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Papa John’s savior has a tough task

The company’s sales have worsened over the past 18 months, and things aren’t getting any easier, says RB’s The Bottom Line.
Photograph: Shutterstock

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The activist investor known most for taking Olive Garden to task for not salting its pasta water now gets a new challenge: turning around the country’s fourth-largest pizza chain after a nightmarish 2018.

Starboard Value, whose proxy fight victory over Darden Restaurants in 2014 set a new standard for activist investing, will invest up to $250 million in Papa John’s in exchange for stock that will give it up to 15% of the company. Franchisees will be able to buy another $10 million in stock at the same terms.

For Papa John’s, the deal could finally signal an end to months of uncertainty following the shocking departure of its former chairman, CEO and founder, John Schnatter.

But numbers Papa John’s released Monday made it clear exactly what kind of task it and its new financial backers have in front of them—a tough one that is far more complex than the one Olive Garden faced five years ago. There is no pasta water to salt this time.

Papa John’s domestic same-store sales fell 8.1% in the fourth quarter—a modest improvement over its nearly 10% decline in the third quarter.

Yet those sales worsened in January, falling 10.5%. Among the reasons for the slowdown: “ineffective promotions in the heightened competitive environment.”

But a different look at the data paint a much dimmer picture of the sales challenges facing the Louisville, Ky.-based chain.

On a two-year, stacked basis, same-store sales worsened from a decline of 8.8% in the third quarter to a 12% decline in the fourth quarter—that’s because the comparisons in the summer months were easier than they were in the last three months of the year.

And the implication from January is even worse. The first part of the year suggests that same-store sales could be down well over 15% on a two-year basis, using Papa John’s 5.3% decline from the first quarter of 2018 as a calculation. The weakness explains the challenges the company is having with closing locations.

As BTIG analyst Peter Saleh noted, the rapid deterioration “necessitated the investment by Starboard.” It probably scared off buyers—who were circling the chain in November only to back off last month, according to reports.

One of the hallmarks of the restaurant business in 2019 is that it’s largely full of locations, especially when it comes to chain restaurants. Consumers are therefore picky.

They have reams of information on company actions from ratings and social media. Any chain that fails to meet expectations or damages its reputation gets swift punishment.

Chipotle Mexican Grill found this out in 2016 when its same-store sales plunged more than 20% after a series of food safety incidents—and the company’s sales have recovered only modestly since.

Papa John’s two-year figures are painting a similar picture. Consumers have clearly punished the chain since Schnatter’s comments about NFL player protests in November 2017. They worsened further after the July incident and the company’s marketing changes since then haven’t helped.

This was also its first season without the NFL sponsorship, which it ceded to Pizza Hut nearly a year ago.

Pizza Hut, the country’s second-largest chain, has worked to take advantage of that sponsorship. What’s more, the country’s largest pizza player, Domino’s Pizza, is about to increase the pace of expansion—promising to grow by a third over the next few years as it seeks to solidify its dominance in the market.

Those two chains, plus privately held Little Caesars, will almost certainly put considerable pressure on the smaller Papa John’s and make recovery in a pizza market known for low consumer loyalty all the more difficult.

Starboard and its CEO, Jeff Smith, who will become Papa John’s chairman, did help turn around Darden, thanks to cost cuts, the sale of some real estate and operational improvements. But much of that credit for the turnaround has been given to Gene Lee, who was named interim CEO before the 2014 proxy and who has led the casual-dining operator since.

Equity investments like the one Starboard is making can prove beneficial to a company. Noodles & Co. received equity infusions from Mill Road Capital and L Catterton in 2017, which provided the financial stability that help them reverse sales declines and rebuild company profitability.

Yet Noodles doesn’t operate in a market nearly as competitive as the one Papa John’s does. It also didn’t have to deal with the public relations problems or fight with its founder over control. And Schnatter hasn’t exactly provided the Starboard investment with a ringing endorsement, leaving open the possibility of legal action in an SEC filing.

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