Investors are taking on a lot of risk owning Papa John's (NASDAQ:PZZA) equity at present levels. Even though we like the fundamentals of the firm, its market price is way ahead of its cash-flow-derived fundamentals. Let's take a look at Papa John's through the lens of a DCF and apply the Valuentum process to shares.
But first, a little background to help with the understanding of some of the terminology in this piece. At our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
Papa John's Investment Considerations
• Papa John's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
• Papa John's operates and franchises pizza delivery and carry-out restaurants and, in certain international markets, dine-in and restaurant-based delivery restaurants. There are more than 4,000 Papa John's restaurants in operation.
• Papa John's is the third-largest global pizza chain. 80% of its units in North America are franchised, and 95% of its roughly 1,000 international units are franchised. The company continues to grow through taking market share thanks to its brand strength, which we attribute to the firm's quality focus.
• The company possesses excellent unit economics and a leverageable infrastructure. Management estimates that the brand can support an additional 3,000+ international units and 1,000+ domestic units. Papa John's continues to be recognized for its pizza, and the company is experiencing rapid growth in online and mobile ordering.
• Papa John's development incentive plan is impressive: zero franchise fee, royalty reduction, set of two middleby ovens -- a value of over $60,000. This should aid expansion.
• If a company is undervalued both on a discounted cash flow (DCF) basis and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Papa John's posts a Valuentum Buying Index score of 4, reflecting our "overvalued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. Even though the company's fundamentals speak to a strong and growing franchise, we'd steer clear of shares at this juncture. A good company does not always equal a good stock, and the company's price drop from $54 per share to $44 per share within the past two months alone is evidence of that.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Papa John's 3-year historical return on invested capital (without goodwill) is 59.8%, which is above the estimate of its cost of capital of 10.4%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Papa John's free cash flow margin has averaged about 4.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Papa John's, cash flow from operations was roughly flat from levels registered two years ago, while capital expenditures expanded about 73% over the same time period.
Our discounted cash flow model indicates that Papa John's shares are worth between $30-$46 each. Shares have fallen rapidly in two months since we published this fair value range on our website, with the company now trading at about $45. We don't think shares are cheap, and we'd caution investors that even after the fall, the company's valuation is far from attractive. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
The estimated fair value of $38 per share represents a price-to-earnings (P/E) ratio of about 24.2 times last year's earnings and an implied EV/EBITDA multiple of about 5.3 times last year's EBITDA. The fair value estimate represents the mid-point of the fair value range, and Papa John's shares trade north of this level. Our model reflects a compound annual revenue growth rate of 6.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 8.5%. Most of the revenue growth decline is driven by the "law of large" numbers -- we don't think revenue acceleration over the next five years makes much sense for an established and well-known pizza concept. Our model reflects a 5-year projected average operating margin of 9.2%, which is higher than the firm's normalized operating margin in the 7%-8% range by our calculations. We're building in some profit expansion thanks primarily to scale benefits.
Beyond year 5, we assume free cash flow will grow at an annual rate of 3.5% for the next 15 years and 3% in perpetuity. The free cash flow growth rates are supported by the company's ongoing growth strategy and the investment it necessitates. For Papa John's, we use a 10.4% weighted average cost of capital to discount future free cash flows.
Our discounted cash-flow process allows us to arrive at an absolute view of the firm's intrinsic value. However, we also understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money-managers--those that drive stock prices--pay attention to a company's price-to-earnings ratio and price-earning-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash-flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes and to provide a broad industry perspective, we compare Papa John's to peers Starbucks (NASDAQ:SBUX), Yum! Brands (NYSE:YUM), and McDonald's (NYSE:MCD). Even on the basis of normalized earnings or normalized EBITDA, Papa John's is expensive. The market is paying too much for growth.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $38 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Papa John's. We think the firm is attractive below $30 per share (the green line), but quite expensive above $46 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Papa John's fair value at this point in time to be about $38 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Papa John's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $50 per share in Year 3 represents our existing fair value per share of $38 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.