2020 0221 Mstar of Domino pizza

Domino's Poised for Big 2020 as Aggregator Disruption Wanes and Carryout and Tech Efforts Accelerate

R.J. Hottovy

Sector Strategist

Analyst Note | by R.J. Hottovy Updated Feb 21, 2020

Domino's big finish to 2019--accentuated by fourth-quarter comps of 3.4% in the U.S. and a sequential improvement in guest counts versus the third quarter--tells us several things. First, disruption from delivery aggregators appears to be leveling-off, and we expect this trend to continue in future (CEO Ritch Allison aptly described third-party aggregators as a "circular firing squad" and we expect more rational pricing going forward as some players exit the market). Second, carryout continues to become an increasingly important contributor to revenue--order counts increased 8.1% in the U.S.--and store-level profits, which should endure into the future as new personalization technology features are rolled out. Third, Domino's remains well ahead of industry technologies such as autonomous delivery, GPS tracking, and in-store operations, each of which should drive outperformance in the years to come. Taken together, Domino's fourth-quarter update validates several pillars of our wide moat rating.

Looking ahead, we believe Domino's momentum will continue in 2020. Assuming a more rational delivery pricing environment, the launch of a new product platform in the summer, continued benefit from carryout, and new customer-facing, store operations, and delivery technology enhancements, we're expecting the company to come in near the high end of its two- to three-year guidance ranges (net unit growth of 6%-8%, U.S. comps of 2%-5%, international comps of 1%-4%, and global retail sales growth of 7%-10%) while posting a modest uptick in restaurant margins (versus 38.8% in 2019) and low-double-digit EPS growth in 2020 (which also assumes in $400 million-$405 million in SG&A expenses and $90 million-$100 million in capital expenditures for 2020). While the stock is now trading ahead of our $275 fair value estimate--which we plan to increase by approximately 10% due to time value of money and increased near-term optimism--we don't identify many near-term downside catalysts.

Business Strategy and Outlook | by R.J. Hottovy Updated Oct 10, 2019

Domino's Pizza is well positioned in the highly competitive global restaurant industry. To endure intense competition, the firm is poised to leverage the wide moat it derives from its strong brand, technological intangible assets, and a cohesive franchisee system, plus its cost advantages rooted in superior technology and delivery route density compared with peers'. Under CEO Richard Allison's leadership, Domino's Pizza's focus on combining unit growth and same-store sales layers to drive systemwide sales, improve unit economics, and bolster returns on capital should further enable it to adapt to evolving consumer preferences. Domino's is committed to its value proposition with low-cost pizza, operational efficiency, and increasing store density globally, and we believe its 2025 targets of 25,000 stores worldwide (versus 16,000 in 2018) and $25 billion global retail sales ($13.5 billion) are achievable.

Domino's generates profit from company-owned stores, franchisee royalties, and supply chain operations that provide food, equipment, and supplies to franchisees. Franchisees own 98% of all Domino's Pizza locations, providing an annuity-like royalty stream with few capital requirements. Domino's Pizza stores focus almost entirely on delivery and carryout ("delco") and are optimized to maximize throughput. This strategy combined with an attractive menu value offering has led to best in class cash-on-cash returns of 40%-plus which incentivizes franchisees to follow Domino's corporate goal of unit expansion.

Despite our optimism about Domino's asset-light business model and long-term growth potential, we believe the global pizza category will become more competitive as existing players attempt to replicate Domino's strategy and as newer fast-casual players continue to expand. Additionally, delivery (70% of systemwide sales) competition continues to intensify as more cuisines become available through aggregator services, which leads to increasing competition for customers and draws from the delivery labor supply. We contend Domino's is not idle in the face of tough competition and is improving its consumer value proposition through technology and menu options.

