Domino’s Pizza Is A Buy After Its 40% Decline (NYSE:DPZ)

Domino’s Pizza (NYSE:DPZ) is one of the most remarkable corporate comeback stories in recent American history. After struggling through the 2008 financial crisis amid lackluster sales and poor brand positioning, Domino’s brought in a charismatic CEO who turned everything around. Shares went up as much as 50x from the lows:

Since 2021, however, Domino’s has cooled back off, with the stock dropping from above $500 back to $300. Some of this is likely related to the same pandemic-related dynamics that have hit so many industries. People stuck at home ordered a lot of delivery pizza. Now that the economy has reopened, there are more food options out there, so Domino’s has to compete more aggressively for business.

That said, Domino’s earnings results haven’t been particularly bad; it’s not like sales have collapsed or anything. So it’s worth diving into Domino’s here and see if shares might be a compelling opportunity after the significant drawdown.

What Gives Domino’s So Much Sticking Power?

Restaurants are a notoriously difficult business to establish much of a competitive moat in. And there’s certainly no shortage of rival pizza brands out there. So what makes Domino’s stand out?

Here’s Morningstar’s Sean Dunlop explaining why Domino’s has a wide competitive moat:

“Comparable sales, which operate as “flows,” accrue over time in higher average unit volumes (“stocks”), allowing franchisees to generate more EBITDA at the same operating margin–improving their cash-on-cash returns and underpinning a strong growth narrative.

To this effect, Domino’s sports higher average unit sales than peers ($1.3 million in the U.S. against $1.2 million at Papa John’s and $860,000 Pizza Hut, per Euromonitor and our calculations), resulting in impressive franchise-level EBITDA just shy of $140,000 in 2022. While Domino’s typically runs at stronger restaurant margins and lower buildout costs than its competitors, strong store-level sales suggest a meaningfully higher franchisee return even at identical margin structures and buildout costs, an advantage that we view as reflective of the firm’s strong brand.”

He also points out other positive metrics, such as the 99% annual franchisee retention rate, which suggests that the average store will last for decades and that Domino’s should enjoy much more stable than usual cash flows as compared to the broader restaurant industry.

Another positive factor is how well Domino’s has fared internationally. A great deal of the company’s growth in recent years has come from foreign markets.

I am a shareholder of Mexico’s Alsea (OTCPK:ALSSF) (MEX:ALSEA) which is the largest franchise restaurant chain in Latin America. As of year-end 2022, it had 4,447 units in total, including 1,370 of Domino’s. Alsea can invest new capital into its various licensed brands, including Starbucks (SBUX), Burger King (QSR), Chili’s (EAT), and P.F. Chang’s, which they operate in Latin America and Spain.

Despite running a multitude of different brand concepts, Alsea has repeatedly put a huge chunk of its overall expansion capital into Domino’s, seeing it as a powerful brand that can scale well across a huge chunk of Latin America.

For one example of this, Alsea operated just 17 Domino’s in Colombia in 2018. This has now grown to 154 stores at the end of 2022, with more coming soon. Alsea also just opened the first Domino’s in Uruguay recently, signifying its willingness to pursue whole new countries for the pizza chain.

Given the highly attractive unit economics of the Domino’s model for its franchisees, it sits in a great position. The franchisees, such as Alsea, are making a ton of money operating Domino’s stores — particularly in comparison to other brands they may also control — and as such are highly motivated to put more capital into the concept which effortlessly increases revenues and profits for the Domino’s corporate parent as well.

Falling Commodity Prices Will Add Near-Term Momentum

Domino’s stock has slumped significantly due to a pair of related concerns. First, sales growth has been limited, with revenues rising just 1% last quarter. And related to that, Domino’s has adjusted pricing and promotional spend to try to drive more activity with more budget-oriented consumers. These are the sorts of signs that understandably make Wall Street nervous.

However, this may simply be a reflection of the cooldown in inflation. After all, if input costs drop significantly, that gives more room for the restaurant to be flexible on pricing.

So how are things looking on input costs? For Domino’s specifically, wheat is a major consideration. And, after spiking at the onset of the war in Ukraine, the price of wheat has now crashed as producers have planted more of the crop elsewhere to account for the shortage:

Specifically, the price of wheat has now dropped by 50% from last year’s peak and is only slightly above where it traded prior to the onset of COVID-19. While wheat is the most dramatic example, other food commodities are also sliding significantly from last year’s highs.

And, on the labor side of the equation, I expect that the Fed’s aggressive and continued rate hiking policy will finally cause the economy to lose steam heading into 2024, which should greatly reduce the rate at which wages rise at Domino’s locations.

Putting these factors together, I believe Domino’s aggressive moves on pricing are a smart move to defend market share and that margins will take care of themselves as inflationary pressures subside.

Share Buyback Is More Effective At Lower Valuations

Domino’s has had a highly impressive share buyback programs over the past 20 years. Just look at the long-term chart of shares outstanding since 2005:

Share count is down by almost half, and the company has really leaned into the program, gobbling up its own shares since 2016.

The biggest drag on the share buyback program however, counterintuitively, was that the stock was overvalued. Indeed, shares have only rarely traded below 30 times earnings since 2014, and have been over 40x on multiple occasions:

At a 33x P/E multiple, Domino’s is only getting a starting 3% earnings yield on their share repurchases, which is not that attractive of a use of capital. With the P/E approaching 20 now, however, Domino’s gets nearly a 5% starting earnings yield on stock that it buys back today. That adds a ton to long-term compounding.

DPZ Stock Verdict

In a 2015 speech, former Domino’s Pizza CEO Patrick Doyle gave a speech that highlighted the unique cultural DNA at Domino’s. In it, Doyle said:

“I think the vast majority of companies are far too conservative in how they approach risk. They simply spend too much time trying to figure out how to de-risk.”

Fortunately, a franchise restaurant model is the perfect sort of business to take lots of risks and push the envelope in terms of pursuing new ideas. Because, after all, it’s the franchisees that end up shouldering more of the day-to-day bottom-line risk whereas Domino’s still gets its sales royalties regardless.

Doyle wasn’t done. Further on in that speech, he included this provocative statement:

“Often people feel far more remorse and guilt about something they do that doesn’t work out well, than something they don’t do that causes same amount of damage or lost opportunity […] I think some of the most damaging words ever written are the Hippocratic Oath, ‘First, do no harm.’ It doesn’t say, ‘go out and heal people.’ It says don’t do anything as a doctor that may actually hurt somebody. That slows down the pace of medicine, slows down innovation.”

It’s fairly audacious to compare selling pizza to practicing medicine. Regardless, the point should be clear. Domino’s grew to be the success it is today because it took calculated chances and worried about the consequences later.

Domino’s has demonstrated this with its aggressive investments into its tech platform, the fortress store expansion model, and the firm’s aggressive and unrelenting share buyback program, among other traits.

That’s not to say that Domino’s will never get burned for taking risks. However, on the whole, Domino’s has produced tremendous shareholder returns due in large part due to its willingness to go full steam ahead.

Usually, investors have had to pay a high P/E multiple to take part in this growth story. Now, though, with the sales slowdown we’ve seen lately, DPZ stock has fallen to a rather unremarkable starting valuation:

If the company indeed returns to double-digit EPS growth next year, as I expect it will, shares appear to be considerably undervalued at today’s price. We can debate how high a P/E ratio is appropriate for DPZ stock, but given its high-quality business model, strong growth and stable cash flows, I’d argue a 20x P/E isn’t the right number.