Domino's Pizza: Don't Get Burned

| About: Domino's Pizza, (DPZ)
This article is now exclusive for PRO subscribers.

Investors in Domino’s Pizza (NYSE:DPZ) have had a great run over the past two years. From a low of less than $3.00/share during the financial crisis, the stock has unceasingly pushed higher, moving briefly over the $28 share Tuesday to another new 52-week high following a better-than-expected earnings release. But the fun is just about over. While Domino’s has made an admirable recovery from the depths of the financial crisis, its current financial profile cannot justify the market’s current valuation of the company.

While the market’s sub-$3 valuation of Domino’s was too low, the company retains a troubled balance sheet, with almost as much debt ($1.4B) as revenue ($1.6B). The company has only $100 million in cash to offset the debt load. Since the company largely franchises rather than owns its corporate stores, the company has little in the way of other tangible assets. Add it all up, and you get a fairly alarming negative $19/share book value. Of course, a negative book value does not imply that a company is worthless. If Domino’s continues to produce strong earnings, the company can still provide value to shareholders despite its flimsy balance sheet.

But Domino’s operating results would have to be a lot stronger than they presently are to justify the company’s lofty valuation and string of new highs. Presently, Domino’s trades at a similar valuation range to competitors such as Papa John's (NASDAQ:PZZA) and Yum Brands (NYSE:YUM) (owner of Pizza Hut). Domino’s trades at a trailing PE of 18 and a forward of 16, which compares unfavorably with Papa John's (trailing PE of 15, forward of 13) and only marginally better than Yum (trailing PE of 21, forward of 16). Domino’s PEG ratio of 1.64 is also the highest of the trio. Domino’s profit margin is only a hair higher than Papa John's’ and is significantly less than Yum’s. There is nothing on the balance sheet or in Domino’s' operating results that justifies the premium investors are paying for its shares versus its direct competitors.

The bullish counterargument to Domino’s weak balance sheet and valuation ratios is that Domino’s is growing more quickly than the competition, This is true, but the difference is not significant enough to justify Domino’s' high stock price. The growth, while definitely positive, is not at a sizzling rate. From the latest quarterly results, we see that net income for Domino’s Pizza, Inc. rose to $25.2 million (40 cents per share) vs. $22.6 million (37 cents per share) in the same quarter last year.

For a company with a hugely negative net worth and a gigantic debtload, incremental increases in earnings are not enough to justify the stock doubling in the past year. The company is already so large, with nearly 10,000 stores in more than 70 countries, that it simply cannot grow very rapidly. And the company may face headwinds from rising input costs in coming quarters. While the company has thus far been able to avoid the impact of higher input prices for goods such as cheese, Domino’s franchisees have had to eat the cost increases. That cannot continue forever. At some point, franchisees will have to make changes to maintain their viability if input costs remain high, and these are likely to cut into Domino’s' bottom line.

Domino’s management has done a great job pulling the company back from the brink of bankruptcy and restoring the fortunes of an iconic brand. But there is a huge difference between a good company and a good stock, and at this point, Domino’s is a poor investment. Domino’s has beaten analyst estimates four quarters in a row, helping to lead the company’s shares to their current overpriced state. When the company inevitably misses expectations in an upcoming quarter, expect a strong and swift pullback in its shares. If you are looking for a pure pizza investment, Papa John's is the much more fairly priced choice as it is also growing earnings acceptably and has a much more stable balance sheet. If international growth is what you are after, Yum Brands is an interesting investment, with its rapid expansion in Asia and multiple strong brands that are gaining international reputation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.