Domino's Group plc DOM.L
July 31, 2017 - 1:44pm EST by
bsp100
2017 2018
Price: 2.61 EPS .17 .18
Shares Out. (in M): 491 P/E 15 14
Market Cap (in $M): 1,276 P/FCF 15 14
Net Debt (in $M): 60 EBIT 100 108
TEV ($): 1,336 TEV/EBIT 13 12

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  • Compounder
  • High ROIC

Description

Summary

Domino’s UK (DOM.L) is the franchisor of Domino’s Pizza in the UK, Ireland and Switzerland, and it has stakes in the Nordics and German franchisors. It has system sales of around £1bn and net revenue of £360m, on which it generates around £85m of operating profit. Around 90% of the system sales come from the UK.

 

 

Domino’s has a wonderful business model. In short, its scale means it can produce and deliver pizzas faster and cheaper than its competitors, which in turn allows it to invest more in marketing. Its share of advertising spend (“share of voice”) is around 65-70% of the UK market, significantly higher than its market share, which is around 45% of UK pizza delivery. With a market share 4-6x its closest competitors, it has far more purchasing power and higher sales density, which lowers the cost of delivery and the wait time for customers. The model is very powerful: I estimate it can produce and deliver a pizza for £4 compared to the £6 it costs its competitors, and it can do this with better ingredients and five minutes faster. It uses these savings to invest in advertising – it spends around £1.50 per pizza on marketing, double what its competitors do – and to give its franchisees higher margins than other franchisees can get. Franchisees reciprocate by opening more stores.

 

 

This has worked a treat for many years. Looking at the system as a whole (combining the franchisee and franchisor), the performance has been phenomenal. Take the UK, DOM’s main market. The systems’ operating margins are around 19-20% and its return on net operating assets is well over 50%. System sales have compounded at a CAGR of 15%. Margin expansion means operating profit has grown even faster at 17% per annum.

 

 

From the franchisors’ perspective, this is further enhanced by the franchisees, which put up the majority of the investment. This means that Domino’s – the franchisor – has returns of over 100% and operating margins of 24%. The franchisees – obviously far more motivated than the typical company hand – have also done rather well. The vast majority are multi-millionaires and some are clearing over £10m per annum.

 

 

The quality of this business is well known, and it has traded at around twenty-five times earnings for most of the last decade. Shareholders have still done very well despite the high multiple – if you’d held the shares from 2006 to 2016, your annualised return would have been 20%. Now, for a multitude of reasons, Domino’s has sold off by 30% in 2017. Most of these reasons are short-term, Brexit-related. Some people don’t seem to understand what the true underlying earnings are because they exclude Domino’s minority stakes, others have ignored the capital-return potential and yet more have forgotten that Domino’s does well even in the worst of economic environments. Others are worried – rightly so – about new entrants like Deliveroo, but I think this is overdone.

 

All of this leaves the company trading at fourteen times’ 2018 free cash flow, the lowest multiple that it has traded at in years, and a huge discount to other listed Domino’s (there are half a dozen listed around the world). It has little debt but a target of 1.25x EBITDA (lower than the 4x Domino’s US (DPZ) operates with) and it is buying back stock. Were it to re-lever to 1.25x through buybacks and dividends, I estimate that it would be trading at 12-13 times free cash flow. Not that I’d encourage it, but if it were to lever up to DPZ’s level of 4x EBITDA, DOM’s would be trading at less than ten times’ free cash flow. This is ridiculous for a high quality business with plenty of growth ahead. Although I hope not, this will no doubt have piqued some private equity interest. Bain Capital has owned several of Domino’s international franchisees in the past. I estimate private equity could pay a 50% premium and still comfortably generate a high-teens IRR on pretty conservative assumptions. But I consider this more a risk than a catalyst.

 

 

The Competitive Moat

Domino’s moat is built on three pillars: scale, brand and the franchise model. I’ll treat them separately, but it’s very important that they’re all reinforcing.

