Why Papa John's Remains a Good Buy

Papa John's has recently been mired in controversy.  When pressed on the firm's negative performance during a heated earnings call, founder and CEO (Papa) John Schnatter made incendiary remarks regarding recent NFL protests.

In effect, Schnatter blamed the NFL's decline in ratings for Papa John's recent decline in sales. He followed this statement with an indictment of the NFL's handling of recent kneeling protests during the national anthem, alleging that the protests were what was causing the NFL's decline in ratings, and thereby Papa John's decline in sales.  These comments and the alleged pressure Papa John's has put on the NFL to resolve the issue caused a furor that led to Schnatter's ousting as CEO.    The market responded negatively to the headlines, and the stock languished below $60.00 for several weeks from a high in the mid 80s earlier this year.  As in any headline effect driven decline in stock price, this may represent a dislocation from the stock's fundamentals.

Pree Yerramilli of Eagle Chase Capital thinks so, and we sat down with him to discuss his recent long on PZZA on SumZero.  Pree has over a decade of experience on the buyside focusing on consumer and technology stocks. Pree's recent long on PZZA was recently featured as a finalist in the Special Situations section of SumZero's Top Stocks of 2018.

He has worked at major funds including ShearLink and Fortress, and has a track record of posting excellent consumer research on SumZero (KATE:US, +25.8%, LULU:US, +23.2%, SFM:US, +25.3%).

Luke Schiefelbein: What about PZZA initially caught your eye as an investor?  What catalyzed your entrance into the name?  

Pree Yerramilli: I invest in companies that are favorably positioned in large addressable markets, benefit from secular tailwinds, and can grow free cash flow significantly over a multi-year period. PZZA exhibits all of these traits. Pizza is a fragmented $125bn+ global industry with only three scaled competitors, all household names: #1 Pizza Hut (parent YUM), #2 Domino's (DPZ), and #3 Papa John's. The food is affordable, popular across demographics and geographies, and designed for delivery and digital/mobile ordering. Digital ordering is what initially stood out most with PZZA given my background is actually in covering technology stocks. The thematic trend that will continue to win is consumer businesses that are executing on mobile app-enabled convenience, and the major pizza chains have all been increasingly transforming into ecommerce businesses. PZZA's digital orders represent 60% of sales today, of which 70% come from mobile. The business is clearly on the right side of secular change given the prevalent consumer attitude today: "I want quality products, cheap, and now". The large chains' ecommerce capabilities should help them continue growing market share at the expense of mom-and-pop operators who dominate the industry landscape in number but lack the benefits of scale to compete effectively.

In terms of unit economics, franchise models are widely regarded as great businesses. 85% of PZZA's store base globally is franchised. A shareholder effectively owns a piece of a massive royalty stream produced by the hard work of franchisees, which converts nicely into free cash flow as the business's financials aren't burdened with the investments required by company-owned restaurant models. PZZA is very shareholder-friendly and has a proven track record of using its free cash flow for share repurchases and growing its dividend. I also tend to like companies with founder-CEOs who retain meaningful equity ownership. Despite the recent controversy surrounding him, PZZA's founder (and CEO until recently) John Schnatter still owns 25% of the business, which has aligned management's incentives well with shareholders over time.

Clearly it isn't easy to find many stocks with all of these characteristics trading at compelling valuations, but uncertainty around a business's future growth trajectory can occasionally represent opportunity. Like many people, I read the headlines about John Schnatter blaming PZZA's decelerating same store sales on the NFL’s player protest controversy. Seeing the stock react negatively and believing that PZZA is fundamentally a good business, I started doing more research in December only to then hear that Schnatter resigned as CEO. The stock fell again and was trading near its 52-week low, implying a 20x forward P/E, a significant discount to DPZ as a pizza pure-play. Despite the well-documented near-term issues, I believed this price was too cheap to ignore relative to the company's long-term growth potential, so I initiated a position.

Schiefelbein: What is the market missing?  What explains the company’s poor performance this year?

