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Is Papa John's Another Chipotle?

A turnaround opportunity at an attractive valuation

November 21, 2019 | About:

Papa John’s International Inc. (NASDAQ:PZZA) is a gem with a turnaround opportunity at an attractive valuation. While it is a great franchise business with a strong brand name, it's reputation has been tarnished. This should pass, however, under the right managment. The company has a new CEO who is right for the job. The blue-sky scenario for the pizza chain is far beyond a short-term turnaround.


I first came across Papa John’s a year ago when I went through the “Manual of Ideas” created by GuruFocus. I browsed all small-cap stocks and picked just a handful of companies that sounded interesting to me. Papa John’s was one of the top ones that caught my eye as it appeared to be a very profitable growing business. The only issues was a messy public relations scandal. I have watched the stock since then. Starboard Value invested in the company, but I passed on buying because I didn’t have confidence that the successor of the founder and CEO was right for the job. At the end of August, Papa John’s hired a new CEO who finally seems right for the job.

Papa John’s is the third-largest pizza chain the U.S. after Yum Brands’ (NYSE:YUM) Pizza Hut and Domino’s Pizza (NYSE:DPZ). You must be familiar enough with the brand and its slogan: “Better ingredients, better pizza.”

Papa John’s is in trouble. Same-store sales dropped from very healthy 4% range in 2016 to -9% in 2018, before slightly recovering in the first two quarters of 2019.

Profitability also plummeted.

The share price has also suffered. 

What is the problem?

Papa John’s problem was caused by its founder and former CEO, John Schnatter. 

In 2017, after several great years of terrific sales and new restaurant openings, Papa John’s slowed down. Comp sales declined to 1.7% for owned stores and 0.7% for franchised stores. These were still decent numbers, but Schnatter, or “Papa John,” was not happy with the results.

Instead of thinking of ways to boost demand, he blamed the NFL for the weaker performance. He indicated during the earnings conference call that the company had unsafisfactory performance because the NFL was not able to resolve the controversy surrounding players kneeling during the national anthem. What really got him in trouble, though, was his use of a racial slur. This ignited a chain of events that became a public relations nightmare for Papa John’s. Same-store sales plummeted. The franchise fee was lowered. Profitability greatly suffered. Schnatter stepped down as CEO and was subsequently stripped of his chairmanship.

Why is the stock a buy?

I recommend buying Papa John’s at its current price. I think this is great business with a temporary problem that can be fixed relatively easily. Now that the company has a new CEO with a good track record of successful brand building, I have confidence that Papa John’s can not only return to its previous glory but also extend even further.

A great business with a strong brand name

Selling pizza is not glamorous, but it makes good money. Its revenue is recurring and recession proof.

Papa John’s had a return on invested capital of 40% before 2017 and ROIC was trending up.

The profit margin was respectable in the high single digits and probably had room to expand further.

Asset turnover was simply outstanding and was going up.

An increasing proportion of franchised stores makes the business more asset light.

Business was so good that over the 20 years of Papa John’s life as a public company, the share base shrank by two-thirds due to buybacks.

Reputational issues will pass under the right management

The severe damage to Papa John’s reputation can and will be fixed. In the short term, we draw Papa John’s in parallel to Chipotle (NYSE:CMG) in 2017.

If you recall, in 2015, 55 people got sick from an E. coli outbreak after eating at Chipotle restaurants. It was definitely a blow to the company, whose customers are typically more health-conscious than average. It was not a very easy fix because the restaurant chain's ingredient sourcing and food processing makes it more prone to having food safety issues. Even though the company continued to have minor food safety issues, Chipotle appears to have gained its reputation back under a new management team who made the right decisions. The stock has doubled.

Compared to Chipotle, Papa John’s issue is that it alienated its customers due to Schnatter’s public racist comments. The damage to the brand is significant, but the issue is not rooted in the business. It is rooted with one person. With Schnatter gone, the root of the problem is eliminated.

Turnaround specialist Starboard Value saw the opportunity and invested in Papa John’s. Its managing partner, Jeff Smith, became chairman of the board. They also brought in a new CEO, Bob Lynch.

As Papa John’s problem is reputational, a good brand manager will be crucial for the company to get back on track. Lynch is the right person for the job. He has held leadership positions at Taco Bell, HJ Heinz Co. and Procter & Gamble (NYSE:PG). In 2013, as the new chief marketing officer of Arby’s, he led the launch of “We Have the Meats” campaign. He became the president of Arby’s in 2017 and is credited for the restaurant chain achieving 16 quarters of same-store sales growth.

Blue-sky scenario is far beyond a short-term turnaround

Looking beyond the short term, we can draw Papa John’s in parallel with Domino’s Pizza.

Domino’s Pizza was on fire. Patrick Doyal, its CEO from 2010 to June 2018, completely turned around the business, whose pizza was previously regarded as “tasting like cardboard.” He helped Domino's improve the taste of its pizzas, invest in online ordering and promotions and make significant share gains.

Over his tenure, Domino’s increased its store count by 77%, outperforming Papa John’s 52% growth. Operating income per store for its North American franchised stores (98% of its store base) more than doubled, again significantly outperforming Papa John’s.

If Domino’s can make these strides, there is a chance that Papa John’s can do the same, maybe even more so, from a smaller base. In particular, there are two areas that Papa John’s can catch up to Domino’s: number of stores and international business.

Papa John’s’ store base is only one-third of Domino’s. In particular, the international store base is less than 20% of Domino’s. Operating income per store overall is lower than Domino's even at the peak in 2016. Operating income per store for international locations are less than half of what Domino’s achieved. Can Papa John’s do better? Why not? Its pizza is regarded as better than Domino’s to start with, and it has the road map drawn by Domino’s.

Valuation is attractive

Simply put, if you believe that Papa John’s can once again generate the same peak earnings of 2017 in a few years with further room for growth, the stock is at 18 times normalized earnings. The price is attractive.

Since the forward earnings are not normalized, the price-sales ratio is more appropriate to get a sense of the value of the stock. The current price-sales ratio is about 1. It is attractive in lieu of a successful turnaround.

When compared to its quick-service restaurant peers on a price-sales basis, Papa John’s is cheap.

My price target of $72 is based on 1.5 times sales assuming 100% conversion of Starboard Value preferred shares.

What keeps me up at night

A turnaround is never easy. Lynch has proven himself as a CEO and in brand building, but there are many other things about the businesses that need to be taken care of.

Consumers have more and more choices due to the advancement of technology. Numerous industries have been disrupted, such as retail, media and transportion.

Domino’s has said food delivery companies are becoming very competitive, many times making deliveries at a loss. This presents a short-term challenge to pizza companies, where historically pizzas were among the limited choices in food delivery. I don’t view this is a big threat in the long term. People choose to get pizza delivered because it is convienient, cheap, quick and safe to feed a group. I don’t think more delivery options can fundamentally change that. Pizza chains will be here for a while.

Disclosure: I own shares of Papa John's. 

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