PZZA - Papa John's: Moving To A Buy As Comparable Sales Are Poised To Recover (Rating Upgrade)

2023-09-19 11:45:03 ET

Summary

• Papa John's revenue growth expected to benefit from improving comparable sales, menu innovation, and new unit openings.
• Transitioning franchise-owned restaurants to company-owned in the U.K. to drive long-term sales growth.
• Margins expected to benefit from moderating inflation and increasing productivity, leading to margin recovery.

Investment Thesis

Papa John's International's ( PZZA ) revenue growth should benefit from potential improvement in franchise restaurants' comparable sales in the back half driven by pricing optimization, and new unit openings. Furthermore, on the international side, the company recently established a company-owned restaurant portfolio in the U.K. by acquiring ~118 restaurants in June and July. This transaction allows the company to have better control over processes and drive sales in the long term. On the margin front, the company should benefit from moderating inflation and productivity gains. The company is trading lower than its historical averages. This, coupled with promising growth prospects, makes it a buy.

Revenue Analysis and Outlook

In my previous article , I discussed the company's near-term headwinds arising from lower guest traffic in an environment where consumers are highly price-sensitive and prefer less expensive dining options. So, I rated the stock neutral despite a lower-than-historical valuation. The company has reported its earnings for the first and the second quarter of 2023 since then, and the stock price has remained almost flat, validating my stance.

In the second quarter, the company's sales growth was impacted by lower comparable transactions (guest traffic growth), in the international market and domestic franchise markets. In addition, moderating commodity costs resulting in lower commissary sales also impacted the company's North American commissary business. This was partially offset by an increase in comparable revenue in domestic company-owned restaurants. As a result, total company comparable sales declined by 1.3% YoY, while reported sales declined by 1.6% YoY to $515 million.

I believe the company's same-restaurant sales or comparable sales have bottomed, and looking forward I expect them to return to Y/Y growth in the back half of this year.

The company-owned domestic stores have already returned to positive Y/Y comps last quarter thanks to strong execution on the revenue management side ensuring that the customer has the right product at the right price, and at the right time, through the right channel. However, the company's North American franchise restaurant sales were down Y/Y. One place where the franchisees have lagged is in optimizing the pricing side which adversely impacted their performance. The company's franchise restaurants took price increases at a faster pace compared to the company-owned restaurants during the last year as they placed more emphasis on margin performance. This has resulted in higher prices at franchise restaurants and, as a result, they saw a larger decline in transactions relative to company-owned restaurants.

Management is now working closely with franchisees to optimize pricing and promotional models and make sure the company's franchise partners are getting the pricing right to grow comparable sales. This approach has led to sequential improvement in transactions as the quarter progressed and according to management, comparable sales at franchisees turned positive in June with further acceleration seen in July. So, I am expecting positive comparable sales for North American franchise restaurants as well in Q3.

The Company launched its new proprietary menu offering Doritos Cool Ranch Papadia in partnership with Pepsi and Frito-Lay at a $7.99 price point in the month of May. This launch generated a significant buzz and a double-digit growth in digital sessions at the start of the promotion. Continuing with the menu innovation, the company recently introduced the Garlic Epic Stuffed Crust Pizza and I believe continued menu innovation and the right promotional strategy should continue to help the company drive both its company-owned restaurant sales, as well as franchisee sales in the domestic markets.

Internationally, while the company's comparable store sales were down slightly at -0.7% Y/Y in Q2 2023, it meaningfully improved versus the -5.8% Y/Y decline seen in Q1 2023. The company is seeing good strength in the Asia and Middle East markets, however, the macroeconomic weakness in the U.K., which is the company's largest market outside the U.S. is adversely impacting its international sales.

While the company's UK portfolio was completely franchisee-owned before, in order to get better control over execution, the company established a company-owned restaurant portfolio in June and acquired a total of 118 franchise restaurants in the months of June and July. The company continues to make strategic investments in U.K. infrastructure and is working on integrating these restaurants with the company-owned portfolio.

This should help the company implement the best practices from the U.S. related to e-commerce, loyalty, and revenue management in its UK portfolio which should help turn around comparable restaurant performance in the U.K. in the coming quarters. So, I am optimistic about the company's international comparable sales growth as well.

In addition to improving comparable sales, the company's revenue should also benefit from increasing the restaurant count. PZZA opened a total of 74 net new units in the first half of 2023, bringing the total restaurant count to 5,780, and plans to accelerate its net new unit openings in the second half to reach its target of 270-310 net new units in 2023.

The company has a good pipeline of new restaurant growth in international markets. For instance, the company has announced plans to open a total of 650 new restaurants in India over the next 10 years in partnership with PJP Investments Group which currently operates more than 100 Papa John's restaurants across the United Arab Emirates, Saudi Arabia, and Jordan. So, I am optimistic about the company's near-term as well as long-term growth prospects driven by improving comp sales and new unit openings.

Margin Analysis and Outlook

In the second quarter of 2023, the company's margins saw benefits from year-over-year moderation in commodity prices. This was further supported by the carryover impact of price increases over the last year. However, these benefits were more than offset by sales deleveraging in the U.K. and higher SG&A as a percentage of sales due to an increase in incentive compensation expenses. This resulted in an adjusted operating margin of 7.2%, a 50 bps YoY decline.

Looking forward, I expect the company to benefit from moderating inflation and increasing productivity.

The company is experiencing moderation in the costs of the majority of its commodity basket, especially cheese which is the company's most used commodity. This is turning in favor of the company's margin growth moving forward. In addition, labor productivity is also increasing. Over the past couple of years, one of the biggest operational issues for the company was lower staffing levels at its restaurants. However, the situation has now improved significantly as compared to the prior years, as the company has managed well to restore its staffing at its restaurants. Now the company is seeing lower labor turnover and increasing productivity from their day-to-day tasks as the speed of service has improved. The company's out-the-door times at its company-owned restaurants have reduced by more than 25% as compared to the previous year. This improving productivity and moderating inflation should help the company's margin recovery moving forward.

Valuation and Conclusion

Papa John's is currently trading at 24.82x FY24 consensus EPS estimate of $3.05. This is below its 5-year historical average P/E of 39.06x. The company's revenue and margin growth prospects look good supported by factors such as increasing comp sales, menu innovation, unit expansion efforts, moderating inflation, and productivity gains. According to consensus estimates, the company should return to low teen EPS growth next year.

The company's improving growth prospects coupled with a lower-than-historical valuation, make me positive about the stock, and hence, I am moving to a buy rating on the stock.

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