April 25th, 2017
Foreword by Roger Lipton for Franchise Money Maker
The following write up about Domino’s Pizza describes a truly “Best of Breed” franchised restaurant chain. Their same store sales gains have been without peer over the last five years, store level economics are excellent. Most of the growth is overseas because the US market is largely developed and/or committed to existing US franchisees. However, there is an important lessor here, in terms of the opportunity with delivery/takeout in a consumer environment that increasingly values convenience. Small footprint locations like Domino’s are emerging as the best Franchise Money Makers among restaurant companies.
DPZ: Company Overview (2016 10-K) (Jan’17 Analyst Day Slides &16Q4 Slides)
Domino’s Pizza is an Ann Arbor, Michigan-based pizza restaurant chain, which, as of its 16Q4 operated and franchised 13,811 units globally, generating an estimated $9.5B in sales (about 1.5M pizzas/day), making it the world’s second largest pizza chain (after Pizza Hut) and the number one U.S pizza delivery company. About half (49%)the sales are produced by the 5,371 domestic stores (392 company, 4,979 franchised), while the remainder is produced by 8,440 franchised stores in over 80 markets around the world.
In 2016 DPZ’s revenues were $2.4B which were derived from company stores (17.8%), royalties and fees from franchisees (12.6% domestic, 7.2% international) , with the remaining 62.4% from sales of food supplies and equipment to company and franchise locations. We estimate the AUV’s of company units are slightly over $1.1M (or about $740/sq. ft., assuming average store size of 1,500 sq ft). We estimate domestic and international franchised unit AUV’s are about 20% and 30% lower, respectively, than domestic company locations. Disclosed average store level EBITDA of domestic franchisees is about $134K, up from $61K in 2009, about 15.2% EBITDA store level margin for domestic franchisees. (These figures are presumably net of royalties, fees and advertising fund contributions). The cash investment for leasehold improvements, furniture, fixture, equipment and signage for a new store at upper end of the range provided in Franchise Disclosure Documents and other materials is about $410K, so the $134k EBITDA store level margin would represent a 32.6% store level cash on cash return for domestic franchisees.
The supply chain provides pricing and distribution scale and uniform ingredient quality to participants. It operates 18 regional dough manufacturing and food supply chain centers in the U.S., one thin crust manufacturing center, one vegetable processing center and one center providing equipment and supplies to certain of the domestic and international stores. It also operates five dough manufacturing and food supply chain centers in Canada and leases a fleet of more than 500 tractors and trailers. As such, it makes approximately twice weekly deliveries of food supplies and equipment to over 5,600 system units, including all company stores and 99% of U.S, & Canadian franchisees. It passes through its prices paid with a small markup to participants and shares a portion of profits with franchisees, which nets out to a segment margin of about 8%. The supply chain segment’s relatively low EBIT margin and capital intensity are a drag on consolidated margins and free cash flows, making them lower than other highly franchised peers. Arguably, DPZ could boost margins by leaving supply responsibilities to franchisees, as, say, DNKN does, but it would lose scale advantages for both their own and franchised stores (less of a concern for DNKN with virtually no company stores). It would also diminish its ability to control quality. Perhaps most importantly, it would lose an important touchpoint with its franchisee partners. (We’re not so much trying to decide the correct strategy as to point out key differences in strategies from other highly franchised peers.)
Domino’s has gone through a series of development stages since its founding in 1960. Its current stage is a brand revival which dates to the end of 2009 when it scrapped its original pizza recipe in favor of a line of premium (and distinctly better tasting) pizzas featuring higher quality ingredients and a wider variety of toppings such as roasted red peppers, spinach and feta cheese in addition to the traditional favorites. The company has gone counter to industry trends by avoiding LTOs which complicate a menu with a stream of new products. Instead it has concentrated on providing consistency and value with a limited and uncomplicated core menu of pizzas, baked sandwiches, pastas, chicken items (like wings), breads, beverages, deserts & extras (sauces). In the past 4 years DPZ has added just 3 items: Specialty Chicken in 2014 and Marbled Cookie Brownie in 2015 and salads (Classic Garden, Chicken Caesar and Chicken Apple Pecan) in August ‘16.
