Papa Murphy’s (FRSH) From Yahoo Finance Most Recent Quarter, ending Mar 31st, 2014

Profitability

Profit Margin (ttm): -2.86%

Operating Margin (ttm): 17.96%

Income Statement

Revenue (ttm): 86.02M

Revenue Per Share (ttm): 22.28

Qtrly Revenue Growth (yoy): 28.20%

Gross Profit (ttm): N/A

EBITDA (ttm)6: 22.57M

Net Income Avl to Common (ttm): -8.89M

Diluted EPS (ttm): -2.30

Qtrly Earnings Growth (yoy): 15.20%

Balance Sheet

Total Cash (mrq): 2.24M

Total Cash Per Share (mrq): 0.13

Total Debt (mrq): 171.00M

Total Debt/Equity (mrq): 484.83

Current Ratio (mrq): 1.14

Market Cap (intraday)5: 145.39M

Enterprise Value (Jun 11, 2014)3: 335.19M

Trailing P/E (ttm, intraday): N/A

Forward P/E (fye Dec 30, 2015)1: 19.93

PEG Ratio (5 yr expected)1: N/A

Price/Sales (ttm): 1.77

Price/Book (mrq): N/A

Enterprise Value/Revenue (ttm)3: 3.90

Enterprise 14.85

Note: The Company’s IPO took place on May 2nd, 2014, where it raised 64.1 million after offering 5.83 million shares at a price of 11 dollars a share. Of these, approximately 60.4 million will be used for the paying down of debt, approximate new debt, $110 million.

Basic facts on Papa Murphy’s:

Papa Murphy’s is a pizza chain that uses the franchise, “take-and-bake” model to generate revenue. Founded in 1981, the company was private until May 2nd of this year, when it IPOed for the first time as an “emerging growth company” with a revenue of less than 1 billion.

As of March 31st, 2014, the Company has 1,429 stores, of which 1,405 are located in the US in 38 states, heavily concentrated in West Coast (150 stores in Washington, 102 in Oregon, and 186 in California). Its international division consists of 20 stores located in Canada with another 4 in the United Arab Emirates.

The company operates on a franchise model, with 1,336 franchised stores and 69 company owned store.

Under the new IPO, it 64.1 million dollars in proceeds, at a price of $11, at the lower end of its 11-13 dollar range. The prices have been trending downwards since.

Current Price 9.13

52wk Range: 8.33 - 12.10

Volume: 494,723

Avg Vol (3m): 487,781

Market Cap: 145.39M

P/E (ttm): N/A

EPS (ttm): -2.3

Market Opening price, June 17th

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The company has a revenue of $80.5 million and $66.9 million in 2013 and 2012, respectively, and a net loss of $(2.6) million and $(2.1) million.

According to its SEC filings, “[Papa Murphy’s] intend to use net proceeds from this offering to repay $60.4 million in aggregate principal amount of indebtedness under our new senior secured credit facilities, to pay a $1.5 million termination fee associated with our advisory services and monitoring agreement with Lee Equity”. Lee Equity is currently the largest shareholder of the company with 40.7% ownership (reduced from 62% prior to the IPO).

The long story:

Innovative leader in the food industry: The Company is a leader in the limited services industry, posing to take market shares away from more established market leaders as well as family-restaurants. The company can ride on the megatrend of people deciding to eat more fresh food that they can cook themselves.

Dramatic unit growth: Papa Murphy’s is expected to open around 105 gross domestic franchises from the entire year of 2014. This growth would mostly come to existing areas as they would require less advertising and where brand awareness is already high.

Franchise model: The Company’s franchise model is asset-light and the opportunities are enormous for it to expand even more in the future. The franchise reduces cost and encourages franchisees to open more stores in the future.

Loyal customer base: The customers are usually women/families with children, and this demographic tends to be more loyal than the youth and men demographic. The company recently tested a price increase for its pizza at selected restaurants (according to Jefferies 2014 Global consumer conference), and the tests performed well.

Excellent management team: Ken Calwell, CEO for the company served in a number of pizza restaurants such as Domino’s and has served as Chief Marketing Officer in Wendy’s International. Mark Hutchens (CFO) has also served in a number of finance positions as well in the restaurant industry. Other officers have similar years of experience as well.

Great valuations for the company: The Company is currently generating around 6-8% unit growth, around 10% EBITDA growth, with 2% SSS growth historically. With more growth potential than its competitors, the company is very cheap considering its currently 10X EV/EBITDA ratio, compared to the restaurant industry average of around 15X. Papa Murphy’s deserved a higher valuation. Based on this, the company’s target price should be around $15.

