Pizza Inn: A 6-Point Inspection

Sep. 4.14 | About: RAVE Restaurant (RAVE)


Pizza Inn’s scale is small.

Pizza Inn’s solid balance sheet is counter balanced by its red ink.

Pie Five units serve as a tiny bright spot.

It's always important for a long-term investor to develop a guide for doing prospective investment research. Over the years I have developed six questions to guide me in my thinking when researching the publicly-traded universe. It's especially important when researching small-cap companies with limited media coverage. With that said, let's take a look at Pizza Inn (NASDAQ: PZZI)

1.) What does the company do?

When you buy shares in a company you effectively become part owner of that company, and it's important for investors to understand what their companies sell.

Pizza Inn and its franchisees operate 274 restaurants under the names Pizza Inn and Pie Five serving up pizza, salad, and dessert options. The largest number of restaurants (255) exist under the name Pizza Inn while the remaining 19 operate under Pie Five, the company's fast casual concept.

2.) What do the fundamentals look like?

Investors should always look for companies that grow revenue and free cash flow over the long term and retain some of that cash for reinvestment back into the business and for economic hard times. Revenue and free cash flow growth serve as catalysts for superior long-term gains.

Pizza Inn's fundamentals leave much to be desired. Revenue went from $44 million in 2009 to $42 million in 2013 according to Morningstar. Pizza Inn's net income remained flat at around $1 million until 2012 when it broke even but then turned a $1 million loss in 2013. Factors such as the closing of stores due to lower product demand contributed to the decreases. Free cash flow has resided in the negative range due to heavy capital expenditures.

Pizza Inn continues to struggle in 2014. While revenue has increased 2%, its net loss widened to $1.2 million so far this year vs. $568 thousand the same time last year. Year-to-date company store sales increases of 30% contributed to the overall revenue gains. Also, Pizza Inn increased its store count by seven restaurants so far in 2014 vs. the same time last year. Higher commodity costs, general administrative expenses, and franchise expenses accounted for the widening of net loss. Its free cash flow went to negative $2.6 million so far this year from negative $867 thousand the same time last year due to increased capital expenditures and unfavorable accruals.

Pizza Inn's balance sheet would normally be considered ok if the company wasn't turning an operating loss. Its $365 thousand in cash equates to 4% of stockholder's equity. Long-term debt only equates to 9% of stockholder's equity. Investors should always look for profitable companies with long-term debt to equity ratios of 50% or less. However, for Pizza Inn even a little long-term debt is too much as it has turned an operating loss of $1.7 million so far this year. The rule of thumb for safety is that operating income should exceed interest expense by five times. With the operating loss, interest payments will need to come from external sources such as the $3.3 million stock offering earlier this year.

3.) How much management-employee ownership is there?

Investors should also look for businesses with managers who own a lot of stock in the company. Managers who own a great deal of stock in the company will take better care to maximize company profit which will enhance share price and their personal wealth along with that of shareholders. In other words, their interests are aligned with yours.

Mark Schwarz, Pizza Inn's Chairman of the Board, and Pizza Inn's board member Clinton J. Coleman together control 36.5% of the company through their affiliation with various investment companies such as Newcastle Partners.

4.) How does its "Report of Independent Registered Public Accounting Firm" stack up?

Every year a company employs external auditors to review financial statements and evaluate whether the company maintains adequate financial controls. At the conclusion of the audit, a positive letter will include language such as unqualified or fairly presents which generally means that the financial statements and internal systems in constructing them were clean or adequate. If you see qualified or adverse in the auditing letter's language then deeper issues in a company's financial statements may exist.

The company's external auditors gave a "fairly presents" opinion on its financial statements which mean the financial statements are clean. However, Pizza Inn's external auditors provide no guidance on internal control.

5.) What types of risk does it have?

It's always important for investors to weigh the various risks such as exposure to political risk in unstable parts of the world, competitive positioning, and market price risk. Roughly 2% of Pizza Inn's year-to-date 2014 revenue comes from outside of the United States which means it faces little political risk.

Competitively speaking the company resides in an inferior position as it lacks the scale of its competitors Papa John's (NASDAQ: PZZA) and Domino's Pizza (NYSE: DPZ) which sport location counts of roughly 4,500 and 11,100 respectively. Pizza Inn lacks the negotiating power to purchase materials cheaply enough on a per unit basis to bring the company into profitability. Papa John's and Domino's Pizza clocked in operating margins of 7.4% and 17% respectively vs. negative 3.4% for Pizza Inn. Pizza Inn's market price risk is near infinite as its turns a net loss and that loss keeps getting wider.

6.) What does its forward analysis look like?

There is a small bright spot in Pizza Inn's attempt at fast casual - Pie Five. Fast casual restaurants are the rage right now in the restaurant industry. Pizza Inn expanded the number of those locations from nine this time last year to 19 so far this year. If the company could achieve a decent economy of scale in the Pie Five units then it may stand a chance. Otherwise your investment dollars may be best served elsewhere.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.