Description

Overview

DP Eurasia is the exclusive master franchisee of Domino’s Pizza in Turkey, Russia, Azerbaijan and Georgia. The group was founded by CEO Aslan Saranga in Istanbul, Turkey in 1996 (at the age of 27). Aslan is well respected within the Domino’s ecosystem and is a member of the Domino’s Pizza General Management Council. At present, DP Eurasia has scaled to 765 locations and Aslan maintains a 5.6% ownership stake in the company – a figure that is significantly higher than comparable Domino’s CEOs. DP Eurasia has consistently been recognized as one of the best performing master franchisees globally, having received more than 10 Gold Franny Awards – the most prestigious Domino’s award given annually to the best master franchisees. In Turkey, Domino’s is the dominant operator with a network base that is 5x larger than its nearest competitor PizzaPizza. In Russia, Domino’s is the second largest operator behind local champion Dodo Pizza. Within Turkey and Russia, DP Eurasia has whitespace to more than triple their store count. DP Eurasia went public at a $400 million valuation in 2017 when they operated 571 locations. Today, the company operates 765 locations and is valued at $74 million. The table below provides an overview of DP Eurasia compared to its listed peers. 

The Domino’s Business Model

Domino’s Pizza is one of the most successful fast food brands worldwide and the strength of their business model is widely recognized. In short, scale advantages allow Domino’s to deliver great tasting pizza, at a cheaper price, and faster than the highly fragmented universe of competitors. These scale advantages manifest themselves in numerous ways. For example: marketing spend / pizza, central SG&A / pizza, rent / pizza, hourly wage of delivery driver / pizza, bulk purchases --> raw ingredient savings / pizza, store density --> improved delivery times --> more repeat orders --> more scale, R&D / pizza --> improved app experience --> more repeat orders --> more scale, … you get the idea. In addition, these scale advantages are turbocharged by a company culture that is entrepreneurial, meritocratic, and highly focused on franchisee economics. It’s been said that the best way to make A LOT of money, is not to figure out how to make money for yourself, but figure out how to make money for others. This dynamic has worked wonders for Domino’s over the last 20 years.

DP Eurasia Operations

DP Eurasia has 765 system stores in Turkey, Russia, Azerbaijan and Georgia, with its highest concentration in Turkey. With respect to Turkey, the group’s stores are located throughout the country, whereas in Russia the stores are highly concentrated in the city of Moscow. In Azerbaijan and Georgia, the group only has stores in the capital cities of Baku and Tbilisi. A typical store consists of a store manager, an assistant manager, a shift manager, three kitchen staff and six drivers. DP Eurasia has a strong focus on efficiency. Their stores do not require large preparation and eat-in areas and, as a result, the average store size is only 1,200 square feet – approximately 2/3 smaller than the typical QSR. Their delivery centric model allows the group to operate in lower footfall areas which provides significant flexibility in choosing a location and results in lower rent per square foot. DP Eurasia’s business development team has a disciplined store location selection process which is referred to as mapping. The mapping process focuses on factors like number of households, GDP per capita, local competition, regional and community acceptance, and traffic information. Proper mapping is critical to ensuring sub-franchisee success and maintaining a commitment to their 30 minute delivery guarantee (95% on time deliveries in Turkey / 90% on time deliveries in Russia).  DP Eurasia maintains a strategic balance between corporate and franchised stores (68% Franchised). The group believes corporate stores provide an important platform to develop best practices and innovate on food offerings (a shortcoming of Domino’s UK). In addition, DP Eurasia is able to establish a network of corporate owned stores in its most densely populated areas, which maximizes profitability. To achieve consistent quality of its products, competitive supplier prices and timely delivery of items to its system stores, DP Eurasia centralizes its supply and procurement function. The group owns and operates 7 commissaries which manufacture the pizza dough and supply system stores in Turkey and Russia with all ingredients and materials required. Notably, 100% of ingredients and materials are sourced domestically for both Turkey and Russia system stores, leaving DP Eurasia operationally unexposed to FX divergences. The group’s 4 commissaries in Turkey have an 850 store capacity (+300 remaining), and the 3 Russia commissaries have a 330 store capacity (+120 remaining).  DP Eurasia incurs capital expenditure primarily in relation to corporate store openings and centralized investments in technology. Consequently, with most new store openings coming from its sub-franchisees, DP Eurasia is able to grow its network in a capital efficient manner. The continued growth of the group’s network is supported by strong underlying franchisee economics. In Turkey, franchisee new store builds have 3-4 year payback rates, and in Russia franchisee new store builds have 2-3 year payback rates. This has allowed DP Eurasia to grow its store count while maintaining considerable diversification among its franchisee base (no single franchisee has more than 15 locations). DP Eurasia’s financial model consists of 4 income streams: profit on corporate owned stores, net royalty spread, food gross margin, and franchise opening fees. The group’s corporate stores operate at an average 20% store level margin, while it earns a 5-6% net royalty spread on sub-franchisee system sales. In addition, in Turkey, DP Eurasia earns a 35% gross margin on food sales to sub-franchisees and in Russia it is approximately half of this figure (margin expected to increase as Russia scales). First-time franchisees are charged $50k for opening a new location ($20k for “homegrown” domino’s employee units which are 1/3 of all new builds), and $20k for each additional location opened thereafter. In other words, each newly opened sub-franchisee location pays for approximately 1 year of maintenance expenditure for a corporate owned location. 

