Papa Murphy’s Holdings (“FRSH” or the “Company”) is yet another gift to short sellers from the JOBS Act, offering a +50% near-term return. Papa Murphy’s went public on May 1 with a unique restaurant franchise concept of selling uncooked pizzas. This is not a joke, they literally only sell raw pizzas across the 1,429 stores (95% franchised). Skepticism of the concept aside, the PE sponsor that has owned FRSH for the last three years has aggressively dressed the Company up for the IPO by expanding into unattractive regions, gearing franchisees on royalties, rolling out unprofitable promotional deals to boost unit volumes and growing the topline through nonrecurring franchisee buyouts. These practices have come back to haunt them in the form of an over-levered balance sheet (6.7x net debt), sputtering growth and more significantly, a highly disgruntled franchisee-base (likely well over a one-third of whom are operating at a loss) and a separate lawsuit alleging fraud and misrepresentation. On April 4, this lawsuit was filed by a group of 20 franchisee representing 60 stores alleging FRSH sold them franchise areas based on misleading store-level financial performance and required advertising contributions in excess of the franchise agreement (they are seeking $23M). If FRSH management does not make some concessions in the near-term then it is very likely that the number and magnitude of lawsuits will increase. This is a fairly similar story to Quizno’s which filed for BK in March. A borrow is presently available from JPM and GS. The Company reports earnings after the close this Thursday so this is a timely situation.

Valuation

FRSH’s current EV is $294M with a market cap of $180M ($10.52 per share on 17M S/O) and trades at 14.6x LTM EV/EBITDA and 27.3x LTM FCF. As a reference, Lee Equity purchased the Company in 2010 for $180M. While EBITDA was about 25% lower then, the business was likely in much better shape. Transactions by Lee as recently as March valued the equity at $82M or $4.70 per share on a post-IPO basis (50% below current). Near-term revenue pressure from royalty concessions with limited offsetting growth and potentially growing legal liabilities should lead to challenged financial performance and revaluation of the stock. 8x LTM EBITDA implies $3 per share, over 70% below the current share price. If you assume the effect of margin pressure from the impending negotiations with franchisees then the picture gets even dimmer.

In a series of recent letters to the FRSH Board, the Papa Murphy’s Franchise Association (PMFA) outlines their demands and provides a troubling view of the financial state of the franchisees. Clearly FRSH did not want this information to be made public prior to the IPO. Despite their material nature, these matters are not disclosed in the S-1. We found two letters through a simple internet search here. In the S-1, FRSH presents a picture of financial strength – seemingly rubbing it in the face of the struggling franchisees. This seems to have exacerbated tensions. We have been told that an expanded letter with increased demands is going to be submitted to FRSH following the recent annual franchisee convention on May 4; incidentally the Company went public just three days prior.

These letters speak for themselves, but below are some key issues noted in the letter from Larry Hodge, President of the PMFA (representing over 70% of the franchise stores). Hodge has been an owner of Papa Murphy’s outlets for over 20 years and has worked with six different CEOs of the Company during that time. 

• “The primary challenge our brand faces surrounds the severe decline in profitability of Papa Murphy's franchised stores in recent years.”
• “Breakeven point for a new store with a manager is just under $8,000 AWS (average weekly sales). For a store with a manager and $175K debt service the breakeven is approximately $10,800.”
• A benchmark study shows 324 franchise stores (~25% of the chain) operating at a loss and 401 stores (~30% of the chain) making less than required to cover the standard debt service to open a store. In the Eastern Division 241 of the 387 stores (63%) averaged under $8,000 AWS. Of all the 52 stores in the Eastern Division, the average AWS was just $6,300. This is the region where FRSH purports to be the main area for growth. It does not appear the concept is resonating in this region.
• In contrast, FRSH highlights the following store-level data in their S-1: AWS breakeven of <$5,100, average AWS of $11,100, EBITDA margin in excess of 15% and franchisee cash-on-cash return of 20%.
• PMFA’s proposed changes to the existing agreement with the Company:
  • “Royalty relief on a sliding scale up to $8K AWS. PMI (the Company) receives fees and royalties on stores we are opening at $6,300 AWS and losing money every day. They need to put some of their skin in the game and give up some of their EBITDA just like they ask franchisee to do.”
  • “Move 50% of the ADF [area direct franchising] to supporting the stores and markets below $8K AWS. That provides 25% for overhead, 25% for production and the rest to markets that need the help the most.”
  • “PMI to provide research to figure out why Papa Murphy’s stores can’t open in new markets with AWS that at least can break them even within the first 12 months.”

