|Shares Out. (in M):||8||P/E||9.8x||6.7x|
|Market Cap (in $M):||13||P/FCF||11.8x||9.0x|
|Net Debt (in $M):||1||EBIT||2||3|
If you like business models that generate ROIC of more than 35% and can be purchased currently at ~5x LTM EBIT that will be growing both its units and profits domestically and abroad, then you might want to explore investing in Pizza Inn ("PZZI"). Since one of the biggest risks regarding investing in the stock is its illiquidity (3 month daily average less than 15,000 shares), this idea requires patient capital but for that virtue, I think an investment will be attractively rewarded based on my $4.75 target (185% upside) over the next two years and downside relatively low for a business at a growth inflection point with high current ROIC and higher incremental ROIC potential.
Virtually everyone eats pizza! In fact, approximately two-thirds of the U.S. population eats pizza once a month and, on average, each American consumes almost 50 slices of pizza annually. Some of this pizza, since 1958, has been consumed at Pizza Inn but if you don't spend much time in Texas or small towns in the South, then I suspect you've never heard of Pizza Inn despite the Company being the 10th largest pizza franchise (by units) and the 15th largest pizza franchise (by revenue) in 2008. Measured solely by units located outside the U.S., Pizza Inn would rank 7th.
The restaurant business is appropriately well-documented as being a lousy business (excess capacity, relatively low barriers to entry, high employee turnover, fickle consumers, etc) but restaurant brands (and especially one that is almost exclusively a franchise system) don't get to be over fifty years old because they're lucky. Although Pizza Inn's history has been far from smooth and steady, the Company has demonstrated a strong foundation to bounce back when confronted with economic environment challenges, management turmoil, and competitive intensity. The Company is at an inflection point of improvement as evidenced by being named 2008 Pizza Chain of the Year, demonstrating momentum of new franchisee interest, attracting experienced new management talent, and showing substantial improvement in profitability and potential for growth.
Franchised-based business models can be very attractive (scalability, low capital intensity, employee productivity, etc) and Pizza Inn has franchised since 1963. In the U.S., the Company's franchise development is focused on locations primarily in the Southeast and in towns with a population of 50,000 or less. As of June 28, 2009 (Fiscal Year ending 2009), there were 309 domestic and international Pizza Inn restaurants, consisting of two Company-owned domestic restaurants, 239 franchised domestic restaurants, and 68 franchised international restaurants. The 241 domestic restaurants consisted of: (i) 152 restaurants that offer dine-in, carry-out, and in many cases, delivery services ("Buffet Units"); (ii) 38 restaurants that offer delivery and carry-out services only; and (iii) 51 express units. The Buffet units are best-known for their all-you-can eat buffet which is typically offered at prices from $5.49 to $6.99, and the average ticket price per meal, including a drink, was approximately $8.30 per person for fiscal year 2009. The average per person ticket is slightly higher in restaurants offering beer and wine.
The 241 domestic restaurants are located in 17 states predominately situated in the southern half of the United States. The largest number of domestic Pizza Inn units is located in Texas (37% of domestic mix), North Carolina (15%), Arkansas (8%), and Mississippi (7%). The 68 international restaurants were located in eleven countries. During FY2009, the Buffet units averaged ~$720K in revenue, the delivery/carry-out units averaged ~$260k in revenue, and the express units averaged ~$90K in revenue. Fourteen new units opened in FY2009 (ended June 2009) while 28 units closed. Thus far in FY2010, eleven new units have been opened with no units closed.
Based in The Colony, Texas, the chain grew to nearly 750 units (during the late 70s) in 33 states but declared bankruptcy in 1989. Although the company managed to regain its footing a few years later, the number of restaurants fell to less than 400. A series of boardroom dramas beginning in 2002 left the company without a clear direction, mired in litigation and bleeding cash. To effectively frame the investment opportunity, some historical context is relevant and described below.
Selected Historical Context
Pizza Inn was founded in 1958, the same year as Pizza Hut, but it's had a very different ride. During the past two decades, Pizza Inn failed to adequately focus on how to assist its franchisees to succeed and hence periodically bathed in red ink and lost numerous units. It is only recently that the Company has been able to get "back-to-basics" of the business of running restaurants (e.g., making dough fresh daily, insuring consistency across ovens so product is cooked perfectly each time, cleanliness of restaurants) but the "back-to-basics" strategy is working. Prior to Charlie Morrison being named CEO and President in December 2007, Pizza Inn had experienced a tumultuous few years which led to losing numerous franchisees.
