Papa John's: Pizza With A Side Of Share Buybacks

| About: Papa John's (PZZA)
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Papa John’s has put together a rather solid operating history.

When you look a bit deeper you find reasonable business growth with very strong per share growth as a result of a robust share repurchase program.

This article illustrates why future growth could be more difficult to formulate than it seems.

I've always considered Traveler's (NYSE:TRV) share repurchase program to sort of be the standard as far as ongoing buybacks. With Travelers you have a lot of things going in the company's favor including: willingness, ability and a consistently low valuation. The company uses billions of dollars each year to buy out past partners, and it only has to do it at 10 times earnings or so (often even less). This process is what has allowed 6.6% company-wide earnings growth to turn into 15%+ earnings-per-share growth over the last decade.

When I see something like Papa John's International (NASDAQ:PZZA) - how's that for a tasty ticker - I'm reminded in a way of Travelers. Perhaps not to the same extent, but it still has had an impressive run on the share repurchase front.

Back in fiscal year 2000, Papa John's had about 92 million common shares outstanding. The earnings-per-share for the company were just under $0.50, meaning that the pizza maker was earning around $44 million in profit.

Let's fast forward to today before jumping back a bit. Last year Papa John's reported net income of about $75 million. If the total number of shares outstanding remained constant during this period, the earnings-per-share number would have now been about $0.82; representing a compound growth rate of roughly 3.4% per annum. That's reasonable growth, but nothing to get too excited about. Of course as you might have guessed, the share count did not remain at 92 million and thus shareholders saw their ownership claim grow at a faster rate.

By the end of fiscal year 2015 Papa John's share count was down to 40 million shares or thereabouts - a 57% decline from where it was a decade and a half ago. Expressed differently, for every 9 shareholders that existed in 2000 just 4 remain today. The company has bought out 5 out of every 9 shareholders on your behalf.

This has a large impact on the amount of earnings that are attributable to each share. Instead of the company earning $75 million and a share representing $0.82 of that claim, the earnings-per-share figure is now around $1.90 (closer to $2.10 without a legal settlement). This represents a growth rate of nearly 9%.

Perhaps just as interesting have been the intermediate-term steps that I momentarily jumped past. In 2000 the company had about 92 million shares outstanding. By 2006 this number was down to 68 million. Total company-wide earnings went up to about $47 million - a 7% increase - and yet earnings-per-share jumped 48%. This was obviously fueled by a large commitment to retiring shares, but also by the low-teens valuation that shares experienced for some time.

From 2006 through 2015, the share count continued to decline meaningfully - moving from 68 million shares down to 40 million; a yearly decrease of nearly 6%. And we know what eventually happened with earnings-per-share. This was once again fueled by a large commitment and a frequent valuation in the mid-teens.

From this I draw two basic lessons. The first is that the propensity to retire shares is certainly there. Sometimes you have to guess about whether or not a company will ultimately retire shares, but in this case you have a clear history - the share count has been going down and in a meaningful way.

The second thing I note is that although the per share performance has been solid - growing EPS by 9% annually for some time now - a very large portion of this was driven by reduced share count and not necessarily spectacular "organic" growth. There's nothing inherently wrong with this, but I think it's important to underscore where the growth story has been derived from as it can have implications down the line.

Which brings us to today. In the most recent earnings announcement Papa John's indicated that it expected to earn between $2.30 and $2.40 per share this year and use $100 million to $150 million to retire shares. Now certainly these two items can work together - with fewer shares outstanding higher EPS is easier to formulate, as demonstrated above. Yet I would like to make a few points.

Over the past decade Papa John's has increased revenues by about 5% to 6%, company-wide earnings by about 6% and earnings-per-share by 12% to 13% per year. As highlighted throughout this article the key to Papa John's very solid growth has been just as much about the share repurchase program as the growth in the business.

If you look up estimates for Papa John's intermediate-term growth, you'll see something in the 15% to 18% range. And with shares trading around 24 times forward earnings, the share price reflects this expectation. Now certainly this is within the realm of possibility. Yet it can also be instructive to think about what this is saying. There are a variety of factors that make this type of growth harder, not easier to formulate.

The first thing is that you're dealing with a larger company. There's always an additional hurdle when you're in 2X locations instead of just X. It doesn't mean it can't work out, it just means you better have a solid growth thesis. If the company was "only" growing at 6% when it was half the size, you have to make an especially compelling case that it can now grow at 12% as a bigger company.

The second thing is that I would contend that it is becoming much more difficult for Papa John's to replicate its past success with its share repurchase program. As of February of 2016 the share count was below 38 million, so Papa John's is telling you to expect that it will make around $90 million in profits for the year. It also told you to expect $100 million to $150 million in share repurchases; which means that some of that has to come from debt or balance sheet flexibility. This can work, but it can also hinder the company in the long-term.

Furthermore, the company initiated a dividend payment in 2013. The quarterly payment now sits at $0.175 or $0.70 on an annual basis. That equates to a dividend commitment of about $26 million. (This doesn't account for a lower share count, but that could be netted out if the company were to increase its per share payout as it has done in the last two years.) So instead of $90 million in income, you're thinking about say $65 million against $100 to $150 million in buybacks. Once more it should be underscored that this can work out fine, but it should nonetheless detail that the amount of "organic" funds available for share repurchases is less than what the company has been actually doing.

Equally important is the valuation at which shares will be retired. Previously the company benefited by being able to buy out partners at say 13 or 15 times earnings in many years. Now the company is continuing its buyback plan, but it has to do so at say 24 or 26 times earnings. This leads to a much less effective buyback program. The same amount of capital may only be able to buy back half the shares that it otherwise could have at a lower valuation.

Combined, I think these factors make it difficult for Papa John's future share repurchase program to be as successful as it's past. So instead of reducing the share count by 5% or 6% per year, you could be looking at say a 2% or 3% yearly decline. To be sure that's still a sizable reduction, but don't forget about the current growth rate expectations.

Previously you had a company trading in the mid-teens, growing company-wide earnings by 6% annually and growing EPS by 12% or 13% a year as a result of a significant share repurchase program. The share repurchase program was successful due to a reasonable valuation and no other commitments (like a dividend payment).

Now you have a much larger company that needs to grow by perhaps 12% to 15% annually to meet its growth rate estimates. The valuation is higher and the percentage of funds available for long-term share repurchases lower; making for a significant reduction in buyback effectiveness. Anything is conceivable, but I think under these circumstances it's harder to make the argument that Papa John's is automatically poised for exceptional growth.

Disclosure: I/we 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.