2023-08-23 04:03:00 ET
Summary
- Domino's Pizza follows a franchise business model, with franchisees covering the costs of opening restaurants and ensuring stable cash flows.
- The company's high levels of debt and capital allocation strategy of share buybacks with debt raise concerns about its future profitability and ability to handle debt payments.
- Rising interest rates, cost increases, and potential lack of pricing power pose additional challenges for Domino's Pizza's future success.
Domino's Pizza (DPZ) is an iconic restaurant chain dedicated to the sale of pizza. Founded in 1967, it has proven to be a successful business. In this article, I am not going to deep dive into the company; I will make a brief introduction to its business model. If you want a full, deep dive into the company, you can let me know in the comments. This article will focus on all the problems that the company is facing and whether there is any solution to fix them. All these problems that I will present make my concerns about the company increase over time.
Business model
I am going to briefly resume its business model, showing some of its most important aspects and KPIs. DPZ follows a franchise business model in which franchisees pay for all the costs of opening the restaurants, helping Domino's to be an asset-light business while at the same time having pretty stable and predictable cash flows. In the image below, the different business segments are shown. As we can see in the image, its main source of revenue is the "supply chain," which basically sells ingredients and machines to their franchises in order to ensure quality, safety, and homogeneity of the product.
The next image displays the number of total restaurants, organic sales, and some other important metrics. As I have mentioned, my intention is not to focus on these aspects in this article, I can write another one discussing all these topics.
Many different business models exist within the sector
Within the restaurant sector, we find different business models that have been equally successful. For example, in the case of Domino's Pizza, it follows a franchise model where the franchisee takes care of all the establishment's costs while paying a royalty to the parent company. In the case of McDonald's ( MCD ), the company purchases the locations, which are then leased to the franchisees. This makes it a real estate business, and cash flows are very predictable and protected against inflation. In the case of Chipotle ( CMG ), they buy their locations and operate them themselves. The most asset-light business model is Domino's, yet it is also the most indebted. To me, this makes little sense. It has served them well during the decade of low interest rates, but now that rates have risen and borrowing won't be as cheap, it will pose new problems to deal with in the future.
A bad capital allocation
DPZ's capital allocation has been based on repurchasing shares with debt (They have bought back 25% of the shares outstanding during the last 7 years). We cannot say that it has not gone well. The company has a 59% ROIC, and its performance on the stock market has been very good. But there are a few things to look at here. DPZ's long-term debt has increased a lot, to the point of reaching a 5.85x Net Debt/EBITDA ratio at the end of 2022.
The timing of the share buybacks has been pretty bad. Buybacks increased a lot while the stock was trading at highs, and now they have stopped them despite having fallen almost 50% from there. We have to take into account that the PE multiples that Koyfin shows are not adjusted by debt. If we take debt into account, DPZ stock was trading nearly at a 50x PE multiple. That is a 2% yield, while the debt was financed at rates between 3% and 5%. This only translates into a destruction of value for shareholders.
One of the things I try to avoid when I invest, is investing in companies with high levels of debt (not more than 3x Net Debt/EBITDA). From my point of view, DPZ has had no necessity for leveraging itself at these high levels. It is an asset light and pretty recurrent business model. They have been able to grow aggressively when interest rates were low, but once they started to rise, the main focus of the management should have been deleveraging the company, not keeping buying shares at stratospheric valuations. They have compromised the business a lot with their reckless actions, and the future is not clear enough for DPZ, so more pain may be ahead for its stock price.
High levels of debt
Right now, I am going to say that this seems to me to be the weakest point of the thesis and that perhaps I am omitting something because the market does not seem to be so concerned. Domino's has half of its capitalization in debt maturities. It has a credit rating of BB-. Its interest expenses have grown to 8.76% (compared to 9% of sales and 16.5% of EPS), and its main strategy has always been to make recapitalizations. That is, pay off debt with more debt, supposedly at lower rates or with better conditions. In the years 2025 and 2027, they have to make payments that triple the FCF of this year. If it recapitalizes again, I assume that the rates at which they will issue will have to be high, increasing interest expenses and therefore the profitability of the company. If not, they may even issue shares, which is the completely opposite strategy that they have been carrying out for the last decade.
Until today, the Interest coverage ratio (EBIT/Interest expenses) has always been around 4 times, which is a healthy ratio despite everything. The company has always been leveraged between 4x and 6x Net Debt/EBITDA. With the high interest rates, they intend to go down to the low range. Below 5x, they can roll the debt, but I imagine that at higher rates, which would erode the benefits because interest expenses would increase.
Just to give you an example of this, back in 2012 , they were in a similar situation. They recapitalized $1.5B in debt at 5.2% when they generated $150 million in FCF. This interest rate does not look too high to me, but the risk-free rate (10-year US note) was low (1.4%); now it is over 4%. When they recapitalize, they will have to do it at higher interest rates, increasing interest payments and eroding FCF and earnings.
