Pizza Pizza Royalty Income Fund 2006 Annual Report

Pizza Pizza Royalty Income Fund CONSOLIDATED ANNUAL REPORT For the Period from January 1, 2006 to December 31, 2006 Table of Contents Part I: Pizza Pizza Royalty Income Fund Glossary .......................................................................................................................6 Management’s Discussion and Analysis.......................................................................7 Consolidated Financial Statements ..............................................................................23 Part II: Pizza Pizza Limited Our Business ................................................................................................................35 Management’s Discussion and Analysis.......................................................................38 Consolidated Financial Statements ..............................................................................51 Unitholder Information ..................................................................................................70 (Note: This annual report and prior quarterly reports, press releases and the final prospectus can be found at www.sedar.com or at www.pizzapizzaroyaltyincomefund.com) -2- 2006 Financial Highlights $ in thousands, except per share data and number of restaurants Year-ended December 31, 2006 Same Store Sales Growth1 New Restaurants: Opened in 2006 Closed in 2006 Restaurants in 2006 Royalty Pool System sales reported by Royalty Pool Royalty – 6% of system sales2 Partnership expenses Partnership Net Earnings Fund Net earnings Earnings per Fund unit Distributions per Fund unit Payout Ratio Total Assets Total Liabilities 1 2 4.5% 30 5 501 $ 353,138 $ 21,188 1,710 $ $ $ $ 19,478 15,890 0.885 0.842 95% $ 171,796 $ 1,275 Performance vs. fiscal 2005. The Fund, indirectly through the Partnership earns royalty income equal to 6% of system sales of Pizza Pizza Restaurants included in the Royalty Pool. -3- Letter from the Chair of the Pizza Pizza Royalty Income Fund To our Unitholders On behalf of the Board of Trustees, I am pleased to present the Pizza Pizza Royalty Income Fund’s operating results for the year ended December 31, 2006 (the “period”). Results This period marks the Fund’s first full year of operations, which saw solid results in the same store sales growth (SSSG) of 4.5%, and two distribution increases to unitholders. The system sales reported in 2006 by the 501 restaurants in the Royalty Pool were $353,138,000. The positive results experienced this year in SSSG and operating results reflects Pizza Pizza’s focus on successful marketing and promotional campaigns, and continuous product development. Distribution Increase During the period, the Trustees were pleased to authorize two distribution increases to you, the unitholders. The monthly distribution was first increased by 2.1% to $0.0695 per unit from $0.0681 per unit, beginning with the February 2006 distribution. In July 2006, we were pleased to announce the second distribution increase for 2006 of 2.16% to $0.071 per unit from $0.0695 per unit. This resulted in an annual distribution of $0.8416 per unit. The Fund’s objective is to provide consistent monthly distributions to unitholders at the highest sustainable level, and the Fund will continue to review distribution levels on an ongoing basis. As a result of our continuous review, subsequent to December 31, 2006, the Trustees authorized an increase to its monthly distribution by 2.8% to $0.073 per unit from $0.071 per unit, beginning with the January 2007 distribution. Federal Government Tax on Income Funds On October 31, 2006, The Federal Department of Finance announced a new distribution tax on distributions received from publicly traded income trusts beginning in fiscal 2011. We are unsure when the proposal will be passed into law, but unfortunately have seen the immediate consequence this announcement has had on our unit value. We will closely monitor any developments and assess the strategic issues from this proposal. Outlook Pizza Pizza remains “Ontario’s #1 pizza” and management is committed to maintaining and improving the high quality and variety, which have made the Pizza Pizza brand strong. Pizza Pizza’s management team is not only focused on increasing Pizza Pizza’s presence in Ontario, but also on growing the brand in markets beyond Ontario, leveraging off the non-traditional locations which are across Canada. The Trustees look forward to another outstanding year at Pizza Pizza. Sincerely, Elizabeth Wright Chair, Pizza Pizza Royalty Income Fund -4- Letter from the Chairman of Pizza Pizza Limited In 2006, Pizza Pizza continued to increase its market share and remains “Ontario’s #1 pizza”, capturing 28% of the Ontario pizza quick service restaurant (“QSR”) market share. Our pledge “Always the best food, made especially for you”, is at the center of everything we do. It is an assurance to our customers that we highly value quality, service, and cleanliness. 2007 marks the 40th anniversary of Pizza Pizza Limited. We at Pizza Pizza will be celebrating this milestone with new promotions and new product introductions. We had a great year in our brand development as we grew our restaurant chain from 501 to 531 stores. We are particularly excited about our growth in the Quebec market, via our non-traditional locations including the Bell Centre in Montreal. We anticipate that 2007 will be another strong year. We plan to continue our expansion in the Quebec market, while evaluating our opportunities in Western Canada. I invite each of you to visit our recently renovated restaurants and let me know how you liked the experience. Michael Overs Chairman Pizza Pizza Limited -5- Glossary of Selected Terms PPL OR PIZZA PIZZA: Pizza Pizza Limited, a privately-held, Canadian Corporation. See “Our Business” page 35. PARTNERSHIP: Pizza Pizza Royalty Limited Partnership. See “Overview and Business of the Fund” page 7. FUND: Pizza Pizza Royalty Income Fund (TSX symbol “PZA.UN”), a publicly-traded entity. IPO: The Fund’s initial public offering, which had a closing date of July 6, 2005. V.I.E.: Pizza Pizza Limited and the Partnership adopted the new Canadian Institute of Chartered Accountants’ Accounting Guideline, Consolidation of Variable Interest Entities (“AcG-15”) and is effective from the IPO closing date. A variable interest entity (“V.I.E.”) is any type of legal structure in which consolidation is required due to contractual or other financial arrangements, as opposed to traditional voting rights, if certain conditions exist. The Partnership is considered a VIE and Pizza Pizza is the primary beneficiary of the Partnership. Accordingly, Pizza Pizza is required to consolidate the Partnership. The Fund also adopted the new guideline and as a result, its subsidiary, the Partnership, will be accounted for on the equity basis. FISCAL YEAR: January 1 to December 31 for both the Fund and PPL. PIZZA PIZZA LIMITED CONSOLIDATED: As it applies to the fiscal year ended January 1, 2006, it means the 13 weeks of operations of PPL and its subsidiary consolidated with the Partnership’s operations for the fourth quarter of 2005. After January 1, 2006, PPL and the Partnership will be consolidated quarterly and annually and will have coterminous quarter-end and year-end dates with the Fund. SYSTEM SALES: Gross sales generated from Pizza Pizza restaurants in Canada. SAME STORE SALES GROWTH (“SSSG”): The increase in gross sales generated from Pizza Pizza restaurants in Canada that have been open 12 months. ROYALTY POOL: In any period, the Pizza Pizza restaurants on which a royalty equating to 6% of their System Sales is to be paid to the Partnership by PPL. In 2006 there were 501 Pizza Pizza locations in the Royalty Pool. QUICK SERVICE RESTAURANTS (QSR): The QSR segment of the Canadian commercial foodservice industry, in which Pizza Pizza operates, usually contains establishments having counter service and emphasizes take-out and delivery; average cheque size is $4.41 as per the Canadian Restaurant and Foodservice Association. NON-CONTROLLING INTEREST: December 31, 2006. The Fund’s indirect, 79.7% interest in the Partnership at PPL RIGHTS: The Fund used the proceeds of the IPO to indirectly acquire, through the Partnership, the trademarks, trade names, operating procedures and systems and other intellectual property and proprietary rights and all goodwill associated therewith owned by PPL and used in connection with the operation of all restaurants operated by Pizza Pizza, its subsidiaries and its franchisees (collectively, the “PPL Rights”). -6- PIZZA PIZZA ROYALTY INCOME FUND Management’s Discussion and Analysis The following is a discussion of the annual results of operations and financial condition of the Pizza Pizza Royalty Income Fund (the “Fund”) for the year ended December 31, 2006. The consolidated financial statements of the Fund are prepared in accordance with Canadian generally accepted accounting principles. The financial results for the 52 week period ended December 31, 2006 are not directly comparable to the 26 weeks of the Fund’s initial, formation year ended December 31, 2005. The Management’s Discussion and Analysis has been prepared as of February 28, 2007. A copy of this report and additional information about the Fund is available at www.sedar.com or www.pizzapizzaroyaltyincomefund.com. OVERVIEW AND BUSINESS OF THE FUND The Fund completed its initial public offering in July 2005, and used the proceeds of the offering to indirectly acquire the trademarks owned by Pizza Pizza Limited (“Pizza Pizza”) used in connection with the operation of all Pizza Pizza restaurants (the “PPL Rights”). The Fund also acquired, indirectly from a bank, a loan outstanding to Pizza Pizza in the principal amount of $30 million (the “PPL Loan”). In July 2005, the Fund licensed the PPL Rights to Pizza Pizza, for which Pizza Pizza pays a 6% royalty on the system sales of those Pizza Pizza restaurants included in the specific royalty pool (the “Royalty Pool”). There were 501 restaurants in the Royalty Pool for the year 2006. From inception, the Fund adopted the guideline of Canadian Institute of Chartered Accountants referred to as “AcG-15”, Consolidation of Variable Interest Entities. As a result, the Fund’s subsidiary, the Pizza Pizza Royalty Limited Partnership (the “Partnership”) which owns the PPL Rights, is accounted for on the equity basis. Pizza Pizza, the operating company that pays the 6% royalty to the Partnership, consolidates the Partnership based on this same guideline. Annually, on January 1 (the “Adjustment Date”), an adjustment is made to the Royalty Pool to include the forecasted system sales from new Pizza Pizza restaurants opened on or before December 31 of the prior year, less system sales from any Pizza Pizza restaurants that have been permanently closed during the year. The change in the amount of the Royalty due to the Partnership as a result of changes in the system sales of the Royalty Pool will affect Pizza Pizza’s retained interest through an adjustment to the rate at which the Class B Partnership units may ultimately be exchanged for units of the Fund. On the Adjustment Date, the adjustment to the Class B Exchange Multiplier (as defined in the License and Royalty Agreement) involves first calculating the “Determined Amount”, which is defined as 92.5% of the royalty revenue added to the Royalty Pool, divided by the prevailing yield of the Fund units. The Determined Amount is multiplied by 80%, then divided by the current market price of the units, and then further divided by the number of Class B Partnership units outstanding. This fraction is added to the Class B Exchange Multiplier from the preceding year, which was “one” on the closing of the initial public offering. On the following Adjustment Date, a second adjustment to the Class B Exchange Multiplier will be made in the same manner once the system sales for new restaurants are known with certainty. The adjustment for new restaurants rolled into the Royalty Pool is designed to be accretive for current unitholders. If, during a year, a restaurant is closed, the sales of the restaurant from the closing date would no longer be included in the calculation of the royalty payable to the Partnership by Pizza Pizza. To compensate for this, in certain circumstances, the License and Royalty Agreement and the Limited Partnership Agreement provide that an amount (the Make-Whole Payment) reflecting the reduction in the royalty resulting from the restaurant closure will be paid by Pizza Pizza to the Partnership for the balance of the year in which the restaurant was closed, commencing from the closing date. The Make-Whole Payment will be the sales of the closed restaurant for the first 52-week period in which it was included in the Royalty Pool multiplied by the royalty rate, payable as to one-twelfth per month. Pizza Pizza has an effective 20.3% interest in the Fund as of December 31, 2006 and has agreed to maintain at least a 20% interest until June 30, 2007. Distributions on the 20% interest will be subordinated during the hold period pursuant to the terms of the Subordination Agreement. -7- Pizza Pizza’s 20.3% interest in the earnings of the Partnership arises from its ownership of Class B and Class C Partnership units. Subject to the Subordination Agreement, each Class B Unit can be exchanged indirectly for that number of units equal to the Class B Exchange Multiplier (as defined in the License and Royalty Agreement) applicable at the date of the exchange. Class C Units can be exchanged by requiring the Fund to purchase those Class C Units in consideration of the assumption by the Fund of an amount of the indebtedness under the PPL Loan equal to $10.00 per Class C Unit transferred. A key attribute of the Fund’s structure is the fact that it is a “top-line” fund. Royalty income of the Fund is based on top-line system sales of the Royalty Pool restaurants and is not determined by the profitability of either Pizza Pizza or the Pizza Pizza restaurants in the Royalty Pool. Given this structure, the success of the Fund depends primarily on the ability of Pizza Pizza to maintain and increase system sales of the Royalty Pool. Increases in system sales are derived from both the development of new Pizza Pizza restaurants and same store sales growth (“SSSG”). The key metric for yield growth of the Fund is SSSG which is dependent on maintaining operational excellence within each Pizza Pizza restaurant, general market conditions, pricing, and marketing programs undertaken by Pizza Pizza. One of Pizza Pizza’s competitive strengths in increasing SSSG is that over 95% of the restaurants in the chain are new or renovated within the past six years. Increased seating is available in these renovated restaurants, offering Franchisees the ability to concentrate on increasing ”walk-in” sales, thereby potentially increasing same store sales. Management is focused on completing the renovation program over the next twelve months. -8- FINANCIAL HIGHLIGHTS The following tables set out selected financial information and other data of the Fund and should be read in conjunction with the attached audited consolidated financial statements of the Fund. Equity earned by the Fund through its interest in the Partnership and interest income from the Pizza Pizza Limited Loan have been derived as shown in the table below: Pizza Pizza Royalty Limited Partnership Analysis of Distributable Cash January 1, 2006 to December 31, 2006 Period from July 6, 2005 to December 31, 2005 (in thousands of dollars, except number of restaurants, days in the period, and per unit amounts) Restaurants in Royalty Pool Days in the Period Same store sales growth System sales reported by restaurants in the Royalty Pool Royalty - 6% of system sales Partnership expenses(1) Partnership earnings for the period before under-noted Pizza Pizza’s interest(2) Equity income related to Pizza Pizza royalties earned by Fund(3) Interest income Net earnings (3) Earnings per Fund unit (3) (4) 501 365 4.5% $ $ 353,138 21,188 (1,710) 19,478 (5,388) $ $ 500 179 6% 173,233 10,394 (781) 9,613 (2,627) 14,090 1,800 $ $ $ $ 15,890 0.885 15,108 0.842 95% December 31, 2006 $ $ $ $ 6,985 880 7,865 0.438 7,041 0.392 89% December 31, 2005 $ $ 170,363 1,223 Distributions declared Distributions per Fund unit Payout ratio Total assets Total liabilities (1) the bank loan for the current year was $1.1 million. (2) $ $ 171,796 1,275 The Fund, indirectly through the Partnership, incurs administrative expenses and interest expense on the $20 million outstanding bank loan. Interest expense on Represents the interest of Pizza Pizza in the earnings of the Partnership from Class B and Class C Partnership units. The Class B units are exchangeable into Fund units based on value of the Class B Exchange Multiplier at the time of exchange as defined in the Licence and Royalty Agreement. (3) For December 31, 2005, earnings shown exclude structuring costs of $9.5 million related to indirectly receiving proceeds from the Fund’s initial public offering. The structuring costs were paid from the initial public offering proceeds and were expensed during 2005 since they were determined to be a cost without a future benefit. (4) The Fund indirectly earns interest income on the $30 million loan to Pizza Pizza, with interest income accruing at 6% per annum, payable monthly. -9- Q4 2006 Q3 2006 Q2 2006 Q1 2006 (in thousands of dollars, except number of restaurants, days in the Period and per unit amounts) Restaurants in Royalty Pool Days in the Period Same store sales growth System sales reported by restaurants in Royalty Pool $ Royalty - 6% of system sales Partnership expenses(1) Partnership earnings for the period before under-noted Pizza Pizza’s interest(2) Equity income related to Pizza Pizza royalties earned by Fund(3) Interest income(4) Net earnings (3) Earnings per Fund unit(3) Distributions declared Distributions per Fund unit Payout ratio $ $ $ $ $ 501 92 5% 93,866 5,632 (426) 5,206 (1,414) $ $ 501 92 4% 90,773 $ 5,446 $ (390) 5,056 (1,385) 501 91 4% 86,015 $ 5,161 $ (455) 4,706 (1,314) 501 90 5% 82,484 4,949 (439) 4,510 (1,275) 3,792 450 4,242 0.237 3,822 0.213 90% $ $ $ $ 3,671 450 4,121 $ 0.229 $ 3,824 $ 0.213 $ 93% 3,392 450 3,842 $ 0.214 $ 3,744 $ 0.209 $ 97% 3,235 450 3,685 0.205 3,718 0.207 101% Q4 2005 (in thousands of dollars, except number of restaurants, days in the Period and per unit amounts) For the Period from July 6, to September 30, 2005 Restaurants in Royalty Pool Days in the Period Same store sales growth System sales reported by restaurants in the Royalty Pool Royalty - 6% of system sales Partnership expenses(1) Partnership earnings for the period before under-noted (3) Pizza Pizza’s interest(2) Equity income related to Pizza Pizza royalties earned by Fund(3) Interest income(4) Net earnings (3) (3) Earnings per Fund unit Distributions declared Distributions per Fund unit Payout ratio 500 92 6% $ $ 89,651 5,379 (418) 4,961 (1,352) $ $ 500 87 6% 83,582 5,015 (363) 4,652 (1,275) 3,608 450 $ $ $ $ 4,058 0.226 3,643 0.203 90% $ $ $ $ 3,377 430 3,807 0.212 3,398 0.189 89% - 10 - Restaurants Added to the Royalty Pool On January 1, 2006, one net new restaurant was added to the Royalty Pool as a result of five new restaurants opening from March 14, 2005 to September 1, 2005 and four closing from March 14, 2005 to December 31, 2005. The additional system sales from the one net new restaurant are estimated at $1.4 million annually. The total number of restaurants in the Royalty Pool has increased to 501. The yield of the Fund units was determined to be 8.06% calculated using $9.97 as a weighted average unit price based on the market price of the units traded on the TSX during the period of 20 consecutive days ending on the fifth trading day before January 1, 2006. As a result of the contribution of the additional net sales to the Royalty Pool, Pizza Pizza’s Class B Exchange Multiplier increased fractionally by 80% of the total adjustment or 0.01674; the new Class B Multiplier is 1.01674. This adjustment will increase Pizza Pizza’s entitlement to distributions of cash and allocations of income on the Class B Units from the Partnership. The second adjustment to the Class B Exchange Multiplier will be made effective as of January 1, 2006 once the actual performance of the new restaurant is determined in early 2007. In lieu of converting the new entitlements into Fund units, Pizza Pizza has increased the Class B Exchange Multiplier. As a result, Pizza Pizza Limited now holds Class B Partnership units exchangeable into 4,563,120 Fund units which equates to 20.3% of the fully diluted units of the Fund, or an additional 0.3% Partnership ownership. The Fund reported an increase in its investment in the Partnership and a contributed surplus of $599 to reflect the increase in value as a result of the vend-in of the new royalty stream. On January 1, 2007, 30 net new restaurants were added to the Royalty Pool as a result of 35 new restaurants opening between September 2, 2005 and December 31, 2006 and five closing during the year. For 2007, the pool will consist of 531 Pizza Pizza restaurants. See “Subsequent Event” for additional information surrounding the transaction. Change to the Seasoning Period for New Restaurants Added to the Royalty Pool During the current quarter, the Board of Trustees unanimously approved amendments to the License and Royalty Agreement with Pizza Pizza and amendments to related provisions of the Partnership Agreement of the Partnership that will result in a removal of the requirement that a restaurant be open for at least 120 consecutive days before it may be included in the Royalty Pool for the subsequent year. The removal of the 120-day seasoning period involves only a change in the timing of the inclusion of restaurants in the Royalty Pool and not the substance of the relationship between Pizza Pizza and the Fund. Previously, restaurants opened after September 1 of a given year would not be included in the Royalty Pool until January 1 of the second following year. Pizza Pizza requested elimination of the 120-day seasoning period in order that the restaurant opening period would coincide with the fiscal year of the Fund. This change will benefit management’s reporting of restaurant openings and closures in relation to the number of restaurants in the Royalty Pool. Existing safeguards, including the holdback arrangement described herein (see “Overview and Business of the Fund”), will continue to ensure that additional entitlements awarded to Pizza Pizza upon adding new restaurants to the Royalty Pool are reconciled based on actual system sales one year after being added to the Royalty Pool. This change will affect the determination of the Royalty Pool as at January 1, 2007 and subsequent years and the corresponding entitlements of Pizza Pizza to indirectly acquire additional Fund units. For January 1, 2007, new restaurants opened between September 2, 2005 and December 31, 2006 will be added to the Royalty Pool. For each January 1 thereafter, restaurants opened between January 1 and December 31 of the prior year will be included in the calculation. 