PAPA JOHN’S PIZZA (PZZA) – NEW WRITEUP – A LOT OF WAYS TO WIN!

CONCLUSION:

While the valuation of PZZA seems high at 49X’21 EPS estimates and about 23x trailing EBITDA, these measures are against results that are still depressed from results just a few years ago. A substantial operating turnaround is now well established and it seems likely that systemwide unit growth will resume. There are a number of operating levers that can help: continued higher sales should expand franchising margins and encourage unit growth, re-franchising (especially with improved results at the stores currently operated by the Company) could generate a lot of cash, leveraging the current strong balance sheet could allow for a larger stock buyback or special dividend. It seems that there are a lot of ways to win by owning PZZA at these levels. Especially compared to its peer group of largely franchised QSR companies, PZZA seems undervalued relative to the higher earnings and cash flow that seem likely. For the same reasons, a private equity (including 14.4% owner, Starboard Value) or strategic buyer (at a premium price) could surface at any time.

STRATEGIC UPDATE

Since our last update in November, 2019, Papa John’s business has improved significantly. For the first time since 2017, the North American division, as shown below has turned in five consecutive quarters of positive same store sales. While that may pale in comparison to Domino’s streak of 43 positive quarters of same store sales, it is a remarkable achievement for the company after comping negative for almost two years. In Q2, the company saw its two-year same store sales turn positive for the first time in 10 quarters. Though it is hard to delineate how much of the improvement the last nine months has come from the pandemic and the shutdown of thousands of competing restaurants, rather than internal organic improvement, it is important to understand that the company already had three consecutive positive same store sales quarters BEFORE the pandemic hit. Business has been so strong in ’20 that the company has hired over 30,000 new employees this year.

Recall that 11.1% of the 5,360 worldwide number of locations are company owned, as are 18.2% of the 3,286 North American units. The in-house delivery capability is also an important strategic asset.

New Products

While the pandemic has no doubt been a big factor in the turnaround in same store sales, the amount of new product innovation that has been occurring since Rob Lynch became CEO is unprecedented. The company has launched six new products in the last year alone. The company launched a garlic parmesan crust in November, which was the first ingredient added to the original pizza dough recipe in the company’s history. The company has also added, “Papadias”, Jalapeño Popper Rolls and the successful “Shaq-a-Roni” pizza, which was a collaboration with board member and franchisee Shaquille O’Neal. According to Mr. Lynch, in 2021 the company is going to have “the biggest launch we’ve ever done”. This will be the “Epic Stuffed Crust” pizza. Results in test markets has been encouraging. These new products are clearly resonating with customers and helping to drive the resurgence in the pizza chain.

Franchisee System Health Improved Substantially

There were several other encouraging signs that the franchisee system is healthy and can begin to grow again.

Franchisee stores have outperformed company owned stores recently, which is unusual. Franchisee owned stores rarely outperform company owned stores because a higher percentage of Company-owned stores are located in more heavily penetrated markets. The average annual unit sales for Company-owned stores is $1.05M compared to only $840K for a franchise unit. It is especially noteworthy that, as the table just below shows, in the last two quarters franchise owned units have outperformed Company-owned units by 700bps each quarter, no doubt indicating that the chain is picking up a significant number of new or lapsed customers. The company has said that, in the last two quarters, North America median unit profits have been the “highest in years.” E-commerce now accounts for approximately 70% of all orders, which also helps overall profitability and increases marketing dollar efficiency.

The company recently ended its “We Win Together” program that was started in Q3 2018 to help support franchisees after same store sales collapsed in the wake of the John Schnatter scandal. As a reminder, the program was a two-part program that provided royalty relief in the form of lower royalties, royalty-based device incentives and targeted relief. The second part was the agreement to make investments in marketing and brand initiatives to support the long term strength of the brand. Over the last nine quarters, these initiatives cost Papa John’s over $100M. While the plan was always scheduled to end in Q3 2020, the fact it was not extended shows how successful it was in getting the franchisees through a very tough period. We also believe it created a lot of goodwill among the franchises which is important if the company wants to continue to grow, both inside the US and internationally.

