Value Investors Club / Papa John's (PZZA)

Description

We are short Papa John’s. Papa John’s shares have had a fantastic run, increasing six-fold in the past

five years. To be clear, the company has performed well in over the past several years. Strong LfLs and

double digit growth in international store-count coupled with buybacks have lead adjusted operating

profit to compound at 12% over the past four years and Adj EPS to grow nearly 17%. The investment

world seems enamored with the idea that international expansion + strong LfLs + continued margin

expansion will drive high single digit/low double digit operation profit growth. Coupled with share

buybacks, EPS growth should be in the low to mid teens. This is certainly possible but even if it comes

true, we see little upside in the stock. At $78/share PZZA is priced like a wonderful business with strong

tailwinds for many years to come. However, we think Papa John’s shares offer an asymmetric short

opportunity as we see limited upside and the potential for ~50% downside over the next 2-3 years:

1) Operating profit growth likely to be lackluster going forward – According to Domino’s, revenue

for the US pizza industry failed to keep up with inflation over the past decade (from 2004 to

2014 market grew $31 bn to 32.9 bn) implying volume declines (we don’t have # of pizzas sold

data but estimate -2% pa). While Papa John’s has posted strong comparables, we believe this

trend will be more difficult to sustain going forward as Papa John’s menu is literally the opposite

of healthy eating. We believe that Papa John’s largest market, the US, is nearing full

penetration. We think there is the potential for the market to view this as a mature in a

competitive industry and ascribe a low multiple to the business (as it did in 2010 when shares

sold for 10-11x EPS before shares rocketed 6-fold).

2) Recent EPS growth has been magnified by share repurchases over the past 5 years. While

repurchasing shares at 8-11x forward EV/EBITA generated strong EPS accretion, repurchasing

shares at 25x forward EV/EBITA is much less so.

3) History shows us that things can go wrong in the pizza business – non-controllable factors

include: a) interest rate hike or improved job prospects limiting attractiveness of franchising (b)

labor cost hikes (c) commodity price hikes (d) increased competition, etc. Looking back, we can

see that heightened competition coupled with rising commodity/labor costs lead to declines in

adjusted operating profits from 2008-2010. 2010 operating income was 30% below 2006.

Should conditions be less than favorable, it is entirely possible that PZZA could earn just $2 in

2018. In such an instance, we expect shares would fetch something closer to 13-16x P/E (as it

has done in at times in the past) implying a fair value of just $26-32 in 2018.

4) Valuation – we think restaurant stocks are quite overdone and believe PZZA is significantly

overvalued at present levels – PZZA trades at a whopping 37x 2015 EPS (25x EBITA) and 24x

2018 EPS assuming everything goes well.

5) Acceleration in insider sales – Insiders more stock ($ terms) in April & May then they had in the

preceding 6 years combined.

6) Unlikely to see a transformation via re-franchising – unlike Yum in the early 2000s or Jack in the

Box in 2010, Papa John’s does not have significant real estate holdings. While it could re-

franchise some of its 450+ company owned restaurants, such a transformation would not justify

the company’s current valuation. This playbook is typically used when shares are cheap and

there is an arbitrage between selling restaurants in re-franchising transactions and repurchasing

stock at ~10x EPS.

Company Background

Papa John’s is the #3 pizza chain in the US (with 8% market share) behind Domino’s and Pizza Hut. Papa

John’s has ~690 company owned restaurants and 2,670 franchised locations. In addition, there are

1300+ Papa John’s internationally (almost all franchised except for 49 stores in China). According to

Domino’s, the US QSR pizza category grew from $31.1 billion in 2004 to $32.9 billion in 2014 (0.6%

CAGR, as prices have risen this implies ~2% volume declines per year). Both Papa John’s and Domino’s

have gained market share over the past decade – together with Pizza Hut, the top three players control

an estimated 55% of the US Pizza delivery business and the top four (including Little Ceaser’s) have 41%

of the takeout business. Of course the pizza category competes in a wide range of QSRs and we are

seeing the continued proliferation of fresh mex, premium burgers as well has healthier alternatives.