 

 

Scale

Domino’s has system sales of £950m in the UK. This is four times larger than Pizza Hut (including Pizza Hut’s eat-in) and around six times larger than Papa John’s. This is a superior competitive position than its US counterpart and only matched by Domino’s dominance in Australia. The rest of the market is made up of small independents. These players typically generate around £250-300k of sales per store. In contrast, Domino’s stores do around £1m of sales. This gives it tremendous economies of scale:

-    Domino’s can buy raw ingredients cheaper than its competitors can. It is the largest customer of Glanbia, for instance, from whom it buys its cheese. And it can produce the base of its pizzas in its commissaries, which are highly automated, £35m factories. In total, I estimate this gives it a 300-400bps margin advantage over the market, particularly against the independents, which use lower quality ingredients but pay more for them.

 

-    Domino’s can put together a pizza faster and cheaper than anyone. The higher volume per store means a chain of people are constantly at work. This is surprisingly important – it takes around two minutes of labour time for an independent to put together a pizza but it might be 30-60 seconds for a Domino’s store. This adds up to as much as a 500bps margin advantage, sometimes more. You can test this yourself: go to your local pizza place and a Domino’s, and time them. You’ll be shocked at the difference in speeds.

 

-    Domino’s high sales density means it can deliver via shorter routes. This means it can deliver faster, for less. This gives it a further 300bps margin advantage, I estimate, and at least a five minute delivery advantage. This only gets better. In Australia, where the sales density is even higher than the UK, the average delivery time is around 22 minutes compared to the UK’s 25 minutes. Some stores in Australia are delivering in 10 minutes on average. One even did an order in 3 minutes, no joke! (They have shoulder surfing technology which means the pizza is being cooked as you’re paying for it.)

 

-    The greater sales per store means than the leverage over rent and rates is very high. Rent is around 2% of sales for a Domino’s. With a ¼ of the sales from similar locations, local independents are spending as much as 8% of sales on rent, a massive 600bps difference.

 

-    Domino’s can develop things like mobile apps and shoulder surfing technology. It can afford to buy ovens that cook the pizzas in 4 minutes rather than 7 minutes. With re-order rates going up dramatically when you’re faster, these can make a huge difference.

 

 

Overall, Domino’s generates operating margins of around 19-20% across its system. Pizza Hut, the next largest player, is roughly break-even after several years of losses. Papa Johns, after years of losses, is now doing quite nicely with 7-8% margins. Most independents are barely afloat.

 

 

Brand

Domino’s superior margins allow it to spend more in marketing. It mandates franchisees to put 4-5% of sales into a national advertising fund. On top of this, franchisees spend around 2-3% of sales on local marketing (e.g. leaflets, text messages, etc.). This means it spends around £80m on advertising in the UK. This excludes of course the halo effect from the global Domino’s brand spend, for which Domino’s pays DPZ nearly 3% of system sales. It’s hard to put a number on it, but speaking to experts I would guess that the rest of the pizza delivery market combined is spending around half of that. This implies Domino’s share of voice is around 65-70%. I always like these situations – market share tends to follow share of voice.

 

 

This is another leg of the virtuous circle: greater marketing spend drives greater market share, which increases economies of scale. These economies of scale can be further reinvested into marketing.

 

 

Franchise Model

The final leg on the stool is the franchise model. All of Domino’s UK stores are franchises. Some other markets are a mix of corporate stores, some are 100% store owned, but the UK is one of the few Domino’s markets that is 100% franchisee owned. This is a sign of the health of the system. The vast majority of stores are making decent money. In other markets, the corporate is forced to buy back stores because there are no buyers or the franchisee is under-water. This doesn’t happen in the UK.

 

 

The advantage of the franchisee model is obvious: you get highly motivated entrepreneurs running the stores who care much more than any company employee would. The typical franchisee is working class (often a first-generation immigrant) that has put up their life savings to build their first store (which might require around £150k of equity or so). They’re hungry.

 

 

The other nice advantage of the franchisee model is of course that the franchisees put up most of the capital in the system. Domino’s has to invest in commissaries, distribution and some inventory. But the store capex is financed by the franchisees. This makes the corporate very capital light.

 

 

The Economics

The real starting point is to look at the system model i.e. combining the franchisee P&L and the franchisor P&L to get the total Domino’s system P&L. There are some estimates in here but it should be directionally right. Few people seem to look at the model like this but I think it’s absolutely essential, and it gives you a different perspective than if you're looking at just the company's financials. The most important thing to highlight is that the company has been taking a smaller share of the system sales over the last few years, passing the profits disproportionately to the franchisees. Franchisees are in rude health, well able to withstand the current margin pressure.

