Description

Investment Thesis

Recommendation: Initiate a short position in Papa Murphy’s Holdings (NASDAQ:FRSH) ("Papa Murphy", "FRSH", or the "Company") with a 12-18 month price target of ~$11 per share versus its current price of ~$21.9 (~50% implied gain).

Papa Murphy is the largest franchisor and operator of “take and bake” pizzas, selling pizzas which customers cook at home (much like the recently bankrupt Homemade Pizza Co. her in Chicago). The Company IPO’d under the JOBS Act in early May 2014, selling 5.8MM shares at $11 per share with proceeds used to de-lever.  Initially, Papa Murphy was a popular short driven by issues brewing amongst its franchisees, significant questions regarding its aggressive unit growth story and 4.1x financial leverage.  Nonetheless, since last summer the Company’s stock price has appreciated by over 100%.

Our variant view is the former, as today Papa Murphy is an even more compelling short driven by (1) franchisee issues, (2) unit growth deceleration, (3) deteriorating free cash flow and margins, and (4) shifting sore mix from being an asset-lite franchise model to an asset-heavy store operator.

Over the past two months, sell-side analysts and a recent short squeeze triggered by the low float have created an attractive entry point.   As the year progresses, Papa Murphy’s stock price is likely re-rate downwards as a declining/flat store count, tough same-store sales year-over-year comparables and insider/sponsor sales weigh down the stock price.

The thesis is predicated on the following attributes, which make the Company a highly attractive short at current prices:

• Unrealistic Valuation: Papa Murphy trades at 17x LTM Adj. EBITDA of $28MM and a sub 5% FCF yield. This is excessive for a business operating in a competitive industry with low / no barriers to entry. Moreover, while certain peers such as Domino’s trade at high multiples due to their asset-lite strategy, international growth prospects and free cash flow generation, three attributes which FRSH lacks.

Looking at precedent transactions utilizing EBITDA, at best FRSH value is pegged anywhere from $6.5 to $15 using an 8.0x – 13.0x multiple, implying significant downside from the current multiple of 17.2x. Recall that Lee Equity Partners paid ~9.5x Adj. EBITDA for this asset in a competitive bidding process.

• Deteriorating Franchisee Base: Papa Murphy faces increasing pressure from its franchisee base. In early 2014 the Papa Murphy Franchise Association “PMFA” issued a letter which highlighted the dire franchisee system outside of the Northwest. The letter was subsequently followed by two franchisee groups suing FRSH citing mis-representation of franchisee profitability and average weekly sales among additional items.

As the lawsuits progressed through 2014, Papa Murphy struck multiple deals with franchisees, either repurchasing stores or granting royalty relief. Store closures and transfers from franchisees accelerated with 70 stores closed/transferred in 2014. This coincided with various reports of multi-unit franchisee bankruptcy/issues in Dallas and Tennessee as well as multiple owners throughout the mid-west selling their stores back to the Company. Moreover, recent news suggests franchisee closures will continue to accelerate going into summer 2015. For a bull thesis predicated on growing units outside their historic Northwest stronghold, reality is not comforting.

Importantly, this trend is not a one-time phenomenon.  In 2015, 23 stores (2% of domestic franchisee stores) have been closed/transferred through March 31. Furthermore, calls into FRSH franchisee development suggest the store count has remained flat if not declined.

FRSH corporate stores generate roughly ~20% higher average weekly sales. This is attributed to FRSH likely having better store management, etc., yet for a franchisee concept that is geared towards mom-and-pop operators who will ultimately operate a handful of stores at best, this is far from a recipe for success.

To keep the store count growth from turning negative, we expect Papa Murphy will continue to cut royalties and buyback troubled locations, which is a significant divergence from the bull thesis.

