6 Reasons Why Domino's Pizza Is Not As Appetizing As It Looks

Domino’s (DPZ) is the largest pizza operator in the U.S. All of its domestic stores and most of its international stores do not offer a dine-in option so its stores are very small and lean. That gives it a cost advantage compared to other pizza delivery operations that have dine-in sections.

It has two basic operations in the U.S. where it makes money; first the franchises that sell the pizza, and second the domestic distribution center which manufactures dough and distributes food. Domino’s has its own fleet of tractors and trailers to help it distribute the food to its franchises.

Purchasing food from the domestic distribution centers is voluntary, but almost all the franchises purchase food from them anyway. This helps create cohesiveness.

Usually there is some kind of negative news or just a negative cloud surrounding a stock to make it a Magic Formula Stock, but Domino’s is unique in that it just completed a recapitalization plan that included a $13.50 special dividend. Well, the special dividend was just completed, the stock price dropped and now it’s just trading for $18.73 compared to over $30 per share before the dividend.

But before I go any further, I have to clear this up. I ran the screen for top 25 stocks with a market cap over $100m and DPZ was on it; it should not be because the screener is not taking the new post-recapitalization $1.7 billion of debt into account, as the recapitalization closed in the 2nd quarter. The last available quarterly statements do not take this into account. The pre-tax earnings yield should actually be about 7%. Here is the calculation involved:

EBIT last 4 quarters = $199.2 million
Enterprise Value = $1.7 billion in debt + $1.2 billion in market value
Pre-Tax Earnings Yield = 6.9%

Industry

The pizza U.S. quick service restaurant industry is very competitive. Domino’s main competitors domestically are Pizza Hut, Papa John’s (PZZA) and other local pizza restaurants. Internationally it competes with Pizza Hut and other local restaurants. Domestically, it's the #1 pizza delivery company with a market share of 19% based on dollar value. This is a very stable industry, growing at the rate of inflation, maybe even a bit higher.

One issue I see with the pizza industry in general is that it does not follow any of the major trends happening inside the country. I don’t know about the rest of the world. People are becoming more health conscious and that will ultimately hurt the pizza industry. Basically, pizza goes against one of the major trends sweeping across the country.

Company

Domino’s has been making pizza for a while, almost half a century. In 1998 Bain Capital acquired a 93% stake in the company and in 2004 it went public, probably so Bain Capital can cash out of its big investment. It has economies of scale in its food manufacturing unit for its retail stores because of its big market presence, which gives it a cost advantage over smaller competitors. It's very unique in its treatment of franchises because a majority of the time a person has to work/train in the Domino’s system for some time before he/she is allowed to become a sole operator of a franchise. It promotes entrepreneurship inside its franchisees.

Domino’s Pizza is a strong brand being one of the most known consumer brands in the world. It spends a lot of money on advertising, over the past 5 years investing an estimated $1.4 billion in the United States. Domino’s also has marketing affiliations with NASCAR and Coca-Cola (KO).

It plans on growing through the growth of its store count. Additional stores will not cost a lot of money due to the size of the stores and the distribution system available. Domino’s has been struggling with its domestic stores same store sales growth. It was negative in 2006 and just in the past quarter it was negative as well. Its domestic distribution system and its international operations have been the two growing areas of the company.

Something to keep in mind: it is currently a defendant in a couple of lawsuits all accusing it of bad working conditions with regard to breaks and meal time.

Valuation

One major factor that bothers me about Domino’s is its debt load, which is $1.7 billion; over half of the company is financed by debt. Its P/E earnings ratios look good at 13.58 for the trailing twelve months and 14.64 for fiscal year 2008. 2.9% of the company is owned by insiders. It has an attractive dividend yield of 2.6%. Domino’s is a great cash generator; cash flow from operations for the past 3 years has been higher than net income.

One great part of Domino’s is that it does a great job managing its working capital. Historically, it has had very little or negative working capital. This is because it receives its receivables a lot faster than it has to pay its payables.

Papa John’s is trading at an earnings yields of over 10% compared to Domino’s of almost 7%. Its cash flow from operations(ttm)/enterprise value is 22.3%. Domino’s cash flow from operations(ttm)/enterprise value is 9.7%. Analysts expect PZZA to grow its earnings a bit faster than DPZ in 2008 compared to 2007 earnings expectations.

Conclusion

There is a whole list of issues I have with Domino’s:

1) Huge debt load
2) Not a “real” top 25 magic formula stock
3) Lawsuits it's facing in regard to working conditions
4) Facing the health trend head-on
5) Pizza is not that good
6) Overvalued compared to Papa John’s

I would not be a buyer of DPZ.

Disclosure: I don’t have a position in DPZ.

DPZ vs. PZZA 1-yr chart: