Domino's Pizza, Inc. (NYSE:DPZ) is a stable and predictable pizza-industry leader with a great long-term track record. The pizza industry is fragmented which means that the company's size and brand recognition provide it with a competitive edge over the majority of its rivals. Domino's will continue to see strong growth going forward which will be fueled by their ambition to continue opening many more stores. We believe DPZ is worth over $500 a share, making the stock undervalued.
Domino's is a leader in the QSR pizza industry with consistent growth and fairly predictable operating income. It has proven to be a winner during COVID-19 with same-store sales and operating income both increasing year over year. Its success can be attributed to the low CapEx, delivery & carry-out business model. The company has only a minor focus on dine-in experiences which is exactly why it did well throughout the pandemic. In addition, it has a very strong e-commerce presence with over 70% of U.S. sales coming from digital channels.
DPZ's continuous focus on innovation has allowed the company to develop proprietary POS systems and new delivery methods with the aim of making the digital experience as frictionless as possible for the customer. This approach is clearly working well as the company has been able to accumulate over 25 million users for its loyalty program (us at StockBros included).
Moreover, in the last 4 quarters, the company has almost doubled its cash position to $330 million while maintaining debt at approximately $4.1 billion. We like the fact that Domino's can maintain a fairly high leverage ratio of approximately 6 times EBITDA. Its strong operating profits allow the company to achieve an interest coverage ratio of 4.14x which equates to a synthetic bond rating of A3/A-.
On a qualitative note, we enjoy the food itself and we believe it is better priced than other pizza chains relative to quality. We started ordering from Domino's Pizza quite often after we realized it offers good tasting food at a great price. This is just our subjective opinion of course, but we imagine many others would agree.
Lastly, we also love the fact that DPZ is an undervalued stock with strong long-term performance. We will go into more detail about its valuation later on in this article.
The total QSR pizza industry is highly fragmented with 51% of the market consisting of regional chains and independents. The fragmentation is less prevalent when focusing on the pizza delivery market as 38% of it is controlled by the same group. The global QSR pizza is worth $88 billion with the U.S. accounting for almost half of it at $41 billion. In the U.S., the industry is expected to see growth in the low single digits whereas internationally it is expected to be between 3-6%. In addition, the carryout and delivery segments are expected to grow faster than the dine-in segments globally.
Domino's controls 36% of the pizza delivery market and 19% of the total QSR pizza market. Therefore, more than 1 out of every 3 people will order Domino's when they want pizza delivered, and almost 1 in 5 people in the world will order Domino's whenever they are in the mood for QSR pizza. This is an impressive feat that translates into a strong competitive advantage in terms of scale and brand recognition, especially in a fragmented industry.
Source: Investor presentation
It is also important to note that the company's market share has been increasing year after year. As per the picture above, DPZ's market share was 24% in 2014 meaning that it increased by almost 50% in just 5 years.
The chart below represents an industry comparison of other quick-service restaurant stocks.
Source: Author using data from Finbox
Capital Expenditures Margin: Lower = better
The formula for CapEx margin is: Capital Expenditures/Revenue
Lower is generally better because it means that the business is less capital intensive. DPZ has the 2nd lowest CapEx margin, with QSR being slightly better at 2%.
Gross Profit Margin: Higher = better
Formula: (Revenue - Cost of Goods Sold) / Revenue
DPZ trails behind in this category with essentially being tied for last with SBUX at 27.4% gross profit margin.
EBIT Margin: Higher = better
Formula: EBIT / Revenue
DPZ makes up for its lower gross profit by having a respectable EBIT margin of around 17.6%, in the middle of the pack.
Net Debt to EBITDA: Lower = better
Formula: Net Debt / EBITDA
Domino's has a fair amount of leverage with about 5x net debt to EBITDA, but it is in the middle for this category too.
Interest Coverage: Higher = better
Formula: EBIT / Interest Expense
In this category, DPZ is 3rd best with a respectable 4.14x interest coverage, meaning its annual EBIT is 4.14x their interest expense.
Return on Capital Employed: Higher = better
Formula: Earnings before Interest & Taxes / Average Capital Employed
The stand-out metric here for Domino's Pizza is its return on capital employed. At 73.42%, it blows everyone else out of the water, with YUM being the closest at 41.76%. Return on capital employed measures a company's profitability relative to the capital employed.
Comparing DPZ to its peers in our analysis shows that for most metrics, the company is average. However, the very high return on capital employed relative to everyone else makes DPZ an above-average company, in our opinion.
The elevated return on capital employed may be one of the reasons for DPZ's outperformance in the past 5 years.
The main catalyst for growth is straightforward - open up thousands of more stores. The strategy is simple but most effective given the nature of the business. People generally like to eat from local restaurants and want their pizzas delivered as fast as possible. Opening up more stores is really the best way to grow. DPZ's low CapEx franchise model allows them to be very aggressive in this regard. From 2012 to 2019, net store growth was 7,278.
Source: Investor presentation
Furthermore, Domino's has identified the potential for an additional 5,200+ stores in the top 15 markets alone.
