Papa John's missteps and mistakes have Wall Street wondering whether the pizza chain is beyond recovery

Key Points
  • Papa John's botched response to the latest controversy may have permanently damaged its brand, crisis communication executives and analysts say.
  • The company's franchise owners are already seeing a drop in foot traffic and sales.
  • Some Wall Street analysts have issued rare "sell" recommendations on the stock and dropped earnings projections.
John Schnatter founder and chairman of Papa Johns
JB Lacroix | WireImage | Getty Images

When Papa John's founder John Schnatter took a shot at the NFL last November, blaming it for "poor leadership" amid players kneeling during the national anthem, it was seen as a temporary piece of bad news that should eventually fade away.

Months later, it's clear that was only the beginning of a terrible run of missteps and mistakes by Schnatter, company executives and the board of directors.

Since then, the third-largest pizza chain has been embroiled in a controversy over a racist comment, claims of extortion and litigation threats — all of which are hammering pizza sales at Papa John's across the country. The stock is down more than 33 percent since Schnatter's Nov. 1 analyst call where he blamed the NFL for a falloff in business. 

That debacle, bad as it was, has only gotten worse. It's highlighted an apparent lack of internal controls, illustrated the dangers of tying a company's brand to its CEO and opened the door to potentially nasty litigation. It's also left the company vulnerable to takeover.

Papa John’s board adopts ‘poison pill’ to block Schnatter control
Papa John’s board adopts ‘poison pill’ to block Schnatter control

Some Wall Street analysts have issued rare sell recommendations on the stock and dropped earnings projections, citing damage to the brand and a projected decline in pizza sales. On Friday, the company appointed a new chair of its board of directors, but that move alone is unlikely to staunch problems weighing on Papa John's stock. 

The company's shares have been further whipsawed since a July 11 article by Forbes that detailed a May conference call in which Schnatter used the N-word. Ironically, that call was designed as a training session to keep him from future PR fumbles. He confirmed his comments, apologized and stepped down as chairman that same day, after giving up his CEO post in November.

“We lowered our estimates within hours of that initial Forbes article. How could you not?" said Mark Kalinowski, CEO of Kalinowski Equity Research. "A lot of what has transpired over the last 2½ weeks is disgusting."

The events since that Forbes article have been out of the ordinary, at the very least.

Papa John's slams NFL leadership for lackluster pizza sales
Papa John's slams NFL leadership for lackluster pizza sales

Two days after resigning, Schnatter told a local TV station in Louisville, Kentucky, where Papa John's is headquartered that giving up his chairmanship was a mistake. In a bizarre twist, he also said that Laundry Service, the PR agency hired for the training, tried to extort $6 million from the company to keep news of the May call quiet.

Melissa Zukerman, a spokeswoman for Laundry Service, declined to comment for this article, but has previously denied Schnatter's claims.

'Not going quietly'

Schnatter's interview didn't hit national news until CNBC reported it on Monday, July 16. That was a day after the board issued a press release at 11:46 p.m. Sunday night, saying the directors decided to prohibit Schnatter from talking to the media. They also removed him from the pizza chain's advertising materials, and barred him from using his office space at the company's headquarters.

Schnatter shot back the following day. His attorney told CNBC he wasn't "going quietly."

Schnatter and his lawyer said his comments on the May call were taken out of context. In a July 14 letter he sent to the board, Schnatter said he was provoked into using the N-word after Laundry Service executives on the call suggested the pizza chain bring on performer Kanye West as a co-spokesman for television spots and promotions.

Schnatter said he refused to work with West because "he uses the 'N' word in his lyrics," according to the letter.

"What was a serious situation now seems to be descending into an ongoing farce with allegations and claims flying around all over the place," Neil Saunders, managing director of GlobalData, told CNBC. "This is not good for the brand, and it is not good for the business which is distracted by fighting fires rather than on more important activities."

'Two-step trainwreck'

A second article by Forbes on July 19 detailed a toxic, fraternity-like corporate culture where sexual harassment was common and executives traveled for business with their mistresses.

Schnatter's lawyer, Patty Glaser, said the story, which Forbes said was based on interviews with 37 current and former employees, contained "numerous inaccuracies and misrepresentations. It’s easy to make false statements when one hides behind the cloak of anonymity." She didn't specify what was inaccurate. Forbes quoted about a half-dozen people on the record, including Schnatter.

The board announced last week that it hired Washington, D.C., law firm Akin, Gump & Strauss to conduct an internal investigation "of the existing processes, policies and systems related to diversity and inclusion, supplier and vendor engagement and Papa John’s culture."

Papa John's spokesman Peter Collins said the company is focusing on “rebuilding trust through action."

"We’ve begun a top to bottom review of our culture and will make whatever changes are needed to ensure that we have an inclusive, equitable and respectful workplace," Collins told CNBC. "We have a lot to do, but this company is committed to getting things right."

This past Sunday, directors adopted a stockholder rights plan, a so-called poison pill designed to prevent Schnatter, who already owns about 30 percent of the shares, from amassing more. It also protects the company against other potentially hostile bidders. Schnatter voted against the measure, his lawyer said.

