International pizza take-away & delivery franchise Domino’s Pizza Inc is my latest equity investment, and this post explains my investment case and the key risks I have identified. Comments on this article would be very much appreciated.
Domino’s Pizza Inc (“DPZ”) has four income streams: (1) 455 company-owned and operated stores in the United States (16% of FY09 gross profit): (2) royalty income from 4,450 domestic US franchised stores (41% FY09 gross profit); (3) the supply of ingredients to US franchised stores (22% of FY09 gross profit); and (4) income from 4,264 international stores (22% of FY09 gross profit) – this is largely royalty income, but this segment does earn some profits from the sale of ingredients to stores. The benefits of the franchise-royalty + ingredient supply business model are, firstly, that the volatility of the business is much reduced, with franchisees taking on a significant portion of the business risk, and secondly, that working capital and fixed asset investment requirements are also much reduced, leading to an asset-light, high cash flow financial model. These factors can be seen in the recent financials, with the standard deviation of gross profits only 6.3% the average between FY02-09 and free cash flow to the firm (which I define as cash from operations, plus interest, less capex) averaging 70% of EBITDA from FY05-09. Again, free cash flow to the firm has been remarkably stable, with a standard deviation of 11.7% around the average. In my opinion, this stable-profit profit, high-cash flow business model makes for an attractive investment proposition.
It is fair to say that in recent years the top-line performance of DPZ has been pretty anaemic, with a revenue CAGR of 2.3% between FY02 and FY09. This has largely been due to weak performance in the US domestic market which still makes up the bulk of gross profits. However, recently the performance of the US business has improved along with better economic conditions and a revamp of the pizza recipe, leading to 15.9% top-line growth in YTD 3Q10. In addition, the international business has been growing rapidly for the last decade (gross profit CAGR of 13.3% from FY02-09) and is expected to continue to grow strongly as a further 1,000 stores are opened over the next four years. The company gives medium-term revenue guidance of 4-6% growth per annum (1-3% LfL domestic, 3-5% LfL international, plus 250-300 – mainly international – new stores per annum); however, for this investment to work-out revenue growth is not necessary (as we shall see, debt reduction through free cash flow generation is sufficient), though it will certainly help.
In 2007 DPZ completed a leveraged recapitalisation, utilising an asset-backed securitisation in order to repay existing debt and to pay-out $897m to shareholders in dividends and share buy-backs. Essentially, this could be characterised as a leveraged buy-out while remaining publicly-listed, as the transaction took net debt to 7.7x EBITDA. Leverage has since declined, but still remains high at a forecast 6.6x EBITDA for FY10. Although at first glance this amount of leverage seems excessive, I would argue that the stability of profits and the high-level of cash conversion makes the business ideally-suited to operating with a leveraged capital structure. This is exemplified by the level of debt service coverage, with free cash flow to the firm being 1.8x interest costs in FY09. In addition, the current state of the leverage finance market, with the average new transaction carrying leverage of 4.9x in FY10 means that DPZ should have no problem refinancing when the principal falls due in 2014.
The key plank of my DPZ investment case relates to the level of free cash flow to equity relative to the current market capitalisation, and the expected level of growth in this metric over the next few years as the company pays down debt (thus reducing interest costs) and increases revenue (thus increasing profits and cash flow given the degree of operating leverage in the business model). In FY10 I expect that free cash flow to equity will equal 7.8% of the current market capitalisation, and by FY14 free cash flow to equity will equal 12.6% of today’s market capitalisation. Consequently, shareholders should benefit from a rapid increase in equity value over the next few years as the company grows profitability and pays down debt, along the lines of the classic LBO model. Assuming that the EV/EBITDA ratio remains constant over the next four years (currently 10.6x according to my own FY10 forecast), I predict that equity-holders will see a return of 15% per annum, or 1.75x today’s investment. However, with such growth in cash flow over the period, it is possible that we may see a re-rating of the EV/EBITDA multiple. An increase in this metric to 11x would see the equity return increase to 19% per annum, or 2x the original investment.
I see four likely risks with this investment idea. The first is a significant deterioration in conditions in the leveraged finance market, which would result in a more expensive refinancing for the company in 2013 or 2014. As net leverage should have reached 4.8x (FY13) or 4.2x (FY14) the refinancing itself should not be a problem given the company’s cash generation, though there is a risk that DPZ will have no choice but to pay an unattractive interest rate. The second is a sustained increase in raw material costs that results in a combination of lower sales and/or reduced gross margins. The key inputs are block cheese, various meats, and paperboard (for the pizza boxes). Global demographic expansion and economic growth is expected to place upward pressure on food prices over the next few years, according to OECD-FAO Agricultural Outlook. The third is a strengthening in the USD which would diminish the value of overseas earnings (which contributed 22% of gross profits in FY09). Finally, the fourth major risk is a general decline in the stock market. During 2010, when the S&P 500 fell by 16% between April and July, DPZ fell by 32% over a similar period, highlighting the risk of investing in companies with leveraged balance sheets. Clearly, this final factor should not impact medium-to-long-term returns.
In summary, DPZ owns the rights to a leading international pizza take-away brand and is the main supplier to stores in the US. Given the franchise business model, that revenues and profits are stable, capex & working capital requirements are low, that cash flow is high relative to interest costs and the current market capitalisation, and that the outlook for revenue growth (particularly from international markets) is positive, I believe that Domino’s Pizza Inc makes for an excellent investment opportunity.