Company Promotes: We see a discrepancy between the company claims and the real case.

1. “Unique” Business Model The company emphasized that consumers can take pizza and bakes them, and this supposedly

has several benefits, “Our store model is also different from many other restaurant models. Because our stores do not have pizza ovens, venting hoods, freezers or dining areas and average 1,400 square feet in size, they require a lower capital investment than traditional pizza, limited service or fast casual restaurants” (SEC IPO fillings). Company claims that it is a leader in the

“limited-service industry”, which are cost saving, combining a freshly made pizza with the option of eat at home.

However, it is also the worst of both, as it stands in between a full-service restaurant and a grocery store. As it does not offer services or dining experiences like the other pizza restaurants, it will lose a large number of potential clients, especially during lunch hours. The amount of savings generated by not has certain capital costs are outweighed by the reduction in prospective customers. At the same time it is not as cost-competitive as the grocery-store bought frozen pizzas.

In addition, the claim that it is unique is challenged by the rise of other take-home-and-bake pizzas. In late 2012, Noble Romans, a major pizza chain with around 1500 stores nation-wide, began to offer take-n-bake pizza at newly opened franchise restaurants. The CEO of Noble Roman’s stated that “Consumers continue to gravitate toward take-n-bake pizza… Consumers continue to gravitate toward take-n-bake pizza”. In March of this year, Godfather’s Pizza (600+ locations in 40 states), unveils its new Take-and-Bake concept, and the CEO stated “As one of the leaders in the industry, we have to look at every possibility of driving our business forward… We feel bringing our expertise into the take-and-bake pizza market will be one of the ways we can do just that”. Papa Murphy’s, despite being the original innovator of the concept, is now facing more competition as other company catches on to this trend. Furthermore, the company’s model of assembling fresh pizza while customers can select the ingredients they want is also being copied by other newly opened restaurants. Pieology, for instance, a small restaurant chain with a focus in California, offers fresh custom-made pizza and also bake it for the customers in a dine-in environment. In May 2013, Chipotle, another huge name in fast casual setting, has also launched a pizza version of its hugely successful restaurant, Pizzeria Locale. Chipotle, with its years of experience and deep pocket (a free cash flow of 328 million as of 2013), is able to apply this concept on a large scale.

2. Franchise Model for growth The company emphasized the franchised business model for growth, by stating that “we expect

that the majority of our expansion will result from new franchise store openings.” However, the company also emphasized that “historically, new stores in existing markets tend to generate higher average unit volumes as markets become more penetrated”.

A closer look revealed that the company in effect lacks solid revenue growth from the same stores year on year. And many of revenues come simply adding more stores to the company-owned store category. While the number of stores continues to grow, the system wide sales growth has declined from 5.7 to 2.6 percent from 2011 to 2013, signaling that more stores does not translate into more sales, and perhaps the market have been saturated.

The company also is expecting increasing amounts of its sales to come from franchise, etc. However, a look at the financials shows that the revenue growth from company owned store sales is far greater than the franchise royalties (at 5% of sales) that the company is receiving, signaling that there is perhaps a problem with the revenue growth model and franchisee system (see chart below). The rate of the company’s royalty payment increases year-on-year has declined from 1.13% to 0.54%, from 2011 to 2013. The company’s projection to grow franchisee’s sales is also unlikely especially considering impending lawsuits and conflicts between management and franchisee owners (discussed in a later section).

For 2013, 2012 and 2011 respectively

Franchise royalties $ 36,897 $ 35,113 $ 33,687 Franchise and development fees 4,330 2,826 2,398 Company-owned store sales 39,148 28,813 15,619

Loss before income taxes (1,567 ) (2,996 ) (376 ) Provision (benefit) for income taxes 1,024 (882 ) 230

Net loss (2,591 ) (2,114 ) (606 ) Net loss attributable to noncontrolling interests 19 — —

Net loss attributable to Papa Murphy’s $ (2,572 ) $ (2,114 ) $ (606 )

3. International prospects: The company also talks about prospects in international development, starting with Canada and

later to the Middle East. In UAE, it has signed master franchise agreement in 2012 to open 100 restaurants for the next 20 years with MAM Foodco LLC, a Dubai based privately owned food company with revenue of between $50-100 million. This all seemed too far of a time horizon, and does not seem realistic, while the company is struggling financially in the US. So far with around 18 stores openings in Canada and 4 in the Middle East, the stores generated revenue of $ 897 thousand for 2013, a negligible amount comparison to the overall revenue of more than 80 million. Despite the fact that the Average Weekly Sales (AWS) is higher, the projected opening of new stores in the international market is too few to matter.

