Description

The writer of this note, related persons, and / or entities ("Writer") currently holds a long position in Domino’s Pizza Group (LSE: DOM). The Writer stands to benefit in the event that the price of DOM’s stock increases. Following publication, the Writer may transact in securities of DOM. The Writer makes no representation or undertaking that the Writer will inform the reader or anyone else prior to or after making such transactions. All expressions of opinion are subject to change without notice, and the Writer does not undertake to update this report or any information herein. While the Writer has tried to present facts it believes are accurate, the Writer makes no representation as to the accuracy or completeness of any information contained in this note and disclaims any obligation to update such information. The views expressed in this note are the opinion of the Writer, which may change at any time. The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Writer harmless and hereby waives any causes of action against Writer related to the below note. This note should not be construed as a recommendation to buy or sell any security.

Investment Thesis Summary

I am long Domino’s Pizza Group (LSE: DOM, herein referred to as “DOM” or the “Company”), because I believe (i) DOM shares are worth at least £3 / share (16x earnings) and current market pricing provides a ~20% margin of safety and (ii) that DOM is likely to generate at least a mid-teens IRR over the next 5 years with minimal risk of capital impairment.

My financial projections do not deviate materially from consensus (MSD revenue growth), and I believe this opportunity is brought to us as a “baby out with the bathwater” situation due to manic selling in the European markets this year. DOM has rarely traded this cheap – After backing out non-core assets, DOM’s shares currently trade for sub-12x 2022E earnings, which is rare for a defensive, high-quality compounder. DOM shares bottomed at 15x forward earnings amidst the GFC and the Company’s enterprise value just declined below its March 2020 COVID low.

I believe this is a textbook “high uncertainty, low risk” situation and that the market is generously compensating DOM owners relative to the business’ risks because the UK’s weak macro outlook (Ukraine-Russia conflict, high inflation / energy prices, etc.). The Company doesn’t screen as well as it should due to most screening tools including franchisee leases in debt / enterprise value calculations, which ignores DOM’s lease receivables from franchisees on the balance sheet that offset the lease liabilities. Domino’s has dominant scale in the UK (48% market share) and is well positioned to take additional market share amidst the challenging backdrop for sub-scale small businesses. I also believe the business will benefit from consumers “trading down” from going out to eat at restaurants (its hard to beat Domino's on price / value).

Furthermore, DOM is aggressively returning capital to shareholders (£136m returns to shareholders via dividends and buybacks in 2021) and I believe this program will be accelerated due to the sale of a non-core, ancillary asset whose proceeds could equal 6 – 8% of the Company’s market cap, which should accrete additional value to shareholders. DOM’s capital allocation framework prescribes (after organic investment initiatives) a dividend of up to 50% of earnings and the balance of excess cash used for share repurchases, so long as the prevailing share price offer a compelling value per management’s internal valuation model.

In the meantime, I expect DOM to generate consistent and high returns due to the Company’s asset light, franchisor business model (pre-tax ROTC of 40%+), variable cost structure, and (long awaited) alignment with franchisees to accelerate new store growth over the next three years. To boot, owners can collect a growing 4.2% dividend yield while value builds and we await Mr. Market coming to his senses and re-rate this valuable franchise.

Market / Product Overview

The ancient human tradition of consuming pizza dates back as far as 500 – 600 BC and today pizza is one of the most popular and consumed foods across the world.

Pizza benefits from a formidable value proposition offered to customers. Eating delivery or takeout pizza is an affordable luxury and cheaper than dining out (a £20 large pizza can feed a family of four or five), made fresh to order, requires no eating utensils (less clean up), and possesses many customizable combinations due to a large assortment of topping options. Furthermore, pizza is the number one food in the world for both delivery and takeout orders because its hot dough base travels and retains heat well. Pizza has benefitted from the convenience of takeout / delivery, busier schedules, and the increased quality of in-home entertainment, all of which have led to secular growth in delivery.

Setting aside DOM’s capital light, franchisor economics, selling pizza offers attractive economics due to its limited number of ingredients, propensity for family / group orders (i.e. high average order size), relatively low protein content (i.e. higher margins) and perishability (i.e. rapid consumption).

And last but not least, the UK is an especially attractive market for a dominant consumer brand operating in a scale-centric, route density business because the UK is a small, prosperous, and densely populated island. For reference, the UK is ~3% smaller than Michigan in terms of land area, yet is home to a population that is only ~3% smaller than the combined population of California and Texas, and has the sixth largest economy of any country in the world ($2.8 trillion GDP).

Company Overview

Domino’s Pizza Inc. (NYSE: DPZ) is one of the largest consumer brands and the largest pizza quick service restaurant chain and delivery company in the world.

