2023-03-28 11:26:17 ET
Summary
- Domino's management has implemented reasonable strategies that have shown success during and after the pandemic.
- Domino's leading market position in many international markets provides it a longer runway for growth than its competitors.
- Domino's is a cash-generation machine and makes good use of leverage, giving ample opportunity for shareholder returns.
- My DCF analysis of DPZ puts a fair price at ~$325 in the base case.
Investment Thesis
After rebounding from its sub-$300 lows, Domino's (DPZ) has approached a comfortable price point. Domino's has a lot going for it -- its exceptional e-commerce interface, successful supply chain segment, international presence, and cash flow generation are all indicators of a successful business with organic growth avenues. However, at its current valuation, there is not a big enough margin of safety to justify a buy. Therefore, I recommend a HOLD for Domino's stock.
Company Overview
Domino's is a restaurant operator and franchiser with more than 20,000 stores across over 90 international markets. The largest pizza restaurant in the world, Domino's generated $17.7 billion in system sales in 2022. Its control (among the 4 largest US chains) of the national market is 42%, according to Bloomberg Second Measure .
As of the end of 2022, Domino's revenue can be broken down as follows:
Royalties and Franchise Fees: 29.4%
Company-owned Stores: 9.8%
Supply Chain: 60.7%
Among royalties and franchise revenues, nearly 25% originate from international locations.
As seen through Domino's revenue streams, it would be more apt to call Domino's a supply chain & consumer marketing business than a pizza chain. Domino's uses its network of 26 domestic and 5 Canadian dough manufacturing/supply chain facilities to concentrate purchasing, preparation, and last-mile delivery for its North American locations.
Competition
Domino's direct industry competitors are Papa John's (PZZA), Pizza Hut (YUM), and Little Caesars. Domino's has 32% share of delivery dollars and 19% share of carryout dollars in the US among QSR pizza brands -- #1 in both categories as of Q4 2022 .
Author
The oligopolistic layout of the industry gives Domino's (and its major competition) an enormous economies of scale advantage over its regional and local peers. Its bargaining power enables its leveraged position, which I'll get into later, and also provides the enormous advantage of its vertically integrated supply chain.
Domino's biggest financial differentiator is its debt position -- currently, Domino's sits at a 3.28 D/A and a 6.25 Total Debt/EBITDA ratio. I'll explain how this works to its favor in a moment.
Domino's competitive advantages consist of its intangibles, like its brand name, its global franchise network including good relationships with its master franchisees, size, and leading e-commerce interface.
Competent Strategy
Domino's has implemented a lot of strategies that have aided its success.
Its supply chain segment is highly successful. Not only does it benefit Domino's by allowing for centralized purchasing, more efficient coverage of stores, and increased access to supply chain data, but it benefits franchisees via easy access to materials and profit-sharing agreements. For example, a franchisee can get their dough shipped directly rather than having to spend time making it. With the opening of 4 new major centers in the last 5 years, this has been Domino's fastest-growing segment -- up 38% since 2019. I find that the symbiosis the supply chain integration creates between Domino's and its franchisees is immensely useful for both parties, and, should Domino's be able to expand this segment internationally into a major market like India or China (though this likely won't happen for several years, if at all), I believe that its advantages will only be compounded.
Domino's has also focused its attention on international development, using master franchisees to get a foothold in foreign markets. These partnerships are strong -- 4 out of 5 major partners have a $2 billion market cap.
One of the things that allowed Domino's to weather the pandemic so well is its digital presence. Its e-commerce interface is highly developed for the industry, coupling GPS tracking and AI-powered routing with quick and easy ordering, a powerful rewards program, digital-only deals, and more. More than 75% of Domino's sales are digital, which is leading among major players. Domino's has 85 million different customers in its database, and its "AnyWare" ordering platform allows for ordering not only through the Domino's app, but across platforms, including Facebook Messenger and Twitter.
This level of digital success also is less labor-intensive, which is beneficial in today's tight labor market. Evidence of its digital success can be seen through its pandemic growth -- while other competitors were floundering in an attempt to breach the digital space, Domino's capitalized and raised its global QSR market share from 1.6% to 2.2% from 2019 to 2021.
