Papa John's PZZA S W
July 14, 2015 - 5:04pm EST by
2015 2016
Price: 78.00 EPS 2.13 2.48
Shares Out. (in M): 39 P/E 37 32
Market Cap (in $M): 3,042 P/FCF 38 33
Net Debt (in $M): 210 EBIT 134 150
TEV ($): 3,315 TEV/EBIT 25 22
Borrow Cost: Available 0-15% cost

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  • Consumer Goods
  • Market Saturation


We are short Papa John’s. Papa John’s shares have had a fantastic run, increasing six-fold in the past
five years. To be clear, the company has performed well in over the past several years. Strong LfLs and
double digit growth in international store-count coupled with buybacks have lead adjusted operating
profit to compound at 12% over the past four years and Adj EPS to grow nearly 17%. The investment
world seems enamored with the idea that international expansion + strong LfLs + continued margin
expansion will drive high single digit/low double digit operation profit growth. Coupled with share
buybacks, EPS growth should be in the low to mid teens. This is certainly possible but even if it comes
true, we see little upside in the stock. At $78/share PZZA is priced like a wonderful business with strong
tailwinds for many years to come. However, we think Papa John’s shares offer an asymmetric short
opportunity as we see limited upside and the potential for ~50% downside over the next 2-3 years:
1) Operating profit growth likely to be lackluster going forward According to Domino’s, revenue
for the US pizza industry failed to keep up with inflation over the past decade (from 2004 to
2014 market grew $31 bn to 32.9 bn) implying volume declines (we don’t have # of pizzas sold
data but estimate -2% pa). While Papa John’s has posted strong comparables, we believe this
trend will be more difficult to sustain going forward as Papa John’s menu is literally the opposite
of healthy eating. We believe that Papa John’s largest market, the US, is nearing full
penetration. We think there is the potential for the market to view this as a mature in a
competitive industry and ascribe a low multiple to the business (as it did in 2010 when shares
sold for 10-11x EPS before shares rocketed 6-fold).
2) Recent EPS growth has been magnified by share repurchases over the past 5 years. While
repurchasing shares at 8-11x forward EV/EBITA generated strong EPS accretion, repurchasing
shares at 25x forward EV/EBITA is much less so.
3) History shows us that things can go wrong in the pizza business non-controllable factors
include: a) interest rate hike or improved job prospects limiting attractiveness of franchising (b)
labor cost hikes (c) commodity price hikes (d) increased competition, etc. Looking back, we can
see that heightened competition coupled with rising commodity/labor costs lead to declines in
adjusted operating profits from 2008-2010. 2010 operating income was 30% below 2006.
Should conditions be less than favorable, it is entirely possible that PZZA could earn just $2 in
2018. In such an instance, we expect shares would fetch something closer to 13-16x P/E (as it
has done in at times in the past) implying a fair value of just $26-32 in 2018.
4) Valuation we think restaurant stocks are quite overdone and believe PZZA is significantly
overvalued at present levels PZZA trades at a whopping 37x 2015 EPS (25x EBITA) and 24x
2018 EPS assuming everything goes well.
5) Acceleration in insider sales Insiders more stock ($ terms) in April & May then they had in the
preceding 6 years combined.
6) Unlikely to see a transformation via re-franchising unlike Yum in the early 2000s or Jack in the
Box in 2010, Papa John’s does not have significant real estate holdings. While it could re-
franchise some of its 450+ company owned restaurants, such a transformation would not justify
the company’s current valuation. This playbook is typically used when shares are cheap and
there is an arbitrage between selling restaurants in re-franchising transactions and repurchasing
stock at ~10x EPS.
Company Background 
Papa John’s is the #3 pizza chain in the US (with 8% market share) behind Domino’s and Pizza Hut. Papa
John’s has ~690 company owned restaurants and 2,670 franchised locations. In addition, there are
