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Are the pizzas better at Dominos?

Companies, Consumer discretionary, Investing Education, Value.able | Comments (33)

Are the pizzas better at Dominos?

PORTFOLIO POINT: Despite the headwinds facing retailers in Australia, Domino’s Pizza is growing and expanding its margins. But is that growth already be priced in?

Retailers in Australia are facing a perfect storm of weak consumer spending, online competition and a rising Australian dollar. But despite these headwinds, there’s one company that is not only expanding its physical footprint, but is becoming a serious force online. It’s also notching up double-digit growth in Europe, in spite of the economic climate, and breaking records to boot. You may be surprised to learn that this success story is in fact Domino’s Pizza Enterprises (ASX: DMP).

Domino’s Pizza listed on the Australian stock exchange in May 2005, and opened its 400th store in the same year. The company is the largest pizza chain in Australia and enjoys a growing presence in France – a country that, with the exception of the United States, consumes more pizza per head than anywhere else in the world – Belgium and the Netherlands, having bought existing operations in those countries in 2006 and becoming the largest Domino’s franchisee in the world. Domino’s Pizza now operates more than 889 stores, employs more than 16,500 people and, according to one report, makes more than 60 million pizzas per year. And all of this is run by a Lamborghini-driving CEO, who is as obsessed about Domino’s today as he was when he merged his 17-store franchise company into what is now Domino’s Pizza Enterprises.

The company’s online strategy has been a raging success, not only for pizza ordering but also for recruitment. When the company launched its iPhone App in 2009, it became the number one free app on the iTunes site within five days. Today, 40% of orders are made online and the company expects this to be 50% in the next six months, with a third of these orders to come from mobile devices.

Domino’s recently reported its half-year results and saw an improvement on almost every KPI. Same-store sales growth was strong, exceeding expectations in both Australia and Europe; margins improved and stall rollouts continued; the balance sheet strengthened, as did free cash flow; and, despite even lower debt, returns on equity increased. Domino’s concluded by upgrading its full-year 2012 guidance.

My friends at American Express should be able to confirm that while fashion retailing is one of the hardest gigs to be in, restaurants and cafes are one of the best. This is something Domino’s Pizza CEO Don Meij would know only too well. Despite challenging economic conditions, particularly in Victoria and New South Wales, same-store sales grew by almost 9% and total sales were up 11.2%. In Europe, where conditions are arguably much worse and youth unemployment is in the high double-digits, Domino’s recorded 12.6% total sales growth and 7.5% same-store sales growth. By the end of financial year 2012, another 60 to 70 stores will have been opened, net profit is expected to grow by 20% (despite adverse currency movements), and same-store sales growth is expected to be in the order of 5 to 7%.

In the last three years, earnings per share have doubled (no doubt the company has also taken market share from its peers, such as KFC) and despite a substantial decline in borrowings, return on equity has increased from 17% to 23% (see Skaffold.com screenshot below)Rising returns on equity, with little or no debt, is an indication of powerful business economics. Generally, as a company gets larger, its returns on equity stabilise or decline. Domino’s, however, enjoys an ability to raise prices and, some say, reduce pizza sizes without a detrimental impact on volume sales. This is, in my estimation, the most valuable competitive advantage it has. Granted, it’s a surprising conclusion to put forward for a franchisee (for a look at how things can go wrong for a franchisee company, look no further than Collins Foods).

Dominos displays declining debt (red columns), rising equity (grey columns), rising return on equity (blue line) and rising profits (green line).  Source:  Skaffold.com

Since 2004, Domino’s profits have increased 40.11% p.a. from $1.954 million to $20.7 million.  To generate this $18.759m increase in profit, shareholders have tipped in an additional $64.37 million of equity and left in earnings of $34.82 million.  In other words every additional dollar contributed and retained has returned around 19%.  During the period under review the company has also reduced its borrowings by $9.11 million from $24.65 million it held in 2004 to $15.54 million at the end of FY2011.

Analysts worry about the risks associated with growing a business in Europe in the present climate. Rising commodity input prices, including oil for delivery vehicles and wheat for flour, and the stronger Australian dollar are also points of concern. In the face of these perceived challenges, the company continues to grow and expand its margins. It also expects greater than 25% profit growth from Australia within three years. Clearly, Domino’s competitive advantages are proving those analysts who said Australia was ‘ex-growth’ wrong. And the company is also moving to electric delivery scooters to hedge against higher fuel prices.

Domino is a high quality business – Source: Skaffold.com

I have not been able to buy Domino’s shares – as much as I would like to – because they have not been cheap enough for me. My valuation is based on the idea that I want to reduce my risks as much as possible by ensuring I obtain a bargain. DMP has simply never traded at a bargain price. But with a price close to $9.00 today, you could (admittedly with the benefit of hindsight) put forward the argument that the $2.65 the shares traded at in 2009 was every bit a bargain. The issue is simply the discount rate that I am willing to use to arrive at my valuation. If I use 8% to 9%, my valuation approximates the lower historical prices. But is 8-9% enough? I think not.

