Is Domino's Pizza A Decent Long Term Buy?

| About: Domino's Pizza, (DPZ)
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Domino's Pizza (NYSE:DPZ) is one of the largest global fast food chains specializing in the delivery and carry-out segment. The company dominates these categories holding the top position in a number of countries where it operates. Domino's Pizza has a presence in all 50 states and in more than 70 countries. In addition to its retail network the company also operates 22 dough manufacturing and supply chain centers; 16 are present in the US and 6 are internationally-based.

Due to challenges in its domestic market the company has targeted international markets in order to boost growth in revenues and earnings. Now as the US fast food market shows signs of recovery I believe that the company will be able to leverage its strong position in the US and expanded international network to grow significantly in the coming years.

Source: Ycharts

Despite the company's share price increasing by approximately 80 percent over the course of a year I still believe the company is relatively undervalued. This claim can be quickly verified by observing the company's forward PE and compare it to the industry averages. Domino's Pizza trades at a forward PE of 27.53x compared to the industry average of 37.76x. The company has a PEG ratio of 1.93 compared to the industry PEG of 2.89. I expect that the company will grow its earning in the upcoming years as it further expands its network internationally and shifts towards a more franchised-based operation in the US. This will lead to an improvement in the margins of the company.

Key Growth Drivers:

  1. High growth in the international network with a focus on its core market of delivery and carry out services
  2. Improving store traffic in the US using the higher spending power of local consumers to drive demand in the domestic market; improvements are expected in its top international markets
  3. Continued shift towards franchised operations in the domestic market; increasing its domestic store count by leveraging its expanded supply chain operations to improve performance in the US
  4. Growing revenue per store will drive margins higher and generate sufficient cash flows to sustain growth for the company

Key Risk Factors:

  1. Slower recovery and growth in the major economies in which DPZ operates may result in a poorer than expected performance of the company
  2. Aging population in the largest economies may result in lower spending on dining out which will disable the company's ability to gain high revenue per store and may result in lower margins compared to industry averages
  3. High leverage and contractual obligations may restrict the company's ability to generate sufficient cash flows to finance growth in the future

Industry and Company Performance

Source: NPD Group

Post financial crisis, the US restaurant industry has been slow to recover. High unemployment rates, as well as low consumer confidence and the uncertain economic environment continue to curtail the growth in the number of diners. Apart from these economic pitfalls, the growing consciousness over health issues, generally in the US population, have also suppressed the growth in traffic of US restaurant outlets. Within the US restaurant industry quick service and fine dining restaurants have been the fastest growing. They have been achieving moderately low single digit growth in traffic over the last few quarters.

Source: DPZ Financial Statements

Currently the US market contributes to 47 percent of the company's total global retail sales. These sales have been relatively flat over the last five years and have increased by only 0.3 percent. The domestic revenues fell by a CAGR of 2.5 percent and are the result of declining traffic, and the closing of more than 100 company operated outlets in the last five years. This fall in company-operated store revenues was partially offset by the increase in domestic franchise revenues at a CAGR of 6.1 percent over the past five years. This growth in domestic franchise revenues has occurred despite a net decrease in store count of 18 domestic franchises over the past 5 years. A large portion of the growth is attributed to improving traffic in stores and improving same store sales over the years.

Domestic supply chain revenues have increased over the years at a CAGR of 5.1 percent after initially decreasing in 2009. The largest growth in domestic supply chain revenues came in 2010 in which the revenues from this segment grew by 14.6 percent due to a net increase in domestic store count. This 14.6% increase is compared to a net decrease seen in the analysis of the revenues of other years and also a higher than average increase in same store sales in 2010.

Total international revenues have increased at a CAGR of 11.2 percent with the largest increase experienced in the royalty revenues of international franchises which increased at a CAGR of 13.2 percent over the last 5 years. The international royalty revenues and supply chain revenues have increased over the years due to the continuous expansion of Domino's network in the international markets and also due to a consistent increase in the same store sales of its international outlets. The company has added 2,039 stores to its international network as per Q2 2013 expanding its international store count to more than 5,500. The company's growth in international outlets and same store sales is shown in the figure below.

