With Americans eating more of their meals out, there is a constant battle amongst restaurant companies to attract and keep these customers. Our review for this week focuses on a company in the quick service restaurant sector (fast food) who has continued to grow even as consumer discretionary spending has declined. NPC International, Inc. is the world’s largest Pizza Hut franchisee, representing a significant 20% of the domestic Pizza Hut restaurant system. The company has also started to accumulate Wendy’s franchises, currently controlling 143 Wendy’s restaurants. In Q1 2015, the company registered a remarkable 11.5%year-over-year growth in its adjusted EBITDA. NPC boasts Franchise Rights valued on the balance sheet at $688.7 million. With total debt currently listed at $595 million, the value of these rights easily exceed the outstanding debt by nearly $100 million. By adding the Wendy’s franchises to its business portfolio, NPC has provided prudent diversification, even as Pizza Hut continues to lead amongst its direct competitors.
This 10.50% senior unsecured debt from NPC matures in January 2020, and is currently trading at about 106, putting its yield to worst call (102.62 in Jan.2017) at about 7.67%. Even at its current premium, these short-term bonds still provide the astute income investor with great cash flow and an attractive yield, well in excess of the current 5-year US Treasury Yield of only 1.58%. In light of these favorable factors, we are targeting these high coupon, high cash flow bonds for our income portfolios, FX1 and FX2.
About the Issuer
NPC International was founded in 1962. Currently, it is the largest franchisee of any restaurant concept in the United States based on unit count. As of December 2014, the company owned 1,277 Pizza Hut restaurants with significant presence in the Midwest, South and Southeast. The company also owns 143 Wendy’s restaurants, primarily located in and around the Kansas City, Salt Lake City and Greensboro-Winston Salem metropolitan areas. Based in Overland Park, Kansas, NPC is the also the world’s largest Pizza Hut franchisee, representing 20% of the domestic Pizza Hut restaurant system. In late 2011, NPC International was acquired by private-equity firm Olympus Partners.
While a vast majority of NPC’s revenues are generated from its Pizza Hut franchises, the company has steadily increased its ownership of Wendy’s restaurants over the past few years, including a transaction in July 2014 that added 56 units. For 2014, NPC’s Wendy’s franchises generated 13.5% of total revenues.
Pizza Hut and Yum Brands
It is worth noting that Pizza Hut’s parent company, Yum Brands, has had outstanding performance this year, with its stock up 20% year to date. Yum Brands also owns other well-known quick service restaurants, Taco Bell and KFC, both of which have had excellent, recent growth. Taco Bell showed a 9% year-over-year revenue increase in Q1 2015, and KFC had a 10% year-over-year increase in operating profit. Yum Brands continues to successfully reinvent its fast food restaurants to keep pace with changing American preferences as well as profit from its international growth in emerging markets.
The Case for Franchises
The franchising model works because it provides a proven formula for operating a successful business by delivering a uniform product and service to customers. It assists franchisors in creating distribution channels, and gives consumers a recognized standard of what to expect.
A recent study by PricewaterhouseCoopers illustrates the effectiveness of franchising in our modern day economy. Franchise businesses are responsible for almost half of all retail sales in the U.S. There are more than 750,000 franchise businesses that generate almost $1 trillion in annual sales, and franchises employ more than 18 million people in the U.S. directly, and over 25 million indirectly.
The modern franchising model continues to evolve and adapt. Over the last decade, multi-unit franchising has emerged where a savvy franchisee will open multiple franchise units sometimes representing several different brands. This is the model NPC has adapted. The multi-unit franchise model continues to gain steam, now accounting for 55% of all franchise units in the U.S.
Because of their brand recognition and consistent product delivery, established franchise locations have continuing value in the event the franchisee needs to sell. There is an existing revenue stream and customer base for that franchise location. Because of its highly successful Pizza Hut and Wendy’s brands, NPC carries a high value on its balance sheet for Franchise Rights, which were valued at $688.7 million in December 2014.