Royalty Relief Subsides

THE OUTLOOK

Franchise Unit Growth May Resume

It is logical that the dramatic improvement in AUVs and profitability would generate a new level of enthusiasm within the franchise system. PZZA has in fact signed a significant new franchise agreement in September. On September 10th, Papa John’s announced its largest traditional store development agreement in North America in over 20 years. The agreement is with HB Restaurant Group, which already owned 43 restaurants in the Mid Atlantic region. The agreement calls for HB to open 40 new stores in Philadelphia and southern New Jersey between 2021 and 2028. After shrinking the store base in North America for years, the company reported net unit growth of two in Q3 ‘20. This is important because at 3,142 stores, the company has less than 50% of the store base of both Domino’s (6,239) or Pizza Hut (6,653). This means that the company has a significant amount of potential growth ahead of it in North America and could now begin to grow again. It is interesting that Pizza Hut recently closed 700 stores in the US, obviously lessening the competition somewhat.

Re-Franchising is a Potential Earnings “Lever”

It is important that the company owns significantly more stores than its peers, Domino’s and Pizza Hut being virtually entirely franchised, obviously  providing an opportunity for re-franchising. Papa John’s owns approximately 600 stores compared to around 125 for Domino’s and 23 for Pizza Hut. The company could lower its ownership base to only 2-3% of the total North American store base (similar to Pizza Hut and Domino’s), by selling 530-540 stores to franchisees. This would improve margins, reduce debt and most likely result in a higher multiple of cash flow. Domino’s has stated it wants to grow its US store base by 2,000 units to over 8,000, which shows the huge growth opportunity in North America for Papa John’s. Internationally, Domino’s and Pizza Hut have more than 5X the number of restaurants of Papa John’s.

Substantial Margin Improvements is Possible

The eight consecutive quarters of same store sales declines from 2017-2019 caused a 700bps decline in the operating margin between 2017 and 2019. General and administrative expenses were deleveraged by 530bps over this time. This has resulted in G&A costs as a percentage of system wide sales to be significantly higher than any of the company’s highly-franchised peers. However, the large increase in same store sales over the last two quarters has helped the company generate significant expansion in margins.

For the nine months ended September 30, operating income margins expanded by 220bps and pre-tax margins have expanded by 360bps. According to SEC filings and conference calls, the improvement in margins is a direct result of operating leverage due to the 20%+ same store sales increases the last two quarters. While we expect a moderation in same store sales increases in the coming quarters, the recent results highlight the significant operating leverage inherent in the business model. In 2016, the EBIT margin was 9.6% or DOUBLE the current margin. We see no reason that a combination of continued positive same store sales (driven in part by continued innovation), accelerated unit grow and the sale of several hundred company stores to franchisees could eventually drive margins back to those levels.

As we noted earlier, Papa John’s G&A as a percentage of system wide sales is significantly above its peer average. The combination of selling a significant number of stores to franchisees, restarting North America franchisee unit growth and the continued expansion of international units should help drive this ratio closer to its peers.

Significant Improvement in Finances

The improvement is sales has significantly improved the company’s finances. For the nine months in 2020, the company generated $169M in cash from operations, which compares favorably to the $50M the company generated in 2019. The company also received $29M in proceeds from the exercising of stock options due to the higher share price in 2020. As a result, the company has a cash balance of $140M compared to $28M in 2019. The company also announced a $75M stock buyback. It is particularly noteworthy that the long term debt is much lower than at other franchised chains. Dunkin’ Donuts, Restaurant Brands, Domino’s, Wingstop have carried debt at 5-6x times EBITDA. PZZA, on the other hand is carrying long term debt, net of cash, of only about $200M, a much lower multiple of depressed EBITDA of  $78 (’18) and $72M (’19), an improved $108M for nine months of ’20 and an aspirational pre-crisis $205M in ’17.

In February 2019, with the company struggling financially after the Schnatter scandal, the company issued $252M worth of Series B Preferred Stock convertible at $50.02 per share (5M shares) to Starboard Value LP. In connection with the investment, the Papa John’s Board of Directors was expanded to include Jeffery Smith, the CEO of Starboard and Anthony Sanfilippo, the former CEO of Pinnacle Entertainment. This Preferred Stock, if converted, will increase the shares outstanding by approximately 13%. In addition, the preferred has a 3.6% coupon that is costing the company about $10M a year in dividends. In February 2022, the coupon goes up to 5.6% ($14M in dividends) and in February 2024 the coupon increases to 7.6% ($19M). The preferred is redeemable by either party in February 2027.  While the deal Starboard negotiated nine months ago looks pretty sweet today, the original 3.6% coupon was not terrible at the time and the conversion price was almost 20% above market.