Yerramilli: The biggest debate is whether PZZA's comparable store sales deceleration is something that can be fixed or a more permanent structural downshift. As usual, the market is preoccupied with the very short term, where admittedly PZZA has not executed that well in the last few quarters. The company is most often benchmarked against DPZ, which has outperformed on comps mostly due to superior execution of an excellent digital advertising strategy that leverages social media and engages consumers effectively. Many growth investors see the difference in comps between the two companies and conclude that PZZA is probably just a competitive loser. The issues of recently weaker numbers and negative press around the NFL controversy are exacerbated by the fact that PZZA is less than 1/4 the market cap of DPZ and less liquid. There just aren't many investors who have the mandate (and frankly, patience) to spend the time on a small-cap stock with this much noise around it.

Where my view varies materially from the market's is that I see the recent trend in domestic comps as nothing to worry about from a medium/long-term perspective. In fact, I think the company has already taken some steps to right the ship that aren't being appreciated by most investors. In recent quarters, the company has hired a new Chief Information/Digital Officer and Chief Marketing Officer. This is important because despite a similar digital sales mix between PZZA and DPZ, studying their online presence and doing proprietary consumer surveys have given me some unique insights on differences in marketing strategy. PZZA's social media presence and overall relevance in positioning its product as digital-first vs. legacy media badly lags DPZ. DPZ has taken full advantage of the direct consumer reach of promoting offers via Instagram, Facebook, and Twitter whereas PZZA has not. Historically, PZZA's advertising has been too reliant on leveraging its relationship with the NFL as the league’s official pizza sponsor. Regular promotions, an essential tool for competing in the space, have targeted football fans and were heavily tied to certain teams winning games. NFL viewership has been declining now for two consecutive years and appears to be headed towards the lowest level in a decade, owing not just to the current controversy but also a proliferation in premium non-sports content that competes for viewers’ attention at the same time that games are aired. PZZA’s newly appointed digital and marketing executives’ top priority over the coming quarters is to deemphasize advertising that over-indexes to the NFL and pivot to higher ROI digital channels. Management has articulated that 2018 will be a year of marketing and technology investments, which also hasn’t helped investor sentiment as people worry about operating margins going down. However, I view these investments as absolutely necessary in making the Papa John’s brand more relevant to millennials and closing the competitive gap with DPZ. I believe there is a lot of low-hanging fruit here that can help PZZA reaccelerate comps and get closer to achieving management’s goal of 80% digital sales mix over time.

Schiefelbein: What key metrics should investors be paying attention to as your thesis matures?

Yerramilli: As with any restaurant or retail stock, PZZA will react the most to comparable store sales, specifically domestic comps. In my view, domestic comps can rebound in the second half of this year as the company increasingly implements the necessary investments management has guided to and faces easier comparisons from last year. The other metric to monitor is EPS growth, which I expect can reaccelerate even with lower reported comps. The reality with majority-franchised models is that fluctuations in comps don't really move the needle on earnings to the same extent as with company-owned restaurants; however, they matter much more for investor sentiment and consequently valuation. While PZZA may see more volatility in its comps in the coming quarters, the company has a new capital structure in place and is now targeting an ongoing leverage ratio of 2.5-3.5x debt/EBITDA. This matters because it allows PZZA to use incremental debt to accelerate its current $500 share buyback program. Therefore, if the stock trades poorly on comps missing expectations, the company is likely to be actively repurchasing shares in the open market. For a company that bought back 20% of its outstanding float between 2013 and 2017, I envision share repurchases will continue being a key component of EPS growth, and this should help support the P/E multiple on the downside.

Schiefelbein: What are the biggest risks associated with your thesis? What could go the most wrong?

Yerramilli: The big near-term risk is simply that things get a lot worse before they get better. It is realistically very tough to handicap the extent to which consumer demand may have been impacted by the founder’s public statements regarding the NFL. When the company reports its fiscal Q4 2017 earnings in February, management may report significantly negative comps and guide investors to a prolonged period of softness. This would be at odds with my view that domestic comps can recover later this year. Another point to monitor is that Pizza Hut is trying to regain market share after several years of declines. Depending on how successful they are in their strategy, this could create a headwind to PZZA’s comp reacceleration as this reintroduces a well-capitalized competitor into an already messy story. A more long-term structural risk arises from online platforms like GrubHub and Caviar, which are effectively democratizing the access to online ordering, payments, and logistics for substitute cuisine categories. The bear case on the pizza space broadly is that the moat enjoyed by the large brands due to digital investments is going to erode as consumers now have more options at their fingertips, and the offline-to-online migration for menus is still in fairly early innings. This could be a valid risk that requires ongoing diligence.