11 Ownership of the Fund on a fully diluted basis is as follows: Issued & Outstanding units, and Exchangeable Equivalent units Units outstanding on December 31, 2006 Fund units held by public unitholders is 79.7% of total Class B exchangeable units held by Pizza Pizza is 20.3% of total Fully diluted units Units outstanding on February 28, 2007 Fund units held by public unitholders is 77% of total Class B exchangeable units held by Pizza Pizza is 23% of total Fully diluted units 17,952,000 4,563,120 22,515,120 17,952,000 5,408,915 23,360,915 ROYALTY POOL SALES System sales from the 501 restaurants in the Royalty Pool for the three months and year-ended December 31, 2006 were $93.9 million and $353.1 million respectively. For the prior year comparative quarter and period from July 6, 2005 to December 31, 2005, system sales for the 500 restaurants in the Royalty Pool were $89.7 million and $173.2 million respectively. Pizza Pizza’s system sales for the quarter ended March 31 have generally been the softest quarter and the December 31 quarter system sales have been the strongest due to seasonality of the business. Same Store Sales Growth, the key driver of yield growth for unitholders of the Fund, increased by 5% for the quarter and increased 4.5% for the year-ended December 31, 2006 compared with the same period in 2005. Industry statistics released by the Ontario Ministry of Tourism reported U.S. border crossings to Ontario decreased by 9.2% in the first eleven months of 2006 over the same period in 2005. A decrease in Ontario tourism, both U.S. and international, negatively impacted sales at a select number of our restaurants. Particularly affected during the summer months were sales at some of our outdoor-themed, nontraditional locations. An independent audited statement of Royalty Pool system sales is performed and reported each year, the results of which follow: System sales reported by Pizza Pizza Royalty Pool Restaurants From January 1, 2006 to December 31, 2006 (in thousands of dollars) Total Pizza Pizza retail sales $ 360,534 New locations (7,667) Closed locations 271 2006 Royalty Pool System Sales $ 353,138 System sales (as defined in the License and Royalty Agreement between Pizza Pizza and the Partnership) reported by Pizza Pizza Restaurants include the gross sales of Company-owned and franchised restaurants, excluding (i) sales and goods and service tax or similar amounts levied by any 12 governmental or administrative authority, and (ii) initial or renewal franchise fees charged by Pizza Pizza upon the establishment or renewal of franchises and franchise agreements. Total Pizza Pizza retail sales for the 52-week period ended December 31, 2006, include sales reported by franchisees and sales from Company-owned locations during the reporting period. Sales from new locations include sales from franchise or Company-owned locations that were opened after September 2, 2005 and on or prior to December 31, 2006. Sales from closed locations include sales from restaurants that were closed on or after January 1, 2006 and on or prior to December 31, 2006, and for which Pizza Pizza is required to pay a “Make-whole” payment. In reference to the License and Royalty Agreement, the Royalty Pool (which at December 31, 2006 included 501 Pizza Pizza restaurants) will be adjusted annually, on January 1 of each calendar year (the “Adjustment Date”), to include Pizza Pizza restaurants that were open on or prior to December 31 of the previous year and not permanently closed prior to the Adjustment Date and which were not previously included in the Royalty Pool. At the same time, the Royalty Pool will be adjusted to remove restaurants that were included in the Royalty Pool during the immediately preceding year but which have been permanently closed prior to the Adjustment Date. Systems sales reported by Pizza Pizza restaurants to the Company are self-assessed by each restaurant on a weekly reporting basis and are submitted without audit or other form of independent assurance. OPERATING RESULTS The operations of the Fund and Partnership are separately analyzed in the following information to provide a better appreciation of the financial condition and results of the Fund and should be read in conjunction with the Fund’s consolidated financial statements and accompanying notes. Partnership Operations The Partnership, which is 79.7% owned by the Fund at December 31, 2006, earns a 6% royalty income on the Royalty Pool system sales of the Pizza Pizza restaurants. The Fund earns equity income from its investment in the Partnership. The Fund’s equity income from the Partnership is calculated as the royalty income less the Partnership’s operating expenses less earnings attributable to Pizza Pizza. The following provides information on the Partnership performance for the quarter and year ended December 31, 2006. Revenues Royalty Income earned by the Partnership was $5.6 million for the quarter and $21.2 million for the year ended December 31, 2006. The 6% royalty is earned on the Royalty Pool of 501 Pizza Pizza restaurants reporting $93.9 million in system sales for the quarter and $353.1 million for the year ended December 31, 2006. Royalty Income earned by the Partnership for the comparative quarter and prior year period from July 6, 2005 to December 31, 2005 was $5.4 million and $10.4 million respectively, and the 500 Pizza Pizza restaurants in the Royalty Pool reported system sales of $89.7 million and $173.2 million, respectively. Expenses The Partnership’s operating expenses include administrative expenses, amortization of deferred financing fees and interest paid on a $20 million bank term loan. See “Liquidity and Capital Resources-Term Loan”. 13 Operating expenses for the quarter were $426,000, including $267,000 of interest expense on its $20 million credit facility, $146,000 of administrative expenses, and $13,000 in amortization of deferred financing fees. Operating expenses for the year were $1.7 million including $1.1 million of interest expense on its $20 million credit facility, $587,000 of administration expenses, and $50,000 in amortization of deferred financing fees. Operating expenses for the quarter ended December 31, 2005 were $418,000 including $311,000 of interest expense on its $20 million credit facility, $94,000 of administrative expenses, and $13,000 in amortization of deferred financing fees. Operating expenses for the period from July 6, 2005 to December 31, 2005 were $781,000 including $544,000 of interest expense on its $20 million credit facility, $212,000 of administration expenses, and $25,000 in amortization of deferred financing fees. A one-time expense for structuring costs incurred in 2005 of $11.9 million, which related to the Fund’s initial public offering (“IPO”), is not reflected in the financial highlights table of this Management’s Discussion and Analysis. The structuring costs were deducted from the proceeds of the IPO before the Partnership purchased the PPL Rights. Therefore, there was no effect on the Partnership’s cash from operations for the prior period. The structuring costs consist of underwriters’ fees, legal and auditing costs, plus other expenses related to the Fund’s IPO for which the Partnership was responsible; these costs were determined to be without future benefit and were expensed. The Partnership disclosed this transaction in the October 2, 2005 Pizza Pizza Limited year end consolidated financial statements. Net earnings The Partnership had net earnings for the quarter of $5.2 million and $19.5 million for the year ended December 31, 2006, which were allocated to the Fund and Pizza Pizza based on their respective interest in the Partnership. The Partnership had net earnings before structuring costs for the comparative quarter of $5 million and $9.6 million for the period from July 6, 2005 to December 31, 2005, which were allocated to the Fund and Pizza Pizza based on their respective interest in the Partnership. Selected Partnership balance sheet items (in thousands of dollars) Current Assets Total Assets Current Liabilities Loan Payable Total Liabilities & Equity December 31, 2006 $ 2,909 234,333 1,443 20,000 234,333 December 31, 2005 $ 2,069 232,744 1,108 20,000 232,744 Fund Operations Equity income is earned by the Fund through limited partnership holdings of LP units representing its effective 79.7% interest in the Partnership. Interest income is earned on a $30 million loan to Pizza Pizza Limited (the “PPL Loan”) and is calculated at 6% per annum, payable monthly. 14 Equity income in the Partnership Equity Income earned for the quarter and the year ended December 31, 2006 by the Fund from its investment in the Partnership was $3.8 million and $14.1 million, respectively. Equity Income earned for the comparative quarter and the period from July 6, 2005 to December 31, 2005 by the Fund from its investment in the Partnership was $3.6 million and $7 million, respectively. Interest Income The interest income for the quarter and year ended December 31, 2006 was $450,000 and $1.8 million, respectively, earned on the $30 million loan from the Fund to Pizza Pizza, with interest paid monthly at 6% per annum. Interest income for the prior year comparative quarter and period from July 6, 2005 to December 31, 2005 was $450,000 and $880,000 respectively. Net earnings Net earnings for the quarter were $4.2 million or $0.236 per unit; net earnings for the year ended December 31, 2006 were $15.9 million, or $0.885 per unit. Net earnings before structuring costs for the comparative quarter and the prior period July 6, 2005 to December 31, 2005 were $4.1 million or $0.226 per unit and $7.9 million or $0.438 per unit, respectively. The structuring costs reduced the Fund’s net earnings for the period from July 6, 2005 to December 31, 2005 to a net loss of $1.6 million or $0.09 per unit. Distributions The Fund declared distributions of $3.8 million or $0.213 per unit for the quarter, equating to a 90% payout ratio; the Fund declared distributions of $15.1 million for the year ended December 31, 2006 or $0.8416 per unit for a payout ratio equal to 95%. As of December 31, 2006, working capital of the Partnership was $1.5 million, accumulated as a reserve to cover seasonality and any unusual administrative expenditures. The Fund declared distributions of $3.6 million or $0.203 per unit for the comparative quarter, equating to a 90% payout ratio; the Fund declared distributions of $7 million for the period of July 6, 2005 to December 31, 2005 or $0.392 per unit for a payout ratio equal to 89%. As of December 31, 2005, working capital of the Partnership was $961,000, accumulated as a cash reserve to cover seasonality and any unusual administrative expenditures. For those unitholders holding units outside a tax deferred plan, the 2006 distributions will be treated as 49.46% taxable income and 50.54% as a tax-deferred return of capital. During the year, the Fund increased its monthly distribution on two occasions, in February (by 2%) and July (by 2%). Distributions declared for 2006 are as follows: Period January 1-31, 2006 February 1-28, 2006 March 1-31, 2006 April 1-30, 2006 May 1-31, 2006 June 1-30, 2006 July 1-31, 2006 August 1-31, 2006 Payment Date February 15, 2006 March 15, 2006 April 13, 2006 May 15, 2006 June 15, 2006 July 14, 2006 August 15, 2006 September 15, 2006 Amount/unit 6.81¢ 6.95¢ 6.95¢ 6.95¢ 6.95¢ 6.95¢ 7.10¢ 7.10¢ 15 September 1-30, 2006 October 1-31, 2006 November 1-30, 2006 December 1-31, 2006 Total October 13, 2006 November 15, 2006 December 15, 2006 January 15, 2007 7.10¢ 7.10¢ 7.10¢ 7.10¢ 84.16¢ Distributions for the year were funded entirely by cash flow from operations. No debt was incurred at any point during the year to fund distributions. LIQUIDITY & CAPITAL RESOURCES The Fund’s distribution policy is to distribute all available cash in order to maximize returns to Unitholders, after allowing for reasonable reserves held at the Partnership level. In light of seasonal variations that are inherent to the restaurant industry, the Fund’s policy is to make equal distribution payments to Unitholders on a monthly basis in order to smooth out these fluctuations. Any further increase in distributions will be implemented in such a manner so that the continuity of uniform monthly distributions is maintained. It is expected that future distributions will continue to be funded entirely by cash flow from operations. As of December 31, 2006, working capital of the Partnership was $1.5 million (2005 - $961,000), accumulated as a reserve to cover seasonality and any unusual administrative expenditures. Term Loan and Operating Loan The Partnership has a $20 million non-revolving, three-year term loan facility, which was arranged during the IPO to partially finance the purchase of the PPL Rights from Pizza Pizza. As security for repayment of the facility, Pizza Pizza Limited granted to the Partnership a continuing, general security interest, subject to certain exceptions, in all present and acquired property of Pizza Pizza which may not be assigned without the prior consent of Pizza Pizza. The facility bears interest at Prime plus 0.50% to 0.75% or the Bankers Acceptance rate plus 1.75% to 2.00%, depending on the level of funded debt to EBITDA, defined as annualized earnings before interest, taxes, depreciation and amortization. During 2005, the interest rate on the facility was fixed with an interest rate swap through January 6, 2010 at 3.55% plus 1.75% to 2% credit spread dependent upon the Fund’s annualized EBITDA (calculated as set forth in the credit facility documentation). In the initial four quarters of operations, the interest rate swap 16 was fixed at 3.55% plus 2%. During that year, the Fund achieved an annualized EBITDA in excess of $20 million resulting in the credit spread being reduced to 1.75% and became effective April 1, 2006, reducing the effective fixed interest rate on the loan to 5.3%. The Bank has also granted an extendable 364-day, committed, revolving operating facility for up to $1 million; no funds have been drawn on this facility. CONTROLS AND PROCEDURES Internal controls and procedures are designed to provide reasonable assurance that relevant information is gathered and reported to senior management, including the Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”) of Pizza Pizza GP Inc., managing general partner of the Partnership and administrator of the Fund, on a timely basis so that the appropriate decisions can be made regarding public disclosure. During the fourth quarter ending December 31, 2006, there was no change in the Company’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. As of December 31, 2006, an evaluation of the design of the Fund’s internal controls and procedures, as defined in Multilateral Instrument 52-109 Certification of Disclosure in Issuers’ Annual and Interim Filings issued by the Canadian Securities Administrators, was carried out under the supervision of and with the participation of management, including the CEO and the CFO. Based on the evaluation, the CEO and the CFO concluded that the design of these controls and procedures are effective. CRITICAL ACCOUNTING ISSUES The Fund’s only critical accounting estimate is the valuation of its investment in the Partnership. As the Partnership’s only significant assets are intangible assets consisting of the PPL Rights, the valuation of the Fund’s investment is based primarily upon the valuation of intangible assets in the Partnership. The PPL Rights are not amortized as they have an indefinite life. The Pizza Pizza GP, Inc., as the general partner of the Partnership and administrator of the Fund, reviews the carrying values of the intangible assets in the Partnership and the Fund’s investment at least annually, taking into consideration any events or circumstances which may have impaired the carrying values of these items. If permanent declines in the carrying amounts are determined, these items are written down to their estimated net recoverable amount. Pizza Pizza GP, Inc. believes that there have been no declines in either the carrying value of the intangible assets in the Partnership or in the carrying value of the Fund’s investment in the Partnership as of December 31, 2006. SUBSEQUENT EVENTS Subsequent to the year ended December 31, 2006, the Fund increased its monthly distribution by 2.8% effective with the January distribution, from $0.071 to $0.073 per unit. The declared distributions are as follows: Period January 1-31, 2007 February 1-28, 2007 Payment Date February 15, 2007 March 15, 2007 Amount/unit 7.30¢ 7.30¢ In January 2007, adjustments to royalty payments and Pizza Pizza’s Class B Exchange Multiplier were made based on the actual performance of the net one restaurant added to the Royalty Pool on January 1, 2006. As a result of the adjustments, the new Class B Exchange Multiplier is 1.02345 and Pizza Pizza’s exchangeable units increase by 30,113 to 4,593,233 Fund units, effective January 1, 2006, which equates to 20.37% of the fully diluted units of the Fund. 17 On January 1, 2007, 30 net new restaurants were added to the Royalty Pool as a result of 35 new restaurants opening from September 2, 2005 to December 31, 2006 and five closings during 2006. The additional system sales from the 30 net new restaurants are estimated at $15.4 million annually. The total number of restaurants in the Royalty Pool has increased to 531. The yield of the Fund units was determined to be 10.56% calculated using $7.94 as a weighted average unit price. Weighted average unit price is calculated based on the market price of the units traded on the TSX during the period of 20 consecutive days ending on the fifth trading day before January 1, 2007. As a result of the contribution of the additional net sales to the Royalty Pool, Pizza Pizza’s Class B Exchange Multiplier increased fractionally by 80% of the total adjustment or 0.18174; the new Class B Multiplier is 1.20519. This adjustment will also increase the entitlement of the holders of the Class B Units to distributions of cash and allocations of income from the Partnership. The second adjustment to the Class B Exchange Multiplier will be adjusted to be effective January 1, 2007, once the actual performance of the new restaurants is determined in early 2008. As a result of the Adjusted Class B Exchange Multiplier, Pizza Pizza will hold Class B Partnership units exchangeable into 5,408,915 Fund units which equates to 23% of the fully diluted units of the Fund as of January 1, 2007. Pizza Pizza has agreed to maintain at least a 20% ownership in the Fund until June 30, 2007, with distributions on the 20% interest to be subordinated pursuant to the terms of a subordinated agreement. OUTLOOK Pizza Pizza management has advised the Trustees that in 2007 it expects to grow the number of restaurants in the Ontario network by 3% and to continue researching potential expansion opportunities outside its predominantly Ontario market, with any potential expansion coming either through organic growth or acquisitions. Pizza Pizza expects to continue franchising its remaining Company restaurants. Same Store Sales Growth, the key driver of yield growth for Unitholders, was 5% for the quarter ended December 31, 2006 and 4.5% year-to-date, compared with the same period in 2005. With the continued increase in same store sales, the Fund increased its January 2007 distribution by 2.8%, from $0.071 to $0.073 per unit. With over 95% of traditional restaurants expanded or relocated within the last six years, Pizza Pizza offers expanded seating capacity, thereby targeting additional day-parts and allowing for additional product offerings to enable restaurants to continue increasing same store sales. Management is focused on completing the renovation program over the next twelve months. RISKS & UNCERTAINTIES The Fund continues to recognize certain risks and uncertainties associated with the ordinary course of business, including those associated with the business and operations of Pizza Pizza, upon which the Fund relies solely for its income. The Restaurant Industry The performance of the Fund is directly dependent upon the royalty and interest payments received from Pizza Pizza. The amount of royalty received from Pizza Pizza is dependent on various external factors that may affect the limited service sector of the restaurant industry. The restaurant industry, generally, is intensely competitive with respect to price, service, location and food quality. Competitors include national and regional chains, as well as independently owned restaurants. If Pizza Pizza and Pizza Pizza franchisees are unable to successfully compete in the limited service sector, system sales may be adversely affected, the amount of royalty reduced and the ability of Pizza Pizza to pay the royalty or interest on the PPL Loan may be impaired. Changes in demographic trends, traffic patterns, and the type, number, and location of competing restaurants also affect the restaurant industry. In addition, factors such as government regulations, smoking bylaws, inflation, publicity from any food borne illnesses, increased food, labour and benefits costs, and the availability of experienced management and hourly employees may adversely affect the restaurant industry in general and therefore, potentially, Pizza Pizza system sales. Pizza Pizza’s success also depends on numerous factors affecting discretionary spending, including economic conditions, disposable consumer income and consumer confidence. 