It’s been a tough start to the year for the major market averages, and the restaurant industry has continued its decline. However, despite Papa John’s (PZZA) being in a better-performing group (pizza) than its restaurant peers, the stock has slid more than 18% from its all-time highs, underperforming the restaurant group by 600 basis points since November. If this sharp correction had left the stock at an attractive valuation, this would present a buying opportunity, with Papa John’s much better positioned than most other segments of the restaurant space. However, at ~31x FY2022 earnings estimates, I still don’t see enough of a margin of safety here above $116.00.
In November, Papa John’s released its Q3 results, reporting quarterly revenue of $512.8 million, representing an 8% increase year-over-year. While this was the company’s lowest sales growth rate in over a year, Papa John’s was lapping 17% sales growth in the year-ago period, pointing to impressive results given the difficult year-over-year comps. These solid results were driven by moderate unit growth and strong comp sales growth, with international and domestic comp sales up 6.9% and 8.3%, respectively. Given the robust results combined with improved margins, the company is on track for triple-digit earnings growth this year ($3.38 vs. $1.40).
However, as I noted in my most recent article in November, while Papa John’s posted solid results and annual EPS was set to hit a new all-time high, much of this growth was already priced into the stock. This is because the stock traded at more than 36x FY2022 earnings estimates, a more than 20% premium to its historical multiple. Since then, the stock has come back to reality, declining nearly 20% from its highs despite two bullish news items, including plans to expand into Africa with Kitchen Express (60 restaurants) and a massive development agreement with FountainVest Partners for new stores in China.
Regarding the most recent China deal, the partnership with FountainVest (one of Asia’s leading independent private equity firms) calls for opening 1,350 new stores across South China by 2040. This is a huge deal for Papa John’s and trounces its suggestion that it had a market opportunity of 1000+ restaurants in China. This is because following this new deal, the company’s footprint in China would exceed 1,500 restaurants, including the 200 restaurants it already has in the country. Combined with the large domestic development agreement with Sun Holdings for 100 locations in Texas and the South by 2029, Papa John’s has a very impressive development pipeline and should have no problem maintaining and potentially accelerating its ~4% unit growth rate in 2021.
So, why has the stock come under pressure?
While the recent development agreements point to the addition of ~1,500 stores, translating to nearly 25% growth vs. Papa John’s current store count (~5,500 restaurants), I believe that this growth was already partially priced into the stock at its November highs. This is because PZZA was up nearly 370% in barely 18 months from its Q1 2020 lows. In addition, while Papa John’s reported higher restaurant margins on a two-year basis in Q3 2021, it may be more difficult to maintain this margin expansion going forward. This is because Domino’s (DPZ) recently guided that its food basket would be up 8-10% from 2021 levels due to inflationary pressures. This led to the company cutting its $7.99 wings from ten pieces to eight.
To date, Papa John’s has been able to skirt around the margin pressure industry-wide, with restaurant and gross margins increasing vs. 2019 levels. The company has benefited from limited-time offers and menu innovation which has boosted average check, like Papadias, Epic Stuffed Crust, and its recent BaconMania promotion. However, with Domino’s not only reporting a much higher average basket vs. 2021 levels but also making a move to cut its wing portions, the margin outlook for Papa John’s is less clear in 2022.
The good news is that the company continues to have impressive average unit volumes, exceeding $1 million in 2020 and growing further in 2021. Therefore, the unit economics are still quite attractive to potential franchisees, even if the margin outlook may get a slight downgrade due to continued inflationary pressures. Besides, while Papa John’s may see some pressure on margins into 2022 at company-owned stores, its margins are still holding up much better than peers, with most fast food names faring much better than their casual dining peers.
