PAPA JOHN’S (PZZA) – SHOULD YOU BE LONG OR SHORT THIS ONE?
We don’t normally disclose our “bottom line” in terms of our position (long or short) in companies that we write about, and the caveat on our website allows us that flexibility. However, this situation is sufficiently liquid in terms of trading volume, and adequately controversial in terms of the investment community’s dialogue that we are happy to go on record here that we are long the stock. We bought it at $51 last Wednesday, and have averaged down at $47 and change this morning. This is what can legitimately be called a “special situation” or a “non-correlated” investment. Our rationale follows:
We said last Wednesday, before Forbes came out with their scathing description of John Schnatter’s “management style”, that this Company is in play, and is cheap enough to attract a private equity fund or a strategic buyer. You can read the rest of our argument here:
While John Schnatter apparently hired attorneys to help him regain his “reputation” if not his formal corporate standing, reports came out over the weekend that systemwide sales may be running down double digits in the wake of the recent disclosures. Meanwhile, the Board of Directors installed a “poison pill” structure that prevents an unfriendly takeover without Board approval.
We have no particular reason to defend John Schnatter. We’ve met him a couple of times, have never had a conversation with him. However, we suspect that the criticism of his “management style” could be a bit overdone. Consider that: starting with nothing he built a major retail company with 4,500 franchised locations around the world, made a lot of money for shareholders and almost a billion dollars for himself. If you or I had anything like the scale of success he has enjoyed, the celebrity status, access to world class athletes like Peyton Manning, Jeff Gordon and all the rest, it’s hard to say that we would be less confident, arrogant, or strong willed.
At this point, what are the various “players” in this case study likely to do?
The private equity firms (Roark, Catterton, and all the rest) and potential strategic buyers (such as Restaurant Brands, (QSR) must be working around the clock to evaluate the potential here. Buffalo Wild Wings (also troubled) went private at a higher price than PZZA trades at, and QSR (for example) paid 18x trailing EBITDA for Popeye’s a little over a year ago. QSR, while already leveraged, could no doubt borrow a couple of billion dollars more to buy PZZA and there are very few franchised brands, available at an acceptable price, that are large enough to “move the needle” for QSR. So, there are buyers out there.
The Board of Directors is in the middle of a mess. They are subject to criticism for past actions, and inactions, individually and collectively, and don’t need a lot more aggravation. This was not part of their original “job description”. We have no knowledge of the degree of “cronyism” that exists on this Board, but with John Schnatter owning 30% of PZZA, it is safe to say that this Board has not been especially adversarial. No doubt, however, that at least some of them could be painted, by attorneys, as not being independent enough. The easiest exit, individually and colllectively, to approve a sale at a reasonable price, just as long as Schnatter is not involved in the bid.
The franchise community must UP IN ARMS. Can you imagine what the phone and email lines look like coming into Louisville from 4500 stores around the world? Whether sales are down double digits or not, and we suspect that they are in fact currently running down over 10%, the franchisees must be apoplectic over the situation. We suspect that more than a few of them have blocked bank accounts so that royalty fees cannot be automatically accessed. That is one obvious way to ramp up the pressure to “do something”.
John Schnatter, himself, has no choice. Unfair as the current public reports might or might not be, Schnatter has a $500M asset that is becoming worth less every day. He can earn back his good name over time, but it won’t help if his $500M has become worth a lot less. While his first instinct, upon reflection of the way his Board treated him, was to fight back, a little bit of time will allow reality to set in and decide that it is everyone’s interest for him to move on.
Can you imagine, also, how many calls are coming in from the investment banking community, offering to help? A firm will likely be hired, to manage the “process”, possibly for no other reason than protecting the Board from criticism. This situation is already so widely publicized, every potential buyer on the planet is already in touch with Goldman Sachs and the rest, and investment banking fees will run into the tens of millions of dollars. CYA consulting is a profitable business, and “asset light” :), just like franchising.