18 Adverse changes in these factors could reduce guest traffic or impose practical limits on pricing, either of which could reduce sales and operating income, which could adversely affect revenue, the royalty and the ability of Pizza Pizza to pay the royalty to the Fund or interest on the PPL Loan. Proposed Tax Changes On October 31, 2006, the Minister of Finance (Canada) announced proposals to significantly change the income tax treatment of most publicly traded trusts and partnerships (other than certain real estate investment trusts) and the distributions and allocations, as the case may be, from these entities to their investors. The proposals were released in draft legislative form on December 21, 2006. Under the proposals, certain income earned by these entities will be taxed in a manner similar to income earned by a corporation and distributions or allocations of such income made by these entities to investors will be taxed in a manner similar to dividends from taxable Canadian corporations. The deemed dividend will be eligible for the new enhanced dividend tax credit if paid or allocated to a resident of Canada. These proposals will be effective commencing in the 2011 taxation year for trusts and partnerships that were publicly traded prior to November 1, 2006, such as the Fund. However, the deferral until 2011 may be rescinded where the affected entity does not comply with the Department of Finance’s “normal growth” guidelines. For illustrative purposes, the consequence for an individual Unitholder, holding units outside a taxdeferred plan who received a $1 distribution would be as follows, assuming that 25% of the distribution was a non-taxable return of capital: 2006 Tax Measures $1.00 $0.00 $1.00 $0.35(2) $0.65 Proposed 2011 Tax Measures $1.00 $0.24 $0.76 $0.11(3) $0.65 Distributable amount before tax Tax paid by the Fund(1) Distribution after the Fund’s tax Tax paid by the unitholder Net amount(4) Notes: (1) 31.5% on the taxable portion (75% of the $1.00 distribution) (2) Assuming a 46.41% combined tax rate currently in effect in Ontario on 75% of the distribution treated as income (3) Assuming a 22.38% tax rate on the deemed dividend income, and assuming that Ontario adopts the reduction in the tax rate on dividends proposed by the Federal government The Fund is currently considering these proposals and the guidelines and the possible impact they will have on the Fund and its investors. These measures do not have a force of law and could be modified or not adopted. These proposals are not expected to have an immediate impact on the Fund's tax treatment or distribution policy or the tax treatment of distributions to investors. Until the final legislation implementing the proposed changes is introduced, the exact impact of the changes to the Fund is unknown. The foregoing presentation is based on the Funds’ understanding of the proposals announced to date by the federal government, which are subject to change prior to the implementation of final legislation and related rules and interpretations by the Department of Finance. The tax consequences of these proposals to a Unitholder that is tax-exempt, holds units in a tax-deferred plan or is a non-resident of Canada would differ from the presentation set forth above. Unitholders are encouraged to consult their own tax advisors concerning the application of these proposals to their investment in units, with reference to their particular circumstances. 19 Litigation In the first quarter of 2006, Pizza Pizza Royalty Income Fund received an update from PPL regarding a potential claim disclosed in the Fund’s 2005 initial public offering prospectus and PPL’s subsequent financial statement filings. The claim, which does not name the Fund or its subsidiaries, was formally served on PPL and certain of its associates by Lawrence Austin, a former consultant to PPL. In the claim, Mr. Austin asserts a right to $45 million in damages and other amounts, including entitlements to a portion of the proceeds of the Fund’s IPO that were directly or indirectly received by PPL and its associates. PPL has advised the Fund that it believes the demand to be without merit and it will vigorously defend the claim. The Fund notes that Michael Overs, the Chairman and CEO of PPL, has agreed in an indemnity agreement to indemnify PPL and the Fund against any liabilities they may incur in this matter. Other For a more detailed list of risks and uncertainties please refer to the Fund’s Annual Information Form which is available at www.sedar.com. 20 THE PERFORMANCE OF THE FUND JANUARY 1, 2006 TO DECEMBER 31, 2006 $11.00 $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 1-Jan-06 1,100,000 1,000,000 900,000 800,000 700,000 600,000 500,000 400,000 300,000 200,000 100,000 0 1-Feb-06 6-Mar-06 6-Apr-06 9-May-06 9-Jun-06 12-Jul-06 14-Aug-06 14-Sep-06 17-Oct-06 17-Nov-06 20-Dec-06 FORWARD LOOKING STATEMENTS Certain statements in this report may constitute “forward-looking” statements which involve know and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward looking statements. When used in this report, such statements include such words as “may”, “will”, “expect”, “believe”, “plan”, and other similar terminology. These statements reflect management’s current expectations regarding future events and operating performance and speak only as of the date of this report. These forward-looking statements involve a number of risks and uncertainties. The following are some factors that could cause actual results to differ materially from those expressed in or underlying such forward-looking statements: competition; changes in demographic trends; changing consumer preferences and discretionary spending patterns; changes in national and local business and economic conditions; legislation and governmental regulation; accounting policies an practices; and the results of operations and financial condition of Pizza Pizza. The foregoing list of factors is not exhaustive. 21 22 PIZZA PIZZA ROYALTY INCOME FUND CONSOLIDATED BALANCE SHEET (Expressed in Thousands of Dollars) December 31, 2006 December 31, 2005 Assets Current assets: Receivable from Pizza Pizza Limited Receivable from Pizza Pizza Royalty Limited Partnership Loan receivable from Pizza Pizza Limited (note 4) Investment in Pizza Pizza Royalty Limited Partnership (note 5) $ $ 150 1,126 1,276 30,000 140,520 171,796 $ $ 150 1,073 1,223 30,000 139,140 170,363 Liabilities and Unitholders' Equity Current Liabilities: Distribution payable to Fund unitholders Unitholders' Equity: Fund units (note 6b) Contributed surplus (note 3c) Deficit $ See accompanying notes to consolidated financial statements $ 1,275 $ 1,223 177,795 599 (7,873) 170,521 171,796 177,795 (8,655) 169,140 170,363 $ Approved by the Trustees: (Signed) RON ROGERS Trustee (Signed) ARNOLD CADER Trustee (Signed) TERENCE REID Trustee 23 PIZZA PIZZA ROYALTY INCOME FUND CONSOLIDATED STATEMENT OF EARNINGS (Expressed in Thousands of Dollars Except Number of Units and Per Unit Amounts) Year ended December 31, 2006 July 6, 2005 to December 31, 2005 System Sales included in the Royalty Pool (note 1) Equity income in the Partnership (note 3a) Loss in the Partnership structuring costs $ 353,138 14,090 14,090 $ 173,233 6,985 (9,479) (2,494) 880 Interest income Net income(loss) Weighted average Fund units (note 6c) Basic income(loss) per Fund unit Weighted average diluted Fund units (note 6c) Diluted income(loss) per Fund unit (note 6c) $ $ $ 1,800 15,890 17,952,000 0.89 22,515,120 0.87 $ $ $ (1,614) 17,820,000 (0.09) 22,308,000 (0.10) CONSOLIDATED STATEMENT OF DEFICIT (Expressed in Thousands of Dollars) Year ended December 31, 2006 Balance, beginning of period Net income (loss) Distributions declared (2006 - $0.8416/unit; 2005 - $0.3922/unit) Deficit, end of period See accompanying notes to consolidated financial statements July 6, 2005 to December 31, 2005 $ (1,614) (7,041) (8,655) $ (8,655) 15,890 (15,108) (7,873) $ $ 24 PIZZA PIZZA ROYALTY INCOME FUND CONSOLIDATED STATEMENT OF CASH FLOWS (Expressed in Thousands of Dollars) Year ended December 31, 2006 Cash provided by (used in): Operating activities Net income (loss) Equity income (loss), an item not affecting cash (note 3a) Distributions received Change in non-cash operating elements of working capital (note 8a) Investing activity Note receivable from Pizza Pizza Limited Financing activities Issue of Fund units Cost of issuance of Fund units Purchase of units of Pizza Pizza Royalty Limited Partnership Distributions paid to unitholders $ 15,890 (14,090) 13,256 15,056 15,056 (15,056) (15,056) Increase (decrease) in cash Cash, beginning of period Cash, end of period See supplementary cash flows information (note 8) See accompanying notes to consolidated financial statements. July 6, 2005 to December 31, 2005 $ (1,614) 2,494 5,088 5,968 (150) 5,818 (30,000) 179,520 (1,725) (147,795) (5,818) 24,182 - - $ $ 25 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Nature of Operations Pizza Pizza Royalty Income Fund (the “Fund”) is an open-ended, limited purpose trust established under the laws of the Province of Ontario on May 26, 2005. The Fund was established to indirectly, through the Pizza Pizza Royalty Limited Partnership (the “Partnership”), acquire the trademarks, trade names, operating procedures and systems and other intellectual property and proprietary rights and all goodwill associated therewith owned by Pizza Pizza Limited (“Pizza Pizza”) used in connection with the operation of all restaurants operated by Pizza Pizza, its subsidiaries and its franchisees (collectively, the “Pizza Pizza Rights”). Concurrent with the acquisition of the Pizza Pizza Rights on July 6, 2005, the Partnership granted Pizza Pizza an exclusive and unlimited licence to use the Pizza Pizza Rights for an initial term of 99 years for which Pizza Pizza pays a royalty equal to 6% of system sales from all Pizza Pizza restaurants in the royalty pool, as defined in the licence and royalty agreement. As of December 31, 2006, there were 501 restaurants in the royalty pool; the royalty pool is adjusted annually, on January 1. The Partnership declares monthly distributions, indirectly, to the Fund; the Fund pays monthly distributions directly to public unitholders. The Fund was also established to acquire indirectly through Pizza Pizza Holdings Trust from a bank, certain debt of Pizza Pizza in the principal amount of $30 million (the “PPL Loan”). Pizza Pizza, a privately owned corporation headquartered in Toronto, Ontario, operates in the food service industry primarily throughout Ontario, and primarily franchises and operates quick-service restaurant businesses under the Pizza Pizza brand. Pizza Pizza derives revenues from franchisees through the sale of franchise restaurants, goods and supplies, and royalties. The company also derives revenues from company owned restaurants through the sale of food products to retail customers. The Fund’s revenues are earned from certain operations of Pizza Pizza, and accordingly, the revenues of the Fund and its ability to pay distributions to unitholders is dependent on the ability of Pizza Pizza to generate and pay royalties to the Fund. 2. Significant Accounting Policies a) Basis of presentation These consolidated financial statements include the accounts of the Fund; its wholly owned subsidiary, the Pizza Pizza Holdings Trust (the “Trust”); and its 79.7% owned subsidiary, Pizza Pizza GP, Inc. (the “PPGP”). The Fund’s investment in the Partnership is held through the Trust’s limited partnership holdings of 14,779,500 Class A LP units. These consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles. The Fund commenced operations on July 6, 2005, the date of the initial public offering. All significant intercompany transactions have been eliminated. The Fund has adopted the Canadian Institute of Chartered Accountants’ Accounting Guideline, Consolidation of Variable Interest Entities (“AcG-15”) and is effective from the initial public offering closing date. A variable interest entity (“VIE”) is any type of legal structure in which consolidation is required due to contractual or other financial arrangements, as opposed to traditional voting rights, if certain conditions exist. The Partnership is considered a VIE and Pizza Pizza is the primary beneficiary of the Partnership. Accordingly, Pizza Pizza is required to consolidate the Partnership. 26 Since Pizza Pizza effectively controls the Partnership as defined by AcG-15, the Fund accounts for its effective 79.7% interest in the Partnership on an equity basis whereby the Fund’s investment in the Partnership is increased by its 79.7% share of earnings or losses of the Partnership and reduced for distributions received. The investment in the Partnership is also adjusted to record the fair value of Fund units issued by the Fund in exchange for Partnership units held by Pizza Pizza. b) Revenue recognition Equity income is earned by the Fund through the Trust’s limited partnership holdings of 14,779,500 Class A LP units, representing an effective 79.7% interest in the Partnership. Interest income is recognized and accrued when earned. c) Investment in the Partnership Investment in the Partnership is accounted for on an equity basis, adjusted by equity income earned and monthly Partnership distributions received. d) Distributions to Fund Unitholders The amount of cash distributed to Fund unitholders is determined with reference to distributable cash, which is calculated within the Partnership as net earnings adjusted for amortization, other non-cash charges and repayment of principal and interest on the term loan. Distributions to Fund unitholders are recorded when declared, made monthly and are subject to the Fund and Partnership retaining such reasonable working capital reserves as may be considered appropriate by the Trustees of the Fund. e) Earnings per Fund Unit The earnings per Fund unit are based on the weighted average number of Fund units outstanding during the period. f) Use of Estimates The preparation of financial statements in conformity with Canadian generally accepted accounting principles requires the Fund’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues or expenses during the reporting period. Significant areas requiring the use of management estimates relate to the determination of impairment in the value of assets, and provisions for contingencies. Actual results could differ from those estimates. g) Financial Instruments The Fund’s financial instruments consist of accounts receivable from Pizza Pizza and the Partnership, the loan receivable due from Pizza Pizza and distribution payable to Fund unitholders. The Fund’s management estimates that the fair values of these financial instruments approximate their carrying values. It is the opinion of management that the Fund is not exposed to significant interest or credit risks from these financial instruments. h) Income Taxes Income tax obligations related to distributions by the Fund are the obligations of the unitholders and accordingly, the Fund will not be liable for income taxes. 27 3. Operations (a) Equity income earned by the Fund through its interest in the Partnership has been derived as shown in the table below: July 6, 2005 to December 31, 2005 2006 (in thousands of dollars, except number of restaurants in the Royalty Pool and earnings per Fund unit) Restaurants in Royalty Pool System sales reported by restaurants in the Royalty Pool Royalty - 6% of system sales Partnership administrative and interest expenses Partnership earnings for the period before under-noted Pizza Pizza interest Pizza Pizza’s interest Equity income related to Pizza Pizza royalties earned by Fund 501 $ $ 353,138 21,188 (1,710) 19,478 (5,388) $ $ 500 173,233 10,394 (782) 9,612 (2,627) $ 14,090 $ 6,985 (b) Annually, on January 1 (the “Adjustment Date”), Pizza Pizza restaurants in the Royalty Pool, on which Pizza Pizza pays a Royalty to the Fund, are adjusted to include the forecasted system sales from new Pizza Pizza restaurants opened less system sales from any Pizza Pizza restaurants that have been permanently closed during the year. On August 26, 2006, the Board of Trustees unanimously approved amendments to the License and Royalty Agreement with Pizza Pizza and amendments to related provisions of the Partnership Agreement of the Partnership to remove the requirement that a restaurant be open for at least 120 consecutive days before inclusion in the Royalty Pool for the subsequent year. This change involves only a change in the timing of the inclusion of restaurants in the Royalty Pool and not the substance of the relationship between Pizza Pizza and the Fund. Previously, restaurants opened after September 1 of a given year would not be included in the Royalty Pool until January 1 of the second following year. This change will affect the determination of the Royalty Pool as at January 1, 2007 and subsequent years and the corresponding entitlements of Pizza Pizza to indirectly acquire additional Fund units. For January 1, 2007, new restaurants opened between September 2, 2005 and December 31, 2006 will be added to the Royalty Pool. For each January 1 thereafter, restaurants opened between January 1 and December 31 of the prior year will be included in the calculation. Effective January 1, 2007, restaurants opened on or before December 31 of the prior year are added to the Royalty Pool. The 2007 additions include all restaurants opened between 28 September 2, 2005 and December 31, 2006 (2006 – March 14, 2005 to September 1, 2005). The change in the amount of the Royalty to be received by the Partnership as a result of changes in the system sales of the Royalty Pool will affect the extent of Pizza Pizza’s retained interest through the adjustment to the exchange rate at which the Class B Partnership units may ultimately be exchanged for Units of the Fund, referred to as the “Class B Exchange Multiplier” as defined in the Licence and Royalty Agreement. On the Adjustment Date, the adjustment to the Class B Exchange Multiplier involves first calculating the “Determined Amount” which is defined as 92.5% of the royalty revenue added to the Royalty Pool, divided by the yield of the Fund units. The Determined Amount is multiplied by 80%, then divided by the current market price of the units, and then further divided by the Class B Partnership units outstanding. This fraction is added to the Class B Exchange Multiplier from the preceding year, which was “one” on the closing of the initial public offering. On the following Adjustment Date, a second adjustment to the Class B Exchange Multiplier will be made in the same manner as the first adjustment once the forecasted system sales for new restaurants are known with certainty. (c) On January 1, 2006, one net new restaurant was added to the Royalty Pool as a result of five new restaurants opening from March 14, 2005 to September 1, 2005 and four closing from March 14, 2005 to December 31, 2005. The additional system sales from the one net new restaurant are estimated at $1.4 million annually. The total number of restaurants in the Royalty Pool increased to 501. The yield of the Fund units was determined to be 8.06% calculated using $9.97 as a weighted average unit price. Weighted average unit price is calculated based on the market price of the units traded on the TSX during the period of twenty consecutive days ending on the fifth trading day before January 1, 2006. As a result of the contribution of the additional net sales to the Royalty Pool, Pizza Pizza’s Class B Exchange Multiplier increased fractionally by 80% of the total adjustment or 0.01674; the estimated, Class B Multiplier was calculated to be 1.01674. This adjustment also increased the entitlement of the holders of the Class B Units to distributions of cash and allocations of income from the Partnership as described above. The remaining exchangeable securities will be calculated in a second adjustment to the Class B Exchange Multiplier and will be adjusted to be effective January 1, 2006, once the actual performance of the new restaurants is determined in early 2007 (note 9). As a result of the Adjusted Class B Exchange Multiplier, Pizza Pizza now holds Class B Partnership units exchangeable into 4,563,120 Fund units which equates to 20.3% of the fully diluted units of the Fund. The Fund reported an increase in its investment in the Partnership and a contributed surplus of $599 to reflect the increase in value as a result of the vend-in of the new royalty stream. Pizza Pizza has agreed to maintain at least a 20% ownership in the Fund until June 30, 2007, with distributions on the 20% interest to be subordinated pursuant to the terms of a subordination agreement. 