Papa John's: Sharpening The Value Perception And Enhancing 1P Channels

seekingalpha11-21 13:09

Papa John's struggles with aggregator channels and outdated loyalty programs, but recent improvements in rewards and value perception show promise for a turnaround.Domino's success with its revamped ...

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Now, this is the 'Fast-Food Exodus' that I have been talking about for a long time. However, the pizza segment has its own peculiarities, and one of them is directing transactions to its own channels as a key priority to maintain control over the experience, data management and margin of each transaction. This becomes an increasingly bigger problem as aggregator channels become increasingly the field of competition, especially in the 'Battle of the Pizzas'. Despite giving in to aggregator channels in 2019, Papa John's was the QSR Pizza chain that was least successful in driving transactions to its own channels, as its loyalty program 'Papa Rewards' had one of the worst redemption structures in the category, requiring the purchase of many points to obtain any reward. This discouraged both the migration from third-party channels to its own and the accumulation of points in 'Papa Rewards'. After all, the occasional guest visits Papa John's about four times a year, and according to data from the chain, a quarter of the active members of the program did not reach the goal of a single reward. This scenario is quite different from its direct competitors. Three years after Papa John’s embraced third-party channels to drive incremental sales, Pizza Hut (YUM) jumped on board, and it wasn’t until the summer of 2023 that Domino’s (DPZ) partnered with Uber Eats (UBER) to participate in this trend in QSR Pizza. However, shortly after embracing third-party channels as part of its strategy, Domino’s launched its revamped rewards program, Domino’s Rewards. This is a big deal, as the chain didn’t give occasional guests enough time to get used to using third-party channels (which would have resulted in Domino’s losing control of the guest experience, guest data, and most importantly, the full price without having to pay app fees). Of course, maintaining a revamped rewards program would naturally drive occasional guests away from ordering on third-party channels, as they could earn points and still get cheaper items. It’s a win-win at the end of the day. The results of this have been great for Domino’s. Membership has grown to 2 million within just a few months of Domino’s Rewards being live. In addition to the initial uptake, comparable sales have accelerated year-over-year since September. In Q4 FY 2023, the earliest in which these trends can be observed in their entirety, comparable sales grew 2.8% year-over-year, accelerating to 5.8% year-over-year growth in Q1 FY 2024. Now, this was the quarter in which many restaurants felt the impact of an extremely weak January, but it didn’t seem to affect Domino’s, which could now maintain its occasional guest base within Rewards while generating incremental sales in aggregator channels. What’s the lesson from this? Before you jump headfirst into aggregator channels, make sure you have a good direction for your own channels. If your occasional guests continue to use aggregator channels, you’ll be losing out on both occasion amplifiers, control over data and experience, and pricing. At the end of the day, you’ll be generating fewer transactions than you could and your average check per guest will become increasingly weaker due to the impacts of a more preponderant sales mix hyper-indexed to these channels. During Q2 2024, we saw headwinds from there. Transaction growth in aggregator channels had a 1% impact on comparable sales within the United States. This repeated itself during Q3, putting the same 1% pressure on comparable sales domestically. Papa John's needed to make Papa Rewards relevant, and fast. Management is aware of this and is making changes to the royalty structure to boost sales in the core channels, but a broader change to the rewards program is planned to take effect in FY 2025 (note that the current Papa Rewards format has remained the same since its second redesign in 2018). In November, Papa John's is allowing members to unlock Papa Dough more quickly (previously, it was necessary to spend $75 to earn 10 Papa Dough, now every order of $15 or less earns 2 Papa Dough). This structure appears to have had positive impacts, as there was a sequential improvement in the number of transactions overall, but still negative year-over-year, and a surprising increase in transactions year-over-year in pickup and delivery, bolstered by a more favorable mix of transactions in the owned channels. This was seen in September and October, which should have increased in November given the incentives in the rewards structure. Still Losing the 'Battle of the Pizzas', But Value Levers Are Being Pulled In addition to the issue of its outdated loyalty program, like most QSRs, Papa John’s is struggling with its perceived value. This was a major driver of the Fast Food Exodus, and while Papa John’s has a gap in value offerings compared to its peers, it makes up for it with premium products and larger checks compared to the traditional pizza QSR. We know that while the chain reports fewer