The outcome: We expect a deal to be done sooner rather than later. The buyers are out there, the price is reasonable enough, we suspect ending up between $60 and $70 per share if PZZA is taken private. Schnatter has little practical choice, so his stock will be sold, with the approval of the Board, and he will step completely aside. The Company could potentially remain publicly held, even if Schnatter sells his stock. A new CEO would be hired and the recovery could begin. Chipotle (CMG) hired a new CEO and the stock has gone from $260 to $460 before anything tangible and significant is really done.
Let’s see what happens here……..
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PZZA: Company Overview (2017 10-K)
Louisville, Ky based Papa John’s Pizza is the operator and franchisor of the world’s fourth largest pizza chain by sale, following Domino’s, Pizza Hut and Little Caesar’s. As of 12/21/17 the system consisted of 5,199 units world-wide (743 company owned, 4,456 franchised of which 2,733 were in North America and 1,758 were International, including 35 units company owned in China), in all 50 states, and 44 countries and territories. Most of the restaurants are operated on a take-out and delivery basis, with a small number of international units offering eat-in service.
Source of Revenues
The company’s operations are organized into five segments: domestic company-owned units, North America commissaries, North America franchising, International operations and “all other” business units (on-line & mobile ordering, print & promotion and related services offered to franchisees). North America is defined as the US and Canada, while Domestic is defined as the contiguous US, International as franchise operations outside of the US and Canada. The table below breaks down the segment revenues for the year ending 12/31/17. The domestic segment reflects 708 US company stores at the end of ‘17; the NA franchise segment the royalties and fees of 2,733 units; the NA commissaries segment includes the “all other” segment for convenience; and the International segment reflects the royalties and fees of 1,758 franchise stores as well as the operations of international commissaries and international company stores located in Beijing & N. China.
|2017 ($M)||% of ’17 Rev.||2016 ($M)||% of ’16 Rev.|
|US Company Units||816.7||45.8%||815.9||47.6%|
The company’s stated strategy is to grow comps in the mature North America segments and grow units internationally. NA franchise and company store growth for the past 5-6 years at 1-2% CAGR is barely moving. The company sees opportunity to continue expanding its NA footprint at this pace, which combined with low single digit comps, can drive top line growth at a satisfactory rate. To this end it is relying on its proven tools of marketing and upgrading menu ingredients, while testing and introducing technology. It does plan to increase marketing spend, recently increasing the funding rate from 4.25% of sales to 4.5%, scheduled to increase to 4.75% in Q4’18 and 5.0% in Q4’19. Management also has apparently given a lot of thought to refranchising, but for now is sticking to its current somewhat agnostic stance—opportunistically buying or selling markets where it makes sense, remaining about 85% franchised.
While the company has trailed sector leader Domino’s Pizza in comps and margins, comps have been consistently positive in the low single digit range and NA company stores have generated store-level EBITDA margins of around 20%. Oddly, its lowest TTM margins occurred in FY13-14 (18.4%) when comps were the highest (price war?):
Meanwhile, the greatest growth opportunity lies in the international sector, which has grown at a double digit rate over the last 5-6 years, though less recently, net of closings. The international markets pose unique challenges with respect to real estate, labor law and practices etc., but especially local tastes. The company recently decided to exit India (conceding misreading local tastes there, though it is eager to re-enter at some point in the future armed with its learnings. It is also seeking to sell and/or refranchise its 35 company stores in China, which have generated losses of $2.9M, $2.3M and $1.2M in ’17, ’16 and ’15 respectively. Since 257 out of the 376 systemwide new units were generated internationally, this continues to be the most rapidly growing portion. It should be noted, however, that the international division had 155 closings in ’17, netting out to 102 net new units.
Finally, PZZA operates a network of QC (quality control) commissaries that purchase and distribute all ingredients and toppings to company and franchised restaurants. The company requires franchisees to purchase pizza dough and pizza sauce from QC centers and all supplies from the QC centers or other approved suppliers. The policy ensures consistent food quality and, by virtue of aggregate purchasing leverage, supplies the system with sharp pricing, even after a markup (we estimate about 2%). The company’s supply chain also smooths the price of volatile cheese costs to enable operators to plan the price of their offerings and promotions. The QC centers are also located in international markets, with the company owning and operating a number of them (UK, Mexico, China), while in other markets they are owned by franchisees or licensed to third parties.
