DOMINO’S PIZZA – Updated Write-Up And Conclusion

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CONCLUSION:

We have no quarrel with the consensus that Domino’s is writing the book in the pizza delivery business, and there is no apparent reason that they will lose market share to Pizza Hut or Papa John’s. We can’t help but point out, however, that the recent rate of increase in Operating Earnings (rather than the more dramatic recent EPS growth), at roughly a “mid-teen” rate, should probably be the expectation. This still admirable growth rate would be driven by a 6-8% (more likely to be closer to 6 than 8 in the near term) rate of net new stores, a mid-single-digit comp (against very tough comparisons), a bit of SG&A leverage and/or fewer shares outstanding. This year’s tax impact won’t be duplicated. Relative to the share repurchases, if we were on the Board we would not be enthusiastic about (according to Bloomberg) share repurchases at 34x ’18 earnings, 24x trailing EBITDA, 33x trailing Cash Flow and 45.3x trailing Fee Cash Flow. Even when borrowing at still low interest rates, the EPS accretion at this valuation is modest. The regular dividend, yielding 0.7% currently, has been increased each year, but perhaps shareholders would better appreciate another special dividend (last paid in 2012 at $3.00 per share), or a substantial increase in the regular dividend, rather than spending hundreds of millions to buy back stock.

We wouldn’t want to be short this fine company’s stock, and DPZ has been a fantastic holding over the last decade, but we have a feeling that “the easy money has been made”.

COMPANY OVERVIEW (2018 10-K; Analyst Day Slides January 2018)

Domino’s, with more than 14,856 locations in over 85 countries around the world, is the largest pizza company in the world based on global retail sales. Founded in 1960, Domino’s roots are in pizza delivery; however, in recent years a significant amount of sales have come from carryout. On average, Domino’s sells more than 2.5 million pizzas each day.

Domino’s business model is simple – they handcraft and serve quality food at a competitive price with easy ordering access and efficient service enhanced by their technological innovations.

Domino’s generates revenue and earnings by charging royalties and fees to their franchisees. The Company also generates revenue by selling food equipment and supplies to franchisees, primarily in the U.S. and Canada, and by operating a number of Company owned stores. In Domino’s international markets, they generally grant master franchises for a geographic area. These master franchises are charged with developing their geographical area and they may profit by sub-franchising and selling food and equipment to these sub-franchisees as well as by running their own stores.

Domino’s business model yields strong returns for their franchise owners and Company owned stores. Historically, Domino’s has returned cash to their shareholders through dividend payments and share repurchases.

Domino’s pioneered the pizza delivery business and has become one of the most widely recognized consumer brands in the world. Since 1998 the Company has been structured with a leveraged balance sheet and has completed a number of recapitalization events. The Company’s most recent recapitalization transaction (in 2017) primarily consisted of the issuance of $1.9 billion of fixed and floating rate notes and the repurchase and retirement of $910.2 million of previously outstanding fixed rate notes. Following this recapitalization, the Company has $3.15 billion in total debt. Excess proceeds were primarily used to repurchase shares of common stock.

LONG-TERM BUSINESS STRATEGY (2018 10-K)

Begun in 2009, Domino’s first priority was to reinvent their core pizza, and they relaunched the brand by introducing a new recipe for their signature product. Next, they improved existing products and/or introduced new items that complimented changes to the core pizza.

Secondly, in 2013 they launched the program to reimage the stores to be more attractive for carryout customers – creating the “Pizza Theater” design which allowed customers to see the process of pizza making. Market studies and current sales trends (from NPD/Crest) had revealed the take-out business was much bigger than delivery. In 2017, delivery business equaled slightly over 1 billion occasions whereas carryout was over 2.5 billion occasions. Since Domino’s carryout focus was launched in QTR-1 2011, Domino’s share of carryout has risen from 7.5% to 14.4%. Carryout necessitates Domino’s to be closer to the customers, therefore, the Pizza Theater helped address this but what was also needed was more locations to make carryout more convenient. In their 2018 Investor Day Presentation, Domino’s management discussed this plan in some detail. It is called Fortressed Markets and is based on realigning the franchise system with programs that encourage strong franchisees that wanted to grow multiple opportunities, both to open new locations and to buy out weaker franchisees in their market areas. Since 2016, Domino’s U.S. franchise base count has moved from 1,300 to 800. This new alignment continues to drive growth with those franchisees who share the Corporate vision. Another component of the Fortressed Market program has franchisees investing heavily by splitting their markets into smaller delivery/carryout areas. According to Domino’s Internal Data (Analyst Day slides) the majority of a location’s carryout business is within 6 minutes of the store. Seattle, WA was one of the first markets to engage in Fortressed Marketing and saw AWGS increase from $20.7K to $26.3K over a 3-quarter period in 2017.