A secondary catalyst for growth to consider is the company's emphasis on technological innovations. Improving their technology will create a better digital experience which could potentially convert more people into customers in areas where stores are already built. As the restaurant and food industries continue their push to online channels, staying at the forefront of this trend is extremely important in order to maintain a competitive position. One of the reasons why we default to ordering Domino's is because we can place an order within seconds. Whether we want to repeat any past orders or set up an "easy order" its app and website are super convenient and require very little effort.
As you might've expected, DPZ's operations are fairly stable, as you can see in the image below. Revenue, earnings, free cash flow, and cash from operations are all on a steady uptrend and we expect this to continue going forward.
We estimate that Domino's Pizza has an intrinsic value of approximately $503 per share. This valuation is based on a 3 stage DCF model using the following assumptions:
- Fundamental Growth Rate for EBIT of 13.96%. This was calculated by multiplying the average reinvestment rate (CapEx - D&A + Change NCWC) of NOPAT of the last 3 years by the average ROIC of the last 3 years. This growth rate is very similar to the historical CAGR of the last 3 and 5 years.
- Marginal Tax rate of 28% to reflect the expected corporate tax hike under Joe Biden. Historically, DPZ's effective tax rate has been very close to the federal marginal tax rate.
- Risk-free rate rounded up to 1%
- Equity risk premium of 6%
- Cost of equity at 5.8% at a beta of 0.8 (actual beta is lower than 0.8 but we like to limit the range to 0.8 to 2.0 for stable stocks such as DPZ).
- Cost of Debt was calculated using the market yield of grade A corporate bonds which currently sits at 1.59% pretax and 1.14% after tax.
- WACC was calculated to be 4.79% which was used as the discount rate. Half-year convention used.
- Perpetual growth rate in the stable stage of the DCF was set to the 2% Federal Reserve inflation target. The stable reinvestment rate was set 41.77% in order to give DPZ an implied ROIC equal to its WACC.
- Growth and reinvestment rate will transition linearly for 5 years from year 6 until the stable growth stage in year 11.
- All historical and forward calculations use last twelve months (ex, LTM - 1, LTM + 1).
The calculations above leave us with the current fair value calculation of $503.01, as seen below.
Source: Author's estimates
Cheese prices: On October 8th of this year, DPZ was down 8% because of news that high cheese prices hurt their profit margins. Papa John's was also down 3%.
DPZ's CEO Stu Levy stated that the company’s food costs decreased 1.2% in the second quarter, and then increased 3.8% in the third quarter, mainly driven by the price of cheese. This resulted in lower profit margins. Domino’s operating profit margin was 37.4% of revenues in the third quarter, down from 38.5% in the second quarter.
Also, according to Domino's executives, higher costs will continue as long as the pandemic does (higher sick pay, other benefits, cleaning costs, etc.).
We believe the reaction to the news on October 8th was an overreaction though (DPZ is still hovering around its October price), as operating margins only dropped by about 1% after a very large price swing in cheese, but same-store sales in the U.S. increased 17.5% (the strongest growth since its IPO in 2004).
In the company filings, it is stated that DPZ periodically enters into financial instruments to manage the risk of cheese price fluctuations. Regardless, DPZ is somewhat exposed to changes in cheese prices so it is something to consider.
Foreign currency risk: DPZ is an international company. About 6% of its revenues are international, which adds foreign currency risk.
From the latest 10-Q report:
"We do not enter into financial instruments to manage this foreign currency exchange rate risk. A hypothetical 10% adverse change in the foreign currency exchange rates for our international markets would have resulted in a negative impact on royalty revenues of approximately $14.1 million in the three fiscal quarters of 2020."
$14.1 million is a drop in the water for a company like Domino's Pizza, so we are not concerned about this risk factor. But, it is just another thing that is good to know if it keeps growing its international presence in the future. It is better to know than to not know.
Barriers to Entry: The pizza industry is a very easy-to-enter business, which means that competitors can easily come in and try to steal business from Domino's. This is currently not an issue though as DPZ has been increasing its market share over the years.
Below is a chart of DPZ on the daily time frame. As you can see, in October, the stock sold off after the earnings report because of the elevated cheese prices and COVID-19 expenses that we discussed above in the risks. We believe those are minor temporary setbacks, and that the drop is a buying opportunity.
DPZ double-bottomed, showing support near the $370-375 area. In early November, DPZ pushed to about $401, and then came back down. After some consolidation, it is now picking up steam and making a higher high, as it is currently above $403 at the time of writing. This indicates a potential trend reversal. Also, gaps also tend to get filled, and there's a gap near $425 that may get filled.
Domino's has grown nicely in the past and it will continue to execute its strategy of opening more stores domestically and internationally. The pizza industry's fragmentation allows the company's size and brand recognition to provide it with a competitive edge over the majority of its rivals. Domino's Pizza is a great stock to own that is currently undervalued, with technical analysis also suggesting that the current price may not be a bad entry point.
This article was written by
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DPZ over 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.