PAPA MURPHY’S HOLDINGS

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Overview   (2016 10-K) (ICR Slides Jan’17) Vancouver, WA-based Papa Murphy’s is the operator and franchisor of 1,550 locations at the end of its 17Q2 selling customized, uncooked fresh pizza that customers bake at home. Founded in 1988, Papa Murphy’s was acquired by PE firm Lee Equity Partners in 2010 and went public in 2014. The company aims to differentiate itself with high quality pizza rivaling the better full-service pizza restaurants combined with a convenience and comfort of home enjoyment rivaling delivery pizza (such as PZZA, DPZ).  Perhaps more than its rivals offering prepared pizza, FRSH competes with take and bake pizza in grocery stores.  Papa Murphy’s system units—1,358 domestic franchised or 87.6% of the total, 149 company (9.6%), 43 international franchised (2.8%)—are located in 39 states, Canada and the United Emirates and generated $876.6M in sales in the TTM through 17Q2.

Strategy Papa Murphy’s offers award-winning pizza products, which, suffering no loss of quality in transit from the store, and can be served at peak when taken from the oven at home.   The pizza products also compare favorably with competitors with respect to convenience and value.  Additionally, its store model requires a low initial investment, and the stores are simple and relatively inexpensive to operate.

Outside its roots in the Northwest. as indicated in the charts below, FRSH’s comps have lagged its pizza peers.  Poor comps have hurt AUV’s and profitability has stagnated.  Similarly, domestic franchise store growth has stalled, with a decline in store count to a net 17 stores in the 12 months through 17Q2.  On the plus side, this stat reflects 53 openings plus 9 refranchised stores, but more worrisome is that it also reflects 79 closures.  Meanwhile, in 17Q2 management announced the closure of 16 company stores, 13 of which have been completed at the time of the 17Q2 earnings release.

These results may be partly explained by the continuing promotional environment in the pizza sector, but may be also inconsistent execution, which has resulted in a less than successful expansion strategy.

FRSH, founded in 1981, became public in May 2014, with an intention of steady expansion into a national brand. The company’s research indicated that a market density of 1 store per 80K population was an inflection point above which AUV’s take off.  It aimed to jump start attaining critical mass in a number of far-flung under-penetrated markets (such as Texas) by building company stores with IPO capital.  It expected that success to encourage investment by franchisees.

The strategy produced mixed results from the beginning.  The company store base grew from 69 at the time of the IPO to 168 by 16Q4.  Company store comps averaged over 7% in the 5 quarters 14Q2-15Q2, while TTM company store-level EBITDA margins averaged above 12%.  However, franchise stores were not as productive and franchisees did not step up their development pace.  Though franchisee comps were also positive, they lagged company stores by 240 bps on average.  In the same period, the domestic franchise store count actually fell by 27 stores (-1.9%).

After 15Q2 system comps turned down at both company and franchise stores, quickly going negative (averaging -6% systemwide 15Q3-17Q2), and the company stores underperformed franchisees by 220bps. The company attempted to maintain the main elements of its strategy while addressing its immediate issues with new initiatives, none more urgent than catching up with its peers, especially DPZ and PZZA, in utilizing technology.  The widening comp separation between FRSH and its pizza rivals in the chart above tracks the payoff for years of their investment in technology (especially DPZ).

Technological catch-up required first installing a state-of-the-art POS platform throughout the system, enabling sophisticated store management and system functions, which would also serve as the foundation for online & mobile ordering and payment, digital marketing, loyalty programs and delivery.  They are currently testing e-commerce marketing functions and delivery and on-line ordering reached 8% of sales in its first quarter (16Q1) with a goal of 50% in several years.  For the moment, however, the company has since been less aggressive in this regard after concluding customer acquisition costs were too high. Most recently (17Q2), the company decided to replace the on-line ordering system it was rolling out with a platform developed and hosted by a third-party.  Though the $9.1M write-off for this false start is costly, perhaps even more costly has been the distraction from other operational priorities.  For example, until this year, the company had not introduced a new product following the successful introductions in 2013 and 2014 when comps were 2.8% and 4.5%, respectively (see more in Menu section).