Thirdly, priority was an aggressive investment in technology (which began in 2010) to be the leader in making connections with consumers through technology that exceeded their expectations. This became an aggressive investment in building digital platforms and eventually data analytics in-house. In 2016 Domino’s developed its own digital platform to manage internal operations and customer-facing actions all with the goal to simplify ordering and payment processing and enable order tracking on virtually any communication device. The system is called GOLO (Global Online Ordering). Together with a sophisticated loyalty program (launched in 2016), the platform provides a rich source of data for its robust marketing initiatives.

While Domino’s continues to innovate around the brand’s interactive experience with consumers, nothing has been, or presumably will be, embraced or created that can disrupt operations. Domino’s has preserved the integrity of their brand with an emphasis on continuity relative to their heritage.

SOURCES OF REVENUE (2018 10-K):

As of its 2018 10-K Report, Domino’s operated and franchised 14,856 units globally generating more than $10,638 billion, making them the second largest pizza chain (after Pizza Hut) in sales and the number one pizza delivery company. Approximately one-half of the global sales are generated by 5,587 domestic stores (5,195 franchise and 392 Company). The remainder is produced by 9,269 franchised stores in over 80 markets around the world. Additionally, $1.7 billion is generated from Domino’s supply chain.

Domino’s revenue is generated from multiple sources: domestic franchise fees (5.5% of franchisee sales), international master franchise fees (3.0%), domestic and GOLO digital fees, and supply chain and Company-owned store segment.

UNIT LEVEL ECONOMICS (2018 10-K; 2018 Analyst Day Slides)

From the FDD and the above sources, we estimate AUV’s of Company units are slightly over $1.2M (or about $837/sq. ft. assuming the average store size of 1,500 sq. ft.) and domestic franchised units AUV’s are about $1.0M. Disclosed average store level EBIDTA of domestic franchisees is about $136K – up from $61K in 2009 or a store level margin of 13.6%. (These figures are presumably net of royalty fees and advertising fund contributions.) The cash investment for leasehold improvements, furniture, fixtures, equipment, signage for a new store (provided from Domino’s FDD) is about $410K. Accordingly, the $136K store level EBITDA would represent a store level cash on cash return of 33.1% for a domestic franchised unit.

The supply chain provides pricing and distribution scale and consistent uniform quality ingredients to participants. It operates 18 regional dough manufacturing and food supply chain centers in the U.S. It also operates centers in Canada and leases a fleet of more than 500 tractors & trailers.

SHAREHOLDER RETURN (2018 10-K):

Domino’s 1, 3 and 5-year stock performance has been 24.4%, 147.3% (35.2% CAGR) and 440.9% (40.1% CAGR) respectively. Including reinvestment of dividends, total return for the same periods have been 25.3%, 153.0% (36.2% CAGR) and 457.4% (41.0% CAGR).

RECENT DEVELOPMENTS (PER Q2 EARNINGS REPORT AND CONFERENCE CALL)

Domino’s continued its outstanding performance in Q2, with domestic same store sales up 6.9%, international up 4.0%. It was the 98th consecutive quarter of int’l SSS growth, only the 29th domestically. Diluted EPS was up 34.8% on a GAAP basis and 39.4% “adjusted”. Impressive as the performance is, it should be noted that Income from operations (pretax) was up a more modest (and sustainable) 11.5%, with the higher percentage increases driven by 12.5% fewer shares outstanding and a tax rate of 15.1% versus 25.7% a year earlier. There were 156 net new stores added to the system, 113 internationally and 43 domestically.

The second quarter was highlighted by the innovate launch, late in Q2, of over 200,000 Domino’s Hotspots in the US. Financially speaking, the April recapitalization included $825 million borrowed, of which $490 million paid off previously issued notes. Also in Q2, 905,556 shares were repurchased for $219M and $0.55 per share was paid in dividends.  Remaining share purchase authorization amounted to $429.9M at the end of Q2. The operating numbers above are fairly consistent with the previous quarter, though lower, and the six month increase in operating income was 13.4%.

The Conference Call provided some additional operating details.

US franchisees’ SSS were up 7%, with company stores up 5.1%. The company continues to spend a substantial sum in technology related capital spending, now expected to be $115-120M in ’18, up from a previous estimate of $90-100M.  Supply chain investment is being accelerated, including additional distribution centers in the US, to support the double digit gross sales growth. Carryout business is viewed as a separate occasion from delivery, largely incremental, and advertising is targeted accordingly. Points of distribution, including Hotspots are also being designed with that in mind. The impact of Hotspots was not clear as of the end of Q2, including the incremental effect, but should be more apparent by the end of Q3. Management is guiding to 3-6% long term SSS growth internationally, slowing a bit from the more rapid growth recently.

On a trailing twelve month basis, 905 total net new stores were added, most of them internationally, as has been the case in recent years.  There was a modest slowdown in the rate of international openings in the first half of ‘18, but that is expected to be temporary, a consolidation of sorts after opening over 1,900 net new int’l stores in 2016-2017. The estimate continues to be 6-8% annual net new units on a global basis. The 905 net new stores opened (almost exactly 6% of the 15,122 base), of which 651 were international, including only 113 in Q2, so the Q2 pace is clearly below that.

CONCLUSION: Provided at the beginning of this article.

 

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