Is This Pizza Stock Rolling in Dough?

Leo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Pizza restaurant chain Papa John’s International (NASDAQ: PZZA) recently lost a slice of its market share after the Louisville, Kentucky-based company posted fourth quarter results that topped estimates on the top line but missed estimates on the bottom line. To make matters worse, Papa John’s also told investors that it needed to restate its earnings back to 2009 after the company and its auditors found an accounting error stemming from a joint venture agreement. Will this double whammy of bad news end Papa John’s streak of strong performance over the past 12 months?

Sales Growth

Papa John’s same-store sales came in strong, at 5.2% growth in North America and 7% internationally. The company attributed its higher same-store sales to an increased number of stores worldwide. During the quarter, Papa John’s opened 156 restaurants and closed 22 locations -- which represents a 7.2% increase over the previous year.

Its North American company-owned restaurants reported 23.6% growth in revenue to $161.6 million. Franchise units reported 4.6% sales growth, which resulted in an 18.3% increase in royalty revenues to $21.2 million. Its domestic commissary segment posted a 15.9% rise in sales to $149.1 million, which it attributed to higher sales volume.

Meanwhile, its international revenues rose 29.1% to $20.7 million, fueled by new store openings and high same-store sales growth.

Room for Improvement

From these figures, I can see two areas where Papa John’s can improve upon to stabilize its growth.

First, it needs to increase the dependence on franchise stores, rather than company-owned ones. Fast food giants McDonald’s, Yum Brands (NYSE: YUM) and Burger King have all strongly benefited from a shift towards franchised businesses. This reduces overhead costs, minimizes risks and allows more store openings.

Second, it should strive to increase its international footprint. Although 1,400 of Papa John’s 4,163 locations are located internationally, they are scattered all over the world -- in the Middle East, Russia, South America, Europe and Asia -- serving a total of 35 countries. That scattershot approach has exposed it to some nasty markets, which offset growth in stronger ones. With a limited number of stores in each country, it also suffers from weaker brand recognition than Yum’s Pizza Hut or Domino’s Pizza (NYSE: DPZ). Like its industry rival Yum, it should concentrate its efforts more on China and the rest of Asia to maximize growth potential, while minimizing its exposure to Europe.

Fourth Quarter

For its fourth quarter, Papa John earned 74 cents per share, or $18.4 million - an improvement from the 65 cents per share, or $16.8 million, it earned in the prior year quarter. Its revenue rose from $306.2 million to $367.3 million.

Analysts had expected the pizza chain to earn 75 cents per share on revenue of $355.4 million.

For the full year, Papa John’s earned $2.58 per share, or $66 million -- up from $2.16 per share, or $58.5 million, in the previous year. Revenue also rose from $1.22 billion to $1.33 billion.

Cash Reserves and Expenses

Papa John’s finished the quarter with cash and equivalents of $16.4 million. Long-term debt was at $88.3 million. Despite its seemingly low cash reserves, Papa John’s free cash flow and long-term debt have been diverging in the right directions, as seen in this chart.

<img src="" />

PZZA Cash and Equivalents data by YCharts

Expenses, though rising, are still under control. However, Papa John’s recently stated that Obamacare measures, which will require the company to pay up to 60% of employees’ health care, could result in an increased cost of 11 to 14 cents per pizza, and a much steeper increase in expenses in 2013.

The ominous “restatement of earnings”

Although Papa John’s initial statement noting that it had to restate earnings sounded ominous, the restatement will not impact its previous state revenue or cash flow -- only earnings.

<table> <tbody> <tr> <td><strong>Net Income</strong></td> <td><strong>Original</strong></td> <td><strong>Revised</strong></td> </tr> <tr> <td><strong>2009</strong></td> <td>$61.2 million</td> <td>$57.5 million</td> </tr> <tr> <td><strong>2010</strong></td> <td>$55.4 million</td> <td>$56.1 million</td> </tr> <tr> <td><strong>2011</strong></td> <td>$59.4 million</td> <td>$58.5 million</td> </tr> <tr> <td><strong>2012 (1Q-3Q)</strong></td> <td>$48.0 million</td> <td>$47.6 million</td> </tr> </tbody> </table>

Source: Papa John’s announcement

Although these decreases in annual earnings, except for 2010, are disappointing for investors, it is encouraging that Papa John’s is honest enough to go back and fix the problems while offering investors full transparency to its process.

The company stated that it found a “material weakness” in its internal controls and is currently “implementing remedial measures” to avoid future mistakes, according to a regulatory filing.

Stackin’ up the pizzas...

Fundamentally, how does Papa John’s stack up to Domino’s Pizza and Pizza Hut parent Yum Brands?

<table> <tbody> <tr> <td> </td> <td><strong>Forward P/E</strong></td> <td><strong>5-year PEG</strong></td> <td><strong>Price to Sales</strong></td> <td><strong>Debt to Equity</strong></td> <td><strong>Return on Equity</strong></td> <td><strong>Profit Margin</strong></td> </tr> <tr> <td><strong>Papa John’s</strong></td> <td>14.71</td> <td>1.57</td> <td>1.02</td> <td>22.96</td> <td>30.12%</td> <td>4.73%</td> </tr> <tr> <td><strong>Domino’s Pizza</strong></td> <td>20.45</td> <td>1.66</td> <td>1.59</td> <td>N/A</td> <td>N/A</td> <td>6.44%</td> </tr> <tr> <td><strong>Yum Brands</strong></td> <td>17.48</td> <td>1.80</td> <td>2.14</td> <td>127.25</td> <td>76.06%</td> <td>11.71%</td> </tr> <tr> <td><em>Best Value</em></td> <td>Papa John’s</td> <td>Papa John’s</td> <td>Papa John’s</td> <td>Domino’s Pizza</td> <td>Yum Brands</td> <td>Yum Brands</td> </tr> </tbody> </table>

Source: Yahoo Finance

Despite its bullish performance over the past year, Papa John’s can still be classified as an undervalued growth stock. However, its margins are the weakest of the bunch, which means that lower commodity prices and increased pricing power could strengthen the company - which brings us back to a previous point: companies with stronger brand recognition, such as Pizza Hut and Domino’s, are usually able to raise prices and pass costs onto the consumer with fewer drawbacks than smaller competitors.

A comparison of top and bottom line growth also reveals a surprising trend.

<img src="" />

PZZA Revenue TTM data by YCharts

Papa John’s profit growth has outpaced both Domino’s and Yum over the past five years, despite only growing revenue by 17%. Its top and bottom line growth is nearly synchronized with Domino’s Pizza, since they share a nearly identical business model -- pure pizza. However, Yum owns other brands, such as KFC and Taco Bell, and is also weighed down by hormone-injected chicken woes in China.

The lesson here? People like pizza, and that human constant doesn’t look to change in the coming year. Looking forward, Papa John’s expects to grow its earnings by 10% to 14% in 2013. North American same-store sales are expected to rise by 1.5% to 2.5%, while international same-store sales are forecast to grow by 5.0% to 7.0%.

The Foolish Bottom Line

Despite its recent setbacks, Papa John’s is still a solid investment in the restaurant industry that rests slightly below the radar of most investors. Robust same-store sales growth and a strong demand for its simple business model could propel this stock to fresh highs next year. However, investors should be wary of increased competition in the pizza market, as well as food inflation, which is expected to crimp the margins of most restaurant operators in the coming year.

Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of Papa John's International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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