4. Pizza Pizza Loan Receivable 2006 Loan receivable with interest payable monthly at 6% per annum, due July 6, 2025. $ 30,000 $ 2005 30,000 The loan arose at the time of the acquisition of the Pizza Pizza Rights from Pizza Pizza in July 2005. The loan is secured by a general security agreement and may not be assigned without the prior consent of Pizza Pizza. Pizza Pizza, as the holder of 3,000,000 Class C Partnership units, has the right to transfer such units to the Trust in consideration for the assumption by the Trust of, and the concurrent release of Pizza Pizza of its obligations with respect to, an amount of the indebtedness under the PPL Loan equal to $10.00 for each Class C Partnership unit transferred. 29 5. Investment in Pizza Pizza Royalty Limited Partnership 2006 Balance - beginning of period Acquisition of Partnership units Accretion of value on change in the royalty pool (note 3c) Loss in the initial public offering Partnership Structuring costs Equity income of the Partnership Distributions declared from the Partnership Balance - end of period $ 139,140 599 14,090 (13,309) $ 140,520 $ $ 2005 147,795 (9,479) 6,985 (6,161) 139,140 The business of the Partnership is the ownership and licensing of the “Pizza Pizza Rights” and through a “Licence and Royalty Agreement” with Pizza Pizza, to exploit the use of the “Pizza Pizza Rights” by Pizza Pizza. Additionally, the Partnership will collect the royalty payable under the “Licence and Royalty Agreement” as well as perform the administration of the Fund pursuant to the “Administration Agreement”. 6. Unitholders’ Equity a) Authorized The Declaration of the Fund provides that an unlimited number of Fund units may be issued. Each unit is transferable and represents an equal undivided beneficial interest in any distributions of the Fund and in the net assets of the Fund. All units have equal rights and privileges. Each Fund unit entitles the holder thereof to participate equally in the allocations and distribution and to one vote at all meetings of Fund unitholders for each whole Fund unit held. The Fund units issued are not subject to future calls or assessments. Pursuant to the Declaration of Trust, the holders, other than the Fund or its subsidiaries, of the Class B Partnership units of the Partnership will be entitled to vote in all votes of Fund unitholders as if they were holders of the number of Fund units they would receive if Class B Partnership units were exchanged into Fund units as the record date of such votes, and will be treated in all respects as Fund unitholders for the purpose of any such votes. Fund units are redeemable at any time at the option of the holder in a price based on market value as defined in the trust agreement, subject to a maximum of $50 cash redemptions by the Fund in any one month. The limitation may be waived at the discretion of the Trustees of the Fund. Redemption in excess of these amounts, assuming no waiving of the limitation, shall be paid by way of distribution in specie of a pro rata number of securities of the Trust held by the Fund. b) Issued On July 6, 2005, the Fund issued 16,830,000 Fund units at $10 per unit pursuant to a public underwriting. On July 27, 2005, the Fund issued an additional 1,122,000 units pursuant to the exercise of the over-allotment option granted to the underwriters in connection with the Fund’s initial public offering. The additional units were purchased by the underwriters at a price of $10.00 per unit. Expenses of the offering of $1,725,000 were charged to Fund unitholders’ equity. 30 Issue of Fund units Expense of the offering Fund units as at December 31, 2006 and December 31, 2005 c) Income (Loss) per unit $ 179,520 (1,725) $ 177,795 Basic net income (loss) per unit is calculated by dividing net income (loss) by the weighted average number of units outstanding during the period. Diluted net income (loss) per unit includes Pizza Pizza Class B exchangeable partnership units using the “if converted” method. Under the “if converted” method, earnings are adjusted for earnings allocated to the Class B exchangeable partnership units interest and the weighted average number of units is adjusted for the conversion of the Pizza Pizza Class B exchangeable Partnership units. For the purposes of the weighted average number of units outstanding, units are determined to be outstanding from the date they are issued. The following table reconciles the basic net earnings to the diluted net earnings: July 6, 2005 to December 31, 2005 $ (1,614) (623) $ (2,237) Basic net income (loss) Equity adjustment allocated to Class B Exchangeable Partnership units Adjusted net income (loss) $ $ 2006 15,890 3,588 19,478 The following table reconciles the basic weighted average number of units outstanding to the diluted weighted average of units outstanding: July 6, 2005 to December 2006 31, 2005(1) Weighted average number of: Units Pizza Pizza Class B Partnership units Weighted average number of units outstanding - diluted Diluted income (loss) per Fund unit 17,952,000 4,563,120 17,820,000 4,488,000 22,515,120 22,308,000 $ 0.87 $ (0.10) (1)In 2005, due to the exercise of the over-allotment option on July 27, 2005, there were 16,830,000 units outstanding for the full 178 days in the period and 1,122,000 units outstanding for 157 days of the period resulting in weighted average number of fund units of approximately 17,820,000. 31 d) Exchangeable units of the Partnership: 2006 4,563,120 2005 4,488,000 Class B Partnership units Pizza Pizza indirectly holds an effective 20.3% interest in the Fund by holding all Class B Partnership units. Subject to the Subordination agreement, Pizza Pizza has the right to exchange one Class B Partnership unit indirectly for that number of units equal to the Class B Exchange Multiplier applicable at the date of such exchange, as described under “Licence and RoyaltyAdjustment of the Royalty Pool-Changes in the Restaurants in the Royalty Pool”. Class B Partnership units held by Pizza Pizza carry voting rights in the Fund equivalent to the number of units into which they are exchangeable at that time. Subject to the prior rights of the holders of Class C Partnership units and to the Subordination agreement, the holders of Class B Partnership units are entitled to receive monthly distributions of remaining Available Cash of the Partnership, if any, on a pro rata basis with Class A Partnership units held by the Trust. 7. Related Party Transactions The Fund has an administration agreement with the Partnership, whereby the Partnership provides or arranges for the provision of services required in the administration of the Fund. Pizza Pizza, as general partner of the Partnership, and pursuant to the Partnership Agreement, is providing certain of these services. The fee for these services, which on an annual basis shall not exceed $25, has been waived for the period. Pizza Pizza is a related party by virtue of holding Class B Partnership units which are exchangeable into units of the Fund. Other transactions with Pizza Pizza are referred to elsewhere in these consolidated financial statements. 8. Supplementary Cash Flow Information July 6, 2005 to December 31, 2005 2006 (a) Change in non-cash working capital: Due from Pizza Pizza Limited (b) Interest received 9. Subsequent Events $ $ 1,800 $ $ (150) 880 (a) On January 1, 2007, adjustments to royalty payments and Pizza Pizza’s Class B Exchange Multiplier were made based on the actual performance of the five restaurants added to the Royalty Pool on January 1, 2006. As a result of the adjustments, the new Class B Exchange Multiplier is 1.02345 and Pizza Pizza’s exchangeable units can be exchanged into 4,593,233 Fund units which is an increase of 30,113 Fund units, effective January 1, 2006, which equates to 20.37% of the fully diluted units of the Fund. (b) On January 1, 2007, 30 net new restaurants were added to the Royalty Pool as a result of 35 new restaurants opening from September 2, 2005 to December 31, 2006 and five closing from January 1, 2006 to December 31, 2006. The additional system sales from the 30 net new 32 restaurants are estimated at $15.4 million annually. The total number of restaurants in the Royalty Pool has increased to 531. The yield of the Fund units was determined to be 10.56% calculated using $7.94 as a weighted average unit price. Weighted average unit price is calculated based on the market price of the units traded on the TSX during the period of twenty consecutive days ending on the fifth trading day before January 1, 2007. As a result of the contribution of the additional net sales to the Royalty Pool, Pizza Pizza’s Class B Exchange Multiplier increased fractionally by 80% of the total adjustment or 0.18174; the new Class B Multiplier is 1.20519. This adjustment will also increase the entitlement of the holders of the Class B Units to distributions of cash and allocations of income from the Partnership. The second adjustment to the Class B Exchange Multiplier will be adjusted to be effective January 1, 2007, once the actual performance of the new restaurants is determined in early 2008. As a result of the Adjusted Class B Exchange Multiplier, Pizza Pizza Limited will hold Class B Partnership units exchangeable into 5,408,915 Fund units which equates to 23% of the fully diluted units of the Fund as of January 1, 2007. 33 34 Pizza Pizza Limited Our Business OVERVIEW Pizza Pizza Limited, a privately-owned, Canadian corporation (referred to as the “Company”, “Pizza Pizza”, “PPL”, or in the first person notations of “we”, “us” and “our”), founded in Toronto in 1967, has grown to become Ontario’s number one pizza restaurant chain, fulfilling over 28 million customer orders annually. At the fiscal year ended December 31, 2006, Pizza Pizza had 531 restaurants in its system, comprised of 355 traditional format restaurants located throughout Ontario and parts of Quebec and 176 non-traditional format restaurants located across Canada. Over its 40 year history, Pizza Pizza has established a strong brand name and reputation as the leader in Ontario in the pizza component of the quick service restaurant (“QSR”) segment. Part of Pizza Pizza’s overall strategy is to reposition itself as a “restaurant with delivery”, thereby highlighting its food quality, menu choices and eat-in dining opportunities. Consistent with these strategies, Pizza Pizza’s sales mix, measured by revenue, has evolved from 90% delivery and 10% take-out in the mid-1980’s to the current mix of 60% delivery and 40% eat-in and take-out. System sales for the 52 weeks ended December 31, 2006 were $361 million, for the previous year having 13 weeks ended January 1, 2006, System Sales, adjusted to 52 weeks, were $353 million. Pizza Pizza is a franchise-oriented restaurant company. Of the 531 Pizza Pizza restaurants at December 31, 2006, 520 are franchised or licensed and 11 are owned and operated as corporate restaurants. Pizza Pizza provides a high level of services and operational support to its franchisees, including turn-key restaurants, a central food distribution centre which provides all food and non-food items used in restaurant operations, and monitoring systems intended to ensure high product and service quality and operational consistency across the chain. Pizza Pizza has a modern restaurant system, with approximately 95% of our restaurants either new or substantially renovated in the past six years. Our centrally managed renovation program, funded by our franchisees, has added significantly to same restaurant sales growth capacity and allows for the continuous renewal of the Pizza Pizza concept. Pizza Pizza has an established track record of innovation in the QSR segment and has adopted new technologies to support its take-out and delivery business. Pizza Pizza enjoys strong brand awareness in the QSR market with a memorable phone number (967-11-11 in the Greater Toronto Area) and accompanying jingle, featured prominently in our marketing campaigns. We were the first take-out and delivery restaurant chain in Canada to develop a one-number ordering system and computerize our call centres; we now offer internet ordering capabilities. Pizza Pizza is also a menu innovator, continuously focusing on food quality and responding to consumer trends with products offerings such as our multigrain, trans-fat-free dough. Pizza Pizza continues its innovative history by recently introducing the electronic Pizza Pizza Club Card on which customers receive prizes and discount offerings in addition to loading the card for personal use or to give as a gift. The strategy is to encourage customers to visit our renovated restaurants. The focus of the Pizza Pizza business continues to be our traditional format restaurants, which represented approximately 91% of the System Sales for our most recent year ended December 31, 2006. Traditional restaurants are typically located in high traffic and high visibility areas and offer the full Pizza Pizza menu. The majority of renovated traditional restaurants provide seating for, on average, approximately 25 customers. Pizza Pizza also licenses non-traditional restaurants that serve a more limited menu and are targeted to “captured traffic” locations such as sport arenas and entertainment venues, food courts, universities and other institutional settings – including Paramount Canada’s Wonderland, the Air Canada Centre and cafeterias at the University of Alberta, the University of British Columbia and Dalhousie University. Non-traditional restaurants complement Pizza Pizza’s market penetration strategy, by building brand awareness and exposure while generating additional sales. 35 SOURCES OF REVENUE Pizza Pizza derives revenue from the following sources: Franchise Fees: Pizza Pizza collects an ongoing franchise fee from each Pizza Pizza franchisee. For traditional restaurants, the franchise fee varies depending upon the level of sales and is typically 6.0% of net sales, paid on a weekly basis. For non-traditional restaurants, the franchise fee averages approximately 4.4% of net sales. The weighted average franchise fee, including both traditional and nontraditional restaurants, was approximately 5.5% in fiscal 2006. Sales of Goods and Supplies: Pizza Pizza franchisees are required to purchase from Pizza Pizza all of the raw materials and supplies used and sold in their restaurants. These materials and supplies are sold by Pizza Pizza through the Commissary and Pizza Pizza is entitled to mark-up such sales by up to 18% of its costs. For the year ended January 1, 2007, the mark-up on cost averaged less than 18%, as Pizza Pizza continued to leverage its economies of scale as retail sales increase, thus providing savings to our restaurants. Initial and Renewal Franchise Fees: Pizza Pizza charges an initial franchise fee at the commencement of the initial term of the franchise agreement, and upon the renewal of such an agreement (typically after five years). The initial franchise fee is $30,000 per Pizza Pizza franchise and is payable in full at the commencement of the agreement. The renewal fee charged by Pizza Pizza to franchisees upon renewal of their franchise agreement is currently $7,500 (25% of the then-current franchise fee). Other Fees: Pizza Pizza charges franchisees fees for the transfer of a franchise and providing plans and specifications for restaurant design and renovation. OUR COMPETITIVE STRENGTHS We believe that the success of the Pizza Pizza concept, and the consistent increases in same restaurant sales and System Sales over the past ten years, are driven by the following factors: Strong brand recognition: Pizza Pizza is a well know brand in its principal markets due in part to our memorable phone number (967-11-11 in the Greater Toronto Area) and accompanying jingle. Number one market position in Ontario: In 2006, Pizza Pizza had significantly more market share among pizza restaurant chains in Ontario by sales revenue (28.1%) than the closest competitor (12.8%), as per the NPD Group for the 52 weeks ended November 2006. An extensive and modern restaurant system. Approximately 95% of the traditional Pizza Pizza restaurants are either new or substantially renovated in the past six years. Pizza Pizza franchisees are obligated to renovate their restaurants and to contribute, on an on-going basis, to a renovation fund. A proven track record of innovation. Since its inception, Pizza Pizza has adopted many innovative concepts including the one-number telephone ordering system, networked call centres, delivery guarantees, the monitoring of restaurants through a live web-feed. Centralized management and controls. Management oversees key aspects of the Pizza Pizza restaurant business allowing franchisees to focus on revenue-generating activities. Pizza Pizza also devotes substantial resources to franchisee support, training programs, product supply and quality initiatives. A strong committed management team. The seven members of senior management have an average of 20 years’ experience with Pizza Pizza. A history of stability of the franchise system. Pizza Pizza maintains a low closure rate throughout its restaurant chain; as of December 31, 2006, 14 traditional and 26 non-traditional restaurants had been 36 permanently closed since 2000, whereas total restaurants increased from 413 to 531 during that same period. OUR BUSINESS STRATEGY Growth: Pizza Pizza is well positioned to continue to build presence in the Canadian, pizza QSR segment. Consistent with our experience over the past decade, future growth is expected to come from a combination of same restaurants sales growth and new restaurant growth. Pizza Pizza expects to grow the number of restaurants in the Ontario network by 3% in 2006, and to continue researching potential expansion opportunities outside its predominately, Ontario market. The necessary conditions, such as system capacity and customer demand, exist to continue the level of growth achieved over recent years. We also believe that Pizza Pizza’s brand recognition, combined with the strength of the franchise system, will provide additional opportunities for growth in new markets in Ontario and eventually across Canada. This growth strategy, if successfully realized, will have a positive effect on system sales. Pizza Pizza’s renovation/image campaign: Pizza Pizza franchisees are obligated to renovate their restaurants and to contribute on an ongoing basis to a renovation fund. We have implemented a renovation campaign aimed at increasing retail sales and market share through improving brand visibility. This campaign is a total rebuild of our restaurants involving the relocation of selected restaurants, upgrading restaurant interiors, adding cooking capacity and seating, adding new signs to draw attention to the restaurants and providing more contemporary uniforms for restaurant employees. If a restaurant is already in a desirable location, an adjacent space is usually taken for expansion of cooking capacity and seating, interior updating and new outdoor signage. As of December 31, 2006, approximately 95% of our restaurants had been renovated or relocated as part of this campaign. We plan to complete this campaign in 2007. Marketing operations: Pizza Pizza’s innovative marketing programs are funded by franchisee contributions to a marketing fund that is administered by Pizza Pizza. In accordance with their franchise agreements, each traditional restaurant contributes approximately 6% of net sales (in addition to the base royalty fee and other franchise fee) to the Marketing fund. The marketing fund is used to pay for the production of advertising and promotional material and media purchases. Pizza Pizza seeks to develop and execute marketing programs that appeal to its customers by differentiating Pizza Pizza from its competitors, thereby attracting new customers, building customer loyalty and increasing frequency of visits. With a substantial restaurant presence in Ontario, Pizza Pizza supports the brand primarily with radio and print advertising such as flyers. For the 52-week, calendar year ended December 31, 2006, Pizza Pizza spent approximately $24 million on its promotional and advertising programs. Advertising funds are also directed towards the development of other materials, such as point of purchase promotions and coupons. Sales promotions and contests, coupons and special discounts, cross promotions with strategic partners and limited-time menu offerings are also used to stimulate purchases and introduce new products. In addition, the marketing fund supports local hockey teams, special events, public service programs and over 1,000 fundraising events in local markets. 