Domino’s Pizza (DOM) is a business that should be doing quite well right now. Covid-19 has changed consumers’ behaviour – perhaps permanently – and has seen takeaway outlets thrive in recent months as restaurants have suffered. Yet Domino’s in the UK was struggling to grow its profits before the lockdowns kicked in. This is because its franchised business model looks broken and there is no guarantee that it can be fixed.
There are good reasons why investors tend to like franchised businesses. The royalty stream that comes from them does not have a lot of costs attached. This makes for predictable cash flows that are very profitable and contribute to high returns on money invested. If you can combine this with an ability to sell more products from each store and add more stores as well then there are all the right ingredients for a very successful long-term investment.
Up until a few years ago this was the bull case for owning shares in Domino’s Pizza UK. However, the company has hit a brick wall in terms of profit growth and the reason for this is mainly down to its business model.
Domino’s Pizza Inc compared with Domino’s UK
Domino’s UK has a very different business model to its parent company, Domino’s Pizza Inc (US:DPZ). Comparing the two sheds some light on why Domino’s UK is struggling and why fixing its problems could be very difficult and certainly not painless.
You may think that this is a strange thing to say as they both make and sell pizzas. However, how they make money is very difficult.
Let’s look at Domino’s Pizza Inc first. This is the parent company that is based in the US. It has 6,239 stores in the US and Canada, which are a combination of company operated and franchise owned. It also has more than 11,000 stores outside the US, and a lot of them are run by franchise partners such as Domino’s Pizza UK, Domino’s Pizza Enterprises in Australia and Dash in China.
The US company stores are a separate profit source. US franchisees pay 5.5 per cent of their sales in royalties back to Domino’s and pay into a national advertising fund, which is run on a no profit or loss basis. Overseas franchisees typically pay 3 per cent of their sales in royalties.
Domino’s also makes money from selling ingredients such as pizza dough, cheese, meat, toppings and sauces as well as equipment to its franchisees.
Domino’s Pizza Inc: Source of profits
Domino's Pizza Inc $m
US store profit
Supply chain profit
General & admin costs
Total operating profit
US store margin
Supply chain margin
Source: Domino’s Pizza Inc/Investors Chronicle
If we take the not unreasonable view that royalty income is a source of pure profit then we can see that these made up two-thirds of its total profit contribution (profits before general and administrative costs) during the past 12 months (LTM) to September 2020.
The US company stores make profits at a margin of more than 22 per cent. The supply chain, which sells ingredients, equipment and supplies (things such as cardboard pizza boxes), accounts for just under a quarter of the total profit contribution at a margin of just over 11 per cent. The company as a whole is currently making very healthy profit margins of 17.5 per cent.
The business has been very successful. Its US business has grown its same-store sales every quarter for nearly a decade, and profits have been growing nicely. Shareholders have benefited in a big way, with total returns over the same period up by a hugely impressive 2,560 per cent. This compares with the 134 per cent that has accrued to Domino’s UK shareholders.
Now let’s look at the make-up of profits at Domino’s UK in recent years. This is a much different business model – it makes its profits in a very different way. Domino’s UK & Ireland holds the master franchise to trade as Domino’s Pizza in the UK and Ireland. It has a perpetual franchise that is renewed every 10 years. It had 1,197 stores at the end of September 2020, virtually all of them operated by franchisees.
These franchisees pay 5.5 per cent of their sales back to Domino's UK, which then pays 2.7 per cent back to Domino’s Pizza Inc (it has a 0.3 per cent discount on the typical 3 per cent overseas royalty rate) to give a net royalty rate of 2.8 per cent.
Royalties are therefore not as big a source of profit for Domino’s UK as for Domino’s Inc. Instead, Domino’s UK makes much bigger profits from selling ingredients.
If we look at Domino’s profits and costs in more detail, its net royalty income has pretty much covered its main operating costs in recent years and supply chain profits account for a very similar number to its total operating profits. The business as a whole also makes very healthy operating margins but profits have stagnated in recent years
Domino’s UK: Source of profits
UK & ROI Profit (£m)
Supply chain revenue
Royalty paid to DP Inc
Supply chain margin
Net overheads & depreciation
Corporate store profits
UK JV's & assocs profit
IFRS 16 leases
Total UK & ROI operating profit
Op profit as % of system sales
Op profit as % of revenue
Supply chain as % of revenue
Supply chain % margin
Source: Domino’s UK/Investors Chronicle
The profit margins on its supply chain are very high at nearly 30 per cent, and considerably higher than what Domino’s Pizza Inc makes from the same business. This dependence on such a lucrative profit stream lies at the heart of Domino’s ongoing problems with its franchisees, in my view.
Why Domino’s UK franchisees are grumpy
Franchisees are crucial to Domino’s future growth prospects. Without them being prepared to open additional stores it is going to be hard for it to grow.
Domino’s franchisees clearly think that the company’s growth strategy is better for the company than it is for their businesses and are refusing to open new stores. There are two main sources of franchisee discontent: They feel that Domino’s is getting too big a slice of the profit cake from additional pizza sales. Domino’s has disputed this and has previously said that around 80 per cent of additional sales value accrues to franchisees.
It is clear that Domino’s makes most of its money from selling more ingredients. The best way to do this has been to open more stores. The trouble is that this has been done by adding new stores in existing franchisee territories.
This splitting of territories can result in more pizza sales and more ingredients sales, but can slash the profits of existing stores as new stores take sales from existing ones. This is good for Domino’s profits, given its lucrative ingredients business, but it does not endear it to its franchisees.
At the same time, franchisees have had to face rising labour costs and increased competition from aggregators such as Just Eat, Deliveroo and Uber Eats, which makes it more expensive to recruit delivery drivers, putting further pressure on their profits. Sluggish order growth over the past couple of years may also be a sign of a much tougher competitive landscape.
Covid-19 has also shifted the sales mix of franchisees away from more profitable collection orders to deliveries, where the cost to serve the customer is harder.
Yet Domino’s says that the average Ebitda per mature franchisee store is still around £140,000 a year. This would equate to around a 30 per cent return on investment, which should be enough to keep most owners happy. Domino’s has also offered financial assistance to franchisees to offset some of the pressures they have faced, such as incentives for opening new stores.
There are also signs that the impact of splits on same store sales is moderating and that over the long term this strategy can bring benefits such as reduced competition and lower delivery costs.
But the impasse between Domino’s and its franchisees remains. Franchisees clearly believe that the business is now less attractive to run than it was. The obvious and fastest solution is for Domino’s to cut the prices it charges for ingredients, but it would have to accept lower profits in return and so far it has shown no willingness to do so.
I think there are good grounds for thinking that Domino’s UK supply chain profits are excessive and that its interests are not aligned with its franchisees. A win-win solution for both parties looks difficult. As a result, it is hard to see how Domino’s UK is going to grow its profits.
UK investors should consider Domino’s Pizza Inc instead
Domino’s Pizza Inc seems to have a much better relationship with its franchisees and puts their profitability at the heart of its business model. It has a profit share on its supply chain with them and does not make excessive profits from it.
As a result, the company is in a much better place to grow than Domino’s UK (which will harm it a little from reduced royalty growth).
Covid-19 has accelerated the trend for food delivery with sales over the internet. Despite increased competition from third-party aggregators, Domino’s has one of the strongest brands out there to exploit this. UK investors looking to get exposure to this are likely to be better off investing in the shares of the US parent company, which has global growth potential rather than the UK business, where profitable growth seems very hard to come by.