2023-06-07 04:00:55 ET
Summary
- Domino's Pizza stock has experienced a 26.7% decline from its average price in 2022, presenting an opportune time for investors to consider adding it to their portfolio.
- The company has demonstrated resilience and growth throughout its history, even during periods of high inflation, and has a strong business model with competitive advantages.
- Investors should monitor the margins of the supply chain segment and franchise EBITDA, but the current price offers an attractive entry point for long-term investors.
Introduction
On February 23 rd of this year, Domino’s Pizza, Inc. ( DPZ ) delivered disappointing revenue numbers for Q4 2022 and revised downwards their two-to three-year global retail sales growth and their net unit growth. Their stock went from $348.46 on February 22 nd to $294.01 on February 28 th .
Their two-to three-year global retail sales growth was revised from 6-10% range to the 4-8% range and the net unit growth from 6-8% to 5-7%. The corresponding stock decline was 15.63%. The stock closed on June 6th at $297.74 which is about 26.7% off from the average price in 2022. The stock is also trading near the 2019 52-week high despite having almost $1 billion more in total revenues in 2022.
In this article, we argue why the current price is an opportune time to consider adding the stock to your portfolio. We look at their recent performance against the backdrop of their many years of business. We evaluate their margins in light of current macroeconomic environment and quantify how management has created value for shareholders from 2013 to 2022. We compare valuation metrics in 2019 as compared to 2022 and opine on the margin of safety available at the current price. We then delve into their business model, assess the resiliency and identify key comparative advantages.
Familiar Themes
Familiar themes emerge when we drill down on why the operating performance has been lackluster as of late. For a typical company-owned store, labor and food costs represent 55% to 65% of sales and, in an inflationary environment, margins will be impacted. In particular, two dynamics in 2022 hurt Domino’s operating performance. First, there was a migration to sit-down dining from delivery as people reverted to pre-Covid-19 behavior. Secondly, for a typical Domino’s franchise, delivery has a higher cost profile than carryout because of the additional labor component. For consumers with stretched disposable incomes, the higher prices considering delivery fees and tips prompted a shift to cooking at home. Domino’s offers delivery and carryout. The two dynamics mentioned impacted the delivery service more than the carryout. More on the carryout later.
A $900 Purchase
Domino’s has thrived in the 60 plus years since Tom and James Monaghan bought the first store in 1960 for $900 and opened their first franchise in 1965. About 22% of their total years in business to date has been in a macroeconomic environment in which inflation exceed the current rate . From 1965 to 1979, inflation was higher than it is today in nine of the 15 years, yet by the time the second OPEC oil crisis hit, Domino’s was on their 200 th store. In 1989, Domino’s opened their 5000 th store at a time in which the inflation rate averaged 4.83%, close to what it is today .
Domino’s had a 7.46% decline in diluted EPS for 2022 as compared to 2021. The previous time that Domino’s reported a decrease in earnings was in 2006 to 2007 in which EPS went from $1.65 to 59 cents per share. It takes a pandemic or a global financial crisis to temporarily take them off their growth path.
Source: 10-K from 2006 to 2022
In the next section, we take a closer look at their margins
Margins
Please take a look at Table 1 in which we look at gross profit margins.
Table 1: Gross Profit Margins | |
Year | GPM |
2013 | 30.46% |
2014 | 29.83% |
2015 | 30.82% |
2016 | 31.05% |
2017 | 31.06% |
2018 | 37.95% |
2019 | 38.76% |
2020 | 38.73% |
2021 | 38.74% |
2022 | 36.34% |
Median | 33.70% |
The costs of sales components include food, labor, delivery, and occupancy costs (rent, telephone, utilities, insurance, etc.). The largest food cost is cheese, which is about 25% and the total food cost and the price of which is loosely tied to the Chicago Mercantile Exchange cheddar block price. Domino’s does not engage in speculative transactions. The gross profit margin in 2022 exceeded the median gross profit margin for the periods presented. In fact, the gross profit margin of 2022 exceeded the margins for 2013 to 2017. This points to a business that can manage the impact of input cost inflation or a business than can pass on the costs to their customers. Or perhaps both. Let us take a closer look.
Please take a look at Table 2.
Table 2: Selected Operating Data ($ in thousands) | |||
2019 | 2022 | % change | |
Revenue | 3,618,774 | 4,537,158 | 25.38% |
Cost of sales | 2,216,275 | 2,888,552 | 30.33% |
In 2022, revenues were 25% higher than they were in 2019 and cost of sales was 30% higher. One interpretation would be that for every 30-cent increase in input costs, 25 cents have been passed on to the customer.
There is one area potential investors should keep an eye on. The largest business segment is their supply chain segment and the margins have compressed in this segment. This is a more direct measure of the impact of food and wage inflation. Please take a look at Table 3.
Table 3: Supply Chain Gross Margin (SCGM) | |
Year | SCGM |
2013 | 10.90% |
2014 | 10.40% |
2015 | 10.80% |
2016 | 11.10% |
2017 | 11.20% |
2018 | 10.90% |
2019 | 11.20% |
2020 | 11.30% |
2021 | 10.40% |
2022 | 8.90% |
Median | 10.90% |
There has been a 10-basis point improvement in Q1 2023 in the supply chain gross margin which is a welcome development. We do expect margins to continue to improve throughout the next several quarters and settle in the mid 10% range.