 

 

The UK System Model (Franchisor + Franchisees)

On System Sales of ~£940m, Domino's generates gross profit of ~£500m, a gross margin of 53%. This is after food costs and store labour. Obviously the gross margins are extremely high and it's more like 80% if you just look at the food margin. Below the line are royalty payments (3%), advertising (7%), rent (2%), depreciation (3%) and overhead/other (18%), which is mostly franchisee overhead. This leaves an EBIT margin of 19-20%.

 

 

 

FY10

FY11

FY12

FY13

FY14

FY15

FY16

System Sales

431

478

543

609

706

823

939

Growth

 

11%

14%

12%

16%

17%

14%

COGS

(101)

(112)

(126)

(132)

(147)

(157)

(173)

% of total

23.4%

23.5%

23.3%

21.7%

20.9%

19.0%

18.5%

Direct Labour

(121)

(134)

(152)

(170)

(198)

(230)

(263)

% of total

28.0%

28.0%

28.0%

28.0%

28.0%

28.0%

28.0%

Gross Profit

210

232

265

306

361

436

503

Gross Margin

48.6%

48.5%

48.7%

50.3%

51.1%

53.0%

53.5%

               

Royalty to Domino's US (DPIF)

(12)

(13)

(15)

(16)

(19)

(22)

(25)

Rent

(11)

(11)

(12)

(13)

(14)

(15)

(16)

National Advertising

(22)

(23)

(23)

(25)

(32)

(42)

(42)

Local Advertising

(9)

(10)

(11)

(12)

(14)

(16)

(19)

Franchisee overhead

(54)

(64)

(74)

(97)

(112)

(130)

(163)

Corporate overhead

(13)

(12)

(14)

(14)

(14)

(17)

(21)

Total EBITDA

90

99

116

129

156

194

217

EBITDA margin

21.0%

20.7%

21.3%

21.2%

22.1%

23.5%

23.1%

               

Maintenance capex - franchisee

(9)

(10)

(11)

(12)

(14)

(16)

(19)

Maintenance capex - corporate

(9)

(10)

(11)

(12)

(14)

(16)

(19)

Total Operating Profit

73

80

94

105

128

161

179

Operating margin

17.0%

16.7%

17.3%

17.2%

18.1%

19.5%

19.1%

 

 

Domino’s has been growing fast for many years, with margin expansion. System sales have been growing around 15% pa and its gross margins have expanded dramatically over the past seven years by 500bps. Most of this is down to greater economies-of-scale, but part of it is down to lower food prices on the back of a weakening sterling and commodity deflation. There have also been some transfers from COGS to franchisee overheads for various reasons, which makes the comparison imperfect.

 

 

Labour inflation has been high due to the increase in minimum wage and tightness in the UK labour market, and this has offset some of the labour advantages of shifting from telephone orders to online orders. Nonetheless operating margins have expanded and operating profit has compounded at 19% pa over the last seven years.

 

 

The growth in stores has accelerated in recent years. These stores can be loss-making in year one and lower margin for a few years, depressing margins. So the margins are even higher if you look at just the mature estate.

 

 

The returns on capital are very nice. Conservatively estimating the initial capex each franchisee has put into their store, I estimate the return on net operating assets is over 50-60% for the system. Given franchisees can borrow up to three times EBIT at interest rates below 2%, the return on equity is probably over 100% for the system.

 

 

Company Model

So how does Domino’s, the franchisor, take its cut?

 

 

 

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Royalties & corporate sales

158

177

201

216

242

268

301

Growth

12%

12%

13%

7%

12%

11%

13%

Royalties

24

26

30

33

39

45

52

Sales to franchisees

135

151

171

182

203

223

250

Rental income on leasehold & freehold

12

12

13

14

15

16

18

Total Revenue

170

190

214

230

258

284

319

Growth

12%

12%

13%

7%

12%

10%

12%

% of total system sales

39.5%

39.7%

39.5%

37.7%

36.5%

34.5%

34.0%

               