Papa John's soap opera continues
Papa John's soap opera continues

The Forbes' articles were a "two-step train wreck," said Lee Pacchia, co-founder and CEO of Mimesis, a strategic communications consultancy firm.

"The conference call was really bad, but from the company's perspective it's pretty simple, separate John as much as you can from the brand as much as you can and move on," Pacchia said. "Now that we have the questions about the broader culture at the firm, it is an entirely more complicated scenario."

Other corporations, marketing partners and consultants are racing to distance themselves from the pizza chain.

The company lost its deal as the official pizza sponsor of the NFL in February. Two of Papa John's public relations agencies cut ties with the brand earlier this year. Major League Baseball indefinitely suspended its Papa Slam promotion earlier this month while several baseball teams have cut ties altogether.

Schnatter's name was removed from the John H. Schnatter Nachand Fieldhouse gymnasium in his hometown of Jeffersonville, Indiana, and the University of Louisville is stripping Papa John's name off of Papa John's Cardinal Stadium.

Wendy's, which was in preliminary discussions with Schnatter about a potential merger before the Forbes articles, has since walked away from any potential deal, according to a person with knowledge of the talks.

PR nightmare

"This is a PR and brand nightmare," said Juan Martinez, president of JMart Strategies, a consulting firm that specializes in crisis communications. "Not to mention a huge problem for its bottom line, as we see more and more partners walk away from them."

Crisis communications executives say the company erred in hiring Laundry Service. Owned by talent management company Wasserman, it's better known for collaborations with Nike's Jordan brand and Beats by Dre, than providing complex media training to corporate executives.

"This could have been better managed from the start ... had the board hired an outside crisis firm with experience, not a creative services firm," said Mark Macias, founder and owner of Macias PR, a New York City-based public relations agency.

Powell Tate, a specialty public affairs unit of IPG's Weber Shandwick, is reportedly working on the company's communications strategy now. Ellen DeMunter at Powell Tate declined to comment.

"The challenge, following recent damning news, will be for the leadership, namely (newly named CEO Steve) Ritchie, to convince internal and external stakeholders that this is a meaningful exercise that will lead to change and not just a PR stunt," said Dan Hill, CEO of Hill Impact.

The outside audit by Akin Gump is one of the few good moves the company has made so far, Brigid Benitez, partner at Steptoe, a law firm specializing in corporate and criminal cases. She said Papa John's needs to "establish credibility."

Sales decline

The company's franchise owners, meanwhile, are already seeing a drop in foot traffic and sales.

One franchisee, who asked not to be named, said sales at his shops have fallen between 5 and 20 percent, depending on the location, since July 11.

The current situation is "pretty scary," he said, adding that he might have to close stores if the falloff in business continues. Franchisees are particularly vulnerable because they are locked in long-term contracts that require them to pay Papa John's for all marketing materials and food as well as a percentage of their sales.

“If I’m a franchisee, if I’m an employee, if I’m a supplier, if I’m a customer, none of this pleases me,” Kalinowski said.

Stifel analyst Chris O'Cull estimated that annual store cash flow for franchise owners will fall to $60,000 in 2018 from $95,000 in 2016, according to a research note sent to investors Sunday. Papa John's may need to provide some financial assistance to keep franchisees from closing their locations, he said.

In the fourth quarter, same-store sales across all of its stores in North America were down 3.9 percent, year over year. In the first quarter, same-store sales for the group dropped by 5.3 percent from the previous year. And this was before the most recent spate of bad news.

Recent checks made by Stifel indicate that same-store sales have continued to decline. O'Cull said he expects same-store sales will fall 12 percent in the third quarter from the same three months last year and drop 10 percent in the fourth.

O'Cull advised investors to sell their shares. The company's market value, currently around $1.48 billion, is almost half its peak of $2.88 billion in December 2016.

Stifel downgrades Papa John's to 'sell'
Stifel downgrades Papa John's to 'sell'

"The implications of the current situation are far-reaching," O'Cull said. "Papa John's is not a trusted brand."

While O'Cull is doubtful a corporate savior will scoop up the company, the weak stock price has piqued the interest of some potential buyers who are keeping a close watch on the situation, according to some M&A advisors.

If the company wants to survive, Hill said the board needs to move fast and disclose its progress to investors.

"I would suggest that they move quickly and unearth all the bad stuff now, disclose it and address the changes they’re making," Hill said. "A slow dribble of bad news is enough to do in any brand, even Papa John’s."

For his part, Schnatter blames the current management team for the company's recent difficulties.

"Look at the numbers," Schnatter's lawyer Glaser said, adding that the company's performance improves when he's running things and has declined whenever he steps away.

"The ability to maintain a strong company for the benefit of customers, employees, franchisees and shareholders takes a lot of skills, and the current leadership team has not proven that they have all of those skills," Glaser said. "Rather, they appear to prefer using public relations to divert attention away from the financial difficulties they have so far been unable to improve."

— CNBC's Lauren Hirsch, Kate Rogers and Dominic Chu contributed to this article.

Correction: John Schnatter's name was removed from the John H. Schnatter Nachand Fieldhouse gymnasium in his hometown of Jeffersonville, Indiana. An earlier version misstated the location.