect the stock split. After the conversion of our Preferred Shares and the stock split but before the shares were sold in the IPO, we had 11,134,070 common shares outstanding.
Our Segments
We operate in three business segments: Domestic Franchise, Domestic Company Stores and International. Our Domestic Franchise segment consists of our domestic franchise stores, which represent the majority of our system-wide stores. Our Domestic Company Stores segment consists of our company-owned stores in the United States. Our International segment

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consists of our stores outside of the United States, all of which are franchise stores. The following table sets forth our revenues, operating income and depreciation and amortization for each of our segments for the periods presented:  
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
July 1,
2013
 
June 30,
2014
 
July 1,
2013
 
(dollars in thousands)
Revenues
 
 
 
 
 
 
 
Domestic Franchise
$
10,324

 
$
9,800

 
$
23,371

 
$
20,202

Domestic Company Stores
11,477

 
9,297

 
23,495

 
18,463

International
45

 
25

 
97

 
50

Total
$
21,846

 
$
19,122

 
$
46,963

 
$
38,715

Operating Income
 
 
 
 
 
 
 
Domestic Franchise
$
4,234

 
$
5,034

 
$
10,228

 
$
9,557

Domestic Company Stores
158

 
(161
)
 
678

 
(71
)
International
(121
)
 
(34
)
 
(225
)
 
(83
)
Other (1)
(3,459
)
 
(1,674
)
 
(5,269
)
 
(2,468
)
Total
$
812

 
$
3,165

 
$
5,412

 
$
6,935

Depreciation and Amortization
 
 
 
 
 
 
 
Domestic Franchise
$
1,261

 
$
1,198

 
$
2,430

 
$
2,389

Domestic Company Stores
698

 
536

 
1,363

 
1,036

International
8

 
9

 
15

 
17

Total
$
1,967

 
$
1,743

 
$
3,808

 
$
3,442

(1)
Represents corporate costs and intersegment elimination
Key Operating Metrics
We evaluate the performance of our business using a variety of operating and performance metrics. Set forth below is a description of our key operating metrics.
Average Weekly Sales. AWS consists of the average weekly sales of domestic franchise and company-owned stores over a specified period of time. AWS is calculated by dividing the total net sales of our domestic system-wide stores for the relevant time period by the number of weeks these same stores were open in such time period. This measure allows management to assess changes in customer traffic and spending patterns at our domestic system-wide stores.
Comparable Store Sales Growth. Comparable store sales growth represents the change in year-over-year sales for comparable stores. A comparable store is a store that has been open for at least 52 full weeks from the comparable date (the Tuesday following the opening date). As of the end of the second quarter of 2014 and 2013 , there were 1,309 and 1,257 domestic comparable stores, respectively. This measure highlights the performance of existing stores, while excluding the impact of newly opened or closed stores. Comparable store sales growth reflects changes in the number of transactions and in customer spend per transaction at existing stores. Customer spend per transaction is affected by changes in menu prices, sales mix and the number of items sold per customer.
System-Wide Sales . System-wide sales include net sales by all of our system-wide stores. This measure allows management to assess changes in our royalty revenues, our overall store performance, the health of our brand and our position relative to competitors.
Adjusted EBITDA . We define Adjusted EBITDA as net income (loss) before interest expense, provision for (benefit from) income taxes and depreciation and amortization, with further adjustments to reflect the additions and eliminations of certain income statement items including non-cash charges, income and expenses that we consider not indicative of ongoing operations and certain other adjustments. For a reconciliation of Adjusted EBITDA to net income, the most directly comparable GAAP measure, see below.


