Papa John's International: The Turnaround Has Just Begun
Dec. 17, 2019 12:36 PM ET | About: Papa John's International, Inc.
Stamina Capital
Summary
We believe that Papa John's International, Inc. fits our turnaround framework with ~50% upside over the next 12 months.
The company has hired a highly qualified new management team with a clear plan to accelerate comparable store sales, drive improved unit economics, and improve net restaurant growth.
We believe PZZA has a reasonable chance of a take out over the next 2-3 years which could drive as much as 75-100% upside.
Elevator Pitch
We believe that Papa John's International, Inc. (PZZA) fits our turnaround framework with ~50% upside over the next 12 months driven by a highly qualified new management team with a clear plan to accelerate comparable store sales, drive improved unit economics and improve net restaurant growth. Furthermore, we believe PZZA has a reasonable chance of a takeout over the next 2-3 years which could drive as much as 75-100% upside.
Rob Lynch (the new CEO hired in September 2019) was part of the highly successful Arby's turnaround where he helped drive average unit volumes (AUVs) >25% over ~4 years through menu innovation and superior marketing - we believe that he will use a similar playbook at PZZA which should drive comps up to 3%+ (from negative over the past two years). [1]
The company has brought on a best-in-class team to support Rob with a new COO (Jim Norberg who was the former Chief Restaurant Officer at McDonald's North America) and a new CMO (Max Wetzel who worked with Rob at Heinz)
Starboard Value owns ~15% of the company which improves alignment across shareholders and the new management team
We believe that PZZA has the potential to dramatically increase new stores over the next decade as it currently has 5,000 units while its closest peers have 15,000 - 20,000 units (Domino's and Pizza Hut). [1]
PZZA currently has ~5,000 units with ~600 company-owned North American locations, ~2,650 North American franchised locations (flat over the past 3 years) and 2,100 international locations (growing at 7-10% per annum)
Primary research suggests that there is a new group of franchisees (brought into the system in 2019) that plan to accelerate net restaurant growth as the unit economics continue to improve
Business Description
PZZA is one of the big 4 in the pizza industry with a ~10% share of total US sales. [1] PZZA is modestly higher priced than its other 3 peers as its quality is perceived to be higher than Domino's, Pizza Hut and Little Caesars - hence the company slogan "better ingredients, better pizza." PZZA predominantly generates revenue through three sources: (1) sells pizza through its owned stores (2) makes a royalty of ~5% on sales of pizza at the franchisees (3) sells dough, sauce, ingredients, and equipment to its franchisees with a markup. While PZZA clearly sells pizza, we frame it slightly differently. We believe PZZA sells entrepreneurship to small business owners. PZZA generates the majority of its income from the franchisees and in turn is highly incentivized to have those franchisees grow units. The franchisees typically invest many multiples of the parent company in capital expenditures and marketing to grow the brand.
Industry and Company Background
The pizza industry is an a-cyclical slow grower in the US, (growing <1% per annum since 2010) but the big 4 have continued to gain share growing LSD to MSD annually as they take business from local mom and pops. Internationally, pizza grows in the MSD to HSD per annum and there is significant white space (PZZA grows units at HSD annually). Between 2010 and 2017 PZZA grew by ~7% CAGR with comps in the 3-4% range and units growing ~3-4% CAGR. Over that period EBITDA grew at ~7% CAGR and EPS grew at ~15% as the company bought back ~30% of the outstanding shares. Returns on capital improved over time and the stock appreciated from ~$12 a share to over $90, generating >6x return.
In the middle of 2017 growth began to slow. While it is impossible to pinpoint why the growth slowed, John Schnatter (the John in Papa John's) attributed it to the NFL where Papa Johns was the official pizza sponsor. As some of you may remember, Colin Kaepernick knelt during the national anthem in response to police treatment of minorities in America. NFL ratings suffered as some viewers believed it was distasteful and Schnatter made his views public on conference calls driving negative publicity. Schnatter decided to seek public relations assistance from an outside consultant through 2018. In July of 2018, one of his private conversations with the outside consultants was leaked to the media. Schnatter used a derogatory racial slur which drove dramatic negative publicity. Comparable company sales imploded, dropping >13% in Q3 and Schnatter was eventually pushed out as both CEO and Chairman. He was replaced by Steve Ritchie, a long-time employee of the company. Schnatter continued to do damage to the brand as he berated the company and board from outside the organization and eventually decided to sell down half of his ~30% stake in the company.