DOM is DPZ’s second largest international franchisor by store count and the business is comprised of (i) the perpetual, exclusive master franchisor of all Domino’s Pizza restaurants in the UK and Ireland, (ii) 33.3% ownership of the exclusive master franchisor of Domino’s Pizza restaurants in Germany, and (iii) several minority stakes in Ireland and Northern Ireland franchisees. ~95% of DOM’s operating revenue is generated from the UK.

The Company has traded publicly since 1999, has ~1,238 stores, ~70 franchisees, and the average UK store generated £245k of EBITDA in 2021. Only 35 stores (all in or near London) are corporate-owned with the balance owned by franchisees. Owning a Domino’s store in the UK possesses a rare combination of explosive upside (30%+ ROEs are typical), small upfront capital commitments relative to other franchise concepts, and safety (as of 2019, only 13 stores were closed in the prior 10 years and DOM grew revenues by double digits during the GFC). ~2/3 of DOM’s revenue and profitability is derived from supply chain revenue – selling ingredients and supplies to franchisees at a ~40% gross margin (the balance is effectively generated from 5.5% franchisor royalties on franchisee sales that exhibit a ~51% margin, because 2.7% of the 5.5% royalty is paid to DPZ).

DOM’s vertically integrated supply chain system, density, scale, and purchasing power lead to high quality / fresh ingredients, lower costs, 99.9% on-time and accurate deliveries, and higher value capture than competitors. The Company manufactures and delivers fresh dough and sources / distributes other ingredients (third-party cheese, pizza sauce, toppings, sides) and non-food supplies daily to DOM stores through supply chain centers (“SCCs”) in the UK and Ireland.

DOM’s UK SCCs consist of (i) two legacy facilities in Milton Keynes, UK (50 miles northwest of London) and Warrington, UK (20 miles east of Liverpool / 16 miles west of Manchester) that have the capacity to serve ~1,400 stores in south and central UK (serving ~965 stores as of January 2019) and (ii) a newly opened (in 1H21) SCC in Cambuslang, Scotland (~10 miles southeast of Glasgow, Scotland) with the capacity to support 150 stores in northern UK. DOM also recently opened a warehouse in Avonmouth to serve the southwest UK and the Company’s Ireland SCC is located in Naas (~25 miles west of Dublin). 40% of ingredients are sourced from overseas (mostly EU). 

DOM’s scale and vertical integration represent durable competitive advantages that should be reinforced through the Company’s growth. DOM exhibits market power relative to its captive store base and its suppliers, judging from its payment terms (collects sales from customers at least 2x as fast they pay suppliers). The Company possesses #1 market share (48%) in the UK’s otherwise fragmented pizza market (~33% of the market is still comprised of independent pizza restaurants). DOM has 2.7x, 3.3x, and 5.8x more stores than its nearest three branded competitors (Papa John’s, Pizza Express, and Pizza Hut, respectively). Both Pizza Express’ and Pizza Hut Restaurants (UK dine-in business) were forced to restructure under a Company Voluntary Arrangement (insolvency regime that is essentially a watered-down version of Chapter 11 in the U.S.) in 2020. Even before COVID, Pizza Hut Restaurants’ UK store footprint declined by a 5% CAGR from 2012 – 2020 from 328 stores to 214.

Store count growth requires minimal capital investment from DOM and strengthens DOM’s purchasing scale, “mind share” (4% of store sales are contributed to DOM’s National Advertising Fund – NAF), and customer satisfaction (a denser store footprint lowers average delivery time). DOM’s average delivery is consistently completed in less than 25 minutes from order time, while studies show average delivery times for aggregators in UK (Just Eat and Deliveroo) are 35 – 55 minutes, consistent with the average delivery times for UberEats, GrubHub, DoorDash, and Postmates in the U.S. DOM’s in-house drivers take direct, point-to-point routes which is inherently more efficient than the aggregators’ more distributed system that may dispatch a driver 10 miles away to pick up the order from the restaurant and deliver it.

This leads to a virtuous cycle that attracts more franchisees and store count growth (new franchisees can leverage the procurement scale of 1,250+ stores and DOM’s leading brand / market share lowers risk of store failure). Furthermore, Domino’s stores offer attractive economics relative to competing QSR franchise concepts: higher sales and profit margins per store than competing pizza concepts, lower upfront costs than competing QSRs such as McDonalds, lower rent / square footage units that are delivery-centric and mostly set up outside of high traffic city center areas, lower labor costs due to no / minimal wait staff, and more variable labor costs that can fluctuate with delivery volumes.

