Description

Though Papa John's appeared on this board over 2 years ago, it deserves another serious look. Not only is the valuation still compelling (perhaps more so), there is a new catalyst: There has been a fundamental shift in the philosophy of the CEO/founder with respect to new products and national TV advertising, which should meaningfully improve results over the next twelve months.

Papa John's operates 570 company-owned and 2,366 franchised pizza delivery restaurants in 50 states and 15 international markets, though international is only 3% of revenue. The company makes money from franchisees two ways: royalties on unit revenue, and selling food and supplies. PJ has a 6% industry share compared to 17% for Pizza Hut, 10% for Domino’s, and 4% for Little Caesars. Since 1999, the company has spent nearly $400 mil buying back almost half its shares outstanding. In Feb ’04, mgmt approved another $400 mil repurchase authorization. John Schnadder, the CEO and founder, owns almost 30% of the stock.

Despite the massive stock repurchases, PJ's stock trades at levels below those of 8 years ago. For the last 4 years, the stock has traded mostly sideways, as the business has suffered from repeated disappointments. Investors today worry about: high commodity and fuel costs, persistent discounting/couponing, 3 years of flat to negative comp sales, and increasingly, a fear that these conditions are a threat to the survival of a significant percentage of the franchisee base. Indeed, short interest now stands at 34% of the float (though it has been high for years).

Variant Thesis:

PZZA is compelling because it is a quality company with a good business, a highly vested management, and a near term catalyst to close the existing price/value gap.

• Good business – PJ has ranked #1 for 5 consecutive yrs in Customer Satisfaction among all national pizza chains, as well as among all national fast food restaurants in the American Customer Satisfaction Index conducted by the Univ of Michigan B-School. Though fast food (QSR) is a tough business, the unit economics of a pizza delivery-only restaurant is surprisingly good. The capital costs are low and unit revs and margins high, allowing comparatively attractive ROI’s. Though MCD and WEN generate just 8-11% ROIC’s, delivery-only pizza restaurants like PJ and Dominos generate superior economics (over 15% ROI’s) by virtue of the following characteristics: 1) cap ex and operating expenses are comparatively lower b/c the restaurants are smaller (only 1,500 sq ft b/c no dining room) and can be in less prestigious/high demand locations; 2) marketing is more efficient because the restaurant knows the names, addresses, and ordering patterns of its customers.
• Vested management – the founder and his family still own 30% of the stock. The former COO (still on the board) owns 4%.
• Clean balance sheet – PJ has very little debt and generates a tremendous amount of FCF (more on this below).
• Catalyst – Beginning in July and continuing through the end of ’04, PJ is launching a major new marketing campaign which should greatly improve same store results. Historically, PJ’s founder had been opposed to new products and national TV ads (preferring to focus on a small menu and grass roots local marketing). However, it is now a well known fact in the pizza delivery biz that new products, when combined with TV advertising, really make the phone ring. Indeed, during 2003 three of the four months that franchisees comped positively were ones in which PJ launched new product promos (even the 4th was a month immediately following their most successful new product). All other months comped negatively. Apparently, the founder has seen the light (or has begun listening to the griping franchisees). Beginning in July PJ is increasing its national TV advertising budget by over 60% (from 2% to 3.25% of sales), and has begun a dedicated effort to roll out new products (mostly various types of pizzas, but also chicken wings in Q4 and salads in 1H ’05 – both of which should nicely drive avg ticket sales. So compare the next twelve months with what PJ did in 2003: Beginning July ’04, PJ will run 7-9 national TV flights, each of which will include new product promotions, compared to the 3-5 national flights and 3 new product intros in 2003. Improved comps at the franchise level will be very meaningful to PJ, as royalty revenues are almost 100% margin, and commissary margins carry high incremental margins.

What could go wrong?

• If the above efforts don't improve results, franchisee growth will be stagnant, and worst case, franchise units closures could outnumber new unit additions, as struggling franchisees might be unable to keep their doors open. Since PJ is about 80% franchised, franchisees generate the large majority of FCF.
• Margins could be squeezed if the increased spending on new products and TV ads fails to generate enough new sales.
• Cheese or fuel prices do not moderate and these costs are not passed along to the customers, thereby squeezing margins.

Valuation:

Notice that FCF/shr is higher than EPS for two reasons: 1) cap ex is $5-10 mil lower than depreciation and 2) PZZA has negative WC, which benefits CFFO as long as the company is growing.

If average weekly unit volumes and margins “normalize”, PZZA could generate in excess of $3.50/shr in FCF next year – possibly even as high as $3.80 (and note that PZZA’s normalized FCF was about $3.60/shr in 2002 based on the current share count). Hence, PZZA trades at about 8x FCF. A conservative DCF suggests an intrinsic value in excess of $40 (assuming 3% perpetual growth, a 10% discount rate, and subtracting for net debt and the options over-hang).

Valuing the company based on comparables suggests a stock price in the mid 40’s. “Cash EPS” (adding back excess depreciation) should be about $3 per share if the above mentioned turn around efforts pay off. Considering mature QSR stocks trade at about 14-15x FY2 earnings, this gets a $42-45 target price (about 50% above current levels).

Longer term, there could be a virtuous cycle: if comps begin growing again, new franchise unit growth resumes, which is very additive to margins and the earning growth rate. And then there is always the Kool-aid of international growth.

Catalyst

• New marketing initiatives (new ads and new product launches) begin to pay off in 2H. Indeed, the increased TV and ad spend began in July, and PJ posted a healthy 3.3% comp, reversing a recent string of negative comps. Expect a so-so August number and very strong September number.
• Eventually fears of high commodity costs and gas prices should pass (hopefully).
• Domino’s just went public in July, so investors finally have a publicly traded comp, and mgmt road shows should hopefully educate investors about: 1) how attractive the pizza delivery biz is relative to traditional QSR, 2) the overall environment for pizza is positive and improving (more levered to an improving economy, less discounting), 3) the history of Dominos strikes remarkable parallels to PJ today. DPZ once had a founder-CEO who staunchly opposed new products, which ultimately resulted in sagging results and strained franchise relations. Eventually, he conceded, Dominos began new products, and results improved.