Pizza Hut Continues to Lead National Pizza Chains
As one might expect, the fast food industry is highly competitive, with new players frequently entering and exiting the marketplace. In addition, those with established businesses continue to battle for market share in a consumer market with ever-evolving tastes and preferences. The National Restaurant Association estimates that Americans eat away from home five to seven times a week and in March of this year, for the first time ever, sales at restaurants and bars overtook spending at grocery stores, according to Commerce Department data that dates to 1992.
Pizza Hut, which was started in 1958 in Wichita, Kansas by brothers Frank and Dan Carney, has stood the test of time and continues to be a leader in the quick service restaurant segment. When compared to its direct competitors, Pizza Hut also has a leading edge. As of September 2014, Pizza Hut surpassed its competitors, claiming 14.79% of annual U.S. pizza sales, the most of any of the national pizza chains. Its nearest competitor was Dominoes, who registered 9.86%.
In 2014, 34% of Pizza Hut’s carry-out / delivery orders were placed via internet or mobile device. Pizza Hut continues to evolve to keep pace with the increasing influence of technology on the quick serve restaurant industry. The company is in the process of enriching its technology offering to better accommodate those customers who prefer to order via the internet or mobile device.
NPC showed excellent growth in its adjusted EBITDA for Q1 2015. Adjusted EBITDA was $32.3 million for an increase of $3.3 million or 11.5% over the prior year.
For its latest reported quarter (Q1 2015), NPC had operating income of $16.187 million and interest expense of $10.465 million for a low, but sufficient, interest coverage ratio of 1.54x. Under its Senior Secured Credit Facilities and Senior Notes, NPC is required to satisfy various financial covenants, one of which is a minimum interest coverage ratio of not less than 1.35x.
NPC increased its cash level in Q1 2015 to $23.7 million, up from its Q4 2014 level of $11.6 million. The company also has access to a Revolving Credit Facility, with an additional $90.9 million borrowing capacity, for a total liquidity of $114.6 million.
The default risk is NPC’s ability to perform. While Pizza Hut International continues to work on its rebranding, NPC’s investment in the Wendy’s franchises has served to provide prudent diversification. This growing business, along with a deflationary commodity environment, resulted in the 11.5% adjusted EBITDA year-over-year increase posted in Q1 2015. Pizza Hut still leads the national pizza chains in terms of annual sales, and with its rebranding efforts, along with improving its digital offerings for internet and mobile customers, the company should continue to be a leader in the quick service restaurant industry.
The quick service restaurant (fast food) industry is extremely competitive. Pizza Hut’s main competitors, such as Domino’s and Papa John’s Pizza, continue to battle for additional market share. Wendy’s restaurants face similar direct competition from McDonald’s, Burger King and Carl’s Jr. As both companies continue to strive to maintain and gain market share, consumer preferences and tastes continue to evolve. If Pizza Hut and Wendy’s are not able to adapt and excel within the marketplace, this will affect revenues and in turn, the revenues of NPC International will be affected as well.
The 7.67% YTW of these NPC 2020 bonds appear to have similar yields and maturities to other bonds reviewed on the Bond-Yields.com blog, such as 7.8% Russian Railways, 7.25% TransOcean, and 9.15% Vanguard Natural Resources.
Summary and Conclusion
NPC represents 20% of the domestic Pizza Hut restaurant system. With Pizza Hut’s well-established presence in the quick serve restaurant marketplace and continued dominance over other national pizza chains, NPC will continue to reap the benefits from this market leader. The company possesses extremely valuable franchise rights whose values are well in excess of its total outstanding debt. These relatively short, high cash flow bonds represent an excellent opportunity for investors to benefit from American’s increasing expenditures on dining out, and as such we have marked them for addition to our Fixed-Income1.com and Fixed-Income2.com global high yield fixed income portfolios.
Issuer: NPC International, Inc.
Yield to Worst Call: ~7.67% (@102.62 om 1/15/2017)
Yield to Maturity: ~8.81%
Disclosure: Some Durig Capital clients may currently own NPC’s 2020 bonds.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for retail clients.
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