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Falling for Dominos

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December 12, 2013 – Comments (1) | RELATED TICKERS: DPZ

Location: pencils2's CAPS Blog

Author: pencils2

I see a bright future for Domino's Pizza (DPZ) and recently purchased shares of the company. My two-part analysis of why I invested in Domino's is included in full below.

Part 1: Why Domino's Brightest Days are Ahead

Part 2: Why Domino's Digital Component Is Important

Domino's Pizza is a common name. But for those who are not familiar, Domino's is one of the world's largest pizza makers. Founded in Michigan in 1960, the company operates 10,566 pizza stores -- 4,939 stores in the U.S. and 5,627 stores internationally -- in over 70 countries worldwide. 

The Pizza Turnaround
Despite its status as the worldwide leader in number of pizza stores, Domino's had its struggles prior to 2010. Domino's food was considered "mass-produced" and akin to tasting cardboard; not what most restaurants are looking to hear from their customers. The stock also reflected Domino's lousy operations -- the stock was down nearly 10% between its 2004 IPO and February 2010. Domino's had thousands of stores around the world but a growing reputation of poor food, lackluster service, and bad marketing were killing its business.

In March 2010, J. Patrick Doyle, who has been with Domino's since 1997, was selected to serve as President and Chief Executive Officer. Doyle immediately began to lead the charge on addressing Domino's problems "head-on." In a project dubbed "The Pizza Turnaround," which began in 2009 with a $75 million marketing campaign, Domino's revamped its food offerings by adding more handmade pizzas, using fresher ingredients, and developing a new store design.

The new Domino's store design attempts to make the customer experience in Domino's more interactive and places focus on its handmade pizzas. Doyle explains that the new design is similar to the "old pizzeria tradition" by "putting these great handmade pizzas up front and center." 

Between 2008 and 2012 Domino's had the lowest American Customer Satisfaction Index or ASCI score, a flat 77%, when compared to other pizza competitors such as Papa John's Pizza, Little Caesars, and Yum! Brands' Pizza Hut. This year, however, Domino's has seen its customer satisfaction score increase 500 basis points to 82%. Today, Domino's score is on par with its primary competitors, meaning Domino's is now tied for the lead in customer satisfaction among pizza makers.

In other words, the Pizza Turnaround campaign is working. Doyle's leadership has played a major role in the turnaround within a relatively short period of time (all you marketing majors, take notes). This quick and significant shift in brand culture and perception, which is still in its infancy, makes me think Domino's brightest days are ahead.

What about the financials?
A brand recovery is great, but it doesn't mean much if it is not accompanied by earnings growth and cash flow generation. We know the brand image is improving under Doyle's leadership, but what do the numbers look like?

Domino's net income increased 9.33% in 2010, 16.6% in 2011, and 6.23% to $112.4 million in 2012. In the first three quarters of 2013, Domino's increased net income by 23.91% to $98.32 million compared to $74.81 million last year. Domino's profit margin has increased to 8% from 6.6% year over year. 

Since 2010 Domino's has added 1,215 new stores. It's heavily franchised -- only 3.69% of Domino's restaurants are company-owned -- compared to Papa John's, who owns 16.55% of its stores. This helps explain the 7.66% profit margin of Domino's versus the 4.8% profit margin of Papa John's. Franchising minimizes costs and boosts margins, especially in the short-term, but it also results in less accumulated revenue compared to company-owned stores.

In the third quarter, Domino's saw domestic same-store-sales increase at a 5.4% clip, versus 3.3% last year. This reaffirms that the Pizza Turnaround is beginning to have a noticeable impact on both customer satisfaction and sales growth. Domino's saw international same-store-sales increase 5% in the third quarter.

Domino's weakest point is its load of long-term debt, which currently stands at $1.52 billion. This is an especially hefty number considering Domino's has a measly $32 million in cash on its balance sheet. A high amount of debt does not spell automatic doom for Domino's, but it means there is extra pressure on the company to produce sufficient and expanding cash flow. 

In 2012, Domino's increased operating cash flow 13.19% to $176.32 million. So far in 2013, Domino's has managed to produce $84.29 million in free cash flow. It is worth noting that operating cash flow has only increased 3.18% to $104.58 million. Results from the upcoming fourth quarter will help us determine if Domino's is capable of continuing to mark solid increases in cash flow production, as it has managed to do over the past several years. Between 2010 and 2012 operating cash flow increased 25.5%.

Even so, Domino's is generating sufficient cash flow to settle short-term obligations. This year, in fact, Domino's has repurchased $76.89 million in common stock (at an average price of $59.34) and issued $23.22 million in dividends. 

My preference would be for management to use cash to pay down debt and reinvest in the business, but management is evidently intent on buying back shares and rewarding shareholders with a dividend. The fact that the company has been buying back stock in such heavy doses could signify that management is confident in the present value of the company when considering its long-term prospects. 

Domino's has seen impressive increases in customer satisfaction and earnings growth over the past year. There is, however, an unexpected component for us to investigate to understand just how innovative Domino's has become under CEO J. Patrick Doyle's leadership.