In February 2019, Starboard Value decided to invest ~$250m via convertible preferred equity. Starboard condemned the actions of the previous CEO and supported the company's new direction that emphasized racial/gender inclusion, employee training, and community outreach to those that were offended by the previous CEO's horrific comments. The proceeds were used to pay down debt and provide liquidity for the company to invest in royalty relief and the marketing fund. In March 2019, PZZA partnered with Shaquille O'Neal to become one of the company spokesmen. Through the first three quarters of the year, the company continued to struggle but made progress in stemming store closures and hiring a new management team. In April the company hired Karlin Linhardt as CMO (former executive from Subway and McDonald's that has since been replaced by a former colleague of the new CEO) and in July added Jim Norberg (former EVP and COO of McDonald's) as Chief Restaurant Operations Officer. Through the period we tracked the company but decided to pass as we wanted a new outsider CEO. At the end of August, the company announced that Rob Lynch would join as CEO. Lynch previously was the CMO and President of Arby's. Arby's was purchased by Roark (private equity) in 2013 and is widely perceived to be a highly successful turnaround where Rob was a significant contributor over his 6 years with the company. Rob was credited with the "We Have The Meats" campaign that to this day defines the brand. Rob also worked under Brian Niccol of Chipotle at Taco Bell (another highly successful turnaround we monetized in 2018/2019).
Thesis/Variant Perception
Thesis Point 1
Pre-2017 PZZA was a highly successful franchise model despite its historically sub-par management team. The new management team is best-in-class and we believe they have the potential to dramatically improve operations, unit economics, and growth.
From 2007-2017 PZZA had ~10 years of positive comps and grew their restaurant footprint by ~60%. Over that period, PZZA had limited menu (all in the pizza category) and marketing innovation and franchisee unit economics were stagnant at best. We believe that Rob Lynch and the new management team have the potential to dramatically improve all components of the business.
Thesis Point 2
PZZA has the potential to drive industry-leading comps driven by menu innovation, improved marketing/loyalty programs and partnering with the platforms (Uber, DoorDash, etc.) to increase their customer base.
The PZZA menu has been stagnant for a decade with limited innovation in health-conscious products (salads, meat-less, etc.) sides or sandwiches. On the Q3 2019 earnings call Lynch suggested menu innovation was top of mind and that they had "taken the guardrails off the innovation team." Over the past year, the company has been testing many new products and primary research suggests there are ~5-10 new products that could launch over the next 1-2 years.
Rob Lynch is a marketing guru and was credited with Arby's highly successful "We have the meats" and the viral "Vegetarian Hotline" which we believe he will use as a template at PZZA. He was also a driving force in re-orienting the marketing mix toward more social media, more effective national media and highly targeted local campaigns. Primary research suggests that the management team has quickly changed advertising agencies de-emphasizing their national sports league spend for more locally relevant community-based advertising and that it has gone a long way. Shaquille O'Neal was brought on as a national spokesman and board member to improve brand image and target lapsed minority customers.
PZZA is partnering with the aggregators (Uber Eats, DoorDash, etc.) to expand their customer base and drive orders at accretive unit economics. PZZA has struggled with finding both in store and delivery labor over the past few years and partnering with the aggregators has the potential to improve service levels and time to delivery. Aggregators have limited customer overlap with the core PZZA customer with the company suggesting ~80% of app users are new to the brand. The margins to franchisees are accretive as the aggregators sell at retail prices (typically $15+ for a pizza) vs ordering direct from PZZA where they offer consistent discounts (typically ~$10 for the same pizza) providing ample margin to pay the aggregator take rates. While under 3% of revenue today, we believe that the company can scale to HSD over the next few years at strong incremental margins to the franchisees.
PZZA has a loyal customer base despite limited personalized marketing. We believe that Lynch has the potential to significantly improve the PZZA loyalty program to increase frequency, expand day parts and drive ticket in line with other leading brands (Domino's, Chipotle, Chik-Fil-A) that have created highly engaging one-to-one customer relationships.
