Description

If you like business models that generate ROIC of more than 35% and can be purchased currently at ~5x LTM EBIT that will be growing both its units and profits domestically and abroad, then you might want to explore investing in Pizza Inn ("PZZI").  Since one of the biggest risks regarding investing in the stock is its illiquidity (3 month daily average less than 15,000 shares), this idea requires patient capital but for that virtue, I think an investment will be attractively rewarded based on my $4.75 target (185% upside) over the next two years and downside relatively low for a business at a growth inflection point with high current ROIC and higher incremental ROIC potential. 

Virtually everyone eats pizza!  In fact, approximately two-thirds of the U.S. population eats pizza once a month and, on average, each American consumes almost 50 slices of pizza annually.  Some of this pizza, since 1958, has been consumed at Pizza Inn but if you don't spend much time in Texas or small towns in the South, then I suspect you've never heard of Pizza Inn despite the Company being the 10^th largest pizza franchise (by units) and the 15^th largest pizza franchise (by revenue) in 2008.  Measured solely by units located outside the U.S., Pizza Inn would rank 7^th. 

The restaurant business is appropriately well-documented as being a lousy business (excess capacity, relatively low barriers to entry, high employee turnover, fickle consumers, etc) but restaurant brands (and especially one that is almost exclusively a franchise system) don't get to be over fifty years old because they're lucky.  Although Pizza Inn's history has been far from smooth and steady, the Company has demonstrated a strong foundation to bounce back when confronted with economic environment challenges, management turmoil, and competitive intensity.  The Company is at an inflection point of improvement as evidenced by being named 2008 Pizza Chain of the Year, demonstrating momentum of new franchisee interest, attracting experienced new management talent, and showing substantial improvement in profitability and potential for growth.

Franchised-based business models can be very attractive (scalability, low capital intensity, employee productivity, etc) and Pizza Inn has franchised since 1963.  In the U.S., the Company's franchise development is focused on locations primarily in the Southeast and in towns with a population of 50,000 or less.  As of June 28, 2009 (Fiscal Year ending 2009), there were 309 domestic and international Pizza Inn restaurants, consisting of two Company-owned domestic restaurants, 239 franchised domestic restaurants, and 68 franchised international restaurants. The 241 domestic restaurants consisted of: (i) 152 restaurants that offer dine-in, carry-out, and in many cases, delivery services ("Buffet Units"); (ii) 38 restaurants that offer delivery and carry-out services only; and (iii) 51 express units.  The Buffet units are best-known for their all-you-can eat buffet which is typically offered at prices from $5.49 to $6.99, and the average ticket price per meal, including a drink, was approximately $8.30 per person for fiscal year 2009. The average per person ticket is slightly higher in restaurants offering beer and wine. 

The 241 domestic restaurants are located in 17 states predominately situated in the southern half of the United States.  The largest number of domestic Pizza Inn units is located in Texas (37% of domestic mix), North Carolina (15%), Arkansas (8%), and Mississippi (7%).  The 68 international restaurants were located in eleven countries.  During FY2009, the Buffet units averaged ~$720K in revenue, the delivery/carry-out units averaged ~$260k in revenue, and the express units averaged ~$90K in revenue.  Fourteen new units opened in FY2009 (ended June 2009) while 28 units closed.  Thus far in FY2010, eleven new units have been opened with no units closed.

Based in The Colony, Texas, the chain grew to nearly 750 units (during the late 70s) in 33 states but declared bankruptcy in 1989. Although the company managed to regain its footing a few years later, the number of restaurants fell to less than 400.  A series of boardroom dramas beginning in 2002 left the company without a clear direction, mired in litigation and bleeding cash.  To effectively frame the investment opportunity, some historical context is relevant and described below.

Selected Historical Context

Pizza Inn was founded in 1958, the same year as Pizza Hut, but it's had a very different ride.  During the past two decades, Pizza Inn failed to adequately focus on how to assist its franchisees to succeed and hence periodically bathed in red ink and lost numerous units.  It is only recently that the Company has been able to get "back-to-basics" of the business of running restaurants (e.g., making dough fresh daily, insuring consistency across ovens so product is cooked perfectly each time, cleanliness of restaurants) but the "back-to-basics" strategy is working.    Prior to Charlie Morrison being named CEO and President in December 2007, Pizza Inn had experienced a tumultuous few years which led to losing numerous franchisees. 