This is evidenced by names like Red Robin (RRGB) reporting meaningful margin compression, with margins dipping 300 basis points vs. Q3 2019 levels to 12.5%. So, with inflationary pressures continuing to wreak havoc on the industry, Papa John’s and other fast-food/fast-casual names like Chipotle (CMG) appear to be the best houses in a bad neighborhood if one wants exposure to the industry. Let’s take a look at the company’s earnings trend below:
As shown above, Papa John’s is on track to grow annual EPS by more than 140% in FY2021 based on current estimates, which would also represent a new all-time high in annual EPS. This represents a massive recovery since the massive sales decline in 2018, with annual EPS sliding nearly 50% year-over-year. Looking ahead to FY2022 and FY2023, earnings growth is set to continue, which is no surprise, given the steady unit growth expected in both domestic and international markets. However, while Papa John’s ranks high on growth, it ranks low on value, evidenced by Seeking Alpha’s Quant ratings above. A closer look at the valuation explains why the stock currently sits on a “D” rating.
Valuation & Technical Picture
Looking at the chart below, we can see that Papa John’s has historically traded at ~28x earnings and closer to 25x earnings since its IPO debut (1993). At a current share price of $116.00, the stock has pulled back from an insane valuation of ~38x forward earnings to ~31x earnings, but this is still well above its historical earnings multiple. Besides, even if we compare the current earnings multiple to its 10-year average of 34x earnings, the below chart shows that the ideal time to buy the stock has been closer to 23x earnings, not more than 30x forward earnings. This is evidenced by the chart below, which shows previous troughs in the stock.
On a P/EBITDA basis, this figure also suggests that Papa John’s is not attractively priced yet, with the stock sitting at a ~5.5% EBITDA yield or just over 18x EBITDA. Over the past ten years, the stock’s EBITDA multiple has averaged ~16, and the best buying opportunities came at below 13x EBITDA (Q3 2014, Q1 2016, Q3 2018). Obviously, with a low likelihood of another major snafu like during the Schnatter Saga, a return to below 12x EBITDA is unlikely. However, even using FY2022 EBITDA estimates of $6.60, the stock is still trading at ~17.5x EBITDA, 10% above the historical multiple. In summary, it’s hard to argue that there’s any margin of safety here even after the 18% correction. This is because the stock has gone from extremely overvalued to slightly overvalued.
As shown in the long-term picture above, PZZA came within 5% of testing the top of its multi-year channel, and as I warned in November, this could present a sticky point for the stock. This is because tests of this upper channel line have not been kind to the stock, with past tests leading to 30% plus corrections. As it stands, PZZA is down 18% from its highs, but it’s still sitting in the upper portion of its long-term channel. For investors looking for the most attractive buy points and willing to be patient, the best time to buy Papa John’s and tuck it away has been on pullbacks to the bottom third of this trading range, which would require a dip below $80.00 per share.
If we zoom in on PZZA’s technical chart above, we can see that the stock formed a clear double top in the $140.00 area, and there is now a new resistance level at $138.50. Meanwhile, with the stock recently making a new multi-month low, the next strong support area doesn’t come in until $102.25. So, while the stock has pulled back sharply from its highs, PZZA is only slightly below the mid-point of its trading range. Generally, I prefer at least a 4 to 1 reward/risk ratio to enter new positions, and PZZA’s reward/risk currently comes in at just 1.60 to 1.0. Hence, we’re not yet at a low-risk buy point. This is based on $22.30 in upside to resistance and $13.95 in downside to support.
Papa John’s continues to enjoy strong unit growth and is expected to grow annual EPS more than 22% from FY2021 levels ($4.13 vs. $3.38), which is extremely impressive given that it will be lapping ~140% earnings growth this year. However, while the recent breakout to new highs in annual EPS is a bullish development, I still don’t see enough of a margin of safety to justify paying up for the stock here at ~31x FY2022 earnings. So, while I believe Papa John’s is a name to keep an eye on if it dips below $102.00, I currently see much better value elsewhere in the sector. One name that appears more attractive is Restaurant Brands International (QSR), trading at just ~18x FY2022 earnings estimates.
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