• Strategy Pivot to Restaurant Operator: Over the past three years and accelerating over the past six months, FRSH has aggressively repurchased franchisee locations in a variety of geographies, particularly those in distressed regions in the Midwest and South regions. In order to take unit growth matters into its own hands, FRSH is now looking to spend $20MM in FY15 (~71% of its LTM EBITDA) on a store-roll out program. This is a high risk endeavor with lower expected return on asset metrics which is contrary to the “franchisor” multiple it currently receives.

It seems FRSH has only been able to exceed revenue and EPS assumptions through its purchase of store locations. Interestingly, if the same ~7% royalty rate is applied to Company-owned stores, EBITDA for the segment is cut by ~45% to 50%. As FRSH continues its transition to an asset-heavy, low ROIC store operator, our expectation is the market will value the business with a lower multiple (i.e. no greater than 10x – 12x).

• Lack of Operating Leverage, Deceleration of Growth & Deteriorating Free Cash Flow: FRSH has shown the ability to grow its top-line in excess of 20% over the past years yet EBITDA growth has significantly lagged at ~10% while margins have compressed a by a staggering 10%.  Moreover, top-line and EBITDA growth continue to decelerate which will continue to press free cash flow, particularly as the company quadruples its CapEx program from $4.7MM in the LTM period to $20MM for FY15E.

With no material free cash flow generation over the next 12 – 18 months, the Company will have little flexibility as it faces continued degradation in its franchisee business and competitive pressures.

• Excessive Leverage Provides a Potential Catalyst: The Company is currently levered at ~4.3x debt to EBITDA, or $115MM. While the Company has re-priced their facility with GE Capital, the Company has not demonstrated the ability to de-lever as debt levels have remained flat YoY. As transitions to a more capital intensive store operator, financial leverage at Papa Murphy’s will continue to pressure equity value.

• Competitive Market with No Barriers to Entry:  Although the management team likes to present Papa Murphy as a unique pizza concept with no real competitors, the reality is vastly different. Papa Murphy competes against traditional take-out pizza concepts such as Pizza Hut/Dominoes/Papa Johns, “mom and pop” operators, and various pizza products from supermarkets with similar products at cheaper price points. Furthermore, these concepts challenge FRSH for franchisees.

For instance, it costs roughly $150K for a Noble Romans (NROM) a take and bake competitor, $141K - $466K for a Dominoes (DPZ), $295K - $422K for a Pizza Hut (YUM), $138K+ for a Papa John’s (PZZA) unit, which carries a reduced royalty rate for four years, free Middleby ovens, food credits and no franchise fee ($25K). Compared to the ~$200K - $250K for a Papa Murphy’s, the “capital-lite” value proposition for a franchisee is questionable.

• Frothy Growth Promises: Revenue growth over the past three years has been driven by franchisee buy-outs which has allowed the Company to post double-digit revenue growth figures. The concept has been around since 1981, making the 4,500 store promise (over 3.0x the current base) unrealistic.

Consensus Thesis

Expectations for Papa Murphy on the street is high as a majority of FRSH’s coverage universe have the equity listed as a “Buy”. Sell-side analysts and "growth" investors have been enamored by Papa Murphy’s, as the consensus bull thesis has been predicated on:

• Long-Term Mid-Single Digit SSS Growth.

Rebuttal: While same-store sales accelerated in the back half of FY14, they have subsequently decelerated into 1Q15 and will be tougher comps going forward. Furthermore, SSS benefitted from promotions as well as marketing dollars disproportionality utilized for company-owned stores.

Recall another driver of SSS growth is derived from Company owned stores, whose SSS comps are 2x franchisee SSS, not a positive when attempting to aggressively sign new franchisees. FRSH attributes to the significant gap to a lack of NCR point of sales systems at franchisees and online ordering at franchisees, two attributes which do not make sense. Realistically, FRSH has aggressively promoted and spent material marketing dollars on the locations to boost their top-line. Moreover, company-owned stores do not pay the ~7% royalty fee which reduces Company-Store EBITDA by ~50%.