1300+ Papa John’s internationally (almost all franchised except for 49 stores in China). According to
Domino’s, the US QSR pizza category grew from $31.1 billion in 2004 to $32.9 billion in 2014 (0.6%
CAGR, as prices have risen this implies ~2% volume declines per year). Both Papa John’s and Domino’s
have gained market share over the past decade together with Pizza Hut, the top three players control
an estimated 55% of the US Pizza delivery business and the top four (including Little Ceaser’s) have 41%
of the takeout business. Of course the pizza category competes in a wide range of QSRs and we are
seeing the continued proliferation of fresh mex, premium burgers as well has healthier alternatives.
While Papa John’s has stated that it believes it can eventually get to 6,000 units in the US (similar to
Domino’s and Pizza Hut), I think this is unlikely as:
1) Overall pizza market is stagnant and could possible decline due to healthy eating trends.
Dominos and Pizza Hut are much older concepts than PZZA as such franchisees of Pizza Hut &
Domino’s built their store bases over very longer periods and in better times.
2) With most large and midsize markets already having a Papa John’s, continued expansion
requires moving into smaller and smaller markets which already have a Domino’s and/or Pizza
Hut. It is unlikely that these markets can support a third chain.
3) This seems to be evidenced by recent #s where we’ve seen declining net North American store
growth (system). Last year in North American restaurant count grew by 1.5%. For 2015
management implicitly guides to 56-62 net NA openings implying 1.5% net unit growth.
Thus the real growth for Papa John’s will take place internationally. The company has more than
doubled its store base over the past five years to around 1400 locations. Despite this progress,
international makes a relatively small impact on the group financially, with franchisee revenues of just
$25 million during 2014 (also up roughly 100% in past 5 years). Of Papa John’s international 1400
international locations, 21% are in UK, 18% China, 6% Mexico, 6% South Korea, and 4.5% Russia. I
expect we will see the company continue to add 175-200 net international locations (all
franchised/master franchised) over the next 5 years and anticipate another doubling of international
franchise revenue.
The company also continues to aggressively repurchase shares. While this will increase EPS, given that I
think they are overpaying by 50% or so as such I’m happy to see them repurchase shares at elevated
levels. Below I show several years of historical data and projections through 2018:
  2008 2009 2010 2011 2012 2013 2014
North America              
  Company owned rest 533.3 503.8 503.3 525.8 592.2 635.3 701.9
  Franchise royalties 59.7 61.0 69.6 73.7 79.6 81.7 89.4
  Franchise development fees 1.6 0.5 0.6 0.7 0.8 1.2 0.7
  Domestic supply chain  431.7 417.7 454.5 508.2 545.9 578.9 629.5
  Other 61.4 54.0 52.0 50.9 51.2 53.3 74.2
Total NA Revenue 1087.6 1037.1 1080.0 1159.3 1269.7 1350.4 1495.7
  Franchise/franch development 12.9 13.2 13.3 16.3 19.9 22.0 25.7
  Company owned & supply chain 25.8 28.2 33.2 42.2 53.0 66.7 76.7
Total Intn'l Reve 38.7 41.5 46.4 58.6 72.9 88.6 102.5
Total Papa John Revenue 1126.3 1078.5 1126.4 1217.9 1342.7 1439.0 1598.1
Adj Operating Income* 89.7 76.4 65.7 87.0 99.8 106.5 117.6
  OPM 8.0% 7.1% 5.8% 7.1% 7.4% 7.4% 7.4%
Diluted wtd avg shs o/s - split adj 56.5 55.8 52.9 50.6 47.8 44.2 41.7
Stated Diluted EPS 0.65 1.03 0.99 1.08 1.29 1.55 1.75
Other metrics              
Systemwide Sales              
NA owned stores** 592 588 591 598 648 665 686
NA franchised stores 2260 2255 2344 2463 2556 2621 2654
International franchised stores 505 600 690 792 911 1084 1274
NA comp growth - owned 1.7% -0.5% -0.6% 4.1% 5.6% 6.6% 8.2%
NA comp growth - franchise       3.1% 2.9% 3.1% 6.2%
International comp growth -franch       5.1% 7.1% 7.5% 7.8%
*Adjusted Op Income adds back restructuring charges and eliminates impact of BIBP purchasing entity which was used
to smooth commodity costs for franchisees. BIBP was shut down in early 2011.      
**Includes 200 JV stores              
Projections 2014a 2015 2016 2017 2018    