What would you pay for a business earning $25 million this year and $29 million next year, perhaps $35 million the year after that? If you said $300 million or $350 million, I’d label you a value investor, but today the market capitalisation is more than half a billion dollars. At that kind of multiple, I would guess the growth has been ‘priced in’. I would rather be certain of a modest return than hopeful of a great one, and at current prices – despite the obvious track record of the company and the very great skill of its management – I think buyers are being hopeful. Unless, of course, they know a takeover is imminent.

Posted by Roger Montgomery, Value.able author, Skaffold Chairman and Fund Manager, 27 March 2012.

INVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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33 Comments

  1. Macca McLennan
    :

    Domino’s Ordering Fantastic

    I just press the button on my IPhone
    say “Call Domino’s”
    In no time i have the nearest store
    And then place my order

    This seems to happen regardless to where i am.

    So Quick So Easy So Simple

    Just wish the shares were lower in price
    so i could buy some

  2. Ash Little
    :

    Hi Roger,

    Nice post

    The company is definitely more appealing than the pizzas’ in my humble opinion.

    Eagle Boy’s are far superior.

    Cheers

  3. Ian Bowditch
    :

    If I had half a billion dollars, I’d just keep doing what I’d done to earn it, not play double or quits making Pizzas.
    Regards Ian Bowditch

  4. Pete Abela
    :

    Hi Roger,

    DMP has long been on my watchlist, but has never floated anywhere near to the top because it has never reached a suitable margin of safety. I suppose you could mount a similar argument that you did for Cochlear (ie it’s always over intrinsic value so make an exception when the price drifts close to intrinsic value, rather than waiting for a sizeable discount).

    However, I’m not smart enough to know which companies warrant making an exception for so have traditionally left this company (and COH) alone.

  5. Simon
    :

    Its been nearly six months since your blog on that other fast food mis-adventure (The largest KFC franchisee (by number of stores) in Australia ) the newly-listed Collins Foods (ASX: CKF).

    Since then CKF share price has fallen from $2.50 to $1.15!
    Yet at the same time Dominos has grown from strength to strength.
    Is there value in CKF as a possible turnaround success story or is this just a broken business model struggling to capture market share it had already lost?

    • Roger Montgomery
      :

      Picking turnarounds can be very rewarding but its a much harder investment strategy and far riskier too. Of course you could wait for evidence of the turnaround but by then the share price will have risen significantly. Some investors watch trading volume and look for spikes that indicate someone has taken a sizable interest (eg:VDM Group recently). But of course someone must have sold down too and in equal volume. (Note: Some of the individuals at Montgomery Investment Management own VDM Group (VMG)).

      • Michael
        :

        Hi Roger,

        I was really surprised to hear Russell talk about VMG on YMYC the other night after taking one look at it in Skaffold. It doesn’t seem like the type of business that you guys normally talk about.

        Cheers,

        Michael

      • Roger Montgomery
        :

        Hi Michael,

        You are right. Everyone on the team however is free to chat about whatever interests them at the time. VMG is being paraded around to fundies by the brokers as a turn around.

      • Michael
        :

        Thanks Roger. I think it was the same show (or maybe the one before) where the prospects of MCE were discussed. You or Russell mentioned that you were putting a question into Chevron to determine why they don’t use any MCE products. Did you get a satisfactory answer that you can share?

        Until I can make a better judgement on the future prospects of MCE, it will remain in the speculative part of my portfolio.

        Thanks again.

        Michael

      • Andrew
        :

        Hi Michael, i understand your point.

        In addition to Rogers reply, i think there is a difference as to what you may personally invest in and what you would invest in if you were managing other peoples money as part of a fund.

        I know there are definitley some businesses which i would like to own personally but if i was managing a fund for other people i would not consider them due to their being perhaps a higher level of risk involved.

      • Mick
        :

        I agree entirely with those comments in relation to turnaround companies.They are higher risk and you should not enter unless you have a clearer picture via company announcements.I will usually watch these companies and wait for an improvement in cashflow or half/full yearly results.In the case of a company such as QTG cash flow was an indication of improvement.You may also see director buying which was seen recently on SYM.But these are only indications that things maybe getting better and I would advocate you do a lot of research and know the company like the back of your hand.Even contact the company to ask a few questions about how things are progressing.

    • Ash Little
      :

      Just my humble opinion but Collins is rubbish…………Just move on to better and brighter prospects in my my view.

      Next……………P

      Cheers

  6. Boon
    :

    Hi Roger,

    I remember you told me there is a big difference between being a franchisor and franchisee, so just wonder if DMP is franchisor or franchisee in Australia? Thanks

      • Boon
        :

        Hi Roger,

        Previously, you mentioned that franchisor is a lot of more profitable than franchisee in franchise hierarchy. That is the reason for CKF.

        What puzzles me now is that, from my understanding, DMP is also a listed group of franchisee enterprises. So if my understanding were to be right, this would mean that DMP would also encounter the same problem, less profitable.

