A Deep-Dish-Dive into Dominos Pizza $DPZ
Domino’s Pizza Inc. is the world’s largest pizza company with over 19,500 locations across 90+ markets. The company comes with a rich history of success and the American Dream. Domino’s was founded in 1960 by brothers Tom and James Monaghan with the two purchasing a small pizza and sub store called “Dominick’s” in Ypsilanti, Michigan. Tom later traded a Volkswagen Beetle used for deliveries to James for his share of the business. Tom went on to open more stores focusing on pizza and pizza delivery. He focused his businesses on college campuses and even invented a new insulated pizza box for carrying multiple pizzas without them getting crushed. In 1965 he would rebrand to Domino’s Pizza. Tom retired in 1998, selling 93% of the company to Bain Capital. Domino’s would IPO in 2004 at $14 a share. Today the company is headquartered in Ann Arbor, Michigan, employing approximately 13500 people among their corporate offices, company owned stores, supply chain operations, and international operations. Domino’s estimates over 350,000 people are employed by their global franchises. According to consumer spending data, Dominoes has 31% share of the pizza delivery space.
Domino’s prides itself on their ability to provide quality food at competitive prices while leveraging technology to enhance ordering, delivery, and the efficiency of their service. The company primarily acts as a franchisor with approximately 98% of Domino’s stores owned and operated by independent franchisees. The rest are company owned. As of January 2022, Domino’s had 6,185 owned and operated by 735 independent U.S. franchisees. Domino’s holds its franchisees and prospective franchisees to rigorous standards. Some of these standards include requiring them to manage a store for at least one year and graduate from Domino’s Franchise Management program. Franchisees are generally restricted from being involved in other businesses as Domino’s wants them to focus on operating their own store or stores. Every U.S. franchisee signs a franchisee agreement in which they are granted the right to operate a store in a particular location for a term of ten years. Franchisees can renew for an additional ten years and approximately 99% of franchisees do renew which is great to see. Under the agreement, franchisees are required to pay a 5.5% royalty fee on all sales. This percentage can vary depending on how much what is already in the fund and what may be needed in the future. Lower rates are paid if franchisees meet certain incentives. Additionally, U.S. stores are required to contribute 6% of sales to fund national marketing campaigns. These campaigns are operated by Domino’s National Advertising Fund (DNAF) as a non-profit advertising subsidiary. In 2018, changes to the accounting laws required Domino’s to recognize advertising funds from its franchisees as a form of revenue. This will explain the increase in gross margin and decrease to operating margin for that year. These funds are kept on the balance sheet as a form of restricted cash. Funds are also used for market research, field communications, public relations, talent payment and other activities to promote the Domino’s brand.
For international markets, Domino’s has a system in which they grant geographical rights to their brand to “master franchisees”. These master franchisees, in turn, are responsible for developing their geographical area via sub-franchising, selling food and equipment to sub-franchisees, and operating Domino’s Pizza stores. Historically, the Domino’s business model has yielded strong returns for franchise owners and company owned stores.
Domino’s generates the vast majority of its revenue by charging royalties and fees to franchisees. The royalties are charged as an ongoing percentage of sales for use of the Domino’s brand marks. Additional revenues are earned through company owned standalone stores and by selling food, equipment, and supplies to franchisees through Domino’s incredibly strong North American supply chain operations. Domino’s operates under three business segments that include U.S. stores, international franchise, and supply chain.
U.S. Stores – U.S. stores consists of U.S. company-owned stores, U.S. franchise royalties and fees. Management also considers U.S. franchise advertising to be a part of this segment, but I list that as its own segment for ease of comparison. The U.S. stores segment makes up approximately 35% of revenues. In 2021, revenue from U.S. Company-owned stores decreased $6.6 million, or 1.4%, due primarily to a shorter 53rd fiscal week and a 3.6% decrease in same store sales. This is after same store sales were up 11% in 2020 fiscal year. One company owned store was added to the count in fiscal 2021. There were 375 U.S. company owned stores to end 2021. U.S franchise royalties and fees increased $36.7 million, or 7.3% in 2021, due primarily to a 3.6% increase in same store sales and a 193 increase in store count. There were 6,185 U.S. franchise stores to end 2021. Advertising increased $17.3 million, or 3.7% in 2021 due primarily to increased same store sales and an increase in store count of U.S. franchisees as previously mentioned. The U.S. Stores segment managed operating margins well, experiencing a decrease in labor costs as a result of lower head count, increased food costs of 1.1% and slightly increased costs in rent and utilities. Operating margins for Company owned stores were 21.9%
Supply Chain – Supply chain consists of the revenues related to selling the necessary ingredients and goods to franchisee locations. In 2021, supply chain revenues increased $144.3 million or 6.0% due primarily to increase volume and retail sales growth. Operating margin decreased $7.4 million, or 2.7%, due primarily to a shortened fiscal period as well as higher labor and delivery costs. Supply chain makes up around 59% of revenues on average. Domino’s operates 26 regional dough manufacturing supply chain centers, two thin crust facilities, one vegetable processing plant, and one facility that provides equipment. They also lease a fleet of 900 tractors and trailers. Domino’s provides a very efficient supply chain that generally offers the best value and consistency to franchisees. To further strengthen relationships Domino’s supply chain operations offers profit-sharing arrangements to U.S. and Canadian franchisees who purchase all their food from their centers.