In August 2002 the Company's board forced the resignation of then-CEO Jeff Rogers because they believed he'd be unable to repay a $1.9 million company loan used to purchase Pizza Inn stock.  Rogers later sold his shares to Newcastle Partners (reportedly for $7.4 million in December 2002), thereby making Newcastle the majority stockholder.  New CEO Ronald Parker (who incidentally was Rogers' handpicked President replacing Rogers) and other executives rewrote their contracts to protect their positions from a change in board control by Newcastle, which they attempted to invoke after Newcastle seated two appointees on the board.  Parker's combined salary and bonus earned him more than $1M per year; this rankled Newcastle Partners, which claimed that management from Parker was mediocre.  Newcastle accused Parker and three Pizza Inn officers of redrawing labor agreements in 2002 to include parachute clauses that purportedly could have bankrupted the company.  The new contracts included golden parachutes that positioned Pizza Inn to pay $7.4M should it undergo a change of control at the board level.  Parker was fired in 2004 and Tim Taft (who orchestrated the turnaround of Whataburger) assumed the CEO post of Pizza Inn which was reeling from the boardroom battles with Parker following the forced resignation of Rogers.

When Taft assumed his CEO post, he hoped to fortify trust with franchisees and shareholders and took the job for $1 per annum, plus modest stock options.  At the time, the Company's share price was ~$2.50.  In 2005, a lawsuit was filed against Pizza Inn by previous-CEO Parker, who claimed he was unfairly fired.  In 2006, PepsiCo sued Pizza Inn for breach of contract when Taft ordered a switch to Coke products.  Those lawsuits distracted management and bred apathy among franchisees.  Both issues were distractions from the task of fixing the Company's problems which included some franchisees not earning enough profit to stay in business, some franchisees being overcharged by the Company's distribution arm, inconsistency of product and service quality, and an overabundance of units that looked tired.  Taft said, "Nobody was reinvesting in the system."

In 2006, the Company settled the lawsuits and also executed a sale-leaseback of its headquarters as well as commenced the outsourcing of certain distribution services like warehousing and delivery.  In 2007, based largely on the work from Taft as well as the Company's CFO Charles Morrison to restore operational stability, balance sheet flexibility, and overall confidence within the company and among franchisees, Pizza Inn was able to increase its franchised units for the first time in many years. 

In August 2007, Pizza Inn lost its third CEO in five years as CEO Tim Taft abruptly resigned, after almost three years, to "take advantage of other opportunities that presented themselves" (one year later Taft was appointed CEO of Sun Capital's Souper Salad).  Taft led PZZI out from what he calls "a death spiral" of negative same-store sales, franchisee apathy and crippling lawsuits.  Taft was said to have accomplished what he sought to do:  heal Pizza Inn and position it for growth.  Taft also admitted to simply being "tired". 

Morrison, who joined Pizza Inn as CFO in January 2007, was appointed Interim CEO in August 2007 and officially the CEO in December 2007.   Prior to joining Pizza Inn, Morrison served as President for Steak and Ale and The Tavern Restaurants; he also served as CFO for Steak and Ale and Ponderosa Restaurants in 2004.  Prior to that, he served as Vice President of Finance for Kinko's, Director of Strategic Planning for Boston Market and Director of Strategic Planning for Pizza Hut (Morrison was with Pizza Hut for six years). 

Current CEO Charlie Morrison has implemented a turnaround strategy that focuses on the basics of good operations, customer service and product quality to improve franchisee profitability and position the chain for expansion.  Morrison and his team decided that improvements were necessary in product quality, operational focus on delivery and carry-out and more effective management of franchisees.  The Company wasn't visiting franchisees to assure that restaurants were kept clean and a quality product was not consistently being served.  A new VP of Operations was hired to oversee a team that visits franchisees.  Furthermore, the Company institutionalized better training of franchisees to assert requisite customer service and restaurant management.  The payoff came in a return to profitability (EBIT improved by over $4.5M between FY06 and FY09 despite revenue declining by over $6.6M) accompanied by six consecutive quarters of comparable-store sales increases (through calendar 2008 Q3). 

Resulting from Morrison's willingness to actively engage the franchise system in an exchange of ideas and to focus on improving the operations and profitability of the franchisees, the quality of the relationship of corporate with the franchisees has improved.  This has led to increased interest among existing franchisees to expand with Pizza Inn as well as improve the Company's credibility towards attracting new franchisees.

Looking forward, as described below, Pizza Inn has recently attracted additional experienced management, is adding franchised units, and is exhibiting substantially stronger average unit economics in a company-owned prototype that should catapult Pizza Inn's performance in the near future.

