Domino's valuation arbitrage machine

Domino’s valuation arbitrage machine

In How to think about Domino’s Pizza, we explored the notion of Domino’s (ASX:DMP) astonishing share price performance being attributable to it being a seller of small businesses (i.e. franchises) rather than as a seller of pizzas. Here I would like to expound on this theme of small businesses as a product and further explore its role behind DMP’s incredible valuation run over the past 12 years.

How profitable is Domino’s Australasian franchise operation?

During DMP’s phenomenal 12 year run as a listed company, the biggest change to its Australasian business has been the shift in its store network mix from Corporate ownership towards Franchisee ownership:

Source: DMP Annual Reports and Presentations.

Correspondingly, DMP Australasia’s EBITDA margins expanded from 12.7% to 36.8% during this same period.

DMP stopped disclosing segment break-downs between corporate and franchise operations in FY10. However, we do have some ideas as to their relative financial attributes from financials prior to FY10:

Source: DMP Financial Reports. Includes European business acquired (FY07 onwards).

Clearly, DMP’s Australasian franchising business was already generating margins close to what they are generating today back in FY05/FY06 (the dip in margin post FY07 was presumably attributable to the inclusion of DMP’s acquired European franchise operations).

Return on Assets was also phenomenal for the Australasian franchising business before it too was obfuscated by the European acquisition:

Source: DMP Financial Reports.Includes European business acquired (FY07 onwards).

We can see below the difference in capital intensity between its corporate and franchise operations:

Source: DMP financial reports. Includes European business acquired (FY07 onwards).

Consequently, franchising has gradually became DMP’s primary source of profits:

Source: DMP financial reports. Includes European business acquired (FY07 onwards).

So based on available information, DMP’s corporate stores appear to generate low margins, low returns on capital and is highly capital intensive. It is therefore almost a no-brainer for DMP to shift the ownership of these stores from its own balance sheet and onto third parties (i.e. franchise owners).

Is it then reasonable to expect these store economics to differ significantly under mum-and-dad ownership? (Especially after DMP takes its “first cut” share of the economics). Unless of course, management wages are excluded by mum and dads in their own calculation of returns. As I have asserted previously, this is essentially the valuation arbitrage at the core of franchising systems generally speaking.

Domino’s incredible valuation run

The economics of a successful franchising business is incredible. There are almost no incremental costs to you as the franchisor when you sell a new franchise (i.e. you simply “carve out” a new territory). Upfront revenue is booked with respect to the initial purchase consideration, and a perpetual recurring revenue stream then ensues with more revenue opportunities whenever maintenance capital expenditure is required. In DMP’s case, franchisees are also directly responsible for marketing and advertising expenditure – collectively to the tune of $108m in 2016 (up from $76m the year previously).

These economics are up there with the best software businesses and DMP bulls have evidently attributed a valuation multiple to DMP accordingly.

And at the heart of DMP is an incredibly elegant valuation arbitrage machine that works on 2 levels.

Firstly, DMP’s franchise system attracts capital from aspiring small business owners at effectively a negative costs of capital to DMP (given that franchisees actually pay DMP for the privilege of expanding DMP’s store network). The “first cut” returns generated from these off balance sheet assets are in turn multiplied by DMP’s own earnings multiple (currently 60+ times) and converted into incremental market valuation – essentially a valuation arbitrage between owner-operator valuation and corporate valuation.

With this tremendous market valuation in hand, DMP can raise further equity and debt capital to acquire new geographic territories. DMP pays a much lower multiple for these earnings compared to what itself trades on (e.g. the most recent European acquisitions were completed at EV/EBITDA of 10x-11x). The acquired earnings are then re-rated to DMP’s own trading multiple resulting in the creation of additional market valuation – essentially a second valuation arbitrage between acquirer multiple and acquiree multiple.

It is therefore not difficult to see how DMP’s market capitalisation can grow from $132m to $5.7bn in a short space of 12 years.

Viewing Domino’s under this prism

Critically underpinning this incredible machine is the premise that Domino’s franchises are attractive and profitable small businesses for aspiring business owners. This is the precondition for the machine to operate.

One could then view various aspects of DMP very differently under this prism. Some examples include:

The narrative of DMP as a technology company and being involved in internet of foods are more important in maintaining a “halo” around DMP to attract potential franchisees and investor capital rather than as the reason for DMP’s exceptional financial performance.

DMP paying for the development of using franchisee marketing funds is in fact a sensible marketing initiative cleverly utilising the narrative of the “delivery driver to multi-millionaire” journey of its own CEO to attract new franchisees to the system (i.e. “You too can do this!”).

Increase in weekend penalty rates? This could be in fact increase DMP’s profitability if franchisees had to work harder and sell more pizzas to counter labour cost increases (given DMP takes a percentage of revenue, not profits). It’s also an opportunity for DMP to sell new capital equipment to its franchisees in order to alleviate labour cost pressures.

At the end of the day, if you were the owner of a struggling Domino’s franchise, your only real path to getting out with your shirt on is to re-sell your franchise on the secondary market. So at which point in time would you be incentivised to publicly portray your franchise as anything but a highly profitable and successful small business with lots of potential?

I have no better idea than anyone else as to the true underlying profitability of Domino’s franchises – but I would regard it as more of a product feature where its impact on DMP’s own Profit & Loss is indirect but nonetheless very important in the long run. As with all product features – perception is at least as important as reality.

Note: The above article constitutes the author’s personal views only and is for entertainment purposes only. It is not to be construed as financial advice in any shape or form. Please do your own research and seek your own advice from a qualified financial advisor. Being obviously passionate about the art of investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this article. Disclosure – I hold a short position in DMP at the time of publishing this article (This is a disclosure and NOT A RECOMMENDATION. Any position held by the author may, for example, be part of a pair trade or a hedging position so it is not informative in isolation).