Domino’s Pizza UK (DOM LN) has considerably underperformed its peer group in the past 15 months despite experiencing accelerating LFL growth rates in its core UK market. Specifically, it has underperformed the US listed Domino’s (DPZ US) by 40% and the Australian listed Domino’s (DMP AU) by >100% while LFL growth in the UK accelerated from 5.2% in 2012 to 7% in 2013 and 11.3% in the first half of 2014. The underperformance was the result of market concerns around DOM’s nascent business in Germany, where expectations have been rebased lower.

Excluding losses from Germany, DOM currently trades on 18x forward P/E compared to historic avg of 22x (DPZ currently trades on 23x and DMP on c.33x). Assuming the business can break even in Germany by 2017 this drops to 13x. If the stock can revert to its historic avg multiple of 22x and including the 3.5% div yield we get a 2-year prospective IRR of 33%. On the other hand if losses in Germany persist and the forward P/E drops to all time low of 15x, and LFL growth slows to 3% from vs our assumptions of 4% (which is far below current trend), the IRR still remains positive at 6%. Therefore we think this represents a highly attractive risk-reward opportunity for a very high quality, non-cyclical, well run and shareholder friendly company.

Background

DOM owns the master franchise agreement (MFA) for Domino’s pizza stores in the UK, Ireland, Germany and Switzerland. It’s UK and Ireland business is 100% franchised with 832 stores (as of 6/14). In the UK the company is adding 40-50 stores per annum with a target of getting to 1,200 around 2020. In addition, the company owns the MFA for Germany (originally acquired a couple of years ago + bought out minorities last year) where it currently has 26 stores, 15 of which are owned and Switzerland where the company there are currently 10 stores.

The company generates revenue primarily from supplying ingredients to franchisees (close to 80% of revenue) and from royalties (5.5% royalty of which 2.8% is passed on to DPZ in the US so net royalty is 2.7%).  

DOM has a dividend payout ratio of c.65% and returns all additional excess cash (post capex and deleveraging) to shareholders via buybacks. Given that the balance sheet is now unlevered and capex requirements are extremely low for this business, the company is recommencing share buybacks in the 2^nd half of 2014.

Structural growth drivers:

• Increasing penetration: The overall population per Domino’s store in the UK is >50% larger than in the US and Australia. In 2013, the UK had 26.5k addresses per store compared to 15k in the US and 14k in Australia. This provides solid underpinning for the company’s target to increase its UK store base by 50%.
• Increasing order frequency: Order per household per year in the UK is just above 5, compared to 9 In the US and Australia.
• Increasing basket size: DOM has been extremely successful in driving e-commerce. In 1H14 ecommerce accounted for 69.7% of total orders (up 4.4ppts y/y), nearly 40% of which came from mobile. This provides a strong tailwind to basket size because it is much easier to push promotions and drive purchases of starters/sides/deserts/beverages on the website or the app than over the phone. In 1H14 67% of LFL volume growth was from non-pizza items.

In general, ecommerce is a significant positive driver for this business as:

• E-commerce orders typically generate c.20% higher average tickets than telephone orders. The reason is that customers get to view the menu comprehensively in front of their eyes with picture, etc. so they are often inclined to add a starter/desert/side dish
• Via E-commerce it is easier to push a promotion than over the phone/mail, driving higher re-orders
• There are cost and time efficiencies as the store’s labour requirements fall somewhat
• E-commerce increases barriers to entry as the customer is captivated by the convenience of his/her online wallet that is already set up with Domino’s

Barriers to entry

DOM’s key competitive advantages lie delivery speed (by far fastest average delivery time in the UK as staff is not distracted by dine-in customers) which is important as consumers usually order food when they are already hungry, the national advertising fund (financed fully by franchisees) which is a multiple of nearest competitor Pizza Hut, the hugely successful ecommerce platform which drives recurring sales through ease of use (i.e. customers don’t search for alternatives due to ease of access) and highly attractive franchisee economics.

Source of the opportunity

In the second half of 2013, Domino’s shares fell more than 30% - at a time when the US and Australian Domino’s shares rose by c.20% each - as investors were spooked by the company’s guidance for increased losses in its nascent German business and reduced its 2020 German stores target to 200 from 400. Then, in December the company’s CEO announced his departure sending the shares down a further 12%.

CEO’s departure: He was offered a position as CEO of a private-equity owned business (Saga PLC) that is 5x the size of Domino’s which was getting ready to IPO(it went public earlier this year). This was a once in a lifetime opportunity for him. Since then the business has continued to perform well and new management has been put in charge.

Germany: Firstly, we cannot see a reason why the concept would not end up being a great success in Germany as is the case in practically every neighbouring country.  In addition, to the UK and Ireland business which DOM owns, other Domino’s franchisers own c.560 stores in France, Belgium and the Netherlands, not to mention all the places outside of Europe that the concept is being successfully deployed. In addition, Germany itself has proven a good market for other American fast food concepts such McDonald’s, Burger King and Subway which have 1,440, 673 and 600 outlets in the country, respectively.  Secondly, while losses are optically increasing this year, this is only due to consolidation of the minorities which the company bought out at the beginning of the year. Total operating losses from Germany are running at £6m-£7m annually which compares to UK EBIT of close to £65m so we’re talking a c.10% current drag on earnings.

Shares have started to rebound already, but are still down 16% from their peak during a time when the peer group (and the overall market) has continued to rally and LFL growth has far exceeded expectations.

Adding up the store openings, conservative LFL growth assumption of 4% and the operating leverage inherent in this business, we get UK operating profit CAGR of >10%. We add some growth in Switzerland and gradual reduction of losses in Germany + buybacks to get mid-teens EPS CAGR for the foreseeable future. So far the company has struggled to turn things around, but it is early days. Any significant turnaround would create further upside to valuation and earnings.