Commissary margin

34

39

45

50

56

66

76

Margin

25.2%

25.6%

26.2%

27.5%

27.5%

29.6%

30.6%

Net Royalty

12

13

15

17

20

23

26

Realty

1

1

1

1

1

1

1

Other

0

0

0

0

0

0

0

Gross Profit

47

53

61

68

77

90

104

Gross Margin

27.7%

27.8%

28.7%

29.6%

29.7%

31.7%

32.5%

% of System Sales

10.9%

11.1%

11.3%

11.2%

10.8%

10.9%

11.1%

               

Net Overhead - ex D&A (includes franchisee incentives)

(13)

(12)

(14)

(14)

(14)

(17)

(21)

Growth

 

-2%

9%

1%

0%

25%

22%

D&A

(2)

(3)

(4)

(5)

(5)

(5)

(6)

Growth

 

32%

34%

31%

4%

-2%

13%

               

Operating profit

32

39

45

50

58

68

77

Margin

18.5%

20.6%

21.1%

21.9%

22.4%

23.9%

24.2%

% of System Sales

7.3%

8.2%

8.3%

8.3%

8.2%

8.2%

8.2%

 

 

In 2016, it took 34% of system sales as revenue. This has been declining as a percentage of system sales from a peak of 40%. In other words, DOM’s growth has lagged the system sales growth. This is a crucial point because company revenue is what you’ll see in the Annual Report and what the market focusses on the most.

 

 

Despite this decline in revenue, it has been taking a constant 11% of system sales in gross profit and 8% in operating profit for the last few years. This is in contrast to the 2006-2011 period when it was constantly increasing this share it took in profit. In fact, the old management team, who left in 2013, used to show a chart every year that said the company’s operating profit would increase from 8% of system sales to 12% in 2020.

 

 

So why has the franchisor been growing sales slower than its franchisees? The reason is that most of the benefit of lower food prices – which came from both better purchasing power and a decline in raw material prices – has been passed on to the franchisees. Franchisee margins and profitability are at an all-time high. The company has passed on a disproportionate amount of the profits to the franchisees in recent years. Franchisees’ share of the total system EBITDA has increased from 58% to 62%. Contrast that mix to Australia, where the mix has gone from 80/20 franchisee/franchisor to 50/50 today.

 

 

Split of Profit Pool in the UK

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Franchisee EBITDA

57

57

67

73

93

121

134

% of total System EBITDA

63%

58%

58%

57%

60%

62%

62%

Franchisor EBITDA

34

42

49

56

63

73

83

% of total System EBITDA

37%

42%

42%

43%

40%

38%

38%

Total EBITDA

90

99

116

129

156

194

217

EBITDA margin (on System Sales)

21.0%

20.7%

21.3%

21.2%

22.1%

23.5%

23.1%

               

Franchisor EBIT as % of System Sales

7.3%

8.2%

8.3%

8.3%

8.2%

8.2%

8.2%

 

 

 

Instead, the UK management has been passing on its profits to franchisees. What does the company expect to get in return? Store openings. In other words, management have been sacrificing short-term profits for long-term growth.

 

 

In Australia, over half of the system profits will go to the franchisor in the next couple of years, which will translate to an EBITDA margin of 40%. This compares to the UK’s 26%. This gives you an idea of where margins could go in the UK.

 

 

The Franchisee Model

I have estimated what a mature store P&L looks like for a franchisee, and how it’s developed over time. The company supplies some of this information but you also need to dig around Companies House to find the private accounts of Domino’s franchisees, and to speak to them, to verify it.

 

 

This is how the unit economics have developed:

 

 

 

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Sales per Year (£k)

780

779

796

852

909

1,015

1,076

Growth (not LFL)

13%

0%

2%

7%

7%

12%

6%

COGS (purchases from the central office)

(244)

(246)

(251)

(255)

(262)

(274)

(286)

% of sales

31.3%

31.6%

31.5%

29.9%

28.8%

27.0%

26.6%

Labour

(218)

(218)

(223)

(239)

(254)

(284)

(301)

% of sales

28.0%

28.0%

28.0%

28.0%

28.0%

28.0%

28.0%

Gross Profit

318

315

322

359

393

456

489

GPM

40.7%

40.4%

40.5%

42.1%

43.2%

45.0%

45.4%

               

Advertising (National Advertising Fund)

(40)

(37)

(34)

(36)

(41)

(52)

(48)