Please take a look at Table 4 which shows general and administrative (G&A) expense as a percentage of revenues in 2019 as compared to 2022.
Table 4: General and Administrative Expenses ($ in thousands) | ||
2019 | 2022 | |
Revenue | 3,618,774 | 4,537,158 |
G&A | 382,293 | 416,524 |
% | 10.56% | 9.18% |
G&A as a percentage of revenues were smaller in 2022 than in 2019.
Another item that potential investors should be mindful of is that U.S. franchisees had an EBITDA of $137,000 which is lower than recent years. You want to see the franchise profitability trend higher. The franchise renewal rate in 2022 was 99%.
Creating Value
There are two metrics that I like to look at when considering an investment: return on retained earnings and market value added against retained earnings.
In business theory, earnings in a particular year can be attributed to all the capital invested in the business up until just before the particular year. So, in theory, earnings in 2022 for a business can be attributed to all the invested capital in the business from inception up until the end of 2021. In 2022, the capital was put to use and delivered earnings for the owners of the business. We are going to narrow the scope and look at retained earnings from 2013 to 2021 for Domino’s and attribute earnings in 2022 to retained earnings from 2013 to 2021.
Source: Mary Buffett and David Clark. The Buffettology Workbook. Simon & Schuster 2001
Please take a look at Table 5.
Table 5: Deploying Retained Earnings (per share information) | |||
Year | Earnings | Dividends | Retained |
2013 | 2.48 | 0.8 | 1.68 |
2014 | 2.86 | 1 | 1.86 |
2015 | 3.47 | 1.24 | 2.23 |
2016 | 4.3 | 1.52 | 2.78 |
2017 | 5.83 | 1.84 | 3.99 |
2018 | 8.35 | 2.2 | 6.15 |
2019 | 9.56 | 2.6 | 6.96 |
2020 | 12.39 | 3.12 | 9.27 |
2021 | 13.54 | 3.76 | 9.78 |
2022 | 12.53 | 4.4 | N/A |
Total retained 2013-2021 | $ 44.70 | ||
Increase in EPS 2022-2013 | $ 10.05 | ||
Return on retained earnings | 22.48% |
As Table 5 shows, from 2013 to 2021, Domino’s retained $44.70 in investor money and delivered an earnings bump of $10.05 per share for a return on retained of 22.48%. The $10.05 is calculated by taking the 2022 EPS of $12.53 and subtracting the 2013 EPS of $2.48. During 2013 to 2021 investors also received $18.08 in dividends.
Let us now turn to how much value Domino’s created during 2013 to 2022 time period. Please turn your attention to Table 6.
Table 6: Market Value Added (per share) | ||||
Year | EPS | Dividends | Retained | Avg. Shr. Price |
2013 | 2.48 | 0.8 | 1.68 | 57.89 |
2014 | 2.86 | 1 | 1.86 | 81.74 |
2015 | 3.47 | 1.24 | 2.23 | 108.76 |
2016 | 4.3 | 1.52 | 2.78 | 137.1 |
2017 | 5.83 | 1.84 | 3.99 | 191.7 |
2018 | 8.35 | 2.2 | 6.15 | 251.08 |
2019 | 9.56 | 2.6 | 6.96 | 260.85 |
2020 | 12.39 | 3.12 | 9.27 | 347.85 |
2021 | 13.54 | 3.76 | 9.78 | 445.36 |
2022 | 12.53 | 4.4 | N/A | 406.16 |
Total Retained 2013-2021 | $ 44.70 | |||
Market Value Added (MVA) | $ 348.27 | |||
MVA per $1 | $ 7.79 |
Employing a similar logic as we have previously, we can say that between 2013 and 2021, Domino’s retained $44.70 of shareholder capital and saw its share price increase by $348.27. The $348.27 figure is derived from the average share price in 2022 minus the average share price in 2013. Thus, for every dollar that Domino’s retained, they created $7.79 in value for the period presented.
These two tables paint a picture of Domino’s management being excellent stewards of shareholder capital.
Please take a look at the next table in which we view the P/E ratio that DPZ typically trades at.
Table 7: Price to Earnings Multiple ($ per share) | |||
Year | Earnings | Average share price | P/E |
2013 | 2.48 | 57.89 | 23.34 |
2014 | 2.86 | 81.74 | 28.58 |
2015 | 3.47 | 108.76 | 31.34 |
2016 | 4.3 | 137.1 | 31.88 |
2017 | 5.83 | 191.7 | 32.88 |
2018 | 8.35 | 251.08 | 30.07 |
2019 | 9.56 | 260.85 | 27.29 |
2020 | 12.39 | 347.85 | 28.08 |
2021 | 13.54 | 445.36 | 32.89 |
2022 | 12.53 | 406.16 | 32.42 |
Average | 29.88 |
On average, DPZ trades at a P/E ratio of 29.88. If we use the 2022 earnings figure and the June 6 th closing price of $297.74, we arrive at a P/E ratio of 23.76x. The last time that shares were available at close to this multiple was in 2013.
