PZZA - Avoid Papa John's International

Summary

• The capital structure has deteriorated fairly massively over the past year, and net income attributable to the company is actually down significantly.
• The market is paying higher prices for $1 of sales, and the dividend yield is about half that of a 10-year Treasury. Investors are paying more, getting less.
• I've done well with my deep out-of-the-money puts, but the premia on offer at the moment are too thin to justify this exercise again.

It's been about four and a half months since I last wrote about Papa John's International, Inc. ( PZZA ), and in that time the shares have returned about 11% against a gain of about 3.3% for the S&P 500. Although I didn't buy stock at the time, I did write 10 put options that will expire in the near future, and so I want to review the name again. Since they've published financials yet again, it's time to see if this is a worthwhile investment at current prices. I'll make that determination by looking at the valuation relative to the most recent financial results.

Welcome to the "thesis statement" portion of the article, where I offer you the gist of my thinking about a given name upfront, so you can get into the article, and then quickly leave again before I have the chance to annoy you too much. You're welcome. I wouldn't recommend buying shares at current valuations because I really don't like the bad combination of more expensive stock, lower dividend yield, and diminished financial position. The company has much more debt on the books now, and therefore more risk. In spite of this, the shares are trading at a much higher valuation. Additionally, the shares are sporting a dividend yield at the moment that's just over half of what an investor can get on a 10-year Treasury. In the domain of investing, everything's relative, and this investment is relatively bad at the moment in my view. Finally, although I did well selling deep out-of-the-money puts, I can't recommend the same trade again. That written, I think it behooves every investor to learn about this strategy now for when generous put option premia return.

Financial Snapshot

The most recent financial results seem "ok, not great" in my view. Revenue of this recession-resistant business was up about 2.4%, and net income was up massively from a loss of about $20.4 million to just under $44 million. We shouldn't get too excited about this, though, because in 2021, net income was massively negatively impacted by the $110 million dividend on redemption of series B. convertible preferred stock. Absent that expense, net income attributable to the company in 2021 was $95.3 million, against the $44.3 million earned in 2022. So, in some ways, 2022 saw a slowdown in the business.

This is troubling in light of the fact that the dividend has increased by 40%, and dividend payments have risen by 44.5% from 2021 to 2022. At the same time, the company has loaded up on debt, which is now about 33% higher than it was the same time last year. Unsurprisingly, interest expenses climbed by 59% in 2022.

Although I'm still of the view that the dividend is reasonably secure, given the deterioration in the capital structure, and the relative reduction in profitability, I'd need this recession-resistant business to be trading at a very reasonable price before I got excited about buying it.

The Stock

If you subject yourself to my stuff regularly, you know that I think the stock is distinct from the business in many ways. A business invests in a number of inputs, like cheese, tomatoes, and the like, adds value to those inputs by turning them into delicious pies, and then sells the results for a profit. That process is fairly straightforward, and not particularly volatile. The stock, on the other hand, is a traded instrument that reflects the crowd's aggregate belief about the long-term prospects for a given company, and the stock is buffeted by a number of forces, some of which may have little to do with the underlying business. Inflation may impact a business like this one significantly, as it might drive up food input costs. The crowd may form a view about the relative attractiveness of stocks in general, and that drives shares up or down. Strangest of all in my mind, stock investors can be mesmerized by the pronouncements of Fed officials, as if the difference between a 50 and 75 basis point move in the overnight rate matters all that much.

Although it's tedious to see your favorite investment get buffeted around for reasons having little to do with the health of the business, within this tedium lies opportunity. If we can spot discrepancies between the price the crowd dropped the shares to, and likely future results, we'll do well over time. It's typically the case that the lower the price paid for a given stock, the greater the investor's future returns. This is why I only ever want to buy a stock that is relatively cheap, and it's why I'm reconsidering Papa John's. In order to buy at these cheap prices, you need to buy when the crowd is feeling particularly down in the dumps about a given name.

As my regulars know, I use a host of measures to judge the relative cheapness (or not) of a given stock, some of which are quite simple, some of which are quite sophisticated. On the simple side, I like to look at the ratio of price to some measure of economic value, like earnings, sales, free cash, and the like. Because I think "cheaper wins", I want to see a company trading at a discount to both the overall market, and the company's own history. In case you've forgotten, I eschewed Papa John's when it was trading at a price-to-sales ratio of about 1.42 times and the dividend yield was a paltry 1.8%. Fast-forward a few months, and the market is paying about 11.7% more for a dollar of sales, and the dividend yield is now about 28% lower per the following:

As my regulars know, I also want to try to understand what the crowd is currently "assuming" about the future of a given company. If the crowd is assuming great things from the company, that's a sign that the shares are generally expensive. If you read my articles regularly, you know that I rely on the work of Professor Stephen Penman and his book "Accounting for Value" for this. In this book, Penman walks investors through how they can apply the magic of high school algebra to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in this formula. In case you find Penman's writing a bit dense, you might want to try "Expectations Investing" by Mauboussin and Rappaport. These two have also introduced the idea of using the stock price itself as a source of information, and then infer what the market is currently "expecting" about the future.

Anyway, applying this approach to Papa John's at the moment suggests the market is assuming that this company will now grow profits at a rate of about 1% from here. That is a pretty pessimistic forecast in my view. While I like that pessimism, I don't like the fact that investors are paying more for $1 of sales, and getting less of a dividend for their troubles.

When I last reviewed the name, the shares were changing hands for about 1.42 times sales, and the dividend yield was about 1.8%.

Options Update

In my previous missive on this name, I suggested that I didn't want to buy the stock, but I was comfortable taking the much lower risk path of selling deep out of the money put options. In terms of the specifics of the trade, I sold 10 of the April 2023 puts with a strike of $60. These were at the time 27% out of the money, and I earned $0.60 for each of these. I liked this trade because I "won" no matter what happened. If the shares remained above $60, I'd pocket the premium, if the shares fell, I'd be "forced" to buy this business at the equivalent of a 2.05% dividend yield and a price to sales ratio of about 1.05. These puts are currently bid at $0, so that trade's worked out well so far, I think.

While I like to repeat success, I can't suggest writing puts at the moment, because the premia have gone from "barely acceptable" last Fall to "not worth the effort" today. For instance, the December puts with a strike of $60 are only bid at $2 at the moment. So, an investor is taking on some small risk to earn a relatively paltry 3.3% on this investment. Given that, the 10-year Treasury is currently offering 3.5% . That trade makes little sense in my view. Again, in the domain of investing, everything's relative.

For that reason, I can't recommend selling puts today, but I will keep watch on this stock and will sell puts aggressively if and when the shares drop in price.

So my strategy will be to put in a bid to close these at $.05, and when that happens, I'll enter the trade I'm about to write about. If you're just joining us and are not obliged to potentially wait for these April puts to expire, I would recommend selling more puts on this company. I consider this strategy to be a "win-win" because the results are positive no matter what happens. If the shares remain above the strike price, you simply pocket the premium and move on. If the shares crash below the strike price, you're obliged to buy, but you do so at a price that you like.

With that in mind, I'm hoping to write the December Papa John's Puts with a strike of $60. These are currently bid at $2.05, which I consider to be a reasonable return for the risk. Once again, if you're just joining us, I would recommend this trade today as a great, lower risk way to "play" this stock.

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