This in-depth article covers one of the most impressive UK growth stocks of the last 20 years — Domino’s Pizza.
Domino’s appeared on my radar after I revisited one of my previous SharePad screens.
The screen in question searches for companies with dependable dividends and reasonable yields.
The exact criteria are:
1) 10 or more consecutive years of dividend increases;
2) annualised dividend growth of at least 5% during the last ten years, and;
3) a minimum forecast dividend yield of 4%.
Back in October the screen highlighted the attractions of PayPoint. Re-running the screen this time provided the following matches:
(You can run this screen for yourself by selecting the “Maynard Paton 23/10/18: PayPoint” filter within SharePad’s brilliant Filter Library. My instructions show you how.)
I selected Domino’s because I was already aware of the pizza chain’s dynamic growth history — and wondered why the shares now offered a dividend yield similar to that of the wider market.
Domino’s magnificent payout history is shown below:
And here is confirmation of the company’s yield being near an all-time high:
Let’s see what is going on.
The history of Domino’s Pizza
Domino’s Pizza launched in the UK during 1985 when the first store opened in Luton and offered twelve different pizzas for £8 each.
However, the full Domino’s story began during 1960 in the United States when Tom and James Monaghan bought an ailing pizza restaurant called DomiNicks:
Within a few years, Tom Monaghan had opened further restaurants, introduced the Domino’s name and commenced a delivery service to local colleges.
Mr Monaghan started a franchising system during 1967, and his decision to use cardboard boxes for deliveries (to keep the pizza warm) and offer a 30-minute delivery guarantee ensured rapid success.
The US is now home to nearly 6,000 Domino’s stores, of which more than 90% are franchised operations.
Domino’s Pizza in the UK — and the company I am evaluating today — was created during 1993 when Gerry and Colin Halpern acquired the master Domino’s franchises for the UK and Ireland.
By the time the UK company floated in 1999, the Halperns had sub-franchised close to 200 stores. These days the store count in the UK and Ireland tops 1,150.
Recent years have seen the UK business acquire the master Domino’s franchises in Switzerland, Iceland, Norway and Sweden, as well as a minority stake in Domino’s Germany.
The growing network of franchised stores has pushed revenue and profit higher to deliver that wonderful dividend:
Domino’s generates its income through two main sources:
1) Royalties:
A 5.5% royalty is collected on every sale made by the franchisees. A 2.7% royalty is then in turn paid to the original US business. Last year Domino’s earned net royalties of £32m.
2) Supply chain:
Domino’s sells dough, cheese, other pizza ingredients and store equipment to its franchisees. Last year such sales came to £323m and produced a £95m profit before central costs.
(Earning a near-30% margin from selling dough and cheese seems an exceptionally lucrative business!)
My spreadsheet chart below illustrates how total ‘system’ sales — that is, the aggregate sales from all of the group’s UK, Irish and European franchisees — have grown steadily to surpass £1.2bn:
The blue bars show Domino’s converting approximately 40% of those system sales into revenue for itself.
This spreadsheet chart shows how the store estate has expanded:
And this spreadsheet chart shows how sales per store (within the main UK and Ireland markets) have more than tripled during 20 years to approximately £1.1m a year:
Domino’s cites four reasons for the success:
1) Food quality: fresh ingredients and chilled dough (not frozen) are delivered to every store three or four times a week;
2) Quick service: the delivery target remains the 30 minutes set by US founder Tom Monaghan;
3) Television advertising: brand awareness jumped after Domino’s sponsored The Simpsons and Britain’s Got Talent, and;
4) Innovative technology: Domino’s pioneered Internet ordering during 1999 and these days the vast majority of sales are made online:
The success has led to Domino’s domestic market share increasing from 18% to 46% during the last 20 years. Within the same time, the UK market for take-away/delivered pizza has surged seven-fold to £2.1 billion.
The rising profit and dividend have naturally done wonders for the shares:
The price has rocketed 50-fold following the 5p flotation. However, the shares are currently well below the 400p highs set during 2016.
Sad to say, but the impressive Domino’s story has faltered during the last few years.
Stand by for details of performance window-dressing, upset franchisees, fruitless overseas expansion and substantial debt-funded buybacks.
Meddling with like-for-likes
My spreadsheet chart below recaps the history of the group’s UK like-for-like sales growth:
(Like-for-like sales reported by retailers are an important measure for investors. They represent the underlying turnover improvements at established stores and can indicate whether the retail format remains popular or not. Negative like-for-like sales could mean fading popularity.)
Delivering 20 years of positive like-for-likes is an extremely impressive achievement.
Mind you, Domino’s has recently meddled with the numbers.
The figures of 4.8% and 4.6% declared for 2017 and 2018 both excluded what Domino’s calls ‘split’ territories.
For the last few years, some stores have ‘donated’ part of their territory to a new store located nearby — and a proportion of the sales from the ‘donor’ store have migrated accordingly.