% of sales

5.1%

4.7%

4.3%

4.2%

4.5%

5.1%

4.4%

Royalty Payment

(43)

(43)

(44)

(47)

(50)

(56)

(59)

% of sales

5.5%

5.5%

5.5%

5.5%

5.5%

5.5%

5.5%

Rental expenses

(19)

(18)

(18)

(18)

(18)

(18)

(18)

% of sales

2.4%

2.4%

2.3%

2.1%

2.0%

1.8%

1.7%

Local Advertising

(16)

(16)

(16)

(17)

(18)

(20)

(22)

% of sales

2.0%

2.0%

2.0%

2.0%

2.0%

2.0%

2.0%

Other

(94)

(104)

(106)

(134)

(138)

(153)

(178)

% of sales

12%

13%

13%

16%

15%

15%

17%

EBITDA

106

97

104

107

127

157

164

EBITDA margin (mature stores)

13.6%

12.5%

13.1%

12.6%

14.0%

15.5%

15.3%

Growth

13%

-8%

7%

3%

18%

24%

4%

 

 

The typical store is making profit of around £165k, an increase of around 60% over the last six years. This is despite new stores opening in smaller towns and regions being split. Strong LFL sales growth of around 7-8% has meant margins have expanded from 12% in 2012 to 15-16% in 2015-2016, an all-time high.

 

 

What do the returns look like for the franchisees? The amount of capital to set up a franchisee is between £200-300k. If you’re a new franchisee, you will have to put up 2/3 of it in equity. If you’re an established franchisee, the banks will put up 2/3 and you’ll be paying 130bps over LIBOR. Very little. In other words, for your £70-100k equity investment, you should be making at least that within a few years. Not bad! No wonder store openings are accelerating. Before you ask where you can sign up, it’s a closed shop. Besides, Domino’s has a ‘no finance person’ rule – apparently we won’t get our hands dirty…

 

 

At the same time, the number of franchisees has consolidated. There used to be 30-40 franchisees with just one store. Today this just doesn’t happen. Instead, the company has encouraged franchisees to consolidate. There are negatives with this approach – more customer bargaining power – but it does mean that the average franchisee is doing very well. Today the average franchisee has 13 stores and is making ~£2m in EBITDA. This is somewhat biased by two franchisees that have around 200 stores between them; but excluding these guys and the typical franchisee has 8-9 stores and is making around £1.3m in EBITDA.

 

 

Average Franchisee P&L:

 

 

FY10

FY11

FY12

FY13

FY14

FY15

FY16

Revenue (£k)

4,129

4,700

5,271

6,648

8,286

11,314

14,757

Total EBITDA

478

499

587

712

986

1,491

1,914

Average EBITDA margin

12%

11%

11%

11%

12%

13%

13%

Growth

26%

4%

18%

21%

38%

51%

28%

Maintenance capex

(41)

(47)

(53)

(66)

(83)

(113)

(148)

EBITDA minus maintenance capex

437

452

534

645

903

1,377

1,766

               

Average PP&E put in per store

250

250

250

250

250

250

250

Capital Invested (ex goodwill)

1,250

1,425

1,563

1,842

2,153

2,632

3,237

Return on capital (pre-tax)

35%

32%

34%

35%

42%

52%

55%

 

 

 

With food and labour inflation, and weak LFLs, the franchisee will see a decline in earnings per store over the next couple of years. Food inflation is running at 4% in H1 2017 and set to accelerate in H2 (cheese is up 12%, wheat prices are spiking, sterling is down, etc.). The company will absorb some of it (especially that cheese inflation, which may lead to a poor H2), but most will be passed on to the franchisees. This will lead to a decline in profits per store. But they can afford it. And with the network growing by 7-8%, overall profits should still be able to grow.

 

 

The effect of this food inflation is that, for the first time in several years, you should see the franchisor sales grow ahead of the system sales.

 

 

Growth Potential

Domino’s has been taking market share over time, and this is likely to continue as the flywheel works its magic. But there are several larger trends that will continue to drive Domino’s growth going forward, and several other factors that mean the 15-20% growth rates of the past are not going to be repeated.

