Dominos Pizza Enterprises Ltd (ASX DMP) is the largest pizza restaurant chain in Australia in terms of both network store numbers and network sales. The Dominos share price has fallen in the past few years and could present an opportunity to buy the stock.
Dominos has a company structure of franchising, which allows the brand to accelerate expansion over wide areas with fewer capital requirements. As a result, it has increased its number of stores from 1,580 to 2,193 stores over a 2-year period between 2016-2018, with 70 new stores added to the network in the first half year of 2018 and operating in three markets and seven countries.
However, the expansion poses threats to the brand itself as all franchises trade under the same brand name. Problems related to any franchise could potentially affect Dominos brand equity negatively as a whole and thus damage other franchisees as a result.
About Dominos Pizza Enterprises Ltd (ASX DMP)
Dominos Pizza (ASX DMP) offers quality food at a competitive price through its takeaway pizza format across a range of different markets.
The company has excelled in creating shareholder value, which has resulted in share price growth but also dividends and capital returns. It was listed on ASX in 2005 at $2.20 and officially became the first publicly listed Australian pizza company.
In just over a decade, the Dominos Pizza share price has surged more than 2061% from $2.20 to $48.420 with a total market capitalization of AU$ 4.13 billion at the time of writing.
The main competitors of Dominos include the Retail Food Group Limited (ASX RFG) who are an Australian franchiser that runs multiple brands including Gloria Jean’s Coffees, Crust Pizza, Donut King, Pizza Capers etc., and Collins Foods Limited (ASX CKF) who is best known for operating restaurant chains such as KFC and Sizzler in Australia and parts of Asia.
Dominos Invests Considerably in New Technology
In terms of digital innovation, Domino’s Pizza has introduced DRU Assist, an artificially intelligent virtual assistant that has revolutionised the way customers interact with Domino’s.
A focus for Domino’s Pizza is to take comparative advantage over the Australian quick service restaurant (QSR) market. Furthermore, the company has also launched Domino’s Anywhere in Netherlands, an app that allows the pizza to be delivered ‘anywhere’ including a park or beach instead of just to a fixed address.
The commencement of the DRU prototype that incorporates with Starship Technologies for daily deliveries in Hamburg boosted the European online sales of Domino’s considerably. As a result, the pizza company continuously broke records in all European countries, with Germany exhibiting the highest online orders growth for the business.
With the help of the new technology, Domino’s Pizza has been empowered to deliver food in the shortest time possible with more engagement, and less friction for customers at every stage.
Opportunities from The Acquisition of Hallo Pizza
During the 2017 financial year, Dominos Pizza acquired Hallo Pizza, which is the largest independent pizza chain operating in Germany. The transaction aims to improve the profitability of Hallo Pizza stores and existing Domino’s Pizza stores for both franchisor and franchisees thanks to national advertising campaigns and digital initiatives which will leverage the larger store network.
The transaction strengthens Domino’s Deutschland’s position and increases the store count from 209 stores to approximately 300-340 stores.
Franchise Related Problems – Allegations of Staff Exploitation
In July 2018, two Domino’s franchises in Auckland were fined for serious breaches of employment law. The Labour Inspectorate investigation found that the franchises failed to provide their employees with minimum rights including the correct employment agreements as well as keeping correct wage, time, holiday and leave records.
Domino’s conducted a wage audit and paid back wages owed to staff in arrears, but it was unacceptable for Domino’s Pizza to step in and ‘fix things up’ after the issue was revealed as there have been allegations of worker exploitation before.
On March 2017, one of the biggest and most powerful Domino’s franchisees Pamir Dehsabzi who runs 10 stores on the outskirts of Sydney was investigated for intentionally keeping labour costs below 27% of sales and manipulating payroll data, including paying workers fewer hours than they actually worked.
Although wage exploitation is a reoccurring issue within franchising companies, Domino’s has emphasised a “zero tolerance” zone against businesses that exploit and underpay wages. They’ve stated that action will be taken against anyone caught deliberately underpaying workers through an ‘internal preliminary audits’ for every two weeks.
