Domino's Pizza

A day after Domino’s Pizza went public in 2004, the Wall Street Journal published a headline, noting: “Domino's Pizza Inc. served up a cold IPO yesterday, trading flat in its market debut. The initial public offering of shares in the nation's largest pizza-delivery company closed on the New York Stock Exchange at $13.50, or 3.6% below its offering price of $14 apiece.”

It turns out IPOs that don’t pop 100% on the first day can still be worthwhile. More than 15 years later Domino’s has returned an astounding 23% annually before dividends, performance typically reserved for the Google’s and Amazon’s of the world.

Here I’ll take a look at how such a simple business – making and delivering pizzas – has turned every $100,000 invested during the IPO into more than $3.5M today.

Overview

Domino’s is the largest pizza company in the world. There are more than 17,250 locations around the globe including 6,400 in the U.S. Franchisees own over 98% of stores with the remaining 2% company owned and operated.

Source: 2021 ICR Conference Presentation

Much like the convenience store or auto parts supply space, the pizza industry is bifurcated into a few large players and a ton of small operators. Domino’s has roughly 22% of the $38B U.S. pizza market. All other large pizza chains combined own about 30% of the market while small regionals and independents account for the other ~48%. In competition, a large market share relative to competitors is more important than a large absolute share, and Domino’s benefits significantly from its relative position. Domino’s is one of only two large global pizza companies and the worldwide pizza market is substantially underdeveloped compared to the U.S.

Because of these dynamics the pizza industry demonstrates oligopolistic characteristics. We love studying oligopolies as scale confers significant advantages to those at the top and provides barriers to scale for competitors. This, combined with an asset-light franchise model and vertical supply chain integration puts Domino’s in an enviable position.

Business Model

Domino’s employs a hybrid approach to franchising. Roughly 20% of revenue, but ~75% of operating profit, comes from high-margin franchisee royalties and fees. Similar to how Hilton and Wyndham operate in the hotel industry, Domino’s franchisees pay a percentage of their store’s revenue to Domino’s for the right to utilize Domino’s brand strength, trademarks, technology, supply chain and advertising power. Franchisees pay Domino’s roughly 6% of revenue in the U.S. and about 3% abroad (which are run under master franchisee structures). In addition, U.S. franchisees contribute a percentage of revenue to a ~$450M national advertising fund which Domino’s uses to run large scale ad campaigns.

On top of this traditional asset-light franchise structure, Domino’s operates a vertically integrated supply chain. The company owns 21 dough manufacturing facilities and supply chain centers in the U.S., two thin crust manufacturing plants, and five dough processing plants in Canada. They also own a fleet of almost a thousand trucks that handle delivery of dough out to restaurants. This segment comprises about 59% of revenue but only ~25% of operating profit. Though lower margin than the franchise royalty segment, the supply chain operation provides a unique advantage to Domino’s and its franchisees.

Franchisees are not required to purchase ingredients from Domino’s supply chain segment, but they’re heavily incentivized to do so. First, Domino’s scale allows it to serve as a low-cost producer for dough. Franchisees know they’re getting the best price for dough, and therefore keeping costs low for customers, by purchasing dough from Domino’s huge operation. It’s also important to know that you’re going to get consistent ingredients day in and day out, and Domino’s decades of experience mean quality and consistency are rock solid. Additionally, Domino’s splits operating profits 50/50 with franchisees that purchase all of their supplies from Domino’s. So, this arrangement is a win-win; Domino’s purchasing power and scale allow for franchisees to realize lower costs, franchisees share in the profits of the supply chain segment, and Domino’s earns substantial profits from operating this segment.

Competitive Advantages

Domino’s enjoys a number of increasingly important competitive advantages, most of which derive from scale.

Enabling success for franchisees is as important as anything else for a business like Domino’s, as a franchisor can only go as far as its franchisees. They’ve knocked it out of the park in this area. Domino’s franchisees have excellent store-level economics, which drives sustained demand for new franchisees to open stores. Franchisees enjoy industry-leading returns, and current average nearly $160K in EBITDA per store. The easiest way to grow your franchisee base is to enable them to make good money, which is what Domino’s has done with increasing success over the last decade.

Source: 2021 ICR Conference Presentation

The proof is ultimately in the pudding, and Domino’s enjoys a 99% franchisee renewal rate – about as good as it gets for a franchisor. Last quarter, just a single Domino’s location closed in the U.S. on a base of more than 6,000 stores. Substantially all of Domino’s U.S. stores are run by former delivery drivers or in-store operators, which both makes sense from an operational standpoint (to make sure they know what they’re doing) and is a huge selling point for employees hoping to advance their careers. Also, Domino’s generally requires franchisees to manage a store for at least a year before granting them the right to franchise their own store. This gives the company time to evaluate operational and financial performance carefully before entering into a long-term agreement. Taken together, it’s no wonder Domino’s has no shortage of eager franchisees to continue their historical torrid growth pace.

Source: 2021 ICR Conference

In addition to superb franchisor-franchisee alignment, Domino’s enjoys world-class brand equity and scale benefits. Domino’s is one of the most widely recognized brands in the world which is something that simply cannot quickly be recreated by others. Most businesses could be impinged upon given enough capital. However, even if you gave me $100B I would not be able to recreate Domino’s worldwide brand recognition in any realistic amount of time. This is a great test of how strong a company’s competitive position is, and Domino’s uses its strong brand to the fullest. Headquarters utilizes the small number of company-owned stores to test promotional strategies and new menu options before rolling out country-wide ad campaigns and promotions using the company’s marketing clout. These “testing sites” allow the business to quickly launch high-ROI campaigns across their vast franchisee base.