International Franchises - In 2021, international franchise operations increased $48.3 million, or 19.3% due primarily to higher retail sales from an 8% increase in same store sales growth and a 999 increase store count. There were 12,288 international stores to end 2021 and international stores have been growing around 9% on average every year. The reported revenues from the international stores can be affected by currency fluctuations. Fiscal 2021 was positively impacted by currency fluctuation whereas 2022 has not been so lucky according to the quarterly reports. I expect currency markets to remain volatile over the next year so watching metrics such as store growth, same store sales, and if possible operating margin will likely be of greater service. Unfortunately, there is little information available on operations in the international markets. I expect that there will be further growth in the international segment in the coming year and Domino’s will also have opportunity to open supply chain operations in certain international regions to better serve and increase revenues of their franchisees. As of January 2, 2022, international stores totaled were India with 1,495 stores, United Kingdom (1,169), Japan (882), Mexico (802), Australia (724), Turkey (605), Canada (568), S. Korea (475), China (472), and France (457).
Compared to domestic stores, international operations do not appear to be nearly as profitable. Domino’s takes in approximately 35% of revenues from around 6643 domestic stores compared to around 12876 international stores that bring in approximately 7% of revenues. International stores also have higher closing rates. I expect that Domino’s will face headwinds in areas of the world where trends of deglobalization are occurring including Russia and China. Domino has stated that it plans to keep their investments in Russia small at this time.
Domino’s business model is focused on cost efficient store models oriented towards delivery and carryout, all the while providing affordable and quality food. They believe that the simplicity of their stores and moderate capital requirements are a competitive advantage. Because of their simplistic business model, Domino’s has been far more successful than its competitors in growing, especially in international markets; India being a great example of this. The ease of their business model and strong economics makes Dominos appealing to a franchisee compared to other opportunities and this results in greater growth. Domino’s uses a strategy called “fortressing” in which they build out new stores and franchise opportunities in already existing markets and regions. At first, I was skeptical to this because it may negatively affect same store sales, but analysis has shown it to be a strong strategy. By increasing their presence in existing markets Domino’s has improved customer service via decreasing delivery areas and times. This results in greater productivity and pay for drivers, decreased turnover, and happier customers which translates into greater incremental sales. I don’t expect this strategy works in every region and market, but it does appear Domino’s has been successful in its overall execution, and same store sales have been in an overall uptrend over the past decade.
A great part of Domino’s success has been their continued pursuit of innovation. Digital ordering and technology has been critical to Domino’s competitive stance with over 75% of sales being made via digital ordering channels. Currently, Domino’s has 13 ways to order digitally including Google Home, Facebook Messenger, Apple Watch, Amazon Echo, and Twitter. GPS capabilities are being leveraged bot only for customer convenience but also to aid drivers in their deliveries and timing of new order pickups. Domino’s has developed its own POS system called Domino PULSE to drive operating efficiencies for our franchisees, corporate management, and marketing. Other innovations include improved pans and kitchen utensils to improve consistency and quality of the pizza, optimized and customer oriented store layouts, corrugated pizza boxes, and delivery Hot Spots for geographical locations without a traditional address. Currently Domino’s is testing the viability of Nuro, a self-driving delivery vehicle. One of Domino’s most initiatives has been their Piece-of-the-Pie Rewards loyalty program. As of the end of fiscal 2021, the loyalty program had over 29 million active members and 70 million customers enrolled. The loyalty program has been successful in driving incremental sales by customers.