In August 2002 the Company's board forced the resignation of then-CEO Jeff Rogers because they believed he'd be unable to repay a $1.9 million company loan used to purchase Pizza Inn stock. Rogers later sold his shares to Newcastle Partners (reportedly for $7.4 million in December 2002), thereby making Newcastle the majority stockholder. New CEO Ronald Parker (who incidentally was Rogers' handpicked President replacing Rogers) and other executives rewrote their contracts to protect their positions from a change in board control by Newcastle, which they attempted to invoke after Newcastle seated two appointees on the board. Parker's combined salary and bonus earned him more than $1M per year; this rankled Newcastle Partners, which claimed that management from Parker was mediocre. Newcastle accused Parker and three Pizza Inn officers of redrawing labor agreements in 2002 to include parachute clauses that purportedly could have bankrupted the company. The new contracts included golden parachutes that positioned Pizza Inn to pay $7.4M should it undergo a change of control at the board level. Parker was fired in 2004 and Tim Taft (who orchestrated the turnaround of Whataburger) assumed the CEO post of Pizza Inn which was reeling from the boardroom battles with Parker following the forced resignation of Rogers.
When Taft assumed his CEO post, he hoped to fortify trust with franchisees and shareholders and took the job for $1 per annum, plus modest stock options. At the time, the Company's share price was ~$2.50. In 2005, a lawsuit was filed against Pizza Inn by previous-CEO Parker, who claimed he was unfairly fired. In 2006, PepsiCo sued Pizza Inn for breach of contract when Taft ordered a switch to Coke products. Those lawsuits distracted management and bred apathy among franchisees. Both issues were distractions from the task of fixing the Company's problems which included some franchisees not earning enough profit to stay in business, some franchisees being overcharged by the Company's distribution arm, inconsistency of product and service quality, and an overabundance of units that looked tired. Taft said, "Nobody was reinvesting in the system."
In 2006, the Company settled the lawsuits and also executed a sale-leaseback of its headquarters as well as commenced the outsourcing of certain distribution services like warehousing and delivery. In 2007, based largely on the work from Taft as well as the Company's CFO Charles Morrison to restore operational stability, balance sheet flexibility, and overall confidence within the company and among franchisees, Pizza Inn was able to increase its franchised units for the first time in many years.
In August 2007, Pizza Inn lost its third CEO in five years as CEO Tim Taft abruptly resigned, after almost three years, to "take advantage of other opportunities that presented themselves" (one year later Taft was appointed CEO of Sun Capital's Souper Salad). Taft led PZZI out from what he calls "a death spiral" of negative same-store sales, franchisee apathy and crippling lawsuits. Taft was said to have accomplished what he sought to do: heal Pizza Inn and position it for growth. Taft also admitted to simply being "tired".
Morrison, who joined Pizza Inn as CFO in January 2007, was appointed Interim CEO in August 2007 and officially the CEO in December 2007. Prior to joining Pizza Inn, Morrison served as President for Steak and Ale and The Tavern Restaurants; he also served as CFO for Steak and Ale and Ponderosa Restaurants in 2004. Prior to that, he served as Vice President of Finance for Kinko's, Director of Strategic Planning for Boston Market and Director of Strategic Planning for Pizza Hut (Morrison was with Pizza Hut for six years).
Current CEO Charlie Morrison has implemented a turnaround strategy that focuses on the basics of good operations, customer service and product quality to improve franchisee profitability and position the chain for expansion. Morrison and his team decided that improvements were necessary in product quality, operational focus on delivery and carry-out and more effective management of franchisees. The Company wasn't visiting franchisees to assure that restaurants were kept clean and a quality product was not consistently being served. A new VP of Operations was hired to oversee a team that visits franchisees. Furthermore, the Company institutionalized better training of franchisees to assert requisite customer service and restaurant management. The payoff came in a return to profitability (EBIT improved by over $4.5M between FY06 and FY09 despite revenue declining by over $6.6M) accompanied by six consecutive quarters of comparable-store sales increases (through calendar 2008 Q3).
