Domino's Pizza DPZ
October 17, 2007 - 4:18pm EST by
pokey351
2007 2008
Price: 14.50 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 900 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Domino’s Pizza, DPZ, at under $15/share, is a buy with a compelling risk/reward skew for investors with a 2-3 year time horizon. I think the current issues – rising commodity costs, low end consumer struggles, obscure what is a great business with international exposure and great returns on tangible capital. My upside target is in the low $20s, or 60%+ from current prices.

The Numbers:
Price: $14.25
S/O: 62.6mm
Market Cap: $900mm
Net Debt: $1,600mm
TEV: $2,500mm
P/E Forward: 10.3x
Historical Range: 13-17x
EV/EBIT Forward: 10.7x
Historical Range: 11.7x – 16.8x
FCF Yield Forward: 11.6%
Historical Range: 5.3% - 6.8%
Investment Recommendation: Domino’s Pizza, simply put, has an excellent business model with over 90% of their stores owned and operated by franchisees which in turn reduces operational risk and maximizes free cash flow. This business model generates free cash flow margins of 17% , returns on invested capital of 40%, and has management has consistently rewarded shareholders through returns of capital by special dividends and going forward a share repurchase plan. At current prices, DPZ is trading at a 11.6% forward free cash flow yield, earnings power of $1.69 ,and cash balance which by FYE 2009 will represent 40% of the current market cap.
Investment Thesis: Domino’s is a public market LBO that has demonstrated a consistent ability to generate free cash flow, has an excellent business model driven by franchisee royalties, and a management team that has demonstrated an ability to allocate capital in the best interests of shareholders. I would also argue that the time to build a position in Domino’s is when the company is facing significant headwinds due to cyclicality and not due to problems with the business model.
Bear Case: The bear case on DPZ is that 1) rising commodity costs, specifically cheese costs, will hurt earnings going forward, 2) the recently completed special dividend has left the company with few ways to create shareholder value from the balance sheet, and 3) is not cheap relative to its peers based on traditional metrics.
Variant Perception: The critical understanding that the market is missing is that 1) the majority of the rise in commodity costs are passed through to franchisees through the distribution segment (please see comments below on Q3 reported yesterday), 2) DPZ is a capital light business model that will generate 40% of its current market cap in cash by FY 2009, most of which will go towards repurchasing shares, and 3) Peer comparisons are a misleading basis for comparison given the capital intensity and economic returns of the business model. The intrinsic value continues to compound at an attractive rate and the commodity input inflation is a transitory issue which may in fact create pricing discipline in the long run among competitors.
The Business Model: DPZ’s business model relies on a combination of royalty payments received from franchisees, a distribution platform providing franchisees with raw materials and equipment, and income generated from company owned and operated stores. The company is the number one pizza delivery company in the United States, has a strong global brand, and generates attractive economics in a growing market space which provides the impetus for franchisee expansion.
Store unit economics are attractive given the low startup costs, the well recognized brand, and compelling value proposition to consumers. Delivery is a $12b market and the channel represents 24% of total sales of pizza in the United States. Within the pizza delivery market, DPZ is number one with a 19% share and has room to grow given that 54% of total delivery is done by small mom and pop chains.
International franchisees operate on a master franchise agreement which allows DPZ to sell the rights to individual countries and receive annual royalty payments. There are two publicly traded Domino’s franchisees in Australia/New Zealand and the UK. International store growth represents between 70% and 80% of net new unit builds and has compounded at 8% annually since 2002. Furthermore, this segment has reported 54 consecutive quarters of positive comps and the company has publicly stated that it believes that there is room to double units within their top 10 markets.
Unit Economics – the company has stated that franchisees generate 30%+ cash on cash returns. The numbers below are backed into through conversations with those franchisees.
Unit Economics







Domestic Company-Owned Store
$ 697.0


Royalty Payments
$ -
5%

Food Costs
$ (170.1)
24.4%

Labor Costs
$ (211.9)
30.4%

Occupancy Costs
$ (80.9)
11.6%

Insurance
$ (21.6)
3.1%

EBIT
$ 212.6
30.5%
Sales/Company Store




1Q
2Q
3Q
4Q
2005
$ 172.9
$ 161.1
$ 158.6
$ 207.4
2006
$ 166.3
$ 156.4
$ 158.0
$ 205.6
2007
$ 167.6
$ 163.7
$ 159.3
$ 210.8





