Description
Domino’s Pizza, DPZ, at under $15/share, is a buy with a compelling
risk/reward skew for investors with a 2-3 year time horizon. I think the current
issues – rising commodity costs, low end consumer struggles, obscure what is a
great business with international exposure and great returns on tangible capital.
My upside target is in the low $20s, or 60%+ from current prices.
The Numbers:
Price: $14.25
S/O: 62.6mm
Market Cap: $900mm
Net Debt: $1,600mm
TEV: $2,500mm
P/E Forward: 10.3x
Historical Range: 13-17x
EV/EBIT Forward: 10.7x
Historical Range: 11.7x
– 16.8x
FCF Yield Forward: 11.6%
Historical Range: 5.3%
- 6.8%
Investment
Recommendation: Domino’s Pizza, simply put, has an excellent business model
with over 90% of their stores owned and operated by franchisees which in turn
reduces operational risk and maximizes free cash flow. This business model generates
free cash flow margins of 17% , returns on invested capital of 40%, and has management
has consistently rewarded shareholders through returns of capital by special
dividends and going forward a share repurchase plan. At current prices, DPZ is
trading at a 11.6% forward free cash flow yield, earnings power of $1.69 ,and cash
balance which by FYE 2009 will represent 40% of the current market cap.
Investment Thesis:
Domino’s is a public market LBO that has demonstrated a consistent ability to
generate free cash flow, has an excellent business model driven by franchisee
royalties, and a management team that has demonstrated an ability to allocate
capital in the best interests of shareholders. I would also argue that the time
to build a position in Domino’s is when the company is facing significant
headwinds due to cyclicality and not due to problems with the business model.
Bear Case: The
bear case on DPZ is that 1) rising commodity costs, specifically cheese costs, will
hurt earnings going forward, 2) the recently completed special dividend has
left the company with few ways to create shareholder value from the balance
sheet, and 3) is not cheap relative to its peers based on traditional metrics.
Variant Perception:
The critical understanding that the market is missing is that 1) the majority
of the rise in commodity costs are passed through to franchisees through the
distribution segment (please see comments below on Q3 reported yesterday), 2)
DPZ is a capital light business model that will generate 40% of its current
market cap in cash by FY 2009, most of which will go towards repurchasing
shares, and 3) Peer comparisons are a misleading basis for comparison given the
capital intensity and economic returns of the business model. The intrinsic
value continues to compound at an attractive rate and the commodity input inflation
is a transitory issue which may in fact create pricing discipline in the long
run among competitors.
The Business Model:
DPZ’s business model relies on a combination of royalty payments received from franchisees,
a distribution platform providing franchisees with raw materials and equipment,
and income generated from company owned and operated stores. The company is the
number one pizza delivery company in the United States, has a strong global
brand, and generates attractive economics in a growing market space which
provides the impetus for franchisee expansion.
Store unit economics are attractive given the low startup
costs, the well recognized brand, and compelling value proposition to
consumers. Delivery is a $12b market and the channel represents 24% of total
sales of pizza in the United
States. Within the pizza delivery market,
DPZ is number one with a 19% share and has room to grow given that 54% of total
delivery is done by small mom and pop chains.
International franchisees operate on a master franchise
agreement which allows DPZ to sell the rights to individual countries and
receive annual royalty payments. There are two publicly traded Domino’s
franchisees in Australia/New Zealand and the UK. International store growth
represents between 70% and 80% of net new unit builds and has compounded at 8%
annually since 2002. Furthermore, this segment has reported 54 consecutive
quarters of positive comps and the company has publicly stated that it believes
that there is room to double units within their top 10 markets.
