Under the Crust at Papa John's

Some investors first look at the bottom line of a company, note a very large jump in earnings per share (EPS) over the previous year, check out the stock price movement for the last year or so, and then call it a day. Needless to say, these folks probably won't do as well with their investments as those who dig a bit more deeply.

Case in point: the recently reported quarterly earnings for pizza maker Papa John's (Nasdaq: PZZA  ) . At first glance, the $0.46 EPS (43.8% higher than last year, and well above consensus estimates of $0.34) looks great. The two-year chart looks pretty good, too, since the price doubled in the last two years before going essentially flat so far this year.

But a bit more digging reveals that almost one-quarter of those earnings came from the consolidation effect of the franchisee-owned cheese purchasing company, BIBP. The core earnings for Papa were $0.34 per share, up 6.2% from last year's $0.32, when there was no significant impact from BIBP. Fellow Fool Mike Cianciolo discussed the same thing last quarter, when one would have to remove $0.10 from the reported $0.47 EPS.

Now you might be tempted to say "so what?" If BIBP continues to make money, it will just keep boosting the results of Papa John's, right? Not quite.

BIBP is a "variable interest entity," and its accounting treatment limits the upside. Because Papa John's is the primary beneficiary of BIBP, the company must recognize both the operating earnings and losses from BIBP. For instance, in Q2 2004, it recorded a loss of $0.66 per share from BIBP. Any operating earnings are also recognized by Papa John's, but only up to the amount of losses previously recognized. The net effect over time is neutral, but in any quarter, it can skew the results downward (Q2 2004) or upward (Q2 2006) or have no effect at all (Q2 2005). This is the kind of odd thing that Foolish investors who look under the surface will find.

Not only are earnings affected, but also free cash flow, which I'll define here as net income - BIBP earnings + depreciation & amortization - capital expenditures - change in non-cash working capital. For the most recent quarter, free cash flow was a negative $341,000, compared to positive $9.9 million in the year-ago quarter. The primary differences between the two quarters were increases in capital expenditures and accrued expenses, along with the $4 million BIBP effect bringing down corrected net income. For the last twelve months, free cash flow, discounting for BIBP effects, was $50.4 million. Based on that, the current price has about 16% growth for the next five years baked in according to my calculations, assuming a 12% discount rate.

Last quarter, Mike argued that shares were a bit pricey. Based on free cash flow, I tend to agree. Investors should probably dig a bit deeper into the financial statements. For instance, why did capital expenditures increase significantly starting three quarters ago? Earnings grew 6% this last quarter, after correcting for BIBP. What were corrected earnings for the last few quarters, and how have they grown? And, why, for the second quarter in a row, did the company increase guidance for the year, but only by raising the lower limit of the projected range? Some of these aren't easy to answer, but might make for a good future column.

Bottom line? Don't always take the bottom line at face value.

More pizza pie Foolishness:

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Fool contributor Jim Mueller likes looking under the hood of companies, but gets totally lost under the hood of his car. He does not own shares in Papa John's. The Fool is all about investing and keeping you informed.


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