I have a soft spot for restaurant and fast food stocks such as Papa John’s (PZZA). Their business models are pretty simple to understand, and they strike me as fairly defensive. That can make for a good overall combination for buy-and-holders. A quick glance at Papa John’s stock price history appears to confirm that. It is up by a factor of around fifteen over the past couple of decades. I have that equivalent to annual shareholder returns of 14.5%, not including the extra bump from dividend cash.
I’d wager most folks in the United States have heard of the company. It sports 5,400 stores worldwide, around 3,300 of which are located at home. All of its international stores are franchised, as are around 2,700 of its domestic stores. That leaves 600 or so domestic stores owned and operated by the company. Ultimately, the business model is quite easy to understand and rests on three revenue sources. The company-owned stores don’t require much by way of comment – they sell pizza, hopefully at a profit after netting out costs. The franchised stores generate revenue by way of franchise fees. At Papa John’s, that basically takes the form of a 5% cut of sales. The company also makes money selling ingredients and paper to franchised stores.
The upshot of the above is that the first and third revenue sources tend to dominate the top line. The second – i.e. franchise fees – brings in hardly any revenue, relatively speaking, but generates a big chunk of the profit. Most readers have seen this story at McDonald’s, where revenue looks like it has fallen even though profit has risen. That effect is, of course, simply a result of swapping low margin company-owned stores for high margin franchised ones.
Papa John’s has seen system-wide sales grow from roughly $1,400m to $3,600m over the past two decades. This does not seem particularly spectacular over 20 years, and indeed it isn’t. Net profit clocked in at circa $32m back in FY00, while analysts only expect the company to make circa $70m in net profit next year.
Now, the company has been in the wars a bit over the past few years. I think that stems from the very messy departure of founder and former CEO John Schnatter, which appears to have weighed heavily on comparable sales growth and profit. The company was making circa $100m in annual net profit back in the FY17 period. Anyway, check out what all of these profit numbers look like in per-share terms. FY00 profit clocked in at 32¢ per share after adjusting for subsequent stock splits. Analyst estimates of FY21 profit equate to around $2.13 per share. That works out to compound annual growth in the 9.5% region. Before the profit decline showed up in FY18, per-share profit was registering in the $2.67 region.
You can put the big difference between the underlying and per-share profit figures down to stock buybacks. Papa John’s has spent around $1,750m on share repurchases over the past twenty years, enough to retire 70% of its float if my math is right. The tailwind from that has obviously been massive.
Here’s what worries me about the above. Earlier today, Papa John’s stock closed at just under $91 per share. It trades at nearly 43x estimated FY21 profit. The lone analyst with earnings estimates out to FY23 sees profit coming in at around $2.70 per share by then. Even that would equate to almost 34x forward earnings, and that’s three years from now! That looks much too expensive.
Just by way of comparison, McDonald’s stock trades at 23x estimated FY21 net profit. That falls to a somewhat more reasonable looking 21x FY22 profit. On that basis, I don’t think it’s too difficult to imagine a scenario in which Papa John’s valuation gets cut in half. Granted, it has strong support from low interest rates, but the effect is still pronounced on a long-term horizon.
Imagine buying and holding the stock for the next two decades. If Papa John’s trades at 20x forward earnings at the end of that period, the headwind from its current valuation amounts to 3.5% per annum. To generate double-digit annual shareholder returns would require earnings growth and dividends to contribute 13.5% per annum. That is quite an assumption over two decades, and for that reason I would hold off the stock at this point.
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