• Franchisee White Space and Growth

Rebuttal: FRSH new store growth has significantly decelerated, with year-over-year store growth decelerating from ~5.3% in FY13 to ~3% in the LTM period. New stores have been driven by FRSH opening company owned stores, while domestic franchisee stores have decreased since FY14, from 1,342 to 1,338 units as of 3/31/15.

More telling, there have been franchisee bankruptcies in growth regions such as Texas, as well as store acquisitions in South-East states such as Tennessee, which were originally pitched as significant franchisee growth opportunities at the IPO. Even areas with prime demographics for FRSH such as various portions of Illinois/Chicago have also utterly failed.  Simply said, the facts seem to suggest FRSH will not be able to grow its store base 3x.

• Competitive Landscape

Rebuttal: The sell-side is only considering competition from other QSR pizza chains (which there are plenty with larger wallet share) along with new interesting true fast casual concepts like Blaze Pizza. The bulls are overlooking competition from super-market freshly prepared pizzas and importantly cheaper frozen pizzas such as DiGiorno.

• Highly Optimistic Financial Projections

Rebuttal: While the sell-side is hanging their hat on ~20% growth in FY15E and ~15% in FY16E, FRSH will have a difficult time attaining top-line growth outside of repurchasing franchises, which it has been aggressive in doing so over the past couple quarters. While FRSH may be able to game its top-line through these purchases and a build-out of new stores, free cash flow will likely not materialize in a significant manner.

Company Overview

Introduction

Papa Murphy’s as known today, was founded in 1981 as Papa Aldo’s in Hillsboro, Oregon and Murphy’s Pizza, which itself was founded in 1984 in California. In 1995, both entities merged to create Papa Murphy’s. After successfully growing in the Pacific Northwest, Terry Collins (founder) re-capitalized the business in 2004 with Charlesbank Capital Partners as the financial sponsor. Fast forward six years later, Lee Equity purchased the Company for $180MM (~10x EBITDA). Over the next three years, the new sponsor increased the Company’s financial leverage (over 6.0x EBITDA) in order to pay dividends and acquire franchisees, transitioning Papa Murphy from an asset-light royalty model to asset-heavy model.  Since the IPO, FRSH has benefitted from increasing valuation multiples for both restaurant concepts and specifically pizza stocks.

The Papa Murphy’s system currently generates ~$850MM in system sales and consists of 1,338 domestic franchised stores, 30 international franchise stores and 108 company-owned stores.

Papa Murphy’s unit growth for its franchisee business has decelerated, particularly from 12/31/14 to 3/31/15, in which unit growth went negative. As mentioned above, the Company has been aggressive in repurchasing troubled franchisees.

Acquisitions

Recent FRSH acquisitions from 2014/2015 Q1 are provided below. Interestingly, they highlight the significant divergence in sales and purchase price per unit between stores in the Northwest and South.

M2AD

• On 3/9/15, FRSH acquired a 6 unit franchisee in Seattle, Washington for $4.1MM with cash on hand.

• This implies a $680K purchase price per store.

•  Assuming the units were purchased and operated at 1/1/15, incremental revenues for the quarter would have been ~$1.1MM or $183K per store.

• Found yelp reviews of the owner, Mark Klingensmith not accepting coupons. I will try to locate the owner and see if I can get a call. Mark was one of the larger franchisors in Washington.

Additional 1Q15 Acquisitions

• FRSH acquired an additional eleven stores through-out the quarter in four separate acquisitions. This includes eight stores acquired in Tennessee on January 26th, one Idaho store on January 12th, Oregon store on March 2nd and a Texas store on March 9th.

• Purchase price was $3.6MM or $330K per store.

• Funded with cash on hand.