The effect of these territory splits on the like-for-likes reported is shown in my chart below:
For 2013, 2014, 2015 and 2016, the blue bars represent the original like-for-like growth declared.
The 2013-2016 figures were then restated in 2017 when Domino’s decided to exclude the effect of split territories. The restatement added an average 1.9% to each year’s like-for-like effort — represented by the green bars.
(For example, the 7.5% reported originally for 2016 was restated in 2017 as being 9.8%.)
For 2017 and 2018, I have represented that additional 1.9% in yellow.
I reckon without adjusting for split territories, like-for-like sales during the last two years would have been close to 3% (and just 1% for the first quarter of 2019).
I am never keen on companies re-jigging old statistics in a more favourable light — such actions always hint at directors window-dressing a substandard performance.
Adding to my suspicion is the like-for-like re-jig coinciding with much less impressive rates of growth.
Delivered-on-time unchanged since 2008
Domino’s management claims splitting store territories ought to benefit franchisees over time.
Territories split during 2014 have since lifted sales by 54%:
However, back in 2014 management boasted that split territories could improve sales by 80%:
I guess splitting territories may no longer be as effective as before.
Trouble is, Domino’s may have no alternative but to split territories in order to sustain the crucial 30-minute delivery target.
The percentage of pizzas delivered on time has not improved during the last ten years:
In fact, the average delivery time during 2018 was 25 minutes — two minutes slower than that recorded for 2009.
Splits affecting franchisee profits
Split territories are part of Domino’s plan to open a further 500 or so UK stores to take the domestic total to 1,600.
Domino’s master-franchise agreement with the US business drives the store expansion. The current arrangement, which runs from 2016 for ten years, requires the UK estate to reach 1,346 locations by 2026.
Opening 200 or so stores over seven years does not seem problematic when 58 UK sites were opened during 2018.
But opening new stores is down to the franchisees — and the profit from running a typical franchised store is sadly becoming hard to fathom.
Domino’s says the average ‘mature’ franchise store witnessed a 3% Ebitda improvement during 2018:
However, the average store — old and new — saw its Ebidta fall 4%.
Domino’s has meddled with these Ebidta numbers, too.
The average store Ebidta for 2017 was deemed to be £136k within the 2018 presentation above — versus £151k within the original 2017 presentation below:
The impression given is one of further performance window-dressing.
Disgruntled franchisees
Domino’s claims the £300k-£350k cost of opening a new UK store can be repaid within three to six years and thereafter earn a £120k-£150k Ebitda profit:
So, the prospective returns for franchisees — at least according to Domino’s — still appear sound.
However, a first-quarter statement issued earlier this month suggests the franchisees have less favourable calculations.
Domino’s admitted (my bold):
“A healthy pipeline of new stores remains, however openings continue to be impacted by ongoing franchisee discussions. We continue to engage actively with franchisees to support volume-driven growth and new store openings.”
Just four new UK stores opened during the first quarter.
The franchisees are unhappy with lower store profits, and so have formed an association and engaged Domino’s in what the company describes as “intense commercial discussions”.
Press reports claim the franchisees want Domino’s to take a greater share of rising food and labour costs. Domino’s appears to be holding its ground.
I suspect the two largest UK franchisees are leading the “intense” discussions, and they could possess a strong negotiating position. The two have grown to represent a third of Domino’s UK revenue:
Domino’s store targets and other growth ambitions may be limited if a compromise with the disgruntled franchisees cannot be found.
Domino’s SharePad summary
Domino’s SharePad Summary is shown below:
I noticed the following:
1) Revenue and EPS are projected to advance at a much lower rate than profit (second row);
2) Debt has increased significantly (third row);
3) Earnings have not converted too well into free cash (third row);
4) The Ebit (or operating) margin seems low given the aforementioned mark-up on selling dough and cheese, and;
5) Return on equity (ROE) is much higher than return on capital employed (ROCE) (fifth row).
Let’s run though the numbers, starting with the revenue and profit projections.
Forecasts and non-underlying costs
SharePad provides these forecasts:
Revisiting Abcam from the other week explains why the Ebit and pre-tax profit projections are so different to all the other estimates.
The 70%-80% improvements are calculated using Domino’s statutory accounts, while the minor changes for Ebitda, post-tax profit and EPS are calculated using Domino’s own, adjusted figures.
Sure enough, Domino’s presented company-adjusted figures that differed markedly to the statutory (that is, non-adjusted) numbers during 2017 and 2018:
The 2018 annual report reveals a bevy of ‘non-underlying’ costs that Domino’s excluded from its company-adjusted numbers:
Substantial ‘non-underlying’ items generally indicate a business not firing on all cylinders.
The SharePad projections for 2020 and 2021 show Domino’s expanding at a single-digit pace. Those estimates certainly appear subdued in light of the rapid growth the business enjoyed during earlier years.