Turkey and Russia Convergence

In the years immediately preceding the IPO, DP Eurasia’s adjusted EBITDA margins in Turkey hockey-sticked from low single digits to the low teens as they began to fully leverage centralized costs, benefit from scale purchases, network density, and a more mature store base. Today, Russia’s adjusted EBITDA margins are in the mid-single digit range and are expected to increase (non-linearly) over the next 2-4 years and converge with Turkey’s adjusted EBITDA margins. This will happen as Russia corporate overhead is leveraged (160 Russia corporate employees for 210 locations vs 200 Turkey corporate employees for 550 locations), commissaries are fully utilized, the store base matures (18 months to fully mature store), and as Russia experiences increased benefits from scale raw ingredients purchasing (note: DP Eurasia buys half the mozzarella production in Turkey). Management has reiterated every year its confidence in margin convergence, which it expects to manifest rapidly around the 350-400 store mark in Russia.   

Digital Sales 

DP Eurasia has a strategic focus on increasing its digital sales penetration to levels generally observed across global Domino’s Pizza master franchisees (70-80%). Orders placed using the group’s online platforms have a higher customer ordering frequency, promote direct customer interaction at the corporate level, allow demand push marketing, and result in a better customer experience. Online ordering penetration has consistently grown since IPO (27% in 2016 to 49% in 2019) and is a strong driver of like-for-like growth. This endeavor allows franchisees’ to become less reliant on their own initiatives, which enables them to divert more focus to operational aspects and allows DP Eurasia greater control over features such as promotions and pricing across its system stores. Indeed, in many ways DP Eurasia is more advanced than global peers on the technology front. By January of 2019, DP Eurasia had successfully rolled out its GPS Order Tracking system across every store in Turkey which shows the location of drivers to the customer real-time and allows the group to capture and monitor delivery activity. This has improved the customer ordering experience, and DP Eurasia is already witnessing improved labor efficiency with an increase in deliveries per driver by 12%. This technology is being rolled out across the US, but is still not widely available. 

Fortressing for Growth

DP Eurasia, and other successful operators like Domino’s Pizza Enterprises, grow through employing a fortressing strategy by infilling stores in a defined mapping area to enhance its delivery proposition, increase customer satisfaction, and build strong local brand presence. This tactic of splitting stores is counterintuitive, but allows Domino’s to leverage the benefits of network density to increase market share. On the surface, it would appear that the bigger the market per location, the better you would do – stores with a lot of additional households would receive more orders. However, in a delivery model with a large territory, many orders actually earn substantially less profit because you have to drive longer, which also results in customers receiving less fresh pizza, which then results in less orders. In addition, physical store presence is a form of brand marketing, and without density the marketing burden per household increases. The bottom line is that faster delivery speeds, which also results in fresher pizza, leads to happier customers who order more and increase total sales. There is, however, an optimum density and Domino’s has done a lot of research and analysis to figure out where this optimum exists – a data advantage that would be difficult for competitors to replicate. Below are a few slide from the 2019 Domino’s Pizza Enterprises Investor Day that highlight the fortressing strategy. 