        What I can differentiate between DMP and CKF is their business model, ie. online order system and delivery where we cannot get it from KFC. But KFC does have a different business which is operating 24 hours as well as having drive-through option for faster processing. I presume online order system and and delivery are much more superior than other approaches currently employed by KFC which has therefore been interpreted into consistent share price surge over the years.

        So, just would like to clarify if my understanding were correct with you. DMP and CKF are both groups of franchisee enterprises and the reason why DMP is A2 is because of its business model. Am I right?

        Many thanks, Roger.

  7. Wayne
    :

    Some comments I would make in terms of competitive advantage:
    Australia and the European businesses are 2 quite different business models. Firstly in Australia Domino’s specifically went out and established pizza shops in designated areas to prevent competitors from beating them to a land grab. For example, Bundaberg might be a 2 pizza store town so Domino’s made sure it was in there first hence why there are so many company owned stores for a franchise model business. Eagle Boys have been around for every bit as long as DMP so it appears there is room for both and as long as they remain rational competiltors.
    In Europe where the market is far more mature in terms of store sites the market is very fragmented and the profits will come from a commisary style model. That is, the dough is made by the commisary and sold to the franchisees making a profit in the process. In Australia, by comparison, all the dough is made in the stores and the distances prevent the European model being used. In France Domino’s is alredy the largest chain and hence the first pizza business to be able to afford to advertise on television – a huge advantage over mum and dad stores.
    Add in the technology of the internet ordering and the cashflow benefits because the funds go straight to Domino’s rather than the franchisee is another reason to like the business..
    The biggest risk in my opinion is if the US parent gets a bit envious and tries to take away or somehow restriict their franchise agreement here and in Europe – witness the problems Jack Cowin (coincidentally a big shareholder in DMP) is having with KFC.

  8. Andrew
    :

    I have had a look at Domino’s in the past and for some reason i just can’t be satisfied with them. Maybe it is because their CEO owns and drives a Lambourghini and my stereotypical views of people who own such cars do not fit with the personality traits i would like running a company i am invested in. However in saying that if it wasn’t for Channel 10’s show undercover boss i would not have known about it and he did come accross that episode with a passion for the business as you mention which can only be a good thing.

    The other thought as to why it just hasn’t made it further in my analysis is perhaps what people have already spoken about. Barriers to entry are low, there are a number of businesses coming up which can compete such as Eagle Boys, Crust etc.

    I will have another look at them when they report their FY results as they are a company where i can see many attractive attributes. Their brand is strong and their online systems seem to really be working well for them and is obviously the future so the fact they saw this and have taken advantage of it is a big tick for management.

    As i mentioned, i look at them every year but just can’t give the thumbs up. I will have to see what my thoughts are this year when they report their FY results, especially as now i have such a tighter philosophy and analysis framework that will help take some perceptions which might not be reality out of the equation.

  9. Matty
    :

    Hi Roger,

    Just wondering if you could comment on the return on incremental equity (ROIE) figures that you are calculating there at 19% from 2004. Is this an indicator that you can give some insights into business performance from one year to the next or do you tend to look at over the longer term as you do here over 8 years. I guess there is some element of how long it takes for the company to utilise the new equity in the business to generate new profits and that it may take more than the course of a single financial year.

    Do you also take note of the actual magnitude of the ROIE (19% good or bad?) or is it the relative change that you are looking at over time (ie increasing or flattening out)?

    Thanks,
    Matt

    Thanks, now I see how easy it is to calculate that number in Skaffold as it was just what I was looking for.

  10. Luke
    :

    Hi Roger and bloggers,

    Back in my university days this is a company I worked for. Reducing pizza sizes is not the only reason I beleive the return on equity has been increasing over time. Here are some other reasons I beleive returns have increased over time:
    Cheese is the most expensive ingredient on a pizza by far. Dominoes removed the cheese pizza from the menu. If you ask for it they will make it however. This drastically reduced cheese pizza sales which were by other flavours with higher margins.
    Friday and saturday nights are a very high portion of weekly sales. Phone operators typically can not keep up in these peak periods which results in a loss of customers who hang up or order something else. The introduction of the online system helps to remove this problem as it frees up telephone operators.
    The managment of the company are also very good at getting good value from their suppliers. I also remember them changing to an inferior cheese to save money.

    My personal opinion is that the dominoes pizza business could be replicated and I do not see any kind of long term advantage over its future competitors.

    Luke

  11. Hiten
    :

    Roger, the question I always ask myself is if someone had half a billion dollars (market cap of domino’s), would they be able to put a serious dent in domino’s market share? Unfortunately, in my opinion the answer is yes.

    Have you heard of another pizza franchise called Eagle boys pizza. I have heard they are expanding at a very rapid pace and are direct competitor to domino’s. It has 335 stores Australia wide with over $200m in revenue. Not that far behind domino’s. I believe it is a private company and if it goes public with the extra money it raises from IPO it can definitely hit hard at domino’s healthy profit margins.

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