Economic Moat | by R.J. Hottovy Updated Oct 10, 2019

Nonexistent customer switching costs, intense industry competition, and low barriers to entry make it inherently challenging for restaurant operators to develop an economic moat. However, after revitalizing its brand and pizza offering in late 2009, we believe Domino's Pizza has established a wide moat. Our moat rating is predicated on Domino's intangible assets in the form of a well-known brand name, consistent technology developments ahead of peers, a franchise system aligned with driving unit-level productivity, and cost advantages stemming from buying scale and delivery route density. Historical adjusted returns on invested capital (excluding goodwill) support this thesis, given the 85% average over the past 10 years, greatly outpacing our 8% cost of capital estimate. Additionally, we forecast the company's average annual adjusted ROICs will exceed its weighted average cost of capital over the next 20 years as required for our wide moat rating. We estimate Domino's Pizza's adjusted ROICs to average 80% over the next decade.

Domino's Pizza's intangible assets are based on strong global brand recognition. Domino's was founded in 1960 and now extends to over 85 countries, with over 15,000 stores. Domino's is the market share leader for the U.S. QSR pizza category (doubling its share from 9% in 2009) with Domino's, Pizza Hut, and Papa John's market shares of approximately 18%, 13%, and 7%, respectively, based on third-party market research from NDP/CREST. Domino's has a larger market share, but this is accomplished with fewer restaurants (about 1,500 less restaurants). Domino's has approximately 5,900 U.S. stores nationwide, compared with Pizza Hut's 7,500 U.S. locations. The U.S. QSR Pizza category remains highly fragmented with regional chains and independents accounting for 52% of the market. Additionally, Domino's has the number 1 or 2 pizza delivery market share position in its top 15 international markets (such as the U.K., Japan, and Australia). Domino's has supported these market share positions through advertisements to drive awareness and requires franchisees to contribute a portion of sales (6% for U.S. franchisees) to fund them. Domino's spends approximately 3% of system-wide sales on advertising (accounting for domestic franchisees and company owned-stores), below the industry average of 4% to 5%. However, Domino's often uses these funds for novel and memorable advertisements such as the recent "Carryout Insurance" and "Paving for Pizza" promotions and the historic "We're Sorry for Sucking" commercial in 2009, which jump-started the brand revitalization process. Highlighting the effectiveness of these campaigns, we estimate that Domino's has spent $0.22 per transaction on average over the past five years, which is much lower than the category average of $0.30 per transaction. Additionally, Domino's franchisees have increased sales almost entirely through order counts with minimal ticket increases from add-on item attachment rates over the past five years (approximately 85% of retail sales growth was through increased traffic). We see this as a positive, given Domino's stakes it's brand identity on customer value and this is highlighted in the lack of menu price changes over the past decade. For reference, Domino's launched its two medium pizzas with two toppings for $5.99 delivery deal in December 2009 and the offer has not changed since. Intangibles also stem from internally generated intellectual property, with Domino's being a leader in restaurant logistics and technology tools that build and maintain customer engagement and loyalty. Additional investments in streamlining its cooking and fulfilment process have fostered the brand image to make Domino's synonymous with fast and reliable service at an affordable price.

Technology plays an important role in Domino's efforts to develop and enhance its brand image. Domino's global technology platform includes a digital loyalty program with a rewards system, electronic customer profiling, geo-tracking of pizzas being delivered to customer homes, and customer geo-tracking to have carryout pizzas ready just as they enter the store. Other innovations include high-speed ovens (which reduced cooking time to four minutes) and Pulse (a unified point-of-sale system) which have re-engineered fulfillment processes to be best-in-class. Pulse integrates all orders (regardless of origin) into a seamless interface that provides detailed monitoring of every aspect of the ordering, cooking, fulfilment, and delivery processes which reduces bottlenecks and minimizes downtimes, enabling Domino's to offer faster delivery times than competitors. These technology developments have helped the firm achieve over 23 million active users on their rewards app (active defined as a customer who ordered through the loyalty program within the last six months) and in turn facilitated the shift of sales to digital platforms (more than 65% of U.S. sales and over half of global system sales were digital in fiscal 2018). We contend this channel shift to mobile/digital has been beneficial as it is easier to promote sides and drinks leading to larger tickets while also reducing labor needs and increasing order accuracy. Domino's remains focused on technology developments seen in the creation of the "Tech Garage" at its Ann Arbor headquarters, which consolidated Domino's R&D investments and led to the 2017 collaboration with Ford Motor Company to test delivery using self-driving vehicles, the 2018 launch of Domino's "HotSpots" which feature over 200,000 non-traditional delivery locations (parks, beaches, and landmarks), and the 2019 testing of autonomous delivery through a partnership with Nuro. While these recent innovations have not led to material economic returns, we contend these highlight the company's culture and efforts to stay ahead of the competition well into the future.