Another important aspect of the Company’s vertical integration is that DOM directly owns the relationship with their customers and the data created by such relationships. More than 90% of system sales consist of orders made through the Company’s website or mobile application (mobile app sales represent ~42% of system sales), which provides DOM with rich data to more effectively inform the Company’s strategy, grow, and maintain customer relationships. Smaller competitors lack the scale to build, operate, and maintain centralized digital engagement and data infrastructure. The Company began replacing their web, mobile app, and CRM platforms starting in 2020 to support omnichannel customer engagement, group ordering, ordering recommendations / upselling, targeted / personalized promotions, drive collection / takeout orders, and generally reduce friction and improve the user experience.

One of DOM’s key areas of focus is to grow system sales, which is the ultimate amount of Domino’s sales to end customers in the UK. Growing system sales in a sustainable way is universally beneficial –(i) DOM benefits by selling more ingredients / supplies and generating royalty revenue and (ii) franchisees benefit from increased sales volume and higher profits. DOM has an element of “scaled economics shared” as ~2/3 of system EBITDA is attributed to stores (DOM only keeps ~1/3 of system EBITDA for itself). The Company’s target is to achieve total system sales on the upper end of their £1.6bn - £1.9bn target range by the end of 2024.

Long Running Franchisee Dispute Resolution (December 2021)

DOM has concentration with two franchisees that represented 19% and 18% of 2021 revenue, respectively. The potential drawback of a concentrated franchisee base is obvious, but this structure also makes it easier for the UK Domino’s system to grow, because DOM’s large franchisees are well funded and have outstanding business acumen. DOM is focused on diversifying its franchisee base, but this is a long-term goal that will take many years to achieve.

The Company muddled through a public dispute with franchisees that I understand started in 2016, which resulted in stagnant store count growth (25 new stores p.a. from 2019 – 2021, versus ~75 new stores p.a. from 2015 - 2018) and a lack of franchisee cooperation on nationwide promotional strategies, which resulted in sub-optimal organic growth. The genesis of the disagreement arose due to franchisee concerns over: overall profit and investment splits between the franchisor / franchisees, split territory / “fortressing” economics, labor costs (National Living Wage was introduced in 2016 and ever since minimum wage has increased by 4% – 5.5% p.a. for workers 16 – 23+ years old in the UK), Brexit growth / supplier concerns, longer payback periods on new stores due to the aforementioned factors, and franchisees’ perceived lack of incentives under the current construct with DOM to compensate for these risks. Another point of contention with franchisees was the effectiveness DOM’s administration / spending of the national advertising fund.

In March 2021, DOM began offering a new store opening incentive to all franchisees (£100k and £150k for virgin and split stores, respectively payable over three annual installments) when many competitors were closing stores. In the grand scheme, this is a very small commitment for DOM (their previous incentive scheme averaged £70k to £75k per store), because these amounts approximate only 2 years and 3-4 years of royalties for virgin and split territory stores, respectively. Even with these incentives new stores generate extremely high incremental returns to DOM – typical split territory store generates 15k of average weekly sales in their first year (£780k annual sales), which generates ~£234k of DOM supply chain revenue or ~£94k of incremental gross profit to DOM in exchange for DOM shouldering zero capital or operating costs. Apart from building DOM’s captive store base to sell more ingredients / supplies, new stores also lock-in future high margin royalty revenue, improve Domino’s delivery route density and customer satisfaction, and help build the Domino’s brand by increasing contributions into the NAF.

In December 2021, DOM reached an agreement with franchisees representing 99% of their store base in order to align with franchisees and drive system sales. The Company agreed to a one-time £20 million investment spread across 2022 – 2024 focused on digital infrastructure and personalized promotions, a mutually beneficial food rebate mechanism that encourages franchisees to drive order / volume growth, and formalized the previously agreed upon new store opening incentives in exchange for franchisees’ cooperation on national advertising campaigns and a pledge from franchisees to open at least 45 new stores per year from 2022 – 2024.

Store Economics

A mature store generates in excess of £1 million p.a. and the general rules for stores is that food and labor costs each account for 30% of sales. Other costs, such as franchisor royalties, NAF contributions, delivery costs (mileage, vehicles, insurance), rent, and local marketing comprise 20% - 30% of sales. Together with food and labor costs, this results in store EBITDA margins of 10% - 20%.

DOM’s delivery-centric business model and small store footprints are less real estate intensive than competitors, which (i) not only provides more attractive economics to franchisees (higher sales / square foot), but also (ii) allows franchisees to profitably operate stores in areas with lower population density / limited competition, where dine-in centric concepts’ cost structure is uneconomical. In less populated areas, DOM stores tend to generate higher sales per household and sales skew 2x or more than average toward takeout orders, which can provide 500 – 700bps of gross margin uplift due to time, labor, and fuel efficiencies (i.e. growth in this channel is highly capital efficient, because it does not require delivery infrastructure). Furthermore, the average new takeout customer is additive to net system sales (volume), because they are incremental to delivery customers. For reference, the collection / takeout channel comprises ~50% and ~65% of Domino’s system sales in the U.S. and New Zealand, respectively versus ~30% of UK’s pre-COVID sales. One of the benefits of “fortressing” (discussed below) is a higher sales mix toward collection / takeout orders – increasing market share in this channel (from ~6% currently) is a major strategic focus for the Company.

