2023-03-28 11:46:14 ET
Summary
- Domino's was well positioned for the pandemic, but now faces several headwinds.
- The company's international growth has been very impressive, and efforts in technology, fortressing, and a push to carry out appear to be paying off.
- The balance sheet is a concern, as are buybacks, but in all, it's a buy.
Domino's Pizza (DPZ) is an interesting business to analyze. The stores themselves are run almost entirely by franchisees, leaving the core company as a supply chain operator, technology provider, and royalty collector while maintaining the strength of the brand. It's been a strong market operator over the long-run, easily outpacing the market returns over the past two decades with around 19% annualized total returns versus the 7.75% or so from SPY.
That's unlikely to continue at that pace. The company's debt load has grown, but the business model is sound. DPZ is now more of a dividend growth company with a relatively reliable revenue stream. Royalties flow in as franchisees absorb cost swings and bear the brunt of store growth. With that, investors can buy the stock for the cheapest it has been since August of 2019 and for a moment at the bottom of the COVID sell-off.
The franchise model has been a boon for DPZ. The value proposition is real, as many of the master franchisees are publicly traded, and the average store earns around a 3-year payback post-opening. The most impressive thing to notice is how well received the company's concept has been internationally. There aren't many companies that have successfully broken into the Indian market, but it's a massive opportunity for those that do. Domino's earns more per store domestically, averaging a 5.4% royalty rate versus 3% internationally, but the international growth is likely the most enticing part of the business. Franchisees also contribute on average 6% of sales towards advertising efforts allowing DPZ to end up on the screen during every football commercial break.
Domino's partnership with Jubilant Foods, which sees stores scaling to over 3,000 over the next 5 years, should provide for a strong growth trajectory in royalty income for a long time to come. International is relatively greenfield, and has outperformed the company's US stores. The international segment effectively dodged the 2008 recession and has maintained steadier growth rates over time, averaging 5.3% same store sales growth since 2000 versus 4% domestically. Internationally, the company's master franchisee relationships offers geographic monopoly where the operator can sub-franchise locations as they see fit. Additionally, these master franchisees are on the hook for their own supplies and generally pay for local advertising. The end result is a steady stream of royalty income to DPZ.
With that, there are additional markets DPZ has yet to really enter. Brazil has faced issues in the past year, and DPZ unwound its franchises in Russia post-Ukraine, but the model tailored by franchisees to local markets has been very successful. In the past year, accounting for pain in Brazil and Russia operations, the International segment grew by 318 stores.
Stateside, DPZ operates a massive supply chain which provides food, equipment, and supplies to nearly all of the American footprint and much of Canada, or around 7,200 stores. Although the supply chain accounts for 61% of revenues, it only drives around 1/4 of operating profits. For the stores that rely solely on DPZ for supplies, the company offers a profit sharing incentive of 1/2 the operating profits from the segment. In 2022, this results in $110M distributed to franchise partners.
The company was well-positioned for COVID considering its low-touch offering, but it has felt the pinch from inflation and staffing costs. Despite these headwinds, the company has expanded its market share by around 220 bps, and continued to drive store growth. Food basket inflation came in at 13.2% in 2022, and is projected for a further 3-5% this year. Many of these costs are passed along to franchisees, but ultimately DPZ has to maintain the strong ties to ensure continued store growth. DPZ sources all of its cheese and separately all of its meat from two suppliers with an ongoing agreement. Commodity price inflation is absolutely something to pay attention to as an investor in DPZ, considering the pain any end-users of dairy products have felt over the past couple of years.
As far as staffing goes, the company's store footprint was affected enough that the company was reporting store sales in separate quintiles based on staffing levels. As of this quarter, they've settled enough that staffing is no longer considered in the operating metrics when looking at performance.
To counteract this, DPZ has aggressively shifted to carryout. In the most recent quarter, same store sales grew in US carryout by 14.3% versus a decline in delivery of 6.6%, resulting in the first overall same store sales growth since Q4 2021 of 0.9%. Carryout now accounts for 43% of transactions and 1/3 of sales for the company, with delivery making up the remainder. Additionally, as staffing costs have increased, the 'fortressing' strategy has proven out. As DPZ increases overall store density, it's ensuring each store is closer to end-users to lower delivery costs while walking the tightrope to minimize cannibalization. With same store sales growth swinging positive for the first time in a year, it will bear watching but metrics appear to be improving.