PZZA prides itself on its fresh, high quality pizza along with side items, including breadsticks, cheese sticks, chicken poppers and wings, dessert items and canned or bottled beverages. Papa John’s traditional crust pizza is prepared using fresh (never frozen) dough. It introduced a fresh dough pan crust in 2016, which was the first new crust offered in 10 years. The pizzas are made from a its blend of wheat flour, real cheese made from mozzarella, fresh-packed pizza sauce made from vine-ripened tomatoes (not from concentrate) and a proprietary mix of savory spices, and a choice of high-quality meat and vegetable toppings. It also offers a par-baked thin crust. The company has an ongoing “clean label” initiative to remove unwanted ingredients from product offerings, such as synthetic colors, artificial flavors and preservatives. The initiative includes chickens raised without antibiotics, cage-free eggs, no MSG or fillers in meat toppings. In 2016, for example, it announced the removal of 14 additional unwanted ingredients across its entire food menu during the year. The company also regularly offers test pizzas and other product offerings both domestically and internationally, which can sometimes become part of the permanent menu.
Unit Level Economics
Traditional Papa John’s domestic restaurants range in size from 1,100 to 1,500 square feet and preferred locations are in strip shopping centers or freestanding buildings that provide visibility and accessibility to facilitate take-out and delivery service. They rarely provide a dine-in area which cuts down on initial investment cost. There are also a small number of non-traditional units located in convenience stores, hospitals college campuses which provide walk-up or carry-out service but not delivery service.
During 2017 the 676 traditional domestic company-owned units averaged annual sales of $1.19M ($1.17M on a 52 week basis). The average cash investment for the seven domestic traditional locations was $354k, vs. $339k for the twelve units of 2016. North American franchise restaurants generated average annual sales of $908k ($891k over 52 weeks), lower presumably because company operated locations are in more heavily penetrated markets. Investment costs have been risking as a result of new units being modestly larger to accommodate higher sales, an increase in the cost of certain equipment with technology enhancements, and higher cost of complying with local regulations. Operating expenses, before depreciation, for domestic company operated stores was 81.4% of sales in 2017 (up from 79.9% in 2016), leaving 18.6% of EBITDA or $217k which calculates to a 61% cash on cash return. (down modestly from 67% in 2016, due to the higher investment cost and lower margin). Franchise investment costs have been about 30% less, or about $247k, so a similar EBITDA margin of 13.6%(after the 5% royalty) on $891k of sales would provide $121k of EBITDA or an also handsome 49% return. Management does not explain why the average cash investment for a franchise unit is about 30% lower (per the FDD document) than company stores, part of the difference may be due to lower real estate expense in less dense markets, but also because the cash outlay provided is based on average historical costs of franchised stores (while the company’s outlay is the 2017 cost of a new unit). The company has noted the cost for new company units has been increasing partly because of building larger units (to accommodate increased sales) and because of the increased costs for enhanced technology. Specifically, per the 10-K’s the cash outlays for new company units were materially lower, at $283K in 2015 and 2014, respectively. In any event, the returns are attractive for both company and franchise stores, so its no wonder that the US is largely “sold out” and the primary expansion is international.
On the other hand, the company offers various development incentive programs to franchisees. These include lower royalties, new restaurant incentives, performance-based incentives, reduction in marketing expense and other offsets to their costs. For example, the 2017 domestic incentive program offers to waive the initial franchise fee, a royalty reduction for several years, 2 Middleby ovens and credit to the first food order. The incentives have a value of over $60K plus royalty relief, which reduces the outlay for a new unit from $340K to about $280K. The company provides little information on the unit level economics of international restaurants presumably because they vary significantly from country to country.
Still a strong cash generator, PZZA’s, free cash flow declined to $82M in ’17, down from $95M in ’16, after capex of $53M in ’17 vs. $55M in ’16. $87M was spent to purchase 1.387M shares in Q4, $209M was spent in the full year for 2.960M shares, and $32M was spent in Q1’18 (until 2/20) for 546k shares.
