Investors find Domino's is topping out

DOMINO'S is a company that has revolutionised the way pizzas are sold, not just in Australia but in Europe as well.

DOMINO'S is a company that has revolutionised the way pizzas are sold, not just in Australia but in Europe as well. In doing so, the company has been able to increase earnings per share by more than 30 per cent annually from 2004 to last year.

With such an impressive record, investors have developed high expectations of management to maintain these returns. Yet the company's latest results indicate that management may be finding it more difficult to maintain this earnings trajectory.

In its recently released 2013 full-year results, Domino's earnings per share increased by only 11.5 per cent.

This number by itself would have disappointed the market were it not for management also announcing the purchase of a 75 per cent stake in Domino's Japan. Investors were certainly buoyed by the news, sending the share price up 9 per cent on the day. While the market interpreted the acquisition as a positive development for the company, a closer look at the performance of the core divisions is warranted to understand if growth can return to historical levels.

Domino's pursues growth by increasing the number of stores in its network, and increasing the number of sales within the stores. At the end of the 2012 financial year, management was aiming to open 80 new stores and expected that same-store sales (or sales from prior year stores) would increase by 3 per cent to 5 per cent. The full-year result was disappointing on both counts: same-store sales increased by 2 per cent, while only 67 stores were opened.

For the most part, Australia and New Zealand appear to be performing well in what are mature markets with intense competition. The company increased the number of stores by 26 to 585, and same-store sales have been supported by the company's new line of "game-changing" gourmet pizzas. Long-term growth will be limited though as management estimate that the markets can accommodate only 750 stores.

Domino's entered the larger European market to supplement the declining Australian market, and it has achieved good growth by operating a central commissary model that supplies dough and ingredients to franchisees.

This year management was unable to increase the number of franchisees to expectations and instead chose to open a higher number of corporate stores operated by the company. This stretched the management team and resulted in sub-optimal food and labour management. The French commissary operation also has been affected by labour and logistics costs, predominantly due to capacity constraints. These issues resulted in earnings before interest, tax, depreciation and amortisation falling from 6.5 per cent of sales to 5.6 per cent.

These issues are not likely to be resolved in the short term. The company is planning to relocate and upgrade the facilities over the coming 12 months. It is also in negotiations with third-party suppliers to effectively manage the French commissary's constraints. Domino's appears reliant on the new acquisition to fill the earnings gap.

Domino's Japan has a network of 259 stores and management expect that this can be increased to 600. About 85 per cent of these stores are run by the company, which is the inverse of the franchisee-centric Australia and New Zealand divisions. If the company can successfully increase the number of stores via franchisees, it has the potential to result in margin improvement. Management is also confident that it will be able to increase same-store sales through improved site locations, formats and marketing expertise.

Japan appears to be a market that is conducive to Domino's management style and it should be well placed to support earnings. Yet the company is expecting that same-store sales in Japan will increase by only 1 per cent to 2 per cent for 2014. Europe is still the growth driver for the business and it is important that the Japanese acquisition does not distract management's attention.

At Montgomery Investment Management, we believe that Domino's is still a quality business that has attractive economics, but at the present share price the Montgomery Fund will sit back and wait for evidence that management can deliver on these reforms to its core business.

Roger Montgomery is the founder of Montgomery Investment Management and the author of Value.able: How to Value the Best Stocks and Buy Them for Less Than They're Worth, available at www.rogermontgomery.com.