Future for Domino’s Pizza
The company has mainly 3 open fronts
- A lot of debt: Not everything is at a fixed rate, and there is a significant payment in 2025 of $1.1 billion and another in 2027 of $1.3 billion. They have generated around $400 million in FCF this year. For those years, I am estimating between $500 million and $600 million. This is only half of the payments they have to make. They will have to stop buying back shares and even stop paying dividends to pay for it, which would not be enough. In Q2, the company reported having $266 million in its balance sheet., again, not enough for cover the payments. So, the question here is, at what interest rates will they be able to finance their debt, with a net debt/EBITDA ratio of almost six times and not enough cash generation if they have to roll over the debt? They will probably be better off issuing shares, but of course, they immediately tarnish the " cannibal stock " reputation because they not only stop the buybacks but also engage in their nemesis (issuing shares).
- Interest rates increase. The buybacks were financed with debt. If financing is going to be more expensive now compared to the past decade, bottom-line growth will decline. We can observe that differences in the past have been due to this effect, as sales have increased by 9% CAGR over the last 7 years, while EPS has achieved a 16.51% CAGR. This superior growth has all been due to the effect of buybacks, as margins haven't expanded. So, if their top-line growth isn't exceptional (we'll look at how we can calculate it later), the bottom line won't grow as much anymore because you won't be issuing (or shouldn't be issuing) as much debt. What do they have left? What multiples do they deserve?
- Cost Increases. Rises in raw materials, wages, and a shortage of personnel haven't been reflected in price increases. I've been surprised here, truthfully. We've already seen that many of the parent company's revenues are recurring, but they haven't been able to benefit much from them. Theoretically, recurring revenue business models have some kind of pricing power, but in the case of Domino's, revenues increased by 5.8% in 2022 and 4.1% in 2023. Pretty low rates, in my opinion. Perhaps they do not want to squeeze the franchisee and are willing to let the fundamentals suffer a bit in the short term? If that's the line of thinking, it might be the right approach. But if they have tried to raise prices but couldn't because they predicted that demand might suffer, that's not a good sign. In the end, DPZ does not just compete against other pizza restaurants; it competes against any food chain, and there's no switching cost here. Price and convenience are rewarded. And, of course, quality and personal preferences play a role, but DPZ is not an Italian pizzeria; there are much better pizzas out there.
In order to support this final idea, I have done an exercise of reflection. Many of us would think that pizza is an inflation-proof business because, if you think about it, if you raise the price of a $7 pizza by $1, the impact on the consumer is very small, but the effect on the price is +14%. But the franchisees are not really showing this, because these effects should be visible in the percentage of royalty income, as it is a percentage based on sales. Royalties sales were up just 3% in 2022, I would have expected a more aggressive growth rate if they had raised prices. So maybe their pricing power is not that strong. As I have mentioned, switching costs in this sector are non-existent, so if the value proposition is not good enough or if there is a shift in consumer preferences, Domio's can suffer.
Valuation
If we take a look at multiples displayed in webs like Tikr, we can get misguided information, as in their calculations, they are not taking debt into account. Many investors state that, as Domino’s Pizza is an asset-light business, they can leverage the company. This is partially true, as, for example, FICO ( FICO ) does the same thing, but their leverage ratios are half those of DPZ and their debt maturity payments do not cause any financial problems for the company. So the situation is not the same.
The image below displays PE multiples of the company for the past 10 years. Currently, it is trading at 25x which may not be a super high multiple, but, if we take debt into account, and calculate the PE multiple with the Enterprise Value (EV) and no market capitalization, the situation is completely different, and we get a PE multiple of 39x . Who is willing to pay for a company whose growth is not going to be stellar (7% CAGR according to estimations) and, when they are not going to be able to take advantage of low interest rates to buy back shares and boost EPS like they have been doing during the last decade anymore? I am not.
Things get worse when we perform a DCF, which takes debt into account. I have used the following assumptions: 10% minimum IRR, 2.5% TGR, -1% CAGR shares outstanding, and 8% FCF CAGR growth. As it has always been a highly leveraged company, maybe it is not fair to calculate its fair value this way, but I try to be as objective as possible, in order to compare it against other applicants to my portfolio. Moreover, if we keep in mind all the future recapitalizations and the rates at which debt may be raised, the situation will not look that good for DPZ. Share prices based on an FCF/share basis applying a 25x multiple are also displayed, but debt position is not taken into account in those price predictions. That is why I rate de stock as a sell.
Conclusion
As I have stated above, I can post another article about DPZ analyzing its business model (which I consider very interesting) in depth. This article was just to show all my concerns about the future of the company. To sum up everything, I think that DPZ has multiple fronts open simultaneously, and the upcoming years will be challenging for the company. It remains to be seen whether they manage to deleverage and at what rates they can refinance the debt. I could be missing something because, despite falling 32% from all-time highs (almost a 50% drawdown in May), the market doesn't seem as concerned with all of these aspects. If they come out of this process unscathed, the new management will have proven their competence, and they won't have as many issues with leverage, which should be positive news in the long run. In any case, I reiterate my sell rating.
For further details see:
Domino's Pizza: All My Concerns With The Company