Why Domino's Shares Are Due To Flatten Out

| About: Domino's Pizza, (DPZ)

Domino's Pizza (NYSE:DPZ) has seen some incredibly bullish activity over the past few years. Since the start of 2009, shares are up over 920 percent on a very consistent upward trend. In the past 6 months alone, shares have increased 25.44 percent, which beats the S&P 500 by 18.82 percent. This sharp rise in stock price can be attributed to the company's bold growth strategies that have caused per annum earnings growth of 26.06 percent over the past five years. In this article, I explain why this trend may not continue going forward.

Domino's has experienced a lot of success in recent years, but the company's opportunity for growth is starting to diminish, and Domino's stock price has not yet adjusted to compensate for its lower future growth. Domino's is expected by analysts to grow earnings by 14 percent per year for the next 5 years, but has a December 2013 forward P/E ratio of 19.63. To compare this to another restaurant chain, Chipotle Mexican Grill (NYSE:CMG) has a December 2013 forward P/E ratio of 25.14, but is expected to have significantly more growth over the next five years (20.2 percent) and unlike Domino's, still has plenty of room for international expansion.

Believe it or not, 52 percent of Domino's stores are located outside of the United States. In fact, Domino's has grown its international presence faster than any other major U.S. chain. The largest source for growth among Domino's competitors like Yum Brands (NYSE:YUM) is in the international market. Looking at the fact that Domino's only has 6 supply chain facilities internationally compared to 19 facilities in the U.S., it may be true that Domino's is running out of room to expand outside the country. Domino's can, of course, build more supply chain facilities internationally, but the money, risk, and time involved in this sort of investment means new locations may take years to be profitable enough to contribute to the bottom line and generate a return for shareholders. The company has grown its international store count by an average of 8.45 percent per year since 2006, and same store sales have been in the mid-single digits. This kind of growth will be very difficult to continue with so many competitors aggressively attacking the international market.

Looking at its domestic business, Domino's current market share is too high to expect reasonably high earnings growth. According to a January 2013 sales presentation, Domino's has 22 percent of the pizza delivery market share. All other major chains combined have 29 percent market share. The rest of the market is controlled by individual businesses and small chains. Pizza delivery is a highly fragmented industry, and it is unlikely that Domino's can penetrate any further. It will also be hard for the company to ever penetrate the sit-down market since its current stores conform to its delivery model and square footage is minimized. Same store sales are increasing by about 3.3 percent per year, which is well below the mid- to high-single digits mark that most high growth restaurant chains achieve.

Domino's hopes to add value to shareholders through 3 financial activities: deleveraging, repurchasing shares, and paying dividends. In its deleveraging effort, Domino's reported a total debt to EBITDA ratio of 5.0 in Q3 of 2012, which is much lower than its 2008 number of 7.7, but still higher than its leverage from 2000 to 2006. The company approved a $200 million share buyback program in July of 2012, which accounts for less than 1 percent of its market cap. Domino's has no regular dividend, but paid a special dividend in early 2012. A regular dividend may lure some dividend investors away from Yum! Brands, but right now, there is no way to speculate on this.

Currently, I put a hold recommendation on Domino's. The company in and of itself has been very successful, but its shares are priced too high for it to be a good investment right now. I expect shares to underperform the market from 3 to 5 percent over the next year. The company reports earnings on February 28th, so it will be interesting to see if Domino's will continue its strong growth trend or show its first signs of maturity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.