Checking In on Papa John's Ongoing, Ugly Decline

The slow implosion of pizza chain Papa John's International (PZZA 1.31%) continues apace, and in this segment from MarketFoolery, host Chris Hill and analysts David Kretzmann and Aaron Bush review what management told the market in its most recent earnings report. Same-store sales are sharply lower, and the company has made a number of questionable and/or desperate-looking moves recently. But what's particularly baffling is that John Schnatter, former CEO and still its largest shareholder, keeps saying things that push the stock price lower. What can the chain do to get itself out of this spiral?

A full transcript follows the video.

This video was recorded on Aug. 8, 2018.

Chris Hill: Papa John's second quarter results were kind of a mess. They missed on the top line and the bottom line. Adding to the drama and the spectacle of Papa John's is the fact that the founder and namesake, John Schnatter himself, who is no longer the CEO, is on the sidelines ripping the current CEO, who he worked with for years and was essentially his protege. This stock is down more than 50% in the last 12 months. For the life of me, I can't think of a time when an established, mature restaurant stock fell that much in a year and it didn't involve some sort of health crisis.

David Kretzmann: Yeah, this is pretty ugly, and it'll probably get uglier going forward. North American same-store sales were down 6%. In July alone, after Schnatter's comments, same-store sales were down 10.5%. This is just brutal. This is almost Chipotle E coli levels from a few years ago.

There are so many issues here. On the conference call, Steve Ritchie, the new CEO for the company, became CEO officially in January, he outlined some different initiatives they're doing with digital and their loyalty program, and even stuff to keep franchisees on board, potentially giving them some kickbacks or relaxing royalty agreements. Apparently, that's something that really only happens in recessions. The fact that they're doing that demonstrates that they're potentially getting a little desperate here.

Then, from a financial perspective, free cash flow was actually up this quarter. But the company last year made the brilliant move to go into more debt to buy back stock. An interesting thing here, in the most recent quarter, the company bought back $5.4 million in shares, which is the least amount of stock they've bought back since the first quarter of 2011 ... even though the stock is basically the lowest it's been in the past three to five years. [laughs] Only $5.4 million in stock bought back in the most recent quarter when the share price is the lowest it's been in quite a while. In the past few quarters, they bought back well over $200 million in shares.

So, from a capital allocation perspective, now the company is swimming in debt, will potentially have to renegotiate that. Management was saying, "We might have some pre-emptive discussions with our lenders." The company has backed themselves into a corner here. You have a ton of debt, you have such a bizarre scenario where you have your founder and former CEO, John Schnatter, on the sidelines, ripping the company.

Hill: And still the biggest shareholder!

Kretzmann: Yeah, he owns 30%. I don't know where you go from here. I think their best option would be to try to find some sort of private buyer, but in this case, I don't think funding is secured for Papa John's. This is such an ugly scenario, for a company that, a couple of years ago, was actually doing pretty well.

Aaron Bush: Yeah, it's terrible. [laughs] It blows my mind a little bit. I think the risk, apart from just consumers not wanting to associate their pizza-buying habits with Papa John's is that franchisees also don't want to associate their business with Papa John's. The franchisees are really the lifeblood of what keeps this business going. If I were a franchisee looking for a new restaurant to franchise with, how would I ever be thinking about Papa John's as a good idea right now? If they can't get the franchising element improved, that's crippling for them.

Apart from that, they really need someone to step in and right-size the culture and the ship of things. I don't know much about the current CEO, but if Papa John's owns 30% of this business, I see that as sort of impossible.

Hill: That's the thing. We can think about ways to right-size this business, but ultimately, Schnatter is the one who has to buy into this. He has 30%. You would think, at some point, since the value of his company has dropped so much in such a short amount of time, maybe he would think, "OK, whatever that takes. If that includes selling the company, rebranding it completely," because, I don't think a culture fix alone is going to do it. I really do think it's going to take a total makeover.

I was thinking about it this morning, coming into work, one of the things that's good to have in life, and I would argue important to have, whether it's business or just your life in general, we all need that person in our life who can pull us aside at a given moment and say, "Look, I know you don't want to hear this, but ... " We all need that person in our life, whether it's a friend or a spouse or a family member. Schnatter needs that friend right now. I don't know if he has that friend, but someone needs to go to him and say, "I know you don't want to hear this, but the only way your net worth is going to start heading north instead of south is for you to walk away from this and back whatever plan it takes to make this company over."

Kretzmann: Yeah. The press release he put out after the company reported earnings yesterday, he made it very clear, "I'm not going anywhere. I'm going to keep doing what I feel like is best for the future of the company and employees and shareholders."

What's interesting is, he was blasting Steve Ritchie, the new CEO, for the company's performance since mid-2016, which is when it started to turn south. They've been underperforming compared to Domino's for a while, but frankly, every restaurant is, so that's not the best comparison. But, Schnatter, if I'm not mistaken, had the CEO title all the way through until January 2018 when Steve Richie took over. So, he can't totally offload all the blame onto Richie and the management team. He was still chairman, he was still CEO -- if nothing else, by title -- over the past couple of years. He still needs to take some of the blame. Going forward, I think you need to find someone who's willing to buy this, but I don't know who would be at this point. It's such a tarnished brand.

Hill: To go back to what you were saying about the franchisees, Aaron, if you're someone who's looking to get into the restaurant business, why would you go to this -- by the same token, if you're an investor looking at this stock, it's dropped this much. The market cap is $1.2 billion. This company is so tiny now. I can imagine a few investors out there going, "Gosh, this thing's cheap!" The fix is, theoretically, easy, because it's a pizza company. This is not a complicated business, this is not nanotechnology we're talking about here. But, I don't know, this stock still screams, "Stay away!"

Bush: I think he needs to pull a Martha Stewart and just --

Hill: Go to prison?

Bush: Yeah, go to prison. And once he's gone, there will be something there. Maybe that's too much. [laughs]

Kretzmann: That's might be what you need there.