Better Marketing, Better Sales, Papa John's

Summary

• Discounting strategy and public relations nightmare continue to haunt margins short term.
• Strong hiring practices and improving guidance point to a potential image restoration.
• Turnaround DCF valuation reveals hidden value for investors.

Source: The Takeout

Introduction

When you tie your brand wholly to your founder and that founder jumps into racial slur-infested waters, the brand will inevitably sink as well. Papa John's International, Inc. (NASDAQ:PZZA) was unable to escape this very fate - its share price now 52% off its late 2016 highs. However, management has slowly but carefully severed the ties between its sinking founder and the brand. Selective hiring and a re-established corporate identity have resulted in Q2 guidance that hints at a potential turning point for the struggling pizza chain.

Data by YCharts

Investment Thesis

According to its Q2 10-Q, PZZA will be forced to pivot its gargantuan Marketing Fund and Starboard Value investments "in response to negative consumer sentiment which has impacted comparable sales." As brand rehabilitation is prioritized over increasing margins, PZZA's financials may continue to stagnate, leading into the final two quarters. However, PZZA's newest executive hires and marketing strategy reveals a defined corporate identity and a long-term plan. If the plan is effectively executed, my DCF model projects an almost 30% rise in stock price.

Margins

A comparison between PZZA and Domino's Pizza, Inc. (DPZ) reveals a painful divergence in gross profit margin. Whereas DPZ seeks to improve margins by spinning off less profitable restaurants to franchisees, PZZA has embarked on a fierce price-slashing campaign. In their Q2 earnings call, management emphasized their dedication to the $6 medium price point, a particularly difficult goal from a profitability standpoint, considering PZZA brands itself as the highest-quality pizza. Lower margins and negative comps have created a significant hurdle for CEO Steve Ritchie's turnaround efforts.

Data by YCharts

Pricing

Another aspect investors should take note of is PZZA's expensive stock. For the past few months, the market continued to price PZZA at more than 40x earnings - making them more expensive than Facebook (FB) or Apple (AAPL) relative to earnings. PZZA continues to trade at a relative premium to its closest competitor, DPZ, without any current financial advantage. There does not seem to be much keeping PZZA from falling further.

Data by YCharts

Hiring

Steve Ritchie's philosophy seems to be that change begins at the top. After replacing Schnatter, he immediately got to work restructuring the c-suite to reflect a restructured culture. Marvin Boakye made headlines January 23 when the former Andeavor VP of Human Resources became PZZA's first Chief People Officer. On March 28, Ritchie brought in Karlin Linhardt, a ten-year McDonald's veteran and SVP of Subway North America, as the CMO. July 8 saw the appointment of Jim Norberg, former McDonald's EVP and COO, as Chief Restaurant Operations Officer. The biggest move, however, came when PZZA announced that NBA Hall of Famer Shaquille O'Neal would join the chain as a board member and investor. While the effect of personnel changes is hard to quantify, new executives and brand ambassadors are an important first step in reversing negative consumer sentiment.

Source: KHTS

Insider activity increased as well after Schnatter's departure. Starboard Value, the hedge fund famous for turning around Darden Restaurants (DRI), made a $200M investment in February. The deal included bringing on two new board members, one of which filled the chairman position vacated by Schnatter. In May, Schnatter reduced his stake in PZZA down from 30.99% to 18.95%. His lockup agreement with UBS ends August 19, so his next move may entail a large price swing in the near term.

Corporate Identity

PZZA has embraced its identity as a sales and marketing machine once again. Perhaps, the biggest blow came when Schnatter's comments on kneeling during the National Anthem cost PZZA their lucrative NFL deal - one that Pizza Hut (YUM) quickly snatched up. Afterwards, the chain languished as it unsuccessfully tried to create sales without effective marketing. However, PZZA has found partners with Hollywood and Snapchat (SNAP). The strategy is reminiscent of one YUM did last year to promote their NFL partnership. PZZA's marketing endeavor makes sense, given the ties between the Spiderman franchise and pizza in popular culture.

Source: Next Reality

During the Q2 earnings call, Ritchie informed shareholders PZZA would capitalize on its big marketing push. $40M of the Starboard investment will be directed towards future marketing investments throughout the next two years. In addition, a 25 basis point increase in the Marketing Fund contribution rate will bring quarterly contribution up to 5% of restaurant sales. PZZA will use these investments to find new partners and provide Shaq a national platform to promote the brand.

Guidance

Management relayed positive news during the Q2 earnings call. While North America saw a net reduction of 17 restaurants for the quarter, global openings saw a net increase of 42 restaurants. That brings the international total of PZZA restaurants to 5,345 for Q2, approximately 80% of which are franchises. In comparison, DPZ has an international total of 16,314 restaurants for Q2, approximately 98% of which are franchises.

Management also tightened the ranges on store opening estimates and comp sales. PZZA plans to open 100-150 restaurants through the end of FY19, up from 75-150. Comps for Q3 are projected at -1% to -4%, up from -1% to -5% and significantly better than the -10% comps we observed a few quarters back.

Valuation

My DCF model assumes a 20% improvement to $60M in FCFF for 2020, a 30% improvement to $80M in 2021, then a deceleration to 13.7% based off PZZA's IRR, and finally, two years of 5.4% growth based off PZZA's 9-year revenue CAGR during the years 2009-2017 used to model average growth. The model then assumes a 2% terminal growth rate. I calculated their $319M net debt by subtracting their Q2 $31M cash and cash equivalents balance from their $350M long-term debt. TTM FCFF of $51M, at a 6.81% WACC, yielded an intrinsic value of $54.77, or a 28.0% upside.

The sensitivity table below shows the delicate position PZZA is in. Even a slight revenue or earnings miss could initiate a damaging selling frenzy. It is also worth mentioning that the sensitivity table reveals that PZZA is still priced on the expensive and bullish side of the spectrum. However, a successful turnaround could initiate gratifying gains for shareholders.

Source: Author's Calculations, Numbers from Morningstar

Looking Ahead

I believe there is still significant value in PZZA. A 28% margin of safety is a bet I would be willing to take on a company with a solid business model. I will be glad to see revenues rising as we start to see more commercials with Shaq holding boxes of pizza. However, PZZA's high PE ratio and unremarkable 2.1% dividend yield, combined with no significant competitive advantage over DPZ and Schnatter's expiring lockup period encourage me to watch the stock until at least the next quarter before I add it to my holdings.

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.