Papa John's: Is The Growth Model Broken? (NASDAQ:PZZA) (2024)

One of my favourite stock screens for new value ideas is to look for stocks making new 52-week lows. For the most part, stocks make new lows because their fundamentals justify their declines. However, fundamentals can also change, and if a turnaround is successful, investors who buy near the bottom can make handsome returns.

One recent name that has come up in my stock screens is Papa John's International (NASDAQ:PZZA), as the company is currently trading at levels last seen in the early days of the COVID-19 pandemic (Figure 1).

Some online commentators with large follower counts mention that PZZA's stock price is even more oversold (lower RSI reading) than during the COVID-19 pandemic and due for a bounce. While they may be correct about the technical picture, I am more concerned about the long-term prospects for the company.

I believe the root cause of Papa John's issue is stagnant same-store sales growth, as it has an inferior ordering app and poor value proposition. Unfortunately, management appears to be myopically focused on improving corporate margins at the expense of franchisees. While that may boost short-term financial returns for the company, franchisees seeing diminishing returns from Papa John's franchises will negatively affect the company's long-term growth trajectory, which may cap the company's valuation multiple. Until Papa John's management can address the same-store sales weakness, I am hesitant to invest. I rate PZZA stock a hold.

Company Overview

Papa John's International is the franchisor of one of the world's most recognized pizza restaurant concepts. The company was ranked #22 in Franchise Times Top 400 list, making it the #2 pizza franchise behind Domino's (DPZ).

The company was started in 1983 by John Schnatter in the broom closet of his father's tavern, with a focus on crafting delivery pizzas using high-quality ingredients. Today, although the controversial founder is no longer associated with the company, Papa John's has grown to become the world's third-largest pizza delivery company with close to 6,000 restaurants in its network (Figure 2).

How Do Franchise Restaurants Create Shareholder Value?

The formula for creating shareholder value in franchising stories like PZZA is very simple. A restaurant can usually increase menu prices at a low-single-digit ("LSD") rate. Combined with modest LSD transaction volume growth, healthy restaurant chains can usually see mid-single-digit ("MSD") same-store sales growth ("SSSG") or better.

At the same time, as long as the brand is not overly saturated, new franchisees can be found to open stores and replicate the business model across the country and even internationally. By opening new restaurants in new geographies or in-fill existing territories, healthy restaurant chains can usually grow the number of stores in its network by MSD rates.

The combination of MSD same-store sales growth and MSD unit growth translates into high-single-digit ("HSD") to low-double-digit ("LDD") revenue growth for the company. Sprinkle in a modest amount of operating leverage, for example, by growing revenues faster than corporate G&A, and restaurant chains can then deliver 15-20% operating income growth, which supports strong valuation multiples and a steadily increasing stock price.

Chipotle Mexican Grill (CMG) is a classic example of a successful restaurant growth story, as the fast-casual chain has grown from 16 restaurants in 1993 to over 3,000 by the end of 2023 (Figure 3).

By consistently delivering steady same-store and unit growth, CMG's stock price has soared from $40 when it IPO'd in 2006 to over $3,000 today, making CMG one of the best stock investments in the past few decades (Figure 4).

PZZA's Growth Formula May Be Broken

For many years, Papa John's was on a similar trajectory, with its stock price steadily rising from a split-adjusted $2 / share in 1993 at its IPO to a peak of over $130 in 2021 (Figure 5).

Along the way, Papa John's has survived the dot-com bust in the early 2000s, the Great Financial Crisis in 2008, the NFL controversy in 2018 (which led to Mr. Schnatter's ouster), and even the COVID pandemic in 2020, each time recovering and surpassing its prior highs as its growth formula had stayed intact.

However, in the past 2 years, Papa John's has seen its stock price decline by over 60% as its growth formula appears to be broken. While Papa John's has continued to open new restaurants at a steady pace, with 208 restaurants net added in 2023 and 48 restaurants net added in 2022 (inclusive of 188 restaurants operating in Russia that were suspended following Russia's invasion of Ukraine), Papa John's global comparable sales growth has stalled to flat or negative since the beginning of 2022 (Figure 6).

Is It The Consumer Or Is It The Company?

Management attributes recent weak comps to value-conscious consumers "check managing a little bit more". However, we see that peer pizza delivery chain Domino's has delivered much stronger comparable sales results with the same consumer headwinds, especially in the last few quarters (Figure 7).

This begs the question, does Domino's have a superior product or value proposition allowing it to outperform Papa John's?

Poor Ordering Experience Could Be A Contributing Factor

Part of Papa John's issue could be an inferior ordering app, as pointed out by some online reviewers. This was confirmed by Papa John's management in the latest quarterly conference call, when they mentioned that continued growth in the aggregator channel (i.e. Uber Eats) was "more than offset by a decline in organic delivery" through their proprietary app.

It appears Papa John's needs to focus on retooling their proprietary ordering app to improve the guest experience and conversions to sales.

Back To Better 2.0 The Main Focus

Unfortunately, management appears to be primarily focused on their Back To Better 2.0 restructuring program, aimed at improving margins in Papa John's commissary business.

As a reminder, Papa John's earns a significant portion of its revenues from its commissary business which sells prepared dough, sauce, ingredients, and cleaning supplies to its franchisees at a fixed 4% operating margin (Figure 8).

After careful review, management decided to change the margin structure of its commissary business, from 4% fixed operating margins to an 8% operating margin by 2027 (Figure 9). Beginning in 2024, Papa John's aims to gradually increase the operating margins of the commissary business by 100 bps per year for most franchisees.

In exchange for higher commissary rates, franchisees may see a rebate for higher volume growth, as well as a reduction in their contributions to the marketing fund.

While improving operating margins in the commissary business is welcome, I believe management's myopic focus may be distracting them from the bigger issue of stagnant same-store sales growth mentioned above.

Readers should note that the past 2 years were characterized by the highest rates of inflation in the past 2 decades, so if a restaurant's comparable sales did not show growth, it means franchisees likely saw a reduction in their financial returns as costs have definitely risen.

If this franchisee-profitability issue is not addressed, then Papa John's will become a less attractive investment opportunity, negatively affecting their future unit growth prospects as well.

Valuation Cheap For A Reason

Valuation-wise, Papa John's stock is currently trading at 16.9x Fwd P/E, a large discount compared to its closest peer, Domino's, at 27.8x (Figure 10).

However, I believe this discount may be warranted, given PZZA's weaker SSSG trend. Until PZZA can regain sales traction, its shares may continue to trade at a discount.

Risk To Cautious View

There are several key risks to my cautious view. First, as mentioned at the beginning of this article, PZZA's stock has been in freefall since early 2022 and is deeply oversold, so a violent rebound may occur.

Moreover, the company recently began transitioning to a new marketing strategy with "new visuals, new tone, [and] new media mix." Perhaps that is enough to turn around the company's flat same-store sales growth.

However, without concrete evidence of a turnaround, investors buying right now may be simply wishful thinking.

Conclusion

Papa John's is the world's # 3 largest pizza delivery chain. The company has recently fallen on hard times, with its stock declining by over 60% from its all-time highs.

I believe the root cause of Papa John's issue is stagnant same-store sales growth, which is not being properly addressed by management, who are myopically focused on boosting commissary margins. Until PZZA returns to positive comparable sales growth, I am hesitant to invest. I rate PZZA a hold.

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