Cash, debt and capital expenditure
This chart compares Domino’s cash and debt:
At the end of 2018, cash was £25m and debt was £228m giving net debt of £203m. In comparison, 2018 operating profit before those non-underlying items was £97m.
While I can’t say Domino’s borrowings are onerous — interest payments during 2018 were just £4m — the direction of travel with debt could amplify any difficulties the business may one day suffer.
Domino’s has occasionally spent notable sums on capital expenditure when building ‘commissaries’ — central hubs that prepare dough and hold ingredients for store deliveries.
The chart below shows the ‘surplus’ capex spent over and above the amount of depreciation charged against earnings (blue bars):
The large bouts of ‘surplus’ capex witnessed during recent years and around 2008 coincide with contractions to the group’s free cash conversion (black line, right axis):
During times when commissaries are not being built, Domino’s cash conversion looks very healthy at 100% or so.
Overseas investment and share buybacks
This next chart is very important. It reveals how Domino’s has invested its free cash:
The reasons for the greater debt now become very clear. The business has spent substantial sums on acquisitions (red bars) and share buybacks (blue bars).
Since 2011, Domino’s has invested £100m in operations within Germany, Switzerland, Iceland, Norway and Sweden.
A further £128m was spent buying back shares throughout 2016, 2017 and 2018.
Sadly for shareholders, neither the foreign investments nor the recent buybacks appear to have been great decisions (at least for now).
Among those earlier ‘non-underlying’ items was a £14m charge for “international impairments” — effectively an admission that £14m of the acquisition spend was wasted.
Furthermore, this month’s first-quarter statement admitted:
“Internationally, performance remains disappointing and trading visibility is limited… Given persistently weak system sales in all our International markets we no longer expect this part of our business to break-even this year.”
Domino’s first ventured into Europe via Germany during 2011 and has since struggled to make any decisive progress on the Continent.
Earning a suitable return on that £100m overseas investment could therefore prove very hard going.
The future return on the £128m spent on buybacks appears just as uncertain.
Average prices paid for the shares during 2016, 2017 and 2018 were 357p, 339p and 323p respectively.
I estimate the £128m is showing a 25% loss with the shares trading at 250p.
Management did justify the buybacks within the 2018 annual report:
“When we have excess capital relative to our target leverage ratio, we will look to return it to shareholders to maintain capital discipline and an efficient balance sheet…”
“We assess the value of share buybacks by reference to the Board’s own view of intrinsic value as well as an internal rate of return calculation.”
The merits of borrowing large sums to fund extensive buybacks has never been clear to me.
Such exercises always smack of ‘financial engineering’, and I would rather boardrooms just hand back surplus cash as special dividends.
With special dividends, shareholders can then decide for themselves whether to reinvest the cash based on their own “view of intrinsic value”.
The recent buybacks have not had a major effect on Domino’s share count:
Margins and return on equity
Let’s finish off the accounting review with a quick look at margins and return on equity (ROE).
The margin drops of 2013, 2017 and 2018 were due to various ‘non-underlying’ costs depressing profits:
However, a lovely 20%-plus of revenue converts into profit during years without mishaps.
Domino’s ROE chart has lost its relevance after the business skewed the calculation by taking on all that debt:
A better judge of Domino’s effectiveness of reinvesting profits is return on capital employed (ROCE), which excludes the effect of borrowings:
Domino’s ROCE has declined significantly during recent years — no doubt due to spending £100m on businesses abroad that have yet to deliver any worthwhile return.
That said, ROCE does remain above 20%, which suggests the core UK and Ireland division enjoys inherent operational strengths that can offset reinvestment woes elsewhere.
Slowing growth and questionable decisions
I now understand why Domino’s shares offer a dividend yield similar to that of the wider market.
Simply put, the last few years have seen growth slow and management decisions become rather questionable. The share price has responded accordingly.
True, the company’s long-term history is superb and backing reliable operators often pays off for patient investors.
However, pedestrian like-for-like growth, stagnant delivery times, upset franchisees and restating presentation statistics all suggest Domino’s main UK and Ireland business is not as efficient as it once was.
Perhaps the board has been distracted by the (expensive) overseas subsidiaries — which have proven extremely reluctant to produce any sort of return. Maybe pizza just does not sell well in Europe.
I am certainly not impressed by the debt-funded buybacks. The exercise has created greater balance-sheet risk for no obvious benefit.
Underlining my concerns is the boardroom’s revolving door — Domino’s has recruited four different finance directors since 2014.
That so many FDs have studied the accounts — and decided better employment opportunities lay elsewhere — must send a message to shareholders.
Perhaps a complete management overhaul is needed. I suspect the upset franchisees — and maybe some investors — might welcome fresh leadership.
Until next time, I wish you happy and profitable investing with SharePad.
Maynard Paton
Disclosure: Maynard does not own shares in Domino’s Pizza.