Unit Economics – the company has stated that franchisees
generate 30%+ cash on cash returns. The numbers below are backed into through conversations
with those franchisees.
|
Unit Economics
|
|
|
|
|
|
|
|
|
|
Domestic Company-Owned Store
|
$ 697.0
|
|
|
|
Royalty Payments
|
$ -
|
5%
|
|
|
Food Costs
|
$ (170.1)
|
24.4%
|
|
|
Labor Costs
|
$ (211.9)
|
30.4%
|
|
|
Occupancy Costs
|
$ (80.9)
|
11.6%
|
|
|
Insurance
|
$ (21.6)
|
3.1%
|
|
|
EBIT
|
$ 212.6
|
30.5%
|
|
Sales/Company Store
|
|
|
|
|
|
1Q
|
2Q
|
3Q
|
4Q
|
|
2005
|
$
172.9
|
$
161.1
|
$
158.6
|
$
207.4
|
|
2006
|
$
166.3
|
$
156.4
|
$
158.0
|
$
205.6
|
|
2007
|
$
167.6
|
$
163.7
|
$
159.3
|
$
210.8
|
|
|
|
|
|
|
INVESTMENT THESIS
Strong Free Cash Flow
Generation: DPZ requires minimal capex to run the business given its
reliance on franchisee royalty payments and generates 17% free cash flow
margins. Funds from operations less capex has been 115% higher than net income
since 2004. DPZ went public in 2004 and since then management has used 58% of
its cash sources to repay debt, 30% to pay common stock holder dividends, and
7% to repurchase shares.
Sources and Uses Analysis (2004 – 2007)
Funds from Operations $521mm
Proceeds from LT Debt Issuance $2,650mm
Stock Issuance $128mm
Other $79mm
Cash Inflow $3,380mm
Operating Expenses ($147)mm
Repayments of Long Term Debt ($1,898)mm
Share Repurchases: ($222)mm
Common Stock Dividends ($974)mm
Other ($46)mm
Cash Outflow ($3,287)mm
Free Cash Flow (FFO – OPEX) $374mm
% of Net Income 115%
Shareholder Friendly
Management: Management (excluding the CEO) has been with the company since
the LBO by Bain in 2002 and understands how to create shareholder value. In
April of this year management issued a $1.85b asset backed note with a fixed
6.06% interest rate, which was used to repurchase all of its 8 ¼ senior sub
notes, repay all outstanding borrowings under its senior credit facility, and
issue a special one time dividend of $13.50.Going forward the company’s
liquidity includes a $150mm revolver and has authorized a $200mm stock
repurchase plan (representing 20% of the company based on the current equity
value).
Messy 1H earnings
obscures Profitability: The repurchase of the senior notes resulted in
several one time charges, in addition to a $5mm legal provision resulted in
reported EPS in 1H07 of $.49 to be significantly below that of the year ago
period of $.73. After stripping out the one time fees, 1H07 earnings were actually
$.65 and would have been slightly in line with 1H06 ex-the debt issuance. The
point is simply that core operations were in line with the year ago period, yet
the bottom line was affected by the messy 1H due to financing decisions which
were made to improve shareholder returns.
RISKS
Higher Cost
Environment: The current commodity environment, particularly for cheese
which represents 1/3 of pizza costs, has resulted in 60bps declines in YOY
margins. Other relevant costs include wheat (5-10%), and wages (50bps increase
per store) due to the new minimum wage hike. DPZ is only affected on the 7% of
company owned stores (and cheese costs are passed through to franchisees), for
which 50 – 75% of these costs are hedged. Looking historically at cheese costs,
the last spike took place in 2004 and resulted in 20bps decrease in that year
and a 140bps increase in margins the following year.
Balance Sheet
Ammunition Gone?: Following the payout of the special dividend total
leverage stands at 6.8x EBITDA. The company has a $200mm stock repurchase
program in place, a $150mm revolver and will generate $300mm in free cash flow
through 2009 which management has proven will go towards increasing shareholder
value.
VALUATION
To determine my target valuation, I used two methods: 1)
Target EV/EBIT multiple and 2) Earnings Power Analysis. My target multiple of 13x
EV/EBIT is my base case forecast for 2008 EBIT and is justified based on the
company’s historical ROIC and growing free cash flow. Secondly, DPZ should earn
$1.38 next year with cash on the balance sheet of $250mm (I assume no share
repurchases). Using a target price/earnings multiple of 18x, in line where its
traded since the IPO, and stripping out excess cash (95%) results in a price
target of $26.89.