CONCLUSION: Provided at the beginning of this article

RESTAURANT COMPANY STOCK HIGHER THAN PRE-PANDEMIC – IS IT WORTH IT?

We published our analysis on October 22nd, showing almost all the publicly held restaurant companies, comparing their current valuations to those before the pandemic. That chart is provided below, with prices updated to midday on 11/9. Based on the 2/15/20 (pre-pandemic) estimate of 2020 earnings, and today’s estimate of 2021 earnings, it appears that Papa John’s (PZZA) while still carrying a very high multiple of earnings and EBITDA, is valued more reasonably today than ten months ago.

Let’s take a more complete fundamental look at Papa John’s.  Back on February 15th, PZZA was selling at $66/share. Trailing EPS, for calendar 2019, had been $1.17/share. This previously troubled multi-thousand unit international franchisor was beginning to turn around. The table just below shows the turn to positive comps in the second half of calendar ’19, after the management change, the new product effort and the introduction of Shaquille O’Neal as a corporate spokesman.

As the following table, as provided by Bloomberg LP, shows: earnings per share had turned slightly positive in Q3’19, dramatically so in Q4, but still far below the earnings power from a few years ago. By February 15th, before the pandemic hit, expectations were no doubt for continued same store sales progress and more earnings recovery. Still, the system was far from healthy as several quarters of low single digit comps don’t begin to compensate for the high single digit negative comps that went on for eighteen months. It is worth noting, however, that international sales (about 30% of the 5300 unit system) were nowhere near as weak during the tough times, apparently not so much concerned with the drama surrounding John Schnatter’s departure. It is also worth pointing out that about 600 domestic units are company owned, providing operating leverage, right now on the upside, to corporate results.

In any event, back in February, before the pandemic came into view, the expectation was for continued positive comps and EPS in the area of $1.40, up from $1.17.  PZZA, at $66/share was therefore trading for about 47x expected EPS, a fairly high P/E, but this is mostly the case when earnings are depressed and investors are anticipating a recovery.

Today, at $83, PZZA is trading at about 37x calendar 2021 consensus EPS. Adjusting for the the fact that calendar 2021 is farther out from today than 2020 was in February of ’20, the comparable multiple is about 39x expected EPS, about 18% less than back in February.

Just as we did in the case of Wingstop, the current question becomes: Is Papa John’s better or worse off today, as a result of the Company’s position in a post-pandemic world.

As the table above shows, the comps have been dramatic, both in North America and internationally. The EPS progress, after the first quarter, has been dramatic. Earnings have also showed dramatic improvement so far this year, with expectations of further progress next year. The Company has said that the  third quarter was the last of the financial support provided to franchisees. Most importantly, free cash flow has been $134M in the first nine months of ’20, $67M in the third quarter alone.  Cash and cash equivalents was $140M at 9/30, up from $28M at 12/31/19. Long term debt was unchanged in the last nine months, at $340M (including $20M current portion), relatively modest in this day and age from franchisors, considering that EBITDA this calendar year should be on the order of $150M. PZZA has a current dividend yield of just over 1% and has recently authorized the repurchase of $75M of common stock.

CONCLUSION:

The pandemic has been productive for Papa John’s, accelerating the improving trends that were already in place. New products have been successfully introduced, marketing has been increasingly effective, operational improvements have been implemented, John Schnatter’s departure and the following management transition are now firmly in the rear view window. The strong  same store sales trends seem firmly in place and newly satisfied customers will likely (if the Company has their way) remain loyal. Earnings can still be considered depressed, especially with the upside leverage from 600 Company operated locations. The balance sheet could be leveraged further, to the benefit of shareholders. Among the (largely) franchised operators, the reward/risk ratio for PZZA seems better than most.

Roger Lipton

Note: The numbers in the table below were calculated as a “first look”, to be refined further as individual situations are reviewed. For example, the PZZA numbers below shows it undervalued by 34%, while the refined analysis above shows the s tock still undervalued but by a more modest 18%.

PAPA JOHN’S PIZZA (PZZA) MAKES NEW RECOVERY HIGH, SHOULD YOU CHASE IT ?

