Domino's Pizza: The Greatest Of All Time?

Summary

• Domino's is benefiting from the increase in mobile ordering.
• DPZ is dominating the global pizza franchise market.
• With the increase in domestic franchise growth, expect supply chain growth as well.

Investment Thesis

With the consolidation of a highly fragmented pizza market, companies who focus on technological advancements and high quality, low prices food are poised to dominate for the foreseeable future.

Catalyst

• Increased ordering through mobile platforms
• Franchise expansion

Catalysts Continued

Domino's (NYSE:NYSE:DPZ) is the leading technologically advanced pizza chain when it comes to how customers are able to access their brand. More than half of the companies U.S. sales are placed digitally and about 45% on average internationally. DPZ is currently accessible on more than 15 digital platforms. For example, a customer can order a pizza by simply texting a pizza Emoji to "DPIZZA". Other platforms that support digital ordering are the Amazon Echo, which allows the customer to speak to order a pizza without talking to a live person. Food from Domino's can also be ordered over twitter with a simple "tweet". The benefits of having technology work for the company is the elimination of wasted productivity answering phone calls and getting orders incorrect. With this new technology, customers can go on almost any smart device and place an order through Dominos in less than 30 seconds. The increase in productivity will allow the employees to focus more on processing the orders efficiently and less time manually taking orders, which we believe will have a positive effect on operating margins over time.

Along with Domino's technological advancements, the company has a business model like no other pizza chain. The company has roughly no overhead expenses unlike most of their direct competitors. This limited overhead is contributed to the number of stores the company actually owns, which only accounts for around 3% of total stores. The rest of the 97% of stores are franchise owned.

The large concentration of franchised owned stores creates steady cash flow generation for DPZ. Domino's franchise revenue is generated through three revenue streams. First, all franchise locations are to pay a royalty of 5.5% of sales (regardless of their profits). Second, a 6% of sales fee is tacked on to cover marketing and advertising costs. And third, a $.21 charge is to be taken from each digital sales transaction domestically and a slightly higher price for international. A royalty for all digital sales is paramount for the company as 55% of all orders in Q3 '16 (up from 50% in Q2 '16) were digital vs 20% for the restaurant industry as a whole. Pizza Hut, Domino's largest competitor, for example, had roughly 46% of their sales coming from digital platforms in Q3 '16. Going forward we feel Domino's can capture 80-90% of their sales through digital channels over the next 2-3 years.

In addition to the franchise revenue mentioned earlier, Domino's also has an in-house ingredient supply chain. The supply chain consists of dough manufacturing, which they sell and deliver along with ingredients, and supplies to over 99% of their domestic locations. DPZ supply chain accounts for over 60% of the company's revenue, this figure has been increasing over the past years with new domestic store expansions. Comparatively, Papa Johns has their own supply chain, which only makes up around 40% of thier total revenue. The largest impact on DPZ supply chain revenue is commodity prices. Domino's passes all their commodity price increases onto their storeowners with a fixed dollar margin. For example, cheese in 2014 rose to over $2.10 from $1.77, DPZ passed that cost down which lifted supply-chain revenue by roughly $8.6 million or 7% of supply chain revenue that year. Having a designated supply chain allows for consistent quality products and allows the stores focus on sales and customer service rather than dough preparation and inventory control.

EPS Growth:

Porter's Five Forces

Supplier Power ((Low)):

Domino's controls a large portion of their domestic supply chain, which makes supplier power low. Switching costs are nearly zero thus finding an alternative supplier is not difficult.

Buyer Power (High):

Customers have the option to buy pizza from almost anywhere, which makes customer-buying power high. Domino's aims to offer the lowest priced quality pizza available. Increased items purchased benefits the customer, which creates discounts.

Competitive Rivalry (High):

Competitive rivalry is high for this market. Customers in this market have an infinite number of choices to choose from in regards to pizza. In the U.S., Domino's competes against regional and local companies as well as nation chains Pizza Hut, Papa Johns (PZZA) and Little Caesars Pizza. Internationally the company competes primarily with Pizza Hut, Papa John's and country-specific national and local pizzerias. Increased competition from existing or new companies in the pizza category could increase pressures to grow the business in order to maintain market share.

Threats of Substitution (High):

Threats of substitution for pizza are high. What makes Domino's a great company is that they offer more than just pizza. Substitutions for pizza that the company offers range from oven baked sandwiches, chicken entrées, salads, and pasta.

Threats of New Entry (Medium to High):

Entry into the pizza industry is fairly low. Any mom and pop could start their own pizza restaurant. It would be more difficult for that same shop to capture the market share like one of the big four pizza chains.

Valuation

To value Domino's we used a Discounted Cash Flow Model using free cash flow projected out to the year 2029. Revenue for the next 13 years is estimated to grow by a compounded annual growth rate of 6.89%. The terminal growth rate used was 3% with a WACC of 7.50%. We have a 12-month target price of $199.05. The stock price is a 13.71% discount to Domino's intrinsic value.

For the next 4-5 years, we expect that Domino's will to be going through a massive growth stage with domestic and international store expansion. We project over this same time period; store expansion could increase as much as 1000 new locations bringing the company's total store count to around 14,250 globally. We have determined growth in revenue will be fueled by increased franchise fee from domestic and international growth along with domestic supply chain expansion. We judges there will be an operating margin increase of 100-300 BPS over the next three years due to customers switching to mobile ordering.

Risks

• The risk of litigation and negative publicity from customers, franchisees, suppliers, employees, and others in the ordinary course of business, which can or could divert their financial and management resources.
• Adverse global economic conditions subject the company to additional risks
• Fluctuation in the value of the U.S. dollar in relation to other currencies may lead to lower revenues and earnings.

Disclosures and Disclaimers

Information and opinions contained in this report have been obtained or derived from sources believed to be reliable, but no guarantees can be made regarding the accuracy of information provided by the original sources. All opinions expressed are subject to change without notice. This research report is not tailored to the investment needs of any specific person and is provided for informational purposes only.

Disclosure: I am/we are long DPZ. 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.