Company: Domino's Pizza Enterprises Code: DMP Share Price: $10.38 (as at Friday 15th February 2013) Broker Calls: Neutral/Hold - JP Morgan, UBS, Credit Suisse, Deutsche, Macquarie Price Target: $10. 40 (Credit Suisse), $10.25 (Deutsche), $9.77 (Macq uarie)
Chart: Share price over the year to versus ASX200 (XJO) Sometimes, the best investment tools truly are your senses. Take pizza, for example. One can apply all sorts of financial metrics to Domino’s Pizza Enterprises or Retail Food Group, which owns the Crust and Pizza Caper chains, but forming a view on their products is just as important. Consider my experience with Domino’s a few months ago. After a school function that went on longer than expected, my wife and I were too tired to cook and well and truly over our screaming, hungry children. In desperation, we stopped at Domino’s. I had rarely bought Domino’s pizza. They always seemed to taste like the box they came in, so I upgraded to the much dearer, tastier Crust pizzas. To my surprise, the two Domino’s pizzas took less than 10 minutes to order and receive, cost less than $20, and were delicious. So delicious that I have been back a few times and have stopped buying Crust pizzas (also delicious). The point of this anecdote is not to gush about Domino’s, but to highlight a key point why its shares can go higher in the long term: its undeniable product value. Love or hate it, it’s hard to argue that $7.95, or maybe a few dollars more, for a freshly cooked pizza that can feed two, is good value. I’m not the only sharemarket follower prone to compare pizza quality when assessing Domino’s and Retail Food Group. A good judge of emerging companies, Schroder Investment Management, this month wrote how its small-cap team blind taste-tested pizzas from Domino’s, Crust and Pizza Hut to better understand consumer value. Marcus Burns, Schroder’s senior portfolio manager, Australian small-cap companies, said: “What we found in a highly unscientific and statistically insignificant way … is that most people could not distinguish between a $7.95 Domino’s Classic Pizza and a $16 Crust version. … So the perception (driven by price) of the pizza turned out to be much greater than the reality (value).” Crust’s growing army of followers will laugh at that lighthearted result, and sharemarket enthusiasts will argue, rightly, that personal opinions on product quality are incredibly subjective. But ask why Domino’s can sell at pizza for $7.95 that tastes as good or better than many dearer versions – and what that means for the company’s long-term competitive advantage and pricing power. Domino’s interim result this month highlighted the power of economies of scale. Same-store sales grew at just 1.5 per cent compared with 8.4 per cent a year earlier, thanks to tough trading conditions in Europe and growth in the Australian and New Zealand stores coming off a higher base. Yet earnings before interest, tax, depreciation and amoritsation (EBITDA) rose 15 per cent to $26.5 million. The EBITDA margin rose from 17.5 per cent to 18.8 per cent – an impressive result for a high-volume, commoditised business one would expect to operate on lower margins. Domino’s was an early adopter of online ordering through phone apps and the like, which is the future of the pizza industry in my view. These devices make it easier and faster for consumers to order pizzas, which means Domino’s stores can operate with fewer staff, and offset rising labour costs. Better pizza production processes and technology are also lowering costs and quickening the delivery of freshly cooked pizza in-store and to homes. As Domino’s opens more stores, it achieves greater economies of scale and a so-called “profit loop”, where more customers enter its stores or order online, buy more of its products, and increase their average spend. I always look for stocks with a clear, sustainable competitive advantage that provides latent pricing power. Warren Buffett once said pricing power is more important than good management. He’s right, of course. Even bad mangers can succeed when they can lift prices because of a strong product. Domino’s has plenty of latent pricing power. My guess is it could lift its pizza prices by at least a dollar or more and barely miss a beat on sales volumes. If same-store sales continue to slow, which seems likely given Domino’s recent guidance, the ability to maintain earnings by lifting prices is a godsend. How many other companies can lift prices significantly in this environment? The other advantage of economies of scale is the ability to compete on price and quality – a formidable combination when it works. Domino’s, for example, has improved the quality of its toppings and introduced a gourmet range obviously aimed at the Crust market. As it become more efficient, and it can reinvest some of the cost savings into producing a better pizza. In turn, it’s winning over previously disgruntled customers like me, who know Crust pizzas taste better than Domino’s, but not enough to justify paying twice as much, and waiting longer for them to be cooked or home delivered. Gourmet pizza chains have plenty to worry about if Domino’s continues to move up the product-quality curve, while keeping prices low. Of course, the market is well aware of Domino’s strengths, having priced it for perfection after a three-year average annual total shareholder return of 28 per cent. Domino’s dropped 35 cents on its interim profit result, and at $9.86 is well down on its 52-week high of $11.10 – in a rising market. Could this be the start of a bigger share-price fall? Plenty of commentators have argued Domino’s is badly overvalued, and ripe for a correction. At the current share price, consensus analyst forecasts have Domino’s on a forecast price-earnings (PE) ratio of 22.5 times - high for a small-cap stock. Domino’s could well fall further: technical analysts would note there was some decent price support for the stock between $8.50-$9 in 2012. A larger correction might provide a buying opportunity for those who have missed out Domino’s in recent years, making it a candidate for portfolio watch lists, in anticipation of improving value. Stronger sales in Europe and greater market recognition of the value of those assets should be the next re-rating catalyst, but it could take time as the market digests the latest result and more steam inevitably comes out of a share price that does not provide a sufficient margin of safety at current prices. Although its share price has run too hard, Domino’s remains one of the market’s best-run, highest-quality small-caps. >> Click here to read other articles from this week's newsletter
- Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at Feb 14, 2013. The author implies no stock recommendations from the above commentary. Readers should do further research or talk to their financial adviser before acting on themes in this article.