Papa John's Recipe for Disaster

Pizza hawker and Motley Fool Hidden Gems Watch List stock Papa John's (NASDAQ:PZZA) reported its first-quarter 2004 earnings on Tuesday, and the results look a bit undercooked. Revenues increased a meager 2% over 2003 first-quarter numbers; earnings, on the other hand, declined 23% to $8.5 million. Diluted earnings per share were $0.47.

Now, to be fair, this was the first quarter in which Papa John's consolidated its financial results with those of BIBP, the company's franchisee-owned cheese-purchasing business, as required by Financial Accounting Standards Board Interpretation No. 46. (FASB, by the way, is the same organization that fellow Fool Bill Mann has several times praised for its crusade to require the expensing of stock options.) But the consolidation can only be blamed for siphoning away $1 million of Papa John's hoped-for profits. Absent this accounting change, earnings would still have fallen 14% over the past year.

Long story short, for all the hoopla about the recent revival of restaurant sales, Papa John's pizza is still not out of the oven on this one. As a former pinch-hitting chef at Pizza Hut (owned by Yum! Brands (NYSE:YUM)), I can aver that the more toppings you put on a pie, the longer it takes to cook. That may be part of Papa John's problem. In an attempt to capture more market share, the company has been increasing its "portion" size to widen the qualitative lead its products have over its rivals. Between that initiative, and the company's program to increase the salaries of managers and assistant managers at its restaurants in order to decrease management turnover, operating margins have taken a hit, down to 6.2% from 8.3% a year ago.

Worse, while acknowledging the decline in operating margins and the similarly bad comparable sales figures from the past two months (down 3.7% in March and 5% in April), Papa John's admitted in its press release that it "cannot predict when operational improvements resulting from these initiatives, or otherwise, may result in improving sales trends." Hardly words to inspire.

Perhaps that is why, for all the company's objective cheapness -- it has an enterprise value-to-free cash flow ratio of less than 10, and analysts predict 10% earnings growth over the next five years -- 34% of its float is sold short. When you see a short interest number that high, a prudent investor has to wonder whether "cheap," is necessarily the same thing as "cheap enough."

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Fool contributor Rich Smith owns no shares of any company mentioned in this article, although he has owned PZZA in the past.