Shares of Domino’s Pizza, Inc. (NYSE: DPZ) are enjoying renewed relief after a mixed earnings report, which showed that while the company continues to battle high inflation, it could be on the verge of turning. Yet even with today rally, the stock has fallen more than 30% in the past year as its multiple has compressed in the face of higher interest rates and lower profit margins. Its highly cash-generating business is attractive and DPZ will likely benefit from the Federal Reserve’s monetary policy tightening. I see the shares can move back into the $350-375 area
In the company’s third quarter, Domino’s earned $2.79, down $0.19 from estimates, in part due to higher taxes. EPS was down 13% from a year ago, although revenue was in line at $1.07 billion and up 7% from a year ago. Rising food and wage prices continue to be a significant headwind. Gross margins fell 290bps to 35.7% as supply chain costs increased 11.8%. Faced with rising input prices, DPZ is tightening its belt elsewhere. As a percentage of sales, it lowered G&A by 110 basis points and advertising by 20 basis points. As a result, operating margins fell but only half as much as gross margins, or 160 basis points, to 16.5%.
During the quarter, Domino’s increased the prices of food it sells to its franchised retail stores by 13.4%. Yet that was not enough to maintain margins. For the full year, the company expects the price of its food basket to be up 13-15%. On the positive side, even in today’s inflation report, we saw food inflation come down slightly. Dairy prices rose a modest 0.3% (less than 4% annualized) while meats remain problematic at 0.7% (8.8% annualized). Even this high meat inflation is better than this 13% food inflation over the past year. While I’m not saying food inflation is going away, the headwind force that DPZ has been fighting seems to be fading.
Importantly, US same-store sales growth was 2%, a nice turnaround from last quarter’s 3.6%. With gasoline prices falling from their peaks, consumers may spend a bit more on their nightlife. Plus, given rising grocery prices, DPZ’s value proposition is actually more attractive. It was encouraging to see this improvement in sales even as it reduced ad spend. Overseas is more problematic as international stores recorded a decline of 1.8% ex-currency. This is partly due to a difficult comparison of tax changes in the UK, which is Domino’s second largest market, based on the number of stores in the starting year.
While I expect Domino’s international operations to remain a headwind, it has a relatively attractive international store mix. In particular, I am very concerned about the economy of continental Europe, as extremely high natural gas prices risk reducing consumer incomes and triggering a recession. France is the only EU member in the top ten of DPZ, and they get most of their electricity from nuclear and not natural gas, a plus point.
Currency will be an ongoing challenge. In fact, global retail sales growth was 4.7%, but the currency was a headwind of 6.3%, erasing all of that gain and then some of it. This revenue growth was aided by the fact that Domino’s continues to increase its number of stores, adding 225 stores, 90% of which are overseas. Given its limited exposure to Europe, I’m relatively comfortable with its overseas geographic mix.
To cope with higher prices, the company is rationing expenses, bringing its cap-ex budget from $120 million to $100 million and its G&A expenses down about $7 million to a range of 415 to $420 million. Even with these pricing pressures, it’s still very cash flow-generating thanks to the asset-light and recurring revenue nature of the franchise business model. In nine months, it generated $279 million in free cash flow despite having $50 million in working capital. Given that cash flow, in the third quarter it repurchased nearly $200 million in stock with $410 million remaining under its authorization. This sent the number of shares down 2.8% from a year ago. Given its $5.1 billion in debt, I would expect share buybacks to largely track free cash flow over the next 18 months, but not significantly exceed it.
Along with having food price inflation that can be about as bad as it gets, the labor situation is improving. Salaries in recreation and hospitality (the category restaurants fall into) have soared over the past year and into the first quarter of 2022 amid widespread labor shortages. At the start of the year, Domino’s reported that it had “recently experienced an increased labor shortage.”
Now, the Fed is actively moving to reduce wage growth and ease the labor market with rate hikes that are expected to slow economic activity. As you can see below, wage growth is now starting to moderate significantly. Up more than 7.5%, it remains too high and incompatible with 2% inflation, so there is still work to be done, and pressures on DPZ margins are not going to improve dramatically today. the next day, but the trend is favorable.
Labor and food costs are 50-60% of the cost of a company-owned store. So, with the Fed working to reduce inflation in these categories and having some success on the labor front, it’s helping companies like Domino’s improve their costs. structure. At the same time, demand is resilient with accelerating US same-store sales growth, and its value proposition is expected to hold up despite moderating economic activity. As a result, I think 2023 can be a year of margin expansion, and this quarter has the signs of a turnaround starting to happen, which is why stocks are up around 7% this morning despite the decline in EPS due to taxation.
If the company can recoup 2/3 of its lost gross margins this quarter over the next 12 months, it has about $15 of earnings capacity and $500 million of free cash flow capacity, which gives shares a P/E multiple of 21.5 and a multiple of 4.4. % free cash flow return. With continued store growth and potential upside margin beyond 2023, the company can generate more than 5% free cash flow growth over the medium term, which can support free cash flow performance 3.5 to 4%, or about $350 to $375 per share.
The main downside risk would be that the Fed is unable to bring inflation down and that these pressures on margins persist for longer. Conversely, if we see the dollar falling along with other currencies, the earning power could rise above $16, creating further upside.
While I don’t expect stocks to return to their highs above $500 as higher interest rates limit potential multiple expansion, Domino’s has improved operating performance and should benefit from the struggle against inflation from the Fed. I see about 10% upside in Domino’s Pizza stock and would be a buyer.