Schiefelbein: Do you think that the market has unfairly punished PZZA for its founder/CEO’s statements about the recent protests in the NFL?  How do you approach negative press events as an investor?  

Yerramilli: I think we know that especially nowadays, you have to be very careful about introducing politics into any conversation, whether directly or indirectly. Doing so on a public company earnings call is definitely foolish. Overall, I think the market’s reaction was warranted to some extent as the statements just sounded like a bad excuse for a problem area in the business (marketing mix) that should have been more closely monitored. No investor wants to listen to scapegoating; if there is a business issue, being straightforward and articulating a thoughtful solution is what we expect from management.

Headline risk is something you just have to have a strong stomach for in investing. You can feel very foolish owning a stock when all you seem to hear is negative news and everyone implies you’re an idiot for making the investment in the first place. My approach is simply to stay grounded in my own research and hold my position as long as I don’t uncover something that invalidates the overall thesis.

Schiefelbein: What will catalyse the market to see the value in PZZA?  What’s a realistic timeline to see this play out?

Yerramilli: Execution, execution, execution. PZZA is in the midst of a big change in senior management. The new CEO was formerly the company’s COO, and the CFO recently joined Jack in the Box with no replacement named yet. The new team will have to manage investor expectations effectively now following a period of underperformance and subsequent reinvestment. Companies that set realistic expectations and beat them consistently get noticed by the market. Once the company initiates FY 2018 guidance in February, I’d expect them to be able to start executing imminently, so hopefully this is reflected in valuation later this year. The other potential catalyst is that PZZA could very realistically be acquired. Restaurant Brands International is a platform acquirer constantly looking for franchised models to add to its portfolio. Given PZZA’s ability to take on leverage and generate meaningful free cash flow, private equity may also be interested.

Schiefelbein: What are PZZA’s biggest problems currently?  Is Domino’s recent resurgence a threat?  Is fast food in secular decline due to a shift in generational tastes?

Yerramilli: I believe the company’s biggest problems are self-inflicted from a lack of attention to hitting consumers with marketing and promotions where it counts the most today. The competitive landscape has been more or less the same for as long as I can remember. Domino’s has been executing well for several years now, so I don’t think they are contributing much incremental pressure at this point. As far as generational tastes changing, that’s always something to watch out for in the consumer space in general. However, I think professional investors are also unusually prone to weigh information readily accessible through their daily lives as more broadly applicable, which can be a flawed assumption. Most investors are located in big cities where average tastes are usually more sophisticated, and people are more affluent and preoccupied with the latest trends. If you walk around downtown Manhattan for 30 minutes, you might be convinced that cold-pressed juice stores are the best way to invest in long-term consumer trends. Of course, the reality is actually that many of these concepts won’t have the staying power as time-tested winners like burgers, fries, and pizza. Too many consumers value the consistency, affordability, and “comfort factor” of these foods, so replacing them is likely going to be very difficult regardless of how much time passes.

Luke Schiefelbein: Where else do you see value in the market today?  

Yerramilli: My investment approach generally defines value in the context of a company’s long-term growth opportunity. Where I see the most value today, ironically to those with more rigid definitions of “value”, is actually in the technology sector. As an example without revealing too many specifics, there are several mid-cap enterprise software companies with truly great products and visionary management teams that are driving multi-year change within large corporate customers. This change is happening due to the continued secular shift to software-as-a-service, allowing best-of-breed products to be delivered as a subscription model with high gross margins and immense free cash flow growth. The issue is that these businesses are selling for what appear to be offensive multiples to the uninitiated value investor. Since these stocks don’t screen well on headline metrics, most investors are priced out of the market, which I view as the opportunity. My research suggests many of these companies will enjoy an exceedingly long (10+ years) runway for sustainable growth and improving profitability, implying that today’s valuations may actually be very reasonable. I also expect this sector to consolidate at a rapid pace in the next five years, so the patient investor could do quite well by betting on the right businesses here.