37 Pizza Pizza Limited Management’s Discussion and Analysis Management’s Discussion and Analysis (“MD&A”) of financial conditions and results of operations covers the 52 weeks ended December 31, 2006. The MD&A should be read in conjunction with Pizza Pizza Limited’s (“Pizza Pizza”) 2006 annual consolidated financial statements and notes thereto. The financial information presented herein has been prepared in accordance with Canadian generally accepted accounting principles (“GAAP”). The MD&A has been prepared as of February 28, 2007. Additional Information This document, along with other information about Pizza Pizza and the Pizza Pizza Royalty Income Fund (“the Fund”) that will be of interest to investors, including the Annual Information Form, can be accessed on the investor relations section of the website www.pizzapizza.ca or on the SEDAR website for Canadian regulatory filings at www.sedar.com. OVERVIEW Pizza Pizza, a privately-owned Canadian corporation, is “Ontario’s #1 pizza” and is a franchise-oriented restaurant company. Of the 531 Pizza Pizza restaurants at December 31, 2006, 520 are franchised or licensed and 11 are owned and operated as Company restaurants; most corporate restaurants are to be franchised over the next two years. Pizza Pizza provides a high level of service and operational support to its franchisees, including turn-key restaurants, a central food distribution centre which provides all food and non-food items used in restaurant operations, and monitoring systems intended to ensure high product and service quality and operational consistency across the chain. Pizza Pizza has a modern restaurant system, with approximately 95% of the restaurants either new or substantially renovated in the past six years. The centrally managed renovation or re-imaging program, funded by our franchisees, has added significantly to the same restaurant sales growth capacity and allows for the continuous renewal of the Pizza Pizza concept. Our two distinct revenue sources, food sales and royalty payments, are driven largely by changes in retail system sales at franchised and company restaurants. Changes in system sales are driven by changes in same stores sales and store counts. We monitor both of these metrics closely, as they directly impact our revenues and profits, and strive to consistently increase the related amounts. For comparability purposes, system sales for the period ended December 31, 2006, increased 5.9% over the same period in 2005; for the 52 weeks ended January 1, 2006 system sales increased 5.5% as compared with the 52week period ended December 31, 2004. We devote significant attention to our innovative marketing programs which are funded by Franchisees’ contributions to a marketing fund and administered by Pizza Pizza. In accordance with their franchise agreements, each traditional restaurant contributes approximately 6% of net sales (in addition to the base royalty and other franchise fees). The marketing fund is used to pay for the production of advertising and promotional material and media purchases. For the 52 weeks ended December 31, 2006, Pizza Pizza spent approximately $24 million on its promotional and advertising programs. In July 2005, the Fund completed its initial public offering and used the proceeds to indirectly acquire the trademarks owned by Pizza Pizza used in connection with the operation of all Pizza Pizza restaurants (the “PPL Rights”). The Fund also acquired, indirectly from a bank, a loan outstanding to Pizza Pizza in the principal amount of $30 million (the “PPL Loan”). In 2005 the Fund, indirectly through the Pizza Pizza Royalty Limited Partnership (the ”Partnership”), licensed the PPL Rights to Pizza Pizza, for which Pizza Pizza pays a 6% Royalty on the system sales of those Pizza Pizza restaurants included in the specific royalty pool (the “Royalty Pool”). There were 501 restaurants in the Royalty Pool for the year 2006. 38 At December 31, 2006, Pizza Pizza has an effective 20.3% interest in the Fund through its direct ownership of Partnership units and has agreed to maintain at least a 20% interest in the Fund until June 30, 2007. Distributions on the 20% interest will be subordinated during the hold period pursuant to the terms of a subordination agreement. Pizza Pizza’s interest in the earnings of the Partnership is from its ownership of Class B and Class C Partnership units. Subject to the Subordination Agreement, each Class B Unit can be exchanged indirectly for that number of units equal to the Class B Exchange Multiplier (as defined in the License and Royalty Agreement) applicable at the date of the exchange. Class C Units can be exchanged by requiring the Trust to purchase those Class C Units in consideration of the assumption by the Trust of an amount of the indebtedness under the PPL Loan equal to $10.00 per Class C Unit to be transferred. Annually, on January 1 (the “Adjustment Date”), Pizza Pizza restaurants in the Fund’s Royalty Pool, are adjusted to include the forecasted system sales from new Pizza Pizza restaurants opened on or before December 31 of the prior year, less system sales from any Pizza Pizza restaurants permanently closed during the year. The change in the amount of the Royalty to be received by the Partnership as a result of changes in the system sales of the Royalty Pool will affect the extent of Pizza Pizza’s retained interest through the adjustment to the exchange rate at which the Class B Partnership units may ultimately be exchanged for Units of the Fund, referred to as the “Class B Exchange Multiplier” as defined in the License and Royalty Agreement. On the Adjustment Date, the adjustment to the Class B Exchange Multiplier involves first calculating the “Determined Amount”, which is defined as 92.5% of the royalty revenue added to the Royalty Pool, divided by the yield of the Fund units. The Determined Amount is multiplied by 80%, then divided by the current market price of the units, and then further divided by the Class B Partnership units outstanding. This fraction is added to the Class B Exchange Multiplier from the preceding year, which was “one” on the closing of the initial public offering. On the following Adjustment Date, a second adjustment to the Class B Exchange Multiplier will be made in the same manner as the first adjustment once the forecasted system sales for new restaurants are known with certainty. The adjustment for new restaurants rolled into the Royalty Pool is designed to be accretive for current unitholders. During the third quarter of 2006, the Fund’s Board of Trustees unanimously approved amendments to the License and Royalty Agreement with Pizza Pizza and amendments to related provisions of the Partnership Agreement of Pizza Pizza Royalty Limited Partnership resulting in the removal of the requirement that a restaurant be open for at least 120 consecutive days before it may be included in the Royalty Pool for the subsequent year. The removal of the 120-day seasoning period involves only a change in the timing of the inclusion of restaurants in the Royalty Pool and not the substance of the relationship between Pizza Pizza and the Fund. Previously, restaurants opened after September 1 of a given year would not be included in the Royalty Pool until January 1 of the second following year. OWNERSHIP OF THE FUND Ownership of the Fund on a fully diluted basis is as follows: Issued & Outstanding units, and Exchangeable Equivalent units Units Outstanding on December 31, 2006 Fund units held by public unitholders Class B exchangeable units held by Pizza Pizza Fully diluted units 17,952,000 4,563,120 22,515,120 On January 1, 2006, one net, new restaurant was added to the Royalty Pool as a result of five new restaurants opening from March 14, 2005 to September 1, 2005 and four closing from March 14, 2005 to 39 December 31, 2005. The additional system sales from the one net, new restaurant are estimated at $1.4 million annually. The total number of restaurants in the Royalty Pool has increased to 501. The yield of the Fund units was determined to be 8.06% calculated using $9.97 as a weighted average unit price. Weighted average unit price is calculated based on the market price of the units traded on the TSX during the period of twenty consecutive days ending on the fifth trading day before January 1, 2006. As a result of the contribution of the additional net sales to the Royalty Pool, Pizza Pizza’s Class B Exchange Multiplier increased fractionally by 80% of the total adjustment or 0.01674; the new Class B Multiplier is 1.01674. This adjustment will also increase the entitlement of the holders of the Class B Units to distributions of cash and allocations of income from the Partnership as described above. The second adjustment to the Class B Exchange Multiplier will be adjusted to be effective January 1, 2006, once the actual performance of the new restaurants is determined. As a result of the Adjusted Class B Exchange Multiplier, Pizza Pizza Limited now holds Class B Partnership units exchangeable into 4,563,120 Fund units which equates to 20.3% of the fully diluted units of the Fund. As a result, the Fund has reported an increase in its investment in the Partnership to reflect the increase in the value of the rights and marks vended in on January 1, 2006. Class B Partnership units held by Pizza Pizza carry voting rights in the Fund equivalent to the number of units into which they are exchangeable at that time. Subject to the prior rights of the holders of Class C Partnership units and to the Subordination agreement, the holders of Class B Partnership units are entitled to receive monthly distributions of remaining Available Cash of the Partnership, if any, on a pro rata basis with Class A Partnership units held by the Trust. 40 SELECTED FINANCIAL DATA In 2005, Pizza Pizza changed its fiscal year end to the Sunday closest to December 31, from the Sunday closest to September 30, to coincide with the Fund’s year end. The change created a 13-week, short-year ended January 1, 2006. The tables below set out selected historical information and other data from the consolidated financial statements of Pizza Pizza which should be read in conjunction with the attached consolidated financial statements of Pizza Pizza. Pizza Pizza Limited Consolidated financial data and Adjusted EBITDA (1) calculation For the 13-week For the 13-week For the 52-week For the 53-week period ended period ended period ended period ended December 31, January 1, December 31, October 2, 2006 2006 2006 2005 (in thousands of dollars except for number of restaurants) System Sales (2) $ 96,883 5% 355 176 12 0 $ 89,917 6% 340 166 1 2 $ 360,958 4.5% 355 176 30 5 $ 334,677 6% 341 166 16 4 Same store sales growth Number of Restaurants: Traditional Non-traditional New restaurants opened Restaurants closed Revenues Cost of food sales and general & administrative Earnings before income taxes and non-controlling interest Net loss Add (deduct) Charitable contribution Non-recurring employee and franchisee bonuses and retention payments Structuring costs Non-controlling interest in Partnership earnings Amortization Interest expense (income) (Gain) loss on sale of Company restaurants Provision for income taxes Current Future (3) $ $ $ $ 44,827 38,858 4,039 (1,651) 3,793 1,148 385 51 (1,191) 3,088 $ $ $ $ 41,800 35,909 4,439 (299) 3,608 1,573 410 (630) 810 320 $ $ $ $ 167,104 147,486 13,162 (2,955) 3,386 14,090 4,812 1,814 (1,266) 122 1,905 $ $ $ $ 162,061 147,649 9,325 (6,979) 20,000 7,143 11,850 (6,102) 6,773 (53) (1,574) 21,200 (30,644) Adjusted EBITDA (1) $ 5,623 $ 5,792 $ 21,908 $ 21,614 December 31, 2006 Total assets Total liabilities $ $ 89,859 79,160 January 1, 2006 $ $ 93,805 80,932 October 2, 2005 $ $ 175,046 122,677 Notes to Selected Financial Data: (1) ‘‘EBITDA’’ is not a recognized measure under Canadian GAAP. References to EBITDA are to earnings determined in accordance with GAAP applicable to the financial statements before amounts for interest, taxes and depreciation and amortization are included in the earnings. In addition, Pizza Pizza has adjusted EBITDA for unusual charges including nonrecurring retention bonuses, gains and losses on sales of assets and non-controlling interest. Pizza Pizza believes that, in 41 (2) (3) addition to net income, EBITDA is a useful supplemental measure in evaluating its performance as it provides investors with an indication of cash available for debt service, working capital needs and capital expenditures. Investors are cautioned, however, that EBITDA should not be construed as an alternative to the statement of cash flows as a measure of liquidity and cash flows. The method of calculating EBITDA for the purposes of this report may differ from that used by other issuers and, accordingly, EBITDA in this report may not be comparable to EBITDA used by other issuers. System sales reported for the 53-weeks ended October 2, 2005 have been adjusted to 52 weeks for continuing comparability. The Fund's 79.7% interest in the Partnership is reported on the equity basis as "non-controlling interest". RESULTS OF OPERATIONS The following should be read in conjunction with the Selected Financial Data provided herein and in conjunction with the Consolidated Financial Statements of Operations and Deficit and related notes of Pizza Pizza for 52 weeks ended December 31, 2006 and the 13 weeks and 53 weeks ended January 1, 2006 and October 2, 2005, respectively. Analysis of System sales System sales for the 13 weeks ended December 31, 2006 increased 7.8% to $96.9 million from $89.9 million for the 13 weeks ended January 1, 2006; for the 52 weeks ended December 31, 2006 system sales increased 7.9% to $361.0 million from $334.7 million for the 52 weeks ended October 2, 2005. Same store sales growth (“SSSG”) for the 13-week period ended December 31, 2006 was 5% and was 4.5% for the 52-week period when compared to the comparable period in 2005. System-wide sales were also impacted by opening 30 restaurants and closing five in 2006. Industry statistics released by the Ontario Ministry of Tourism reported U.S. border crossings to Ontario decreased by 9.2% in the first eleven months of 2006 over the same period in 2005. A decrease in Ontario tourism, both U.S. and international, negatively impacted sales at a select number of our restaurants. Particularly affected during the summer months were sales at some of our outdoor-themed, non-traditional locations. New restaurant development and restaurant closures Pizza Pizza opened 12 restaurants and closed none during the 13-week period ended December 31, 2006, bringing the total number to 531 locations. There was one restaurant opened and two closed during the comparable 13-week period in 2005. For the 52-week period, there have been 30 restaurants opened and five closed; there were 16 restaurants opened and 4 closed during the comparable 53-week period in 2005. Over 95% of the traditional Pizza Pizza restaurants are either new or have been substantially renovated in the past six years. Management is focused on completing the renovation of the remaining restaurants over the next twelve months. Revenues Food sales, royalties, franchise fees and related revenue for the 13-week period ended December 31, 2006 were $44.4 million, compared with $41.4 million for the 13-week period ended January 1, 2006. Food sales for the current period increased $2.5 million to $38.1 million from $35.6 million for the 13-week period ended January 1, 2006. Royalties, franchise fees and related revenue were $6.3 million for the 13 weeks ended December 31, 2006 and were $5.8 million for the 13 weeks ended January 1, 2006. The total $3 million increase in food sales, royalties, franchise fees and related revenue is due largely to opening 12 additional restaurants and increasing system sales by 7.8% during the current quarter. Food sales, royalties, franchise fees and related revenue for the 52-week period ended December 31, 2006 were $165.6 million, compared with $160.1 million for the 53-week period ended October 2, 2005. Considering one less week of operations during the current year, food sales during the period increased $3.3 million to $142.4 million from $139.1 million for the 53-week period ended October 2, 2005. Royalties, franchise fees and related revenue were $23.3 million for the 52-week period and were $21.1 million for the 53 weeks ended October 2, 2005. The total $5.5 million increase in food sales, royalties, 42 franchise fees and related revenue is due largely to operating 24 additional restaurants and increasing system sales by 7.9% during the current year compared to the 53-week period ended October 2, 2005. Cost of food sales and general and administrative expenses Cost of food sales and general and administrative expenses net of amortization were $38.9 million for the 13-week period ended December 31, 2006, and were $35.9 million for the 13-week period ended January 1, 2006. Food costs increased $2.3 million due largely to opening 12 additional restaurants and SSSG of 5%. General and administrative expenses increased $680,000 due largely to a $350,000 increase in salaries; a $240,000 increase in professional fees and a $100,000 increase in maintenance costs. Cost of food sales and general and administrative expenses net of amortization were $147.5 million for the 52-week period ended December 31, 2006, and were $147.9 million for the 53-week period ended October 2, 2005. Food costs decreased $525,000 due to one less week of operation in the current year offset by additional restaurants and SSSG of 4.5%. General and administrative expenses increased $104,000 due largely to an increase in salary and benefits of $850,000; offset by an decrease in rent expenses of $240,000; a decrease in professional fees of $200,000 and a decrease in travel of $240,000. Non-controlling interest in Partnership earnings For the 13 weeks ended December 31, 2006, the Fund’s non-controlling interest of $3.8 million in Partnership earnings is deducted from the consolidated earnings of Pizza Pizza and the Partnership compared to $3.6 million for the 13 weeks ended January 1, 2006. For the 52 weeks ended December 31, 2006, the Fund’s non-controlling interest of $14.1 million is deducted from consolidated earnings compared to $6.1 million for the 53 weeks ended October 2, 2005; the $8 million difference is due to the Fund’s initial public offering date being July 6, 2005, thus operating for a partial period of time during the year ended October 2, 2005. Interest expense Interest expense was $731,000 for the 13-week period ended December 31, 2006 largely as a result of Pizza Pizza paying $450,000 in interest on the $30 million loan from the Fund as well as the Partnership paying $229,000 in interest on a $20 million bank credit facility. For the 13-week period ended January 1, 2006, interest expense was $760,000, consisting mostly of $450,000 on the $30 million loan from the Fund, as well as the Partnership paying $282,000 on a $20 million bank credit facility. Interest expense was $2.9 million for the 52-week period ended December 31, 2006 as a result of Pizza Pizza paying $1.8 million in interest on the $30 million loan from the Fund and the Partnership paying $1.1 million in interest on a $20 million bank credit facility. For the 53-week period ended October 2, 2005, interest expense was $874,000 consisting of $430,000 paid on the $30 million loan from the Fund, $182,000 on various credit facilities related to owning Company restaurants, and the Partnership paying $262,000 on the $20 million bank credit facility. Gain on sale of Company restaurants For the 13-week period ended December 31, 2006, no Company restaurants were sold compared with eight Company restaurants sold during the 13-week period ended January 1, 2006 for a gain of $630,000. Pizza Pizza continues to own 46 Company restaurants, operating 11 corporately and licensing 35 to associate franchisees. Pizza Pizza expects to continue selling its remaining Company restaurants. For the 52-week period ended December 31, 2006, 15 Company restaurants were sold for a gain on sale of $1.3 million compared with 13 Company restaurants sold during the 53-week period ended October 2, 2005 for a gain on sale of $1.6 million. Adjusted EBITDA (see “Selected Financial Data”) Adjusted EBITDA was $5.6 million for the 13-week period ended December 31, 2006; adjusted EBITDA was $5.8 million for the 13-week period ended January 1, 2006. For the 52-weeks ended December 31, 2006 and 53-weeks ended October 2, 2005, EBITDA was $21.9 million and $21.6 million, respectively. 