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Avoid Domino’s turnaround pain

The pizza delivery company remains at war with its franchises
April 16, 2020

At the start of May, former Costa Coffee chief executive Dominic Paul will take the helm at Domino’s Pizza (DOM). Mr Paul will have his work cut out. The company is locked in a bitter dispute with franchisees that has already lasted over two years, its own-operated stores are struggling and its attempt to ignite growth by expanding internationally has proved a costly failure. Debt has risen sharply over the past five years, while profit quality has deteriorated. We don’t foresee Mr Paul being able to find a quick fix and think the shares should be given a wide berth.

IC TIP: Sell at 283p
Tip style
Sell
Risk rating
High
Timescale
Medium Term
Bull points

Coronavirus delivery boost

New chief executive

Bear points

Dispute with franchises

Rising debt

Heavy profit adjustments

International problems

In exchange for a royalty on overall sales of about 3 per cent, Domino’s controls the master franchise of the eponymous pizza delivery brand in the UK and Ireland, as well as a number of smaller international markets. The UK and Ireland accounts for nearly 90 per cent of sales, with stores mainly operated by franchisees, while the group’s small-scale international businesses are predominantly made up of company-run stores. Domino’s has 63 UK franchisees and seven in Ireland. It sells these operators dough and other ingredients and also takes royalties and fees for providing the Domino’s brand, national advertising, e-commerce and other services such as menu planning. The franchisees decide on local pricing and promotional activities.

When things go well, the franchise model is a great one. Franchisees take care of day-to-day operating issues and also supply much of the investment needed for growth. But good relationships are key and over recent years there has been significant deterioration in this regard. Disagreement has centred on who should bear the burden of rising costs, as well as Domino’s plans to split existing territories to expand store numbers. The franchisees have considerable power, with the two largest accounting for 36 per cent of stores in the UK and Ireland and the next largest 6 per cent. As the dispute has gone on, Domino’s has struggled to grow and a growing proportion of underlying profit has been accounted for by adjustments (24 per cent in 2019).

Fortunately for Domino’s, Covid-19 should not pile on too much extra pressure on franchisees. They should benefit from government assistance and increased demand for home delivery orders. However, the virus has undermined the fifth of sales that come from more profitable in-store collections, which Domino’s has been keen to promote as a way to support franchisee profitability.

The cost pressures that have caused such chagrin with franchisees are also being felt at company-operated stores in the UK. Domino’s increased its exposure to own-run stores with acquisitions in 2017 and 2018 aimed at providing a springboard for growth in London. However, the poor performance of these stores led to an £18.7m write-down of goodwill last year as cash profit margins fell from 7 per cent to 4 per cent. The increased focus on corporate stores has been a drain on capital, which has seen a £40m net cash position five years ago turn into a £234 net debt position at the end of 2019. Share buybacks are also a factor.

At one time, international expansion was considered another would-be growth engine, but this has proved costly and disappointing. Domino’s is looking to dispose of its lossmaking businesses in Sweden, Norway, Switzerland and Iceland. The company has announced plans to offload its Norwegian business by the end of May at a cost of up to £7m. However, since then the virus outbreak has seen double-digit sales drops in international markets.

Domino's Pizza (DOM)

    
ORD PRICE:283pMARKET VALUE:£1.3bn 
TOUCH:283-284p12-MONTH HIGH:336pLOW:219p
FORWARD DIVIDEND YIELD:3.8%FORWARD PE RATIO:16 
NET ASSET VALUE:*NET DEBT:£232.6m 
Year to 29 DecTurnover (£m)Pre-tax (£m)Earnings per share (p)Dividend per share (p)
20174759615.89.00
20185579315.99.50
20195089917.49.80
2020*5329917.410.20
2021*54710318.210.80
% change+3+4+5+6
Normal market size:5,000    
Beta:1.12    
*Negative shareholders' funds
**Peel Hunt forecasts, adjusted PTP figures