2023-09-19 12:11:26 ET
Summary
- Domino's Pizza has improved its profitability metrics by reducing the cost of sales year-over-year, leading to expanding margins.
- The company remains committed to returning value to shareholders through dividends and share buybacks, which appear safe, sustainable, and well-covered by cash flow from operations.
- The stock is still overvalued compared to its peers, while revenue and EPS growth have been underwhelming in the past years.
- We maintain our "hold" rating.
Domino's Pizza, Inc., ( DPZ ) through its subsidiaries, operates as a pizza company in the United States and internationally.
We have initiated coverage on the firm in May 2022 with a neutral rating. The arguments for our decision have been primarily related to potential macro- and microeconomic headwinds, including supply chain disruptions, labour shortages, and increasing costs. As a result, we have highlighted declining EPS and contracting margins as important concerns. At the same time, the firm's stock has been trading at a significant premium compared to its peers in the restaurant industry, which we believe was not warranted.
Since then, despite some volatility, the stock price has increased by about 14%, just in line with the broader market.
The aim of today's article is to review our previously established rating and assess whether that is still relevant, taking the latest information into account. We will also be discussing the firm's valuation, primarily based on a set of traditional price multiples.
Profitability
Just like previously, let us start our discussion by looking at the firm's profitability, which can be best assessed by three ratios, namely the gross profit margin, the operating margin, and the net profit margin. The following chart shows these three metrics and their development over the past 5 years.
While we were concerned mid-2022 that the profitability was trending downwards, now the picture is somewhat better. All these margins have expanded since our last writing, proving that the company has been able to deal with the above-mentioned headwinds in an effective way.
The firm's latest quarterly report from July 2023 can help us understand what factors have been fuelling the expansion. The following table compares the cost of sales from fiscal Q2 2022 vs. fiscal Q2 2023.
Cost of sales - Q2 (DPZ)
The positive development of the supply chain costs as well as of the costs related to the U.S. Company-owned stores have been driving the positive change in both the gross- and operating margin. At the same time, SG&A and advertising expenses have remained relatively stable.
Comparing these figures with those of DPZ's peers in the restaurant industry can help us understand DPZ's competitiveness in the industry. While DPZ's profitability metrics are in the top half of the peer group, we cannot say that they are outstanding.
Looking forward, we would like to see the profitability measures further improve, before we can upgrade our rating to a more bullish one.
Return to shareholders
DPZ has remained committed to return value to its shareholders both in the form of dividend payments and share repurchases.
The firm has managed to pay dividends each year in the past decade and has also managed to increase the amount every year. While the dividend payout ratios are higher than the firm's own 5YR averages, they are relatively closer to the consumer discretionary sector medians.
On top of the dividends, DPZ has continued to repurchase its common shares. We believe this may be an even more attractive way of returning value to shareholders, as they are slightly more flexible than dividends, and they can offer tax advantages in certain jurisdictions, where capital gains are taxed at a lower rate than dividends.
For these reasons, we believe that the company is likely to keep paying dividends and also keep buying its shares back in the coming quarters, as they appear to be sustainable and well-covered based on the cash flow figures.
Valuation
In our previous article, we have already raised our concern with regards to overvaluation. And this concern still exists. Based on a set of traditional price multiples DPZ's stock is selling at a premium compared to most of its peers in the restaurant industry.
In our opinion, this premium is still not warranted. First of all, we have shown above that DPZ is profitable, but its profitability metrics are not outstanding. Its revenue-, earnings- and CFO growth over the past years have also not been particularly strong.
At this point we also need to mention a key risk that can have a significant influence on the earnings, and therefore on the valuation. The following table shows the maturities of DPZ's lease liabilities:
A significant portion of both the operating- and finance leases are maturing in the next three years. Due to the high interest rate environment - which we do not expect to improve in the coming quarters - newly initiated leases may have significantly higher costs, putting a potential downward pressure on the bottom line results.
Based on these factors, we believe that the current valuation cannot be justified. In order for the stock to become attractive for us, we would like to see either sustained revenue and earnings growth in the coming quarters, or a significant reduction in the valuation. Until then, we cannot justify a bullish rating on the company's stock.
Key takeaways
Our previously raised concern with regard to deteriorating profitability is no longer relevant. The firm has managed to expand its margins and improve its profitability metrics by significantly reducing the cost of sales, primarily driven by the lower supply chain costs.
The firm has remained committed to return value to its shareholders both in the form of dividends and share buybacks. Based on the company's operating cash flow, these are likely to be safe, well-covered, and sustainable in the coming quarters.
DPZ's stock still appears to be relatively overvalued compared to its peers in the restaurant industry. At the same time, revenue and EPS growth have been underwhelming in the past quarters.
For these reasons, we cannot justify assigning the stock a more bullish rating. Therefore, we maintain our previously established "hold".
For further details see:
Domino's Pizza: The Reasons We Are Remaining Neutral On The Stock