Selected Investment Considerations

Evidence of operational and profitability improvements at the franchisee level

• Franchisees are re-investing back into the business and generating positive impact from such investments to revamp their store's image and make store and product improvements
• Pizza Inn updated the design of its restaurant prototypes to include salad bars, warmer interior colors and exposed brick; over one hundred units have recently been remodeled
• The first franchisee, who spent $75,000 to remodel a unit, said his dine-in business improved by 25-30%
• Customer complaints are substantially down
• Through September 2008, franchisees evidenced six consecutive quarters of same-store sales growth
• o Although this pattern ended during the December 2008 quarter (with a decline of 3.3%), it can be ascribed to the "perfect storm" that materialized across the economy; same-store sale trends were recently better than industry trends
• As both evidence of the Company's elimination/closure of underperforming franchisees and improvements across the remaining franchised system, the average Buffet unit sales have increased from $641,800 in FY2006 to $718,565 in FY2008 (CAGR of ~4%)

Strong momentum for recently signing new franchisees

• In February 2009, to advance its expansion, the Company hired a thirty-year veteran
• o Vice President of Development Madison Jobe is responsible for leading the chain's franchise development program
• o Jobe's experience includes franchise development leadership positions with Stockade Companies (i.e., Sirloin Stockade, Montana Mike's, Coyote Canyon), Red Robin, Ruby's Restaurants, Shakey's, and Fuddrucker's
• Pizza Inn had 14 new openings in FY2009 and already another 11 in FY2010
• Pizza Inn's standard 4% royalty rate is attractive when compared to other options in the industry, many of which charge as much as 6% of gross sales coupled with higher net worth requirements and overall investment costs)

International franchise development growth has recently been and is envisioned to continue being robust

• Pizza Inn's international presence (started almost 20 years ago) makes it the 7^th largest pizza franchise outside the U.S.
• o Pizza Inn's strongest foothold abroad is the Middle East; international presence exists as well in China and Mexico
• o Approximately 25% of PZZI units are located outside the U.S.; that proportion of non-U.S. mix is more than at Wendy's, Taco Bell, and Papa John's
• In July 2009, to advance its international expansion, the Company hired a twenty-year veteran from Domino's
• o Managing Director of Development for Asia Pacific Anthony Kwok is responsible for overseeing franchise sales growth in the Asian Pacific region
• o Kwok's most recent experience is as Regional Director of Development and Franchising for Domino's Pizza. Prior to Domino's, his 20 years of restaurant experience spans across franchise development, strategic planning and operations management in senior executive positions with pizza chain Papa Murphy's, Wendy's, Hardee's, and Burger King
• In April 2009, PZZI announced a 12 multi-unit development agreement with the opening of the newest international location in Chihuahua, Mexico; the new buffet restaurant was the 70th Pizza Inn to open up outside the Unites States
• In December 2008 , PZZI announced the opening of the first of a 20 multi-unit development agreement in Kuwait with Raja Company W.I.I

Prototype store has performed beyond expectations

• In October 2008, Pizza Inn opened a Company-owned store in Denton, TX; this unit is intended as a prototype for franchisees to witness improved interior and operational design
• The main difference at the prototype unit is a horseshoe buffet table to improve the visibility and operational "back-fed" flow of the Company's mainstay $6.49 all-you-can-eat buffet
• The prototype is achieving more than $30,000 of weekly revenue; this is substantially better (more than 100%) than the average PZZI system buffet unit (some which do just $10,000-15,000 per week) and although it is difficult to assert total comparability to its other markets, my dialogue with numerous PZZI franchisees suggests it exemplifies the enormous opportunity that is available for PZZI's existing and future franchisees as they upgrade their current facilities and interior infrastructure
• o For context highlighting the opportunity to grow average sales per unit at Pizza Inn, it's worth noting that the average sales per unit at PZZI is below all of peer group members; some of this difference is ascribed to the absence of beer in many of PZZI's units and this issue is also among the opportunities being addressed for improvement
• o Note that if the current franchisees were to achieve 60% of the prototype $1.56M in revenue, that would be equivalent to an additional $217,000 of annual revenue per franchised buffet unit which translates to an additional $1.3M in revenue (at 4% royalty and 150 franchised Buffet units as of June) at 100% (since all incremental) franchise margin to PZZI
• o For conservative forecasting purposes, I assume that half of the 150 franchised Buffet units will have improved, on average, their average sales to 60% of the Denton prototype in 2-3 years (i.e., $0.65M of incremental EBITDA to PZZI)
• The Company recently opened another Co-owned unit in Fort Worth which is also generating ~$30,000 of weekly revenue
• o Although management has yet to disclose the cash-on-cash ("4-wall") return of its Company-owned unit, my dialogue with Morrison leads me to believe it's ~30% based on ~$550,000 of investment and at least 10% margin (am using 11% assumption)