Thesis Point 3
PZZA has the potential to accelerate new unit growth in both North America and internationally with over 1,000 new units already under negotiation. PZZA has doubled international units since 2012 but is still a fraction of its major competitors that have ~4-5x the number of units. There is significantly less competition outside of North America and the brand is already in 44 countries. Over time we expect the company to densify its network in Europe/Russia and drive incremental growth in Asia and Latin America. Primary research suggests the potential to expand the European unit count by 1,000-1,500
PZZA has not been focused on growing its North American unit base for the past few years but that is set to change as the company improves unit economics. Primary research suggests the majority of closures are behind us. Since joining, the new management has re-engaged the North American franchise base and primary research suggests they are extremely excited about menu innovation and cost savings opportunities which have the potential to take unlevered cash on cash paybacks to ~3 years. The research also suggests there are many opportunities to consolidate and add new and better capitalized franchisees with the potential to meaningfully grow new units. Through the recent weakness, we believe savvy franchisees have started to consolidate the base and have already committed to growing.
Thesis Point 4
PZZA has a reasonable likelihood of being acquired by one of the large restaurant consolidators who value (1) the international growth opportunities (2) a-cyclical demand and (3) the resulting leveragability of assets which significantly reduces the cost of capital
At $2.6bn total enterprise value the asset is highly digestible by the much larger industry consolidators
Restaurant Brands International, Roark (private equity that owned Arby's/Buffalo Wild Wings/Sonic, etc.), JAB (owns Panera, Peet's Coffee, Einstein Bagels, Pret-A-Manger) and Wendy's are all potential bidders
Set Up
We believe that the set up for the stock is strong as there are forced buyers, a known short-term seller that has pressured the stock but will have fully liquidated their position in Q1 and accelerating comp store sales growth
PZZA is heavily shorted with ~4.9m shares on loan representing >18% of total shares and ~30% of lendable shares. As our thesis plays out we believe there will be "forced buyers" to accelerate the return profile
PZZA's former CEO (John Schnatter) has been aggressively liquidating his stake in the company selling ~2.5m shares or 6 days of trading volume in the past 6 weeks pressuring the stock and despite that the stock is up which speaks to the investor interest
Comps have inflected positively and have accelerated to >4% based on the most recent data and primary research checks.[2]
A combination of easier comps (down ~8% in Q4 2018), better advertising and modest menu innovation has driven an improvement in traffic that we think sets the stage for a strong 2020
Further, we expect strong margin flow through as the company has put new cost savings measures in place aimed at accelerating margin recovery
Valuation
Base Case
Our base case implies a value of ~$85-90 per share based on a discounted cash flow model where we assume:
~200 net restaurant growth ("NRG") per annum (160 international and 40 in North America which is in line with the 2011-2016 openings)
System wide comps of ~3% per annum (in line with the industry and below the 2011-2016 average) which drives AUV back to the previous peak of $1.1m by 2023
Operating margins that recover to "pre-crisis" 2016 levels in 2023 (at ~9.6%) and grow ~40-50 bps per annum thereafter
An 8% weighted average cost of capital and a 2% perpetuity growth rate
Risk Case
Our risk case implies a ~$50 stock price (NRG of 180, ~0-1% comps, margins that reach previous peak levels in 2027, similar discount rates).
Our reward case implies a price over $100 and assumes a faster recovery (~5% comps in 2020 and 2021, 300 NRG and back to peak margins by 2023, similar discount rates).
Pre-Mortem/Risks
1) Management turnover - we are explicitly betting on the new team and would consider exiting the position if the CEO/COO were to abruptly leave without a comparable replacement.
2) Food scare that drives customer defection - while unlikely given the nature of the cooking process, this is always a risk in the restaurant space.
3)"John Schnatter risk" - the former CEO has consistently made derogatory public comments about the business and its management team. While we doubt that the comments matter to customers or the fundamentals, we would be concerned if he were to repeat his racial slurs or potentially alienate customers through his political affiliation.
4) Platform proliferation - UberEats, Grubhub, DoorDash, Postmates, and other upstarts have increased competition in the delivery space. While PZZA has partnered with the winning platforms, there is always a chance that new food choices could drive lower pizza consumption (the most common bear case for Domino's).
Key Investment Factors
1) Comparable store sales - marketing, menu innovation, platform partnerships
2) Franchisee unit economics
3) Net restaurant growth
