Updated: Mar 4
Domino’s Pizza Inc is an American, multinational pizza chain headquartered in Michigan. It is the world leader in pizza delivery, with more than 1 million customers enjoying a Domino’s pizza across every inhabited continent each day (more than 500 million pizzas are sold by Domino's worldwide every year). The coronavirus created a boom in orders for Domino’s delivery chains globally, as a large proportion of us became confined to our living rooms. However, the stock market has now focused its interest on ‘re-opening' plays (companies that will benefit from the removal of public restrictions) as opposed to ‘stay at home winners’, and Domino’s Pizza Inc’s stock is now 20% down from its recent high. This article seeks to analyse whether Domino's is worth buying at current levels.
Domino’s revenues are derived from the following sources:
Domestic and International franchise royalties.
Retail Sales from Company-owned stores.
Domino’s Pizza Inc is primarily a franchise business, with approximately 98% of its stores owned and operated by independent franchisees. This helps to keep the business capital-light and allows for the efficient investment of capital from the parent business. Domino’s Pizza Inc is not to be confused with its UK-listed peer ‘Domino’s Pizza plc’, which is a ‘Master Franchisee’ of the parent business in the U.S.
In the U.S., stores are primarily franchise operations, with 5,784 franchised Domino's retail units located in the United States alongside 342 U.S. company-owned stores. Franchisees of U.S. stores pay a license fee to Domino’s Pizza Inc; in 2020 these fees amounted to just over $500 million. In return, Domino’s Pizza Inc advertises the brand on behalf of all franchisees through centrally-owned marketing campaigns.
Their international franchise segment is made up of 10,894 international franchised stores. Stores in eight of Domino’s Pizza Inc’s top ten international markets are operated by master franchise companies that are publicly traded on stock exchanges. These master franchise companies account for approximately 63% of Domino’s international stores. Domino’s master franchise agreements generally last for ten years and allow the franchisee exclusive rights to develop and sub-franchise stores. They are required to pay a continuing royalty fee as a percentage of sales, which averages around 3.0%. This international business is potentially more lucrative for Dominos as they are not responsible for advertising in the international market — that is the responsibility of the master franchisee. Therefore, international royalty revenue is almost pure profit.
Domino’s Pizza Inc’s Supply Chain business segment accounted for 58% of Domino’s revenues in 2019. These Supply Chain centres produce fresh dough and deliver quality ingredients to virtually all of Domino’s U.S. stores and most of its Canadian franchised stores, regularly supplying over 6,600 stores with various food and supplies. Franchisees can choose to obtain food ingredients directly from these centres — and if they do so, they will benefit from profit-sharing arrangements. Margins are lower in this segment due to the high costs related to running this supply chain. However, over time Domino's can build scale and leverage the sunk cost of this supply chain to improve margins, whilst also keeping franchisees purchasing ingredients from the parent company.
Domino’s growth in the years ahead will be derived from increased store unit growth both in the U.S. and internationally — in Domino’s 2021 investor presentation, management stated that they believe they can squeeze approximately 1700 more stores in the US and over 5000 more stores in its top 15 international markets. At the current level of around 800-1000 openings a year, Domino's still has significant potential to increase its global footprint even within its current top markets. I would expect more growth to come in the subsequent years from emerging countries such as those in South Asia and South America.
Looking at its financials, Domino’s Pizza Inc has increased revenues on average 13.7% per annum in the last few years. Operating margins are currently at 17.7% — a very solid level of profitability. Due to the nature of Domino’s franchise model, return on capital employed (ROCE) is usually above 50% with a 66% ROCE figure in 2020. Typically, franchise models allow for high returns on capital because the assets are owned by franchisees and royalty payments deliver a high level of profitability.
However, Domino's does have quite a large debt position on its balance sheet — around 4.8x EBITDA. This is much higher than a typically listed company and is a result of a series of ‘recapitalization’ events in the years after private equity firm Bain Capital listed Domino’s on the stock market in 2004 with a large debt balance. Domino’s has typically used its cash to invest in the business and re-purchase Domino’s stock, which has served shareholders much better to date than paying down the debt. Standard and Poor’s ratings agency recently gave Domino’s debt a BBB+ rating, for which they justified Domino’s +50 year operating history, highly franchised business, steady royalty payments and consistently growing net units as allowing for a relatively low-risk outlook for holders of Domino’s Inc’s debt.
Although Domino’s debt may be secure for bondholders, as a shareholder, debt is still debt! And a leveraged balance sheet can be cumbersome for a business in the years to come. Domino’s has essentially avoided paying this debt since its market re-listing and it has swelled to roughly four times the initial balance in 2004. I would imagine the strategy Domino’s wishes to deploy is to grow significantly for many years, which will in turn reduce the leverage ratio as profits end up significantly higher down the line. However, Domino’s has been continually adding to its debt balance even as profits have been increasing, meaning that over its recent history the leverage ratio has not come down.
A few scenarios could ensue for Domino’s and each scenario carries different risks for shareholders. The first scenario would be that Domino’s is able to keep growing at the rate it has been whilst interest rates are kept to a minimum level. This would see Domino’s able to grow scale and slowly deleverage over time, providing a minimal impact to shareholders. This relies on consistent growth, which is probably likely. However, the key factor in this scenario are interest rates remaining low, thus the cost of servicing the debt would be minimal and cash would be better deployed elsewhere. The event of interest rates staying at these historically low levels for the long term is probably less likely, but in all honesty, it is very difficult to predict.
The second scenario carries more risk to shareholders. If interest rates rise significantly in the years to come, this could cause a significant profit headwind for Domino’s as the cost of financing their debt rises. It may still make sense to deploy cash in other areas if the company is growing, but the level of debt would likely be of more risk to the company and become a priority for management.
Lastly, the worst scenario would be that Domino’s top-line growth begins to slow and interest rates rise simultaneously. These two factors could be correlated — for instance, an increase in interest rates may cause less capital investment and mean that fewer franchisees are willing to invest in new Domino’s stores, which would have a knock-on effect on Domino’s royalty revenues.
Whilst the leveraged nature of Domino’s has provided tailwinds for Domino’s in recent years, it does present a higher risk to shareholders, and thus reduces the investment case for the company.
The recent drop in shares has reduced the stock to reflect a valuation of 26 times estimated earnings in 2022. For this price you have access to a growing, quality business with superior operating metrics. However, a keen eye needs to remain on Domino's debt balance and on monitoring the wider economic environment to ensure the debt scenario works for you.