While Papa John’s has stated that it believes it can eventually get to 6,000 units in the US (similar to

Domino’s and Pizza Hut), I think this is unlikely as:

1) Overall pizza market is stagnant and could possible decline due to healthy eating trends.

Dominos and Pizza Hut are much older concepts than PZZA as such franchisees of Pizza Hut &

Domino’s built their store bases over very longer periods and in better times.

2) With most large and midsize markets already having a Papa John’s, continued expansion

requires moving into smaller and smaller markets which already have a Domino’s and/or Pizza

Hut. It is unlikely that these markets can support a third chain.

3) This seems to be evidenced by recent #s where we’ve seen declining net North American store

growth (system). Last year in North American restaurant count grew by 1.5%. For 2015

management implicitly guides to 56-62 net NA openings implying 1.5% net unit growth.

Thus the real growth for Papa John’s will take place internationally. The company has more than

doubled its store base over the past five years to around 1400 locations. Despite this progress,

international makes a relatively small impact on the group financially, with franchisee revenues of just

$25 million during 2014 (also up roughly 100% in past 5 years). Of Papa John’s international 1400

international locations, 21% are in UK, 18% China, 6% Mexico, 6% South Korea, and 4.5% Russia. I

expect we will see the company continue to add 175-200 net international locations (all

franchised/master franchised) over the next 5 years and anticipate another doubling of international

franchise revenue.

The company also continues to aggressively repurchase shares. While this will increase EPS, given that I

think they are overpaying by 50% or so – as such I’m happy to see them repurchase shares at elevated

levels. Below I show several years of historical data and projections through 2018:

Historicals
	2008	2009	2010	2011	2012	2013	2014
North America
Company owned rest	533.3	503.8	503.3	525.8	592.2	635.3	701.9
Franchise royalties	59.7	61.0	69.6	73.7	79.6	81.7	89.4
Franchise development fees	1.6	0.5	0.6	0.7	0.8	1.2	0.7
Domestic supply chain	431.7	417.7	454.5	508.2	545.9	578.9	629.5
Other	61.4	54.0	52.0	50.9	51.2	53.3	74.2
Total NA Revenue	1087.6	1037.1	1080.0	1159.3	1269.7	1350.4	1495.7
International
Franchise/franch development	12.9	13.2	13.3	16.3	19.9	22.0	25.7
Company owned & supply chain	25.8	28.2	33.2	42.2	53.0	66.7	76.7
Total Intn'l Reve	38.7	41.5	46.4	58.6	72.9	88.6	102.5
Total Papa John Revenue	1126.3	1078.5	1126.4	1217.9	1342.7	1439.0	1598.1
Adj Operating Income*	89.7	76.4	65.7	87.0	99.8	106.5	117.6
OPM	8.0%	7.1%	5.8%	7.1%	7.4%	7.4%	7.4%
Diluted wtd avg shs o/s - split adj	56.5	55.8	52.9	50.6	47.8	44.2	41.7
Stated Diluted EPS	0.65	1.03	0.99	1.08	1.29	1.55	1.75

Other metrics
Systemwide Sales
NA owned stores**	592	588	591	598	648	665	686
NA franchised stores	2260	2255	2344	2463	2556	2621	2654
International franchised stores	505	600	690	792	911	1084	1274
NA comp growth - owned	1.7%	-0.5%	-0.6%	4.1%	5.6%	6.6%	8.2%
NA comp growth - franchise				3.1%	2.9%	3.1%	6.2%
International comp growth -franch				5.1%	7.1%	7.5%	7.8%

*Adjusted Op Income adds back restructuring charges and eliminates impact of BIBP purchasing entity which was used
to smooth commodity costs for franchisees. BIBP was shut down in early 2011.
**Includes 200 JV stores

