Papa John’s comeback from a brutal 2018 could face a huge obstacle: its franchisees.
Specifically, the chain’s operators don’t generate the cash flow to cover the discounts required in the highly competitive pizza market.
That, at least, is according to Stifel analyst Chris O’Cull, who in a note earlier this week downgraded Papa John’s to a rare “Sell” and suggested that it was at least in part due to the challenges facing the brand’s franchisees.
O’Cull estimates that Papa John’s domestic operators average just $40,000 in earnings before interest, taxes, depreciation and amortization, or EBITDA, per location. That is low. By comparison, Domino’s Pizza operators’ EBITDA is more than three times that much. And O’Cull estimates that Pizza Hut franchisees average EBITDA is more than $50,000 per location.
Franchisee unit economics matter. It is tougher for brands to compete when their operators don’t make money. Franchisees are less likely to build new units, add new technology or remodel locations. And they certainly can’t afford discounts.
This is especially true in the brutal pizza market, one in which the largest player, Domino’s, is increasingly dominant and planning to build 2,000 more locations over the coming years.
The hallmark of the pizza market is price. Pizza customers are disloyal, and value is vital to the largest companies.
Those companies are competing heavily on price right now. As O’Cull noted, Little Caesars has $5 Hot-N-Ready pizzas, Pizza Hut has a $5 lineup and Domino’s has a $5.99 deal that it has had for years.
Papa John’s was able to get a $200 million lifeline from activist investor Starboard Value to keep its finances straight. But operators face their own challenges.
Franchisees in 2017 averaged about $900,000 in sales per location in 2017 and then saw same-store sales fall close to 10% in 2018.
But those operators have also been closing locations for the past year as the chain’s sales worsened. As we pointed out recently, Papa John’s two-year, same-store sales have deteriorated since July to an estimated 15%-16% decline in January.
The company has made efforts to bolster operators’ finances—notably by providing royalty relief, for instance.
Operators’ financial position likely means they’ll need to receive further subsidies in the future. Or more franchisees could close units, which also hurts Papa John’s earnings.
Papa John’s faces a major challenge in rebuilding its sales following the controversies over the past year, which started when founder and then-CEO John Schnatter blamed NFL player protests for his chain’s poor sales late in 2017. They worsened last summer, when he resigned after acknowledging using a racial slur during a conference call.
Convincing customers to return to the company would be a major challenge regardless of any other situation.
Operator finances complicate the situation, because it means the operators are less able to withstand the discounting that might be necessary to generate customers in today’s environment.
Those operators signaled their concerns last year when they hired a litigation attorney in the wake of the Schnatter controversy.
In addition, competitors aren’t exactly sitting still. Domino’s is building more locations, and Pizza Hut has the NFL contract Papa John’s once owned.
None of this is to say that Papa John’s can’t turn it around under new Chairman Jeff Smith. It’s just not as easy as many might think.