43 Net loss Net loss for the 13-week period ended December 31, 2006, was $1.6 million compared to a loss of $299,000 for the 13-week period ended January 1, 2006. The $1.3 million increase in loss was largely due to a $700,000 decrease in gain on sale of company restaurants and a $767,000 increase in income tax provision; offset by a $168,000 decrease in amortization expense . Net loss for the 52-week period ended December 31, 2006, was $2.9 million largely a result of paying $3.4 million in management retention bonuses related to contracts signed during the Fund’s initial public offering. The 53-week period ended October 2, 2005, during which the Fund was formed, had a net loss of $7.0 million, largely as a result of the Partnership writing off $11.8 million in structuring costs related to the initial public offering, charitable contributions of $20 million, and employee and franchisee bonuses of $7.1 million. The structuring costs, charitable contributions and bonuses were paid from the initial public offering proceeds. These non-recurring expenses were largely offset by a net credit in provision for income taxes of $9.4 million and a credit of $6.1 million in non-controlling interest in Partnership earnings. Shareholders’ deficiency The $129.2 million shareholders’ deficiency in the consolidated balance sheet at December 31, 2006 is largely a result of Pizza Pizza having paid $107.5 million in dividends to shareholders in 2005. The source of dividends to shareholders was the proceeds received from the Partnership in payment for the PPL Rights. Pizza Pizza Limited has a deferred gain on the sale of the PPL Rights of $185.8 million, which is not reflected in the consolidated shareholders’ deficiency. SUMMARY OF QUARTERLY RESULTS 13 weeks ended December 31, 2006 (unaudited) Revenue Net Income (Loss) Adjusted EBITDA $ $ $ 44,827 (1,651) 5,623 13 weeks ended October 1, 2006 (unaudited) $ $ $ 41,734 (1,629) 5,721 13 weeks ended July 2, 2006 (unaudited) $ $ $ 40,898 (354) 5,131 13 weeks 13 weeks ended ended April 2, January 1, 2006 2006 (unaudited) (unaudited) (in thousand dollars) $ 39,645 $ 41,800 $ $ 679 5,708 $ $ (299) 5,792 13 weeks ended October 2, 2005 (unaudited) $ 39,596 12 weeks ended July 3, 2005 (unaudited) $ $ $ 35,826 1,983 4,378 12 weeks ended April 10, 2005 (unaudited) $ $ $ 37,959 2,931 4,667 $ (15,544) $ 4,437 SUBSEQUENT EVENTS In January 2007, adjustments to royalty payments and Pizza Pizza’s Class B Exchange Multiplier were made based on the actual performance of the net, one restaurant added to the Royalty Pool on January 1, 2006. As a result of the adjustments, the new Class B Exchange Multiplier is 1.02345 and Pizza Pizza’s exchangeable units increase by 30,113 to 4,593,233 Fund units, effective January 1, 2006, which equates to 20.37% of the fully diluted units of the Fund. On January 1, 2007, 30 net new restaurants were added to the Royalty Pool as a result of 35 new restaurants opening from September 2, 2005 to December 31, 2006 and five closings during 2006. The additional system sales from the 30 net, new restaurants are estimated at $15.4 million annually. The total number of restaurants in the Royalty Pool increased to 531. The yield of the Fund units was determined to be 10.56% calculated using $7.94 as a weighted average unit price. Weighted average unit price is calculated based on the market price of the units traded on the TSX during the period of 20 consecutive days ending on the fifth trading day before January 1, 2007. As a result of the contribution of the additional net sales to the Royalty Pool, Pizza Pizza’s Class B Exchange Multiplier increased fractionally by 80% of the total adjustment or 0.18174; the new Class B Multiplier is 1.20519. This adjustment will also increase the entitlement of the holders of the Class B Units to distributions of cash and allocations of income from the Partnership. The second adjustment to the Class B Exchange Multiplier will be adjusted to be effective January 1, 2007, once the actual performance of the new restaurants is determined in early 2008. As a result of the Adjusted Class B Exchange Multiplier, Pizza 44 Pizza will hold Class B Partnership units exchangeable into 5,408,915 Fund units which equates to 23% of the fully diluted units of the Fund as of January 1, 2007. LIQUIDITY & CAPITAL RESOURCES The following table provides an overview of the cash flows for the periods: For the 13-week period ended December 31, 2006 Operating activities Investing activities Financing activities Increase (decrease) in cash $ 6,214 (4,524) (3,654) (1,964) For the 13-week For the 52-week period ended period ended January 1, December 31, 2006 2006 (in thousands of dollars) $ (14,973) $ 13,338 (5,861) 4,344 (65,405) (13,345) $ (86,239) $ 4,337 For the 53-week period ended October 2, 2005 $ (22,462) (6,574) 119,372 90,336 $ $ As of December 31, 2006, Pizza Pizza had positive working capital of $14.6 million and cash and cash equivalents were $13.6 million. As of January 1, 2006, Pizza Pizza had positive working capital of $2.5 million and cash and cash equivalents of $9.2 million. Historically, Pizza Pizza has operated with negative working capital primarily because our receivable collection periods and inventory turn rates are faster than the normal payment terms of our current liabilities. We collect most of our receivables within seven days from the date of the related sale and pay the payables within 30 days; we generally experience over 100 turns of inventory per year. These factors, coupled with significant and ongoing cash flows from operations, which are used primarily to pay the Partnership a 6% royalty on the Royalty Pool system sales, reduce our working capital amounts. Our primary sources of liquidity are cash flows from operations. We have historically funded capital expenditures and debt repayments from cash flows from operations and proceeds from the disposal of Company restaurants. We did not have any material commitments for capital expenditures as of December 31, 2006. Cash provided by operating activities for the 13-week period ended December 31, 2006 was $6.2 million compared with cash used by operations of $15.0 million for the 13-week period ended January 1, 2006. The increase in cash provided by operations of $21.2 million, when compared to the prior year comparative period is attributable to a $20.3 million increase change in non-cash operating elements of working capital. On a year-to-date basis, cash provided by operating activities for the 52-week period ended December 31, 2006 was $13.3 million compared with cash used by operations of $22.5 million for the 53-week period ended October 2, 2005. The majority of the $35.8 million increase in cash provided by operations compared to the prior year is largely attributable to a $4.0 million increase in net income, a $32.5 million change in future income taxes, a $20.1 million increase in non-controlling interest, a $4 million increase in deferred revenue, and an offsetting $24.3 million decrease in non-cash operating elements of working capital. Cash used in investing activities for the 13-week period ended December 31, 2006 was $4.5 million compared with $5.9 million for the 13-week period ended January 1, 2006. The $1.4 million decrease is due to a $2.1 million decrease in capital expenditures offset by increases to the advances to related companies. On a year-to-date basis, cash provided by investing activities for the 52-week period ended December 31, 2006 was $4.3 million compared with cash used in investing activities for the 53-week period ended October 2, 2005 of $6.6 million. The $10.9 million increase is largely attributed to a $5.8 million reduction in capital expenditures, a $1.1 million net decrease in receipt of repayments from related parties, a $3.3 million net decrease in issuance of notes receivable and a $3.4 million decrease in disbursements from renovation funds. Cash used in financing activities was $3.6 million for the 13-week period ended December 31, 2006 ($13.3 million year-to-date), due to distributions to the Fund of $3.4 million ($13.3 million year-to-date). 45 The Partnership has credit facilities which have not changed since the end of the previous fiscal year. Certain covenants must be maintained by the Partnership and Pizza Pizza for the credit facility to be in good standing, all of which were met as of December 31, 2006. The Partnership is presently making interest-only payments on the non-revolving credit facility. Based upon our current level of operations and anticipated growth, we believe that the cash generated from our operations will be adequate to pay the Partnership a 6% royalty on the Royalty Pool system sales and meet our anticipated debt service requirements, our capital expenditures and our working capital needs. Our ability to continue to fund these items could be adversely affected by the occurrence of any of the events described in the Risks and Uncertainties section that follow herein. Our future operating performance and our ability to pay the Partnership a 6% royalty on the Royalty Pool system sales and meet our anticipated debt service requirements will be subject to future economic conditions and to financial, business and other factors, many of which may be beyond our control. OFF-BALANCE SHEET ARRANGEMENTS Pizza Pizza is a sublessor under the head lease for all restaurant locations, other than locations operated by certain licensees. Should franchisees fail to meet their obligations under the terms of their sublease, Pizza Pizza would become liable for the obligations under the related head leases. The gross lease obligations are summarized in the following table: 2007 Minimum lease obligation Less: Sublease to franchisees Net lease obligation $ 19,668 15,562 $ 4,106 Payments due by Period 2008 2009 2010 (in thousands of dollars) $ 17,748 $ 15,679 $ 12,248 14,069 $ 3,679 12,650 $ 3,029 10,337 $ 1,911 2011 $ 8,593 7,276 $ 1,317 Pizza Pizza has provided certain guarantees as disclosed in note 13 of the consolidated financial statements with respect to certain franchisee loans. Management believes that guarantees of franchisee loans are a low risk since Pizza Pizza has, historically, been able to replace a defaulting franchisee with a new franchisee who has assumed the obligations of the defaulting franchisee. OUTLOOK Same store sales growth for the current quarter was 5% and 4.5% year-to-date compared with the same periods in fiscal 2005. With the increased network capacity and exceptional promotional campaigns, Pizza Pizza is well positioned for similar growth and continues to strengthen its position as “Ontario’s #1 Pizza”. With over 95% of traditional restaurants expanded or relocated within the last six years, Pizza Pizza offers expanded seating capacity, thereby targeting additional day-parts and allowing for additional product offerings to enable restaurants to continue increasing same store sales. Management is focused on completing the renovation of the remaining restaurants over the next twelve months. As a result of the consistent same store sales growth during the reporting period, the Fund increased its monthly distribution in February and July, 2006 by 3.7% in total, from $0.0681 to $0.071 per unit. Subsequent to the year end, the Fund increased its January 2007 distribution by 2.8%, from $0.071 to $0.073 per unit. Pizza Pizza expects to grow the number of restaurants in the Ontario network by 3% in 2007, and to continue researching potential expansion opportunities outside its predominantly Ontario market, with any potential expansion coming either through organic growth or acquisitions. Additionally, Pizza Pizza expects to continue franchising its remaining Company restaurants. 46 CRITICAL ACCOUNTING POLICIES & ESTIMATES The preparation of the consolidated financial statements of Pizza Pizza requires our management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On an ongoing basis, our management evaluates its estimates, including those related to basis of consolidation, revenue recognition, non-controlling interest, long-lived and intangible assets and income taxes. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from those estimates. Changes in our estimates could materially impact our results of operations and financial condition for any particular period. We believe that our most critical accounting policies are: Basis of Consolidation. As “consolidation” applies to the 13-week and 52-week periods ended December 31, 2006, it means that the operations of Pizza Pizza and its subsidiary have been consolidated with the Partnership’s operations. Revenue Recognition. Food sales are recognized when the products are delivered to the traditional and non-traditional restaurants. Franchise royalties are recognized as earned and are based on a percentage of the franchisees' sales as provided for in individual franchise agreements. Initial franchise fees are recognized when the franchised outlet becomes operational. Renewal fees are recognized when the franchise renewal agreement is signed. Company restaurant sales are recognized when the services are rendered and the products are sold to the public. Construction fees are recognized when the related franchise location becomes operational. Interest and other income are recognized and accrued when earned. Non-controlling Interest. The Partnership is considered to be a VIE and the Company is the primary beneficiary of the Partnership, accordingly, the Company consolidates the Partnership. The Fund’s interest in the Partnership is shown as non-controlling interest in the balance sheet and the noncontrolling interest equity allocation is shown in the statement of operations. Future Income Taxes. The Company follows the liability method with respect to accounting for income taxes. Future tax assets and liabilities are determined based on differences between the carrying amount and the tax basis of assets and liabilities (temporary differences). Future income tax assets and liabilities are measured using the substantively enacted tax rates that will be in effect when these differences are expected to reverse. Future income tax assets, if any, are recognized only to the extent that, in the opinion of management, it is more likely than not that the assets will be realized. Renovation Funds. The Company maintains a long-term renovation program whereby franchisees contribute towards future store renovations and upgrades. The franchise owner acknowledges that the renovation fund contribution may be used by the Company, without interest or other compensation to the franchise owner, to fund the renovation, expansion or relocation of other Pizza Pizza outlets until such time as the funds are required by the franchise owner for renovation, expansion or relocation of the franchised outlet. The Company changed the accounting for the non-controlling interest in Pizza Pizza Royalty Limited Partnership (the “Partnership”) as new restaurants are added to the Royalty Pool. The Company has restated the January 1, 2006 financial statements where previously it recorded a gain on acquisition of its investment in Pizza Pizza Royalty Limited Partnership. 47 The above resulted in various adjustments to the January 1, 2006 audited comparative financial statements as follows: Increase (Decrease) Balance sheet: (i) Future tax asset (ii) Non-controlling interest (iii) Deficit Statement of operations: (iv) Gain on acquisition (v) Future tax expense CHANGES IN ACCOUNTING POLICES, INCLUDING INITIAL ADOPTION Variable Interest Entities. Pizza Pizza Limited’s consolidated financial statements consolidate the accounts of the Company, its wholly owned subsidiary, Pacific and Canadian Food Services Inc., and the effective, 20.3% interest in the Partnership. On consolidation, all significant inter-company transactions and balances have been eliminated. In June 2003, the CICA issued Accounting Guideline 15, “Consolidation of Variable Interest Entities” (“AcG-15”), requiring the consolidation of variable interest entities (“VIEs”) by the primary beneficiary of the expected residual returns or losses, or both, of the VIE. A VIE is any type of legal structure in which consolidation is required due to contractual or other financial arrangements, as opposed to traditional voting rights, if certain conditions exist. The Partnership is considered to be a VIE and Pizza Pizza is the primary beneficiary of the Partnership. Accordingly Pizza Pizza, rather than the Fund, consolidates the Partnership, and AcG-15 is effective from the initial public offering closing date of July 6, 2005. The following major assets and liabilities were eliminated upon consolidation: Pizza Pizza: (in thousands of dollars) Investment in LP Units Deferred gain on Pizza Pizza Rights $ $ $ $ $ 230 635 405 (635) (230) $ 28,120 $185,945 The Partnership: (in thousands of dollars) Rights and Marks Class B LP Units issued Class C LP Units issued $231,424 $ 42,219 $ 30,000 Impairment of Long-lived Assets. Effective September 29, 2003, the Company adopted prospectively the new recommendations of The Canadian Institute of Chartered Accountants (‘‘CICA’’) with respect to accounting for impairment of long-lived assets. The new recommendations state that long-lived assets comprise capital assets subject to amortization. The long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. For purposes of evaluating the recoverability of long-lived assets, the recoverability test is performed using undiscounted future net cash flows of the asset. The amount of the impairment is measured as the difference between the carrying value and the fair value of the asset and recognized by way of an additional current period amortization charge. Previously, the Company measured impairment, if any, as the difference that carrying value exceeded net recoverable amount (undiscounted cash flows). There is no material impact on the financial statements from this change in accounting policy. Financial Instruments and Other Instruments. Pizza Pizza’s financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities and bank loans that are 48 all short term in nature and, as such, have carrying values that approximate fair values. The carrying amounts for the notes receivable, long-term debt and loan payable to Pizza Pizza Holdings Trust approximate their fair values. The fair values are based on the estimated future discounted cash flows using a comparable market rate of interest. A reasonable estimate of fair value could not be made for recoverable franchisee expenses, advances to/from parent company and renovations funds as there is no comparable market data. Pizza Pizza’s financial instruments exposed to credit risk include accounts receivable. Accounts receivable primarily comprise amounts due from franchisees and we believe that accounts receivable credit risk exposure is limited. Credit risk is managed by performing ongoing credit evaluations of franchisees and maintaining an allowance for doubtful accounts. TRANSACTIONS WITH RELATED PARTIES Pizza Pizza and the Partnership have entered into related party transactions with companies under common control. These transactions are entered into in the normal course of business and are measured at the exchange amount, which is the amount of consideration established and agreed to by the related parties. Significant related party transactions include rent expense, distributions on partnership LP units, management fees and food purchases as disclosed in note 17 of the consolidated financial statements of Pizza Pizza Limited. Distributions payable and advances to or from related parties and receipt of or repayments of advances from related parties are summarized in note 17 of the consolidated financial statements of Pizza Pizza Limited. The management agreement with the commonly controlled company terminated as of January 1, 2006 and no further management fees are anticipated. RISKS & UNCERTAINTIES The Restaurant Industry The performance of Pizza Pizza Limited is primarily dependent upon its ability to maintain and increase system sales at the Pizza Pizza restaurants, add new profitable restaurants to the network and attract qualified restaurant operators. Sales are subject to a number of factors that affect the restaurant industry generally and the quick service segment of this industry, in particular, which is highly competitive with respect to price, service, location and food quality. In addition, factors such as the availability of experienced management and hourly employees may also adversely affect the system sales. Competitors include national and regional chains, as well as independently-owned restaurants. If Pizza Pizza Limited and the Pizza Pizza restaurants are unable to successfully compete in the quick service sector, system sales may be adversely affected. Changes in demographic trends, traffic patterns and the type, number and location of competing restaurants also affect the restaurant industry. In addition, factors such as government regulations, inflation, publicity from any food-borne illnesses and increased food, labour and benefits costs may adversely affect the restaurant industry in general and therefore, potentially, Pizza Pizza system sales. Pizza Pizza’s success also depends on numerous factors affecting discretionary spending, including economic conditions, disposable consumer income and consumer confidence. Adverse changes in these factors could reduce guest traffic or impose practical limits on pricing, either of which could reduce revenue and operating income, which could adversely affect system sales and the ability of Pizza Pizza to pay the royalty to the Fund or interest on the PPL Loan. Litigation A claim was formally served on Pizza Pizza and certain of its associates by Lawrence Austin, a former consultant to Pizza Pizza. In the claim, which does not name the Fund or its subsidiaries, Mr. Austin asserts a right to $45 million in damages and other amounts, including entitlements to a portion of the proceeds of the Fund’s IPO that were directly or indirectly received by Pizza Pizza and its associates. Pizza Pizza has advised the Fund it believes the demand to be without merit and it will vigorously defend the claim. Pizza Pizza notes that Michael Overs, the Chairman and CEO of Pizza Pizza, has agreed in an indemnity agreement to indemnify Pizza Pizza and the Fund against any liabilities they may incur in this matter. 