Other strategies include fortressing, which essentially includes flooding the market with stores. The idea is to try to expand carry out market share by making Domino's a more ubiquitous brand, even at the cost of potentially stealing business from existing Domino's. I imagine that, somewhere out there, there are legions of economists sputtering about inefficiency, but Domino's has proved them wrong, successfully securing a larger part of the carryout pie. Carry out is a larger piece of the QSR market than delivery -- in theory, providing a longer runway for growth.
Last, even in the face of expanding competition via the growth of delivery categorically, Domino's has doubled down on its core competencies of price and convenience. I find this to be well-thought out, since it exposes Domino's to much less operational risk than menu diversification or other untested initiatives.
International Presence and Organic Growth
Domino's is the leader in international QSR Pizza, which I believe gives them a significant growth advantage as developed markets become saturated with stores. For example, Domino's anticipates nearly doubling its store count in India and opening ~4600 new stores in China eventually. While I find these projections to be optimistic, if even part of that growth is achieved, it can be expected that international franchising revenue would increase significantly (and potentially serve as motivation to expand the supply chain business internationally).
Domino's
International revenues have expanded ~22.5% since 2019, while U.S. revenues have increased only ~17% for the same period. Given the ubiquity of the COVID pandemic, I don't anticipate the COVID delivery tailwind to have affected one of these figures disproportionately.
Domino's per-store EBITDA has risen an average of 10.2% CAGR since 2010, which should compound upon store growth internationally to outperform its major competitors. International store sales growth has outperformed domestic sales growth in recent years, so I anticipate Domino's international presence to be a major factor in the future.
Cash Flow and Shareholder Returns
Domino's has generated >$600 million in FCFF since 2020, with an FCF to Net Income ratio of 1.02. This impressive level of cash generation has allowed Domino's to distribute cash to shareholders even after reinvestments into the business.
As proof, Domino's has one of the healthiest trends of share buybacks of any company, and cash generation implies potential room for dividend growth. Domino's has bought back 20 million shares since 2013, 36.2% of total shares. I anticipate the continuation of this trend, severely limiting any risk of dilution.
2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 | |
Shares Outstanding in Millions | 56 | 56 | 56 | 50 | 48 | 43 | 41 | 39 | 39 | 36 |
Percent Change | N/A | 0% | 0% | -10.7% | -4% | -10.42% | -4.7% | -4.9% | 0% | -7.7% |
Often, leverage is seen as a warning sign. However, Domino's leveraged strategy has lived through multiple financial crises already, suggesting that the company is unlikely to suffer enormous losses due to its debt position. Further, the weighted average interest rate of its $5.25 billion in debt is only ~3.77%. A majority of this debt is not due until ~2028, which is also favorable for the leveraged position.
I find Domino's buyback habits to more than make up for its poor dividend.
Lastly, as a bit of an aside, the company's lack of direct involvement with its restaurants allows for more efficient capital management on a macro level.
Valuation
For my DCF, I used the following inputs:
Revenue Build & EBITDA Margins | ||||||||||
$ in millions except share-related items | 2018 | 2019 | 2020 | 2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 |
Revenue | 3,432.90 | 3,618.80 | 4,117.41 | 4,357.37 | 4,537.16 | 4,647 | 4856.68 | 5138.28 | 5426.146545 | 5751.123193 |
% Growth | 5.42% | 14% | 6% | 4.13% | 2% | 5% | 5.80% | 6% | 6% | |
COGS/COR | 2,130.20 | 2,216.30 | 2,522.92 | 2,669.13 | 2,888.55 | 2876.636 | 3006.195 | 3180.501 | 3358.684706 | 3559.839261 |
% of Revenue | 62% | 61% | 61% | 61% | 64% | 62% | 62% | 62% | 62% | 62% |
Gross Profit | 1,302.70 | 1,402.50 | 1,594.49 | 1,688.24 | 1,648.61 | 1,770.73 | 1,850.48 | 1,957.78 | 2,067.46 | 2,191.28 |
Gross Margin | 38% | 39% | 39% | 39% | 36% | 38% | 38% | 38% | 38% | 38% |
