Domino’s Pizza: Delivering A Superior Business Model

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This company saw large market share gains throughout the pandemic and is positioned for years of more profit growth, but its stock has fallen 30% year to date and is trading at pre-pandemic levels. The company is mischaracterized as a restaurant chain when it is really more of a supply chain operator and consumer marketing firm. Domino’s (DPZ) is this week’s Long Idea.

Domino’s stock presents quality risk/reward given the company’s:

  • position as the world’s largest pizza chain
  • consistent market share gains
  • efficiencies from its integrated delivery system that third parties cannot replicate
  • ability to overcome current labor shortages over the long term
  • superior profitability to peers
  • valuation implies the company’s profits will permanently fall 10% from current levels
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Cheapest PEBV Ratio Since 2013

Like many companies that grew sales during the pandemic, Domino’s Pizza’s stock price soared ~50% above pre-pandemic levels. Then, as traders unwound their pandemic trades, the stock has tumbled 30% year-to-date and now trades below its price-to-economic book value (PEBV) ratio (0.9) for just the second time since 2013. See Figure 1 .

A PEBV ratio of 0.9 means the stock is priced for profits to immediately fall and permanently stay 10% below 2021 levels, which as I’ll show below, is highly unlikely. For more details about the upside embedded in Domino’s stock price, see the scenarios analyzed using my reverse discounted cash flow (DCF) model in the valuation section.

Figure 1: Stock Price and Economic Book Value per Share: 2013 – Current

Proven International Force

Domino’s has more than 18,800 locations in 90 different markets around the world. Domino’s US and international retail sales have each grown by 10% compounded annually over the past 10 years. Per Figure 2, Domino’s international segment accounted for 51% of its global retail sales in 2021.

Global reach exposes the company to geopolitical risks but a wide geographic dispersal limits exposure to individual countries outside the United States. For example, Domino’s risk from rising tension between China and the international community is limited as just 5% of its international stores are in China.

Figure 2: International and US Retail Sales: 2021

Franchise Model Drives Store Count Growth

Domino’s is thought of as a restaurant chain, but the company owns just 2% of its stores. The company generates revenue from franchise royalties and its supply chain operations in the United States. Dominos is more of a supply chain operator and consumer marketing firm than it is a restaurant chain.

This franchise model is beneficial to investors because it enables the company to efficiently manage its capital while having the flexibility to pursue strong growth opportunities. For potential franchisees, the company offers a streamlined operating model, national marketing campaigns, and a cash-on-cash return of investment in three years or less.

Clearly the opportunity is attractive to franchisees globally because the international market has been the main driver of store growth. Per Figure 3, Domino’s grew its store count from 11,629 in 2014 to 18,848 in 2021.

Figure 3: International and US Store Count: 2014 – 2021

Continued growth in the global Quick Service Restaurant (QSR) market will support Domino’s global retail sales growth. Research and Markets expects the global QSR market to grow at a 4.9% CAGR from 2022 – 2027.

Domino’s continues to see opportunities for profitable store growth. The company believes the US market has the potential to grow to 8,000 stores, compared to 6,560 at the end of 2021, and its top 14 international markets could add an additional 10,000 stores, which would nearly double its international store count.

Taking Control from Start to Finish

A key contributor to Domino’s success as a franchisor is the control exerted over its product quality and customer experience, from end-to-end. Here’s how the company maintains that control:

  • Supply chain: Supply chain operations provide quality-assured ingredients at competitive costs, freeing time for franchisees to manage other parts of the business. For example, Domino’s delivers mixed dough to stores, saving operators a time-consuming preparation step.
  • Franchisee selection: Over 95% of the company’s US franchisees started as drivers or in-store employees. The company requires franchisees to have extensive Domino’s and management experience. By being selective, Domino’s protects its brand with franchisees who understand its business model and culture.
  • Delivery: Domino’s operates an efficient delivery system that ensures customers gets a hot, quality product delivered in a timely fashion.

By taking ownership over the entire process, Domino’s eliminates cost inefficiencies and maintains a consistent quality level across its entire business.

Digital Business Enhances Customer Experience and Profitability

Domino’s digital capabilities enrich the customer experience by offering quick and easy ordering options, a rewards program, exclusive digital-only deals, and a voice ordering application. Digital orders create more customer engagement, ensure a more consistent customer experience, and drive higher sales against lower costs. Domino’s carryout tickets that are ordered online are 25% higher than those ordered over the phone, and are less labor-intensive, which is helpful in a tight labor market.

Domino’s digital capabilities paid off when customers relied upon ecommerce channels during the pandemic. Per Figure 4, retail sales generated through Domino’s digital channel rose from 60% of total sales in 2017 to 75% in 2021. For comparison, McDonald’s systemwide sales from digital channels in 2021 were ~25% of systemwide sales in its top 6 markets.

Figure 4: US Digital Retail Sales as a Percent of Total US Retail Sales: 2017 – 2021

Equipped to Navigate Pandemic Disruption

Domino’s large digital presence, integrated supply chain, robust delivery service, and carry out capabilities made the company ideally situated to strengthen its market position during the COVID-19 pandemic. While weaker competitors struggled to reach customers during the pandemic, Domino’s market share soared from 1.6% of the global quick service restaurant (QSR) market in 2019 to 2.2% in 2021.

Far from being a recent anomaly, Domino’s strong business model was taking market share long before the pandemic. Per Figure 5, Domino’s grew its share of the global QSR market from 1.1% in 2012 to 1.6% in 2019. A strong business model positioned the company to benefit when other businesses were retreating. This is ground won that Domino’s will not likely give back post-pandemic.

Figure 5: Share of Global QSR Market: 2012 – 2021

Industry-Leading Profitability

Domino’s business model not only generates impressive top-line growth, but it also industry-leading invested capital turns and return on invested capital (ROIC). At 59%, Domino’s trailing-twelve-month (TTM) ROIC is 1.6x its closest competitor. See Figure 6.

The company’s high ROIC isn’t just the result of a one-time pandemic boost either. The company’s 5-year average ROIC is actually slightly higher at 60%. Looking at the entire S&P 500 reveals that only four companies have a higher 5-year average ROIC than Domino’s.

Figure 6: Domino’s Profitability Vs. Peers: TTM

Steady Economic Earnings Growth

Domino’s continues to create shareholder value as it expands its business. The company has generated positive economic earnings every year since going public in 2004. More recently, Domino’s economic earnings grew from $151 million in 2011 to $627 million in 2021.

Figure 7: Economic Earnings Since 2011

Healthier Eating Is Not a Big Risk

The company’s operation is specifically configured to the mass production of quality pizza, which limits direct competition from most other QSRs. However, such dependence on one product means the company’s success is also tied to the popularity of pizza.

The rise of health consciousness poses a threat to the industry that serves loads of highly caloric carbs, fats, and processed meats. A change in dietary habits toward healthier options could pose a long-term headwind for the industry and its largest supplier. However, this threat is not likely to keep the pizza market from growing. Despite an ever-increasing array of diet and healthy eating options, the American QSR pizza market grew from $35.9 billion in 2016 to $40.6 billion in 2021.

Furthermore, Domino’s experience with innovation means that it can offer better-for-you options, such as gluten-free crust, should consumer preferences shift away from traditionally made pizza.

Rising Costs Could Hurt Margins But Drive More Market Share Gains

Management noted in its 4Q21 earnings call that it expects Domino’s US stores to see up to a 10% increase in its food supply costs. These rising costs will have an immediate impact on stores’ profitability. The company will also feel the negative…

Credit: www.forbes.com /

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