Domino’s has always stayed on the front-edge of technology. Even before COVID, Domino’s aggressively marketed online ordering and usage of their app to drive volume. Now, over half of all sales are generated via digital channels. From smartphones to Facebook messenger to Amazon Echo it is increasingly easy to order a Domino’s pizza and have it arrive within minutes. 

This early widespread adoption of technology is extremely important because it allowed Domino’s to avoid participating in costly 3rd party food delivery arrangements through DoorDash, Uber Eats, or others. These food delivery apps are harmful for many reasons. First, they’re very costly. Customers pay more for their food from the delivery surcharges and restaurant owners keep less of the profit. Additionally, restaurant operators lose control over the delivery process and experience as well as miss out on collecting valuable data on ordering patterns and preferences. Delivery is the primary touch point with a customer, and if it goes wrong the brand will be damaged in the customer’s eye. Domino’s is able to control this critical customer interface by avoiding food delivery apps.

Because Domino’s is already “top of funnel” and takes orders through digital channels and has delivery operations, when customers order directly through Domino’s they are able to collect customer data to more effectively market and promote in the future, ensure the food is delivered quickly, and keep costs much lower than those relying on food delivery companies. All of this adds up to a sizeable advantage over smaller pizza competitors and other QSRs in general.

As mentioned above, Domino’s scale and internal supply chain operations enable the company to serve as a low cost provider for customers. While no one expects gourmet pizza when ordering Domino’s, you can get a solid pizza for almost laughably low prices. A quick visit to the website tells me I can order any size 3-topping carryout pizza for $7.99. That is a price most restaurants simply cannot match, and there will always be a market for fast and cheap pizza.

Domino’s has figured out a repeatable mousetrap and maintained excellent discipline in scaling its store base. Rather than offering a sprawling menu, Domino’s keeps it simple by focusing on just a few options, namely pizza, breadsticks and wings. They’ve also elected to focus solely on delivery and carry-out, meaning, much like Dollar General, stores are cheap to build, cheap to operate, come online quickly, and offer a repeatable customer experience. There’s a lot to be said for simplification and Domino’s relentless focus on keeping things simple and repeatable has worked wonders.

As the battle for food delivery dominance heats up across different types of restaurants, pizza shops have a built-in advantage as pizza is perhaps the food best suited for delivery. It keeps well, is easy to box, stack, and deliver. Also, DPZ's dough is specifically formulated to be optimized for delivery. Mom-and-pop's don’t have the resources to match this. So, pizza in general and Domino’s in particular has an advantage over restaurants delivering foods like hamburgers and French fries.

Many restaurants that offer in-house delivery have focused on expanding their delivery reach. The theory is that locations can be more profitable if delivery drivers can deliver longer distances and thus require less restaurants per area. Domino’s has taken the opposite approach. Instead, Domino’s has pursued what they call “fortressing”, or building local density of stores to ensure that delivery and carryout orders can be as fast and convenient as possible. The bare-bones carryout and delivery-only nature of their stores enables the company to build more stores without sacrificing profitability. Under the fortressing strategy, customers get their food faster, drivers earn better tips from more deliveries, and carry-out becomes more likely for nearby customers.

Fundamentals

Similar to Hilton and other franchisors, Domino’s employs what I consider a continuous leveraged recap process. The stability, quality, and capital non-intensity of the business allow Domino’s to operate with a much higher amount of leverage than a normal business and therefore return free cash flow to shareholders via buybacks and a modest dividend. Domino’s has decreased shares outstanding by more than 5% annually since 2015, creating an attractive per share tailwind. Domino’s currently has leverage of 6x EBITDA, and is one of very few businesses I would be comfortable owning that doesn’t maintain a traditionally conservative balance sheet.

As you probably expect by now, Domino’s enjoys excellent returns on capital. Thanks to the capital-light nature of the franchise segment and given the levered recap structure mentioned above, Domino’s has historically earned outstanding 60-100% returns on capital.

Over the past five years Domino’s has retained roughly 30% of operating cash flow, or ~$570M, mainly due to investments in the supply chain segment. Over the same time period operating cash flow has grown $300M for an exceptional 52% incremental returns on reinvested capital. In addition, thanks to the company’s advertising and brand strength, same-store sales have grown 7% annually over the last five years in the U.S. and 5% abroad. This is very high margin growth as no capital is required to obtain this extra revenue.

Domino’s is showing no signs of slowing down and COVID-19 only served to accelerate the business. Last quarter Domino’s delivered its 40th straight quarter of same store sales growth, with comp sales increasing 13.4%. One might assume as COVID lockdowns have eased that Domino’s will see a marked pullback in revenue, but early signs tell a different story. Over the last quarter, Domino’s saw healthy growth across all geographies and did not witness a significant difference between markets that have largely reopened and those that remained restricted. This tells me that the increased demand from COVID has created a meaningful amount of repeat customers.

Source: 2021 Investor Presentation

It seems reasonable that Domino’s will continue growing its franchisee base and same-store sales by at least mid-single-digits each, retaining a modest amount of capital to pursue high-return supply chain segment growth, and plowing free cash flow into share repurchases. The business may have years of international expansion ahead of it and should see sustained demand from new U.S. franchisees for the foreseeable future. All told it’s not hard to see persistent mid/high-teens annual compounding in intrinsic value per share for several years. The stock trades at ~37x free cash flow, which seems a little rich but not ridiculous given present interest rates and the quality and growth characteristics of the franchise.

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