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Investment Conclusion
Domino’s Pizza (NYSE:DPZ) reported disappointing F2Q2022 financial results. Although somewhat mitigated by gains related to an increase in menu prices, the Boost Week promotion, the continued upswing in carry-out transactions, and higher check values/transaction, the curtailed operating hours associated with staffing shortages, and the inability to meet customer demand due to insufficient delivery drivers, resulted in a decline in U.S. sales on a year-over-year basis. Similarly, international sales decreased on an annualized basis due to tough comparables linked to the U.K. business which last year experienced a sales surge due to the VAT Tax Holiday which began in the second quarter.
As a result, although supply-chain revenues increased due to commodity inflation, the offset was insufficient to counter revenue losses related to lower royalties derived from franchisee businesses and decreased sales associated with company-operated stores. In addition, margins suffered because of revenue deleveraging (as marginal fixed cost/dollar of sales increased) and the continued operating challenges that company-owned stores have been experiencing over recent quarters. Therefore, although earnings and free cash flows remained significant, they expanded at a lower rate than during F2Q2021. Over the period, the firm launched 233 new stores, comprised of 22 openings in the U.S., and 211 debuts overseas.
Over upcoming quarters, we expect DPZ’s business to continue to struggle domestically due to manpower insufficiency and inflationary pressures (despite commentary on an upcoming recession), and internationally because of exchange rate challenges due to a surging U.S. dollar, and the greater availability of dining options as economies further reopen. However, based on the strategies the company is implementing to turnaround U.S. corporate stores, easing in labor market conditions (including more delivery drivers), and the expected decline in commodity prices, we anticipate some improvement in financial performance, on a sequential basis. Overall, we believe, DPZ will experience a decrease in decline rates associated with sales, revenues, margins, earnings, and free cash flows over the back-half of FY2022, compared to those evidenced over the front-end of the year. Therefore, although earnings and free cash flows for the period will be below that of FY2021, the shortfall will be marginal.
Over the long-term, the international business will drive most of DPZ’s revenue growth, through a substantial increase in the store count as well as significant same-store sales growth, leading to a dramatic upsurge in retail sales. Domestically, we expect relatively slower revenue growth, with footprint expansion driving most of the advances in retail sales, and same-store sales growth remaining tepid. Nevertheless, based on dramatic success in international markets, DPZ will handily achieve its two to three-year retail sales growth target of ~6% to ~10%, in our assessment. In addition, based on our longer-term expectations of lower commodity costs and no shortage of labor, as well as improvements in operations, and economies of scale and scope related to corporate spending, the digital platform, and advertising, we anticipate significant margin expansion. The revenue leverage from the potential sharply higher retail sales will come on top of the opportunities for margin expansion described above, driving further operating leverage. Overall, the expected dramatic upsurge in retail sales and margins will reflect in considerable escalation in profits and free cash flows on a secular basis, in our opinion.
Although DPZ is likely to encounter near-term headwinds, we remain upbeat on the firm on a long-term basis. Therefore, we are confident that DPZ is likely to meet and exceed our conservative 5-year normalized revenue growth rate of 7.75% and 5-year straight-lined operating cash flows growth rate of 12.75%. Accordingly, we are maintaining our 1-year Price Target of $479/share for the company. Reiterate Buy Rating. (Please go through our initiation report “Domino’s Pizza: Set To Capture An Additional Fraction Of The High Growth Global Pizza Market” for our long-term opinion on the stock).
Key Takeaways From The Second Quarter
F2Q2022 Results Summary. For the period, revenues of ~$1.07 billion (+3.2% on a year-over-year basis), beat consensus estimates of ~$1.05 billion, and earnings per share of $2.82 (-7.8% compared to F2Q2021), was below analyst projections of $2.90. On a year-over-year basis, global retail sales decreased 3%, U.S. sales declined 0.6%, and international sales were down by 5.4%. U.S. same-store sales declined by 2.9%, while those associated with the international business contracted by 2.2%, compared to F2Q2021. Net income for the period was ~$103 million, reflecting a contraction of 12.1% over the previous year’s same quarter. During the first two quarters, the firm generated operating cash flows of ~$153 million, and free cash flows of ~$121 million.
Momentum In Carry-Out Sales Somewhat Offset Delivery Sales Losses. Although, on a sequential basis, compared to the previous quarter, carry-out and delivery sales volumes improved by ~5%, carry-out sales clearly outshone. To be specific, carry-out sales increased by ~14.6% in the second quarter versus by ~11% in the first quarter, on a year-over-year basis. Considering the three-year stack, carry-out sales went from an improvement of ~24% in the first quarter, to an improvement of ~33% in the second quarter. Delivery sales, despite a decline of ~11.7% on an annualized basis, went from an increase of ~6% in the first quarter to an advance of ~8% in the second quarter, on a three-year basis.