 

 

Firstly, food delivery is no different – there is a huge shift towards the internet. The delivery market is still around 50% telephone but online and in particular mobile ordering is growing at 15-20% pa. This has been a boon to Domino’s, which has the scale to invest in a decent site and mobile app in a way that a small restaurant cannot. Today around 80% of Domino’s sales are through the internet and over half of these are mobile, which is growing at 15-20% pa. The app has been downloaded 15m times in a country with 65m people. This channel shift brings other advantages – it’s easier to promote sides and drinks and so orders are larger, it takes less labour time and orders are more accurate.

 

 

Secondly, the delivery market has been growing at around 10-15% pa, ahead of the restaurant market, which is also growing faster than GDP. As people get richer, work longer and look for more convenience, they’re increasingly likely to order food in. And they’re going to favour the company that can deliver the fastest.

 

 

Thirdly, chains are growing at the expense of independents.

 

 

Fourthly, by splitting territories and adding new stores, Domino’s will naturally grow its market share. A new store increases its collection business (as more people pass the store) and reduces wait time for online orders, which increases repeat rates. Within 1km, 21% of households order from Domino’s over a year. But at 2-3km, this falls to 17%. So by adding a second store 2-3km away, the share goes back up to 21%, a 20-25% boost in sales from those local addresses. Management refer to this as the “golden mile”.

 

 

Domino’s believes it can grow its store to 1600 from the current 950. It is less penetrated than the US despite having a significantly higher market share, and far less penetrated than Australia where the market share is comparable. It’s hard to compare countries because eating habits are very different, but it does give you some comfort that these targets are reasonable.

 

 

At the moment the franchisees are growing the store base by around 80-90 pa, or ~9%. This is the fastest rate in years. It has accelerated partially because Domino’s struck a deal with its large franchisees. It allowed them to acquire some smaller franchisees and in return they had to guarantee to open more stores. Many stores are also at capacity and need to be split, especially in London. Some are doing £50k per week or £2.5m per annum. They’re bursting at the seams. With store openings growing at high-single-digits, LFL sales growth can be zero and system sales will grow healthily.

 

 

Nonetheless, growth is not going to match the historic 15% for a host of reasons. Firstly, much of the growth in the last ten years has been growing into new territories, where there is built-up demand. Today, around 90% of the country is covered, so 2/3 of the store growth is from splitting territories and the remaining 1/3 is going to be in less attractive locations.

 

 

Secondly, Domino’s has had much of the mobile and online space to itself. Now many of the independent restaurants are on online aggregators and so are more competitive. I’ll come back to this point, as it’s the greatest risk for Domino’s long-term.

 

 

Thirdly, while Domino’s performed extremely well in the last downturn (system sales grew 15-20% in 2008 and 2009), the economic squeeze might be worse this time. Domino’s prices are higher than they were back in 2009 and so there may be fewer people trading down from restaurants to pizza nights. Note the corporate can’t force franchisees to lower prices because of UK regulation (they can only recommend prices).

 

 

Nonetheless, I think it can sustain mid-to-high-single digit growth for many years, which would be equivalent to -1 to 2% LFL sales growth and 5-10% store growth.

 

 

Why is it so cheap?

Brexit, slowing LFLs and cost inflation: The sell-off in the shares started when Domino’s showed declining system sales growth. In the first half, system sales growth fell to 7% for the UK and Ireland, the lowest rate in years. LFL growth was 2.5% or 0% including split territories. Clearly there is weaker consumer demand and more competition than there has been in the past.

 

 

This is hardly a disaster. While LFLs are important in showing the store health, because each franchisee owns around 12 stores now, it is not as important as it once was. And it’s not comparable to retail LFLs because 80% of the orders are coming from home (rather than someone passing a store). Domino’s is no longer adding many new addresses, so the growth in sales per address is close to 7%, not far off the average over the last ten years. There is still healthy growth in the demand for Domino’s. Indeed, it continues to take market share.

 

 

It’s also different to retail because the franchisees are the ones putting in the growth capex, and they would be doing so at an exceptional return even if LFLs and store profits were to fall somewhat.

 

 

I suspect LFLs will get worse before they get better. And with sterling weakness and minimum wage increases, cost inflation will be higher over the next couple of years. As stores become less profitable, franchisees will be less inclined to roll-out stores.

