Description

Papa John’s International (PZZA) is the third largest Pizza chain in the world, and the fourth largest domestically. Founded in 1985 by current CEO John Schnatter, PZZA went public in 1993 with 270 stores and now has over 2600 stores in operation. From day 1, Schnatter has differentiated the company from competitors by a fanatical focus on quality pizza, as opposed to Pizza Hut which emphasizes a dining experience with nonpizza choices, and Domino’s which emphasizes speed of delivery. Furthermore, Schnatter has kept the operation simple by focusing only on take-out pizza, which makes for low store startup costs, low inventory, and simple operations.

In the competitive Pizza industry, PZZA has managed to grab market share from its larger, established competitors, Pizza Hut (#1), Domino’s (#2), and Little Caesar’s (#3 domestically), growing via internal growth, franchising, and acquisitions. By almost every measure, PZZA is blowing away the competition:

· leads all national pizza chains in per store sales averages and comparable sales growth

· PZZA rated #1 in quality and customer satisfaction among ALL national fast food chains since being included in University of Michigan’s American Customer Satisfaction Index 2 years ago.

· ROE, ROIC consistently among the highest of ALL national fast food chains.

· Exceptional unit economics (see p.3 of 1999 10-K).

Threatened by PZZA’s rapid growth and success, Pizza Hut (YUM) went to court to stop Papa from using their advertising slogan “Better Ingredients, Better Pizza.” After 2 1/2 years and several appeals, Pizza Hut was defeated on March 19, 2001, when the Supreme Court declined Pizza Hut’s request to review the case (thus upholding the Fifth Circuit Court of Appeals’ ruling that Papa John’s could continue using the slogan).

A quick glance at PZZA’s financials shows annualized increases in revenues, cash flows, earnings, and book value all in excess of 30% for the past 5 years. ROIC has been running higher than 15% for the last few years except for 2000. Earnings quality is suspect, as PZZA engaged in a bit of “big bath” accounting in the fourth quarter of 2000 – most of the “nonrecurring” charges should have been part of recurring but lower earnings in the past. Nevertheless, even spreading out these charges into the past, PZZA has had in impressive 8 years since going public.

Shareholders are understandably more interested in the present and the future than PZZA’s wonderful past. Increased competition (primarily price promotion) has led to rapidly declining sales comparisons and earnings during 2000 for PZZA as well as its competitors. 2000’s net income declined 37%, though EPS declined by a lesser amount due to share buybacks. PZZA’s stock price has fallen along with earnings, as many investors now believe that the category has become hopelessly competitive, not allowing PZZA to resume high margins, high ROIC, and rapid growth. PZZA’s P/E, which has historically been above 30, is about 13 (excluding nonrecurring Q4 charges).

However, I believe that much of the pizza industry’s problems (especially PZZA) are temporary, due to unusually low cheese prices in 2000. Cheese is about 40% of the food cost in pizza. While PZZA does not like to engage in price discounting, its competitors routinely intensify discounting when the price of cheese drops, which forces PZZA to follow suit. During 2000, discounting was particularly fierce, as cheese prices were the lowest they’ve been in years.

While low cheese prices have the positive effect of lowering material costs, this advantage is overwhelmed by three negative effects:

1) price discounting by competitors increases, pressuring sales
2) PZZA also discounts, which lowers sales and margins
3) PZZA’s “cheese price stability” program (begun 12/27/99), designed to protect restaurants from rising cheese prices, also acts as a hindrance when cheese prices are very low and/or falling, as the price adjustments to the stores lags the cheese market.

To test my theory, I prepared a chart of comparable store sales per quarter in 2000, along with an estimate of average quarterly cheese block prices (see http://www.ams.usda.gov/dairy/mncs/graphs/$cheese_cme_weekly_blocks_web.PDF for a graph of cheese prices over the past few years). I computed the difference in cheese prices between Q1 ’99 and Q1 00, Q2 ’99 and Q2 ’00, and so on. There was a fairly strong negative correlation between these cheese price differences and the comps. For example, the third quarter had the largest cheese price differential (Q3 ’99 about $.35/lb lower than Q4 ’00), and it also had the worst comps in PZZA’s history (0.6% comps systemwide). During the fourth quarter, the differential decreased while PZZA’s comps increased. Keep in mind that this comparison is crude as I do not know the actual dollars PZZA and its competitors are paying for cheese, and due to contracting there may be lags of at least a few weeks, if not longer, between the prices I got from the USDA graphs and the time they show up in PZZA’s (and competitor) pricing.

A further test of my theory was whether a prediction would come true. For the first time in over a year, cheese prices have begun rapidly rising since mid February, causing cheese prices to actually be higher than they were a year ago, instead of lower. Therefore, my prediction was that competitors would slow down price promotions and so would PZZA, causing comps to rise in February or March, and especially April. February’s comps were higher but this was an unfair test as PZZA ran its anniversary promotion in 2/01 but not 2/00 (plus it was probably too early for higher cheese prices to be having an industry wide impact). However, PZZA reported March numbers 4/12/01, and they were 2.9%, which I believe is the highest comps they have reported (February with its promotion excepted) over the last 12 months. April will also be an unfair test as PZZA ran their anniversary promotion 4/00 but will not do so 4/01, which will cause difficult comparisons. Anniversary promotions may obscure the relationship between cheese prices and PZZA’s sales and margin performance for a couple of months, but I believe that the overall trends are in place – so long as cheese prices continue to climb, the pizza industry should benefit, and PZZA especially for the 3 reasons listed above working in reverse.

It may take investors a few months to believe the increasing comps will continue, given the obfuscation caused by special promotions. Short term, retailer stock prices tend to (irrationally) react to near term comps as opposed to assessments of intrinsic value. So long as cheese prices continue to climb, comps will rise for PZZA, and this will cause investors to react accordingly. While I am not expecting a return to PZZA’s prior history of 30+ P/Es, even a 20 P/E puts PZZA’s stock price in the vicinity of $40.

For investors looking to hold onto PZZA for the long term, their world pizza market share is less than 5%, allowing for many years of potential expansion. If you do a side by side comparison of PZZA to MCD (dominant company in a similar industry), you will see that despite having more promising growth prospects and better financials, PZZA trades at a considerably lower P/E than MCD. Like MCD, PZZA has an unwavering focus on doing a few things well, which should allow it to continue to beat out its competitors for many years to come.

Catalyst

Rising cheese prices will lead to higher comps.