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Starboard Invests $200-250M, into Papa John’s – is PZZA a Buy or Sell?

Papa John’s is all over the news again. After PZZA bottomed last Friday at $38 and change, on expectations of disappointing North American sales in Q4 and January (down 8.1% and 10.5% respectively, now announced). Observers were apparently taken by surprise yesterday morning, Monday,  when it was announced that Starboard Value LP has invested $200M in Papa John’s, with the possibility of $50M more, into a preferred stock convertible at a 22.5% premium to the average price over 10 days ending 2/15/19. Parenthetically, franchisees are allowed to purchase $10M worth on the same terms. This will provide Starboard with a stake equal to 11-15% of Papa John’s equity. Starboard will also be entitled to two Board seats, including Jeffrey Smith, CIO of Starboard. Steve Ritchie, PZZA’s new CEO, joins the Board as well.

We have written a number of times on this situation over the last six months. We liked PZZA in the high 30s, suggested lightening up in the low 50s. Lastly, on December 10th, with the stock at $45 and change, we speculated that a deal was in the offing, with Schnatter having lived through a cooling off period and having hired an investment banking advisor.

We think PZZA is a good bet again (at $43 and change), with more upside potential than downside risk, both in the short term and longer.

  • Starboard has an excellent reputation, having invested in Darden, modifying the Board of Directors, and helping to implement some operating initiatives. Their involvement provides a floor under the stock, both short and longer term.
  • While the disappointing sales in Q4 and January are a material negative, it is sometimes overlooked that there are 1,700 franchised stores internationally (1/3 of the system), and their sales were down nowhere near as much as in North America, down 2.6% for Q4 and flat in January.
  • John Schnatter’s influence is diminished materially, with a Board expanded by two new independent Directors plus CEO Steve Ritchie, and his stock ownership diluted by 11-15%, to be closer to 25% than the current 31%.
  • There are still hundreds of billions of dollars of private equity capital looking for a home and we believe there is sufficient potential at PZZA to justify a price at least in the low 50s, even with the recent sales trends. Starboard will end up paying close to $50 for their stake.
  • We think the chances are perhaps 50-50 that another suitor will emerge relatively soon, since the stock is more likely to firm up than decline substantially from this level and a competing investor knows that. In essence, the time to move is now !

We indicated months ago that we own this one. Though the stock is up over 10% in the last two days, we are sticking with our position. Greed has replaced Fear.

Roger Lipton


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We have written several articles regarding Papa John’s since John Schnatter left the company, the first written on July 23rd, when PZZA closed at $46.56. We outlined why it was in the interest of all stakeholders : current management, franchisees, board of directors, stockholders, debt holders, and “even John Schnatter” to arrange a going private transaction.

On August 8th, when PZZA closed at $38.94, after the dismal Q2 was released with North American comps down 6.1%, including July down about 10.5%, we said “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”.  We concluded: “We feel that sales will more likely stabilize than deteriorate…..especially during Q4 when….YTY comparisons get easier as well. We expect that the most important stakeholders in this equation, specifically John Schnatter …….will come to a rational conclusion that toned down rhetoric is in everyone’s best interest…..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.”

On October 9th, with PZZA closing at $54.90, after several P/E firms had expressed interest, including Nelson Peltz’ Trian Fund, and comps had apparently stabilized, we said “while PZZA is still statistically cheap relative to other franchising companies….there are some unique uncertainties here”…one of which, and the most important now today…..”to what extent John Schnatter, who owns 30% of the stock will muddy the waters” We suggested investors take partial profits since “we doubt that a deal will be done at much more than $60 per share, and the process could drag on for months. Should a transaction be delayed, or not seem likely, due to continuing weak sales or Schnatter’s requirements, PZZA could fall back to the high 40s.”

Schnatter’s resistance in various forms over the last two months continued to be in place, and when press reports indicated that Trian has lost interest, PZZA came down from $57 on 11/7 to $45 and change..


It  was announced late Friday that John Schnatter has engaged a financial advisor “to assist him in reviewing the financial prospects of the Company and in assessing alternatives for increasing shareholder value.”

We consider this critical in terms of the possibility of a private equity deal, especially with PZZA trading back in the mid 40s. While we have suggested that a transaction would be in the interest of all stakeholders, including John Schnatter,  a “cooling off” period has obviously been necessary for Schnatter, company founder, with emotions playing an important role over a decision relative to his $500M stake. The challenge of satisfying Schnatter, the founder and previous face of the company, and the owner of 30% of the stock, has obviously been an important stumbling block in getting a deal done.

We believe private equity buyers will  be far more interested and Trian could even come back to the table,  now that the stock is back in the 40s and with investment bankers now advising Schnatter. There is a huge difference between the two price ranges, compounded by the fact that Schnatter’s stake  (and his personal future role) could be far more negotiable. We consider the stock to be attractive at the current level.

Roger Lipton


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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.

Unit Growth

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.

Bank Covenants

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.

Roger Lipton


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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.

Our thoughts:

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……..

Roger Lipton

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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.

Roger Lipton


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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%
NA Commissaries 733.6 41.1% 681.6 39.8%
NA Franchise 106.7 6.0% 103.0 6.0%
International 126.3 7.1% 113.1 6.6%
1783.3 100.0% 1713.6 100.0%

Company Strategy

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.

 Shareholder Returns 

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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