The concept of ‘super-cheap’ pizza at an unsustainably low price squeezes the profits out of franchises and thus puts pressure on franchisees to get involved in widespread wage fraud.
Since the worker exploitation has been revealed, Dominos share price was hit, dropping to their lowest point from Feb 15, 2016, to Jun 5, 2017, closing at $55.318 on 13th of March 2017.
While Domino’s franchises share the same brand name, any misconduct prompted by one franchise could potentially affect other franchises, damaging the brand image globally.
Meanwhile, it is an ongoing concern for Domino’s current operations as there is a lack of support and loss of control over franchises. This issue should be explored further.
Domino’s Strong Financial Performance
DMP network sales have increased from 919.6 million in H1 2016, to 1248.9 million in H1 2018, with the average annual growth rate running at 17%. Among the three markets; Australia/NZ, Europe and Japan, Europe has the most number of stores and sales, while Japan shows strong growth trends and terms of sales revenue, accounts for approximately 36.19% of its total sales in H1 2018.
In general, Domino’s EPS has grown over the years in the line with its strong growth in sales. Compared to its main competitors Retail Food Group and Collins Food, DMP also has a comparatively higher EPS growth in the half-year of 2018 of 5.8% from 67.4 to 71.3. In comparison, Retail Food Group and Collins Food both experienced a retreat of 34% and 30% respectively.
On a like for like basis, Dominos Pizza has outperformed the other franchise companies by far and this shows in the Dominos share price which has held up much better than its peers.
Over the last two years, the profit margin of Dominos continues to lead its peers, running at around 17%. Meanwhile, RFG has declined to a negative profit margin of around 55% due to their own wage fraud issues. RFG’s incredible 31.81% profit margin in H1 2017 is now proven to be unsustainable. CKF has positive margins but at a low level. Of the three companies, ASX DMP has the strongest ability to make a profit and it is expected that the business will maintain the advantage.
At the current Dominos share price and time of writing, Domino’s P/E is 33.51 which is higher than the market P/E (17.01) and the two competitors (1.65 for RFG and 23.64 for CKF). A higher PE suggests that investors are expecting higher earnings growth in the future compared to companies with lower P/E and are willing to pay the premium to capture the potential growth opportunity. Dominos growth looks sustainable so the higher PE is reasonable.
Dominos Share Price Has Strong Growth Potential
Domino’s profit should continue to increase in the next year with the introduction of new technologies that enhance ordering and delivering efficiency.
Meanwhile, the acquisition of Hallo Pizza has boosted Domino’s leading position in Germany as well as opening a gate to gain a higher proportion of market share in the European market. The joint venture allows Domino’s to reduce operational costs and expand market share, thus increasing profit margins and subsequent profits.
However, the potential concern related to current Domino’s operations such as incidences of worker exploration could affect the sustainable growth of Domino’s in the long term.
With its low-price policy and the extent of independence granted to each franchise, it is relatively difficult to entirely prevent this issue from happening again. Potential solutions that Domino’s should undertake include regular company audits within the franchise network, establishing a phone number for employees to report any potential underpayments or ensuring the franchise agreement require franchisees’ compliance.
As Domino’s plan to expand its global store network size, the company is busy working behind the scenes at the same time to leverage technology to increase the margins of its stores. If both plans can be delivered while putting more effort into the management of the worker exploitation issue, the business should experience positive ongoing results.
We see relatively strong upside for the Dominos share price in the medium term.
Henry Fung is a Partner Managing Director and co-founder of MF & Co. Asset Management. He is a highly experienced equities, derivatives and financial markets professional with over 12 years of experience. Henry specialises in building trading algorithms & systems, quantitative & qualitative analytics across macroeconomic, fundamental and technical disciplines and currently runs the MFAM VPAC AU/US models portfolios. The management Partners and Adviser team have decades of experience between them, with experience from major Investment Banks and Brokers. Their Advisers are highly experienced, having dealt with some of the wealthiest clients in Australia.