  Company owned rest        701.9        758.0        803.5        839.6        877.4    
  Franchise royalties          89.4          96.6        102.4        107.0        111.8    
  Franchise development fees             0.7             0.7             0.8             0.8             0.8    
  Domestic supply chain         629.5        679.9        720.6        753.1        787.0    
  Other          74.2          77.9          81.8          85.9          90.2    
Total NA Revenue     1,495.7     1,613.1     1,709.1     1,786.4     1,867.2    
  Franchise/franch development          25.7          28.0          32.7          38.1          44.3    
  Company owned & supply chain          76.7          83.6          97.4        113.5        132.2    
Total Intn'l Reve        102.5        111.7        130.1        151.6        176.6    
Total Papa John Revenue     1,598.1     1,724.8     1,839.2     1,937.9     2,043.7    
Operating Income        117.6        133.8        149.5        163.6        179.0    
  OPM 7.4% 7.8% 8.1% 8.4% 8.8%    
Less Interest Expense             4.1             5.8             5.8             5.8             5.8    
  Assume debt stays constant        230.5        230.5        230.5        230.5        230.5    
Less Taxes @ 32%          36.6          41.0          46.0          50.5          55.4    
Less Minority             4.4             4.6             4.8             5.1             5.3    
Net Income to shareholders          72.6          82.5          92.9        102.3        112.4    
Shares o/s - year end          39.8          38.7          37.5          36.2          34.8    
  Asssume all NI spent on buybacks @ 78              
EPS 1.83 2.13 2.48 2.82 3.23    
EPS growth   16.7% 16.2% 14.1% 14.5%    
At $78/share 2014 2015 2016 2017 2018    
P/E 43 37 32 28 24    
EV/EBITA 29 25 22 19 17    
My NA revenue projections assume that PZZA is able to grow its store base 1.5-2% pa in North America
(which I think is generous given my thoughts above) and comps decelerate from 5-6% in 2015 to ~3% by
2018 (3% is still a very good comp). Because of the assumed strong comp performance I assume a
higher margin on incremental domestic revenue. Internationally, I assume 12% growth from new stores
+ 3-4% from comparables (I assume 2015 to be weaker due to FX). Because all international growth will
be franchised, I assume a 90% flow through of international franchise revenue to operating profit.
While a 90% flow-through is probably too high, I assume no contribution from supply chain sales. All in,
 this gets me to 30-40bps of operating margin expansion during the forecast period and an 11%
operating profit CAGR during the forecast period. I assume free cash flow is equal to net income (if I had
to guess, I’d say FCF will trail net income by 5% or so) and that all free cash flow is used to buyback stock
at $78/share (consistent w/ 2015 guidance). This produces EPS of $3.25 in 2018. At today’s $78, PZZA
trades at 24x EPS three years out. It seems that at today’s price, management could execute its
playbook perfectly and the stock could be dead money or worse. I don’t believe anything but a near-
best case scenario is reflected in the stock.
In an alternate universe, comps could fall off as consumers eat less pizza while pizza makers compete
aggressively to try and win them back. Perhaps this occurs as wages and/or commodities rise. It is
possible we’d see modest decline in US revenues and fairly significant declines in profitability (as we’ve
seen in the past have a look at the historicals). Were this coupled with a slowdown in international
franchise growth, it is within the realm of possibility that 2018 EPS is not materially different than
current EPS but the market might put a 13-16x multiple on PZZA resulting in a $26-32 stock.
-Comp growth weakens
-Commodities/labor costs pressure margins
-Price competition increases
-Market continues to love restaurant stocks
-Comps continue at mid-high single digit pace


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


-Comp growth weakens


-Commodities/labor costs pressure margins


-Price competition increases

-Enthusiasm for restauarant stocks wanes

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