The current brand revival stage is also supported by DPZ’s “Pizza Theater” re-imaging of system stores (expected to be substantially complete in 2017); its innovative marketing (e.g. the iconic campaign trumpeting the scrapping of its former pizza recipe); and its use of state of the art technology to take the complexity out of operations and improve the customer experience. One of the first with on-line ordering, DPZ has since developed a digital platform, which is nearing utilization by the entire system, including international units, to manage internal operations (re-supply, scheduling, payroll, order accuracy, etc.) and customer-facing actions to simplify ordering, payment processing (with a range of payment systems in addition to credit & debit cards) and enabling order tracking (from prep through delivery) on virtually any communication device. Together with a sophisticated loyalty program, the platform provides a rich source of data for its robust marketing initiatives. Not content with 50% of domestic sales transacted via digital orders and the fast growing international acceptance, the company is continuously improving the platform. For example, in 2016 it launched a “Zero Click Ordering” app, seemingly the penultimate in ordering ease (the ultimate being that your order appears by just thinking about it).
The proof of the brand revival is in the numbers. From 2009 through 2016, domestic system revenues have grown at an 8.4% annual rate on domestic system comps averaging 7.4% (including 24 consecutive Q’s with positive comps) and 6.9% international comps (91 consecutive Q’s of positive comps!). Most of the unit growth has been international (11.0% CAGR since 2009). Although management believes there’s room for 1,000 more domestic units, it is very selective about granting new franchises and the annual domestic unit growth (company and franchised stores) since 2009 has been only 1.0%. During the same period EBIT, EBITDA and FCF have grown at annual paces of 13.0%, 12.4% and 16.5%, respectively. Long term, the company expects global retail sales will grow at 8% to 12% on domestic comps of 3-6% and international comps of 6-8%, while net global new unit growth will be 5-7%. If it achieves its top line targets, margins will continue to expand and net income and free cash flows will grow at a double digit pace.
Domino’s, like many of its highly franchised peers has borrowed heavily to finance share repurchases. The company’s ratios of total debt to 2016 EBITDA and lease adjusted debt to 2016 EBITDAR at 4.4X and 4.9X, respectively, are comparable with its peers. Cash flows from operations of $287.3M net of $58.6M cap ex, generated free cash flows of $228.7M in the year, or a FCF margin of 9.2%. DPZ returned $374.2M to shareholders in 2016, nearly $74M in dividends and $300.3M in share repurchases. In 2016 DPZ spent $300.2M to repurchase 2.8M shares (average price $106.60, or a 5.7% reduction of shares outstanding at the end of 2015) against about $15.2M proceeds from about 1M stock options (average exercise price $14.69, or a 2.1% increase in shares outstanding).
DPZ: Current Developments (16Q4 Release) (16Q4 Conf Call Transcript)
The fourth quarter provided another exceptional performance, with domestic same store sales up 12.2%, international up 4.3%. This represented the 92nd consecutive quarter internationally and 23rd for domestic locations. The full year results are noted in the table above, impacted by expenses related to the Company’s recapitalization and the 53rd week in the fourth quarter of 2015. 2016 was a record year in terms of new store growth, with 171 new domestic stores and 1110 new international locations. In the 4th quarter: 104 domestic stores opened and 6 closed. 487 international stores opened and 26 closed.
The fourth quarter eps YTY gain of $0.33 (28.7%) as adjusted for the New Year’s calendar shift, included negative influences from higher interest expense ($.03/sh.), higher tax rate ($.04), foreign exchange ($.03). Positive influences were share repurchases ($.12) and improved operating results including $.02 from the calendar shift of $.31.
The company’s major initiatives continued in the fourth quarter. Capex was allocated toward aggressively building out their technology capability, 102,000 shares were repurchased (at $160/share) for $16.4M, $18.2M was returned to shareholders as dividends, and $9.6M worth of debt was repaid.
In terms of the future, the successful strategy which has produced such outstanding results, as described above, remains in place. Management provides no short term guidance, but has raised certain long term (“3-5 year outlook”) parameters slightly. Domestic same store sales growth is expected to average 3-6% annually (up from 2-5%). International same store sales growth is expected to grow at 3-6%. (unchanged). Net unit growth (overall) is expected to grow 6-8% (up from 5-7%). Global retail sales growth is expected to build at 8-12% annually (up from 7-11%).
About the Author:
Roger Lipton is an investment professional with over 4 decades of experience specializing in chain restaurants and retailers, as well as macro-economic and monetary developments. After earning a BSME from R.P.I. and an MBA from Harvard, he began following the restaurant industry as well as the gold mining industry. While he originally followed companies such as Church’s Fried Chicken, Morrison’s Cafeterias and others, over the years he invested in companies such as Panera Bread and shorted companies such as Boston Chicken.
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