Is it time to buy Domino's Pizza Enterprises Ltd (ASX: DMP)? Shares are down 22% in the past year, and the company just upgraded its full year guidance a few months ago.
With forecast net profit growth of 'in the region of 32.5%', Domino's looks likely to earn around $109 million in net profit after tax (NPAT) this year, pricing the company at a more 'reasonable' 43x full year earnings.
By all accounts Domino's is running a successful franchise business, with booming same-store sales and store numbers growing both organically and by acquisition.
There are two key questions:
- What sort of growth could justify today's prices?
- What could happen that could lead this growth not to eventuate?
Potential growth
First, the required growth. Domino's has a long-term 1200-store target in the ANZ region, implying approximately 60% more stores compared to the current footprint of ~738. In Europe, Domino's has 838 stores and is targeting 2600. It has 472 stores in Japan and is targeting 850.
Management also has the goal of lifting margins, with earnings before interest, tax, depreciation and amortisation (EBITDA) margin targets of 45% in ANZ, 25% in Europe, and 20% in Japan within the next 5 to 6 years.
Current EBITDA margins, according to the recent half-year presentation, are 36.8% in ANZ, 18.2% in Europe, and 13.8% in Japan.
So the company unquestionably has room to grow. Domino's is planning to both grow its store numbers and generate more in earnings from each store on average as it scales up.
Potential pitfalls
There's an open question in Australia regarding the company's treatment of franchisees and employees. Domino's has paid Deloitte to conduct an independent, nationwide audit of all corporate and franchised stores to check for compliance with regulations.
The audit was recently delayed by a further 6 months, which some have suggested is evidence of rats in the kitchen. There will be an update provided at the full year result.
A related concern is the profitability and general pleasant-ness (or perhaps, lack of) of running a Domino's franchise. Page 20 of the recent investor presentation provides useful information on franchisee profitability and so on.
Domino's is aiming to have 5 franchises per franchisee, which seems a smart strategy as it should help select only those who really want to own multiple pizza restaurants. Still, with only 1.8 franchises per franchisee currently, this suggests there will be a considerable amount of consolidation occurring over the next few years. Does this point to franchisees exiting the business? It's hard to say.
It's also important to consider Dominos' debt load, with the company's gearing currently at 66%. There's no danger of it not being able to meet its interest repayments due to strong cash flows, but to my mind the company could struggle to add more stores to hit its targets. It would appear to have to rely on franchisees to do the lifting, which may be difficult given that each new store has a 3-5 year payback period (to recover the initial outlay).
Personally, I'm not convinced that company earnings in 5 years' time will be high enough to justify the risks of planned expansion not eventuating, or of the company being revalued downwards to a more normal Price to Earnings (P/E) multiple. As a result I'm leaving Domino's on the shelf for the time being.