Below are noteworthy points raised in a letter from Terry Collins, Papa Murphy’s co-founder, former CEO and chairman, currently consultant to PMFA.

• “Despite all of the communications and meetings that have come out of corporate over the past couple of months can anyone honestly say these problems have been addressed and real significant solutions provided? For over a month PMFA has tried to set up a meeting with PMI top management to discuss these issues.”
• “With the store closures that took place last year and the likelihood of that number dramatically increasing this year, the rumblings many of you have heard about lawsuits could become a reality. The odds of these problems hitting the press instead of being discussed and dealt with internally will only grow.”

The fact that FRSH’s 69 company stores generated operating income of -$0.4M in 2013 without even including the 5% royalty expense supports the claims of store-level struggles. Clearly the current franchise-franchisee economics are very out of balance and unsustainable. Collins’ letter indicates that FRSH management has been outright avoiding meetings and been unwilling to make concessions. Following the May 4 PMFA convention, the number of franchise gripes has grown. Apparently cannibalization and intrusion of territories due to the Company’s push to increase store count was a major issue at the convention.  

Franchisee Group v. Papa Murphy's International

A group of franchisees first notified FRSH of its plan to sue in January. When the lawsuit was filed on April 4, the group had tripled (link to court filing). Nine of the plaintiffs are listed as TX-based and the rest are from MO, GA, FL, LA and TN. The 11-count complaint asserts that FRSH “misrepresented and omitted material facts related to the financial performance of its franchises and of collecting more than the contracted amount for advertising.” These advertising contributions were alleged to have increased to 10% from the contractual 5%. The facts uncovered in discovery do not bode well for FRSH:

• “Defendants knew that the Plaintiffs’ weak sales and poor revenue were endemic to the franchise region….the performance of the “benchmark stores” was not representative of the franchise system as a whole and outlets which had not submitted “appropriate” profit and loss statements or whose statements had been excluded from the compilation were performing significantly worse.”
• "…the franchisees located in the Plaintiff’s region had spent almost twice the required local advertising expenditure in advertising in order to achieve 40% less than the average in net sales."

The inaccurate store-level financial performance was related to the Southern and Southeastern states, the regions that have accounted for almost all recent store growth. This shows the constraints of the Company’s growth potential and could result in a $23M settlement plus FTC and various state franchise association fines. The bigger issue is that the plaintiffs’ group may expand or that another suit may be filed. It would obviously be catastrophic to FRSH if the discontented franchisees of the other 820 stores were to seek an equivalent award.

