Description

We are short Domino’s Pizza (DPZ), the world’s largest pizza company, or a mid-cap tech company depending on whether you’re speaking with a bullish or bearish investor.  We believe that competitive threats, coupled with an overly leveraged balance sheet, will lead to a continued de-rating of Domino’s shares.  We think Domino’s best days are in the past, and that earnings and same store sales estimates will continue to come down for the foreseeable future.

                Domino’s, under Former CEO Patrick Doyle, is a business turnaround case study.  Doyle took over a struggling brand coming out of the Great Recession, and through an improved product, clever advertising and innovative technology, turned Domino’s operations into the Holy Grail of the restaurant industry.  In 2010, Domino’s had a reputation for terrible pizza and was going through a public relations crisis after two store employees uploaded a video of contaminated ingredients making their way into customers food.

                Doyle ran a series of creative advertising campaigns, featuring actual customers in focus groups complaining about the quality of the pizza – the crust tastes like cardboard, the tomato sauce like ketchup, etc.   Domino’s created all new recipes, and began selling a better pizza.  The short thesis isn’t a referendum on the taste of Domino’s pizza, it’s certainly good enough.  In addition to the improvement in the product, Domino’s was one of the first restaurant chains to invest in technology.  The company created a great online ordering platform, and pioneered order tracking.  The technology investments were hugely successful, and Domino’s same store sales numbers were routinely in the double-digits.  Doyle would frequently pitch Domino’s as a technology company that sells pizza, and with the stock up some 1,700% percent during his tenure, who could argue with him.  

Patrick stepped down in the middle of last year, and we think it’s likely that he top-ticked his exit.

                Competition from third party delivery aggregators, a more focused Papa John’s, wage inflation and a balance sheet that’s looking stretched for a business with declining fundamentals are all near-term issues for the stock. 

Domino’s primary point of differentiation in the crowded restaurant space was the ease of ordering.  In 2015, when Domino’s last put up a plus double-digit same store sales number, DPZ’s online ordering system was novel and unique.  Today, you can log in to an aggregator like DoorDash, Grubhub Uber Eats, or Postmates amongst others, and just as easily get delivery from your favorite local pizza shop, your second favorite pizza shop, or order any other cuisine you want at that moment.  When I read a sell-side report claiming that aggregators will not have an impact on Domino’s sales, I can’t believe it – how does a customer having significantly more options at their fingertips, with roughly the same technology / ease of use to order, not negatively impact Domino’s in the short and long-term?  Domino’s digital order rate of 65% of all orders isn’t as impressive as 100% from the aggregators.  Delivery pizza is continuing to lose share, and popular new delivery items from Grubhub go well beyond pizza and include items like tuna poke, buffalo cauliflower and ribs.  Even if you don’t think pizza will continue to lose share, there are more pizza ordering options than ever, with the same ease of ordering through Domino’s once unique system.  The aggregators are extremely well-funded and determined, and the idea that they will not have an impact on Domino’s growth seems completely misguided.

                On Domino’s most recent conference call, the first 20 minutes of Q+A were spent discussing the aggregators, with management saying aggregators are aggressively spending on marketing and discounting to attract new customers, and that they do not expect a slowdown in the near future.  Management expects there will be survivors in the space, and said there is very limited pricing power amongst restaurant operators in the current environment.  The company doesn’t appear to have a strategy to combat third party aggregators other than to wait them out, and hope prices eventually increase for end customers.  Given there will be survivors, it’s unlikely that DPZ’s competitive position will never be as strong as it was the past few years, and waiting it out until competitive forces subside will be painful in the short-run.  DPZ had a first mover advantage with the ordering technology and has reaped the rewards, but that advantage has now vanished.

                In addition to competition from every other type of cuisine, DPZ will face increased pressure from Papa John’s and Shaq.  As well run as Domino’s has been over the past decade, Papa John’s has had an equal and opposite run the past two years.  Papa John’s founder and the centerpiece of all its advertising campaigns, John Schnatter, went off the rails during a late 2017 earnings call, complaining about NFL players kneeling during the national anthem, and followed that up with racist remarks on a marketing call months later.  The negative press surrounding the Founder / face of the company led to an eighteen month period of declining sales at Papa John’s.  Schnatter is now out of the picture, and Papa John’s recently added Shaq to the Board of Directors.  Shaq will own nine Atlanta franchises and will begin featured in national advertising campaigns (he was posting food pictures from the Board meeting on Twitter today).  I’m not sticking my neck out by saying Shaq will have somewhere from a slightly positive, to Oprah at Weight Watchers level impact, but given where Papa John’s has been the past 18 months, they will be a more fearsome competitor for Domino’s.  It’s worth noting PZZA has a national partnership with DoorDash, and it will be interesting to see how that develops as Papa John’s gets back on its feet.

