Domino’s Pizza Inc Update

Posted on 15/05/2011

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Regular readers will be aware that shares in Domino’s Pizza Inc (NYSE:DPZ) is one of my key equity holdings, and I have previously written bullish posts on the company here and here.  Since I invested in late December 2010, the DPZ share price has increased from $16 to $23.53, a return of 47% in a matter of a few months.  This strong return has led me to consider whether Domino’s shares still offer good value to investors.  My conclusion is that DPZ still offers excellent value and therefore I’m holding on to my position. The key points are as follows:

  • Domino’s still offers an incredibly strong free cash flow yield.  I forecast that cash from operations in FY11 will be approximately $148m, while capital expenditures will be around $26m, leaving operating free cash flow of $122m.  Based upon the current market capitalisation of $1.36bn, this is equivalent to a free cash flow yield of 9%.  This should also grow over time as the company grows its top-line and deleverages its balance sheet.  Management state that free cash flow is most likely to be used to reduce indebtedness or repurchase shares, creating further value for DPZ shareholders.
  • Top-line growth is better than expected.  In my financial model built to analyse DPZ, I modelled revenue growth of 4% per annum.  However, in 1Q11, underlying sales growth across the Domino’s store base was 6.2% (excluding a positive currency impact).  Clearly, even if sales growth was to decline back to 4% over the medium-term, the fact the near-term sales significantly exceed this is a boost to the valuation.
  • A debt refinancing is looking more likely.  DPZ’s current debt facilities take the form of a whole-business securitisation (ie the debt is secured on all the operating assets of the business) and they mature in April 2012, with two one-year extensions available if certain covenants are met.  Given DPZ’s current performance against its business plan covenants there appears little doubt that the company will qualify for these maturity extensions.  In addition, the prepayment penalty on the debt (currently ~$50m) quickly amortises to zero between now and April 2012, allowing the company to refinance from other sources rather than extending its existing facilities.  Conditions in the high yield bond market are strong at present, with BB-rated bonds yielding 5.72% and B-rated bonds yielding 6.97%.  This should enable DPZ to refinance at a similar rate to that which it pays on its existing facilities.
  • Not only would the refinancing lead to an extension of the debt maturities – which in turn should reduce the equity risk premium given the relatively short-term nature of the company’s indebtedness, but it is also possible (likely) that the company will also re-lever the balance sheet in order to make a distribution to shareholders.  The recent earnings conference call included the following exchange:

Amod Gautam – JPMorgan – Analyst:  “I guess, historically, you have taken leverage to about three times and then leveraged up. I just wanted to know what your thoughts are about taking leverage up again and whether you feel like you could do it at a higher level than maybe the past.”
Patrick Doyle – Domino’s Pizza, Inc. – President and CEO: “I don’t know because it’s going to depend on when we do it and the rate spend and the exact conditions in the marketplace when we decide to pull the trigger on that. But your question was specifically could you go up today. The answer is clearly we could go up today. The markets are clearly open for us. The markets are pretty attractive right now. Don’t know that we would, but we clearly would have the ability to if we chose to.”

  • The implication of the company increasing leverage is that the business will receive cash in excess of that required to refinance the debt, and the only likely use of that cash is as a distribution to shareholders.  Assuming the company refinances in early 2012 and releverages the balance sheet to 6x EBITDA, the company would have approximately $350m to distribute to shareholders, equivalent to 25% of the current market capitalisation.  Receiving cash to the value of 25% of my holding in less than a year sounds like quite an attractive prospect to me.  Even if the refinancing didn’t include a shareholder distribution, the pushing-back of debt-maturities should cause a lower equity risk premium.  At present I model the cost of equity capital at 12% (which gives a fair value of $24.87 per share, slightly above the current share price).  However, if this was to decline to 10.5%, then each Domino’s share would be worth $30, a premium of 27% above the current market price.
To sum-up, given revenue growth is exceeding my expectations, the free cash flow yield remains strong, and a comprehensive refinancing appears closer and more likely (with various possible benefits for shareholders), I’m happy to continue holding shares in Domino’s Pizza Inc.
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