PAPA JOHN’S (PZZA) REPORTS Q2 – STOCK DOWN AGAIN, HOW BAD IS IT?
Papa John’s reported Q2, dismal, as expected. You don’t need us to rehash all the operating details. Everyone knew the results would be poor, that the Company and their founder, namesake, and largest shareholder are having a protracted battle. The questions revolve around how much damage has been done in terms of sales, profits, reputation and future potential. There is widespread speculation that PZZA is a takeover candidate (including by ourselves), and debate continues as to whether the current problems can be overcome or whether the competition (including Domino’s) is just too tough and whether the brand is beyond repair. We refer our readers back to our previous report on PZZA, datedJuly 23rd, which outlined why all the major stakeholders: current management, franchisees, board of directors, stockholders, debt holders, and even John Schnatter, would be best served by a going private transaction, and the current financial parameters could still support that process.
The earnings release and the Conference Call updated observers on the results to date, sales trends through July, guidance for all of ’18 was adjusted downward, operating initiatives were described to rectify the sales trend, and management strongly defended their decision to move aggressively ahead without John Schnatter as corporate spokesperson. Suffice to say that there is a great deal of work to be done to deal with a 4,600 unit franchisee system, including redirection of a marketing effort in an industry segment that is always highly promotional. On the other hand, PZZA has competed, and grown successfully, for many years, and it was less than twelve months ago that the brand was widely admired. We encourage our sufficiently interested readers to fill in further details from the full earnings release and Conference Call transcript. We are trying to provide here a timely interpretation of the most important issues, and present a reasoned conclusion as to how the situation plays out.
Among the most important issues: Sales Trends, Unit Growth Prospects, Debt Covenants
The Same Store Sales Trend
First quarter systemwide North American comp sales were down 5.3%, International comp sales were up 0.3%. In the second quarter, North American same store sales were down 6.1%, International comp sales were down 0.8% so there was a sequential deterioration of about one point. North American comp sales in July (from 7/2 until 7/29) were down approximately 10.5%. When questioned on the Conference Call about the Q2 sequence into July, Management said: “the cadence of comps through Q2 were consistent with the 6.1% Q2 decline….after the July 11 article…we saw a precipitous drop of roughly 4% from the trend…we do think we have stabilized a number there…it’s very early into Period 8…but we do think we have experienced the significance of the decline…have provided our outlook based on the infancy of what we have seen and that’s why we have re-guided to a negative 7-10% for the year.” Our interpretation is that the -7 to -10% implies an assumption that the July negative 10.5% range continues or even worsens to the mid teens in H2. Management, of course, hopes that comps firm up and the year’s result is closer to the 7 than 10. International comps are now expected to be between from -2 to +1% for 2018, several points worse than previously indicated.
Among the changes of guidance from management, net global unit growth has been adjusted from a positive range of 3-5% to a range of flat to 3%. Virtually all the unit growth continues to be international, and those sales have been far less affected than domestic locations. There was quite a bit of discussion on the Conference Call about unit closings and royalty relief. Management indicated that they are working with franchisees, as always, to alleviate financial problems at specific situations. With the current sales trends, margins are naturalized squeezed for all operators, unit growth can be expected to be slower and closings can even increase. While it is natural to be concerned about the rate openings and closings, there has been very little indication (so far) of wholesale franchisee disillusionment. Internationally there has been steady unit growth with hardly any closings. In the more mature North American market, there were 79 locations closed in H1’18 (42 in Q2), but 44 new locations opened in H1, for a net reduction of 35 on a base of over 2700 units.
Our conclusion here is that it is pretty early to be overly concerned about a collapse of a franchise system that was doing rather well for many years until about nine months ago. This situation could obviously change if the current negative sales trend is not, at the very least, stabilized.
The Leverage Ratio is defined as outstanding debt divided by consolidated EBITDA for the most recent four quarters. The Interest Coverage Ratio is defined as the sum of consolidated EBITDA and consolidated rent expense, divided by the sum of consolidated interest expense and rent expense for the most recent four quarters.
Per the 10Q filing for the second quarter, the actual leverage ratio and interest coverage ration in Q2 were 3.4 to 1.0 in each case. The Permitted Leverage Ratio was not to exceed 4.5 to 1.0 at the end of Q1, subsequently decreasing to 4.25, decreasing over time to 3.75. The Permitted Interest Coverage Ratio is not less than 2.75 to 1.0, with no indication that it is structured to change. As the 10Q says:
“We were in compliance with all financial covenants as of July 1, 2018. Based on our revised lower financial forecast, we plan to work with the banks within our Credit Facility to evaluate options with the covenants to mitigate the possibility of violating a financial covenant in the future. If a covenant violation occurs or is expected to occur, we would be required to seek a waiver or amendment from the lenders under the credit agreement. The failure to obtain a waiver or amendment on a timely basis would result in our inability to borrow additionalunds or obtain letters of credit under our credit agreement and allow the lenders under our credit agreement to declare our loan obligations due and payable, require us to cash collateralize outstanding letters of credit or increase our interest rate. If any of the foregoing events occur, we would need to refinance our debt, or renegotiate or restructure, the terms of the credit agreement. ”
On the conference call, management indicated that the leverage ratio is expected to be in excess of 4.0 (stilll OK) at t he end of ’18, no doubt based on the assumptions most recently provided, including N.A. comps negative in the 7-10% range.
While we can’t know the exact definition within all the above ratios, both ratios will no doubt narrow if the second quarter (and July) trends persist, or get worse, and it makes sense that the Company negotiate potential adjustments to the current credit agreement. The bottom line here is that there is still substantial operating cash flow, EBITDA, and free cash flow, by any definition. Absent a very substantial additional decline in sales, the credit situation should be controllable. This, in our mind, seems a compelling reason for all parties involved to negotiate an amicable parting of the ways between the Company and John Schnatter. Even Schnatter’s recent statement that he has the interest of all stakeholders leaves opoen his departure as an acceptable solution once the current emotional atmosphere cools.
We feel that sales will more likely stabilize than deteriorate, followed by at least modest improvement, over the course of Q3 and especially during Q4 when new marketing efforts should take hold and the YTY comparisons get easier as well. We expect that the most important stakeholders in this equation, specifically John Schnatter, current management and the Board of Directors will come to a rational conclusion that toned down rhetoric is in everyone’s interest. Meanwhile, there is a great deal of P/E capital looking for a home, and the valuation of the Company supports PZZA as a buyout candidate. We continue to believe that, over the next six months to a year, there are more ways to win than lose from these levels. If the Company remains publicly held, the stock could rebound sharply with just a stabilization of sales, let alone resumption of positive comps. Chipotle stock is up over 200 points since they hired a new CEO, and sales have yet to improve meaningfully. There’s lots of press coverage right now regarding PZZA, but this too shall pass, and nobody died or went to the hospital with this situation.