Other initiatives have also been disappointing.  The company had great expectations for a 6-week national cable TV advertising campaign in 17Q1.  Its research pointed to this media as the most cost effective way to build brand awareness with the estimated 79% of viewers in FRSH markets with little or no exposure to the brand.  However, the company concedes that the initiative fell short of expectations though it is still analyzing the results.  Similarly, the company has reversed course on building out of selected new markets with company stores, and plans instead to reduce company stores by about 100 stores with a goal of returning to a 95% franchise mix in the next 2-3 years.  It expects to accomplish this objective by refranchising, although, as mentioned above, it may also require closing stores. Delivery is being tested (36 stores in 17Q2, with a goal of 30% by year end).  We believe that lack of delivery is a key competitive disadvantage with rivals whose pizzas lose freshness in transit. Moreover, FRSH’s less perishable product might well be more cost effectively transported and delivered than hot pizza. Further, stores designed more for delivery could boost unit level returns through lower rents and more scalable operations.

In the midst of these disappointments, Ken Calwell, the company’s long-time CEO left in January 2017 and the board appointed Weldon Spangler as his replacement in June 2017.  Mr Spangler has 30 years of restaurant industry experience, serving most recently with Dunkin’ Donuts Brands, as Senior VP of Baskin-Robbins US, Canada and Puerto Rico.

Menu & Dayparts  Papa Murphy’s pizza making process aims to live up to the “Fresh” connoted by its stock ticker.   Dough is mixed daily in the store; cheese is grated daily from blocks of 100% whole-milk mozzarella; fresh, never-frozen vegetables are sliced by hand and high-quality meats have no fillers.  It offers a range of traditional pizza styles and crusts, as well as a wide range of toppings to customize the pizzas. To provide value options, the company offers $5 Faves (a smaller pizza with a single topping) and to address health and diet concerns it offers Gourmet Delite pizzas (lower calorie, chicken or vegetable toppings) and gluten-free crusts.  (The company credits the strong comps in 2013 and 2014 to the introduction of these latter products). Salads, sides, desserts and beverages are also offered.

The company’s target customers are mothers and families who want a quality home-cooked dinner without spending a lot of money or time (15 minutes at 425°).  As such, the company’s limited customer base and single daypart concedes a relatively large customer base to the competition.  The company has renewed its commitment to new product introductions with a XLNY pizza in 17Q1 which is being well received.  An extra-large traditional NY style pizza (garlic red sauce, pepperoni, sausage, parmesan cheese on a foldable thin crust), the XLNY has been well received.  However, it is currently aggressively priced at $8 and the company is still testing for a more normalized price.

Unit Level Economics Oddly FRSH’s company store profitability is harder to discern than that of the franchisees.  We estimate company store AUV’s are about $526K for the TTM to 17Q2, though this estimate is muddied by the flux in the store count from openings, closings and refranchisings.  Similarly, company store profitability is affected by the many moving parts, but the company provided some illumination in the last several quarters by reporting on a core 76 (75 in 17Q2) company stores in 10 markets not affected by the store count flux.  These core stores, whose comps management says were generally consistent with the entire company store fleet, averaged about 13% EBITDA margins in the TTM though 17Q2.

The table below is drawn from the company’s Franchise Disclosure Document (FDD) and reflects the unit economics for 850 franchise units open a full 12 months ended September 30, 2016. While the sales figures are the basis for royalty payments, the company notes the profitability figures are based on unaudited survey data supplied by the franchisees.  That said, clearly the two thirds of the sample generating mid to high AUV tranches demonstrate the potential for satisfactory returns.

Balance Sheet and Cash Flows FRSH’s ratios of debt to EBITDA and lease adjusted debt to EBITDAR of 6.7X and 7.1X, respectively, the company is more leveraged than its 85%-95% franchised peers (WEN, YUM. SONC, DENN, MCD and PZZA) averaging 4.2X and 4.9X.  The company’s free cash flow in the TTM through 17Q2 was $4.3M (CFO $15.1M, CapEx  $10.7M) for a FCF margin of 3.5%. The company pays no dividend and has not been repurchasing stock.