SG&A | 372.50 | 382.30 | 406.61 | 428.33 | 416.52 | 467.5345 | 488.5914 | 516.9209 | 545.880883 | 578.5741651 |
U.S Franchise Advertising | 358.50 | 390.80 | 462.24 | 479.50 | 485.33 | 503.4942 | 526.1707 | 556.6791 | 587.8664714 | 623.074307 |
Refranchising gain | - | - | - | - | 21.17 | - | - | - | - | - |
Operating income | 571.70 | 629.40 | 725.64 | 780.41 | 767.93 | 799.71 | 835.72 | 884.18 | 933.71 | 989.64 |
Operating Margin | 17% | 17% | 18% | 18% | 17% | 17% | 17% | 17% | 17% | 17% |
Other Income | - | - | 36.758 | - | - | - | - | - | ||
Interest income | 3.3 | 4 | 1.654 | 0.345 | 3.16 | 3.015606 | 3.151424 | 3.33415 | 3.520941936 | 3.731814219 |
Interest expense | 146.3 | 150.8 | 172.166 | 191.806 | 198.25 | 198.7372 | 207.6879 | 219.7301 | 232.0402589 | 245.9373523 |
Provision for Income Taxes | 66.7 | 81.9 | 63.834 | 115.238 | 120.57 | 132.8764 | 142.0168 | 153.5902 | 165.7208645 | 179.3831812 |
Net Income | 362.00 | 400.70 | 491.30 | 510.47 | 452.26 | 471.11 | 489.17 | 514.19 | 539.47 | 568.05 |
Net Margin | 11% | 11% | 12% | 12% | 10% | 10% | 10% | 10% | 10% | 10% |
% Growth in net income | 10.69% | 22.61% | 3.90% | -11.40% | 4.17% | 3.83% | 5.12% | 4.92% | 5.30% | |
Diluted EPS | $8.35 | $9.56 | $12.39 | $13.54 | $12.53 | $13.24 | $13.94 | $14.86 | $15.71 | $16.66 |
And for my WACC, the following:
WACC Calculation | |
Current Share Price | 322.22 |
Total Shares | 36,093,754 |
Total Debt | 5,252,354,000 |
Debt Weighted Average Interest | 3.77% |
Beta | 0.73 |
Risk-Free Rate | 4.74% |
S&P Return | 9.10% |
Cash Balance | 60,356,000 |
Market Value of Equity | 11630129414 |
WACC | 7.4700688849487600% |
I used a terminal value based on a terminal growth rate of 2%, which I find reasonable given the relative maturity of the company.
I used a revenue-segment based revenue build-out, basing my assumptions on a harsh 2023 and then mean reversion of growth in each segment (some growth rates declining, like US franchising, while others increased slightly, like international franchising). Double checking against FactSet analyst estimates, we are mostly in agreement on the top line numbers. After going through the necessary calculations, assuming that most expenses are held near-constant (slight decreases in some cases) as a percent of revenue, and using historical averages for things like change in net working capital, I landed at a fair value for DPZ of $327.14 at a 2% terminal growth rate. This provides minimal upside, which, despite some relatively bearish assumptions on my part, does not provide a sufficient margin of safety for me to recommend a buy at its current price.
I did account for buybacks in other cases, but this still only raised upside to 8-9%, not quite enough for me to suggest a buy.
Risks and Other Considerations
Despite this not being a buy recommendation, I still think it's important to point out potential risks with Domino's. I find the main risks to be as follows:
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Current macroeconomic environment is not favorable to sectors reliant on discretionary income, pressuring delivery revenues
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Improvements in delivery categorically pressure delivery market share
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Domino's has experienced some staffing issues that may put upward pressure on operating costs
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Commodity cost inflation in the near term puts pressure on the supply chain segment, which accounts for a majority of revenue
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Due to mid-single digit revenue growth, any pressure on margins severely limits upside
Despite all this, I find Domino's tailwinds to be sufficient enough for a generally bullish sentiment on Domino's long-term -- but at its current valuation, not quite enough to warrant a buy.
The Bottom Line
In my view, Domino's sits at a very comfortable valuation right now. Based upon its international market position, cash generation and shareholder returns, and management's very competent handling of the business, I find Domino's to be a quality business that is more than worth holding a position in. However, I find its upside to be limited at its current price, and suggest a HOLD.
For further details see:
Domino's: Give Me A Slice At A Better Price