Domino's intangible assets are also supported by a globally cohesive franchisee system. Franchisee financial health remains exceptionally strong; franchisees have strong cash-on-cash returns of just above 40% (versus an industry average for quick-service restaurants of 15% to 20%) that rank among the highest in the U.S. quick-service restaurant industry and have low franchisee bankruptcy rates. U.S. cash-on-cash payback is about two-and-a-half years (with average store costs of $300,000), while globally it is just below three years. Additionally, while these returns are extremely attractive for outside investors, Domino's continues to implement a rigorous process to accept new franchisees. All prospective operators in the U.S. must start by working in the stores and then complete Domino's' proprietary franchise management school to understand the operating model above the store level. In this vein, Domino's enforces franchisee exclusivity, where Domino's franchisees are not allowed to participate in multi-brand franchising (which is unique relative to other national quick-service franchisors). The advantage of this model is clear, Domino's gets highly motivated entrepreneurs who understand the business of running the stores, while also controlling the number of franchisees. At the same time, the number of franchisees continues to consolidate; in 2008 there were 1,270 franchisees (552 single store operators) and in 2017, there were 788 franchisees (278 single store). This consolidated profile reduces the franchisee risk as the owners are more capitalized to withstand the inherent sales volatility in the restaurant industry (average EBITDA per franchisee is $900,000) while also more clearly defining territorial rights among franchisees. Domino's also utilizes data-driven pricing recommendations, which are designed to help franchisees more effectively price by product category relative to the competition instead of blanket recommendations from management, helping to better manage labor cost inflation. Finally, Domino's utilizes an international master franchise model where more than half the international stores are owned by four public companies (Domino's Pizza Enterprises, Jubilant FoodWorks Ltd., Domino's Pizza Group PLC, and Alsea SAB de CV). These companies are well capitalized and have local management teams which allows them to capitalize on local experience and ownership to facilitate international growth as Domino's navigates unique cultural and culinary preferences.

Domino's boasts healthy operating margins which is partly the result of being 98% franchised. Given the brand's considerable presence throughout the United States, we believe Domino's has meaningful influence over suppliers, which helps to provide access to food and other raw materials to its franchisees at competitive prices. Using its supply chain buying arm, Domino's effectively consolidates the buying power of its franchise base to achieve competitive pricing while also passing the volatility of commodity prices to the franchisee and insulating corporate level profits. Measured by system-wide sales, Domino's is the #1 player in the U.S. pizza quick-service category, and the number-nine player in U.S. quick-service restaurant market (behind McDonald's, Yum Brands, Subway, Starbucks, Restaurant Brands International, Wendy's, Dunkin' Donuts, and Chick-Fil-A) making it difficult to argue Domino's has more favorable bargaining clout with suppliers. However, given the fragmented nature of the pizza industry, we believe Domino's has significant purchasing power versus these peers. Relative to other pizza quick-service restaurants, this advantage is seen in Domino's superior restaurant level margin. Over the past five years, Domino's has averaged a 24% restaurant margin while Papa John's and Pizza Hut have lagged at 19% and 6%, respectively. Additionally, we believe that franchisee buildout costs for Domino's stores remain lower than peers, but the gap is shrinking as Pizza Hut and Papa John's pivot to more delivery friendly "delco" store models. Relative to Domino's $300,000 cost, we estimate Pizza Hut averages $600,000 (while this is partly due to 42% of its stores being "dine-in") and Papa John's averages $350,000.

