2023-07-08 06:58:52 ET
Summary
- Domino's Pizza's share price is down 16% in the past year, despite rising profits and sales growth in constant currency in Q1 FY23.
- However, unfavourably market exchange rates and high debt levels work against it, as does the economic slowdown. Projections for the rest of FY23 also indicate a slowing down in revenue and earnings growth.
- DPZ's TTM P/E is competitive compared to peers and its own historical levels, suggesting a possible near-term upside. But it is best to go with a Hold rating until better times next year.
The Domino’s Pizza ( DPZ ) share price is down by 16% over the past year, a striking contrast to the 12.7% rise in the S&P 500 ( SP500 ) index over this time. And even more glaring compared to the 18.1% increase in the S&P 500 consumer discretionary index. Here I look at what is holding it back based on its fundamentals and market valuations to assess whether it just happens to be left behind in the otherwise buoyant sector performance or if there are good reasons for it. Especially, with an eye to its second quarter (Q2 FY23) results due later in the month.
Demand Growth, But Exchange Rates Unfavourable
There is certainly some encouragement held out by its first quarter sales figures at constant currency. They grew by 5.9% year-on-year (YoY), which reflects a genuine return of demand despite the slowdown in the US economy, which is a big market for it, and elsewhere, like in Europe, as well as the persistence of relatively high inflation.
However, this is just one part of the story. At market exchange rates, its revenue growth was a small 1.3% during the quarter. This is a drop from the 4.1% increase seen for its financial year ending January 2023 and the five-year growth of an even higher 9.1%. Note that the company differentiates between sales and revenue figures. Sales numbers at market exchange rates have done a shade better at 2.2%, but are still a far cry from the levels seen at constant currency.
Revenue Weakness Likely
If exchange rates continue to be disadvantageous, chances are that the company’s growth can stay weak, especially as we can’t really hope for any upturn in real demand. The US economy is expected to head into a recession later this year, and food inflation is still firm .
Analysts actually expect only 0.3% revenue growth in the next quarter and a 1.6% growth for all of 2023. It is also worth noting that the company has surprised analysts’ revenue estimates on the downside for the last three years running (see chart below), implying that growth might just be slower than already expected to be.
The company itself isn’t terribly optimistic, either. Along with its Q4 2022 figures, it also released its revised outlook for the next two-to-three years, where it expects 4-8% sales growth at constant currency, down from the 6-10% expected earlier. It explains that this is because of “the current macroeconomic headwinds that are impacting the Company’s U.S. delivery business in particular..”. Further, for 2023, it expects growth to come in “towards the low-end” of the range. This means that we can brace for a softening in demand.
Healthy Profits
The company’s profits, however, are another story. As the cost of revenues, which is 73.4% of total revenues for the latest quarter, stayed almost flat from the same time last year, the company’s gross margin rose to 26.6%, the highest level in six quarters. Both its operating profit and net profit grew for the second straight quarter, and not trivially. While operating profits saw a 7.9% rise, net income grew by 15.2%.
Earnings growth is expected to continue in Q2, 2023 as well, with analysts estimating an EPS increase of 8.3%. The rate of increase is expected to slow down in the subsequent quarters, but the company is still expected to see a healthy EPS growth of 6.1% in 2023.
The Market Valuations
This translates into a forward price-to-earnings (P/E) ratio of 25.1x , which is way higher than that for the consumer discretionary sector at 15.3x. However, compared to its closest peers like Yum! Brands ( YUM ), of eateries like Pizza Hut and KFC, as well as McDonald’s ( MCD ), which have forward P/Es of 26.2x and 27.1x respectively, DPZ doesn’t appear out of line.
Its trailing twelve months [TTM] picture looks even more favourable. DPZ stands at 25.7x compared to Yum! Brands at 31.5x and McDonald’s at 31.7x. And this is when there is nothing that stands out about their performance , which could explain a higher P/E. Another point to note here is that from a historical standpoint, DPZ’s P/E ratio looks relatively low right now (see chart below). Or to put it another way, it indicates further upside to the stock.
High Debt Levels
There is one factor that concerns me about Domino’s Pizza, though, and that is its debt level. In all fairness, its peers have elevated debt too, but among them, it has the highest debt ratio of 3.3x for FY22. This is uncomfortable by any standards. Normally, companies with significant debt on their books talk about when and how they plan to pay it off in their financial releases, but there is no such mention in this case. I’d put a flag on this aspect and watch how it develops going forward.
At the same time, it is some comfort that its interest coverage ratio as of the last financial year is very comfortable at 3.3x, indicating that it has more than enough to pay off its interest obligations. This is key at a time of rising interest rates. Its comfortable liquidity is also visible in its current ratio of 1.5x.
What Next?
All in all, though, I just do not see enough justification to buy the Domino’s Pizza stock, at least right now. While demand was indeed growing until Q1 2023, it is expected to slow down over the remainder of the year. It does not help that an unfavourable market exchange rate has reduced its revenue growth to a trickle as well. Its earnings story is more positive, thanks to a softening in costs, but the best of the growth spurt for income appears to be behind us too. A healthy operating income, though, does give it a good interest cover despite the company’s otherwise uncomfortably high debt levels.
The company’s market valuations are better placed. While they are not low in themselves, the TTM P/E in particular is competitive compared to peers and also its own historical levels. There could be more upside to DPZ in the near term, but I would not bet on it, especially as forward valuations indicate it is fairly priced. I think more robust times will roll in for it from next year onwards as it gets past the worst of the current slowdown and food prices cool down more. For that reason, I am going with a Hold rating on Domino’s Pizza for now.
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Domino's Pizza: Revenue And Earnings Growth Slowdown Can Hold It Back