4. Analysts promoting this as a buy The main analysts that are covering the stocks are also the ones that have underwritten it, such

as Raymond James, Jefferies, and Wells Fargo. All of which started coverage in late May 2014. Later on June 12th, Raymond James issued a report, showing their positive analysis of the company and discounting “internet chatters” that have caused the stock’s decline. In the report, it is projected that the company will have revenue growth of 12.6 percent, again, based on the strength of its franchise royalties.

Key problems with Papa Murphy’s:

1. Company remains unprofitable: The basic fact is that Papa Murphy’s is not profitable; Papa Murphy’s had a loss increase despite

its total revenue increasing substantially over the same time period. The company has been around for over three decades, yet it still struggling to break even.

In a February 2014 newsletter released by the Papa Murphy’s Franchisee Association (PMFA), the franchisees state that in order for a store to break even, they need a weekly sale of $8000. However, 430 stores (out of 1317) averaged less than that and are in danger of closing down; if they do close down, the amount from royalties would drop significantly .The PMFA recommended that the royalty payment be cut from its present 5 percent, at least until the store breaks even. However, this will only worsen the financial conditions of the company by cutting off a key source of income; at the same time if nothing is done, the 430 stores or so will

close their doors pretty soon, especially since many of them are highly leveraged in order to fund the opening.

The company is also transforming from an asset-light to an asset heavy model (contrary to its claims) by purchasing some of the most successful franchise stores.

Revenues Franchise royalties $ 36,897 $ 35,113 $ 33,687 Franchise and development fees 4,330 2,826 2,398 Company-owned store sales 39,148 28,813 15,619

Number of stores at end of period Domestic franchise 1,327 1,270 1,232 Domestic company-owned 69 59 51 International 22 18 18

Total 1,418 1,347 1,301

Assuming that the royalties remained a fixed percentage of store’s revenue and taking into account the increase in the number of stores, we can generate the following numbers (in thousands):

2013 2012 2011

Average royalty payment per store (per year) 27.80 27.65 27.34 Average company revenue per store (per year) 567.36 488.

35 306.25

Royalty payment increases 0.54% 1.13% — Company revenue increases 16.18% 59.46% --

2. Problems between management and Franchisee According to the February 2014 newsletter by PMFA, a growing gap in communication exists

between management and the franchisee, and PMFA felt a lack of understanding and attention

from management. “Management has come back and wants to have another larger meeting

that would include some PMFA Board members, FAB members and management team. Our

Board strongly believes those types of meetings will not provide the timely and substantive

changes needed to affect the lives of those that were crying out for help in the survey.”

In a September 20th, 2013 letter from the franchisee to the company headquarters, the

franchisees are worried that the company is shifting its focus from quality to low-cost offerings.

For a company that talks about its ability to work in a franchise format, these conflicts are

troublesome. For example, according to PMFA, the management wanted to open new stores,

even in areas already saturated, and the store owners argued that this will hurt their margin,

detrimental to the management as well as the new owners. In addition, the franchisees are

extremely annoyed at the company’s methods, which are perceived to be autocratic, such as

providing advertising that does not suit their local conditions.

Lawsuits: The Company faced a lawsuit from its business franchisees, accusing Papa Murphy’s of not revealing the true state of its financial performance in Southern United States, where sales of the pizza is unsuccessful. The franchisees believed that management misled them by providing average sales figures that did not take into considerations of geographical locations, as areas with key sales are located in the West and large cities(AWS: Oregon ($16,700), Washington ($15,500), Idaho (17,600)), while Southern stores have fallen way behind (Texas (7,800), Arkansas (7,400), Louisiana (6,300)). In addition, the franchisees alleged that they have to contribute excessive marketing costs despite being not profitable.

A second lawsuit was filed in the week of June 16th in Washington State by the Bundy Law Firm, based in Seattle. The firm represents 28 franchisees currently owning 71 stores. The complaints is roughly the same as that of before, namely that stores in different regions have different sales volume and the company misrepresented these differences among the regions.

