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How Papa John's got bigger by getting better

Sunday - 5/13/2012, 1:18pm  ET

I’ve written before about a quote from Chick-fil-A founder Truett Cathy who once said, “If we get better, our customers will demand we get bigger,” in response to a looming threat from a fast-growing competitor.  Those companies that take this concept seriously do tend to outgrow their competition.  One industry that would seem to be big enough already is the quick-serve pizza industry, but Papa John’s is using, “better ingredients to make better pizza,” and taking a bigger slice of the pie because of it.    

The quick-serve pizza industry has one of the lowest barriers to entry -- all you need is a storefront, an oven, and some simple ingredients.  Given the popularity of the pizza pie and the ease of setting up shop, the industry now consumes about 17% of all restaurants in the US.  For the most part it’s a very fragmented industry with independents representing about 58% of all pizza outlets.   As far as national brands go, the largest is Pizza Hut, which is a unit of Yum! Brands .  They have over 13,000 units and about a 12% slice of the pie and are followed closely behind by Domino’s Pizza and their over 9,000 units, giving them an 8% slice.  Papa John’s is a distant third at around 4,000 units for around 5% of the market. 

Papa John’s, however, has been growing at a very fast clip and whereas both Pizza Hut and Domino’s have been shedding stores, Papa John’s has been adding stores and eating into their competitors' market share.  They’ve been able to add a net 226 stores from 2009 to 2011 while Pizza Hut has shed 30 stores and Domino’s has dropped 153.  They have another 300 stores in the pipeline in the US and see potential for another thousand stores.  They also have another 1,200 international stores in the pipeline, which should be built over the next six years. 

So what makes Papa John’s better?  They have developed their brand image around product quality thanks to the authentic message of founder John Schnatter who started the company in 1984.  John felt that there was a certain quality missing in the pizza delivered by the national chains and he wanted to make a better quality pizza. 

They start from the bottom up with their hand-tossed dough that is never frozen.  Their high-quality dough is made with high-protein flour and clear-filtered water.  Their sauce is made from fresh tomatoes and not from a concentrate that are blended with herbs, spices and all-natural ingredients.  They use locally sourced vegetables that are always freshly cut and never vacuum-packed or pre-cut.  Finally they use only authentic, superior quality meats that are made with 100% beef and pork.  They don’t use any TVP (Texture vegetable protein) or other fillers in their meats.  The cheeses are crafted from 100% mozzarella and high-quality milk.  Their mission statement for their customers is to “create superior brand loyalty through authentic, superior-quality products with legendary customer services.”  This helped them to be ranked first in customer satisfaction in the limited service restaurant industry in 2010, though they did slip to fifth place in 2011.

Their focus on quality has resonated with their customers who have kept coming back for another slice of the pie.  They have been able to grow earnings by an average of 21% the past two years and project to grow earnings by 14% in 2012 and another 13% in 2013 as they have been able to accelerate their earnings growth rate, which had been about 10% the past five years.  They’ve been making the dough for investors over the past few years as the stock has doubled since mid-2010. They generate strong cash flow and have a conservative balance sheet, which has enabled them to return their free cash to shareholders in the form of buybacks. 

Given its run of late, especially considering its last earnings release, the shares are solidly in the fairly valued category.  With their strong corporate culture to be better, they have the potential to get a lot bigger in the future.  However, for investors with a long-term outlook, Papa John’s just might be a better ingredient to add to your portfolio if you want it to grow bigger. Now, who is hungry?

This article was originally published as How Papa John’s Got Bigger by Getting Betteron Fool.com

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