Combined with the ability to source inputs at a competitive price and store/delivery route density, we believe Domino's developed a cost advantage. In 2012, Domino's implemented a fortressing corporate strategy where the firm focused on increasing store density by splitting and subdividing franchise store territories. Domino's utilizes a data-driven approach to allocate territory splits using statistics such as population density, the success of current stores in the area by sales and foot traffic, and the percentage of a new store's deliveries that would fall within one mile. Additionally, with the consolidated franchisee base, most fortressing occurs with franchisees building inside of their own territories, so cannibalization does not pit franchisees against each other (avoiding what occurred with McDonald's in the late 1990s). In a fortressed market, delivery drivers are able to double their average deliveries per hour, from two and a half to five. This increased number of deliveries is a valuable tool to attract labor in especially tight markets. The increasing trends in delivery initiated by other chains and delivery aggregator businesses has made sourcing labor highly competitive. However, Domino's strong deliveries per hour statistics have been able to continue to attract drivers at a reasonable cost as they are paid more for each delivery they complete (primarily through additional tips). The improved store density also reduced average delivery time to 22 minutes (management cited in ideal markets this drops to 17 minutes) versus Pizza Hut, reportedly sitting at around 30 minutes. We contend this proximity generates a virtuous cycle where proximity leads to better service, which leads to more orders, which incentivizes delivery drivers to work for Domino's as they will get more deliveries. Additionally, this allows Domino's to deliver for cheaper making it extremely difficult for smaller chains to compete on price. Essentially, as Domino's fully penetrates a market the marginal cost to serve a new delivery customer is far lower than a potential new entrant leading to a sustainable cost advantage.

Fair Value and Profit Drivers | by R.J. Hottovy Updated Oct 10, 2019

After accounting for third-quarter earnings for fiscal 2019, we are maintaining our $275 fair value estimate for Domino's Pizza. The benefits from the time value of money were offset by the weaker than expected near-term results and tempered full year 2019 expectations due to the intense competition from third-party delivery aggregators. This valuation implies a 2019 price/adjusted earnings multiple of 29 times, enterprise value/adjusted EBITDA multiple of 22 times, and a free cash flow yield of 3.6%. These metrics are at a premium to current franchised QSR industry averages, but we believe this is warranted as Domino's exhibits a more convincing growth story.

We find management's updated two- to three-year guidance--calling for mid- to high-single digit unit growth and low- to mid-single digit same-store comps rolling up to global retail sales growing 7% to 10%--to be reasonable (just shy of the firm's five-year average growth of 11%). Our model is relatively aligned with this outlook, with our estimate of global retail sales growing 10% on average over the next five years. For 2019, we estimate 5.5% top-line growth, backed by domestic comps of around 3%, international comps of 2%, 6% system-wide unit growth, and 7% supply chain growth. For the year, we see limited operating margin expansion (50 basis points) to 17.2%, as the firm continues to improve operating efficiencies offset by tight labor conditions.

Our 10-year forecast calls for 7% average annual top-line growth, restaurant margins expanding to mid-to-high 20s (from 23% in 2018) and adjusted operating margins expanding to approximately 20.7% by 2028 (implying about 40 basis points of annual improvement). Our longer-term revenue growth forecast assumes low- to mid-single-digit comp growth (owing to improved franchisee unit economics stemming from inflationary price increases, carryout expansion efforts, and continued loyalty program marketing) and mid-single-digit unit growth as the firm continues to build store density and improve delivery speeds. By 2028, we assume there will be around 27,000 Domino's locations globally, with 19,600 international units and 7,700 domestic units, well ahead of the current 15,900, 10,000 and 5,900 locations, respectively.

Domino's maintains a moderately more aggressive capital structure than much of our restaurant coverage because of its franchised business model, resulting in one of the lower cost of capital assumptions (7.8%) in the industry.

Risk and Uncertainty | by R.J. Hottovy Updated Oct 10, 2019

We assign Domino's a medium uncertainty rating. Restaurant chains are victim to cyclical headwinds, including consumer tastes, unemployment rates and commodity, labor, and occupancy cost volatility. We expect QSR chains, including Domino's, McDonald's, Yum Brands, Papa Johns and Little Caesars, to increasingly compete on price and product differentiation while also facing encroaching competition from fast-casual chains like Blaze Pizza and MOD Pizza. If competition were to cause a decline in restaurant productivity metrics, it could signal impairment of the Domino's brand intangible asset and negatively affect its intrinsic value. On top of competitive issues, Domino's must also strike a balance between growth initiatives and unit-level profitability, which can occasionally result in friction between management and franchisees.