• Assuming the stores were purchased and operated at 1/1/15, incremental revenues for the quarter would have been $560K or ~$51K per store/$4K per week, materially lower on a per store basis when compared with the Northwest stores. This is consistent with our thesis that the non-Northwest stores are not performing as strong. While this could be skewed by one or two poor stores, directionally this jives with the lawsuit findings of stores outside the Northwest generating under $7K of average weekly sales.

Drake Enterprises

• On 8/14/14, FRSH acquired 9 stores in Minneapolis from Drake Enterprises, a multi-unit operator for $3.5MM or $390K per store.

• The acquisition was funded with cash on hand as well as a $2.9MM seller note.

• Assuming the acquisition was consummated at 1/1/14, the acquisition generated $2.9MM of revenue or $322K per store for an implied average weekly sales of ~$6.2K. This is below the break-even average noted of ~$7K.

Additional 2014 Acquisitions

• FRSH notes 13 additional stores acquired in six acquisitions: five in Florida, four in Texas, three in Oregon and one in Washington. The acquisitions were consummated on December 2014, excluding Washington which was purchased on November 2014.

• Collectively paid $4.1MM or $315K per store from cash on hand.

• If operated since 1/1/14, the transactions generated $5.6MM of revenues or $428K per store or $8.2K on an AWS basis.

Competition

The Company competes in a heavily saturated pizza market, going head to head against companies such as Pizza Hut, Dominoes, Little Caesars, Noble Romans, Papa Johns, supermarket prepared pizza, frozen pizza brands in addition to numerous regional and local chains. Further, it appears the fast casual trend is making waves in the space, with concepts such as Blaze Pizza performing well.

The real takeaway is marketing and branding is key.  Papa Murphy competes against competitors with vastly larger marketing budgets and franchisee support and infrastructure (the 2014 PMFA letter/lawsuit clearly supports this).

Historical Financials

(1)  Per Company’s calculation. Please see the “EBITDA Bridge” in the appendix.

Keys items from the above include:

• Domestic franchisee revenue growth has significantly decelerated, coinciding with the reduction in domestic franchisee stores.

• Adjusted EBITDA margins continue to decline, as well as deceleration of EBITDA growth.

• From FY14 to 3/31/15, franchisee stores declined, with ~17 units purchased from the Company. This represents ~2% of the domestic franchisee store base.

• Per the above chart(s), SSS accelerated in in the back half of FY14, driven by strong performance in Company-operated sales. While Company operated store revenues have been strong, the EBITDA and cash flow impact has been negligible.

Scenario Valuation Analysis

Base Case

The base case portrays a scenario of top line growth and gradual margin improvement.  Below are the assumptions used in the base case scenario:

• Sales are expected to grow 23% in FY15E, 13% in FY16E, declining to 6% in FY19E. Sales growth is predominantly driven by a transition to Company owned stores.

• EBITDA margin expected to remain flat at 24% in FY15E, and increased through-out the forecasted period to 26%. Note that due to the transition to Company-Owned stores, EBITDA margins will likely continue to decline.

• Capital expenditures forecast at $20MM in FY15E declining to $8MM per annum thereafter.

Upside Case

Stress Case

In the LBO auction held in 2010, Papa Murphy’s was purchased for ~9.5x EBITDA.  As shown below, a 9.5x LTM multiple would indicate a price of $9 per share (loss of 58%).  Given the franchise issues denoted above, and transition from an asset-lite to asset-heavy business model, the business could easily trade for less than 9.5x.  The following chart quantifies the range of hypothetical valuation outcomes:

Catalysts to Value Realization

Risks & Mitigants

Why the Consensus is Wrong / Recommendation

The short thesis in regards to Papa Murphy is fairly simple, as the Company is being touted as a fast-growing differentiated pizza concept with tremendous white space, while in reality FRSH is a levered, mature regional concept with low barriers to entry, with an intrinsic value materially lower than the current price.

Appendix A: EBITDA Bridge

Catalyst

Continued deceleration of growth, unit count decline, sponsor exit, capital deployed into low margin stores.