Although the current sensibility of the time is that America has too many MBA financial engineers running companies and not enough skilled operators with the good horse sense to grow revenues, much of America’s corporate history was filled with the opposite concern. People used to worry about founders and controlling families having no idea how to allocate surplus capital–especially when it came to stock buybacks.
There were three reasons that could explain why a founding family would have trouble figuring out the buyback price.
The first reason is sentimentality–you know those studies that show how we overweight the commercial value of our possessions because of the sentimental value we place them? Well, if we are willing to value an old coffee mug we’ve had for ten years at $5 when it is worth $1, imagine how someone is going to value a business that is the source of all of their material possessions and social prestige. I don’t want to call out any families that are running publicly traded enterprises for lacking discretion in repurchasing stock because on the whole they have been a significant plus to the civilization, but paying 30x earnings, 40x earnings, or 50x earnings to retire company stock is not going to be one of the reasons why the other shareholders get rich.
The second reason is wrong incentives–oftentimes, the Board at a corporation run by insiders try to create objective measurements for awarding stock-based bonuses. They do this to avoid the impression of being in bed with the founding family. Oftentimes, these hurdles are low and tied to earnings per share growth. If the hurdle is 6%, an unremarkable business can easily grow its earnings by 3% just to match inflation and then retire 3% of the outstanding stock to trigger the bonus award. All buybacks increase earnings per share, and a bonus based on earnings per share rather than intrinsic value can create the undesirable incentive that encourages indiscriminate buying.
The third reason is much more benign–mild incompetence. Operating a business and growing its revenues requires a different skill set from figuring out whether the price of the stock is undervalued or overvalued. This statement is even more true if the business is cyclical. If you are good at drilling oil, does it necessarily follow that you will understand 2007 is a bad time to repurchase stock? I’m not so sure–even people who are shrewd accounting analysts aren’t able to figure it out.
All of that said, some Renaissance men–those who can operate a company and figure out what to do with surplus capital–do still exist. And if you can find them at the right time, you stand to make a lot of money. One candidate for consideration is John Schnatter, the founder and CEO of Papa John’s still still owns a 29% overall interest in the company despite selling $330 million worth of Papa John’s stock since 2000.
Up until 2013, CEO Schnatter had discretion over allocation of all the company’s retained earnings because it did not a dividend. Given that the empire is sprawling–over 4,000 pizza chains spread out across 36 countries–there are many competing demands for capital that could make it difficult to act efficiently. There is usually a temptation to use every available dollar to create another store to engage in empire building (this mindset led Ken Lewis to purchase Countrywide Financial in an effort to make Bank of America the largest bank in the country rather than the one that delivered the best returns to shareholders.)
Schnatter has so far resisted this temptation. He has been selective in choosing where to grow–avoiding the Subway syndrome in which locations are built so close to each other that they begin to cannibalize each other’s sales. In the past year, Papa John’s managed to report 6.8% same-store sales growth. That is excellent, and a testament to Schnatter’s restraint in not saturating the markets with too many Papa John’s chains.
By not expanding store count as quickly as possible, Schnatter has been able to use the available capital to build out a commissary that distributes the ingredients to Papa John’s. Specifically, Schnatter has secured ownership over the tomato sauces, bacon, cheeses, and pizza crusts that he requires Papa John’s franchisees to use as part of the terms of the franchise agreement.
When you buy a share of Papa John’s, you really are acquiring ownership of three things: almost 800 corporately run pizza chains that contribute 12% to overall earnings, over 3,200 franchisee stores that make rental and revenue-sharing payments to the Papa John’s brand that contribute 49% to earnings, and the commissary that sells the ingredients to franchisees that contributes the remaining 39% to earnings.
It was wise of Schnatter to plan the growth in three stages. First, build out restaurants that Papa John’s itself owns. Then, start charging franchisees rent and a fixed percentage in exchange for the right to use the Papa John’s brand and systemic intellectual property. And then, instead of expanding the franchises as rapidly as possible, he developed ownership in the ingredients to develop another profit stream for shareholders. Once this template was created, he then cast his sights overseas and has begun expansion efforts in three dozen countries.
As if that is not enough praise, I want to add this: Schnatter has real competence for knowing when to buy back his own company stock. Between 1999 and 2004, when Papa John’s was trading between 12x earnings and 14x earnings, Schnatter took on debt and reduced the share count from 120 million to 66 million. The stock was so cheap he almost raised earnings per share by 50% from buybacks alone in five years because he was able to retire stock on the open market for 12x earnings. Absolutely excellent work.
And then, between 2008 and 2011, when the stock got cheap again with a P/E ratio in the mid teens, Schnatter reduced the share count by 20 million–taking it from 65 million to 45 million. That was reduction of 30% of the outstanding stock in just three years. He moved quickly when the opportunity arose.
It should be equally telling, though, that he has dramatically slowed down the level of stock repurchases since 2013. There was 40 million shares outstanding two years ago, and now there are 39.4 million shares in existence. That is a reduction of only 1.5%. Why the cautious attitude towards repurchases? Because the stock trades at $72 and only makes $2 per share for a P/E ratio of 36.
And that’s an authentic P/E ratio. Even though it operates in three dozen countries, it is mostly just getting the basic troops on the ground–over 94% of Papa John’s profits is generated in the United States. The current price of the stock has a P/E ratio that is nearly twice what it ought to be, and Schnatter is wise to tone down the stock buybacks at this time.
Schnatter is such a good enough operator that even five years down the line, someone that pays this outrageous price for the stock may still be able to eke out positive returns because of the superior operating skills of the executive team. But make no doubt about–the stock currently has a negative margin of safety. During the internet craze in 1998, the stock traded at 25x earnings. The current price of the stock is even more elevated than what we saw almost seventeen years ago.
In the past fifteen years, Schnatter turned every $1 invested into his company into $11 today. Some of this elevated by the lofty valuation right now–shareholders probably deserve around $8.50 today for every $1 invested in 2000.
But if you study how these returns happened, you should be impressed with Schnatter’s approach to business. He is the king of synthetic capital–creating systems where he and the fellow shareholders collect a percentage from the best efforts of others (namely, the franchisees). He is gearing up for strong international growth, and has preferred buying out elements of the supply chain rather than cannibalizing his own sales. And he has the discipline to buy back his own stock when it is cheap, and avoid doing so when it is expensive.
Knowledge of Schnatter’s strategy is something you should keep in your back pocket–wait until the stock comes down to at least 18x earnings or so before creating a buy order. In the meantime, you can learn a lot from how Schnatter structured the financial side of his life. People see him on TV and think he is this goofy guy that is super enthusiastic about pizza, but the truth is more nuanced than that: He is a disciplined businessman that knows how to create systems that create outsized financial rewards that involves leveraging the efforts of others.
Originally posted 2015-11-02 20:32:00.