Projections	2014a	2015	2016	2017	2018
Company owned rest	701.9	758.0	803.5	839.6	877.4
Franchise royalties	89.4	96.6	102.4	107.0	111.8
Franchise development fees	0.7	0.7	0.8	0.8	0.8
Domestic supply chain	629.5	679.9	720.6	753.1	787.0
Other	74.2	77.9	81.8	85.9	90.2
Total NA Revenue	1,495.7	1,613.1	1,709.1	1,786.4	1,867.2
International
Franchise/franch development	25.7	28.0	32.7	38.1	44.3
Company owned & supply chain	76.7	83.6	97.4	113.5	132.2
Total Intn'l Reve	102.5	111.7	130.1	151.6	176.6
Total Papa John Revenue	1,598.1	1,724.8	1,839.2	1,937.9	2,043.7
Operating Income	117.6	133.8	149.5	163.6	179.0
OPM	7.4%	7.8%	8.1%	8.4%	8.8%
Less Interest Expense	4.1	5.8	5.8	5.8	5.8
Assume debt stays constant	230.5	230.5	230.5	230.5	230.5
Less Taxes @ 32%	36.6	41.0	46.0	50.5	55.4
Less Minority	4.4	4.6	4.8	5.1	5.3
Net Income to shareholders	72.6	82.5	92.9	102.3	112.4
Shares o/s - year end	39.8	38.7	37.5	36.2	34.8
Asssume all NI spent on buybacks @ 78
EPS	1.83	2.13	2.48	2.82	3.23
EPS growth		16.7%	16.2%	14.1%	14.5%

At $78/share	2014	2015	2016	2017	2018
P/E	43	37	32	28	24
EV/EBITA	29	25	22	19	17

My NA revenue projections assume that PZZA is able to grow its store base 1.5-2% pa in North America

(which I think is generous given my thoughts above) and comps decelerate from 5-6% in 2015 to ~3% by

2018 (3% is still a very good comp). Because of the assumed strong comp performance I assume a

higher margin on incremental domestic revenue. Internationally, I assume 12% growth from new stores

+ 3-4% from comparables (I assume 2015 to be weaker due to FX). Because all international growth will

be franchised, I assume a 90% flow through of international franchise revenue to operating profit.

While a 90% flow-through is probably too high, I assume no contribution from supply chain sales. All in,

this gets me to 30-40bps of operating margin expansion during the forecast period and an 11%

operating profit CAGR during the forecast period. I assume free cash flow is equal to net income (if I had

to guess, I’d say FCF will trail net income by 5% or so) and that all free cash flow is used to buyback stock

at $78/share (consistent w/ 2015 guidance). This produces EPS of $3.25 in 2018. At today’s $78, PZZA

trades at 24x EPS three years out. It seems that at today’s price, management could execute its

playbook perfectly and the stock could be dead money or worse. I don’t believe anything but a near-

best case scenario is reflected in the stock.

In an alternate universe, comps could fall off as consumers eat less pizza while pizza makers compete

aggressively to try and win them back. Perhaps this occurs as wages and/or commodities rise. It is

possible we’d see modest decline in US revenues and fairly significant declines in profitability (as we’ve

seen in the past – have a look at the historicals). Were this coupled with a slowdown in international

franchise growth, it is within the realm of possibility that 2018 EPS is not materially different than

current EPS but the market might put a 13-16x multiple on PZZA resulting in a $26-32 stock.

Catalysts

-Comp growth weakens

-Commodities/labor costs pressure margins

-Price competition increases

Risks

-Market continues to love restaurant stocks

-Comps continue at mid-high single digit pace

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

-Comp growth weakens

-Commodities/labor costs pressure margins

-Price competition increases

-Enthusiasm for restauarant stocks wanes

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			2015	2016
Price:	78.00	EPS	2.13	2.48
Shares Out. (in M):	39	P/E	37	32
Market Cap (in $M):	3,042	P/FCF	38	33
Net Debt (in $M):	210	EBIT	134	150
TEV (in $M):	3,315	TEV/EBIT	25	22
Borrow Cost:	Available 0-15% cost