 

 

However, I think the franchisees can handle a decline in per-store profitability. Sales per franchisee are still growing at high single-digit rates through store openings and they are highly profitable. They will likely continue to roll-out new stores because the economics remain strong, even if margins do come down. They have strong balance sheets and have agreed to the current roll-out plan. One franchisee admitted to me, after some grumbling, a bad year might just mean buying two luxury sports cars this year, rather than three.

 

 

Rise of Just Eat and Deliveroo: Much has been made on the rise of Just Eat and Deliveroo, which aggregate small independents and some chains such as Pizza Express. This has indeed given independents a platform to better compete against Domino’s, there’s no doubt.

 

 

But I do think it’s worth fleshing this out. Just Eat, an aggregator, has been growing rapidly. In 2016, it grew UK revenue by 40% and orders by 31%. In Q1 2017, its order growth was 17%. Some are pointing to it taking market share from Domino’s. Domino’s orders grew by just 11% in 2016, so this implies that Domino’s lost market share, right? Not quite. A big chunk of Just Eat’s growth is acquiring new customers rather than growth in orders per customer. Say the growth in orders per customer is more like 15-20%. Well, Just Eat’s growth refers to just the online channel of the independents. This channel is growing at around 20% pa for Domino’s, similar to the independents’ growth rate.

 

 

In fact, independents are fall further behind Domino’s. Online represents three-quarters of Domino’s sales, compared to around a third for the independents. Telephone sales are falling by around 7% for both. If one-third of the independents’ sales are growing at 20% and the other two-thirds are declining at 7%, then independents’ overall sales are growing low-single-digits. In other words, despite the huge growth through Just Eat, independents are falling behind Domino’s high-single-digit system sales growth.

 

 

Even if Domino’s were to lose market share online (it hasn’t), because of its sales mix is so heavily online, it would still grow faster than the delivery market.

 

 

Deliveroo is a bigger threat to Domino’s because (1) it delivers from big restaurant brands such as Nando’s and McDonalds, and (2) it isn’t just an aggregator but also a delivery company. It can over time build sales density and even start to get some of the delivery economics that Domino’s has. It has some challenges – it can’t integrate with kitchens so its delivery times are slower than Domino’s. But it has some advantages, such as paying its drivers on a per order basis, which motivates speed. The government may eventually clamp down on Deliveroo, who doesn’t treat its drivers as employees but suppliers, but for the moment it is gaining tremendous traction. No doubt it is contributing to some of Domino’s slowdown in LFLs, although Domino’s LFLs are similar in London (where Deliveroo is strong) to the rest of the UK (where Deliveroo is weak).

 

 

My conclusion is that Deliveroo is the biggest risk to the Domino’s investment thesis, but I think the perception of the risk is overdone. Deliveroo is helping expand the food delivery market. It gives delivery options to chains that previously could not (e.g. KFC, Nandos). Some of these don’t deliver well (soggy burger and chips anyone?) They will add choice and take an ever bigger share of the online food delivery market. But because the online channel is growing so fast, and because it is such a big chunk of Domino’s sales compared to most pizza delivery stores, I think Domino’s growth will remain solid. In fact, with the “internet of food” growing at over 20% pa, my high-single-digit growth rate implies that Domino’s will lose market share to Deliveroo. This doesn’t mean it should trade as if it’s a mediocre, ex-growth company. Far from it.

 

 

A misunderstanding of the underlying earnings: At the end of 2015, Domino’s sold 2/3 of its ownership of the German franchise to Domino’s Enterprises (DMP), the Australian franchisor. The German franchisor then bought Joey’s Pizza, the #1 player in Germany. DMP is by far the best run Domino’s and it has one of the best management teams I’ve ever met. They have already turned around Germany and it is now earning far more than it was under DOM. Using DOM’s 1/3 share, it adds around £3m to the underlying profits in the UK. Similarly, adding in the true earnings of its other stakes in the Nordics and some franchisees it owns in the UK adds a further £3m (you might want to look at their accounts via Companies House). Thus, I think the earnings guidance many analysts are using is being understated by around 5%.

 

 

Worries about the health of the products: Pizzas are unhealthy and it seems some people have just remembered that in the last few months. It’s been another reason added to the list of sellers.

 

 

Other Risks and Issues

I thought I should address a few more issues that weren’t mentioned in the “Why is it cheap?” section. These haven’t been mentioned much by sellers, but they worry me.

