2023-03-28 02:54:04 ET
Summary
- Domino's has dropped over 15% since my last coverage in September.
- Inflation and the strong dollar have started to come down, which should reduce its headwinds moving forward.
- Its latest earnings remain soft, but some improvements are being shown, especially in the bottom line.
- The current valuation finally looks more reasonable, with multiples in-line with restaurant peers.
- I rate the company as a hold.
Investment Thesis
Domino’s ( DPZ ) has dropped another 15% since my coverage in September last year , now trading nearly 45% below its all-time high. Despite the decline, the company’s backdrop has improved slightly in the past few months. Although the overall financials are still weak, it has shown some progress and reported modest growth in both the top and bottom line. Inflation and the dollar have also eased as the market is now worrying about a potential recession, which should take some pressure off the company. The valuation has compressed significantly, with multiples now below peers and its own historical average. I believe the current downside potential should be limited, therefore I am upgrading Domino’s to hold.
Market Dynamics
Domino’s fundamentals remain solid, with ongoing market share gains in an expanding market. The market trend of QSR (quick-serve restaurant) pizza continues to be positive, as lower-priced meals remain favorable in an elevated inflation environment. According to the management team , the category grew roughly 10% compared to pre-pandemic levels, while Domino’s market share was up approximately three points during the period.
However, the delivery segment should continue to be under pressure in the near term. According to the company , the overall QSR delivery market was down by high single digits in FY22. As customers move past the pandemic, they have now shifted their preference back to in-house dining, which reduced the volume of delivery. Higher inflation has also increased delivery costs and related expenses, which further impacted demand.
Easing Headwinds
As mentioned in my last article, high inflation and the strong dollar were the company’s major headwinds in 2022. High inflation put substantial pressure on costs and expenses, while the strong dollar weakened the value of other currencies, resulting in lower revenue (on a dollar basis) from international stores. In the past few months, inflation and the dollar have finally started to drop. As shown in the chart below, the latest US CPI (consumer price index) was 6% in February, much lower than the 9.1% peak in June. The figure remains elevated but I believe it will continue to trend down, as prices for larger CPI components such as rent should start to moderate. The dollar index has also declined meaningfully, down roughly 10% from the peak in September, as the fear of recession rises.
I am not too worried about a recession at the moment. Even if it does happen, the impact on Domino’s should be relatively limited. The company’s products are mostly cheaply priced, which should provide solid resilience during economic downturns. It may even benefit from other customers down-trading from more pricey pizza places in order to save money.
Trading Economics
Improved Bottom Line
Domino’s announced its fourth-quarter earnings last month. The results are still very weak, but it demonstrated some progress compared to the past few quarters, especially in the bottom line. The company reported revenue of $1.39 billion, up 3.7% YoY (year over year) compared to $1.34 billion. US same-store sales growth was 0.9%, while international same-store sales growth was 2.6%. The net store growth for the quarter was 361.
The revenue growth is mostly driven by the supply chain segment, which increased 6.4% YoY from $800.9 million to $852.2 million. Revenue from franchise royalties and fees was also solid, which increased 6.1% YoY from $166.9 million to $177 million. This was partially offset by the decline in revenue from US company-owned stores, which dropped 17.1% YoY from $141.2 million to $117 million. Gross margin dipped 90 basis points from 37.7% to 36.8%, as costs of sales remain pressured by inflation.
The bottom line was the highlight of the quarter, as the slowdown in spending boosted earnings. Despite revenue being up, operating expenses were roughly flat at $284.2 million compared to $283.5 million. This is attributed to the 6.8% decline in G&A (general and administrative) expenses, offset by the increase in advertising expenses. The moderated spending resulted in operating income up 11.7% YoY from $222.7 million to $248.8 million. The operating margin also increased 130 basis points from 16.6% to 17.9%. The diluted EPS was $4.43 compared to $4.25, up 4.2% YoY.
Sandeep Reddy, CFO, on profitability improvements
Second, efficiencies in our cost structure as we seek to ensure that revenues consistently grow faster than expenses. We saw another sequential improvement in year-over-year operating income margin as a percentage of revenues, as margins expanded to 130 basis points in Q4 versus the 160 basis points contraction in Q3.
Valuation
After the substantial pullback, the company’s valuation looks much more reasonable now. It is currently trading at a PE ratio of 24.8x, which is starting to get compelling in my opinion. The multiple is meaningfully below its 5-year average PE of 34.2x, which represents a discount of 27.5%. The multiple is also now in line with restaurant peers like Yum! Brands ( YUM ), Starbucks ( SBUX ), and Chipotle ( CMG ), as shown in the first chart below. The average PE ratio of its peers is 33x, which represents a premium of 24.8%. However, it is worth noting that the company’s revenue growth is slower compared to peers, as shown in the second chart below. It is also lower than its own historical average of 11.1%, therefore a discount in valuation makes sense.
Investors Takeaway
I believe the improved backdrop should limit the further downside of Domino’s stock. Both inflation and the dollar have been trending downwards in the past few months, which should reduce some of its headwinds moving forward. Although revenue growth was still soft in its latest earnings, the bottom line showed solid improvements. The current valuation is also discounted, with multiples below peers and its own historical average. However, the near-term upside should also be muted due to weak growth rates and ongoing pressure from the delivery segment. Therefore I rate the company as a hold.
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Domino's: Improved Backdrop Should Limit The Downside