Tangible evidence of improvements in financial performance at the Company

• ROIC for FY2008 was 58%, this was largely based on the improvement in EBIT margin at 6.7% in FY2008 versus 1.5% in FY2007
• o Given some margin decline, to 5.5%, and lower asset turnover for the LTM ended September 2009, ROIC was recently 37% (this compares to Papa John's at 26% and Domino's at 42%)
• Food and Supply Margin has been substantially improved, this was largely derived from centralizing distribution efforts with Performance Food Group's Norco and selling warehouse facilities
• o Margin (which includes co-owned units since not reported separately) improved from 4.2% in FY06 to 8.3% in FY08
• o 3-year profit CAGR of more than 20% despite revenue CAGR decline of more than 4.6% (note revenue decline is primarily related to reduction in units from 375 to 309)
• Franchise Margin has also substantially improved
• o Margin improved from 34.9% in FY06 to 53.9% in FY08 despite the decline in units from the end of FY06 (at 375) to the end of FY09 (at 309)
• o Franchise profit CAGR of more than 10% despite revenue CAGR decline of 4.5%
• G&A also has substantially improved
• o G&A as a percentage of total sales improved from 11% in FY2006 to 7% in FY09
• EBIT improved by $4.5M from FY06, at -$2.3M, to FY09, at $2.3M
• o The improvement was driven by margin improvement from -4.5% to 5.2% but there is substantial additional margin improvement available through continued execution
• o Upside opportunity exists to drive margin towards the 12-13% EBIT margin for the peer group (based on publicly-traded restaurant companies with substantial franchised mix, excl MCD); note EBIT margin for Papa John's is 10% and for Domino's is 13%

Recently announced management appointments provide improvements in the quality of management experience to further enable the Company's capacity to execute its expansion and profitability plans

Longer-term upside opportunity is further reinforced by substantial Company buyback coupled with recent insider buying plus the governance and owner-orientation dictated by large hedge fund shareholder (but this same large shareholder is also the key reason the stock was dislocated to as low as $1 last year as described below)

• In 2007-2009, the Company bought back ~2.2M shares at ~$2.17 per share (purchases were made at range of $1.32-2.92)
• In the past year, insiders have purchased $700,000 of stock (i.e., ~5% of the outstanding)
• As described earlier, Newcastle Capital Group is the largest owner and Newcastle's Portfolio Manager/Chairman Mark Schwarz is also Chairman of Pizza Inn
• o As of Q3'09, Newcastle managed ~$150M in equities; this is down from almost $400M at the end of Q3'08; Newcastle has experienced substantial redemptions and distributed PZZI stock to LPs seeking to redeem from the Fund and not surprisingly these LPs sold the stock indiscriminately once received; this has partially created the opportunity but also still looms among the risk considerations
• o As evidence of his own fundamental conviction for PZZI, Newcastle's VP Clinton Coleman, also a Board member, purchased ~$135,000 of stock in the past 24 months
• o Newcastle currently owns 29% of PZZI, down from ~55% in November 2008

Equity Upside based on continued improvement to existing top-line, to existing margin, to expansion in number of franchisees, and some multiple expansion as visibility improves