49 FORWARD-LOOKING STATEMENTS Certain statements in this report may constitute “forward-looking” statements, which involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. When used in this report, such statements include such words as “may”, “will”, “expect”, “believe”, “plan”, and other similar meaning in conjunction with a discussion of future operating or financial performance. These statements reflect management’s current expectations regarding future events and operating performance and speak only as of the date of this report. These forward-looking statements involve a number of risks and uncertainties. The following are some factors that could cause actual results to differ materially from those expressed in or underlying such forward-looking statements: competition, changes in demographic trends, changing consumer preferences and discretionary spending patterns, changes in national and local business and economic conditions, legislation and governmental regulation, accounting policies and practices, and the results of operations and financial condition of Pizza Pizza. The foregoing list of factors is not exhaustive. 50 51 PIZZA PIZZA LIMITED CONSOLIDATED BALANCE SHEET (In Thousands of Dollars) December 31, 2006 ASSETS Current Assets Cash and cash equivalents Accounts receivable Inventories Prepaid expenses and sundry assets Income taxes recoverable Current maturity of notes receivable (note 5) Recoverable franchisee expenses, net Total current assets Capital assets (note 4) Notes receivable (note 5) Advances to parent company (note 17) Investment in Pizza Pizza GP Inc. Renovation funds Deferred charges (note 6) Future income tax asset (note 10) $ LIABILITIES AND SHAREHOLDERS' DEFICIENCY Current Liabilities Accounts payable and accrued liabilities (note 7) Deposits from franchisees Advances from parent company (note 17) Current maturities of long-term debt (note 8) Total current liabilities Long-term debt (note 8) Deferred revenue Loan payable to Pizza Pizza Holdings Trust (note 9) Renovation funds Total liabilities Non-controlling interest (note 11) Commitments and Contingencies (notes 12 and 13) SHAREHOLDERS' DEFICIENCY Common shares and special voting shares (note 14) Deficit $ See accompanying notes to the financial statements (Signed) MICHAEL OVERS Director January 1, 2006 (Restated – note 2) $ 13,559 3,441 3,150 2,722 726 10,140 4,057 37,795 16,139 372 10,103 683 24,767 89,859 $ 9,222 3,377 2,897 3,365 340 8,757 1,069 29,027 20,647 92 6,922 10,352 93 26,672 93,805 $ $ 22,187 928 3 52 23,170 20,146 4,005 30,000 1,839 79,160 139,921 $ 25,119 1,404 52 26,575 20,185 1,894 30,000 2,278 80,932 139,140 (129,222) 89,859 $ (126,267) 93,805 52 PIZZA PIZZA LIMITED CONSOLIDATED STATEMENT OF OPERATIONS AND DEFICIT (In Thousands of Dollars) For the 52-week period ended December 31, 2006 For the 13-week period ended January 1, 2006 (note 3) (Restated - note 2) $ 35,637 5,769 394 41,800 35,909 14 1,308 450 310 (630) 37,361 4,439 4,439 For the 53-week period ended October 2, 2005 (note 3) Revenue Food sales (note 15) Royalties, franchise fees and other related revenue (note 16) Interest and other income Expenses Cost of food sales and general and administrative Amortization of deferred charges (note 6) Amortization of capital assets (note 4) Interest on loan from Pizza Pizza Holdings Trust (note 9) Interest on long-term debt (note 8) Gain on sale of company restaurants Earnings before the undernoted, income taxes and non-controlling interest Structuring costs Charitable contributions Earnings (loss) before income taxes and noncontrolling interest Provision for (recovery of) income taxes (note 10) Current Future Earnings (loss) before non-controlling interest Non-controlling interest in Partnership earnings (note 11) Net loss for the period Deficit - beginning of period Recovery of refundable taxes paid (note 10) Dividends Refundable taxes paid (note 10) Deficit - end of period See accompanying notes to the financial statements $ 142,376 23,261 1,467 167,104 147,486 106 4,706 1,800 1,110 (1,266) 153,942 13,162 13,162 $ 139,062 21,063 1,936 162,061 147,649 60 5,727 430 444 (1,574) 152,736 9,325 11,850 20,000 31,850 (22,525) 122 1,905 2,027 11,135 14,090 (2,955) (126,267) $ (129,222) $ 810 320 1,130 3.309 3,608 (299) (86,356) (39,612) (126,267) $ 21,200 (30,644) (9,444) (13,081) (6,102) (6,979) (11,512) 1,452 (67,865) (1,452) (86,356) 53 PIZZA PIZZA LIMITED CONSOLIDATED STATEMENT OF CASH FLOWS (In Thousands of Dollars) For the 52-week period ended December 31, 2006 Operating Activities Net loss for the period Amortization of capital assets Amortization of deferred charges Non-controlling interest Amortization of deferred revenue Gain on sale of company restaurants Future income tax expense (recovery) For the 13-week period ended January 1, 2006 (Restated - note 2) For the 53-week period ended October 2, 2005 $ (2,955) 5,803 106 14,090 (1,889) (1,266) 1,905 15,794 4,000 (6,456) 13,338 $ (299) 1,559 14 3,608 (476) (630) 320 4,096 (19,069) (14,973) $ (6,979) 6,713 60 (6,102) (1,745) (1,574) (30,644) (40,271) 17,809 (22,462) Receipt of deferred revenue Changes in non-cash operating elements of working capital (note 18) Cash provided by (used in) operating activities Investing Activities Additions to capital assets – maintenance Additions to capital assets – restaurants Proceeds from sale of company restaurants Proceeds from sale of capital assets Advances to related companies Receipt of payments from parent company Repayment of notes receivable Issuance of notes receivable Contributions to renovation funds Disbursement from renovation funds Deferred charges Cash provided by (used in) investing activities Financing Activities Proceeds of long-term debt Repayments of long-term debt Repayments of bank loan Proceeds from issuance of Pizza Pizza Royalty Limited Partnership units Loan from Pizza Pizza Holding Trust Advances from related companies Repayment of advances from related companies Distributions by Pizza Pizza Royalty Limited Partnership (note 11) Dividends Redemption of preferred shares Cash provided by (used in) financing activities Increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of period Cash and cash equivalents, end of period $ (1,288) (3,367) 4,557 69 (9,363) 16,285 10,455 (12,118) 21,809 (21,999) (696) 4,344 (1,002) (1,336) 1,501 (7,608) 2,020 3,963 (4,607) 7,625 (6,417) (5,861) (1,996) (8,473) 4,670 10 (18,056) 25,740 5,296 (10,306) 16,686 (20,214) 69 (6,574) (39) 3 (13,309) (13,345) 4,337 9,222 13,559 $ 23 (17) 1,367 (7,375) (3,193) (39,612) (16,598) (65,405) (86,239) 95,461 9,222 $ 20,632 (5,246) (315) 147,795 30,000 5,137 (2,119) (2,968) (67,865) (5,679) 119,372 90,336 5,125 95,461 54 See supplementary cash flows information (note 18) See accompanying notes to the financial statements NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Nature of Business Pizza Pizza Limited (the “Company” or “Pizza Pizza”), a privately-held corporation, operates in the food service industry primarily throughout Ontario, and primarily franchises and operates quick-service restaurant businesses under the Pizza Pizza brand. The Company derives revenues from franchises through the sale of franchise restaurants, royalties, and food and beverages. The Company also derives revenues from Company owned restaurants through the sale of food products to retail customers. During the period, the Company acquired 16 franchises (January 1, 2006 – 8; October 2, 2005 – 8) and franchised 40 (January 1, 2006 – 15; October 2, 2005 – 33). Below are the number of franchisees and licensees as at: December 31, 2006 Franchisees and licensees Company restaurants 520 11 January 1, 2006 487 19 October 2, 2005 485 21 2. Accounting Adjustment The Company changed its policy regarding the accounting for the non-controlling interest in Pizza Pizza Royalty Limited Partnership (the “Partnership”) as new restaurants are added to the Royalty Pool. This change has been applied retroactively and has restated the January 1, 2006 financial statements where the Company previously recorded a gain on acquisition of its investment in Pizza Pizza Royalty Limited Partnership. Under the previous accounting: (i) (ii) (iii) (iv) Future tax asset was understated by $230. Non-controlling interest was understated by $635. Gain on acquisition was overstated by $635. Future tax expense was overstated by $230. The above resulted in various adjustments to the January 1, 2006 comparative financial statements as follows: Increase (Decrease) Balance sheet: (i) Future tax asset (ii) Non-controlling interest (iii) Deficit Statement of operations: (iv) Gain on acquisition (v) Future tax expense $ $ $ $ $ 230 635 405 (635 (230 55 3. Summary of Significant Accounting Policies Fiscal Year End and Interim Period Effective January 1, 2006, the Company changed its floating year-end to the Sunday closest to December 31. Interim periods consist of four 13-week periods with an additional week added to the last interim period every 5 to 6 years. Previously, the Company's fiscal year ended on the Sunday closest to September 30. Basis of Consolidation These financial statements consolidate the accounts of the Company, its wholly-owned subsidiary, Pacific and Canadian Food Services Inc., and its interest in the Pizza Pizza Royalty Limited Partnership (the “Partnership”). On consolidation, all significant inter-company transactions and balances have been eliminated. In June 2003, the Canadian Institute of Chartered Accountants issued Accounting Guideline 15, “Consolidation of Variable Interest Entities” (“AcG-15”), requiring the consolidation of variable interest entities (“VIEs”) by the primary beneficiary of the expected residual returns or losses, or both, of the VIE. A VIE is any type of legal structure in which consolidation is required due to contractual or other financial arrangements, as opposed to traditional voting rights, if certain conditions exist. The Partnership is considered to be a VIE and the Company is the primary beneficiary of the Partnership, accordingly, the Company consolidates the Partnership. The Pizza Pizza Royalty Income Fund’s (the “Fund”) effective 79.7% interest as of December 31, 2006, in the Partnership is shown as non-controlling interest in the balance sheet and the non-controlling interest equity allocation is shown in the statement of operations. Revenue Recognition The Company recognizes revenue on the following basis: • Food sales are recognized when the products are delivered to the franchised restaurants. Pizza Pizza franchisees sign a franchise agreement which requires the franchisee to purchase from Pizza Pizza, at an agreed markup on cost, all of the raw materials and supplies used and sold in their Pizza Pizza restaurant(s). Payment for materials and supplies are due within seven days. • Company restaurant retail sales are recognized when the services are rendered and the products are sold to the public. Payment by the public is immediate. • Franchise royalties are recognized as earned and are based on a percentage of the franchisees' sales as provided for in individual franchise agreements. Royalties are due within seven days. • Initial and renewal franchise fees are recognized at the commencement of the initial term of the franchise agreement and upon the renewal of such an agreement. The initial franchise fee is payable, in full, at the commencement of the agreement. The renewal fee is charged to franchisees upon renewal of their franchise agreement which is typically five years from the initial agreement. • Construction fees are recognized when the related franchise restaurant becomes operational. Fees are generated by the Company acting as general contractor as per a franchise agreement. • Interest and other income is recognized and accrued when earned. Interest income is derived from promissory notes with franchisees and investments in cash equivalents which have maturity dates less than three months. 56 Cash and Cash equivalents Cash and cash equivalents consist of cash on hand, balances with banks and short-term investments with a remaining term at date of acquisition of three months or less. Inventories Inventories are valued at the lower of cost and net realizable value. Cost is determined on the first-in, first-out basis. Recoverable Expenses The Company provides advertising and order processing services on behalf of certain franchised and Company restaurants. Expenses related to the provision of these services are paid by the Company. The Company recovers advertising expenses based on a percentage of individual restaurant sales and order processing service expenses based on the number of orders directed to the restaurant. Recoveries from franchisees are recorded as a reduction of the related expenses. To the extent that expenses recovered exceed or are less than expenses paid by the Company, the difference is recorded as a receivable or a payable. Amortization On the declining balance method Equipment Furniture and fixtures Automobiles and trucks On the straight-line method Leasehold improvements Computer - software - hardware Company restaurant assets Long-lived Assets Long-lived assets comprise capital assets subject to amortization. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. For purposes of evaluating the recoverability of long-lived assets, the recoverability test is performed using undiscounted future net cash flows of the asset. The amount of the impairment is measured as the difference between the carrying value and the fair value of the asset and recognized by way of an additional current period amortization charge. Derivative Financial Instruments Interest rate swap contracts are designated as hedges of the cash flow relating to interest payments of the outstanding long-term debt or a portion thereof. The interest payments relating to swap contracts are recorded in net earnings over the life of the underlying transaction on an accrual basis as an adjustment to interest expense. The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking various hedge transactions. 5 years 3 years 4 years 5 years 20% 20% 30% 57 The Company also formally assesses both at the hedge’s inception and at the end of each quarter, to ensure the derivatives that are used in the hedged transactions are effective in offsetting changes in cash flows of hedged items. Long-term Investments Investment in Pizza Pizza G.P. Inc., the managing general partner of the Partnership, is accounted for using the equity method, under which the original cost of the investment is adjusted for the Company’s share of post-acquisition earnings or losses and is reduced for distributions received. Deferred Charges Certain excess renovation costs, which are considered to have future benefits, are deferred and amortized over the term of the franchise agreement, generally being 5 years. Future Income Taxes The Company follows the liability method with respect to accounting for income taxes. Future tax assets and liabilities are determined based on differences between the carrying amount and the tax basis of assets and liabilities (temporary differences). Future income tax assets and liabilities are measured using the substantively enacted tax rates that will be in effect when these differences are expected to reverse. Future income tax assets, if any, are recognized only to the extent that, in the opinion of management, it is more likely than not that the assets will be realized. The refundable portion of taxes on investment income is charged to retained earnings. The recovery of refundable taxes previously charged to retained earnings is credited to retained earnings in the period it becomes receivable. Deferred Revenue Deferred revenue relates to an allowance received from a supplier in consideration of the achievement of certain volume commitments. The deferred revenue is being amortized based on the proportion of volume commitments met during each year. Renovation Funds The Company maintains a long-term renovation program whereby franchisees contribute towards future restaurant renovations and upgrades. The franchise owner acknowledges that the renovation fund contribution may be used by the Company, without interest or other compensation to the franchise owner, to fund the renovation, expansion or relocation of other Pizza Pizza outlets until such time as the funds are required by the franchise owner for renovation, expansion or relocation of the franchised outlet. Estimates The preparation of financial statements in conformity with Canadian generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the year. Significant areas requiring the use of management estimates relate to the valuation of accounts receivable and long-term receivables, capital assets, future income tax benefits, deferred charges, deferred revenue and estimated income taxes payable. Actual results could differ from those estimates. 58 4. Capital Assets As at December 31, 2006 Accumulated Cost Amortization Net Equipment $ 9,335 $ Furniture and fixtures 936 Automobiles and trucks 1,173 Leasehold improvements 5,948 Computer - software 5,496 - hardware 3,244 Company restaurant assets 24,415 $ 50,547 $ 6,786 545 767 4,834 5,101 2,047 14,328 34,408 $ 2,549 $ 391 406 1,114 395 1,197 10,087 $ 16,139 $ Cost 9,026 913 1,380 5,831 5,269 2,630 26,998 52,047 As at January 1, 2006 Accumulated Amortization $ 6,047 439 676 4,434 4,636 1,493 13,675 31,400 $ Net 2,979 474 704 1,397 633 1,137 13,323 $ 20,647 $ Amortization for the 52-week period ended December 31, 2006 is shown net of recoveries from franchisees in the amount of $1,097 (January 1, 2006 - $251; October 2, 2005 - $986). Included in amortization of capital assets is amortization on Company restaurant assets for the 52week period ended December 31, 2006 that amounted to $3,311 (January 1, 2006 - $925; October 2, 2005 - $3,541). 5. Notes Receivable As at December 31, 2006 From franchisees, bearing interest between 6.0% and 10.0% From franchisees, non-interest bearing Less: current maturities $ As at January 1, 2006 $ 10,162 350 10,512 10,140 372 $ $ 8,668 181 8,849 8,757 92 The notes receivable from franchisees are due on demand and are repayable in varying monthly principal amounts. 