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Reconciliation of Net income to Adjusted EBITDA
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
July 1,
2013
 
June 30,
2014
 
July 1,
2013
 
(dollars in thousands)
 Net loss (income)
$
(1,607
)
 
$
(6
)
 
$
(788
)
 
$
705

 Depreciation and amortization
1,967

 
1,743

 
3,808

 
3,442

 Income tax provision (benefit)
(1,112
)
 
686

 
(421
)
 
1,145

 Interest expense, net
2,297

 
2,476

 
5,375

 
5,069

 EBITDA
1,545

 
4,899

 
7,974

 
10,361

Loss on disposal or impairment of property and equipment (a)
36

 
37

 
42

 
101

Management transition and restructuring costs (b)

 
488

 
178

 
488

Expenses not indicative of future operations (c)
278

 

 
473

 

Management fees and related expenses (d)
1,543

 
152

 
1,678

 
277

Transaction costs (e)
60

 
2

 
62

 
8

New store pre-opening expenses (f)
1

 

 
11

 

Non-cash expenses and non-income based state taxes (g)
1,033

 
231

 
1,611

 
209

Loss on early retirement of debt (h)
1,191

 

 
1,191

 

 Adjusted EBITDA
$
5,687

 
$
5,809

 
$
13,220

 
$
11,444

(a)
Represents non-cash losses resulting from disposal or impairment of property and equipment, including divested company stores.
(b)
Represents non-recurring management transition and restructuring costs, consisting of recruitment, relocation and other costs in connection with recruiting a new chief financial officer.
(c)
Represents non-recurring advisory expenses.
(d)
Represents the elimination of management fees and related costs paid to the Sponsor for advisory services provided pursuant to an advisory services and monitoring agreement and the termination fee as part of the IPO.
(e)
Represents transaction costs relating to acquisitions and divestitures.
(f)
Represents expenses directly associated with the opening of new stores and incurred prior to the opening of new stores, including wages, benefits, travel for the training of opening teams and other store operating costs.
(g)
Represents (i) non-cash expenses related to equity-based compensation; (ii) non-cash expenses related to the difference between GAAP and cash rent expense; (iii) non-cash expenses related to the fair valuation of certain common stock and Series A Preferred Stock subject to put options; and (iv) state revenue taxes levied in lieu of an income tax.
(h)
Represents losses resulting from refinancing of long-term debt.
Store Openings, Closures, Acquisitions and Divestitures . Management reviews the number of new stores, the number of closed stores, and the number of acquisitions and divestitures of stores to assess growth in system-wide sales, royalty revenues and company-owned store sales.
The following table sets forth our AWS and comparable store sales growth for domestic stores (franchise and company-owned), our system-wide sales, Adjusted EBITDA and our number of system-wide stores for the three and six months ended June 30, 2014 and July 1, 2013 .  
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
July 1,
2013
 
June 30,
2014
 
July 1,
2013
Domestic store AWS
$
10,848

 
$
10,846

 
$
11,296

 
$
11,189

Domestic comparable store sales growth
1.5
%
 
3.6
%
 
2.5
%
 
2.1
%
System-wide sales (dollars in thousands)
$
200,718

 
$
190,743

 
$
416,701

 
$
392,223

Adjusted EBITDA (dollars in thousands)
$
5,687

 
$
5,809

 
$
13,220

 
$
11,444

Number of system-wide stores at period end
1,436

 
1,365

 
1,436

 
1,365

 
Key Financial Definitions
Revenues. Substantially all of our revenues are derived from sales of pizza and other food and beverage products to the general public by company-owned stores, as well as the collection of franchise royalties and fees associated with franchise and development rights. Lease and other includes revenues earned from the sublease of real estate under a master lease agreement with a national retailer and revenues derived from the resale of POS licenses to franchise owners at cost. Lease

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income is recognized in the period earned, which coincides with the period the expense is due to the master leaseholder. See Selling, General and Administrative below for the related offsetting expense to the POS licenses resold to franchise owners.
Selling, General and Administrative. Selling, general and administrative costs consist of wages, benefits and other compensation, franchise development expenses, travel, marketing, accounting fees, legal fees, the costs of POS licenses sold to franchise owners at cost, sponsor management fees and other expenses related to the infrastructure required to support our franchised and company-owned stores. See Revenues above for the related offsetting revenue from the POS licenses resold to franchise owners. Selling, general and administrative costs also include net advertising expenses of an advertising fund we manage on behalf of all domestic stores.
Provision for Income Taxes . Provision for income taxes represents federal, state and local taxes based on income in multiple jurisdictions.
Results of Operations
The following table sets forth our results of operations in dollars and as a percentage of total revenues for the three and six months ended June 30, 2014 and July 1, 2013 .  
 