• Although PZZI has already evidenced tremendous improvements, substantial opportunity for additional improvements still exists
• o PZZI's LTM 5.5% EBIT margin compares to the mean of other publicly-traded franchised systems (excl MCD) at 12% and median at 13%; DPZ is at 13% and PZZA is at 10%
• o With the exception of Famous Dave's and Nathan's, the "comps" have more units and hence scale advantages to post higher margins but I think PZZI has additional margin opportunity from existing units and I assume 8% in my forecast (note that PZZI achieved a 6.7% margin in FY08)
• PZZI's LTM EBITDA multiple of 5.3x compares to the publicly-traded franchised systems at ~8x; for my two-year target I assume 6.5x EBITDA
• Forecasting PZZI two years from now, I assume the following:
• o $3.4M of EBIT based on improving margin on existing revenue to 8%
• o Incremental $0.65M of EBIT as described above from conversion of half of current buffet to improved Denton-like economics (at 60% factor)
• o Incremental $0.7M of EBIT based on assuming 24 new buffet franchisees over the next two years (11 already announced in FY2010 and CEO anticipates at least a dozen per annum) at just the current average of $718,565 and the 4% royalty and excluding any incremental value from food/supply margin
• o D&A at $0.5M based on existing $260K plus D&A associated with two Company-owned units
• o Not included above but of substantial potential value is the embedded option value associated with new company-owned units generating 30%-plus cash-on-cash return
• § Management intends to expand the company-owned mix as described in the financing agreement the Company recently announced. I think each new company-unit has the potential to drive ~$.05-.10 of incremental value per share.
• o Capital spending has increased, because of the two Company-owned units recently launched, from the $250,000 that was spent in the prior two fiscal years; in the absence of additional company-owned units for which I have not ascribed any value, I anticipate free cash flow generation of $4.5M on a cumulative basis in the next two years
• o Assuming no share repurchases (perhaps a conservative assumption given the consistent pattern the Company has appropriately pursued to buyback its shares), my analysis leads to a target of PZZI within two years at $4.75:
• § $4.75 based on 6.5x 2012E EBITDA of $5.25M, $3.9M net cash, 8.0M shares outstanding

Selected Bearish Arguments

Consumer discretionary issues:  yes, I agree that many consumer discretionary businesses will continue to confront risks associated with the deleveraging of household spending and rising unemployment.  I am short many such businesses but PZZI provides a low-cost alternative for the ongoing consumption patterns that will continue to exist for eating out.

Newcastle redemptions:  as described above, this has created the attractive opportunity and further liquidation by Newcastle LPs would pressure the stock but I embrace the PZZI investment for the longer term and hence the Newcastle risk as an attractive opportunity that might develop for price dislocation and volume. I think the pattern of price improvement throughout the past year's redemptions is demonstratively positive given that incremental buyers have quickly emerged.  Newcastle principals continue to evidence their own conviction through personal purchases and it appears the magnitude of redemptions has moderated.

Competition:  there is much competition across the pizza spectrum as 25% of all restaurants are pizza venues.  We all know Pizza Hut, Domino's, Papa John's, Little Caesar's but there are many others that abound including every town's local pizza chain but also other franchise systems like Boston's The Gourmet Pizza, Sbarro, CiCi's (its main competitive peer and incidentally considering a sale), Papa Murphy's, Pizzeria Uno, Round Table, Hungry Howie's, Old Chicago, Peter Piper, Gatti's, etc.  PZZI's success is based on both its appeal to franchisees and obviously to the end market consumer.  Although PZZI competes with every pizza chain in its market, I view PZZI's focus towards smaller markets as among the more attractive parts of its strategy.  There is less competition in smaller markets.  I also deem PZZI as being appealing to the consumer because of its low-price ($6.49) all-you-can-eat buffet and what is also (subjectively in my opinion) a very good tasting product.  On the franchisee front, potential franchisees have thousands of options beyond pizza of course.  From my discussions with PZZI franchisees, I consistently heard that PZZI appealed to them because of the i) low-cost entry; ii) simplified business model; iii) attractive economics often exceeding 40% cash-on-cash return; and iv.) product quality with strong historical brand equity.  These same franchisees would not consider (nor would the chain necessarily embrace) opening a Pizza Hut in a town of 50,000.  As for Domino's and Papa John's, they obviously compete but the buffet franchisees deem a full-service alternative as preferred to the delivery/take-out option.

Execution:  The restaurant industry is a lousy industry but much money can be made from it if management executes well.  The overarching issue of execution is key to unlocking the potential value I envision at Pizza Inn.  As noted, PZZI has suffered from management turnover and governance distractions but CEO Charlie Morrison has thus far orchestrated a strong turnaround as evidenced by improving profitability, renewed interest among franchisees, and success with two company-owned units.  His prior experiences are substantial for a company of Pizza Inn's size and there is of course some risk that more attractive opportunities are offered to him and other members of his high-quality management team.  However, I ascribe little risk to this issue in the short-term as 485,000 options (struck at $2.49) are a motivating factor to the management team and Morrison is rooted for a variety of personal reasons to working in proximity of The Colony, Texas. 

Microcap:  less stock liquidity, no research coverage but hence the opportunity if patience exists and position is sized accordingly for risk management.

Catalyst

• Announcement of additional franchisees
• Continued improvement to margins
• Adoption among existing franchisees to modify design and upgrade facilities to co-owned prototype to drive higher average sales
• Successful launch of additional company-owned units