Aggregators

A popular question for any company in the QSR space, particularly Domino’s, is what the impact of aggregators will have on business. Many higher quality Domino’s Master Franchisees, like Domino’s Pizza Enterprises and DP Eurasia, have taken a different outlook on the role of these players – viewing the platforms as an digital advertising channel (note: both DPE and DPEU interact with all of their aggregator relationships under a first generation model, where Domino’s completes the delivery themselves). Domino’s has advertised for many years on Google and Facebook, witnessing strong ROI on platform spend. After years of experience and across many geographies, spend through aggregator platforms has shown to result in similarly compelling rates of return. In addition, Domino’s believes that they are able to effectively segment customers and add less price sensitive incremental business via the aggregators. Pizza fanatics are offered a level of customization for their pizzas on the Domino’s app that does not exist aggregators, and Domino’s has regular promotions and discounts that are only offered through their own app. Aggregators allow the group to capture customers who value the convenience of online ordering, but are otherwise not particularly interested in these qualities. Finally, the interplay between aggregators and brands needs to be assessed at the local level – and I would posit that DP Eurasia is exceptionally well positioned. In Turkey, there is one aggregator that has 99% of the market share, Yemeksepetti. The company is a first generation aggregator (no delivery offered), and DP Eurasia has worked with them since the early 2000’s. Approximately half of DP Eurasia’s digital sales in Turkey come from Yemeksepetti, and their margins per order are the same as their own platform. In Russia, the picture is entirely different. Until 5 years ago there was no real presence of aggregators. Today, Yandex.Eats and Delivery Club (JV between Mail.Ru and Sberbank) are competing aggressively in the space as second generation operators. Importantly, the former head of DP Eurasia’s Russian unit left the company last year and is now leading Delivery Club. After sitting on the sidelines for 5 years, DP Eurasia began a 50 store test on Delivery Club’s platform at the end of last year (3 months after the arrival of their former employee) and struck a deal to act only as a first generation model (where Domino’s would deliver the pizza). The results were impressive and DP Eurasia announced on the March earnings call their intention to immediately roll out all stores on the platform. This is particularly important because Domino’s largest competitor in Russia, Dodo Pizza, has been vocally against aggregators for some time and will almost certainly cede market share to DP Eurasia with this transaction. 

Other Management Talent

It is worth noting that in addition to benefiting from Aslan Saranga’s experience, DP Eurasia has been able to attract key talent to its operations. Guvenc Donmez was essential to turning around the Domino’s Russia business post-acquisition, and being named the head of Delivery Club is a testament to the quality of executive Aslan was able to recruit. The former CFO, Mustafa Ozgul, has replaced Guvenc as CEO and to complement his skillset Aslan was able to recruit Tarun Bhasin, a 20 year veteran of Domino’s India to join the Russian operations as COO. Tarun last served as the President and COO of Domino’s India, and was responsible for successfully scaling the business from 100 to 1000 units. Tarun started in February 2020 and will be a tremendous asset to the team. Finally, Anna Masalova joined Domino’s Russia as CFO after recently leaving her position as head of finance for McDonald’s Russia. 