In the last 5 years PZZA’s stock has almost doubled, from around $30 to the high $50s, though down from a high around $90 at 12/31/16. The current dividend provides a current yield of 1.6%. Founder, John Schnatter, though no longer CEO, owns about 28% of PZZA stock.
PZZA: Current Developments: Per Q4’17 Report and Conference Call (2/27/18)
Results for Q4’17 were somewhat admittedly (my management) disappointing, with North American systemwide comps down 3.9%, up only 0.1% for the year. Int’l comp sales were up 2.6% in Q4 and up 4.4% for all of ’17. There were 98 net unit openings in Q4 and 102 for the full year, of which 102 were international. While international results were better in terms of revenues, it was not nearly enough to offset domestic weakness, especially with the negative effect of foreign currency rates. Consolidated income before taxes was down 36.6% in Q4, but excluding the effect of special items, adjusted income before axes was down a more modest 14.5%, representing 7.2% of consolidated revenues vs. 9.0% in Q4’16.
Also in Q4, divisional results included: a decrease of 3.3% in domestic company owned restaurant operating income, a decrease of 0.4% in NA Commissary and “other” operating income, and an increase of 1.5% in International operating income. G&A expenses were up 0.5% as a percentage of operating income. Interest expense, still modest relative to other line items, was up $2.9M, or 154%, with more debt outstanding from stock purchases as well as higher rates. The effective income tax rate was only 9.6% in Q4, lower by 22.6% from Q4’16. The effective tax rate for all of ’18 is expected to be 21%, down from 35%.
In terms of guidance, diluted EPS in ’18 is expected to be in the range of $2.40-$2.60 vs. $2.83 on a GAAP basis in ’17. $0.30-0.40 of the EPS decline is due to continued soft domestic sales, higher delivery and insurance, technology and marketing costs. $0.20-.24 positive effect will be from the new tax code. It is assumed that NA comp sales will be from a negative 3% to flat, international comps will be up 3-5%, net global unit growth will be 3-5%, block cheese prices in the low $1.60s, capex of $45-55M and total debt to EBITDA will be in the range of 3-3.5x.
The new CEO, Steve Ritchie, chaired the conference call on 2/27/18, having spent 22 years as part of Papa John’s system, including ownership and operator of franchised stores. Predictably, he expressed optimism over the future prosperity of this well established brand. In particular, he emphasized the need to re-establish PZZA’s differentiation within their always competitive segment by improving product quality, service. marketing, technology, and other necessary aspects such as delivery. While acknowledging the challenges, he pointed out that the full year report included positive NA systemwide comps for the 14th year in a row (but not by much, 0.1%), and positive international comps. The well known divorce from NFL sponsorship has taken place, no doubt costing some viewership in the short run. Longer term, the Company hopes to gain much of it back through partnership with 22 specific NFL teams, usage of league broadcast and digital platforms and through relationships with NFL players and personalities. First quarter sales were said to remain weak so the challenge is obviously to gain traction as the year progresses.
In the Q&A, store closures over the last couple of years were discussed, in particular in the Northeast and on the West Coast, partially due to labor pressures, especially with the soft sales trends. To be expected, there was a great deal of discussion relative to new marketing strategies as well as a variety of operating initiatives. A new position has been created, to focus on store level economics, in an attempt to ensure that every franchisee is as profitable as possible. Since a new creative ad agency has been retained, it seems fair to say that it will be a number of months before a new marketing program is put into place. A new PR agency has been added as well, which could also help to improve consumer perceptions. Shares will continue to be purchased under the $500M authorization from 8/17, to take leverage to 3-3.5x EBITDA, versus about 3.0 today. Since trailing EBITDA is about $150M, another “half turn” would be $75M, which in addition to $80M of free cash flow, would allow for something like $120M of stock repurchases and the $30M annual dividends. Over $200M was spent in ’17, and management indicated that the dollars spent in ’18 would be similar, so that would take the ratio slightly above 3.5x, the stated top of the range. We interject here that, compared to their heavily franchised peer group, in today’s “new age” of financial management, 3.5x trailing EBITDA is considered a modest level, and the Board could decide to take this ratio materially higher.
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