transactions, the relative number of checks with two or more pizzas is higher than its direct competitors. The average check is $17 per transaction, driven by menu innovations like the $10.99 XL New York pizza and Shaq-a-Roni, not to mention the Cheesy Burger Pizza in Q2. But as we know, QSRs are volume-driven segments. Without them, you won’t make enough money. The key is to find a balance of innovation and value, but your focus should always be on your core menu. This seems to have been an area that Papa John’s has been marginalized by, and it’s cost them dearly in their value scores. Looking at YouGov’s recent survey from September, it shows that Papa John’s only scores 2.4. That’s about 2.8 points behind the QSR average and a whopping 22.8 points behind Domino’s, which has proven to be a fantastic value-per-dollar option with both its Domino’s Rewards and programs like Emergency Pizza. According to the same research, Papa John's is well behind other competitors such as Pizza Hut (18.5 points difference) and Little Caesars (17.1 points difference). Looking now at Chatmeter's QSR Reputation Ranking 2024, Papa John's ranks third among the worst chains in overall reputation, but here it falls behind the worst-rated Pizza Hut. Along with Papa John's and Pizza Hut are KFC, Jimmy John's, and Subway. In this way, combined with the philosophy of 'Better Ingredients, Better Pizza', Papa John's is working to optimize the main menu without impacting the innovation calendar, in addition to spending more on national and local advertising for long-term value platforms such as Papa Pairs. Both these changes and the structuring of a rewards program are expected to boost transactions in the medium term. Looking now at comparable sales trends, we see the old story of transactions improving sequentially since July, which was a very weak month for the entire restaurant industry, with a mixed August and a much better September. It appears that for Papa John's, transactions started to pick up in Q4, with Halloween being the biggest sales day for Papa John's in the brand's history. In October, comparable sales were down 4% year over year, which is an acceleration compared to the 6% year-over-year decline in Q3. It is important to note that this gap in value perceptions was only in the US segment, as the International segment followed the same pattern of declining comparable sales driven by fewer transactions in China and the Middle East. The important thing here is that domestic transactions are being boosted in Q4, reversing the trend of a sharp decline in Q3. FY 2024 guidance expects comps to decline between 3.5% and 4.5% for the full year, in line with year-over-year transactions in October (-4%). Still looking inward, Papa John's is the second largest QSR Pizza chain in strategic regions such as the Southeast and Midwest, some areas that will become the focus of openings from now on. The idea is to do this while pulling the value levers through the barbell, combining value platforms such as Papa Pairs and innovations. The focus will also be on leveraging owned channels within the United States as soon as possible. Looking at the International segment, we can see that comparable sales are holding up more strongly thanks to strong performances in markets such as South Korea (with mid-single-digit growth in comparable sales year-over-year) and especially in Latin America (with double-digit growth in comparable sales year-over-year). I would like to highlight the markets of Peru and Chile, which have been showing accelerated growth areas for Papa John's through its master franchisee Drake Food Service. After more than 50 year-on-year closures of low-performing locations in the UK (and a further double-digit number in China and the Middle East, bringing the total to over 130 year-on-year as it restructures its international footprint), Papa John’s is looking forward to international developments now that the system is free of these locations. Earlier in Q2, the company refranchised 60 restaurants to its UK master franchisee, creating some headwinds to top-line sales, but these are expected to be offset by improved margins for the system. Papa John’s currently has just 16 company-owned restaurants in the UK. See the chart below to see how Papa John's comparable sales behaved across all of its reportable segments:   Comparable sales (Author) Note that Papa John’s US was outperforming the LSR SSS Index until the fateful Q1 2024, with company-owned locations facing increasingly difficult comparisons as it tries to navigate declining value perceptions in an environment where guests increasingly value per dollar. Remember, Papa John’s premium positioning within QSRs has not handled this well, as the segment is hyper-indexed to lower-income guests. Looking at the International segment, we can see that it faces much easier comparisons, already challenged by headwinds in China and the Middle East due to stagflation and military conflicts, respectively. This is evident when we look at the International segment, excluding the Middle East. It was forecast to grow 3% in Q2 2024, and decline 1% year-over-year in Q3, weighed down by the Chinese market. This indicates that other key markets such as Europe (excluding the UK) and Latin America are growing comparable sales rapidly. In aggregate, total