The Vancouver, Wash.-based pizza chain's expectations for store growth are unrealistic, the company is highly leveraged and some important investors have been cashing out.
Restaurant stocks had a sizzling first half of 2015, and Papa Murphy's led the pack. In June, the stock logged an intraday high of $22.72, giving it a year-to-date gain at the time of more than 95%. The stock has since retreated but is still up more than 70% in 2015.
That type of price gain indicates investors have been betting on a massive surge in revenue growth. But looking at Papa Murphy's business, it's hard to figure out where that growth will come from.
Papa Murphy's is a franchisor and operator of a chain of "Take 'N' Bake" pizza stores that sell fresh, uncooked gourmet pizzas that consumers buy and then bake at home.
Some observers still describe this as a novel new restaurant strategy, but Papa Murphy's has been in this business for more than 30 years.
In 2014, the company was sued by more than 20 plaintiff groups representing franchisees who alleged that Papa Murphy's misrepresented sales and profitability numbers to them in order to entice them to open franchises. The company has already entered into confidential settlements with some of them, but others have updated and expanded their claims.
Cynthia Hofmann, a Papa Murphy's representative, said: "We believe the lawsuit has no merit whatsoever and we will defend these claims vigorously. We have actively pursued resolutions with the 28 plaintiff groups and of those, 10 plaintiff groups which represent a significant portion of the stores involved in the litigation, have dismissed their claims. We are continuing to work hard to come to an amicable resolution."
The key factor driving the share price to its highs has been the prospect of Chipotle (CMG - Get Report)-like growth. Unlike Chipotle, however, which consistently shows same-store sales growth in the midteens (on a percentage basis), Papa Murphy's is stuck with growth in the low single digits.
Growth can also come from opening new stores. And the company has said it aims to expand from less than 1,500 stores overall to 4,500 stores in the U.S. alone. (In addition to its U.S. stores, the company has some in Canada and the United Arab Emirates.)
Yet investors who are betting on this tripling of stores are in for an unpleasant surprise.
The problem is that Papa Murphy's has a long history of overestimating its growth prospects.
As far back as 1998, Papa Murphy's said that it could have 1,500 stores by 2002, according to an article in Restaurant Business. Then in 2005, company founder Terry Collins said, "We're going to end up with thousands and thousands of stores," The Oregonian reported. At the time, it had about 900. Those remarks followed a leveraged recapitalization the company needed in order to fund its expansion. Yet 10 years later, the company still has yet to hit 1,500 stores. The current store count is at 1,476.
Papa Murphy's declined to comment when asked whether it is overestimating potential store growth.
In more recent years, the company has continued to overpromise and underdeliver.
As recently as November, management said the company was on track to open 105 new stores for all of 2014. The company fell short of that goal, opening 95 stores. But more importantly, that opening figure doesn't account for the 52 stores that were closed during the year. The company's 10-K reveals those closing and shows that net new stores totaled only 43. Unfortunately, many investors may have focused on the 95 number.
There's some confusion, too, about net new store openings during the first quarter of this year. In first-quarter 10-Q, Papa Murphy's said there were 22 new openings against 7 closures. What this ignores is that the company had to acquire 11 struggling franchises back from their owners. One suspects these businesses weren't doing well.
The company declined to comment on the store repurchases.
We can see in the 10-Q filing that the fair value for these 11 stores was just $3.6 million, roughly in line with what it costs to open a single new store. The point is that net new openings really totaled only four stores for the first quarter.
An analysis of the past few annual reports shows that new store growth has been consistent and steady as a rock. In each of the past three years, net new store growth has come in right around 40-50 stores. This is how the company has grown to 1,476 stores after nearly 30 years. Yet somehow investors are once again buying the message that there will soon be 4,500 stores.
The first key point here is that no one should realistically be expecting to see much more than marginal growth in store count, just as we have seen in the past. As investors come to terms with this, the stock's price will need to correct dramatically following the sharp run-up, which has more than doubled the stock's price since this time last year.
But aside from the obvious growth conundrum, there are other problems.
Papa Murphy's debt is more than four times its annual earnings before interest, taxes, depreciation and amortization. That's a level that is typically considered worrisome by investors, because it indicates a company could have trouble managing its debt.
This is the case even after the company paid down $55.5 million in debt following its initial public offering, using all of the IPO proceeds and then some.
In Papa Murphy's latest 10-Q, the company said this about its debt and liquidity:
"As of March 30, 2015 , we had $115.0 million of outstanding indebtedness. ... We believe that our cash flows from operations, available cash and cash equivalents and available borrowings under our revolving credit facility will be sufficient to meet our liquidity needs for at least the next 12 months."As of March 30, 2015, we were in compliance with all of our covenants and other obligations under our senior secured credit facility."
Aside from just betting on the "fresh" concept, Papa Murphy's competes on price and has even emphasized sales to customers using food stamps. The point here is that, despite the seeming novelty of the uncooked pizza concept, Papa Murphy's clearly lacks pricing power. Because it operates in a highly competitive industry, has low margins and sells to people with food stamps, it seems unlikely this company will be able to significantly raise prices without losing customers.With Papa Murphy's, there is currently a very large disconnect between what investors are expecting and what the company is delivering. That disconnect has caused the share price to double over the past year. But it is doubtful that Papa Murphy's can demonstrate a Chipotle-like level of growth.
In June, Papa Murphy's conducted a secondary offering of stock for 2.5 million shares at a price of $17.55. All those shares came from two private equity holders, who realized $40 million. Papa Murphy's did not realize any proceeds from the sale.
Other investors might want to follow this lead from the insiders and take profits on Papa Murphy's while the share price is still near its all-time highs.