Investing great Peter Lynch once said that "If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighborhood shopping mall, and long before Wall Street discovers them." Pizza chains found in your local shopping center plaza such as Domino's (NYSE:DPZ) and Papa John's (NASDAQ:PZZA) can represent good places to start your research. Of course Lynch also advocated researching companies for things like good financials. If the company you own doesn't produce cash flow, then it will veer toward bankruptcy and take your stock price toward zero.
Debt laden balance sheet
Domino's and its franchisees operate more than 10,800 stores. As with most chains of this size it's performing spectacularly on the international front. In 2013, same stores sales increased 6.2% internationally versus 5.4% domestically. International retail sales growth more than doubled the domestic rate when excluding currency translations during that time frame. Domino's increased its revenue, net income, and free cash flow 7%, 27%, and 5%, respectively.
However, its balance sheet leaves much to be desired. Domino's debt exceeds liabilities, leaving a stockholder's deficit of $1.3 billion. This makes it impossible to put its $1.5 billion in long-term debt into perspective as its long-term debt to equity ratio is incalculable. Interest on long-term debt can kill the profitability of any company. Operating income currently only exceeds interest expense by four times. The rule of thumb for safety resides at five. Cash clocked in at a minuscule $14.3 million at the end of 2013. Domino's does pay a small dividend; last year Domino's paid out 22% of its free cash flow in dividends. As of this writing, it pays shareholders $1 per share per year, equating to a 1.3% dividend yield.
Warren Buffett, another investing great, likes companies run by owner-oriented managers. Managers who own a great deal of stock in the company they run will make sure it grows because they want to see their personal wealth expand. In other words their interest is aligned with yours. With that said, Papa John's Founder, Chairman and CEO John Schnatter owns 27% of the company, meaning he possesses a vested interest in making sure that company shareholder value gets maximized.
Papa John's and its franchisees operated 4,428 stores as of the end of last year. Papa John's also performed well on the international front with comparable international sales up 7.5% versus 4% for domestic comparable sales. Overall, revenue and net income increased 7% and 13%, respectively, during 2013. Its free cash flow decreased 18% due mainly to increased capital expenditures. Its cash equated to approximately 10% of stockholder's equity at the end of 2013. Papa John's balance sheet shows a 79% increase in long-term debt for 2013 with long-term debt to equity coming in at 114% more than double the rate of 2012. However, operating income exceeds interest expense by 270 times. Papa John's paid out 21% of its free cash flow in dividends. Currently the company pays shareholders $0.50 per share per year and yields 1%.
What to look for
Papa John's relatively stable fundamentals and smaller size gives the company more potential. Investors really need to eye Domino's interest expense. If it gets too large relative to operating profit then you need to shy away from it. Look for both companies to continue robust expansion on the international front as long as their balance sheets allow it due to lower market penetration in emerging and developing economies. Feel free to add these two companies to your Motley Fool Watch List.
William Bias has no position in any stocks mentioned. The Motley Fool owns shares of Papa John's International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.