Domino's key ingredient: technological innovation
550 individuals work at Domino's headquarters in Ann Arbor, Michigan. Out of those 550 employees, approximately 170 work in its largest department: technology. 30% of the employees at Domino's HQ work to design mobile apps, develop and analyze Domino's websites, and perform other digital duties. Not exactly what I would expect from a pizza maker.

One of Domino's core strengths is its technological innovation. Domino's mobile apps are now available to 95% of the mobile phone market, including apps for the iPhone, Android, and Windows 8, with an app specifically for the iPad on the way. Digital sales, which include mobile and computer ordering, now make up 40% of all Domino's sales (up from 30% in 2012). In India -- one of Domino's largest and fastest-growing markets with over 600 stores -- digital sales make up 20% of total sales. In the third quarter of 2013, sales from mobile devices increased 102% in the United Kingdom.

Michael Lawton, CFO, believes mobile apps represent an opportunity to develop customer loyalty (which is uncommon in the pizza field). Think about it: if someone downloads a mobile app, uses it to order a pizza, and is satisfied with the experience, they will use the app any time they want to order a pizza. Hassle-free and quick ordering, coupled with customer profiles being developed by Domino's (which remembers your pizza preferences for online and mobile ordering), will entice customers to remain with a certain pizza maker. Domino's is prepared for this market shift.

Noah Glass, founder of OLO -- an online and mobile ordering firm -- states it bluntly, "Smart restaurants will evolve to meet changing consumer needs with mobile ordering and payment experiences."

The benefit of "digital sales" is two-fold. Customers can order a pizza without making a phone call; a pizza can be fully ordered and paid for through a mobile device or computer. Less hassle to order equals higher order frequency. This helps Domino's employees concentrate on completing orders in a timely manner, saving time and money for Domino's.

Smartphones now make up 60% of all mobile phones in the U.S., and the rest of the world is following suit digitally. Mobile ordering is the direction the pizza market is heading, and Domino's has the employees and infrastructure to capitalize on this movement.

What are Papa John's Pizza and Pizza Hut doing?
While Domino's certainly has the personnel and infrastructure to continue its technological innovation, it is by no means the only pizza maker taking advantage of the growing digital market. Papa John's Pizza is also heavily invested in mobile ordering, claiming that 45% of its sales now come through digital avenues. Papa John's recently surpassed $5 billion in cumulative systemwide digital sales.

Pizza Hut is also engaged with mobile ordering and digital sales, while maintaining the largest social media presence of pizza makers on sites such as Facebook, Twitter, Pinterest, and YouTube. Pizza Hut claims 30% of its orders occur through digital channels. While Pizza Hut has surpassed $1 billion in cumulative systemwide digital sales, Pizza Hut CEO Scott Bergren acknowledges that Domino's has been more effective promoting its digital capabilities. 

Domino's does have major promise and an advantage over competitors in the global market. Since 2012, Domino's international locations have outnumbered its U.S. locations. Domino's has only implemented online ordering in 32 international countries so far, meaning less than half of Domino's international countries currently have the capability to order pizza via the Internet. As more countries become digitally connected, both with computers and mobile phones, Domino's can capitalize by expanding online ordering to a majority of its international locations. 

There is significant potential for Domino's in its continued rebranding as well as innovation in the growing digital market. Domino's is trending toward offering a more efficient and satisfying customer experience, supported by a new store design and increased utilization of technology, embracing the sustained popularity of fast-casual restaurants.

Why invest now?
Domino's stock is flirting with its 52-week high of $70.10. The stock has increased over 57% this year, and currently trades at a P/E multiple just below 30. Some may argue that the stock is trading at a slight premium; I believe the premium is warranted considering the company's improved same-store sales, earnings growth, and evidence of the Pizza Turnaround's successful implementation.

Quality leaders come in unexpected places. J. Patrick Doyle has proven himself to be an innovative leader, turning around a struggling brand with the financial results now beginning to follow suit. As Domino's continues rebranding and implements its new store design, in addition to capitalizing on a growing digital pizza market, the company's financials will increasingly reflect a more efficient pizza service and improved customer experience.

Domino's rebranding is still in a young stage of implementation. I believe the company's noteworthy success is merely a precursor for what lies ahead. An improving and innovative concept, coupled with an experienced and proven leader at the helm, leads me to believe that Domino's brightest days are still yet to be realized.  

Long-term investors might be inclined to open a small position in Domino's and add on dips, so long as the company's strengths remain intact. I expect market-beating returns over the long run as Doyle and company continue to execute one of the more innovative brand comebacks in recent memory.

 

1 Comments – Post Your Own

#1) On December 13, 2013 at 6:09 PM, gr8twhtebuffalo (48.58) wrote:

I like Dominos pizza. I didn't like it before but I recently tried it again because of the massive amount of advertising they've been doing. I like this stock and today purchased a small position. Let's see what they do in 2014.

 Thanks for the read.

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