PZZA - Papa John's International: Why Would You Buy This?

2023-10-10 03:59:34 ET

Summary

• Papa John's financial performance has improved with cost management efforts, but the capital structure remains a concern.
• Revenue and net income are higher compared to pre-pandemic levels, but interest expenses have increased significantly.
• The stock is currently trading at a discount, but the dividend yield is still below the risk-free rate, making it a less attractive investment.

It’s been over four months since I suggested that people should avoid buying Papa John’s International, Inc. ( PZZA ), and in that time the shares have returned a negative 10.3% against a small gain of about .9% for the S&P 500. While this is gratifying on some level, and I would much prefer to just revel in my call here, it’s time to review the name yet again. The company has reported financials, and a stock trading at $63 is, by definition, a less risky investment to one that’s trading at $71. I’m going to determine whether or not it makes sense to buy or not based on a combination of those financials and the current valuation. Additionally, because everything in the world of investing is relativistic, I need to put this analysis in the context of risk-free returns that investors can receive in mid-October of 2023.

Welcome to the “thesis statement” portion of the article. It’s here where I give you the gist of my thinking in a single, hopefully pithy, paragraph. This allows you to get in, get the main thesis, and then get out again before you’re exposed to too much of my writing style. You’re welcome. In some ways, I’m very impressed by the financial results. The company did a great job of cost containment in the teeth of slowing revenue, to the point where operating profit and net income have both surged nicely. The problem for me remains the capital structure. I suggested in my previous article that the debt level can’t help but put a break on future dividend growth, and nothing’s happened on that score to change my mind. Finally, the dividend yield remains well below the risk-free rate. This prompts what I consider to be an unanswerable question to bulls: if an investor can earn a higher, and safer return in government Bills, Notes, and Bonds, why would they buy this? For that reason, I’m going to continue to eschew these shares and would recommend others do the same.

A Tale of Two Financial Statements

I admit that I’m actually impressed with the financial performance here to some degree. In spite of the fact that revenue declined by about 2.2%, or $23.8 million, from the year-ago period, operating income rose by $19.4 million, and net income was up by $4.5 million. This is largely the result of cost management efforts on the part of the company. For instance, domestic company-owned restaurant expenses, North American commissary expenses, and G&A expenses were down by $12.2 million, $14.7 million, and $8.3 million, respectively.

When we compare the most recent results to the pre-pandemic era, things look even better operationally. Compared to the first half of 2018, revenue and net income were higher in 2023 by 18.4% and 40% respectively. Operationally, the company is improving nicely in my view.

The balance sheet is another issue altogether, though. While the company managed to reduce operating expenses, interest expenses for the first half of 2023 were $9.95 million, or 96% higher than they were in the same period in 2022. In my view, the company needs to reduce the debt level here. Instead, we see that debt today is about 46% greater than it was in 2022 and about 36% greater than it was in 2018. In my view, the company would have been better off paying down debt, rather than spending $209.7 million on buybacks for the first half of 2023. Previously, I wrote that the debt level will eventually act as a break on future dividend growth, and nothing’s happened to move me from that view. I’d be willing to buy the stock at current levels assuming the valuation is reasonable, and assuming the current dividend is reasonable. Once again, I expect little growth from the dividend until the capital structure is cleaned up, so if the dividend is not sufficiently high now relative to the risk-free rate, I doubt I’ll get too excited about the stock.

The Stock

While the financial performance has been fairly good recently, I feel compelled to remind investors that the more you pay for $1 of future cash flows, the lower will be your subsequent returns. This is why I try my best to buy shares when they are cheaply priced. Put another way, there’s a strongly negative relationship between price paid and future returns.

I point this out so often in my articles because I frequently come upon people who talk about the need to buy a company because it’s growing well. These investors decide to buy, regardless of price, simply because a company’s earnings are on the upswing. This is naive in my view. This view that it’s reasonable to buy stock in a company because that company is growing cash flows quickly is related to the idea that we “don’t buy stocks, we buy businesses.” Let me repeat myself yet again. We very much do buy stocks and not businesses. If you doubt me on this score, please consider the tale of two investors. Investor “A” bought Papa John’s shares the day after their (fairly decent) earnings call on August 3rd. That person is down about 22% since then. Investor “B” bought virtually identical shares two months later, on October 4th. That person is down only about 3% since. Not enough happened at the firm over this short span of time to account for a 17% variance in returns, so no one bought “the company”, both parties bought “the stock.” Additionally, the person who bought the stock at the cheaper price did less badly. This is why I try to buy shares cheaply.

With that sermonizing out of the way, I should point out that I measure the cheapness of a stock in a few ways, ranging from the simple to the more complex. On the simple side, I like to look at ratios of price to some measure of economic value, like earnings, free cash, book value, and the like. I like to see shares trading at a discount to both their own history and the overall market. When I last reviewed Papa John’s, the price-to-sales ratio was sitting around 1.19 times, and it’s now about 11% cheaper on that basis per the chart below. Additionally, the dividend was yielding about 2.37% previously, and is about 14% greater today, per the following:

Source: YCharts

Source: YCharts

To add some context to this, the previous dividend yield was about 286 bps lower than the then 1-year risk-free rate. Today, the yield is “only” 272 basis points below that rate .

In the world of investing, everything is relative. If you buy “X”, you are, by definition, eschewing any number of “Y”s. In my experience, the trick is finding that ideal combination of risk and return. You want to take on as little risk to achieve your return needs as possible. At the moment, investors can earn significantly higher returns while taking on significantly lower risk. Given that, bulls are confronted by an unanswerable question at this juncture: if you can earn a higher, safe, sleep-at-night return from a government instrument, why would you buy this? For that reason, I’m going to continue to avoid this name until the dividend spikes higher, and/or the debt level drops precipitously.

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