Stores that operate in split territories generally will generate lower EBITDA margins (HSD – LDD), because they have less addresses to serve in their split territory. Hybrid-split territories are those where a new store cannibalizes some addresses from an existing store, but also extend the delivery footprint to new addresses in an adjacent area that the existing store footprint could not reach. More density tends to increase sales mix toward takeout, which increases franchisee margins and also provides labor and local marketing efficiencies.

Current franchisees will split their territory by opening a new store as part of a “fortressing” strategy to keep competitors from entering the market and competing with their one standalone store. The best way to effectively compete with a scaled, incumbent operator like Domino’s is to target their locations where route density is lowest and therefore customer service levels are most challenged. Although opening a new location creates a new set of fixed costs, DOM franchisees have successfully split territories for years because it de-risks franchisees’ existing store investments and still generates attractive incremental returns. Split stores are known to generate more sales from collection / takeout from nearby customers (takeout customers typically are a different customer set than delivery customers and will not drive several miles) and have stickier customers, because delivery areas are tighter, so service levels are higher than average.

One of the main risks of an investment in DOM is the aggregators taking delivery share that hampers DOM’s competitive position and the profitability of the core delivery business (although I think the risk is muted at this point). I believe that DOM’s franchisee resolution and new store incentives are a powerful risk mitigant that will also generate attractive returns on capital for DOM shareholders from higher volumes and long-term royalty revenues.

Management and Alignment

The Company will have a new CEO (TBD) and CFO (Edward Jamieson) starting in October 2022 to replace DOM’s current interim CFO (David Surdeau). Mr. Jamieson will join DOM from Just Eat (Euronext Amsterdam: TKWY) where he served as the Regional Finance Director of UK / Ireland.

DOM’s CEO (Dominic Paul) will leave in January 2023 to become the CEO of Whitbread (LSE: WTB; £8.7bn EV). DOM’s previous CFO (Neil Smith) left the Company in November 2021 to become the Finance Director of UK pub chain Fuller, Smith, and Turner (LSE: FSTA; £552mm EV). He previously served for nine years as the CFO of Ei Group, the largest pub company in the UK.

I believe Sarah Barron (Chief Marketing Officer) has done an outstanding job since joining in January 2021, merging digital and marketing teams, and launching the Company’s highly successful “Domin-Oh-Hoo-Hoo” marketing campaign as the UK exited omicron lockdowns.

70% management’s stock options are subject to performance based on earnings per share targets and 30% are based on relative total shareholder return, over a three-year performance period ending December 2023. A two-year post-vesting holding period applies as well. CEO and CFO bonuses (150% and 125% of base) are 70% linked to pre-tax income and 10% linked to meeting order count (volume) budgets.

Risks

- New management team (execution)

- Supply chain / technology disruptions

- Deep recession that hurts all dining businesses

- Franchisee relationships

Mitigant – Despite a 5-year dispute with franchisees controlling 50%+ of stores, the business continued to compound value and ultimately franchisees economic interests are aligned with DOM (increasing brand strength, competitive advantages, and system sales / profits)

- Changing consumer preferences / regulators running amok

- DPZ relationship (terms of the Company’s Master Franchise Agreement were stuck in 2016 and expire in 2026)

- Competition

Catalyst

- Buyback / Capital Return Program

- German Franchisor Put / Call Right Exercise: DOM’s investment in Domino’s German franchisor is a hidden asset that does not meaningfully contribute to DOM’s earnings or cash flow. The investment is held on the Company’s balance sheet at a value of ~£31 million and Domino’s Pizza Enterprises Limited (ASX: DMP) has a call option to purchase DOM’s stake at fair value beginning on 1/1/2023. DOM disclosed their expectation that an exercise of the call option would generate cash proceeds of £70 - £80 million (~6% of DOM’s current market cap on a post-tax basis). The Company has previously disclosed that a sale of the Germany stake could generate as much as £100 million to DOM. Proceeds from the put / call right exercise could accelerate the share buyback and accrete value to shareholders

- PE Buyout: Without a long-term CEO and with so much PE money sloshing around, I wouldn't be surprised to see PE make a play here. Bain Capital (when Mitt Romney was in charge) owned DPZ, then Domino's Japan, and now owns PizzaExpress (or at least used to alongside HIG). Levine Leichtman and others have been active investors in pizza franchisors before as well