 

 

Risk of Vicious Cycle: I think the likelihood of something going wrong in the business is low, but I do think the business is leveraged in one way – if LFLs do fall sharply, with cost inflation, the decline in per-store profitability could cause the virtuous circle to become a vicious one. Stores are shut and economies-of-scale reverse. This further hurts the system, leading to further declines in per-store profitability. This has happened to some franchise models in the past, including brands like Burger King. I think this is unlikely because margins and returns are just so high at a franchisee level, much higher than they ever were at more vulnerable franchisees such as Burger King, and the long-term trends are supportive. But it remains a worry.

 

 

Overly Penetrated Market: I reckon 20-25% of the country ordered from Domino’s in 2016 and each customer is ordering once every 8 weeks on average. The business is highly penetrated and it will definitely not be able to grow like it has in the past. Yet some other markets are far more penetrated and that hasn’t stopped pizza delivery from continuing to grow.

 

 

Management: I think management are decent but they pale in comparison to the Domino’s Australia’s entrepreneurial management team. I like that they have transferred some margin to franchisees. This will help drive growth long-term. But they have been a follower in terms of technological advancement and I’m uncomfortable with the level of pay that the CEO has received the last couple of years (the CEO’s pay is a big chunk of the corporate overhead in 2016 and accounts for a significant portion of overhead growth in the last few years). Thankfully, some of these concerns are being addressed.

 

 

Master Franchise Agreement (MFA): The MFAs give Domino’s UK (DOM.L) the right to sub-franchisee Domino’s stores. In return, Domino’s has to pay 2.7% of system sales to Domino’s Pizza Inc (DPZ), the US listed holding company. This agreement is renewed every ten years but in reality it’s a perpetual agreement. Domino’s UK just has to be in “good standing”. I don’t think it’s a risk that this doesn’t get renewed, at all, but it would be amiss to not mention it.

 

 

Valuation

On headline numbers, it trades at around 17x 2017 earnings and 15x 2018 earnings, which incorporate a significant slowdown in growth rates and a margin decline (the first ever). But I think this understates the real earnings power. Firstly, corporate tax rates are coming down to 17% from 20% over the next three years. Secondly, the company is planning to lever up to 1.25x EBITDA through dividends and buy-backs over the next year. Incorporating these two things into the valuation and Domino’s is trading at around 12-13x. As someone whose holding period is 5+ years, this is what I deem the right multiple to look at.

 

 

I don’t like being overly prescriptive of what the valuation should be, but I see plenty of upside and I think it’s hard to lose money. It’s a strong, growing company which generates a return on operating assets of over 100% and has a strong balance sheet. It’s priced as if it’s ex-growth despite it benefitting from a great business model and many tailwinds, with embedded store growth (financed by franchisees) and significant operating leverage. I think double-digit FCF growth is quite reasonable longer term (short-term will be worse than that). Yet it trades at a below-market multiple. It is pretty resistant in downturns – in fact, it marched right through the last one. I wouldn’t be surprised if it doubled over the next couple of years after it has reminded everyone of its quality.

 

 

The other listed Domino’s trade at much higher valuations. Compared to DOM’s EV/NOPAT (2018) of 14x, DPZ trades at 33x and DMP trades at 29x (despite the shares falling 35% from its peak). DPP is unprofitable but trades on 5x sales. Jubilant, the Indian franchisor, trades at around 43x. Other peers, with far less growth and/or quality, trade much higher.

 

 

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I hold an investment in the issuer's securities.

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Return of capital: I think Domino’s will return over 10%+ of the market cap over the next 18 months through dividends and buybacks and it may increase that. There is talk of taking leverage up to 2x EBITDA, which is still low enough to keep me comfortable. That would allow around 20% of the market cap to be returned over the next 18 months.

 

 

Acquisition target: I really hope not, but Domino’s is an obvious acquisition target. Bain Capital has owned the franchise in other countries (US, Japan and Australia) and would love to own the UK business. They could stick 5x net debt/EBITDA on it (DPZ has operated at 7x in the past) and make the equity at under 10x FCF at the current price level. I reckon that private equity could pay a 50% premium and still comfortably get a high teens IRR without the company shooting the lights out. This would tantamount to robbery, but if you’re looking for a catalyst, there’s one.

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