Papa John's: A Great Business That Simply Costs Too Much

| About: Papa John's (PZZA)
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Summary

PZZA has seen its stock go parabolic in recent weeks.

Terrific operating results have bolstered investor sentiment and sent shares to their all-time highs.

I think valuation has gotten ahead of fundamentals and PZZA has become a momentum stock, increasing the likelihood of downside.

Shares in pizza chain Papa John's (NASDAQ:PZZA) have seen a meteoric rise in their value in the past three years. In just that time shares have more than tripled amid torrid growth and optimism from investors. After pushing to all-time highs in a nearly parabolic move earlier this year, the stock was hammered almost $20 lower before renewed buying has sent it up sharply to challenge all-time highs once more. After yet another strong earnings report is there any room to run here or should investors take profits and head for the exits? In this article I'll take a look at PZZA to see if the valuation is reasonable or if the business has some room to catch up.

To do this I'll use a DCF-type model you can read more about here. The model uses basic inputs including earnings estimates, which I've borrowed from Yahoo!, dividends, which I've set to grow at 5% each year and a discount rate, which I've set at the 10 year Treasury rate plus a risk premium of 6.5%.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$1.73

$2.07

$2.38

$2.73

$3.14

x(1+Forecasted earnings growth)

19.50%

15.00%

15.00%

15.00%

15.00%

=Forecasted earnings per share

$1.73

$2.07

$2.38

$2.73

$3.14

$3.62

Equity Book Value Forecasts

Equity book value at beginning of year

$2.27

$3.44

$4.92

$6.68

$8.77

$11.23

Earnings per share

$1.73

$2.07

$2.38

$2.73

$3.14

$3.62

-Dividends per share

$0.56

$0.59

$0.62

$0.65

$0.68

$0.71

=Equity book value at EOY

$2.27

$3.44

$4.92

$6.68

$8.77

$11.23

$14.13

Abnormal earnings

Equity book value at begin of year

$2.27

$3.44

$4.92

$6.68

$8.77

$11.23

x Equity cost of capital

8.75%

8.75%

8.75%

8.75%

8.75%

8.75%

8.75%

=Normal earnings

$0.20

$0.30

$0.43

$0.58

$0.77

$0.98

Forecasted EPS

$1.73

$2.07

$2.38

$2.73

$3.14

$3.62

-Normal earnings

$0.20

$0.30

$0.43

$0.58

$0.77

$0.98

=Abnormal earnings

$1.53

$1.77

$1.95

$2.15

$2.38

$2.63

Valuation

Future abnormal earnings

$1.53

$1.77

$1.95

$2.15

$2.38

$2.63

x discount factor(0.0875)

0.920

0.846

0.778

0.715

0.657

0.605

=Abnormal earnings disc to present

$1.41

$1.49

$1.51

$1.54

$1.56

$1.59

Abnormal earnings in year +6

$2.63

Assumed long-term growth rate

3.00%

Value of terminal year

$45.80

Estimated share price

Sum of discounted AE over horizon

$7.52

+PV of terminal year AE

$27.69

=PV of all AE

$35.20

+Current equity book value

$2.27

=Estimated current share price

$37.47

At first blush the fair value calculated seems a bit shocking; shares are trading for $53 as I write this, a mere couple of percent from their all-time highs. A fair value of $37 seems ludicrous but hear me out; the model is intended to provide a price at which investors can achieve a margin of safety by going long. With the fair value so far below the current price - nearly 30% - not only is zero margin of safety implied but gross overvaluation can also be inferred. Let's take a look and see what lies beneath here before making any judgments.

Papa John's is absolutely on fire. The company has been growing profits at a rapid rate for years now and the results are evident in the stock price; this company is firing on all cylinders. Sales have been growing at a nice clip and profits have been boosted by double digits each for the last few years. Margins have been steady so they are not contributing to the profit growth - this has been a sales growth story for the most part. Papa John's is still opening new stores in the US, albeit at a moderate pace, and its international expansion continues, offering up room for growth in the future.

However, I do think the stock is expensive right now. We're looking at earnings estimates in the 15% to 20% range from analysts and with sales growing at a projected 5% to 10% next year and stable - but not rising - operating margins, I think that may be a bit tough. PZZA has done a great job growing profitably, a concept that is harder to do than it may sound. Many companies sacrifice margins to grow the footprint of the business but PZZA has been able to maintain margins while growing.

However, with stable operating margins virtually all of PZZA's EPS growth has to come from the top line. Truly rapid EPS growth comes from boosting revenue and margins simultaneously but PZZA has thus far found that elusive. But therein lies the opportunity (and hope) for longs, I suppose.

It is my personal feeling that investors getting long PZZA are buying the future instead of the present. And before you rightly point out that all investors should be buying the future in any company, of course that is true. What I'm saying is that the current valuation of PZZA implies enormous expansion for the next 5 or 10 years, not just what is within the realm of accurate forecasting. It seems to me PZZA is priced for years and years of perfection and that is not a good setup for longs because it skews the risk/reward equation the wrong way.

Commodity costs (like cheese) are out of PZZA's control but are significant inputs that can drive profitability gains or losses. I believe that is a strong reason why PZZA hasn't been able to grow margins even though its scale has increased significantly in recent years but, to its credit, these costs haven't derailed margins either, a testament to discipline elsewhere in the business.

I think investors are buying a dream here. The dream is that PZZA figures out how to increase margins while continuing to put up ridiculous comp sales increases. Perhaps that will happen but the odds are low simply because that is incredibly difficult to do. And also, if PZZA could do that, don't you think it would have already seen rising margins? The current price is assuming what I consider to be an unrealistic amount of earnings growth given flat margins and nice but not spectacular sales growth. There is nothing wrong with this business, just the price you have to pay for it.

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.