For a franchised restaurant model, we view the pace of new restaurant openings as key variable for our long-term cash flow assumptions. Based on consumer acceptance of the brand, market saturation rates, franchisee access to capital, and commercial real estate availability, we believe Domino's has meaningful growth opportunities. In our view, a new more technological-leveraged and "delco" focused restaurant format will continue to drive unit growth expansion. However, we believe competition in the QSR and pizza categories will become more pronounced in the years to come due to aggressive expansion plans from existing and emerging players and delivery expansion from quick-service restaurant chains. Other pizza chains, such as Pizza Hut, are emulating Domino's playbook by optimizing their store base for delivery/carryout, while traditional QSR players are partnering with delivery aggregators (UberEats, GrubHub) to offer delivery for cuisine that traditionally has not had a delivery option. These increased delivery offerings could eat into Domino's system-wide sales derailing its growth aspirations.

Stewardship | by R.J. Hottovy Updated Oct 10, 2019

Domino's Pizza appointed President of Domino's International Richard Allison as CEO in July 2018, with previous CEO Patrick Doyle resigning after 20 years of work at Domino's (with eight years as CEO). Prior to becoming CEO, Allison headed the international business from October 2014 until his promotion. Allison also brings a long career of restaurant experience gained while working at Bain & Company Inc. for more than 13 years, serving as a partner from 2004 to December 2010, and as co-leader of Bain's restaurant practice. While early, we believe Allison will continue to execute on the fortressing strategy laid out by his predecessor that has been a positive for franchise relationships, restaurant operations, channel expansion, and digital innovation efforts. Additionally, we have a favorable view of Allison's international experience and see his promotion to CEO as signaling Domino's maintaining its focus on expanding international sales.

We've assigned Domino's an Exemplary equity stewardship rating predicated on its balanced approach to financial leverage and a franchise restaurant model, shareholder-friendly efforts to return cash through dividends and buybacks, and investments over the past 10 years that have enhanced the firm's brand intangible asset and cost advantage moat sources.

Operating with a capital light franchise model has allowed Domino's to optimize their capital structure, focus on returning cash to shareholders while maintaining high returns on newly invested capital. Domino's has returned over $3.5 billion to shareholders through $3 billion in share buybacks and $500 million in dividends since 2008 (as of fiscal 2018). We have viewed these repurchases as prudent uses of shareholder capital when completed at prices below our assessment of the firm's intrinsic value. Additionally, the firm has maintained high levels of adjusted returns on incremental invested capital averaging 111% over the past five years. We believe this highlights the firm's "moat-accretive" investments with its heavy focus on technology, delivery, and store density. These investments have paid off, as evidenced by adjusted returns on invested capital and comparable store sales growth of 85% and 6%, respectively, on average over the past 10 years. We believe the current board and management team will continue to be prudent stewards of shareholder capital as they continue to execute on corporate goals outlined until 2025.

Additionally, we believe the board has awarded fair executive compensation and has reasonable corporate governance practices. In 2018, Allison's total compensation was $9.1 million: a base salary of $740,000, stock and option awards of $6.7 million, and nonequity incentive compensation of $1.4 million. This strikes us as reasonable relative to executive compensation levels at other quick-service restaurant chains and justified by the company's recent operating performance. Incentive compensation is based on annual segment income (earnings before interest, taxes, depreciation, and amortization adjusted for one-time charges) targets, which we see as fair as it adequately represents cash flows generated by the firm, but we would prefer it to be tied to returns on invested capital. With 70% of Allison's compensation derived from equity awards, we believe he is adequately aligned with common shareholder interests.

The nine-member board consists of David Brandon (former CEO and current chairman), Allison, and seven independent directors (including two representatives with Bain Capital experience, the firm's former private equity sponsor). We have a favorable view of the annual elections used for all board members and believe they have extensive restaurant, technology, and retail experience. Directors and executive officers collectively control roughly 4% of the total shares, including former CEO Patrick Doyle's 2.6% stake.