comparable sales have been underperforming the LSR SSS Index for some time, dragged down earlier by the International segment and more recently by the Domestic segment. We may have reached a bottom in the US, as Papa John's now faces easier comparisons and the company is already seeing improvements in value perception within the US. In fact, in FY 2025 the revamped Papa Rewards will start rolling out, incentivizing occasions and a royalty structure that allows for repeat purchases. The outlook is definitely positive from here. The worst has already passed. Despite Pressures, Footprint Keeps Growing Unlike other concepts that are targeting 5% year-over-year net unit growth, Papa John's is content to restructure its portfolio, eliminating its underperforming units to restore the system's health. However, it did deliver net unit growth both domestically and internationally in Q3. Recognizing that this growth is still very modest compared to other chains, Papa John's reported during Q3 that it had managed to reduce average construction costs from $631,000 to around $500,000. This represents a 20% reduction in the initial investment for franchisees, opening the door to a flood of development deals in strategic markets. This was the main rationale behind the restructuring of the portfolio in the United Kingdom and the Southeast and Midwest of the United States. But what is the difference in practice for a franchisee? The payback period, which was previously 3 years, is now 2 years, in addition to a 25% increase in the Cost-Benefit Index. These will be the costs of openings starting in FY 2025, which should accelerate the pipeline of new openings and move Papa John's to a net unit growth rate of 5% year-over-year. Looking at what’s happened over the past nine months, Papa John’s has opened 49 restaurants in the U.S., offset by 28 closures. That represents a net unit growth of 21 restaurants, or 0.6% of its U.S. footprint of 3,454 restaurants. Openings are expected to range from 50 to 60 restaurants, which indicates 1 to 11 restaurants will open during Q4. Barring no additional closures, year-over-year net unit growth will be 0.6% to 0.9%. In the International segment, Papa John's opened 115 restaurants, which was fully offset by 130 closures. This was the result of a complete redesign of its UK footprint and additional closures in the Middle East and China. As the headwinds from this redesign in the UK will subside in FY 2025, we will once again see net unit growth. For the nine months of FY 2024, the International segment posted a net decrease of 15 units, bringing the count to 2,454. This could reverse in Q4 if there are no further closures. Papa John's plans to open 170 to 190 gross restaurants in FY 2024 as a whole, expanding on its previous guidance of 100 to 140 restaurants. It appears that there will be an additional 55 to 75 openings during Q4. If this happens it will most likely reverse the net decline of 15 restaurants, bringing the net growth to between 40 and 60 restaurants, a 1.6% to 2.4% increase in footprint year over year. Note that unlike other restaurants like First Watch Restaurant Group (FWRG), Papa John’s is not offsetting comparable sales from more openings and refranchises. This is creating headwinds to top-line sales. In Q3, systemwide sales were $1.2 billion, down 3% year over year, driven by lower comparable sales, a tighter check given the dynamics between owned and aggregator channels in the U.S., fewer transactions, and headwinds from the U.K. reformulation, conflicts in the Middle East, and stagflation in China. This was partially offset by the increase in footprint we saw earlier. Total revenues also fell 3% year-over-year due to the same factors mentioned above, reaching $507 million. Operating income also fell $4 million due to sales deleveraging, seasonality of the margin in Q3 (which tends to be the worst of the year) and reinvestment in the business to generate positive tailwinds in the perception of value. Now, I am not bringing all bad news. Labor costs did not increase, despite operational deleveraging. This stability based on exceptional hour control caused the operating margin in the last nine months to grow 0.3% year-over-year, reaching 7.3%. My Recommendation Since my last article on Papa John's, the price has fallen nearly 14%, with the total return just under 13%. Now, we knew the chain needed to pull some levers to work on its perceived value, and it looks like those levers are starting to show up now, with a much more positive Q4 than Q3 on the horizon. Betting on a turnaround (or just Papa John's closing the gap to other QSR Pizza), the risk/reward of this call still seems worthwhile. At the end of the day, it's a potential 36% upside to my PT of $64.25.  For FY 2025, Papa John's is expected to further leverage the effects of the incrementality of occasions leveraged in the redesign of the royalty structure. By doing so, Papa John's will be one step closer to solving the dilemma of owned channels vs. third-party channels, by directing occasional guests to 1P and keeping 3P only for incrementality. Therefore, I reiterate my 'Buy' rating for Papa John's at $64.25 PT.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.2","shortVersion":"4.29.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2485381934"}