Minimum wage costs and driver competition are pinching margins at company owned stores.  Domino’s is now looking to hire delivery “drivers” that currently don’t, or never had, driver’s licenses to deliver pizzas via bike, e-bike or scooter.  If the recent survey that 30% of delivery drivers admit to eating customer’s food is accurate, I’m guessing this new group will skew higher and probably isn’t great for the overall customer experience.

Domino’s fortressing strategy is hurting same store sales, and could lead to issues with Franchisees in the future.  In order to better serve customers with faster delivery times, Domino’s has been fortressing its store locations – basically a densification strategy where they are adding more stores in proximity to existing stores.  This is obviously cannibalizing same store sales, and thus far not having a positive impact on franchisees in the fortressed areas.  If fortressed sales are not incremental, it is likely that franchisees will push back on adding units.  There are a lot of strained franchise / franchisee relationships in the QSR space, and if the fortressing strategy erodes the ROIC for franchisees, we could be adding Domino’s to the list. 

Capital Allocation

In combination with the early adoption of technology, Domino’s was also an early adopter this cycle of share buybacks.  The company targets an aggressive at 3-6x Net Debt / EBITDA ratio and is currently at the high-end of the range.  The buybacks have been prolific – against $330 of TTM free cash flow the company has completed the following buybacks:

Share Repurchase Programs

The Company’s open market share repurchase programs have historically been funded by excess operating cash flows, excess proceeds from our recapitalization transactions and borrowings under our variable funding notes. The Company used cash of approximately $591.2 million in 2018, $1.06 billion in 2017 and $300.3 million in 2016 for share repurchases.

                When Domino’s was comfortably comping at 6-10%+, such an aggressive buyback policy juiced equity returns.  With such strong results likely a thing of the past, and near-term results showing significant deceleration, buybacks will slow even if DPZ maintains its leverage ratio.

                Given the transformational turnaround and phenomenal execution at Domino’s, I don’t want to take away from the incredible stock returns over the past decade, but it has been a near perfect environment for a company running a levered buyback playbook.  With business trends showing clear deceleration, one would think they might look to take down leverage, but the company says they are comfortable at the top-end of the 3-6x range.

Outlook

Domino’s targets 3-6% same store sales growth, which analysts take as gospel given the company’s history of execution.  Same store sales have been on a steady decline since an impressive 12% figure posted in 2015.  In the quarters following Doyle’s exit, same store sales have seen a meaningful deceleration.  International growth has slowed more recently, with 1Q19’s 1.8% SSS the lowest comp over the last decade.  In the most recent quarter, domestic same store sales were at the low end of guidance and that was all ticket pricing. 

We think Domino’s is entering a period of stalling growth due to competition from third party aggregators and traditional pizza chains.  The technology company that sells pizza is no longer as unique as it was when Doyle began the business transformation a decade ago. 

                This seems like a situation where as long as the stock goes up, everyone is fine with aggressive leverage to fund buybacks, but we’ll look back and wonder why the market was so forgiving of a 6x levered pizza chain facing increased competition from all angles with a clear deterioration in same store sales in all geographies. 

We think Domino’s is at the start of a slower growth period and multiple de-rating.  We expect the top-end of the 3-6% range to look increasingly impossible to reach, and the company to trend below the low-end of the range in the coming quarters.  If the fundamentals continue to weaken as we expect, the company will lose the premium multiple.  If investors start to value the company on any unlevered metric, DPZ shares could see meaningful downside.

Risks

Same store sales improve while lapping easier comps

Investors stop funding losses at third party aggregators

Partnership with Beyond Meat for pizza toppings

Leverage cuts both way

Catalyst

Continuation of both domestic and international same store sales trends

Pizza as a category continues to lose delivery share

Share growth within pizza slows as Shaq reinvigorates Papa John’s

Franchisees begin to push back on Fortressing strategy, open fewer stores

Lower profit growth while at the high-end of leverage targets results in fewer share buybacks

Lower confidence in new management and competitive position lead to a de-rating in the multiple