Papa John’s International, Inc. – (PZZA) – THE LATEST “SITUATION” WITHIN THE RESTAURANT INDUSTRY – A BUY OR A SELL?
As background for the following piece, readers may want to peruse our basic descriptive piece, dated 3/27/18, available here:
It’s hard to miss the news that John Schnatter, founder, largest shareholder with 29% of the equity, and company spokesperson, has resigned from the Company. The circumstances have been widely documented in all kinds of press reports, and we believe have been amplified by the fact that everything in America is “politically charged”.
Opinions vary widely as to what the future holds for the Company and the stock. There are lots of obvious reasons why customers could shy away from the pizza, further weakening the sales trend that already turned down in Q1’18 and further penalizing the stock that is trading at 22x calendar ’18 estimates of earnings. Though the dividend yield is 1.75% at the current stock price, some could question whether a new CEO will maintain the dividend when earnings are down sharply, especially when long term debt is over $500M against negative equity as a result of stock buybacks. Uncertainty is always a substantial negative when evaluating the desirability of owning a particular stock.
The argument has been made perhaps no other consumer products company has been so dependent on the image of its founder, “Papa John” Schnatter who has consistently appeared on TV, with Peyton Manning and others, touting the “Better Ingredients, Better Pizza”. Observers have recalled that Steve Ells, Howard Schultz, Dave Thomas, and Jimmy John have been the face of their Brands, but not to the extent of Papa John.
However, we suggest that the “face” of PZZA has more been “Better Ingredients, Better Pizza” than the personality of John Schnatter. How long it takes PZZA to rebound from this PR nightmare is anybody’s guess, but nobody died (as with Jack in the Box), went to the hospital (as with Chipotle) or lived through the operational problems at Starbucks when Howard Schultz had stepped aside. Jimmy John’s sandwich shop have continued to prosper even after Jimmy’s hunting habit was criticized by the anti-gun lobby.
At Papa John’s, to the contrary, even after same store sales turned down by 5.3% in Q1’18, not only did nobody die, and we never heard that the product had deteriorated, the stores were dirty, delivery service was poor, or there was negligence from an operating standpoint. The delivery pizza business has always been competitive, especially in light of Domino’s technological lead, so the PR problem relating to the NFL, and the delay of rolling out a new campaign could well have cost a few points of same store sales performance. As for the latest press coverage relating to Schnatter’s inappropriate remarks, the reaction of his Board, and his own attitude toward the episode, we believe it will fade as the 24 hour news cycle moves on. Ninety days from now, the concern at Papa John’s will be about new products, new marketing, how the search for a new CEO is coming along, and technological innovation that can help catch up with Domino’s. One can argue that the departure of John Schnatter will work out for the best in the long run because the brand will no longer be so dependent on a single personality’s reputation.
Meanwhile, the stock, while not what we would consider dirt cheap, is selling at a much lower valuation than its peers. There are over five thousand stores in 45 international countries and territories. The long term debt at $568M is only a little over 3X trailing twelve months EBITDA. Other well established franchise companies are carrying debt at 5-6X EBITDA, so PZZA could be leveraged further to buy back common stock or taken private at a premium to the current price. The current enterprise value at 12.5X trailing twelve month EBITDA and 22X calendar ’18 estimated earnings (even if those estimates come down) is materially cheaper than peer asset light franchising companies such as DNKN (17.9X and 26.0X), QSR (20.5X and 23.9X), DPZ (25.6 and 33.7), and WING (42.5X and 61.2X). DIN and JACK are selling at comparable multiples as PZZA but have had operating issues. YUM’s valuation is also comparable but is much more comples, with three brands, very dependent on China for future growth, and has an enterprise value fifteen times as large with 45,000 (9X that of PZZA) systemwide restaurants.
In summary, we think there are a number of ways to win here, and there is enough substance to avoid much downside risk over the intermediate to long term. There are hundreds of billions of dollars of private equity capital looking for a home, and everybody loves “asset light”, “free cash flow” stable situations. Anything can happen in today’s environment that sometimes allows for outsized stock moves in unexpected, and sometimes irrational direction. Aside from possible short term volatility, we think there is more upside potential than downside risk with PZZA (“Better Ingredients, Better Pizza”) at this time.