Papa John’s (PZZA) reported its third quarter, ending 9/29, the first under the leadership of new CEO,  Robert Lynch. It is safe to say that Lynch, in place only for two months at the moment , had nothing to do with the reported fundamental results. The results, Adjusted, along with Lynch’s excellent reputation, were sufficiently encouraging to take the stock up about 10%. The adjusted earnings per share was $0.21 vs. $0.19 a year earlier, but the most important aspect was that the comp sales have bottomed out, up 1.0% in North America and up 1.6% internationally.

Robert Lynch arrives at Papa John’s with great credibility, and will hopefully provide the consistent and informed leadership that has been lacking over the last two years. Franchisees, who have been undoubtedly in distress, are no doubt encouraged by Lynch’s arrival, and will support him every way they can.

Our object here is to reflect on the current valuation relative to the current EBITDA run rate, and we will accept the non-recurring nature of Adjustments as the Company suggests. We will compare today’s valuation with that of Papa John’s, at its peak in late 2016. In evaluating the stock at this point, it seems to us a comparable situation to that faced by Chipotle, which fell from grace about four years ago, brought in new management about two years ago, and the stock, CMG, has outraced the earnings recovery to make new highs.

THE PREVIOUS PEAK VALUATION

At the end of 2016, the market value of the equity was $90/sh. X 37.7M shares outstanding, or $3.39B. Adding the $300M of long term debt provided an enterprise value of $3.69B. This was 17.8x the EBITDA for calendar 2016 of about $207MM

TODAY’S VALUATION

Today, at the end of 2019, the market value of the equity is $61/sh. X 31.6M shares outstanding, or $1.93B. Adding the $346M of long term debt provides an enterprise value of $2.28B. This is about 19.8x the apparent Adjusted EBITDA for the year ending 12/31/19. This, by the way, is in the same range of EBITDA multiples that other large scale publicly traded franchise systems sell for.

THE POSSIBILITY OF RECOVERY

We view Papa John’s rebound at least as probable as that achieved by Chipotle. There are lots of differences to be sure. Chipotle is largely company owned, Papa John’s franchised. Chipotle had food borne illness problems, Papa John’s had leadership/political problems. There was a leadership crisis at both companies with both founders, Steve Ells and John Schnatter losing credibility for very different reasons. The QSR industry is more competitive than ever, but PZZA had the scale to compete two years ago, and there seems to be no major reason why they can’t regain most, if not all, of their previous market share.

THE CHIPOTLE COMPARISON

The following charts show the revenue and earnings statistics, and the stock price performance, per Bloomberg, for CMG over the last five years. You can see that revenues and earnings peaked in calendar 2015, the stock turning down at the end of 2015 as the food borne illness issue arose. You can see that the stock bottomed in late 2017-early 2018, just before Brian Niccol arrived as the new CEO. The stock moved almost immediately from about $250 to $400, before Brian had learned where the bathrooms were (especially since headquarters was moved from Denver to San Diego, at a cost of over $100M). Be that as it may, Chipotle has made great strides, in all kinds of ways, and the stock recently hit a new all time high above $800. It is worth noting that the $13.88 eps estimate for 2019 is still below the $15.43 high in 2015. So….that’s Chipotle.

Now we have Papa John’s. The following charts shows the earnings statistics and the stock price chart.

The stock price peaked in late 2016, with earnings reported at $2.55 in 2016, no doubt expected to be higher in 2017 than the $2.61 reported. In any event, the stock has bottomed in 2019, with PZZA under the control of interim management. It is interesting to us that the Enterprise Value at the bottom, this year, was very close to the 17.8x trailing EBITDA at the end of 2016. With the stock price up from the 40s to the low 60s, the Enterprise Value of about 19.8x the trailing Adjusted EBITDA does not seem outrageous to us. In fact, valuations in terms of Price to Earnings or Enterprise Value to EBITDA are almost always highest at the bottom of a cycle, when earnings and EBITDA are depressed, and the stock price is hope for some sort of recovery.

CONCLUSION

The current price of PZZA seems to reflect a very small portion of a potential recovery. There are no certainties, of course, but Robert Lynch is a qualified leader, the Company has a strong enough balance sheet to support an extended recovery period, if necessary, and the franchise system has little choice but to make every effort to do their part. Unit growth has been mostly international in recent years, those sales trends never suffered as much as those in North America, so that third of the worldwide 5,000 unit system should continue to provide unit growth. Overall, we think it likely that the run rate of EBITDA will increase materially over the next two to three years, if not sooner, and the stock price could move in lockstep.

Roger Lipton