Domino’s Pizza Inc: 30% Potential Upside

Posted on 09/03/2011


Following the recent FY10 results released by Domino’s Pizza Inc, I’ve now revised my financial model for the new information and have also firmed-up a number of the assumptions since my previous post entitled “How Domino’s Pizza Inc Will Deliver Big Profits to Investors“.  I have also made my financial model available to download here, so readers can review the assumptions and make changes to key inputs if they so wish.

The first factor I wish to draw attention to is the strong growth of the International segment.  Not only is the revenue growth rate much higher than the rest of the business, having recorded a compound annual growth rate of 10.1% from FY02-10 vs 2.6% for the business as  whole, but gross margins are much higher too, at 57.2% vs 27.9% for the whole group.  As can be seen from the chart below, this combination of high growth rate and high gross margin in the International segment has been an important driver of growth in absolute gross profits at the group level.

This strong performance from the International segment has therefore allowed the group to continue to grow revenues and gross margins despite slow revenue growth in the United States.  Given that Domino’s is expecting to roll-out 250-300 stores per annum (mainly overseas) and that the major international franchisees are predicting strong like-for-like sales growth.

From Domino’s Pizza UK & Ireland plc:

We have had a solid start to 2011, with like-for-like sales for the first seven weeks up 4.7% and are encouraged by the recent strength in like-for-like sales growth. This figure comes against the backdrop of exceptional comparatives from the same period in 2010 and the current difficult economic climate. We are pleased with this performance and we will be benefiting from our accelerated store openings, the recent deal with Moto motorway services, and the operational gearing which will drive our profits going forward.

From Domino’s Pizza Enterprises Ltd:

Looking forward, Mr Meij said the Company had a well developed product rollout plan for the remainder of 2011 including adapting ANZ programs for the European market.  He also said record franchisee enquiries in Australia meant the Company was confident of solid growth in the second half of 2011. “We are on track to open 60 new stores this financial year and we are very impressed with the number of new franchisee enquires we are getting in Australia in particular. This interest will help spearhead our corporate store sell down and new store openings over the next six months,” Mr Meij said.

This is a key factor in why the board of Domino’s Pizza Inc is able to guide to medium-term group revenue growth of 4-6% per annum, made up of 1-3% like-for-like growth in the United States, 3-5% like-for-like growth overseas and 250-300 new stores per annum.  Given the mix-shift away from the United States, this should also lead to increasing gross margins over-time (though in the short-term, there is clearly the risk of this being offset by increasing raw material input costs).

In my model, I assume that group sales will increase at 4% per annum to FY15E and at 3.5% per annum thereafter, while gross margins increase at around 6bps per annum, reaching 28.2% in FY15E versus the current level of 27.9%.

The chart above shows how Domino’s Pizza Inc should be able to achieve operating profit growth of 4.4% per annum over the next few years.  To the perspective of the investor, this is steady but unexciting.  However, because Domino’s leveraged its balance sheet in FY07, I expect the growth in equity free cash flow to be substantially higher.  In FY11E is expect that Domino’s will generate $237m of operating profit which should be converted to $116m of equity free cash flow.  The difference being accounted for by depreciation (+$25m), share-based payments (+$11m), cash taxes (-$53m), interest (-$77m) and capex (-$26m).  This is equivalent to an equity free cash flow yield of 11.5%.

As can be seen from the chart below, not only is the equity free cash flow yield very high at 11.5%, but that it can be expected to increase rapidly over the next few years.   This is due a a deleveraging effect whereby free cash flow is used to pay-down debt, which subsequently reduces the interest bill for the following year, increasing free cash flow even further.  Consequently, I expect equity free cash flow to increase at a rate of 12.3% per annum from FY10-15.  This should mean that FY15 free cash flow will be equivalent to 16.2% of the current market capitalisation.  With: (a) such a high free cash flow yield; and (b) such a high prospective growth rate of free cash flow; I view Domino’s Pizza Inc as an exceptionally attractive investment opportunity.  Given that Domino’s should have deleveraged from 5.6x net debt/EBITDA at present to 2.3x at FY15E, the cost of equity should also decrease over time, commensurate with the lower level of financial risk.  Assuming this is reflected by a decline in the equity free cash flow yield from 11.5% at present to 7.5% in FY15E, then this would mean a market capitalisation of $2.2bn, equivalent to a share price of $36.06, more than double the current share price of $17.32.

Another way of considering the value opportunity in Domino’s Pizza Inc is to estimate the present value of the future cash flows.  Such a methodology is clearly susceptible to small changes in assumptions of the terminal growth rate and the cost of equity.  However, if these assumptions are conservative, it can still provide guidance on whether inferences gained from other metrics are senisble.  The table below shows my own estimate of the current equity valuation which has been generated using the free cash flow to the firm model.  For the cost of equity I use 12% and for the terminal growth rate I use 3% per annum.

Based on the operational assumptions discussed above (and others which can be seen in the financial model), I arrive at an estimate of the fair value of Domino’s Pizza Inc shares of $21.93 each, which is 27% above the current share price of $17.32.  This is lower than the estimate of $36.06 for the end of 2015, the difference mainly being due to the time value of money for shareholders (the cost of equity at 12% per annum accounts for 90% of this).

In conclusion, I continue to believe that Domino’s Pizza Inc will generate substantial growth in free cash flow and high returns for shareholders over the coming years.   Consequently, it remains a key holding in my equity portfolio.

Posted in: Investment Ideas