6. Deferred Charges As at December 31, 2006 Accumulated Cost Amortization Net As at January 1, 2006 Accumulated Amortization Cost Net Deferred charges $ 922 $ 239 $ 683 $ 226 $ 133 $ 93 59 7. Sales Tax Payable The Company collects provincial sales tax and federal goods and services tax on behalf of certain franchised restaurants in addition to the collection of tax on its own account. These accounts are included in accounts payable and accrued liabilities as follows: As at December 31, 2006 Sales tax disbursed in the Company's operations $ Sales tax collected on behalf of certain franchised restaurants $ (36) 4,828 4,792 $ $ As at January 1, 2006 (55) 4,676 4,621 8. Long-term Debt As at December 31, 2006 Bank loan is a committed non-revolving, three-year facility granted to the Partnership maturing on July 6, 2008, used to finance a portion of the acquisition costs of the Pizza Pizza Rights and Marks. As security for repayment of the facility, Pizza Pizza Limited (“PPL”) grants to the PPRLP a continuing, general security interest, subject to certain exceptions, in all present and acquired property of PPL, and may not be assigned without the prior consent of PPL. The facility bears interest at Prime plus 0.50% to 0.75% or the Bankers Acceptance rate plus 1.75% to 2.00%, depending on the level of funded debt to EBITDA with EBITDA defined as annualized earnings before interest, taxes, depreciation and amortization. During 2005, an interest rate swap agreement maturing January 6, 2010 fixed the facility interest rate until January 6, 2010 at 3.55% plus the credit spread. The effective interest rate for the 52-week period ended December 31, 2006 was 5.36%. (January 1, 2006 – 5.55%); The Bank has also granted an extendable 364 day, committed, revolving operating facility for up to $1,000; no funds have been drawn. The facility is subject to certain financial covenants. $ Notes payable, bearing interest at 8.9%, repayable in varying monthly principal amounts, maturing between 2007 and 2009. These notes are secured by specific Company restaurant assets. The effective interest rate for the 52-week period ended December 31, 2006 was 8.9% (January 1, 2006 – 8.5%). Less: current maturities $ 20,000 As at January 1, 2006 $ 20,000 198 20,198 52 20,146 $ 237 20,237 52 20,185 60 8. Long-term Debt, cont’d Interest incurred on long-term debt for the 52-week period ended December 31, 2006 amounted to $1,110 (January 1, 2006 - $310; October 2, 2005 - $444). Principal repayments on long-term debt in each of the next three fiscal years are as follows: December 30, 2007 December 28, 2008 January 3, 2010 $ 54 20,056 88 20,198 $ 9. Loan Payable to Pizza Pizza Holdings Trust The loan bears interest at 6.0% per annum, payable monthly, secured by a general security interest and a securities pledge, subject to certain exceptions, in all present and acquired property of Pizza Pizza Limited and may not be assigned without the prior consent of Pizza Pizza Limited. The full principal amount is due July, 2025, with option for extension at renewal. Interest incurred on the loan payable for the 52-week period ended December 31, 2006 amounted to $1,800 (January 1, 2006 - $450; October 2, 2005 - $430). 10. Income Taxes (Recovery) The Company's effective income tax differs from the statutory combined Canadian income tax rate as follows: For the 52-week For the 13-week For the 53-week period ended, period ended, period ended, December 31, 2006 January 1, 2006 October 2, 2005 Federal and provincial statutory tax rates Income taxes at statutory rates $ Share of Partnership’s earnings taxable to non-controlling interest Manufacturing and processing tax credit Under (over) provision in prior years Other Income taxes (recovery) $ 36.1% 4,751 (2,810) 122 (36) (2,724) 2,027 $ $ 36.1% 1,603 (631) (50) 208 (473) 1,130 $ $ 36.1% (8,135) (628) (181) (88) (412) (1,309) (9,444) Significant components of future income tax assets are as follows: As at December 31, 2006 Deferred gain Deferred charges Tax loss carryforward $ 27,190 2,752 610 30,552 $ As at January 1, 2006 27,673 3,832 212 31,717 $ $ 61 Significant components of future income tax liabilities are as follows: As at December 31, 2006 Capital assets Pizza Pizza Rights and Marks Investment in Class B LP units Future income tax asset $ (2,914) (2,849) (22) (5,785) $ 24,767 $ $ As at January 1, 2006 (3,786) (936) (323) (5,045) 26,672 In 2005, the Company paid a refundable dividend tax of $1,452 which has been charged to retained earnings and which will be refundable to the Company at the rate of $1 for every $3 of taxable dividends paid. During 2005, the payment of taxable dividends of $67,865 gave rise to a recovery of refundable taxes of $1,452 resulting in $Nil of refundable taxes available as at December 31, 2006 and January 1, 2006. If, at any time, the Company ceases to qualify as a private corporation, the right to refunds will be lost. The Company has losses in the amount of approximately $1,688 of which $581 can be carried forward to January 1, 2016 and $1,107 to December 31, 2016. The benefit of these losses has been recognized in the accounts. 11. Non-controlling Interest In July, 2005, the Company sold the Pizza Pizza Rights & Marks (“PPL Rights”) to the Partnership. Funding for the purchase came from the Fund completing an initial public offering in July, 2005, issuing 17,952,000 units at $10 per unit. The Fund used the net proceeds, after paying a $1,725 underwriter fee, to indirectly acquire 14,779,500 of Class A LP Units of the Partnership for consideration of $147,795 and also acquired certain debt of the Company for $30,000. The Partnership used the majority of the proceeds from the issuance of the Class A LP Units, together with drawings under a $20,000 term bank loan, to acquire the PPL Rights from the Company for the purchase price of $230,675. The purchase price consisted of a $155,795 cash payment, $30,000 in Class C Partnership Units and $44,880 in Class B exchangeable Partnership Units. Concurrent with the acquisition of the PPL Rights, the Partnership granted the Company an exclusive and unlimited licence to use the PPL Rights for an initial term of 99 years for which the Company pays a royalty equal to 6% of system sales for all Pizza Pizza restaurants in the royalty pool, as defined in the Licence and Royalty Agreement. The Company retained an effective 20% interest through ownership of 4,488,000 Class B LP units of the Partnership and earns revenue on these security holdings. Annually, on January 1 (the “Adjustment Date”), Pizza Pizza restaurants in the Royalty Pool, on which Pizza Pizza pays a Royalty to the Fund, are adjusted to include the forecasted system sales from new Pizza Pizza restaurants opened on or before December 31 of the prior year, less system sales from any Pizza Pizza restaurants that have been permanently closed during the year. The change in the amount of the Royalty to be received by the Partnership as a result of changes in the system sales of the Royalty Pool will affect the extent of Pizza Pizza’s retained interest through the adjustment to the exchange rate at which the Class B Partnership units may ultimately be exchanged for Units of the Fund, referred to as the “Class B Exchange Multiplier” as defined in the 62 Licence and Royalty Agreement. On the Adjustment Date, the adjustment to the Class B Exchange Multiplier involves first calculating the “Determined Amount” which is defined as 92.5% of the royalty revenue added to the Royalty Pool, divided by the yield of the Fund units. The Determined Amount is multiplied by 80%, then divided by the current market price of the units and then further divided by the Class B Partnership units outstanding. This fraction is added to the Class B Exchange Multiplier from the preceding year, which was “one” on the closing of the initial public offering. On the following Adjustment Date, a second adjustment to the Class B Exchange Multiplier will be made in the same manner as the first adjustment once the forecasted system sales for new restaurants are known with certainty. Effective January 1, 2006, as a result of the Adjusted Class B Exchange Multiplier, Pizza Pizza holds Class B Partnership units exchangeable into 4,563,120 Fund units which equates to 20.3% of the fully diluted units of the Fund. Pizza Pizza has agreed to maintain at least a 20% ownership in the Fund until June 30, 2007, with distributions on the 20% interest to be subordinated pursuant to the terms of a subordination agreement. The Fund’s investment, effectively 79.7%, in the Partnership is as follows: As at December 31, 2006 Balance – beginning of period Non-controlling interest in earnings of the Partnership Distributions received from the Partnership Balance – end of period $ 139,140 14,090 (13,309) 139,921 $ As at January 1, 2006 138,725 3,608 (3,193) 139,140 $ $ 12. Commitments i) Future minimum lease payments to related companies and non-related entities for each of the next five fiscal years are approximately: Third Party December 30, 2007 December 28, 2008 January 3, 2010 January 2, 2011 December 31, 2012 $ 17,109 15,445 14,005 11,601 8,170 Related Party $ 2,559 2,303 1,674 647 423 During the 52-week period ended December 31, 2006, lease payments of approximately $15,972 (January 1, 2006 - $3,370; October 2, 2005 - $12,700) were recovered under sub-lease agreements with various franchised restaurants. These recoveries are offset against rent expense. ii) The Company entered into employment contracts with senior management beginning July 6, 2005. An amount of approximately $8,200, representing retention bonuses, may be required to be paid to senior management if certain conditions are met. The amount will be paid equally over three years and expensed if the conditions are met. During the 52-week period ended December 63 31, 2006, certain conditions were met resulting in the payment of approximately $2,800 plus interest to senior management. The remaining contractual amount of approximately $5,400 plus interest has not been accrued as of December 31, 2006. 13. Contingencies The Company is a party to various legal proceedings, mainly related to claims brought against it by former franchisees. It is not possible at this time to determine the outcome of these proceedings and accordingly, no provisions have been made in the accounts. The Company has entered into an agreement with a lender to establish a line of credit of $16,000 for the purpose of providing certain equipment and leasehold improvement loans to its franchisees. As security under this line of credit facility, the Company has provided certain guarantees as described in the agreement including a letter of credit in the amount of $1,600. The Company has the right to increase the limit under this credit facility by providing additional letters of credit. The Company has guaranteed financing loans of certain franchisees. As at December 31, 2006, this indebtedness was approximately $2,980 (January 1, 2006 - $3,700). In the case of default by the franchisee, the Company has various means of recourse relating to the guaranteed amounts. The Company and the indirect controlling shareholder of the Company have received a statement of claim from a former consultant claiming the right to $45 million in damages and other amounts, including entitlements to receive a portion of the proceeds from the initial public offering received by the indirect controlling shareholder. The Company and the indirect controlling shareholder believe the demand is without merit. The indirect controlling shareholder has agreed to indemnify the Company and the Fund against any liabilities that it may incur in respect of this matter. It is not possible at this time to determine the outcome of this matter and accordingly, no provision has been made in the accounts. 14. Common Shares and Special Voting Shares As at December 31, 2006 Authorized without limit as to number Common shares Special voting shares, non-participating, entitling the holder to one vote per share Issued 100 common shares 100,000 special voting shares $ $ 100 100 200 $ $ 100 100 200 As at January 1, 2006 64 15. Food Sales Food sales include the following: For the 52-week period ended, December 31, 2006 Food sales Company restaurant sales $ $ 130,084 12,292 142,376 For the 13-week period ended, January 1, 2006 $ $ 31,794 3,843 35,637 For the 53-week period ended, October 2, 2005 $ $ 120,577 18,485 139,062 16. Royalties, Franchise Fees and Other Related Revenue Royalties, franchise fees and other related revenue include the following: For the 52-week period ended, December 31, 2006 Royalties Construction fees Initial franchise fees $ 19,645 1,762 1,854 23,261 For the 13-week period ended, January 1, 2006 $ 4,778 496 495 5,769 For the 53-week Period ended, October 2, 2005 $ 17,560 2,123 1,380 21,063 $ 17. Related Party Transactions $ $ The following table summarizes the Company's transactions with commonly controlled companies in the normal course of business measured at the exchange amount: For the 52-week period ended, December 31, 2006 Rent expense Management fees incurred Food purchases $ 3,414 11,346 For the 13-week period ended, January 1, 2006 $ 926 2,744 2,795 For the 53-week period ended, October 2, 2005 $ 3,591 11,225 10,291 As at December 31, 2006, the Company had accounts payable of $953 (January 1, 2006 - $1,018) payable to a company under common management control. As at December 31, 2006, the Company had amounts payable of $1,275 (January 1, 2006 - $1,223) to the Fund, which were paid subsequent to the end of the period. Subsequent to January 1, 2006, the management agreement with the commonly controlled company was terminated and no further management fees are anticipated. 65 As at December 31, 2006, the Company had accounts receivable of $2 (January 1, 2006 – $Nil) receivable from a company under common management control. In addition, the Company has the following advances to and from Parent Company: As at December 31, 2006 Advances to (from) Parent Company $ (3) As at January 1, 2006 $ 6,922 The advances to (from) Parent Company are non-interest bearing with no fixed terms of repayment. 18. Statement of Cash Flows Information Additional cash flows information is as follows: For the 52-week period ended, December 31, 2006 Accounts receivable Inventories Prepaid expenses and sundry assets Income taxes recoverable Recoverable franchisee expenses, net Accounts payable and accrued liabilities Deposits from franchisees Income taxes payable $ Interest paid Income taxes paid (recovered) $ $ (64) (253) 643 (386) (2,988) (2,932) (476) (6,456) 2,910 572 For the 13-week period ended, January 1, 2006 $ 554 (523) 377 (340) (248) 1,859 49 (20,797) (19,069) 860 21,949 For the 53-week period ended, October 2, 2005 $ (1,097) (495) (2,335) 459 502 848 (870) 20,797 17,809 612 (57) $ $ $ $ 19. Segmented Information The Company’s operations consist of one operating segment principally being franchise sales and support activities. All of the revenues are from customers in Canada and all capital assets are located in Canada. 66 20. Financial Instruments Fair Value December 31, 2006 Fair Value $ 387 $ January 1, 2006 Fair Value 408 Notional Amount Interest rate swap $ 20,000 Contract Expires January 6, 2010 Fair value of the above-noted item was determined using estimated future discounted cash flows using a comparable current market rate of interest. Accounts receivable and accounts payable and accrued liabilities are all short-term in nature and as such, their carrying values approximate fair values. The carrying amounts for the notes receivable, long-term debt and loan payable to Pizza Pizza Holdings Trust approximate their fair values. The fair values are based on the estimated future discounted cash flows using a comparable market rate of interest. A reasonable estimate of fair value could not be made for recoverable franchisee expenses, advances to/from parent company, and renovation funds as there is no fixed terms of repayment. Credit Risk The Company is exposed to credit risk with respect to collectibility of accounts receivable from franchisees since the franchisees all operate in the same commercial food service segment and, predominately, in one geographic area. Interest Rate Risk The Partnership has entered into an Interest Rate Swap Agreement to mitigate the risk associated with the fact that the bank loan bears interest at floating rates. The notional amount of the Swap is equal to $20,000 of the outstanding principal balance on the bank loan. The Partnership is obligated to pay the Swap Counterparty an amount based upon a fixed interest rate of 3.55% per annum plus a fee of 1.75% and the Swap Counterparty is obligated to pay the Partnership an amount equal to the Canadian Banker’s Acceptance rate. 20. Subsequent Events i) In January 2007, adjustments to royalty payments and Pizza Pizza’s Class B Exchange Multiplier were made based on the actual performance of five restaurants added to the Royalty Pool on January 1, 2006. As a result of the adjustments, the new Class B Exchange Multiplier is 1.02345 and Pizza Pizza’s exchangeable units can be exchanged into 4,593,233 Fund units which is an increase of 30,113 Fund units, effective January 1, 2006, which equates to 20.37% of the fully diluted units of the Fund. ii) On January 1, 2007, 30 net, new restaurants were added to the Royalty Pool as a result of 35 new restaurants opening from September 2, 2005 to December 31, 2006 and five closing from January 1, 2006 to December 31, 2006. The additional system sales from the 30 net, new restaurants are estimated at $15.4 million annually. The total number of restaurants in the Royalty 67 Pool has increased to 531. The yield of the Fund units was determined to be 10.56% calculated using $7.94 as a weighted average unit price. Weighted average unit price is calculated based on the market price of the units traded on the TSX during the period of twenty consecutive days ending on the fifth trading day before January 1, 2007. As a result of the contribution of the additional net sales to the Royalty Pool, Pizza Pizza’s Class B Multiplier increased fractionally by 80% of the total adjustment or 0.18174; the new Class B Multiplier is 1.20519. This adjustment will also increase the entitlement of the holders of the Class B Units to distributions of cash and allocations of income from the Partnership. The second adjustment to the Class B Exchange Multiplier will be adjusted to be effective January 1, 2007, once the actual performance of the new restaurants is determined in early 2008. As a result of the Adjusted Class B Exchange Multiplier, Pizza Pizza will hold Class B Partnership units exchangeable into 5,408,915 Fund units which equates to 23% of the fully diluted units of the Fund as of January 1, 2007. 68 Corporate Responsibility In 2006, Pizza Pizza’s Corporate Social Responsibility program included: DONATIONS: Pizza Pizza provided donations to more than 200 different organizations throughout Canada, from children’s causes to health and education. FUNDRAISING: Pizza Pizza worked closely with more than 1,900 elementary schools and organizations of all sizes, such as the United Way, to help volunteers – the true heroes – raise money for those who need it. COMMUNITY SPONSORSHIP: Maintaining a tradition, Pizza Pizza sponsored hundreds of communityrelated initiatives and nurtured participation in and enjoyment of sports, arts and cultural activities. ENVIRONMENT: Pizza Pizza worked with suppliers, franchise partners and community groups to develop practices that eliminate waste, encourage recycling and help protect the environment. SELECTING SUPPLIERS: Pizza Pizza continued its policy of accepting only those suppliers that meet high standards of ethical and social conduct and share the Company’s commitment to the freshest ingredients. When possible, Pizza Pizza purchased ingredients from local farmers and suppliers. DIVERSITY AND EMPLOYEE WELL-BEING: Attracting and retaining the best staff and franchise partners to keep pace with a growing base of customers and sales volume continued to be a Pizza Pizza priority. Pizza Pizza is a mosaic of cultures that form a cohesive and rich tapestry. 69 UNITHOLDER INFORMATION – PIZZA PIZZA ROYALTY INCOME FUND Trustees of the Fund Arnold Cader (1)(2) Richard McCoy (2) Terence Reid (1) Ronald Rogers (1) Elizabeth Wright (2) (1) Denotes Audit Committee member. (2) Denotes Governance Committee member. Board of Directors and Officers of the Pizza Pizza GP Inc., the General Partner of the Pizza Pizza Royalty Limited Partnership Arnold Cader Curt Feltner (1) Richard McCoy Michael Overs (1) Terence Reid Ronald Rogers Daniel Vukovich (1) Elizabeth Wright (1) Denotes members of Pizza Pizza Limited management team. Corporate Head Office Pizza Pizza Royalty Income Fund 580 Jarvis Street Toronto, Ontario M4Y 2H9 Registrar and Transfer Agent CIBC Mellon Trust Company P.O. Box 7010 Adelaide Street Postal Station Toronto, ON M5C 2W9 Mellon Investor Services LLC 480 Washington Blvd., 29th Floor Jersey City, NJ 07310 Stock Exchange Listing Toronto Stock Exchange: PZA.UN Investor Enquiries Curt Feltner Chief Financial Officer Telephone: (416) 967-1010 Facsimile: (416) 967-5941 Email: cfeltner@pizzapizza.ca Website: www.pizzapizzaroyaltyincomefund.com 70