Three Months Ended
 
Six Months Ended
 
June 30,
2014
 
July 1,
2013
 
June 30,
2014
 
July 1,
2013
 
$
 
TOTAL
% OF
REVENUES
 
$
 
TOTAL
% OF
REVENUES
 
$
 
TOTAL
% OF
REVENUES
 
$
 
TOTAL
% OF
REVENUES
 
(dollars in thousands)
Revenues
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Franchise royalties
$
9,315

 
42.6
 %
 
$
8,970

 
46.9
 %
 
$
19,384

 
41.3
 %
 
$
18,473

 
47.7
 %
Franchise and development fees
862

 
3.9
 %
 
823

 
4.3
 %
 
2,031

 
4.3
 %
 
1,705

 
4.4
 %
Company-owned store sales
11,477

 
52.5
 %
 
9,297

 
48.6
 %
 
23,495

 
50.0
 %
 
18,463

 
47.7
 %
Lease and other  (1)
192

 
0.9
 %
 
32

 
0.2
 %
 
2,053

 
4.4
 %
 
74

 
0.2
 %
Total revenues (1)
21,846

 
100.0
 %
 
19,122

 
100.0
 %
 
46,963

 
100.0
 %
 
38,715

 
100.0
 %
Costs and Expenses
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Store operating costs (exclusive of depreciation and amortization shown separately below):
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cost of food and packaging  (2)
4,499

 
20.6
 %
 
3,544

 
18.5
 %
 
9,089

 
19.4
 %
 
6,968

 
18.0
 %
Compensation and benefits  (2)
2,905

 
13.3
 %
 
2,658

 
13.9
 %
 
5,935

 
12.6
 %
 
5,230

 
13.5
 %
Advertising (2)
1,122

 
5.1
 %
 
962

 
5.0
 %
 
2,244

 
4.8
 %
 
1,808

 
4.7
 %
Occupancy (2)
674

 
3.1
 %
 
583

 
3.0
 %
 
1,334

 
2.8
 %
 
1,137

 
2.9
 %
Other restaurant operating costs (2)
1,007

 
4.6
 %
 
917

 
4.8
 %
 
2,076

 
4.4
 %
 
1,847

 
4.8
 %
Selling, general, and administrative  (1)
8,824

 
40.4
 %
 
5,513

 
28.8
 %
 
17,023

 
36.2
 %
 
11,247

 
29.1
 %
Depreciation and amortization
1,967

 
9.0
 %
 
1,743

 
9.1
 %
 
3,808

 
8.1
 %
 
3,442

 
8.9
 %
Loss on disposal or impairment of property and equipment
36

 
0.2
 %
 
37

 
0.2
 %
 
42

 
0.1
 %
 
101

 
0.3
 %
Total costs and expenses
21,034

 
96.3
 %
 
15,957

 
83.4
 %
 
41,551

 
88.5
 %
 
31,780

 
82.1
 %
Operating Income  (1)
812

 
3.7
 %
 
3,165

 
16.6
 %
 
5,412

 
11.5
 %
 
6,935

 
17.9
 %
Interest expense
2,316

 
10.6
 %
 
2,498

 
13.1
 %
 
5,428

 
11.6
 %
 
5,113

 
13.2
 %
Interest income
(19
)
 
(0.1
)%
 
(22
)
 
(0.1
)%
 
(53
)
 
(0.1
)%
 
(44
)
 
(0.1
)%
Loss on early retirement of debt
1,191

 
5.5
 %
 

 
 %
 
1,191

 
2.5
 %
 

 
 %
Other expense, net
43

 
0.2