3. Competition: Based on 2012 sales figure, Papa Murphy’s is the fifth largest pizza chain in the nation with 733

million in sales, with behind Pizza Hut (sales 5.7 billion as of 2012), Domino’s Pizza (3.5 billion), Papa John’s (2.4 billion), and Little Caesars (1.7 billion). These are the established competition that the company has been competing with since its establishment

In addition the business environment places Papa Murphy’s at a competitive disadvantage: the restaurant industry has very low barriers to entry and the competition - Pizza Hut, Little Caesars, and Papa John’s, etc - are all highly established, and all with higher levels of revenue and larger share of the pizza market. The Company also competes against regular grocery stores carrying frozen pizza.

The competition is one key reason why Papa Murphy’s haven’t been able to expand to the East Coast and the South, where many more independent, traditional pizza-parlors are based. According to CHD Expert, a food industry survey group, the states with the highest percentage of independent pizza chains (up to 87% independently owned) are Connecticut, New York, Vermont, New Jersey, Massachusetts, and other states along the East Coast and parts of the South. These areas are difficult for Papa Murphy’s to break through.

Currently, the company has an advantage in some states when compared to prepared pizza stores, as the take-and-bake pizza is exempt from state-wide sales tax as it is not considered to be a “prepared food”. For example, in the state of Wisconsin, which recently decided to re-categorize Papa Murphy’s as a prepared pizza chain, will place a tax of 5% of its sales. In Wisconsin, the company has sales of 45 million, and 5 % would increase costs by 2.25 million, which Papa Murphy’s would have to pass on to its customers, increasing the price of each pizza by 50-75 cents. Recently, the national Streamlined Sales Tax Governing Board recommended that uncooked pizza be considered a prepared food. More importantly, if the pizzas are considered to be prepared food, those on food stamps will no longer be able to afford. According to the company’s SEC filings, approximately 10-12% of its weekly customers are using government assistance to purchase the pizza. The company would be affected if this sector is unable to purchase its products.

4. Debts It appears that the company managed its IPO solely to raised money to pay off its debt (which

amounts to 170 million prior to the IPO). Even after the IPO (and the subsequent paying of a portion of its debts) the company still has about 115 million dollars of worth of long-term debt,

given that it has an EBITDA of 24.4 million in 2014, the debt to EBITBA ratio is about 4.7, which signified that the company is still heavily debt-ridden, and unlikely to be able to borrow more to finance its operations.

Free Cash Flow has declined for the company for 2 years and the company’s net loss is at 2.5 million for the past year, signaling that the company might not be able to meet its short-term financial obligations.

The company has stated that the bulk of its customers are from family that is more loyal. At the same time, according to Todd Suckow, a regional Papa Murphy chain supervisor, “the bulk of our daily, weekly and monthly sales come from single family and low income homes.”

Possible risks in shorting this stock:

The company’s will continue to show growth in its financial statements because of its strategy of franchising new stores in different areas (not because of same store growth).

Papa Murphy’s is a real company and has a devoted fan following, it should be able to cling to large cities and the Western US as for market.

Papa Murphy’s has strong name recognition and good brand imaging.

The company’s management are all very qualified; for example, Ken Calwell (CEO), has served as executives on Wendy’s International, Domino’s Pizza, PepsiCo’s Frito Lays division, and Pizza Hunt, etc, many in marketing positions.

An opinion I came across is interesting as well, someone wondered if Papa Murphy’s might because part of the Russell 2000 Index; cause certain index fund to purchase it. In my view, this is unlikely as the company is currently trending downwards and its potential to rise in market capitalization is low.

Opinion:

The company promotes itself as a growth company, however, in its SEC filings it states that most its growth will come from existing market and that key regions in the US (the West coast) will be its chief emphasis. The markets there are already saturated while at the same time it is not making as headways into the new markets in the US, such as the South and East Coast. Indeed, the company has been around since 1981 and it can no longer be considered to be a “growth” company.

The main problems of the company will continue to cause its prices to fall: a lack of net income growth, flawed business model, impending lawsuits and conflicts between management and franchisees, lack of future markets for growth, impending insolvency for franchisees and high levels of debt both on the franchisees and cooperate level

Despite the overwhelmingly bearish signs regarding the company, the company is not a short at the moment.

This is because many others have taken notice of it as well, and in accordance with our investment philosophy, we should not short with the crowd. The short interest on the stock is over 50 percent.

The borrowing rate for the stock is very high as well (in the double digits), and since our time horizon is 6 months, I don’t foresee the stock depreciate in price to a significant degree to justify the high cost of borrowing.