|
DPZ Valuation
|
|
|
|
|
|
|
|
2008 Estimates
|
Low Case
|
Base Case
|
High Case
|
|
Earnings Power
Analysis
|
|
|
EBIT
|
$219
|
$234
|
$247
|
|
|
|
|
Margin
|
14.0%
|
15.0%
|
15.8%
|
|
2008 EPS
|
$ 1.39
|
|
Multiple
|
11.0x
|
13.0x
|
15.0x
|
|
Less: Interest Income
|
$ (0.11)
|
|
Firm Value
|
$2,404
|
$3,044
|
$3,706
|
|
EPS
|
$ 1.28
|
|
Net Debt
|
$1,617
|
$1,617
|
$1,617
|
|
Multiple
|
18.0x
|
|
Equity Value
|
$787
|
$1,427
|
$2,089
|
|
Cash
|
$ 246
|
|
Share Price
|
$12.58
|
$22.80
|
$33.38
|
|
Market Value
|
$ 26.89
|
|
|
|
|
|
|
|
|
|
Low and High case multiples represent historical peak
and trough
|
|
|
|
|
multiples since 2004 IPO.
|
|
|
|
|
|
Comps (all numbers all LTM):
The key metric to highlight is that DPZ is trading at a
slight premium on EV/EBIT multiple but at a significant discount on a EV/EBITDA
– CAPEX matrix which is indicative of the company’s asset light business model.
It has the highest percentage of franchised restaurants in the group.
|
Comparable Analysis
|
|
|
|
|
EV/
|
|
|
|
Price
|
Market Cap.
|
EV
|
EBIT
|
EBITDA
|
EBITDA - CAPEX
|
|
Papa John's
|
PZZA
|
$ 24.11
|
$ 720
|
$ 827
|
9.7x
|
7.2x
|
14.0x
|
|
Burger King
|
BKC
|
$ 26.34
|
$ 3,560
|
$ 4,333
|
14.6x
|
10.5x
|
12.2x
|
|
YUM Brands
|
YUM
|
$ 36.91
|
$ 18,897
|
$ 20,806
|
17.1x
|
12.0x
|
13.5x
|
|
Sonic
|
SONC
|
$ 24.55
|
$ 1,578
|
$ 2,231
|
15.6x
|
11.9x
|
17.5x
|
|
Wendy's
|
WEN
|
$ 34.18
|
$ 2,986
|
$ 3,377
|
26.4x
|
13.7x
|
13.9x
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average
|
16.7x
|
11.1x
|
14.2x
|
|
Domino's
|
DPZ
|
$ 14.25
|
$ 892
|
$ 2,509
|
12.0x
|
10.5x
|
10.9x
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Q3 – 10/15: DPZreported earnings that were $0.06
below consensus based on a tougher consumer environment (on the call the
company commented that traffic was down domestically though average ticket was
up) and lower margins due to higher commodity costs. I do not have any insight
into the company’s hedging program (for commodity costs, particularly cheese),
and going for higher average tickets at the expense of traffic is likely the
right strategy. I do not know when these issues will resolve themselves though I
feel very confident in the company’s ability to continue to grow
internationally, and continue to build cash. The big picture on the company’
business model does not change based on the numbers reported yesterday and the
reaction provides an opportunity to buy.
Catalysts:
1) Value
is its own catalyst – the stock is too cheap to ignore.
2) Continued
international growth, and the potential for sales of master franchisee
agreements. Domino’s Pizza UK
and DPZ Australia are both publicly traded and both are acquisitive. Furthermore,
DPZ has not begun to penetrate the China market which offers significant
potential.
3) Easing
comps heading into next year – reduced noise from 1H expenses related to the
debt offering and special dividend.
4) Going
into Q4, the strongest seasonally with low expectations and a stock trading at
its lows for the year.
Catalyst
1) Value is its own catalyst – the stock is too cheap to ignore.
2) Continued international growth, and the potential for sales of master franchisee agreements. Domino’s Pizza UK and DPZ Australia are both publicly traded and both are acquisitive. Furthermore, DPZ has not begun to penetrate the China market which offers significant potential.
3) Easing comps heading into next year – reduced noise from 1H expenses related to the debt offering and special dividend.
4) Going into Q4, the strongest seasonally with low expectations and a stock trading at its lows for the year.