Shareholder Returns Since its May 1, 2014 IPO at $11, FRSH has returned a loss of 53.6% (CAGR -20.6%), reaching a high of $17.55 in September 2015 and a low of $3.78 in November 2016.  Lee Equity Partners, which acquired a majority stake in 2010, when the company was still private, still owns 26.0% of outstanding shares. Also, Michael Price and his MFP Partners LP own a combined 27.2% of outstanding shares. There has been consistent insider buying over the last two months, at prices under $5.00 per share.

Current  Developments (17Q2 Release) (17Q2 Transcript) (17Q2 10Q)

As indicated in the table above, comp sales were down again, 4.3% systemwide domestically. Company operated stores continued to lag franchised sales results, down 6.6% vs. down 4.1% for franchisees. The $0.07 eps shown was “Pro Forma Net Income” adjusted for $7.3 million of after tax writeoffs which included $2.8M recovery of the advertising fund deficit. There is apparently $4-5M more to be recovered from this deficit in H2’17. GAAP Net Income was negative at $6.2M or $0.37/share. Adjusted EBITDA was $7.9M vs. $5.7M a year earlier. Franchisees opened 13 new stores in Q2, eleven of which were in the US and the company re-franchised 7 company owned stores in the quarter.

In terms of operating details, company store operating expenses increased by 530 basis points, totaling 99.4%. Components included a 470 bp increase in occupancy expenses, 300bp increase in comp and benefits, 160 bp increase in marketing expenses, partially offset by lower cost of goods and certain operating expenses. The huge increase in occupancy expenses was driven by the portfolio shift, the comp store decline and a one-time $700k charge related to lease terminations. Management pointed out that 73 stores in 10 markets unaffected by the portfolio changes showed comps slightly better than the system average and operating costs of 88%, much better than the systemwide average. (Not great, but better.)

The Company lowered most guidance parameters for the balance of ’17: domestic systemwide comps from negative 2%-flat to negative M-LSD, domestic franchised openings from 60-75 to 40, Adjusted EBITDA from $24M to $20M. The number of company stores to be refranchised was increased from at least 15 to 35.

A great deal of attention was predictably paid on the Q2 conference call to the thoughts of Weldon Spangler, new CEO. He is highly qualified and of course expressed his confidence in moving the brand forward. He summarized his broad goals as “continue to drive franchise owner engagement and profitability, improve our end customer’s experience through continued innovation, convenience and relevance”.

Accelerated testing of digital marketing efforts has apparently been promising in initial markets, so  that is being expanded. New products have also shown promise in test markets, including an extra large NY style pizza. Profitability at the store level apparently shows promise through productivity and procurement initiatives. Delivery is obviously an area with huge potential, was available in 36 stores across four markets during Q2, and the Company expressed satisfaction with incremental sales results that include a higher average ticket. Third party delivery, now using Amazon, Grubhub and other third party providers, is expected to be available in about 30% of the system by yearend. The Company’s e-commerce channel is being taken over by Olo, the prominent provider of online and mobile ordering capabilities. Hopefully, Olo will provide a problem free integration with the various third party delivery services, which will take place in Q4’17 and Q1’18. The Company estimates that the move to Olo’s platform will benefit forward EBITDA by about $900k, but that, of course, remains to be seen.

A substantial increase in store transfers, 69 through Q2’17, most due to existing franchise owners increasing their respective footprints. This system “rationalization” could prove to be productive over the longer term as seasoned franchise partners achieve critical mass over which to spread administrative services.

Our concise conclusion regarding the outlook for Papa Murphy’s is that it remains “pregnant with possibilities”. There is nothing wrong with this system that a 20% increase in sales wouldn’t solve. Many of the sales building initiatives that have been implemented at other restaurant chains such as: new product development, social marketing, mobile order and pay, and delivery each have substantial potential to add to the base that FRSH has established. It will be interesting to see whether new CEO, Spangler, and his team, can invigorate this, recently disappointing, still promising franchised QSR system.

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