Michigan-based Domino’s Pizza (DPZ) is a stock that is very easy to overlook. I say that for two reasons really. One, selling pizza is obviously a fiercely competitive business. Pizza joints are relatively easy to set up, while consumer switching costs are zilch. As a result, regional and independent chains account for circa 50% of the US pizza market. Two, the stock typically trades at an elevated valuation. Sure, growth is great, but these types of businesses are also prone to over-expansion. That can lead to quite nasty ‘boom and bust’ style cycles – with sandwich chain Subway a well-known recent example.
As for Domino’s, it has done extremely well since overhauling its menu and pricing just over a decade ago. Back then, global systemwide sales clocked in at circa $6.2b off a store count of around 9,000. Annual sales have since risen to over $15b, with the total restaurant count now at around 17,250. The stock is also up circa 2,700% over the past decade. Note that over 11,000 stores are located abroad, but that half of system sales come from the US. The royalty rate is also lower overseas, averaging around 3% of sales, due to its various master franchise arrangements. The firm also makes money selling ingredients and equipment to its domestic franchisees. Anyway, the point its that most profit comes from the US.
Growth aside, Domino’s is also throwing down some serious profitability numbers. The vast majority of its estate is franchised, with US franchisees typically shipping 5.5% of sales to the head company. That means margins tend to be high, while the capital base is small compared to the amount of profit it generates. Together, those points lead to very high returns on invested capital. We are talking in the 90% region here, which is the sign of an outstanding business. Store-level numbers – the most important metrics in franchised businesses – look very strong too. The average US store generates EBITDA of circa $150k per annum, while start-up costs appear modest at circa $325k. You can do the math and see that this is very attractive for franchisees. Profit margins also look very attractive at the store level.
Unlike dine-in establishments, Domino’s did not suffer from the kind of public health measures that became commonplace in 2020. Folks can order and pay online, while contactless delivery is no problem either. The firm has incurred extra costs on the back of the pandemic, but COVID has been good for Domino’s on the whole. US same-store sales advanced 17.5% in Q3 2020, contributing to US franchise royalties and fees revenue of circa $335m over the first three quarters of 2020. That was up from $290m in the equivalent 2019 period. EPS over the first three quarters of 2020 stood at $8.54, up from $6.44 in the year-ago period. The company reports full-year results next week.
The million-dollar question – can Domino’s keep on going? Competition is fierce, and more restaurants are turning to delivery options such as those offered by third-parties like Uber Eats and Grubhub. The pandemic has spurred that trend on for obvious reasons. Historically, Domino’s has done exceptionally well in capturing customers via its online presence. Ordering a pizza from them is very easy, which is the whole point of convenience food. Not only that, but quality and delivery tends to be very reliable in my experience – something that can’t always be said about food ordered from third parties.
Furthermore, its large share of the pizza market and its fortressing strategy allow it to enhance its offer to customers. For instance, the firm wants to increase its store density, an upshot of which is reduced delivery times. Now, this does come with some risk as it raises the prospect of stores competing against each other like at Subway. That said, it can also pay-off big time by squeezing competition out of the industry. Assuming demand is there, sales can then recover very quickly for any affected stores. Further, certain problems which badly hampered Subway, such as a more fractured franchisee base, don’t apply here.
Domino’s stock closed the week at circa $371.50. Analysts expect the firm to report 2020 EPS of circa $12.40, implying a current PE of around 30. The annualized dividend currently stands at $3.12 per share, equal to a yield of 0.85%. Expect the payout to rise when the company announces full-year results next week. Note also that net debt stands at circa $4b, or roughly 6x EBITDA. That looks high, though surplus cash growth is still strong and the dividend payout ratio remains very modest at just 25%.
Previously, management had targeted 25,000 stores and $25b in systemwide sales by 2025. That target includes 8,000 stores in the US, up from its current level of circa 6,250. The timing of that is now under question, though the firm was keen to stress that it was simply a timing issue. Still, the implied level of growth remains strong, even with some slippage in terms of timescale. Additional growth in franchised revenue is also very high margin – the net result being the strong free cash growth mentioned above. High ROIC businesses also mean a ton of cash for stockholder returns – always a good thing to write on a dividend blog. That also means shareholders can enjoy lower growth while still grinding out decent returns.
Assuming it retains its competitive edge, the stock is not really expensive. Profit growth will slow this year, but mostly because of how strong 2020 was. Analyst profit estimates for 2022 imply a forward PE of 25 – not expensive for a super-high ROIC business with strong growth. That, plus low interest rates, can keep the PE elevated here in the near-term. The current price also allows for some longer-term multiple contraction and an eventual slowdown in growth.
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