Papa John’s (NASDAQ:PZZA) is addressing lagging commissary margins with a new system that it is rolling out now. It expects that over the next 4 years, it will double commissary margins, which should have a welcome effect on operating income growth, excluding the fact that it is also doing a decent job of keeping up volumes and topline growth. However, current multiples suggest all of that is priced in, and they seem a little desperate to produce growth with the industry also becoming more competitive and less disciplined. At current multiples it’s not interesting, as is almost universally the case for these well-known publicly listed brands.
Papa John’s has been doing a pretty good job of keeping its prices competitive and in its positioning. Moreover, it’s been getting volume growth, and quite a lot of the margin pressures have eased YoY, namely in labor and in costs for ingredients like protein which had a jump of inflation last year. This on top of decent growth, around 6% for company owned stores, and a 2% growth in NA franchises. Still, adjusted operating income is around flat YoY, netting for some legal one offs that made last year’s figures less favorable, as well as this year’s repositioning costs around their UK strategy.
The key dynamic we are interested in is the changes in its commissary business that they have planned. The business earns a fixed margin of 4% and is the place where ingredients and dough must be bought for franchisees and for company owned stores. Around 40% of the sales or so are from the commissary business, but it has less than half the blended margins of everything other than it. Consequently, it accounts for around 20-30% of the operating income depending on the year. By the end of 2027, they want to double the margin performance of the business. In order to have some give for franchisees, they are also introducing a rebate system that can be very favorable if franchises achieve good unit growth.
This system follows some larger impairments last year among franchisees and some more active efforts to close down underperforming franchises or to even buy their businesses and merge it into the company owned segments. We don’t see a major issue in the franchisees absorbing this, and apparently the margins benchmark quite low relative to the cut that other chains take at the commissary level.
The margins won’t double immediately by the way, they will gradually increase into 2027.
How exactly this will impact profits is pretty unclear, since it will interact with the performance of franchisees. Assuming that company owned stores outperform franchisees in terms of growth, the full brunt of the margin increases will most likely pass into the bottom line from the franchisees. Papa John’s doesn’t have a huge amount of revenue from franchises, around 7% in NA, but of course these are based mainly on royalties, and they also make money on the franchises by selling them goods through the commissary. There’s crudely around a 10:1 split between franchises and company owned including domestic and international figures.
The increase in margin for commissary revenues is going to take a lot more from franchises, but comes in exchange of lower required marketing spend rates by franchisees, so the net effect shouldn’t be too bad after all.
The company estimates that for every 100 bps increase in commissary margins, there will be a 50 bps increase in overall margin, or a 50% pass through which sounds about reasonable given all this information.
We expect that the initiative will provide around 30% growth in operating income over the next 4 years. However, we feel that all that growth is already well priced in, with a 30x PE. Underlying growth rates aren’t great, and the UK push is into a competitive market, and we don’t have that much optimism about it, and it is the center of the company’s forward-looking efforts. We don’t count on this materializing to great effect. Also, in the earnings analysts were commenting on aggressive promotions by competitors for some years now. While Papa John’s shows its brand power by maintaining a level of growth, it’s an industry that is getting tougher, and inflation also continues to be a point of concern. The effects of downtrading from other types of eating may also be seeing some limits now as discretionary expenditure risks becoming further impacted by economic woes.
Without superb growth, and counting mainly on the commissary effect, we wouldn’t want to buy it for 30x P/E, especially since the commissary margin growth will take some years.
Read the full article here