Let us turn to some qualitative aspects of Domino’s business model and assess their competitive strength in light of the current macroeconomic environment. If we are going to assume that they can weather the current macroeconomic headwinds and improve their margins, let us ground that assumption by connecting it to their business model.
Business Model
Domino’s has three segments. In the U.S, they generate revenues from company-owned stores and from franchisees. Revenue from company-owned stores is straightforward, they book revenues when food items are delivered or carried out. They had 286 company-owned stores in 2022.
In addition, in the US, they earn a 5.5% of sales royalty fee from franchisees. They had 6400 franchised stores at the end of 2022. Combining the store-owned and franchised stores, the U.S. segment earned $1.49 billion in 2022 and it represents 33% of consolidated revenues. Included in this figure is a 6% of sales contribution that franchisees make to fund a national advertising campaign, which is a flow through in their income statement. Disaggregating this and the U.S. segment earned just over $1 billion in sales for 2022.
Let us dig a little deeper with this segment.
One of the key differentiators of Domino’s from others in the Quick Service Restaurant ((QSR)) category is that their stores are made for carryout and delivery, not dine-in. This is purposeful since the focus away from dine-in simplifies business operations, reduces the capital required for the build-out of new stores and refreshing older stores. It also reduces the labor required to run a store than a comparable dine-in store. In some jurisdictions, this eases the regulatory burden that is imposed by the local board of health. They also offer a simple, value-oriented menu. By simplifying the menu, they can consolidate the purchase of ingredients through their supply chain segment and leverage their scale.
The increased rate of inflation affects their business differently depending on how an order is fulfilled. As discussed earlier, delivery is impacted more than carryout because delivery is more labor intensive and there is a higher fee for the customer due to delivery charges and tips. The carryout part of the business could actually benefit from the current macroeconomic environment as customers trade down from other more expensive options. There is about a 15% overlap from delivery to carry out, so 85% of the impact is from the substitution effect. As consumer's real disposable income decreases, they trade down from other more expensive dining options. The CEO highlighted this dynamic in the recent earnings call . Time will tell if this dynamic shows up in the numbers, but the economic theory behind it is well grounded.
Another dynamic with the segment is the slower pace of new U.S store build-outs. This is likely a temporary situation because supply chain issues affecting construction inputs are still being worked through. In addition, there are bottlenecks with regard to securing permits for new store construction. The pace should get back to normal towards the end of this year.
The second segment is the international segment. This segment is relatively small in terms of revenue and accounts for 6.5% of revenues. However, the international segment is an important in terms of store count. There are twice as many stores internationally as there is in the U.S. The terms are different for international stores and there is only a modest amount of administration expense incurred to support international franchisees. Additionally, agreements with international franchisees are structured as master franchise agreements that include a growth clause requiring franchisees to open a minimum number of stores within a specified period. Some of these franchisees are large and publicly traded in their respective markets.
In Q3 2022, the international segment streak of 113 consecutive quarters of same-store-sales growth ended. However, positive growth was restored in Q4 2022 and continued in Q1 2023 .
The third and largest segment of Domino’s is their supply chain logistics which in 2022 accounted for $2.75 billion or 61% of revenues. Their supply chain business comprises of 22 regional dough manufacturing and supply chain centers, two thin crust manufacturing facilities, and one vegetable processing center. Domino’s supply chain segment delivers to the U.S. and Canada based franchisees (and the 286 company owned stores) ingredients, supplies and equipment. With this segment, they can exert some degree of control and moderate the impact of the increase in input costs.
Competitive Strength
One of the not-so secret ingredient to Domino’s success, is the fact that substantially all of U.S. franchisees started as either delivery drivers or in-store positions. Delivery drivers are the “boots on the ground” in terms of the business. They see what customers want and respond to. They know the competition in their local market. They take their market knowledge and enroll in the Domino’s Franchise Management School where they can receive training to transition from store operations to store ownership. For a delivery driver, the opportunity to own a small business can be a powerful motive.
Domino’s growth story requires growth in store count. And growth in store count requires motivated franchisees to take on the business risk and the time investment to open their own franchise. The Domino’s system provides both a path to channel that motivation and the eventual financial reward.
Conclusion
From how designed their stores to internalizing their supply chain to developing new franchisees, Domino’s has built a resilient business and is one of one of the most recognizable consumer brands in the world.
There are two items which potential investors should be mindful of. The first is that we would like to see the gross margin of the supply chain segment returns to historic levels. Secondly, some steady improvement in franchise EBITDA over time would be welcome, though this is less of an issue given the strong profitability of the franchisees.
In conclusion, investing requires the balance of risk and reward. Given their track record on one side and temporary headwinds on the other, long-term investors should consider the current price as an attractive entry point. The margin of safety is more than sufficient. For investors still on the fence, we suggest managing the position size of the investment. As DPZ shows improvement per quarter in the areas mentioned, an additional investment may be contemplated.
For further details see:
Domino's Pizza: A Bargain Despite Temporary Margin Compression