Resulting from Morrison's willingness to actively engage the franchise system in an exchange of ideas and to focus on improving the operations and profitability of the franchisees, the quality of the relationship of corporate with the franchisees has improved. This has led to increased interest among existing franchisees to expand with Pizza Inn as well as improve the Company's credibility towards attracting new franchisees.
Looking forward, as described below, Pizza Inn has recently attracted additional experienced management, is adding franchised units, and is exhibiting substantially stronger average unit economics in a company-owned prototype that should catapult Pizza Inn's performance in the near future.
Selected Investment Considerations
Evidence of operational and profitability improvements at the franchisee level
Strong momentum for recently signing new franchisees
International franchise development growth has recently been and is envisioned to continue being robust
Prototype store has performed beyond expectations
Tangible evidence of improvements in financial performance at the Company
Recently announced management appointments provide improvements in the quality of management experience to further enable the Company's capacity to execute its expansion and profitability plans
Longer-term upside opportunity is further reinforced by substantial Company buyback coupled with recent insider buying plus the governance and owner-orientation dictated by large hedge fund shareholder (but this same large shareholder is also the key reason the stock was dislocated to as low as $1 last year as described below)
Equity Upside based on continued improvement to existing top-line, to existing margin, to expansion in number of franchisees, and some multiple expansion as visibility improves
Selected Bearish Arguments
Consumer discretionary issues: yes, I agree that many consumer discretionary businesses will continue to confront risks associated with the deleveraging of household spending and rising unemployment. I am short many such businesses but PZZI provides a low-cost alternative for the ongoing consumption patterns that will continue to exist for eating out.
Newcastle redemptions: as described above, this has created the attractive opportunity and further liquidation by Newcastle LPs would pressure the stock but I embrace the PZZI investment for the longer term and hence the Newcastle risk as an attractive opportunity that might develop for price dislocation and volume. I think the pattern of price improvement throughout the past year's redemptions is demonstratively positive given that incremental buyers have quickly emerged. Newcastle principals continue to evidence their own conviction through personal purchases and it appears the magnitude of redemptions has moderated.
Competition: there is much competition across the pizza spectrum as 25% of all restaurants are pizza venues. We all know Pizza Hut, Domino's, Papa John's, Little Caesar's but there are many others that abound including every town's local pizza chain but also other franchise systems like Boston's The Gourmet Pizza, Sbarro, CiCi's (its main competitive peer and incidentally considering a sale), Papa Murphy's, Pizzeria Uno, Round Table, Hungry Howie's, Old Chicago, Peter Piper, Gatti's, etc. PZZI's success is based on both its appeal to franchisees and obviously to the end market consumer. Although PZZI competes with every pizza chain in its market, I view PZZI's focus towards smaller markets as among the more attractive parts of its strategy. There is less competition in smaller markets. I also deem PZZI as being appealing to the consumer because of its low-price ($6.49) all-you-can-eat buffet and what is also (subjectively in my opinion) a very good tasting product. On the franchisee front, potential franchisees have thousands of options beyond pizza of course. From my discussions with PZZI franchisees, I consistently heard that PZZI appealed to them because of the i) low-cost entry; ii) simplified business model; iii) attractive economics often exceeding 40% cash-on-cash return; and iv.) product quality with strong historical brand equity. These same franchisees would not consider (nor would the chain necessarily embrace) opening a Pizza Hut in a town of 50,000. As for Domino's and Papa John's, they obviously compete but the buffet franchisees deem a full-service alternative as preferred to the delivery/take-out option.
Execution: The restaurant industry is a lousy industry but much money can be made from it if management executes well. The overarching issue of execution is key to unlocking the potential value I envision at Pizza Inn. As noted, PZZI has suffered from management turnover and governance distractions but CEO Charlie Morrison has thus far orchestrated a strong turnaround as evidenced by improving profitability, renewed interest among franchisees, and success with two company-owned units. His prior experiences are substantial for a company of Pizza Inn's size and there is of course some risk that more attractive opportunities are offered to him and other members of his high-quality management team. However, I ascribe little risk to this issue in the short-term as 485,000 options (struck at $2.49) are a motivating factor to the management team and Morrison is rooted for a variety of personal reasons to working in proximity of The Colony, Texas.
Microcap: less stock liquidity, no research coverage but hence the opportunity if patience exists and position is sized accordingly for risk management.