Reporting into fiscal 2022 has continued to show overall growth in revenues across Domino’s U.S. franchise royalties and supply chain. Other segments were down slightly, year over year. With that said, retail sales were up .7% domestically and 5.7% internationally compared to the same period in 2021. Same store sales declined 1.6% domestically and .8% internationally compared to same period of 2021. So far into 2022, net Income declined 17.1% with management placing blame on inflationary pressures, labor and fuel costs, and negative foreign currency impacts. Being that wheat is a major ingredient in pizza and Ukraine produced a significant portion of the world’s wheat, I am not surprised by some of these cost pressures. Nonetheless, margins took a heavy hit and I intend to watch how Domino’s addresses these increased costs in the coming year as well as assist its franchisees. Although it is still early, Domino’s results are consistent with that of the slowing economy in the broader market.
Over the past decade Domino’s has grown its revenues an average of 10.3% annually. In 2021 they rolled in a total of $4.357 billion of dough (pizza joke). Earnings per share has an average of 23.4% annually over the same period. In 2014, Domino’s began paying a dividend and has grown that consistently since. Margins have been steady over the past decade with slight improvement in overall net margin. Return on assets has improved overall and return on invested capital has consistently remained above 40%. In my own calculations of ROIC, I came up with a higher figure around 70% but intend to use something lower in my calculation of fair value.
Domino’s negative return on equity makes it tough to value. The company uses leveraged recapitalization to issue debt so that they may repurchase stock. Recapitalization is the process of restructuring a company's debt and equity mixture. Currently Domino’s has leveraged over $5 billion in debt to repurchase shares, service previous debts, and excel growth. Because of this, Domino’s has accumulated a retained deficit on the equity section of the balance sheet resulting in a negative return on equity. Over the past decade Domino’s has repurchased around 40% of its stock. This included a total of 2.9 million in 2021 and 739 thousand as of the third quarter 2022. I estimate roughly $500 million remains available under management’s current share repurchase program. Domino’s management takes a systematic approach to repurchasing shares where the balance sheet dictates when and what funds can be used to return capital to shareholder. On one hand this is nice as, to an extent it, removes bias from the capital allocation process. Unfortunately, it can also lead to repurchasing shares at elevated prices. I anticipate that management will cut back on share repurchases as economic growth slows, and they must pivot to servicing debt with higher interest rates.
At this time, Domino’s seeks to maintain a leverage ratio above five. The 2022 third quarter 10Q states, “In accordance with our debt agreements, the payment of principal on the outstanding senior notes may be suspended if our leverage ratio is less than or equal to 5.0x total debt to adjusted EBITDA, as defined in the related agreements, and no catch-up provisions are applicable. As of the fourth quarter of 2020, we had a leverage ratio of less than 5.0x, and accordingly, did not make the previously scheduled debt amortization payment on our then-outstanding notes in the first quarter of 2021. Subsequent to the closing of the 2021 Recapitalization, we had a leverage ratio of greater than 5.0x, and accordingly, resumed making the previously scheduled debt amortization payment on our notes beginning in the second quarter of 2021.” In my research it seemed that Domino’s previously attempted to keep their leverage ratio between 3 and 5. However the low interest rates of the past few years seem to have encouraged them to greater leverage operations. I expect that Domino’s will seek to decrease their leverage ratio as interest rates continue to increase. Their high degree of leverage is a risk in my opinion and could lead to trouble in the event of a “black swan event”. Currently, interest payments are manageable and cashflows are sufficient to cover debt obligations coming due. As of the 2022 third quarter report, Dominoes has a debt schedule that included $51.5 million due in each of 2023 and 2024, $1.17 billion in 2025, $39.3 million in 2026, $1.31 billion in 2027, $811.5 million in 2028, $625.9 million in 2029, $10.0 million in 2030 and $905.0 million in 2031. Debt obligations are subject to certain financial and non-financial covenants, including a minimum coverage ratio of 1.75x total debt service to securitized net cash flow.
Moving on, Domino’s has grown free cash flows significantly over the past decade. Free cash flow has consistently been used to return capital to shareholders through dividends, share repurchases, and small acquisitions. I expect free cash flow decline and normalize in the coming years but maintain an overall upward trajectory. The payout ratio is sustainable and leaves room for further dividend growth moving forward.
Using a discounted cash flow model, I estimated a fair value of $433. This is assuming a conservative growth rate of 6%, operating margin of 17.5%, ROIC of 45%, and WACC of 6.8%. My estimated fair value gives Domino’s a margin of safety of 18%, at its current price of $355.17. With regard to valuation ratios, Domino’s currently trades towards the low end of its historical price to earnings radio. Price to sales is within its historical range and I am ignoring price to book in this case.