COVID

While coronavirus has upended the restaurant industry globally, DP Eurasia (and Domino’s more broadly) will be a distinct beneficiary. However, the group has not been without its own short term headwinds. In Russia and Turkey, approximately 10-15% of sales are dine in customers and an additional 20-25% of sales are take away customers.  According to Aslan on the March 2020 earnings call, global Master Franchisees have witnessed a short term impact from losing these sales before recovering to previous levels after ~4 weeks. On April 22nd, DP Eurasia released a COVID update announcing that like for like sales in Turkey were down 12% for the 5 weeks ended April 19th, and like for like sales in Russia were down 31%. While this performance is markedly worse than the broader Domino’s ecosystem, each market has its own distinct challenges. For example, the Turkish government instituted a strict curfew for the weekends of April 11‐12 and 18‐19 that included food delivery. This obviously impacted like for like figures. There was also a curfew announced for the long weekend of April 23‐26, but food delivery was granted an exemption. DP Eurasia is optimistic that this will be the case with any curfews going forward. Takeaway sales continued to operate in Turkey, albeit at a lesser rate, and 10% of the total store base is temporarily closed (either located in malls or for labor efficiency). In Russia, social distancing has been more stringent which has led to a complete halt in takeaway sales, and 10% of the store base is closed for labor efficiency. Heading into COVID, Turkey system sales were up 23.5% like for like through mid-march, and Russia system sales were down 10% (resulting in a 35% and 20% sales differential compared to the prior months). Delivery system sales remain strong in both countries, and DP Eurasia is confident the outlook will improve as consumers grow tired of cooking (shown to happen in other geographies), as food delivery reopens in Turkey, and as stores are rolled out across the aggregator in Russia. The group is also confident in the strength of its balance sheet. With current liquidity, DP Eurasia could operate at its current cost structure for 6 months if all locations were completely shut down (zero sales) - and cost cutting measures would extend this runway. While it is an unfortunate circumstance, it also looks probable that DP Eurasia will come out on the other side of this epidemic with materially less competition from the fragmented universe of restaurant operators. And while it is suffering in the short term on an absolute basis, this epidemic could serve as a catalyst to level the playing field between Domino’s and their formidable Russian competitor Dodo Pizza. Dodo Pizza locations are 50% larger than Domino’s, they are more focused on dine in ordering, and they have been vocally opposed to working with either of Russia's large aggregators.  Finally, Aslan shared some good news recently via LinkedIn that showed the DP Eurasia’s net promoter score in Turkey has dramatically accelerated since the beginning of the year. As shown previously by DPE, NPS scores and like for like growth are highly correlated. As a point of reference, Domino’s globally has a NPS of 3. 

Historical Financials

Valuation

Assumptions - Base Case:

- 115 Turkey store openings and 310 Russia store openings over next 5 years

- Turkey SSS of 7% and Russia SSS 14% (in TRY)

- EBITDA Margins in Russia converge to Turkey in year 5

- Annual maintenance CAPEX per unit of $20K, increasing with inflation at 15% per annum

- New store build CAPEX of $150K per unit, increasing with inflation at 15% per annum

- Average debt cost of 12%

- 15X FCF exit multiple and 20% discount rate

- 197% upside to Intrinsic Value

Assumptions - Bear Case:

- 45 Turkey store openings and 70 Russia store openings over next 5 years

- Turkey SSS of 5% and Russia SSS 8% (in TRY)

- EBITDA Margins in Turkey fall to 10% and Russia margins level off at 6.5%

- Annual maintenance CAPEX per unit of $20K, increasing with inflation at 20% per annum

- New store build CAPEX of $150K per unit, increasing with inflation at 20% per annum

- Average debt cost of 20%

- 15X FCF exit multiple and 20% discount rate

- 24.3% downside to Intrinsic Value

Risks

Macro / Currency:

- Currency devaluation is a significant risk to a USD investor in DP Eurasia. There are a few things that give me comfort here. The Russian operations are becoming an increasingly significant portion of the business, and Russia’s economy is far less reliant of foreign flows than Turkey. The last 5 years were about as bad of an environment as you could have in Turkey, and DP Eurasia showed the ability to maintain EBITDA margins and hold USD sales flat – an impressive feat. I get comfort in having seen a live worst case scenario play out. I use a 20% discount rate to help account for this risk.  

Execution Risk:

- Dodo Pizza is a strong competitor, and while DP Eurasia is confident in its ability to increase margins in its Russia operations, there remains execution risk before reaching the critical level of units (300-400). If Dodo Pizza were to significantly lower its fees charged to franchisees, this could impact Domino’s ability to reach their desired number of units in a timely manner. 

Catalyst

- outperformance amid COVID 19

- Russia / Turkey margin convergence

- deleveraging as model becomes increasingly capital light