Domino’s: this share price has all the toppings

For South Africans, Domino’s Pizza is associated with business failure. Taste Holdings operated the brand in this country under a master franchise agreement and it simply didn’t work. They couldn’t even sell the operation last year; it was put into voluntary liquidation and the assets were auctioned off.

It was a sad and sorry end to the Scooters Pizza brand, which had been successfully operated by Taste before the CEO at the time went on a crazy drive to bring American brands to a country that doesn’t want them here.

Internationally, Domino’s Pizza is a different story entirely.

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Pizza has been resilient.

The company has benefitted from its delivery and take-away (or carryout, as Americans say) model. Domino’s has focused on digital ordering channels and quick turnaround times including a 2-Minute Guarantee for car-side delivery.

You can just imagine how fresh and delicious a pizza tastes that takes a whopping two minutes to prepare. Yuck. Nevertheless, Americans have been queuing up for the stuff and investors aren’t losing sleep over customer waistlines or their questionable taste buds.

In terms of restaurant category resilience, we’ve seen a fairly similar situation in Famous Brands locally, where the take-away outlets (usually called quick-service restaurants or QSRs) are proving to be far more adaptable than eat-in (or full-service) restaurants (which Famous Brands calls its Signature Brands). It’s perfectly logical – fancier restaurants rely on people sitting at tables and ordering wine. Debonairs relies on people comfort-eating, which there has been plenty of over the past year.

From a sales perspective, investors are questioning whether Domino’s will give back market share when the world fully re-opens and people no longer need to rely on pizza deliveries for entertainment. CEO Ritch Allison noted that sales growth has been stronger in this quarter in markets that have fewer Covid-related restrictions, which is obviously encouraging.

Another critical driver in the business which the management team hopes will stick post-Covid is the shift to digital channels. In China, 95% of orders come through digital channels. Across the group, the average is 75%. There is a strong focus on bringing the rest of the operations closer to the numbers in China.

However, I don’t believe it is realistic to assume that these sales growth numbers can possibly continue. Independent restaurants will come back and people will return to sit-down eateries.

The threat of third-party aggregators is real.

The food delivery space has heated up and competition is rife, driving eye-watering expenditure and losses for many of the players. The likelihood of winner-takes-all economics is significant here, as I am not convinced that the food delivery model makes a profit long-term.

The underlying problem in my view is that the restaurants don’t necessarily benefit from companies like Uber Eats, as the commission structure is high. To make it work, there would need to be numerous “dark kitchens” that are delivery-only. Consumers order food they are familiar with and there’s no way to become familiar with dark kitchens other than through ordering from them in the first place.

It’s a chicken-burger-and-egg problem.

For Domino’s, the risk is that customers order via aggregators rather than directly through the pizza company’s own channels. The Domino’s CEO specifically references third-party delivery as being part of the primary competitive set, rather than just the other pizza chains.

The group will compete with third-party aggregators by continuing to run an owned-fleet with transparent pricing and the obvious efficiencies of controlling the entire process from the pizzas going into the oven to them arriving at customers’ doors.

“Lapping a tough quarter” – what does that mean?

The CEO’s opening remark in the Q2 earnings call was that Domino’s isn’t focused on managing a 12-week quarter. Analysts talk about “lapping a tough quarter” which means that the performance in the comparable period was unusually strong, making it difficult to look good on a year-on-year basis.

In a nod to the Olympics, imagine posting your PB time in a race and then being compared to that race the next time you run. This is also known as a “tough comp” or comparative period.

To demonstrate that in practice, Domino’s US business achieved sales growth of 19.9% in Q2’20. In Q2’21, sales growth of 7.4% was a strong result against this base. The international business did even better, growing 29.5% in Q2’21 against 13.9% growth in Q2’20.

A “through-the-cycle” view would look at several race performances rather than specific data points, hoping for a trend of general improvement. The Domino’s management team refers to a “two-year stack” to describe the results compared to 2019. That’s the first time I’ve seen this terminology.

Domino’s has achieved 41 consecutive quarters of same-store sales growth in the US. Internationally, this has been achieved in 110 consecutive quarters. You don’t need to be a data scientist to see that the sales trend is up.

There’s room for new store growth as well. Domino’s opened 884 stores in the past year, with 35 net openings in the US in the second quarter and 203 net openings internationally. “Net openings” just means new stores minus stores that were closed in the period.

The 18,000th Domino’s outlet was opened in this quarter. That’s a whole lotta pizza. It would’ve been even more in the US but there are store level staffing challenges. That’s a theme in the US at the moment, with companies having to offer ridiculous sign-on benefits to attract employees.

Other markets have no such issues, as China went through the 400-store milestone and Japan reached 800 stores. India struggled terribly as Covid swept through the country, with 175 temporary store closures.

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So the sales are there, but does Domino’s make a profit?

Oh yes, it does. Take the South African business failure out of your mind entirely. In the second quarter alone, Domino’s generated free cash flow of $126m.

Margins on company-owned stores increased to 24.5% from 23.1%. Higher food costs were a factor but lower labour costs more than made up for them. This isn’t because each person earned less (remember the note on attracting employees) but because each store is running with fewer people. I wouldn’t treat this as a sustainable improvement in margin, based on the CEO’s comments. They need more staff per store.

For franchise stores, the holding company makes money from franchisees through royalties and by providing them with ingredients and other inputs from a centralised supply chain. This is a textbook model, similar to that followed by companies like Spur and Famous Brands. Supply chain operating margin dropped to 11% from 11.9% because of higher insurance and food costs, as well as increased depreciation from the opening of new facilities.

The company invested $17m in capital expenditure in the quarter, which included costs related to a rewrite on the point-of-sale system.

With some adjustments for once-offs related to a debt refinancing transaction, diluted earnings per share for the quarter came in at $3.12. A quarterly dividend of $0.94 will be paid and a further $1bn will be invested in share buybacks.

Net income was lower by 1.7% vs. Q2’20 because of extreme swings in the tax rate (19.6% this quarter vs. 4.7% in Q2’20). This is because of tax deductibility rules in the US linked to employee stock-based compensation (i.e. share options for employees).

My understanding is that US companies can claim a tax deduction for the difference between what employees pay for the stock and what it is worth at the time, even though it costs the company nothing to issue the options. I’m no expert in this field but it does explain the volatility in the tax rate.

The average repurchase price during the recently concluded share buyback programme was $444.29 per share.

But, the share price has all the toppings.

As is so often the case, a solid year of growth has resulted in frightening traded multiples.

On a TTM basis (trailing twelve months i.e. the four most recent reported quarters), Domino’s is on a 4.7x revenue multiple and a 42x P/E multiple. That’s higher than many leading tech companies, let alone restaurant businesses. For perspective, Yum is on a 32x P/E and Wendy’s is on a 35x P/E.

We know that there’s a lot of money running around in the markets and that share prices are frothy. In this case, the share price appears to me to have all the toppings already. If the growth rate slows down because people go back to eat-in restaurants or if the food delivery businesses put major pressure on Domino’s earnings, it could be an unpleasant experience for anyone investing at this share price level.

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