How to think about Domino’s Pizza

Over the past 12 months I have received numerous emails from readers asking for my thoughts on Domino’s Pizza (DMP) – not surprising given the huge earnings multiple it trades on for what appears to be a boring pizza retailer.

So, in light of Fairfax’s excellent investigative piece over the weekend and ahead of DMP’s earnings announcement, I will offer my two cents for what it’s worth.

DMP sells franchises not pizzas

Let’s focus on DMP’s Australasian business given it’s clearly the primary driver of DMP’s exceptionalism (its European and Japanese businesses appear to be fairly ordinary when viewed in isolation).

Firstly, DMP at its core is a franchising business. Its primary success driver is not its ability to operate pizza stores (although I’m sure it’s very good at it), but its ability to operate and grow its franchise network.

The beauty of a successful franchising model is that the bulk of the assets utilised in generating your returns are held off-balance sheet, funded by your franchisees. As long as your franchisees continue to sell pizzas, you get to clip the ticket. The aforementioned Fairfax article provides an outline of the economics for DMP:

Alongside a store’s purchase price, which can range from less than $300,000 to more than $1.5 million and stamp duty, there’s a $60,000 franchise fee for the right to use the Domino’s brand, a $20,000 training fee for a six-week course and a $5500 administration fee for the preparation of documents.

Each store pays a 7 per cent royalty on gross sales each month and a maximum of 6 per cent of sales to an advertising fund and an additional local store marketing fee, an e-store management fee and Domino’s phone number charge. An estimated 50 per cent pay a weekly book-keeping service fee of $165 plus GST.

Domino’s also makes money from the raw food it sells to franchisees.

DMP’s core Australasian business generates a phenomenal Return on Assets of 41% and a juicy EBITDA margin of 34%. It is by no accident that approximately 90% of its Australasian store network are franchised. These types of economics, along with consistent over-delivery of earnings growth, is what has justified DMP’s premium valuation multiple historically.

Owner-operator valuation arbitrage

Let’s also be clear that DMP’s franchisees do not achieve these type of economics (An investor would have done significantly better having invested in the franchisor (i.e. DMP) compared to investing in its franchisees).

Obviously as a franchisor you want all your franchisees to be doing well, but the reality is that some franchisees would be doing really well and generating true economic profits (these are the ones you showcase to your potential franchisees), and some would not be doing so well. Now, we do not yet know what the specific mix is for DMP, but we do know there is a spectrum and DMP makes money along the entire spectrum.

Importantly, franchisees that are not generating a true economic profit are still very appealing to a certain type of investor – the owner-operator.

When buying and selling private small businesses, generally the larger the size of the business, the higher the earnings multiple it attracts, all else being equal. This makes sense given size / scale generally correlates with more established and sustainable businesses.

However, there is an aberration at the bottom-end of the private business market. Namely, micro-businesses where purchasers are looking to buy themselves a job, and this is where valuations based on conventional earnings multiples no longer make sense. This is because these micro-businesses often do not make a real economic profit once you factor in the owner’s wage. However, the owner’s wage in itself is still extremely appealing from the perspective of an owner-operator viewed under the prism of “working for yourself”.

So in a franchise system, what would have been an uneconomic store to the corporate head office (given they have to actually pay management wages), can now be an economically viable business in the hands of an owner-operator – who are also willing to put in that extra heart and labour in pursuit of the entrepreneurial dream.

And in financial effect, the franchisor would have been able to firstly capitalise “owner’s earnings” in selling the franchise for a lump sum and then derive a recurring revenue stream for itself going forward. So when franchise business models work – they work beautifully for the franchisor.

What to look for going forward

DMP’s phenomenal economics is in my view attributable to the efficacy with which its excellent franchising model is able to source off-balance sheet capital from franchisees and generate a return from these assets for itself. In other words, the ability to continue to attract new franchisees and maintain strong secondary market value for its existing franchises is core to DMP’s economic model.

And viewed in context of franchisees being the actual real customers of DMP, sentiments around the underlying economics and profitability of DMP’s franchises will clearly have a very significant impact on DMP’s financial performance going forward. Accordingly, DMP’s promised disclosure tomorrow with respect to franchisee profitability will be scrutinised very closely.

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 no positions in DMP at the time of publishing this article (This is a disclosure and NOT A RECOMMENDATION).