Source: DPZ Investor Presentation

Domino's has been the fastest growing international fast food chain in the pizza category. It has exceeded the growth of major competitors in its international network. This high growth is evidence of its growing brand recognition and high demand for its products. Due to this high growth the company has been able to take advantage of improving market conditions while its domestic market reached maturity and slow growth due to challenging economic conditions.

Source: DPZ Investor Presentation

The high growth in its international network, same store sales in the international market as well as the improving conditions in the domestic market have enabled the company to increase its earnings since 2007. The graph below demonstrates the company's strong growth in earnings over the last few quarters and a comparison of the year on year results of the company.

Source: DPZ Investor Presentation

Future of the Company

Despite the high growth achieved by the company in the international markets Domino's still has the potential to further expand internationally. A large part of the company's current network is concentrated in the top ten international markets. Thus, the company can still spur growth by expanding into other countries while also increase outreach in the existing markets in which it operates.

Source: DPZ Investor Presentation

The top markets of the company accounted for approximately 74 percent of the total international store count. The graph above shows the company's presence in the top 10 markets, the potential for store count growth in those markets, and the competitive position held by the company in its core delivery operations in those markets. As per the estimates, the company still has the potential to increase its penetration in these markets which will result in added royalties and international supply chain revenue growth. I believe that in the short run the growth of the company will be driven by the increase in penetration in the existing international markets. In the long run the company will achieve multi factor growth through the expansion into other countries, improvement in the domestic market sales, and by continuing to widening expand its presence in existing international markets.

Despite these goals there are certain risks that may hinder the company in achieving future potential. One potential risk is the economic and demographic outlook of the domestic market. The US economy was expected to rebound in the current year and continue growth in the future. However, the growth in the US economy has been slower than expected and many factors such as an increase in unemployment rates, and the federal debt crisis have caused the country to fall short of market expectations. The slower than expected growth may result in a slower rebound and lessened demand for business in the US restaurant industry. This may create problems for Domino's and curtail its ability to grow its cash flows. Apart from this, the increased health consciousness and the aging US population may further suppress growth in the US market. The elderly in the US spend a significantly lower proportion of their food budget on dining out as compared to the younger age groups. As per estimates of Ibisworld, those in the age brackets of 50-60 and 65 plus spend an estimated 42.8 percent and 37 percent of their food budgets on dining out, respectively. Compare those figures to the 44.8 percent of the spent on dining out by 18-25 year olds and 42.3 percent spent by 25-30 year olds. Thus the aging population and the slowdown in spending on dining out may result in slower than expected growth in the US market.

Source: DPZ Financial Statements

Apart from these concerns relating to future growth, Domino's leverage is higher than industry averages and may result in certain difficulties for the company in the coming years. The company operates at a significantly high debt to asset ratio and although the nature of franchised operations usually generates a regular stream of cash flow, the company may face difficulty in satisfying future obligations. Also, the high level of debt in the company's capital structure may result in added restrictions. These restrictions are enforced by the debt suppliers and may limit the company's ability to raise the debt ceiling which may adversely impact its growth prospects.

Conclusion

Domino's has had a strong history of besting analyst estimates over the last few quarters. Thanks to an improving global industry and its Restaurant Performance Index sustaining a level higher than 100 the Company will report better earnings and revenues in the future. Based on my assumptions of a growing international and national franchise network as well as growing store traffic I believe the company will be able to increase revenues. Also, an increased franchise network will help the company in enhancing its margins. My estimates are summarized in the following table.

Based on my analysis I expect the company to beat analyst estimates for the current quarter and current year. According to estimates of the company's earnings and an estimated year earnings multiple of 25x, which is lower than the company's current TTM PE, I have estimated that the company's share price is $69.5. The company does not appear to offer much for the short term but I find that Domino's provides significant upside potential in the long run. However, this potential is dependent upon the company's ability to grow its international network and improve its margins in the coming years. Thus, based on my analysis I recommend buying Domino's stock as a long term investment. For short term investors I would suggest waiting to see if the stock falls below $65 in order to achieve substantial returns.

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.