Background & Financial Performance

The Company’s “Take ‘N’ Bake” pizza concept has been around for over thirty years. Then in 1995, bound by their shared passion for raw pizza, the founders of Papa Aldo’s Pizza of Hillsboro, OR and Murphy’s Pizza of Petaluma, CA combined forces to create Papa Murphy’s. Over the course of nearly two decades, CEO Terry Collins successfully grew the franchise system in the Pacific NW and then in 2004 sold the Company to Charlesbank. The new owners expanded into the MW and South, bringing the franchise system to 1k stores by 2007. This growth was built on a low price strategy and an ability to accept food stamps/ EBT cards. Despite the fact that the pizza is sold by a restaurant, it has historically been categorized as a “grocery item” and thus eligible for purchase with food stamps (restaurants selling “food for consumption” such as Domino’s cannot accept food stamps) and are not subject to sales tax (establishment tax is upwards of 10% in some states). This provides FRSH with significant competitive advantages. These advantages, however, are under pressure and may be eliminated outright. In February, a law was signed cutting $8.7B in food stamp benefits over the next 10 years, causing households to lose an average of $90 per month in assistance they can use to buy raw pizzas. Tax authorities in CA and other states have taken notice and are reviewing the closure of this categorization loophole. Last week the Streamlined Sales Tax Governing Board (an organization which establishes sales tax practices for 44 US states and DC) approved an amendment that would allow a state the flexibility to remove take-and-bake pizza from the prepared food category. All member states must report to the executive director of the SSTGB by 8/1/14 with their tax position. This would obviously increase the price of FRSH’s pizza, but more significantly, the pizza could no longer be purchased with food stamps. Franchises surveyed have estimated that 30-40% of sales are transacted with food stamps. In some markets that number was over 50%.    

In mid-2010, the Company was acquired by sponsor Lee Equity Partners for $180M. Over the course of the next four years, the PE group saddled the Company with debt. In order to alleviate some of the debt burden and eventually get liquidity, they took FRSH public and raised $55M. Despite the fact that all the IPO proceeds went to debt pay-down, the balance sheet is still very stretched, bearing 5.7x turns of leverage. The IPO sale story was of a high return, asset light, royalty-driven business with significant growth potential. At first glance the total topline growth rates of +20% over the last two years look impressive. However, the majority of this growth (88% in 2012 and 76% in 2013) has come from revenue from franchisee stores that the Company has acquired and is thus nonrecurring. During this period core royalty revenue has only grown 4.2% and 5.1%. Since these company-owned stores are unprofitable, the impact to the bottom line has been negligible – EBITDA only grew 5% last year. FRSH now generates 10-11% ROEs – not exactly the return profile commensurate of a royalty business model. The Company’s balance sheet is also now close to being tapped-out as a consequence of its weak FCF profile and store buyout decisions. This precludes them from pursuing additional store purchases and constrains their ability to properly invest in the brand. Circumstances will become more precarious if they are forced to make royalty concessions or lose the pending lawsuit. 

Competitive Dynamics

As noted, the advantages the Company derives from tax and food stamp loopholes are declining, if not disappearing entirely. Regardless, FRSH operates in an oversaturated fast casual pizza category. Last year the Company pushed out the “$5 fave” to match competitors’ $5 pizza offerings. Needless to say, this unprofitable item has not been a favorite with the already struggling franchisees. The Company also competes with supermarkets. Costco, Safeway, Walmart grocery and others all sell unfrozen, readymade and DIY pizzas at equivalent or lower prices in just as convenient a format. Meanwhile, DiGiorno and many more frozen pizza brands are broadly available at 50% of the price of a Papa Murphy’s pizza. A major appeal of pizza in general is its speed and convenience – having to cook it yourself eliminates both those qualities. From a franchisee perspective, take-and-bake competitor Noble Roman’s (OTC: NROM) stores require <$150k upfront investment vs $226k-414k for FRSH. This is another major gripe of the PMFA and will likely require a concession on initial franchise fees (accounting for 5% of FRSH’s total revenue). FRSH claims to be asset light, yet the total upfront investment for a FRSH store of $226k-414k is actually comparable and in some instances higher than peers Papa John’s ($220k), Dominos ($119k-461k) and Pizza Hut ($295k-422k).       

1)       Financial pressure from royalty concessions with no offsetting growth

2)       Increased litigation

3)       Secondary offering by PE

4)       Store closures in challenged markets outside Pacific NW

5)       Elimination of sales tax loophole

6)       Reduced food stamp payouts and potentially outright loss of ineligible for purchase with food stamps