As I mentioned above, I see the strongest growth trajectory for the company internationally. US store count grew by 43, or 1.9% with some churn of moved or closed stores included. The market isn't necessarily at saturation, but economic conditions, supply chain, and permitting issues have weighed on domestic store growth overall.
The last piece I want to highlight is the wins on the digital front. Around 2/3 of sales are made digitally today, and 'AnyWare' ordering allows for links to smart home appliances like Amazon (AMZN) Echo to place and check in on an order. If you haven't ordered a pizza from Domino's lately, you can actually see each step of the way as it's put into the oven, given to the delivery driver, etc. There's been more than one occasion I've had hungry kids staring at the status screen waiting for their pizza. The company's POS system allows for significant customer data collection, and digital ordering combined with the Piece of the Pie rewards program allows for repeat order saving, targeted upsell, and low friction transactions. The POS system is deployed in 79% of international stores and every domestic store. These gains have set Domino's apart over the years, despite the gap closing with competitors.
On the cost front, DPZ cut G&A expenses 2.8% YOY in the most recent quarter. Supply chain remains the most asset-intensive part of the business, with distribution centers all over the US and Canada. The company has continually built these out as store count has grown to improve its supply chain, which was likely helpful to them considering the havoc played on companies beholden to third parties during the pandemic.
ROIC shot through the roof into the pandemic, but still resides at a stellar level, showing massive shareholder value creation for every dollar deployed and well above the weighted average cost of capital.
As for the balance sheet, the debt load is a definite fly in the ointment. At a market capitalization of around $11B today, the company's debt load will remain a real concern for investors from here. While serviceable, I'd like to see dividend increases, buybacks, and anything less than necessary improvements to the supply chain take a backseat to deleveraging considering the current environment. The current ratio is a solid 1.5, the average interest rate is relatively low, and the company isn't facing near-term maturities that cause me stress, but in general I try to avoid highly leveraged companies.
That being said, DPZ should be able to pull some levers here and drop the debt burden with its relatively steady cash flow.
Speaking of the dividend, DPZ recently hiked it 10%. However, buybacks have not been well-timed in the past couple of years. Looking at the stock chart below, the price was very inflated at several points in the past few years, but the company has insisted on repurchasing shares. This is sometimes a dealbreaker for me when assessing an investment. I think DPZ's value proposition is such I can look past some poor buyback behavior, but the value destruction to shareholders is just as bad as excessive stock-based compensation among the technology high-fliers in my view. I'd rather they stick to the dividends and let investors decide whether or not to reinvest.
Consider how much better the balance sheet would look if that $900M or so wasn't deployed in 2021.
Looking at the long-term stock price chart, DPZ has been on a ride the past few years. As I mentioned above, the company was well-positioned into COVID, and enjoyed some nice outsized gains. Like many of the rest of the companies benefiting from the pandemic, it's come crashing right back to its long-term multiples.
Looking at the shorter-term, the company has averaged a 32X multiple on average, which is pretty steep considering the projections. Management recently guided down from 6-10% sales growth in 2023 to 4-8%, and store growth was guided down from 6-8% to 5-7%. Considering the macro environment, this isn't surprising, but don't expect growth to come roaring back to pre-2020 levels as DPZ continues to mature. Staffing issues, inflation, and lower store count growth are the reality for now and it's difficult to project past 2023 how those headwinds will turn out.
Based on maintaining the current valuation, an investment today could yield around 11% annualized total returns based on analyst estimates for earnings growth.
Based on multiple expansion back to the shorter-term average, an investment could yield as high as 22%. I don't think the catalysts are there for this in the short to medium-term.
In summary, DPZ is a strong operator with a proven business model that has successfully spread to 90 international markets and maintained a solid lead in quick service pizza restaurants. There are definitely headwinds affecting the business, and the debt load and ill-timed buybacks remain a concern to me. However, the international opportunity is real and should provide strong revenue streams well into the future. The company is on the high end of its leverage targets, so I anticipate some meaningful deleveraging going forward, and the macro environment will eventually improve. When it does, I think investors will be happy to own shares of DPZ in a long-term portfolio.
For further details see:
Domino's: The Cheapest It's Been In Years