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Domino’s Pizza Enterprises Ltd could face a profit hit

Credit: Dominos

Shares in Domino’s Pizza Enterprises Ltd (ASX: DMP) are down 2.8% to $67.17 in afternoon trade after news reports surfaced suggesting the company could face a big hit to its profitability if it’s forced to raise wages for its Australian franchisees’ staff.

The pizza maker has long wowed the market with its healthy margins, despite the fact it sells super cheap pizzas. Much of its success was attributed to its strength as a digital retailer able to keep staff costs low by extracting efficiencies wherever necessary. For example customers are encouraged to order online via marketing promotions in order not to waste employees’ time taking orders over the phone when they could be making pizzas.

However, the Fairfax press is reporting that Deutsche Bank analysts believe Domino’s already pays its staff a lower base rate than Pizza Hut, McDonald’s and KFC. The company is now in negotiations with the fast food workers’ trade union over a new Enterprise Agreement that will see pay rates for its franchisees’ employees rise, including the potential for the levy of penalty rates according to the Deutsche Bank analysts.

This afternoon Domino’s delivered a typically quick announcement to the market conceding that talks over new pay agreements were ongoing and claiming that it had been formulating its business model for the prior four years in preparation for the coming changes. It also stated that some parts of the Deutsche Bank report were incorrect, although it’s admitting these changes will have an impact on the business.

Is the Domino’s story about to unravel?

If I were a shareholder I would be nervous over today’s revelations as staff overheads are a key expense for a business that enjoys a competitive advantage by virtue of the fact that it is able to charge cheap prices for pizza and still turn healthy profits. If the playing field is set to be leveled and Domino’s expenses set to rise notably it could be headed for something of a double whammy in financial year 2017.

Shares are up 79% over the past year and at $67.17 currently trade on 66x analysts’ estimates for earnings per share of $1.02 in financial year 2016. Evidently, if the effect of higher wages feeds through into FY 2017’s results the stock is ripe for a fall as it needs to deliver more growth in Australia to justify today’s valuation.

Shares look expensive to me, with real risk to the downside.

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Motley Fool contributor Tom Richardson has no position in any stocks mentioned.

You can find Tom on Twitter @tommyr345

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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