INVESTMENT THESIS
Strong Free Cash Flow Generation: DPZ requires minimal capex to run the business given its reliance on franchisee royalty payments and generates 17% free cash flow margins. Funds from operations less capex has been 115% higher than net income since 2004. DPZ went public in 2004 and since then management has used 58% of its cash sources to repay debt, 30% to pay common stock holder dividends, and 7% to repurchase shares.
Sources and Uses Analysis (2004 – 2007)
Funds from Operations $521mm
Proceeds from LT Debt Issuance $2,650mm
Stock Issuance $128mm
Other $79mm
Cash Inflow $3,380mm
Operating Expenses ($147)mm
Repayments of Long Term Debt ($1,898)mm
Share Repurchases: ($222)mm
Common Stock Dividends ($974)mm
Other ($46)mm
Cash Outflow ($3,287)mm
Free Cash Flow (FFO – OPEX) $374mm
% of Net Income 115%
Shareholder Friendly Management: Management (excluding the CEO) has been with the company since the LBO by Bain in 2002 and understands how to create shareholder value. In April of this year management issued a $1.85b asset backed note with a fixed 6.06% interest rate, which was used to repurchase all of its 8 ¼ senior sub notes, repay all outstanding borrowings under its senior credit facility, and issue a special one time dividend of $13.50.Going forward the company’s liquidity includes a $150mm revolver and has authorized a $200mm stock repurchase plan (representing 20% of the company based on the current equity value).
Messy 1H earnings obscures Profitability: The repurchase of the senior notes resulted in several one time charges, in addition to a $5mm legal provision resulted in reported EPS in 1H07 of $.49 to be significantly below that of the year ago period of $.73. After stripping out the one time fees, 1H07 earnings were actually $.65 and would have been slightly in line with 1H06 ex-the debt issuance. The point is simply that core operations were in line with the year ago period, yet the bottom line was affected by the messy 1H due to financing decisions which were made to improve shareholder returns.
RISKS
Higher Cost Environment: The current commodity environment, particularly for cheese which represents 1/3 of pizza costs, has resulted in 60bps declines in YOY margins. Other relevant costs include wheat (5-10%), and wages (50bps increase per store) due to the new minimum wage hike. DPZ is only affected on the 7% of company owned stores (and cheese costs are passed through to franchisees), for which 50 – 75% of these costs are hedged. Looking historically at cheese costs, the last spike took place in 2004 and resulted in 20bps decrease in that year and a 140bps increase in margins the following year.
Balance Sheet Ammunition Gone?: Following the payout of the special dividend total leverage stands at 6.8x EBITDA. The company has a $200mm stock repurchase program in place, a $150mm revolver and will generate $300mm in free cash flow through 2009 which management has proven will go towards increasing shareholder value.
VALUATION
To determine my target valuation, I used two methods: 1) Target EV/EBIT multiple and 2) Earnings Power Analysis. My target multiple of 13x EV/EBIT is my base case forecast for 2008 EBIT and is justified based on the company’s historical ROIC and growing free cash flow. Secondly, DPZ should earn $1.38 next year with cash on the balance sheet of $250mm (I assume no share repurchases). Using a target price/earnings multiple of 18x, in line where its traded since the IPO, and stripping out excess cash (95%) results in a price target of $26.89.
DPZ Valuation






2008 Estimates
Low Case
Base Case
High Case

Earnings Power Analysis

EBIT
$219
$234
$247



Margin
14.0%
15.0%
15.8%

2008 EPS
$ 1.39
Multiple
11.0x
13.0x
15.0x

Less: Interest Income
$ (0.11)
Firm Value
$2,404
$3,044
$3,706

EPS
$ 1.28
Net Debt
$1,617
$1,617
$1,617

Multiple
18.0x
Equity Value
$787
$1,427
$2,089

Cash
$ 246
Share Price
$12.58
$22.80
$33.38

Market Value
$ 26.89







Low and High case multiples represent historical peak and trough



multiples since 2004 IPO.





Comps (all numbers all LTM):
The key metric to highlight is that DPZ is trading at a slight premium on EV/EBIT multiple but at a significant discount on a EV/EBITDA – CAPEX matrix which is indicative of the company’s asset light business model. It has the highest percentage of franchised restaurants in the group.
Comparable Analysis




EV/


Price
Market Cap.
EV
EBIT
EBITDA
EBITDA - CAPEX
Papa John's
PZZA
$ 24.11
$ 720
$ 827
9.7x
7.2x
14.0x
Burger King
BKC
$ 26.34
$ 3,560
$ 4,333
14.6x
10.5x
12.2x
YUM Brands
YUM
$ 36.91
$ 18,897
$ 20,806
17.1x
12.0x
13.5x
Sonic
SONC
$ 24.55
$ 1,578
$ 2,231
15.6x
11.9x
17.5x
Wendy's
WEN
$ 34.18
$ 2,986
$ 3,377
26.4x
13.7x
13.9x












Average
16.7x
11.1x
14.2x
Domino's
DPZ
$ 14.25
$ 892
$ 2,509
12.0x
10.5x
10.9x
















Q3 – 10/15: DPZreported earnings that were $0.06 below consensus based on a tougher consumer environment (on the call the company commented that traffic was down domestically though average ticket was up) and lower margins due to higher commodity costs. I do not have any insight into the company’s hedging program (for commodity costs, particularly cheese), and going for higher average tickets at the expense of traffic is likely the right strategy. I do not know when these issues will resolve themselves though I feel very confident in the company’s ability to continue to grow internationally, and continue to build cash. The big picture on the company’ business model does not change based on the numbers reported yesterday and the reaction provides an opportunity to buy.
Catalysts:
1) Value is its own catalyst – the stock is too cheap to ignore.
2) Continued international growth, and the potential for sales of master franchisee agreements. Domino’s Pizza UK and DPZ Australia are both publicly traded and both are acquisitive. Furthermore, DPZ has not begun to penetrate the China market which offers significant potential.
3) Easing comps heading into next year – reduced noise from 1H expenses related to the debt offering and special dividend.
4) Going into Q4, the strongest seasonally with low expectations and a stock trading at its lows for the year.

Catalyst

1) Value is its own catalyst – the stock is too cheap to ignore.
2) Continued international growth, and the potential for sales of master franchisee agreements. Domino’s Pizza UK and DPZ Australia are both publicly traded and both are acquisitive. Furthermore, DPZ has not begun to penetrate the China market which offers significant potential.
3) Easing comps heading into next year – reduced noise from 1H expenses related to the debt offering and special dividend.
4) Going into Q4, the strongest seasonally with low expectations and a stock trading at its lows for the year.
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