Overall, during the prior twelve months, the volume mix has shifted in favor of carry-out sales as compared with delivery-sales. However, as the check values/transaction are significantly higher for delivery transactions, the substantial uptrend in carry-out sales has been insufficient to completely mitigate the losses associated with declines in delivery sales. Nevertheless, carry-out pizza sales are highly valuable as they account for a larger fraction of the pizza market and are part of the Quick Service Restaurant category which generates significantly higher sales. In addition, DPZ’s carry-out sales are incremental to its delivery transactions for the most part, with only ~15% overlap between the segments.
We believe that the momentum associated with DPZ’s carry-out business is sustainable and likely to expand further. Factors driving our conviction are the economics behind the transactions (as delivery pizza could be higher priced and have additional surcharges) and the roll-out of the firm’s Car-Side Delivery service which delivers customers’ pizzas to their cars within minutes of their arrival.
Margin Expansion Opportunities On Tap. As DPZ’s U.S. business has suffered over recent quarters, the company’s margins have contracted. Although operating margins improved sequentially over the second quarter, they remained below F2Q2021 levels. However, management believes margin challenges are temporary and expects the domestic business to derive significant leverage in upcoming quarters.
The predominant element expected to drive margin expansion is recovery in retail sales as operations revert to normal pre-pandemic schedules as staffing levels improve and the unmet customer demand the firm has been encountering over the prior few quarters is fulfilled. Another factor, which will ignite margin growth is incremental pricing, as management is committed to raise prices to balance the customer value proposition with franchisee profitability requirements. Ultimately, on the corporate level, DPZ plans on leveraging operations to improve margins by reducing SG&A expenses and optimizing economies of scale.
In addition, we expect some easing in commodity costs and labor efficiencies, to further support margin expansion, over upcoming quarters. Overall, margins levels are likely to keep increasing on a sequential basis, during the remainder of the year, in our judgment. Further, we are convinced that DPZ will handily rebound to its best-of-class margins, over time.
New Unit Development Targets Appear Mixed. Based on management commentary, domestic footprint development over the foreseeable future might fall below the ~3% growth rate experienced over the previous twelve months. The anticipated pullback in the opening of new stores in the U.S. has little to do with business fundamentals, as unit economics as reflected by growing EBITDA margins remain above industry standards and are based on supply-chain bottlenecks and cost inflation related to construction material. In addition, DPZ indicated that new unit development is likely to rebound to the historical ~4% to ~6% rate, on path to the 8,000 stores footprint (from the current 6,619), once these factors subside. The plan is to keep rolling out new stores in close vicinity to each as part of fortressing strategy, in order to benefit from the strong momentum in carry-out sales.
The growth in the number of international stores is likely to remain at ~9% evidenced over the past twelve months, to achieve a global new unit development rate of ~6% to ~8% for FY2022. Considering that international sales are expanding more rapidly than domestic sales and generating high margin royalty revenues, we are encouraged by the potential substantial new unit development planned for the year.
Balance Sheet Remains Strong. At the end of F2Q2022, the company had an unrestricted cash and cash equivalents balance of ~$114 million and long-term debt of $5.05 billion on its balance sheet. In regard to available funding, DPZ has $156 million from a variable note it issued previously, and additional capital from a recent refinancing. Given these factors, we believe that the firm will handily maintain liquidity to fund operations and new unit development. DPZ announced a dividend of $1.10/share for the second quarter and had ~$606 million remaining on a $1 billion share repurchase program.
Bottom Line
Considering the runaway growth DPZ’s U.S. business experienced over the pandemic, squeezing out additional strong growth from the domestic market, will be a challenge. Combining that element with difficult macro conditions, the company is in for tepid U.S. growth for the foreseeable future. Although some of the slack in earnings related to state-side operations will be offset by the strength of the international business, growth rates witnessed during the pandemic are unlikely to reoccur.
We view DPZ as a mature company with its rapid growth days behind it. That being said, we don’t see much on the horizon that will knock the firm off its front-runner position in the global pizza market. Given that DPZ generated ~$18 billion in retail sales last year, the reasonable growth in revenues and earnings we are predicting will handily fund the large dividends the company routinely provides investors.
Overall, DPZ’s stock is a must Buy for folks seeking a safe investment which provides significant quarterly dividends.
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