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Why the Domino’s share price is retreating from its 19-month high

The Domino’s Pizza Enterprises Ltd. (ASX: DMP) is underperforming on Thursday after a leading broker downgraded its recommendation on the fast food franchisor.

The DMP share price slumped a little over 1% to $55.35 in the last hour of trade when the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) index shed 0.7%. The stock hit a 19-month high of $56.88 only last week.

At least Domino’s isn’t among the worst performers of the day. That dubious honour goes to the Downer EDI Limited (ASX: DOW) share price and Cimic Group Ltd (ASX: CIM) share price. Both these companies issued shockingly bad earnings outlooks.

Earnings risk

Domino’s didn’t issue a profit downgrade, but that doesn’t mean it won’t disappoint on the earnings front, according to Citigroup.

The broker cut its recommendation on Domino’s to “sell” from “neutral” even as it modestly increased its price target on the stock to $48.60 per share.

“Domino’s high P/E ratio reflects its prospects for store growth, particularly in Europe,” said Citi.

“FY20e store growth has been soft, and Europe more so. We take a more conservative stance on store openings and reduce our EPS forecasts by 5% in FY20e and 8% in FY21e.”

Rollout at risk of missing target

The company’s network of stores increased by 75 (on a net basis) in the first half. While there is usually a second half skew, Citigroup believes that even if Domino’s can meet the broker’s forecast of 176 new stores this financial year, that’s still 25% below what’s needed to meet its 2030 targets.

Store rollouts are an important earnings driver for any retailer. This is usually because of operating leverage where the increase in sales from new outlets will outpace the increase in costs.

“We expect almost half of Domino’s store openings in FY20e will be corporate stores,” said the broker.

“This is much higher than usual and will result in capex near the top end of the A$60-100 million range in our view.

“We expect the trend to continue beyond FY20e, given the smaller scale and lower sales productivity in both Japan and Europe results in Domino’s taking the initial store risk.”

Expensive taste

In light of this challenge, Domino’s FY20 forecast price-earnings multiple of around 30 times looks too rich for the broker’s taste.

What’s more, the ASX-listed franchisor trades at a more than 20% premium to its UK counterpart. Some premium is justified as the locally listed stock has better growth prospects, but the gap is too big to justify.

And if you are wondering why Citigroup increased Domino’s price target despite these negatives, its because the broker is accounting for the re-rating among its listed peers and the broader market.

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Motley Fool contributor Brendon Lau owns shares of Downer EDI Limited. The Motley Fool Australia has recommended Domino's Pizza Enterprises Limited. 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 Scott Phillips.

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