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Wednesday, July 28, 1999

An Investment Opinion
by Louis Corrigan

Papa John's Got the Same Old Bag

In my continuing endeavor to learn the basic lesson of Peter Lynch -- and think about buying those companies I already buy from -- I bring you a look at Papa John's International (Nasdaq: PZZA), which last night reported second quarter earnings slightly ahead of estimates. Because I don't live and work at Fool HQ, I actually don't eat that much takeout pizza. But when I do, Papa John's is The Man, eh, company. Once I finally tried Big Daddy, the pies spun by Domino's and Tricon's (NYSE: YUM) Pizza Hut just tasted second-rate.

Indeed, Papa John's extraordinary success this decade has forced these old pizza oligopolists to hustle to improve their product or get left behind. On today's conference call, Papa's founder and CEO John Schnatter wouldn't take complete credit for Little Caesar's recent announcement that it would close some 400 stores. But he noted that "Papa John's has raised the bar in the pizza category," both for service and quality. The folks who brought us the immortal "Pizza, pizza" are apparently having troubles vaulting that bar.

I'd love to report that Papa's got a brand new bag, but the second quarter offered the same-old, same-old: terrific revenue growth combined with even better earnings gains. Revenues leaped 21% to $200.4 million versus $165.2 million a year ago, after restating year-ago results to account for the March 28 pooling-of-interest acquisition of Minnesota Pizza, formerly a franchisee operating 37 Papa John's restaurants.

After opening 103 new stores during the quarter, including 6 company-owned units and 97 franchised units, Papa John's exited June with 519 company-owned units and 1,538 franchised restaurants for a total of 2,057 stores. The company is on plan to meet its target of opening 400 new units in 1999. An already pending deal that should close late this quarter or early in Q4 should also get the company close to its target of acquiring a total of 60 Papa John's restaurants this year.

Comparable store sales shot up 4.2% for company-owned units (versus 2.9% in Q1) and 6.5% for franchised stores (versus 9.2% in Q1), for a systemwide same-store sales increase of 5.8% (versus 7.2% in Q1). This represents the 25th consecutive quarter of comp-store sales gains -- exactly what you want to see from a growing retail chain since stronger sales at the individual store level leverage fixed costs like leases, equipment, and distribution systems to produce more operating profits per unit.

The actual increase in pizzas sold on a comparable store basis came in an even stronger 10%. Every year the company runs an anniversary promotion to attract new customers. Papa John's management believes it served 700,000 new customers as a result of this year's promotion, which offered 2 pizzas for $12 rather than 2 for $13 like last year's special. As anyone captivated by the Star Wars mania knows, Pizza Hut was heavily promoting what turned out to be a not-so-successful toy tie-in. You can see the anxiety in Papa John's stock, which dipped below $35 per share around the time of the movie's premiere.

The extra discount probably helped counteract the competitive sales environment. In any case, the company expects Q3 comps to run 5% to 7% overall, with company-owned stores in the 4% to 6% range and franchised units in the 6% to 8% range -- guidance similar to that given for Q2.

Given the operating leverage that results from increased same-store sales, it's not a shock that profit margins continued to rise. Net income soared 47% in the period to $12.3 million versus $8.6 million a year ago, pushing net margins to 6.15% for the period versus 5.22% a year ago. Even after factoring in a modest uptick in share count to 31.1 million from 30.7 million, earnings per share (EPS) shot up 43% to $0.40 per share from $0.28 last year. That beat the 11-analyst Wall Street consensus by a penny per share.

Looking at the stores in the comp-store group, operating expenses dipped to 24.7% of revenue from 25.8% last year. Overall, general and administrative expenses rose slightly to $14.3 million from $13.9 million, but fell to 7.15% of revenues from 8.4% a year ago, a 125 basis point improvement. An increase in pre-opening and other general expenses resulted partly from the costs of moving a commissary.

Another factor offsetting the other improvements was the slightly higher-than-expected spending on advertising late in the quarter, which management says contributed to better comps in June and a good start to Q3. As Papa John's continues to build its brand, however, overall advertising expenses as a percent of sales should continue to decline, boosting profit margins. For instance, ad spending in Q3 should be 8.5% of sales versus 8.9% a year ago, and 8.5% for FY99 overall.

The company's balance sheet also remains quite strong, with $79 million in cash and investments and virtually no long-term debt. That's a sign of what a fast-growing and well-run business this has been in recent years. Overall system revenues have grown from just $298 million in FY94 to $1,156 million last year. That's a 40.3% compound annual growth rate (CAGR)!

The company's revenues have been cooking, too, rising from $162 million in FY94 to $670 million last year, a 42.7% CAGR. The compound annual EPS growth rate over this period was 40.2%, or 42.9% before the effects of an accounting change. Last year, revenues shot up 31.6% while EPS vaulted 37.4% to $1.25 (before the accounting change; $1.16 after) from $0.91 in FY97. Return on equity was a solid 15.9% last year.

Papa John's has been gaining market share because it offers a superior product, and it's changing and improving a market in the process. Such companies are fun to follow. But investors have the added benefit here of thinking about hedging cheese costs! That's not something most of us get to worry about on a daily basis. Actually, like coffee prices for Starbucks (Nasdaq: SBUX), cheese represents a major raw materials expense for Papa John's. A year ago, average prices hit $1.64 per pound due to a milk shortage. Though cheese prices have recently risen from $1.40 to $1.75 per pound, Papa John's management says current milk futures prices translate into cheese prices of $1.40 per pound. So while they're doing some hedging, they expect cheese prices to fall since there's no shortage of milk like there was last year.

At $43 a share, Papa John's trades at 26.7 times the consensus FY99 earnings estimate of $1.61 per share and about 21 times the FY2000 consensus of $2.05. Analysts put long-term annual growth at 27.6%. Figuring in the cash of over $2.50 per share and the company's growing franchise, the stock looks like a modest value. It's at least worth watching for the next time the market takes a swing at it.

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