Domino’s is strong company with appealing economics both for franchisees and investors. They continue to drive efficiency in their stores and franchise models via innovation and overall design. The company is cashflow rich, which has enabled for the return of capital to shareholders via dividends, share repurchases, and reinvestment towards furthering growth. Domino’s invests in retaining and building talent because they know that this increases their chances of growing franchise locations. An interesting fact I found is that 95% of Domino’s store and franchise owners started their careers as delivery drivers, pizza makers, and hourly workers. There remains ample opportunity for Domino’s to grow stores in the United States and international markets remain just as much a growth opportunity although they don’t provide the same level of profitability. Domino’s will likely have flat revenues over the next year or two due to the slowing economy, but their future outlook remains bright because of their strong operations. The current CEO of Domino’s is Russel Weiner, who served as president of U.S. operations and COO prior to taking over his current role in May 2022. Domino’s leadership holds strong tenure and experience among its members. Many have held prior roles in board seats on other companies including Starbucks, Clorox, PepsiCo, Philips Electric, Unilever, Focus Brands, McDonald’s, Hyatt Hotels, Subway, and others. In reviewing Glassdoor, and other sites I see that sentiment towards the company is relatively high and that a majority (around 65%) approve of management.
It is important to acknowledge some of the risks associated with Domino’s business model and the current state of the business. One of the more substantial risks associated with Domino’s is the level of debt ($5.07 billion as of this writing) they carry on the balance sheet with respect to their leveraged recapitalization. Although, current cashflows are enough to cover their debt and interest schedule, the level of indebtedness makes Domino’s more susceptible to adverse events in the economy. Their debt is secured by the cashflows of their franchises. Some potential consequences could be redirection of cashflows from operations to servicing debt, disruption of future planning and growth, and difficulty obtaining future credit or downgrades to their credit rating. I intend to watch Domino’s leverage ratio and cashflows moving forward.
Other risks to Domino’s business model include continued labor shortages and food related costs. Through 2022, labor shortages and increased costs were an issue for Domino’s. Disruptions to Domino’s supply chain, such as their dough factory of vegetable processing plant could have negative effects on operation. Domino’s holds its franchisees to strict standards, however poor conduct by franchisee could have a negative impact on the overall brand. Much of Domino’s success is dependent on strong relationships with their franchisees and deterioration of such relationships would negatively affect the company. On both a domestic and international level, Domino’s faces regulatory risks that make it difficult for their franchisees to run. Some such threats increase to minimum wage making if difficult for franchisees to operate, covid shutdowns, taxes, regulatory changes, lawsuits, food compliance related risks, inflation, tariffs, and trade. Domino’s has received pressure to fully close operations in Russia due to the Ukraine conflict but resisted and answered by keeping further investment to a minimum. In a world with greater conflict and trends towards deglobalization we may see increased operational risks on a foreign level (looking at you China). Other risks include the ability to protect intellectual property, cyber security, include insufficient insurance coverage, ESG, and incidents of food born illness or recalls.
The last notable risk I will mention is competition. U.S. pizza QSR’s (Quick Service Restaurant) is a large and fragmented space, meaning one company is not able to exert significant influence to move the industry. Domino’s is the largest pizza chain on the Unites States market but they do face competitors on local, regional, and national levels. Their most notable competitors include Pizza Hut, part of Yum! Brands Inc. ($YUM), Little Caesars, Papa John’s ($PZZA), and Papa Murphy’s Pizza. On an international level, Domino’s most commonly competes with Pizza Hut and Papa John’s, plus other country-specific national and local pizzerias. When held into comparison with their competitors, Domino’s has some of the best revenue growth and returns on investment in the pizza market and is consistently a top pick among prospecting franchisees. With that said, some competitors are not as leveraged as Domino’s is, which certainly reduces risk profile. One of Domino’s schticks has always been delivery and it is an area where the company differs from it’s competitors. Domino’s refuses to sign with third party delivery platforms such as Grubhub, Uber Eats, or Door Dash because of their often-negative economics. Domino’s states that they have never made a dollar on delivery and instead they focus on providing volume and efficiency for their drivers so that they can essentially work for tips. Embracing technology and using GPS and order tracking have been one of the ways that they have driven these efficiencies and propelled themselves past their competitors.
My personal intentions with Domino’s are to open a small position. As economic outlook shows signs of improvement and assuming there is still reasonable margin of safety, I will continue to build a position via dollar cost averaging. I am concerned that as consumer spending declines, Domino’s and the pizza industry in general will report lower same store sales and greater store closures especially in international markets. This may provide for more opportune times to build a position as long as cashflow remains relatively intact to cover debt levels. Domino’s 2022 annual report is expected for mid to late February. Until then, here is a link to some informative FUN FACTS on Domino’s Pizza.
Bon Appétit!